[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]




 
                 WASTE, FRAUD, ABUSE, AND MISMANAGEMENT

=======================================================================

                                HEARINGS

                               before the

                             TASK FORCE ON
                       HOUSING AND INFRASTRUCTURE

                                 of the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             SECOND SESSION

                               __________

HEARINGS HELD IN WASHINGTON, DC: APRIL 13, MAY 25, JUNE 9, AND JULY 25, 
                                  2000

                               __________

                            Serial No. 10-1


           Printed for the use of the Committee on the Budget

                     U.S. GOVERNMENT PRINTING OFFICE
63-822cc                     WASHINGTON : 2000



                        COMMITTEE ON THE BUDGET

                     JOHN R. KASICH, Ohio, Chairman
SAXBY CHAMBLISS, Georgia,            JOHN M. SPRATT, Jr., South 
  Speaker's Designee                     Carolina,
CHRISTOPHER SHAYS, Connecticut         Ranking Minority Member
WALLY HERGER, California             JIM McDERMOTT, Washington,
BOB FRANKS, New Jersey                 Leadership Designee
NICK SMITH, Michigan                 LYNN N. RIVERS, Michigan
JIM NUSSLE, Iowa                     BENNIE G. THOMPSON, Mississippi
PETER HOEKSTRA, Michigan             DAVID MINGE, Minnesota
GEORGE P. RADANOVICH, California     KEN BENTSEN, Texas
CHARLES F. BASS, New Hampshire       JIM DAVIS, Florida
GIL GUTKNECHT, Minnesota             ROBERT A. WEYGAND, Rhode Island
VAN HILLEARY, Tennessee              EVA M. CLAYTON, North Carolina
JOHN E. SUNUNU, New Hampshire        DAVID E. PRICE, North Carolina
JOSEPH PITTS, Pennsylvania           EDWARD J. MARKEY, Massachusetts
JOE KNOLLENBERG, Michigan            GERALD D. KLECZKA, Wisconsin
MAC THORNBERRY, Texas                BOB CLEMENT, Tennessee
JIM RYUN, Kansas                     JAMES P. MORAN, Virginia
MAC COLLINS, Georgia                 DARLENE HOOLEY, Oregon
ZACH WAMP, Tennessee                 KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                RUSH D. HOLT, New Jersey
ERNIE FLETCHER, Kentucky             JOSEPH M. HOEFFEL III, 
GARY MILLER, California                  Pennsylvania
PAUL RYAN, Wisconsin                 TAMMY BALDWIN, Wisconsin
PAT TOOMEY, Pennsylvania
                                 ------                                

                Task Force on Housing and Infrastructure

                JOHN E. SUNUNU, New Hampshire, Chairman
GARY MILLER, California, Vice        KEN BENTSEN, Texas,
    Chairman                           Ranking Minority Member
NICK SMITH, Michigan                 BENNIE G. THOMPSON, Mississippi
JOE KNOLLENBERG, Michigan            DAVID MINGE, Minnesota
PAUL RYAN, Wisconsin                 EVA M. CLAYTON, North Carolina
PAT TOOMEY, Pennsylvania             BOB CLEMENT, Tennessee
                                 ------                                

                           Professional Staff

                    Wayne T. Struble, Staff Director
       Thomas S. Kahn, Minority Staff Director and Chief Counsel
                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held in Washington, DC, April 13, 2000: Abuse of the 
  National Transportation Safety Board's Rapidraft Payment System     1
    Statement of:
        Kenneth M. Mead, Inspector General, U.S. Department of 
          Transportation.........................................     3
        James E. Hall, Chairman, National Transportation Safety 
          Board..................................................    11
    Prepared statement of:
        Mr. Mead.................................................     6
        Mr. Hall.................................................    14
        Hon. Paul Ryan, a Representative in Congress from the 
          State of Wisconsin.....................................    42
                              ----------                              

Hearing held in Washington, DC, May 25, 2000: Lack of Income 
  Verification in HUD-Assisted Housing--The Need to Eliminate 
  Overpayments...................................................    49
    Statement of:
        Emil J. Schuster, Special Agent in Charge, Southeast/
          Caribbean Field Office of the HUD Inspector General....    52
        Raymond A. Carolan, Special Agent in Charge, New England 
          Office of the HUD Inspector General....................    56
        Saul N. Ramirez, Jr., Deputy Secretary, U.S. Department 
          of Housing and Urban Development.......................    61
        Sheila Crowley, President, National Low-Income Housing 
          Coalition..............................................    65
    Prepared statement of:
        Hon. John E. Sununu, a Representative in Congress from 
          the State of New Hampshire.............................    50
        Mr. Schuster.............................................    55
        Mr. Carolan..............................................    59
        Mr. Ramirez..............................................    63
        Ms. Crowley..............................................    68
                              ----------                              

Hearing held in Washington, DC, June 9, 2000: Government Failure 
  in Disposing of Obsolete Ships.................................    85
    Statement of:
        Thomas J. Howard, Deputy Assistant Inspector General for 
          Maritime and Departmental Programs, U.S. Department of 
          Transportation.........................................    89
        John E. Graykowski, Acting Maritime Administrator, U.S. 
          Department of Transportation...........................    99
        Vice Adm. James F. Amerault, Deputy Chief of Naval 
          Operations Logistics...................................   103
    Prepared statement of:
        Mr. Sununu...............................................    87
        Hon. Peter A. DeFazio, a Representative in Congress From 
          the State of Oregon....................................    88
        Mr. Howard...............................................    91
        Mr. Graykowski...........................................   102
        Vice Adm. Amerault.......................................   105
                              ----------                              

Hearing held in Washington, DC, July 25, 2000: Implications of 
  Debt Held by Housing-Related Government-Sponsored Enterprises..   127
    Statement of:
        Barbara Miles, Specialist in Financial Institutions, 
          Government and Finance Division, Congressional Research 
          Service................................................   129
        Thomas J. McCool, Director, Financial Institution & 
          Market Issues, General Government Division, General 
          Accounting Office......................................   137
        Bert Ely, President, Ely & Co., Inc......................   144
        Armando Falcon, Jr., Director, Office of Federal Housing 
          Enterprise Oversight...................................   214
        William C. Apgar, Housing and Urban Development Designee 
          to the Federal Housing Finance Board...................   225
    Prepared statement of:
        Ms. Miles................................................   132
        Mr. McCool...............................................   140
        Mr. Ely..................................................   147
        Hon. Eva M. Clayton, a Representative in Congress from 
          the State of North Carolina............................   200
        Mr. Falcon...............................................   217
        Mr. Apgar................................................   229


 Abuse of the National Transportation Safety Board's Rapidraft Payment 
                                 System

                              ----------                              


                        THURSDAY, APRIL 13, 2000

                  House of Representatives,
                           Committee on the Budget,
                  Task Force on Housing and Infrastructure,
                                                    Washington, DC.
    The Task Force met, pursuant to call, at 10:15 a.m. in room 
210, Cannon House Office Building, Hon. John Sununu (chairman 
of the Task Force) presiding.
    Members present: Representatives Sununu, Knollenberg, 
Miller, Ryan, Toomey, Bentsen, Clement and Lucas.
    Mr. Sununu. Good morning. Today's hearing is the first of 
the Housing and Infrastructure Task Force, one of six such 
panels recently established by the House Budget Committee. The 
overriding objective of these panels is to identify and review 
cases of mismanagement or misuse of Federal funds in an effort 
to better allocate resources, improve government operations and 
ultimately look out for the taxpayers' interests.
    I do not view these issues that we are going to be 
addressing in these hearings as partisan, and it is not our 
objective to point fingers or place blame. Frankly, both the 
administration and the Congress share a responsibility to 
oversee these agencies. If problems occur, we need to work 
together to look for solutions.
    I believe that success in the continuing efforts here will 
not be marked by a dramatic hearing or simplistic legislation 
that guarantees accountability but instead by painstaking 
review and evaluation of what works and, of course, what 
doesn't work in government.
    Today's hearing is a modest step in this direction. In 
reviewing the problems associated with the Rapidraft check 
writing system within NTSB, I hope that this Task Force can 
address three specific areas:
    First, we need to understand what basic flaws of the 
Rapidraft system led to very significant abuses, a significant 
number of drafts being processed for inappropriate uses. 
Second, we should consider the corrective action that has been 
taken by NTSB leadership and assess whether or not similar 
changes should be implemented in other Federal agencies that 
might still be relying on Rapidrafts or other similar third 
party systems. And, third, I believe we should consider whether 
extending legislation such as the Inspector General Act or the 
Chief Financial Officers Act to additional Federal agencies 
would help prevent similar problems from occurring in the 
future.
    I believe that today's two witnesses and NTSB Chairman Jill 
Hall and Inspector General Ken Mead will help provide answers 
to these important questions.
    Before we begin, however, I want to make a few personal 
observations about the NTSB itself. In my view and I believe 
the view of Congress and the American people, the NTSB is 
without peer in the performance of its core mission. The 
technical expertise and objectivity of its investigators helped 
to ensure the safety of travelers not just in the United States 
but throughout the world. And this is indeed a unique role. The 
NTSB provides an invaluable service to the country and has 
earned its reputation for integrity.
    It should be emphasized that the problems we are going to 
discuss today relating to the Rapidraft system are unrelated to 
the core investigatory work of the NTSB. Moreover, it was the 
leadership within the NTSB itself that first identified the 
problems and requested that the Department of Transportation 
Inspector General work to begin an audit and make 
recommendations to the Board.
    This could not have been an easy request for Mr. Hall and 
the Board to make. Moreover, implementing the changes to 
financial systems, which the NTSB has already begun, is a 
difficult task in any organization. Yet, throughout this 
process, the Board has continued to meet its critical 
responsibilities in an exemplary fashion. It is a fact that I 
believe is a great credit to Mr. Hall's personal leadership.
    The objective of this hearing is not to assign blame or 
responsibility for a system that we know is flawed and that the 
current Board inherited and which had been in place for about 
10 years. The Task Force's goal is not to second-guess the 
overall effort of Mr. Hall or Mr. Mead. To the contrary, Mr. 
Hall's initial problem identification and request should really 
serve as a model for others in similar positions.
    Instead, I hope we will work to make the best possible use 
of the hard work already done by Mr. Hall and Mr. Mead and 
their respective staffs and apply the important lessons before 
us across all areas of the Federal Government.
    It is my pleasure to yield at this time to Mr. Bentsen for 
an opening statement.
    Mr. Bentsen. I thank my chairman of the Task Force, Mr. 
Sununu, for yielding to me.
    I want to thank or welcome both Chairman Hall and Inspector 
General Mead here today. We appreciate you testifying.
    I can't help but say that--it's not Mr. Sununu's fault--but 
we probably should have had the FAA here today. Because, as we 
speak, the conference report on the budget resolution is coming 
up on the floor, and you have got members of the committee who 
are stuck here. But we do have important business before us 
today, and I know Mr. Sununu and I are eager to get over to the 
floor and do rhetorical battle with respect to the budget, as 
well as the other members are.
    The Task Force is charged with holding oversight hearings 
on waste, fraud and abuse and reporting our findings and 
recommendations to the full House Budget Committee. I know of 
no one, Democrat or Republican, in the Congress who believes 
the American people should tolerate any waste, fraud and abuse 
involving their hard-earned tax dollars.
    In this our first oversight hearing we turn to the 
Rapidraft check writing program of the National Transportation 
Safety Board. With all due respect to Chairman Hall, the NTSB 
is not really on the Nation's radar screen except for those 
tragic times when there is a major accident. When there are 
tragedies in our skies like the Egyptair crash off the coast of 
Nantucket or the TWA flight 800 in New York, we look to the 
NTSB to investigate. I think I can safely say that there is a 
broad agreement by Members on both sides of the aisle that the 
NTSB is the world's premiere independent accident investigation 
agency.
    I would like to start also by commending you, Chairman 
Hall, on your proactive stance with respect to financial 
inconsistencies that your agency unearthed at the NTSB.
    From my reading of the materials supplied, in 1999, when 
your Office of Finance became aware of potential abuses of the 
Rapidraft system, you contacted the Inspector General, who did 
not have jurisdiction over your agency, and requested that he 
come in and conduct an audit. You then terminated the Rapidraft 
system and replaced it with a program universally used 
throughout the government. Shortly after, the Chief Financial 
Officer, who failed to properly audit payments under the 
system, was voluntarily separated from his position. All the 
while, you apprised the authorizing congressional committees of 
your activities. Moreover, I understand that you recently 
contracted with an outside firm to have them conduct a complete 
audit of the abandoned Rapidraft system that goes beyond the 
Inspector General's investigation.
    Chairman Hall, I want to commend you and your agency for 
showing us how an agency can take the reins of responsibility 
and initiate reform that deters waste, fraud and abuse. I think 
this is something that you ought to be proud of and something 
that, at the conclusion of these hearings, Mr. Chairman and 
members, that we ought to hopefully hold out as a model for the 
Federal Government in standing up and addressing problems 
within an agency rather than not doing anything.
    And, with that, I yield back the balance of my time.
    Mr. Sununu. Thank you, Mr. Bentsen.
    Mr. Sununu. At this time, it is my pleasure to welcome both 
of our witnesses. We will take testimony from each, Mr. Mead 
and Mr. Hall, and then allow members 5 minutes on alternating 
sides for comments and questions.

STATEMENTS OF KENNETH M. MEAD, INSPECTOR GENERAL, DEPARTMENT OF 
     TRANSPORTATION; AND JAMES E. HALL, CHAIRMAN, NATIONAL 
                  TRANSPORTATION SAFETY BOARD

    Mr. Sununu. Welcome, Mr. Mead. We're pleased to have you 
begin.

                  STATEMENT OF KENNETH M. MEAD

    Mr. Mead. Thank you, Mr. Chairman and members of the Task 
Force.
    I want to at the very outset here reaffirm what you said in 
your opening remarks. The Department of Transportation 
Inspector General does not have statutory audit or 
investigative jurisdiction over the National Transportation 
Safety Board. We did our work at the request of Chairman Hall, 
who called us promptly upon learning of some issues concerning 
this Rapidraft program; and he just as rapidly took action upon 
our recommendations. Indeed, even in advance of us issuing our 
formal recommendations, the chairman acted.
    And that is not always the case. As you look about 
government, when you find recommendations from the Inspector 
General or GAO, you don't always see such expeditious 
implementation. So I just want to say I hold Chairman Hall in 
the highest personal and professional regard.
    Now, beginning in 1984, NTSB contracted with a vendor to 
provide a line of credit for writing third-party checks, which 
in our testimony we will refer to as Rapidrafts. They are much 
like your own checks except they have NTSB's name on them. A 
primary purpose of these Rapidrafts was to eliminate extra 
paperwork and processing time required to issue Treasury 
checks. The vendor administered the Rapidraft program, 
including issuing blank checks and providing NTSB with monthly 
transaction statements and canceled checks.
    Now our testimony is going to cover three areas: First, the 
established internal controls for this program were not working 
as intended, and clearly so; second, what our recommendations 
were and NTSB's response; and, finally, I think our findings 
illustrate the need for some type of institutional oversight of 
NTSB in the financial management area.
    The Rapidraft system was in operation from 1984 through 
September 1999. It authorized some NTSB employees, 177 of the 
total complement of about 450 staff, to write Rapidrafts for 
accident and nonaccident investigation purposes.
    During the past 3 fiscal years, NTSB issued 26,000 
Rapidrafts totaling nearly $13 million. During the first 11 
months of 1999 about $3.6 million in Rapidraft payments were 
made. This system was under the general management of NTSB's 
Chief Financial Officer, called a CFO for short. Its operation 
was governed by an NTSB order.
    In late August 1999, after learning about incidents of 
possible abuse, Chairman Hall asked for our assistance in 
investigating and auditing the suspected abuse. We agreed to do 
so.
    We performed the work under what is called a memorandum of 
understanding, which actually had been under discussion between 
NTSB and our office even before this abuse was uncovered. 
Chairman Hall told me that he wanted audit coverage just as a 
good financial management practice.
    Well, our audit revealed that the Rapidraft system was 
seriously mismanaged. Of the 1,000 Rapidrafts paid during 
fiscal 1999 which we sampled, 902 of those, or over 90 percent, 
failed to comply with NTSB internal controls. Now what do I 
mean by that? There are seven specific deficiencies that I 
would like to note here.
    First, 678 of the 1,000 Rapidrafts didn't contain a 
required explanation for the check. Now, without an explanation 
or supporting documentation, it is difficult to determine 
whether the disbursement is for a legitimate purpose. An 
example: in November, a $2,150 Rapidraft was issued and 
negotiated with no payee and there was no explanation on the 
Rapidraft as to what the purpose of the check was.
    Second deficiency: 222 of the 900 checks were paid without 
the required signature or authorization number. We found, for 
example, a $1,416 check that was paid--issued--but it bore no 
authorizing signature. It is like you cashing a check but not 
signing it.
    A third deficiency: 22 Rapidrafts were issued in 1999 in 
excess of the $2,500 ceiling. For example, six ranging from 
$7,800 to $24,000 were issued for building renovations.
    Fourth deficiency: as a matter of practice, paid Rapidrafts 
were not reconciled with supporting documentation by NTSB. In 
fact, when my staff retrieved the canceled Rapidrafts from 
NTSB, they were still in the same unopened envelopes that the 
vendor used to send them to NTSB. That compares to getting your 
bank statement, throwing it in a drawer and never looking to 
see whether the checks were yours or the charges appropriate.
    Fifth: employees separating from NTSB weren't required to 
turn in their unused checks, and many did not. Moreover, the 
contractor was not notified, in turn, that 37 employees, 37 of 
the 177 users, had left the agency. The headquarter's employee 
who embezzled over $70,000 and who in fact worked for the Chief 
Financial Officer used Rapidrafts that were left behind by a 
former employee.
    Sixth: employees could order blank Rapidrafts from the 
contractor without management approval or knowledge. Management 
didn't track how many Rapidrafts were issued to the employees, 
and they were not kept in secure locations.
    And, finally, these checks were used to split purchases and 
circumvent Federal regulations. Splitting is the practice of 
using multiple checks to divide a single purchase to avoid 
competition. For example, one employee wrote three checks 
totalling $4,600 to the same vendor on one day for the same 
thing. And this lack of adherence to internal controls overall 
rendered the system susceptible to fraud, waste and abuse.
    Our investigations disclosed that two employees had 
embezzled government funds using the Rapidraft system. The 
employees have resigned. Criminal prosecution has been 
initiated against both of them.
    On April 4, one former employee was indicted by a Federal 
grand jury on seven felony counts.
    On April 11, the other former employee, the one who worked 
under the Chief Financial Officer, was charged with a felony 
for embezzling nearly $74,000.
    In November 1999, we apprised NTSB of our findings. We 
recommended that they discontinue the Rapidraft system, 
implement an approved payment program using credit cards and 
ensure that the Chief Financial Officer's Office developed and 
implemented comprehensive internal controls.
    Chairman Hall told us that he had discontinued the 
Rapidraft Payment System. He adopted the governmentwide 
purchase credit card and travel credit card programs. He also 
appointed a new CFO. He has retained the services of a private 
sector audit firm to audit the financial management systems.
    Now the NTSB, as your opening remarks indicated, is held in 
very high regard for its investigations. And, in this case, 
NTSB took prompt action to get help, and it took prompt 
corrective action, and they have committed to a meaningful 
course of corrective action on a broad front.
    Now, it is necessary for Chairman Hall to seek outside 
assistance, because NTSB doesn't have an Inspector General or 
an equivalent institutional oversight mechanism. We feel that 
if they had been subject to some type of institutional 
oversight and follow-up of corrective action, it is likely that 
the problems uncovered in 1999 may have been avoided.
    And just by way of illustration, I should say that, because 
of the experience at NTSB and our own prior audit work at FAA, 
the Department is terminating a similar program at FAA where 
similar weaknesses were found. And that wouldn't be possible if 
we weren't there to constantly monitor the situation. It just 
shows I think the value of continuing oversight. And that 
concludes my remarks.
    Mr. Sununu. Thank you very much, Mr. Mead.
    [The prepared statement of Mr. Mead follows:]

  Prepared Statement of Hon. Kenneth M. Mead, Inspector General, U.S. 
                      Department of Transportation

    Mr. Chairman and members of the Task Force, we appreciate the 
opportunity to discuss the National Transportation Safety Board's 
(NTSB) Rapidraft Payment System.
    In 1984, NTSB contracted with a vendor to provide a line of credit 
for third-party check writing privileges. A primary purpose of these 
checks, referred to as Rapidrafts, was to eliminate the extra paperwork 
and processing time required to issue checks through the Treasury 
Department. The vendor served to administer the Rapidraft program, 
including issuing blank checks (drawn against the vendor's bank 
account), maintaining a list of authorized NTSB users, and providing 
NTSB with monthly transaction statements and canceled checks. NTSB 
renewed the firm's contract, most recently in 1996.
    The Rapidraft Payment System--in operation from 1984 through 
September 1999--authorized some NTSB employees, including on-site 
accident investigators, to write Rapidrafts ``for accident and 
nonaccident investigation costs.'' These Rapidrafts were limited to 
$2,500 per transaction. During the past three fiscal years (FY), 1997 
through 1999, NTSB issued 26,097 Rapidrafts totaling $12.9 million. 
During the first 11 months of FY 1999, only $227,776 (6 percent) of the 
$3.6 million Rapidraft payments were associated with on-site accident 
investigations.
    The Rapidraft Payment System was under the general management of 
NTSB's Chief Financial Officer (CFO). Its operation was governed by an 
NTSB Order prescribing the procedures and internal controls on use of 
Rapidrafts.
    In late August 1999, after learning about incidents of possible 
abuse of the Rapidraft Payment System by one or more NTSB employees, 
NTSB Chairman Jim Hall requested our assistance in investigating the 
suspected abuse. In addition to rendering investigative services, we 
agreed to perform a broader audit of the Rapidraft Payment System. As 
NTSB is not within the scope of our investigative and audit authority, 
we performed the work under a mutually agreed to Memorandum of 
Understanding and Agreement.
    In brief, our audit revealed that the Rapidraft Payment System was 
seriously mismanaged. Our review of 1,000 Rapidrafts paid during FY 
1999 showed that 902, over 90 percent, were noncompliant with NTSB 
internal controls. Specific deficiencies we identified include the 
following:
     678 Rapidrafts did not contain the required explanation 
for the check.
     222 Rapidrafts were processed and paid without the 
required signature or authorization number.
     22 Rapidrafts were issued in excess of the $2,500 limit. 
In the two prior fiscal years, more than 150 Rapidrafts exceeded 
$2,500, including eight Rapidrafts issued for $20,000 or more.
     As a matter of practice, paid Rapidrafts (forwarded by the 
contractor to NTSB, similar to a bank's return of canceled checks to a 
customer) were neither reviewed nor reconciled with supporting 
documentation by NTSB.
     The contractor was not notified that 37 of the 177 
authorized users had left NTSB.
     Employees separating from NTSB employment were not 
required to turn in unused Rapidrafts and many did not.
     Employees ordered and received blank Rapidrafts from the 
contractor without management approval or knowledge.
     NTSB management did not track how many Rapidrafts were 
issued to employees.
     Rapidrafts were not kept in secure locations at NTSB.
     Rapidrafts were used to ``split'' purchases and circumvent 
Federal Acquisition Regulations and NTSB Orders. (``Splitting'' is the 
practice of using multiple Rapidrafts to divide a single purchase--
which exceeds the Government's $2,500 micropurchase ceiling--into a 
series of separate, smaller purchases in order to circumvent the 
ceiling.)
    NTSB's lack of adherence to internal controls rendered the 
Rapidraft Payment System susceptible to fraud, waste and abuse, as 
evidenced by two known embezzlements which we investigated. Our 
investigations disclosed that two NTSB employees, one in a field office 
and one at Headquarters had separately embezzled Government funds using 
the Rapidraft System. The employees resigned before our investigation 
commenced in August 1999. Since then, our findings concerning each of 
those former employees have resulted in criminal prosecution by the 
Department of Justice.
    Our investigation disclosed that a former employee was responsible 
for misappropriating in excess of $20,000. On April 4, 2000, she was 
indicted by a Federal grand jury in the Northern District of Georgia on 
seven felony counts of embezzlement. On April 11, 2000, the other 
former employee--who worked under NTSB's former CFO--was charged in a 
one-count felony Information by the U.S. Attorney's Office for the 
District of Columbia for embezzling approximately $74,000.
    In early November 1999, we apprised NTSB of our audit and 
preliminary investigative findings, transmitting our formal audit 
report. Our audit report recommended that NTSB:
     Discontinue the Rapidraft Payment System.
     Implement approved payment programs, such as the 
Governmentwide commercial purchase card and a Federal payment processor 
for travel-related reimbursements.
     Ensure that the CFO's office develops and implements 
comprehensive internal controls for these programs.
    In response to our recommendations, Chairman Hall notified us that 
he had discontinued the Rapidraft Payment System and NTSB adopted the 
Governmentwide purchase credit card program. Moreover, NTSB appointed a 
new CFO in January 2000 and has retained the services of a private 
sector audit firm to assist in identifying weaknesses and recommending 
procedures and resources for improved audit control. This outside audit 
firm will audit and examine internal control weaknesses in other 
financial systems, such as NTSB's travel program, accountability of 
property and internal controls, and electronic certifications. These 
programs and systems were beyond the scope of our review of the 
Rapidraft Payment System.
    The NTSB is held in high regard for its expertise and role in 
assuring the safety of all modes of transportation. It is widely 
regarded as the preeminent investigative agency of its kind in the 
world. We note NTSB's prompt action in requesting assistance to 
identify the cause and extent of the problems with the Rapidraft 
program and appreciate its cooperation with our auditors and 
investigators. NTSB has committed to a meaningful course of corrective 
action on a broad front, promptly ending its use of Rapidrafts even 
before the completion of our audit, and must now follow through in its 
implementation of these actions.
    To help the Task Force in its efforts, our testimony today 
addresses three areas related to the problems identified with the 
NTSB's Rapidraft program.
     First, the established internal controls were not 
operating as intended,
     Second, our recommendations to correct the problems 
identified and NTSB actions relative to those recommendations, and
     Finally, our findings in this matter illustrate the need 
for some type of institutional oversight within NTSB in order to 
provide the Chairman and the Board with independent reviews of NTSB's 
financial management programs and business operations. This capability 
presently does not exist.
    In December 1997, we issued an audit report to the Federal Aviation 
Administration (FAA) regarding the closeout of its imprest fund, which 
included recommendations concerning third-party drafts. At that time, 
we recommended FAA limit its use of third-party drafts to exceptional 
circumstances. As a result of our work with the NTSB in this matter, we 
made follow-up inquiries about the continued use of third-party drafts 
in the Department of Transportation (DOT).
    On March 30, 2000, DOT's Assistant Secretary for Budget and 
Programs issued a memorandum informing all DOT operating 
administrations that the use of third-party drafts will be discontinued 
by the end of Fiscal Year 2000. As originally designed, third-party 
draft programs once served a useful purpose by providing a payment 
mechanism for time-sensitive missions such as NTSB's. However, the 
Government's adoption of purchase and travel credit card programs has 
supplanted the need for third-party drafts.
            internal controls were not operating as intended
    The Rapidraft Payment System was seriously mismanaged and subjected 
to embezzlement. During fiscal years (FY) 1997 through 1999, NTSB 
issued 26,097 Rapidrafts totaling $12.9 million. While intended ``for 
accident and nonaccident investigation costs'', Rapidrafts were 
predominately used to reimburse employees for nonaccident related 
travel, pay tuition for training, make equipment purchases, and pay 
employees' salaries. Also, Rapidrafts were processed and paid when they 
exceeded the $2,500 limit, and employees ``split'' purchases to 
circumvent that limit and the Federal Acquisition Regulations.
    The internal controls designed for the Rapidraft Payment System 
were not followed, resulting in numerous weaknesses that left the 
System inherently vulnerable to fraud, waste, and abuse. For example, 
Rapidraft stocks were not protected from unauthorized use, Rapidrafts 
were paid without the required signature or authorization number, and 
37 of the 177 authorized users no longer worked for NTSB. Rapidrafts 
were also paid when the signatures of current and former employees were 
forged. The CFO's office did not review paid Rapidrafts or reconcile 
them with required supporting documentation to ensure payments were 
authorized and appropriate.
    Our review of 1,000 Rapidrafts paid during FY 1999 showed that they 
frequently lacked supporting documentation. The lack of documentation 
precluded us from determining whether many of the payments were for 
legitimate NTSB purposes.

            Rapidrafts Were Used in Violation of NTSB Policy

    Contrary to NTSB policy, Rapidrafts were paid when they exceeded 
the $2,500 limit, and payments were split to circumvent acquisition 
regulations and the $2,500 limit. NTSB Order 1542 Section 5b(2) states 
``Rapidrafts are limited to a maximum of $2,500 per item/service.'' 
During FY 1999, the Rapidraft Payment System contractor processed 22 
NTSB Rapidrafts that exceeded the $2,500 limit, including ones for 
$11,076 and $4,070. During a limited review of FY 1998 and FY 1997 
Rapidrafts, we identified 107 and 49, respectively, that were processed 
for more than $2,500 including individual Rapidrafts as follows:
     $28,532 for hotel services;
     $24,461, $20,000, and $13,357 for building renovations (FY 
1997);
     $16,404, $10,000, and $7,890 for building renovations (FY 
1998); and
     $5,795 for telephone service.
    Also, NTSB Order 1542 Section 5b(3) notes ``A paid Rapidraft does 
not eliminate or mitigate . . . the prohibition against subdividing 
foreseeable purchases, merely to use simplified procedures.'' However, 
NTSB employees--including the former CFO--were ``splitting'' payments 
using multiple Rapidrafts to divide a purchase that exceeds the 
government's $2500 micropurchase ceiling into a series of separate, 
smaller purchases in order to circumvent the ceiling, a violation of 
Federal Acquisition Regulations and NTSB Order. For example, one 
employee wrote three Rapidrafts totaling $4,649 to the same payee on 1 
day for computer equipment.
    Internal controls were not sufficient to protect the System from 
fraud, waste, and abuse. Although some controls existed on paper, the 
controls were not followed. Also, NTSB staff were not trained in the 
proper use of Rapidrafts (NTSB Order 1542, Section 5a) or the penalties 
for misuse (NTSB Order 1542, Section 7a).
    NTSB Order 1542 prescribes internal control procedures for 
Rapidrafts, including segregation of duties, limitations on use, 
requirements for supporting documentation, and guidance on safeguarding 
the Rapidrafts. For example, Section 6d states ``If the Rapidrafts do 
not meet certain pre-established criteria, [the contractor] will reject 
them for payment. The amount may not exceed $2,500. The signature 
appearing on the Rapidraft must be an authorized employee, and the 
authorization number must match the one assigned to that employee.''
    However, the internal control procedures were not followed by NTSB 
and the contractor. Specific weaknesses OIG identified include:
     Rapidrafts were paid without the required signature or 
authorization number.
     Rapidrafts were paid without the required supporting 
documentation.
     The contractor was not notified that 37 of the 177 
authorized users had left NTSB.
     Employees leaving NTSB were not required to turn in unused 
Rapidrafts and many did not.
     Employees ordered and received blank Rapidrafts from the 
contractor without management approval or knowledge.
     NTSB management did not track how many Rapidrafts were 
issued to employees.
     Rapidrafts were not kept in secure locations at NTSB.
     As a matter of practice, paid Rapidrafts (forwarded by the 
contractor to NTSB, similar to a bank's return of canceled checks to a 
customer) were neither reviewed nor reconciled by NTSB.
    Our sample of 1,000 Rapidrafts from the 7,749 paid during the first 
11 months of FY 1999 showed that 902 Rapidrafts (90 percent) were 
noncompliant with NTSB internal controls. For example, 678 Rapidrafts 
(68 percent) did not contain the required explanation of the purpose 
for the check. Also, 222 Rapidrafts (22 percent) were processed and 
paid even though they did not include the required authorization 
number. Additionally, 52 Rapidrafts contained more than one deficiency 
such as no signature on the check and no explanation of the purpose for 
the check. While the contractor should not have paid Rapidrafts without 
signatures or authorization numbers, NTSB officials did nothing to 
check the contractor's actions or processes.
    Specific examples of Rapidrafts issued and transacted in violation 
of the usage procedures are as follows:
     In August 1998, a $1,416 Rapidraft bearing no authorizing 
signature was issued and subsequently negotiated.
     In November 1998, a $2,150 Rapidraft for which no payee 
was listed was issued and later negotiated.
    Further, canceled Rapidrafts were not reviewed or reconciled with 
supporting documentation to verify that the payments were for 
legitimate products or services, and that the transacting employee was 
authorized to make the payment. Bundles of paid Rapidrafts from the 
contractor were stored unopened, and the CFO's office did not compare 
them against supporting documentation.
    The CFO's office only compared a listing of check numbers and 
dollar amounts on the contractor's bill with check numbers and amounts 
entered into the accounting system by employees who issued the 
Rapidrafts. If there was a match, NTSB paid the bill without question. 
Reconciling Rapidrafts to the supporting documentation is an important 
control mechanism because it provides independent assurance that 
payments and purchases are authorized and appropriate.

             Control Weaknesses Were Previously Identified

    Weaknesses in internal controls for the Rapidraft Payment System 
were identified on at least two previous occasions. A 1992 audit report 
by the General Services Administration's (GSA) Inspector General on 
NTSB's travel procedures and practices identified internal control 
weaknesses in the use of Rapidrafts. Also, staff began raising concerns 
to the NTSB CFO in early 1999 that internal controls were not being 
implemented.
    The GSA Inspector General concluded that Rapidrafts were not 
properly safeguarded and were improperly used. Specifically, the GSA 
Inspector General's report noted that investigators or their 
supervisors were routinely issuing Rapidrafts for travel advance 
purposes even though they were not authorized to do so. The report also 
noted that subordinates issued Rapidrafts to their supervisors for 
travel purposes. The GSA Inspector General noted that these practices 
were of particular concern because they circumvented a fundamental 
control--separation of duties.
    The then-Comptroller (former CFO) responded to the report outlining 
planned corrective actions to be taken, including issuing a memorandum 
to all employees on authorized uses and safeguarding of Rapidrafts. 
Based on our work, corrective actions were either never implemented or 
sustained because we identified the same weaknesses as the GSA 
Inspector General.
    Also, in January 1999, CFO staff began raising concerns to the CFO 
that Rapidraft users were not complying with internal control 
requirements. Specifically, CFO staff noted that Rapidraft users were 
not submitting required supporting documentation for purchases and not 
entering required data into the accounting system. When these concerns 
were ultimately raised to and reviewed by senior managers outside of 
the CFO's office, instances of embezzlement were uncovered. Further, we 
found that in January 1999, NTSB personnel in the office of the CFO 
alerted the former CFO to irregularities involving the use of 
Rapidrafts by the former Headquarters employee who has since been 
charged with theft. Yet the CFO did not take timely or adequate action 
and, in the next 8 months, until the Headquarters employee resigned in 
August 1999, this employee embezzled approximately 34 Rapidrafts 
totaling $30,000. The CFO resigned effective November 29, 1999, after 
our investigation was commenced.

          Rapidrafts Were Exploited in Two Known Embezzlements

    In the end, the lack of adherence to internal controls subjected 
NTSB to separate known embezzlements by two employees. We investigated 
a former GS-7 employee in the Atlanta field office of the NTSB 
suspected of embezzling approximately $20,000. The employee resigned in 
July 1999. Investigation disclosed that between October 1998 and June 
1999, the employee embezzled money from NTSB by writing Rapidrafts to 
employees of NTSB and then fraudulently endorsing the Rapidrafts to 
herself. The employee then deposited the Rapidrafts into a personal 
bank account. On April 4, 2000, the employee was indicted by a Federal 
grand jury in Atlanta, charged with seven counts of theft.
    We also investigated a former GS-8 employee of the NTSB 
Headquarters staff who resigned in August 1999. On April 11, 2000, the 
former employee was charged in a one-count felony Information by the 
U.S. Attorney's Office for the District of Columbia for embezzling 
approximately $74,000 between September 1997 and August 1999, by 
fraudulently writing 97 Rapidrafts to herself using the signature 
authority of a former NTSB employee and then cashing the majority of 
these Rapidrafts at a local liquor store. The Headquarters employee 
knew that once cashed, the canceled Rapidrafts were not reviewed by 
NTSB for purposes of reconciliation.
             ig recommendations and ntsb corrective action
    On October 26, 1999, we met with Chairman Hall and senior NTSB 
staff to discuss our audit results and preliminary investigative 
findings. On November 8, 1999, we issued an audit report to the NTSB 
that recommended NTSB discontinue the use of the Rapidraft System and 
instead use the Governmentwide commercial purchase card program for its 
on-site investigative expenses and other purchases. We recommended that 
NTSB discontinue processing employee travel claims and instead use a 
Federal processor for reimbursement of travel claims to ensure that 
proper voucher examination is performed.
    By letter dated November 5, 1999, we notified the NTSB of our 
preliminary investigative results. Subsequently, on March 21, 2000, we 
issued a final investigative report to the NTSB. Our investigative 
report supported the earlier recommendations of the audit and 
recommended that NTSB consider disciplinary action for employees as 
appropriate.
    The NTSB generally concurred with our recommendations. By letter 
dated November 23, 1999, Chairman Hall responded that NTSB had 
discontinued the Rapidraft System and adopted the Governmentwide 
Citibank Purchase card Program in its place. The Chairman also reported 
that NTSB had commenced discussions with a private sector audit firm 
for assistance in identifying audit weaknesses and recommending 
procedures and resources for improved audit control. We were recently 
informed that such a contract has been executed and that an audit will 
begin in the near future.
    On January 3, 2000, the NTSB appointed a new CFO. The new CFO was 
hired from the U.S. Treasury Department and has 35 years of Federal 
service in the field of financial management. We have met with the new 
CFO several times to review our audit and investigative results. He has 
identified and initiated specific actions necessary to implement our 
recommendations, but his efforts require the full support of the NTSB 
Board and senior staff if he is to succeed in reforming and improving 
the financial management of the NTSB.
            need for institutional oversight within the ntsb
    To his credit, NTSB Chairman Hall promptly sought our assistance in 
this matter. It was necessary for the Chairman to seek outside 
assistance because the NTSB is without an Inspector General or an 
equivalent institutional oversight organization. The NTSB has 
historically relied on agreements with other Inspectors General or 
private sector firms for audit assistance. Outside oversight has 
included General Accounting Office audits and congressional oversight 
exercised through the authorizing and appropriations process.
    There is no full-time oversight of NTSB. Our work with respect to 
the Rapidraft System was carried out in accordance with an August 31, 
1999, Memorandum of Understanding (MOU) between our office and the 
NTSB. The MOU allows for our office to conduct investigations and 
audits at the request of the NTSB on a reimbursable basis. It does not 
provide authority for us to self-initiate audits or investigations as 
we do for the Department of Transportation, nor does it authorize, or 
create a responsibility for us to ascertain whether or not NTSB 
implemented the corrective actions discussed with us. As you are aware, 
such follow-up is critical to oversight. For example, as noted above, 
the GSA IG was not in a position to follow up on its 1992 audit 
results. If NTSB had been subject to some type of institutional 
oversight, it is possible that the 1992 audit would have resulted in 
real corrective action and the problems uncovered in 1999 may have been 
avoided.
    Similarly, if the NTSB had an institutional oversight organization, 
the employees who reported irregularities to the CFO in January 1999 
would have had an in-house channel to pursue when they did not see 
action on the part of the CFO in response to their reports of 
irregularities. At the Department of Transportation, we receive 
approximately 600 telephone calls, letters, and E-mail messages a year 
reporting suspected fraud, waste and abuse within the Department. Our 
fraud, waste and abuse Hotline offers employees confidentiality or the 
opportunity to provide information anonymously. Reports to our Hotline 
receive independent attention from our staff and are also shared with 
the Department management. For management, they serve as a useful 
source of information about programs and operations in the Department 
that, at a minimum, require management attention. The NTSB does not 
have a vehicle similar to our Hotline to ensure an independent review 
of suspected fraud, waste and abuse.
    ``The National Transportation Safety Board Amendments Act of 
1999,'' (H.R.2910) was passed by the House on October 1, 1999. The 
legislation reauthorizes the NTSB and also contains provisions that 
address Inspector General oversight at the NTSB. The bill provides that 
the Inspector General at the Department of Transportation will carry 
out Inspector General responsibilities only with respect to the 
financial management and business operations of the NTSB. While we did 
not seek this additional responsibility, we concur that our audit and 
investigation concerning the NTSB's Rapidraft System strongly suggests 
that some type of institutional oversight is appropriate. The Senate is 
considering similar provisions as part of its reauthorization 
legislation for the NTSB.
    Mr. Chairman, this concludes our testimony. I would be happy to 
answer any questions you may have.

    Mr. Sununu. Welcome, Mr. Hall. We're pleased to hear your 
testimony.

                   STATEMENT OF JAMES E. HALL

    Mr. Hall. Thank you very much, Mr. Chairman, Congressman 
Bentsen, members of the committee.
    I was invited to appear before you today regarding the 
National Transportation Safety Board's request for an audit and 
investigation by the Department of Transportation's Inspector 
General regarding financial discrepancies found during an 
August 1999 document reconciliation in preparation for our end-
of-year financial closeout. I have brought with me today our 
Managing Director, Dan Campbell; our General Counsel, Ron 
Battocchi; and our Chief Financial Officer, Mitch Levine, who 
will be available to be responsive to any questions the 
committee may have as well.
    Before I begin, permit me, Mr. Chairman, to spend just a 
few moments on the NTSB and its mission. Since Congress created 
it as an independent agency in 1967, the Safety Board has 
served as the eyes and ears of the American people at more than 
100,000 aviation accidents and thousands of surface 
transportation accidents. Over time, it has become one of the 
Board's premiere accident investigation agencies. In fact, it 
is only one of nine independent investigative organizations in 
the world.
    Perhaps more importantly, as part of our investigations we 
make safety recommendations that we hope will prevent similar 
accidents from recurring. In its 33-year history, the Board has 
issued almost 11,000 recommendations in all transportation 
modes to more than 1,250 recipients. In 1990, we began 
compiling the ``most wanted list'' that highlights some of what 
we considered to be our most important but not yet implemented 
recommendations and covers concerns such as data recorders in 
all transport vehicles, aircraft icing, fuel tank flammability 
and human fatigue.
    It is important to note that, because the Board does not 
have regulatory or enforcement powers, we rely on our 
reputation for impartiality and thoroughness to get our 
recommendations implemented. To date, more than 80 percent have 
been adopted. Many safety features currently incorporated into 
airplanes, automobiles, trains, pipelines and marine vessels 
have had their genesis in Safety Board recommendations; and 
over the years Board recommendations on ground proximity 
warning systems, windshear, crew resource management, railroad 
passenger safety, drunk driving, seat belts, child safety 
seats, graduated licensing and emergency response to hazardous 
material substances have been implemented. At an annual cost of 
less than 20 cents a citizen, the 400-member Safety Board I 
believe is one of the best investments this Congress makes.
    My testimony submitted for the record details the series of 
events that led up to the August 1999 discovery. Today, I would 
like to focus on what actions have occurred since I requested 
Mr. Mead's assistance.
    I would, however, like to emphasize several facts. NTSB 
staff discovered the discrepancies and notified me of the 
findings. Because I was concerned about this compromise to our 
agency's financial integrity and our reputation, I immediately 
requested the Department of Transportation Inspector General to 
perform an audit and criminal investigation to determine if our 
concerns were valid and whether there were any additional 
problems even though, as previously mentioned, the IG had no 
jurisdiction over the agency. The NTSB staff and leadership 
cooperated fully throughout the IG's audit and investigation. 
We were already taking corrective actions before the IG 
completed their work, and we kept our appropriating and 
authorizing committees fully informed throughout the 
investigation.
    I asked the IG to look at three areas during their audit 
and investigation. Was there criminal conduct by any NTSB 
employee? Were there systemic problems with the Rapidraft 
program? And were there sufficient financial controls for small 
purchases?
    Mr. Mead and his staff responded to my request quickly and 
very effectively. He sent a full team of auditors and 
investigators who devoted 3 months to the audit and 7 months to 
the investigation. The IG's audit did conclude that there were 
weaknesses in our internal controls and that existing controls 
were not followed.
    The report made three recommendations: to discontinue the 
Rapidraft Payment System immediately; to implement an approved 
payment program to meet NTSB's needs; and, third, to ensure 
that the Chief Financial Officer's Office develops and 
implements comprehensive internal controls.
    I terminated the Rapidraft system even before I received 
the IG's preliminary report in October 1999, based on an oral 
briefing from the Inspector General and his staff. Following 
that report, we took a series of additional actions. I placed 
the Chief Financial Officer on administrative leave. In January 
2000, I hired a new Chief Financial Officer, Mr. Mitch Levine 
who is with us today, who has 35 years of Federal financial 
management service.
    We are currently recruiting to fill vacancies in accounting 
operations and system accounting. We implemented governmentwide 
commercial credit card programs for travel expenses and small 
purchases. Travel vouchers and purchase card bills are now paid 
through the Treasury Department Disbursing Centers.
    And we selected an independent audit firm, 
PriceWaterhouseCoopers, which began work yesterday to develop a 
program for comprehensive financial integrity. As part of their 
audit, they will conduct a closeout review of the Rapidraft 
Payment System; document NTSB's financial management processes 
and systems; perform a baseline analysis of existing financial 
policies, procedures and systems; test internal controls; 
develop internal control recommendations; and assess our audit 
readiness.
    We received the Inspector General's investigative report on 
March 21st. It did not find any additional criminal activity 
beyond that already found by the NTSB. It concluded that the 
two previously identified employees had embezzled about 
$95,000. Both employees have left the NTSB. I have been advised 
that one has been indicted by a grand jury and the other is 
pleading guilty for criminal acts involving embezzlement and 
that restitution to the American people will be sought.
    Let me close, Mr. Chairman and members of this committee, 
by saying to you that I take this situation very seriously, and 
it is the most deeply troubling experience I have had in all my 
years of public service. It has unduly impugned the reputation 
of this agency and its dedicated employees.
    This has been an especially difficult time for the Board's 
employees, and it has been a distraction from our mission. As 
you may know, while we have been managing this event, we have 
had to deal with both the Egyptair and Alaska Air 
investigations.
    We are taking, Mr. Chairman, every action necessary to 
ensure that these deficiencies are rectified and procedures are 
put in place to ensure that they do not recur. I give my this 
committee my pledge that will be done.
    Now, I fully support independent oversight of the Board's 
operations on a regular basis. In fact, that concerned me most 
when I became chairman of this agency, and I was trying to move 
in the that direction at the time these events occurred.
    I want to publicly express my appreciation to Mr. Mead and 
his staff, and to thank them for assisting us in this task.
    Mr. Chairman, I appreciate your attention and the attention 
and time the committee staff and you and the members have given 
me. That completes my statement.
    Mr. Sununu. Thank you very much, Chairman Hall. I 
appreciate your statement and its candor and certainly want to 
invite Mr. Levine and Mr. Campbell to assist you as we go 
through the questioning process with any details that might be 
helpful.
    [The prepared statement of Mr. Hall follows:]

   Prepared Statement of Jim Hall, Chairman, National Transportation 
                              Safety Board

    Good morning, Chairman Sununu and Members of the Task Force. I was 
invited to appear before you today regarding an audit and an 
investigation that the National Transportation Safety Board (NTSB) 
requested from the Department of Transportation's Inspector General 
(IG). In August 1999, as the NTSB's staff was engaged in reconciling 
documents to close our books for the fiscal year, financial 
discrepancies were found and brought to my attention. I promptly called 
Inspector General Mead and asked for a full and independent 
investigation.
    Before turning to the circumstances of that request, I would like 
to put the problems we discovered in our program for Rapidraft payments 
program in context. I became Chairman of NTSB in October 1994, and 
inherited a financial accounting system and organization that had been 
in place for many years and had not been modernized with automated 
information capabilities. Weaknesses in its utility for budgeting 
purposes were apparent, and after preparation of budgets for 1996, I 
asked senior managers at NTSB to rethink our finance and budget process 
to make recommendations to improve our performance. Staff reviewed the 
provisions of the Chief Financial Officer Act, which, although it does 
not apply by its own terms to a small agency such as NTSB, appeared to 
reflect a ``best practice'' approach to financial operations. As a 
consequence of this review, in February 1997, I requested the 
Department of Treasury's Financial Management Service (FMS) to do a 
top-to-bottom evaluation of the finance accounting system that had been 
in place at NTSB for more than a decade. The cost for this service was 
$55,000, not insignificant for NTSB, but we believed that modernization 
was critical.
    NTSB received FMS's initial report in June 1997. The report found 
that the existing accounting system was insufficient to support 
modernized accounting practices. It recommended that we acquire a new 
accounting system. We contracted again with FMS for assistance in 
selection of such a system. This resulted in the purchase of an off-
the-shelf, Joint-Financial-Management-Improvement-Program (JFMIP) 
compliant accounting program. The FMS report also recommended that we 
target October 1, 1998, as the date for changeover to a new system. We 
met that date, and began use of an entirely new, modern system for 
fiscal year 1999. Achieving this target placed a substantial workload 
on the accounting staff, but we believed it was a critical first step 
in permitting us to achieve a clean audit opinion on NTSB's financial 
statements. The goal of a clean audit was a key recommendation of FMS 
and is a central concept embodied in the Chief Financial Officer Act. I 
wholeheartedly agreed with this approach.
    I concurrently elevated the organizational structure of the 
comptroller's function to independent office status, headed for the 
first time by a Senior Executive level official, also as recommended by 
the FMS report and the Chief Financial Officer Act. And we undertook 
intensive training of administrative staff in the program offices, in 
order to use the new accounting system to its full potential. We knew 
that the total process of modernization and information integration 
would take several years. However, by the middle of 1999, we were in 
the midst of a substantial revision in our financial processes, with 
the goal of meeting financial accounting practices at a level not yet, 
even today, required of us.

                       Discovery of Embezzlement

    From April 1989 until August 1999, Safety Board offices used what 
was for a time a governmentwide, GSA-approved Rapidraft payment system. 
Rapidraft is a service offered by a commercial vendor that enables a 
government employee to write checks to pay for goods and services. NTSB 
Board Order 46A, issued in October 1990, established the Rapidraft 
program for payment of small purchases, travel advances, travel 
expenses, training registration, and other services. Proper 
reconciliation of accounts within the program was a shared function 
between program offices and the financial specialists within what is 
now organized as the Office of Chief Financial Officer (CFO). In August 
1999, during reviews to prepare for the fiscal year-end closeout, a 
highway safety program officer asked for assistance from the CFO office 
in reconciling records discrepancies concerning a particular Rapidraft 
payment. That meeting triggered further analysis, and the subsequent 
review identified suspect behavior on the part of two NTSB employees 
concerning possible embezzlement. Approximately $95,000 appeared to be 
at issue.

            NTSB's Request to IG for Audit and Investigation

    NTSB has traditionally used the services of outside, independent 
auditors to assess financial management issues. In this instance, I 
asked DOT IG if it would conduct an audit and a criminal inquiry. The 
IG does not have jurisdiction over the NTSB. However, NTSB has the 
authority to use the services of other Federal agencies and has used 
the services of other IGs in the past. We were in the process of 
finalizing a new voluntary audit agreement with the DOT IG when the 
discrepancies were uncovered. We believed that an IG, with the ability 
to simultaneously pursue a financial audit and a criminal 
investigation, was especially well suited to assist us. Consequently, 
we broadened the scope of our pending agreement to include criminal 
investigations and requested the DOT IG commence an immediate two-
pronged review of the problem we had uncovered. Staff and management 
were instructed to cooperate fully with the work of the IG. NTSB (with 
DOT IG participation) briefed its Congressional authorizing and 
appropriating committees on the problems identified and the initiation 
of work by the DOT IG. The concerns shared with the Inspector General 
were:
     Was there criminal conduct by any NTSB employee? (criminal 
investigation)
     Were there systemic problems with the Rapidraft program? 
(audit)
     Are there sufficient financial controls for small 
purchases? (audit)
    The IG completed its audit work and briefed top NTSB management on 
its results on October 26, 1999, and their final report was delivered 
on November 8, 1999. In addition, the IG periodically shared 
information on the progress of their criminal investigation, and 
delivered the results of that investigation on March 21, 2000.

           IG Audit and Investigation Report Recommendations

    The IG's audit report concluded that there were weaknesses in 
internal controls, and that existing controls were not followed. The 
report made the following three recommendations:
    1. Discontinue use of the Rapidraft Payment System immediately.
    2. Implement an approved payment program to meet NTSB needs, 
specifically for:
     On-site investigative expenses, office supplies, computer 
equipment, tuition and training payments, and other similar expenses, 
NTSB should use the Governmentwide Commercial Purchase Card Program.
     And, travel-related reimbursements, NTSB should use the 
same organization that currently provides their payroll services (FAA) 
or another Federal processor.
    3. Ensure that the CFO's office develops and implements 
comprehensive internal controls over these programs.
    The IG investigative report concluded that there was criminal 
activity on the part of the two employees that were originally referred 
by the NTSB.\1\ No other embezzlements were uncovered by the IG. 
Criminal enforcement is ongoing and restitution will be pursued. In 
addition, the report recommended administrative action be considered 
for certain irregularities concerning use of agency e-mail, and that 
NTSB ensure proper procedures for the acquisition of small purchases, 
the payment of performance bonuses only within the payroll process, and 
adherence to government regulations regarding the use of frequent flyer 
mileage upgrades.
---------------------------------------------------------------------------
    \1\ Both employees identified by NTSB resigned from the agency 
prior to investigation by DOT IG and the Federal Bureau of 
Investigation.
---------------------------------------------------------------------------

                     NTSB Actions Taken and Planned

    In September 1999, NTSB terminated the Rapidraft Payment System. 
After receiving the October 26 briefing on this subject, the then 
incumbent CFO was placed on administrative leave. In January 2000, a 
new CFO with 35 years of Federal financial management service was 
hired. Recruitments are underway to fill additional vacancies in 
accounting operations and system accounting. After the new CFO 
familiarized himself with the circumstances of DOT IG's work, a series 
of briefings were undertaken with NTSB's authorizing and appropriating 
committees of Congress concerning the results of the IG's work and our 
responses. The NTSB has initiated implementation of all the IG Audit 
Report's recommendations.
    1. Rapidraft Payment System has been canceled.
    2. Governmentwide commercial credit card programs have been 
implemented for travel expenses and small purchases. Travel vouchers 
and purchase card bills are being paid through Treasury Department 
Disbursing Centers.
    3. An independent audit firm (PriceWaterhouseCoopers) has been 
selected to develop a program for comprehensive financial integrity.\2\ 
PriceWaterhouseCoopers will perform the following tasks:
---------------------------------------------------------------------------
    \2\ A copy of the PriceWaterhouseCoopers proposal, and the Board's 
acceptance letter, were provided to the Committee. 
PriceWaterhouseCoopers began their audit activity on April 12, 2000, 
and we expect the review to take about 4 months.
---------------------------------------------------------------------------
     Conduct a closeout review of the Rapidraft Payment System;
     Document NTSB's financial management processes and 
systems;
     Perform a baseline analysis of existing financial polices, 
procedures and systems;
     Test internal controls;
     Develop internal control recommendations; and
     Assess audit readiness.
    As I noted, the IG's report on the investigation was received at 
the Board on March 21, 2000, and we are currently preparing an action 
plan that will address all stated recommendations. As a result of the 
IG's work, we understand that one of the two clerical employees 
originally referred to the IG by NTSB has been indicted, and the other 
is pleading guilty for criminal acts involving embezzlement.
    I would like to close by indicating NTSB's appreciation for the 
work of Ken Mead and members of his staff. This has obviously been a 
difficult time for NTSB, but as an institution we strongly favor having 
the ability to resort to independent, expert assistance as a means of 
quality assurance and improved performance. We would like to thank the 
DOT IG for providing that service to us in this case. Mr. Chairman, 
that completes my statement and I will be happy to respond to 
questions.

    Mr. Sununu. I would like to begin the questioning by 
discussing the 1997 Treasury FMS recommendations and the 
changes that were recommended as part of that process. And also 
I know there were some controls, control changes recommended as 
part of the Inspector General's audit. Could I ask you to talk 
about those changes? Specifically, has the new system for 
financial control been implemented, what elements are in place 
and working, and what elements are yet to be implemented?
    Mr. Hall. I think the person with the most knowledge to 
respond to that is our CFO, Mr. Levine.
    Mr. Levine. This is history, Mr. Chairman, so I am looking 
back at a time when I wasn't at the Board. The Board selected 
the new accounting system based on work done by the Center for 
Applied Financial Management, which is a Treasury entity that 
they brought in to look at their old financial system. They 
concluded that in order to comply with most of the government 
regulations dealing with financial management and the plethora 
of laws that have been enacted by the Congress, we needed to 
move to an integrated financial management system that was 
approved by the Joint Financial Management Improvement Program 
and certified by the General Services Administration.
    NTSB selected a system with an assistance from the same 
consulting group from Treasury. A system was selected. The 
vendor is ICF Kaiser, it is called FINASST. That system 
recently was again recertified through independent testing by 
the Joint Financial Management Improvement Program as a system 
that complies with the core financial requirements that are set 
by JFMIP and GSA.
    Mr. Sununu. If I may, you are not required, though, by law 
to comply with the Chief Financial Officer's Act, is that 
correct?
    Mr. Levine. I have to defer to the Chief Counsel or the 
Managing Director on that.
    Mr. Hall. No, we are not.
    Mr. Sununu. I don't believe that is the case.
    So, to be clear, you are setting--as a set of compliance 
standards you are using the Joint Financial Management 
Improvement Program. Are you required to meet that standard by 
law or that is the one that you chose as a best practice model?
    Mr. Campbell. There are elements within it that we would be 
required to meet. We intend to meet all the elements, because 
we do see it as a best practice approach.
    Mr. Sununu. And have all of the elements been implemented 
to date that enable you to meet those standards? And, if not, 
what system needs to be implemented to meet the standards you 
have established for yourselves?
    Mr. Levine. The system is the accounting system of record, 
and was the accounting system of record for all of fiscal 1999. 
It is the system we are using to account for the fiscal year 
2000 appropriation. It meets all the accounting standards. 
Where we find it lacking is we need to better improve the 
financial management information reporting capabilities of the 
system. I look at it as a powerful data warehouse, but somehow 
we don't have a key to opening all the doors.
    Basically, we can do the obligation accounting, the 
expenditure accounting, all the things required to make 
Treasury reporting, but we do not have all the capabilities we 
need to provide information to the executives and the managers 
of the NTSB to manage their resources as effectively as they 
could.
    Mr. Sununu. Have you set a time line for achieving those 
goals of providing the Board with executive financial 
management information?
    Mr. Levine. This year we are working with our vendor to 
develop scripted management reports that we can put on the 
desktops of our managers so they can click on an icon and get 
the kind of management information they need.
    We are working with the different managers and the 
administrative officers to determine what is needed. In other 
words, we are not just pushing it, we are trying to work with 
them as if they are customers, which they are.
    Through the remainder of FY 2000 and into FY 2001, we plan 
to invest about $100,000 to $150,000 more for necessary system 
enhancements. We are also hiring an additional systems 
accountant to help us roll this out.
    Mr. Sununu. Let me ask you specifically about the 
disbursement system that is, I hope, fully in place fully now 
to replace the Rapidraft system. You have gone to a commercial 
credit card system, is that correct, the governmentwide credit 
card system?
    Mr. Levine. Yes, the Board, long before I got here, 
implemented both the Citibank travel card and the Citibank 
purchase card programs. We have issued more than 350 travel 
cards to our investigators and employees who travel. We have 
also issued over 100 purchase cards to our investigators and 
others with procurement responsibilities.
    Mr. Sununu. Do you have documentation requirements that are 
more formal than what was used in the past? And are you 
performing--I should ask, how frequently are you performing 
reconciliation on those credit card accounts?
    Mr. Levine. The personal travel cards are like your own 
personal card. When Chairman Hall or Dan Campbell travel, or 
whatever, the price of the airline ticket is put on the card 
through our approved travel agency. All travel expenses are 
placed on the card. When we return, we file a travel voucher. 
That travel voucher comes to the CFO organization and is 
reviewed and processed.
    I am concerned because I don't believe the review is 
sufficient. One of the things that Ken Mead reported in his 
audit report was that we needed to look to a third-party 
processor. We are in negotiations with the Department of 
Veterans' Affairs to implement a travel voucher processing 
system where they will review and pay our vouchers and conduct 
post audits.
    My intent is to also have DVA perform a post audit on a 
sample of FY 2000 vouchers.
    Mr. Sununu. Mr. Mead, I want to ask you a couple of 
questions about the Rapidraft system in general before opening 
it up to Mr. Bentsen for questions. Could you talk a little bit 
about the degree to which the Rapidraft system was used in 
other departments within agencies within the Department of 
Transportation, the volume of Rapidrafts that were previously 
used by the FAA, for example, prior to canceling their program?
    Mr. Mead. Yes. The FAA this past year spent about $14 
million using a like system.
    Mr. Sununu. Conceptually, at least, the subcontractor--
third-party subcontractor--was the same Gelco, and the 
contractual limitations, $2,500 maximum and authorization 
number requirements were similar, is that correct?
    Mr. Mead. Yes. But the fact is, we went in and audited the 
FAA system in 1997. Although we found no embezzlements, we did 
find weaknesses that were remarkably comparable to the ones 
that we found at NTSB, unauthorized signatures and so forth. 
And we recommended that--at the time, that FAA tighten up that 
program.
    We could understand how there might be exigent 
circumstances or emergencies where you needed it. I don't think 
that they fully responded to the recommendations. As a result 
of the experience at NTSB and that prior audit work that 
program must be terminated.
    The Volpe Center is in Massachusetts, the research center. 
They, too, were using the like system, as was the Federal 
Highway Administration.
    Mr. Sununu. Now, there are 10 other Federal departments or 
agencies that are using a similar third-party payment system 
through the same subcontractor; and another six we have 
identified that are using a different third-party draft system. 
I understand that you don't know all of the limitations 
associated with each of the contracts, but I do want to ask you 
a general question which is, do you believe that the weaknesses 
you have identified in the nature of a third-party check 
writing system, in particular the system that was used through 
this subcontractor, do you think those weaknesses are likely to 
exist at other agencies--Department of Education, Department of 
Energy, Immigration? Do you think it is in the interest of the 
committee at least to raise your concerns about the weaknesses 
of the system with these other agencies?
    Mr. Mead. Yes, I would. I would be surprised if you didn't 
find weaknesses, at least to some degree. And here is why: When 
you just talk NTSB, which is a small agency cashing 
approximately 8,000 checks a year worth about $4 million, it is 
a very paper-intensive system. And when you have holes that 
turn up where there is no reconciliation, where checks are 
being paid and nobody is even signing the check, where there is 
no payee, where there is no purpose on the check, you have to 
have a very rigorous oversight system to make sure that a check 
writing program, is going to be airtight. And that is tough. In 
fact, that is why the Federal Government moved to credit cards. 
It is much tighter accounting system.
    Mr. Sununu. Thank you.
    One final question for Chairman Hall, and that is--and Mr. 
Levine as well--as you move through this credit card system, 
have you found that there is anything unique regarding the 
NTSB's critical mission that in certain cases might make the 
commercial or government credit card system impractical and do 
you think there may be situations in some of these other 
agencies that would somehow prevent them from ever implementing 
a government credit card system if they chose?
    Mr. Hall. I am not aware of any. My answer would be no.
    Mr. Sununu. Thank you.
    Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman.
    Let me say, first of all, Mr. Mead, with respect to the 
chairman's most--his line of questioning there that, on its 
face, I think the credit card system clearly works better than 
a Rapidraft. And it is an antiquated type structure to use and 
does raise the potential, if not for abuse, the potential for 
sloppy recordkeeping, if nothing else.
    I have yet in my experience in the private sector or the 
public sector found an expense reimbursement system that has 
been smooth and clean. I know in my old banking days we always 
wondered whether the company was carrying us or we were 
carrying the company. I am sure that is sometimes the case here 
as well.
    That being said, obviously the system has some problems; 
and I do have a number of questions. Let me go to the 
chairman's last question, though.
    Mr. Hall, I can see certainly in most cases where you are 
buying an airline ticket, charging a hotel room, that the 
credit card system works pretty well. In fact, in some cases 
you couldn't do it without a credit card. But are there 
instances that you could explain to us in the--where in the 
case of NTSB, which is a somewhat unique agency, where a credit 
card system might not work? I don't think we want to have 
Federal employees walking around with a pocketful of cash, but 
there are cases where you are on the ground that you have to 
have something a little more liquid than a credit card.
    Mr. Hall. Well, I might ask Mr. Campbell to comment on this 
as well. He has more years of experience than I do in this 
area, Congressman.
    In the aviation area, our investigators operate sort of the 
highway patrol of the skies. Every time there is a fatal 
aviation accident, we have an investigator there. They have to 
take charge of that wreckage. They have to be responsible for 
assisting with the wreckage removal, with the engine tear 
downs, other things that are routinely done as part of the 
investigation. Obviously, to be able to pay for those things is 
very important.
    On major accident investigations, it is hard to anticipate 
in advance things that you may be called upon to do.
    The credit card system, to my knowledge, so far has served 
us fairly well.
    Mr. Levine wanted to comment. Somebody over was there was 
rustling.
    Mr. Levine. Congressman Bentsen, the credit card contract 
permits the use of convenience checks to handle situations 
where credit cards are not accepted by a vendor.
    Convenience checks are set up for unique situations. Let me 
give you some examples. Convenience checks are limited to 
investigators in charge at an investigation, and a handful of 
others.
    NTSB often has to take custody of wreckage or equipment and 
often needs to buy services from the local economy. For 
example, the local police department may moonlight and be 
willing to provide protection of that material overnight. Last 
I heard, off-duty policemen don't take credit cards. The 
convenience check program is one way we can handle that.
    It is also possible for our people to get cash advances 
from their travel card from an ATM machine. They can take these 
funds and then seek reimbursement through proper channels when 
they come back to their duty station.
    So there are a few cases where the credit card just doesn't 
work, and the contract with Citibank which GSA negotiated for 
all of government does provide for that. We have limited the 
utilization of the convenience checks, and very few of them 
have been used. We have very bright people doing this work. 
They know how to get it done.
    Mr. Bentsen. Let me ask just a few other questions. With 
respect to the Financial Management Service Review in 1997, 
there were a number of recommendations in that report. Some 
included adding budget officers and staff, implementing new 
systems technology for management--for financial management. 
The agency didn't follow through on all those. Were there 
budgetary reasons related to that? In the scheme of your agency 
that you all go from one emergency to the next emergency?
    Mr. Hall. The last 10 years almost any mode of 
transportation in the United States doubled. As a result, there 
has been a tremendous impact on the work of our agency and the 
number of employees we need to accomplish our mission at a time 
when everyone else in Washington is basically downsizing.
    I have requested every year I have been chairman more 
people in my budget. And our committees of Congress normally, 
usually over the objection of the Office of Management and 
Budget, have assisted us in getting more people. In retrospect, 
we took most of those additional people and placed them in 
investigative positions in order to accomplish the mission. And 
I did not, at the same time, put enough people in our 
accounting and budget office to perform the mission of the 
additional amount of money that we were using.
    We will have additional employees in the new fiscal year. 
Many times, I find those employees are tied by OMB or Congress 
to specific slots. I have difficulty getting money to fund 
accountants. I am going to take the first people we get and be 
sure that we have enough people to be responsible stewards of 
the money we are given.
    So that is a long answer of saying I think, yes, we have 
had some difficulties in being able to accomplish everything 
that we wanted to do because of manpower limitations.
    Mr. Mead. My I offer a perspective on that?
    I think in this case, as in the case in many situations in 
government and private industry, the leadership and stewardship 
of the people you have in place is critical. And here, as is 
illustrated by the experience with the Rapidraft system, there 
were plenty of early warning signs given directly to the Chief 
Financial Officer. And they were not acted on. And I think with 
the new leadership in place, that you should see a strong 
improvement.
    Mr. Bentsen. This reminds me a little bit of graduate 
school. This is going to be a great case study some time.
    Mr. Mead, two things. One is, as I understand it, H.R. 
2910, the NTSB reauthorization that passed last year now does 
give you authority to look at NTSB?
    Mr. Mead. Yes, sir, on rather nonjudgmental financial 
management areas only. And I think it would be inappropriate to 
have the Inspector General for the Department of Transportation 
in a position to second guess programmatic judgments or 
investigative judgments of the NTSB. So, yes, that is in the 
bill. It has passed. It hasn't moved through the Senate yet, 
and we are prepared to do it if the Congress wants us to, but 
we don't want authority into the programmatic areas.
    Mr. Bentsen. So you want to limit it to the financial 
scope.
    Mr. Mead. Keep it clean, rules and regulations, internal 
controls that reasonable people can agree upon and you can 
empirically audit.
    Mr. Bentsen. That would solve that part of the problem in 
your testimony.
    Mr. Mead. Yes, it would.
    Mr. Bentsen. In your investigation and in the investigation 
that was carried out that Justice is now involved in with the 
two individuals that have been indicted, is the loss to the 
government, the taxpayers, the fraud or theft limited to the 
two payments, the $90,000? Did you find any overpayment of a 
contractor? Or was it a case of inefficient bookkeeping, 
recordkeeping, questionable use of using the Rapidraft Payment 
System for paying accounts that probably should have been paid 
out of another vouchering system? Or have you found a situation 
where there might be other, higher dollar misuse of funds?
    And I know there is a difference of agreement with respect 
to Board orders in 1992 and 1995 as to what areas are covered, 
and we could get into that debate. But I guess my question is, 
bottom line, other than lax controls and using the Rapidraft 
system for vouchers that other systems should have been used 
for, did you find other cases where Acme Trucking Corp. was 
paid more money than it should have been paid or anything like 
that?
    Mr. Mead. We do not know of any embezzlements other than 
the one that we have reported to you. I would be surprised if 
there were not other instances of abuse of this system, but 
they would be very difficult to track down. Why? Well, when 
nobody signs the check and it is paid or there is no purpose 
and no documentation underlying it, it is difficult to tell 
what the purpose was for or whether it was for a legitimate 
expense.
    I think the fair answer to your question is that the vast 
majority of these checks were probably written by upstanding 
people for legitimate purposes. Where there were weaknesses was 
in internal controls and so forth, and sloppiness. But I can't 
vouch that we have uncovered all the abuse in this program.
    Mr. Bentsen. I assume the PriceWaterhouseCoopers audit 
should show some of that.
    You raised one issue that I hadn't thought about, and my 
time is up, but the way this system works is there is a 
contractor who is the bank account holder on behalf of the 
agency, and the check is written and passed through them. But 
they cleared checks without a signature?
    Mr. Mead. Yes, sir. Do you see this package here? When we 
went to NTSB when Chairman Hall said come on in here and 
investigate and audit, we said, let's see the checks. And my 
auditors picked up unopened packages of checks that had been 
sent to NTSB's Chief Financial Officer unopened, bundles of 
them. Well, under the contract----
    Mr. Bentsen. Canceled checks.
    Mr. Mead. Oh, yes. These are all paid, and it was never 
opened by anybody, so there was never any reconciliation done. 
And under the terms of the contract with the vendor, at least 
our reading of it, NTSB had 45 days to tell them don't pay this 
check. But since there was no reconciliation or review, that 
just wasn't done. And now the 45-day period that NTSB did have 
to assert a claim has expired.
    Mr. Sununu. If Mr. Bentsen would--thank you, Mr. Bentsen.
    So that point--we have a check here that is displayed on 
our far right that gets to the point that you raise, which is a 
check that was cleared by the third-party contractor and it has 
no authorizing signature on it whatsoever. And there is a 45-
day period where there might be a response but clearly there 
were significant problems with both internal controls not 
performing reconciliation but with the controls and the process 
used by the third-party contractors.
    I would like to ask unanimous consent that all members be 
allowed to revise and extend their remarks and also ask 
unanimous consent that we include in the record a list of other 
departments or agencies that are using this third-party 
contractor. Without objection.
    [The information referred to follows:]

List of Federal Departments or Agencies That Gelco Provides Third-Party 
                           Draft Services To

African Development Foundation
U.S. Department of Treasury--Bureau of Engraving & Printing
Federal Aviation Administration
Immigration & Naturalization Service
Internal Revenue Service
U.S. Department of Treasury
U.S. Mint
Office of Thrift Supervision
Federal Highway Administration
Internal Revenue Service--Southeast
U.S. Department of Energy
U.S. Department of Energy--Oak Ridge
U.S. Department of Education
U.S. Department of Transportation--Volpe

    Mr. Sununu. I recognize Mr. Miller for 5 minutes.
    Mr. Miller. Rapidrafts, often in the private sector known 
as voucher systems, meet accountability standards when they are 
used properly and they are reviewed properly, so I don't want 
to get the focus off the Rapidraft, saying that is the problem. 
That is not the problem. But when you have checks written to 
Myriad Investments and the intent of those checks, as you said, 
Mr. Mead, are supposed to be used for accident and nonaccident 
purposes. A flag should have come up to somebody that you don't 
pay it.
    When a check comes to Gelco with no signature, the fact is 
it should not have been paid. When a check comes to Gelco--and 
please put one of the ones up that exceed $2,500--exceeding 
$2,500, the fact is the check should not be paid. Period.
    Now, there is not any question that there was some 
corruption internally. But I don't think there is any doubt 
that there is incompetence on the part of Gelco if you look 
what has happened and transpired. If you go to the Gelco 
contract, it is very specific. Gelco Payment System and the 
National Transportation Board agree to notify each other 
immediately of any misuse of the Rapidraft authorization--
Rapidraft orders.
    Now a certain amount of those were done. Many were not, 
based on the investigation.
    Also, Gelco's payment system assumes responsibility for the 
face value of Rapidraft orders which fail to properly screen or 
be rejected. And if you look at their daily draft processing 
and standard violation systems, these checks did not comply 
with the criteria necessary to process those checks.
    Travel cards are going to be no better than Rapidrafts if 
oversight does not occur. I have done dozens of loans when I 
was in the building industry with lending institutions that we 
used voucher systems or Rapidrafts, and they work if done 
properly, without a doubt.
    And I don't want to get off the focus of Rapidrafts, saying 
that is our problem here and we are going to stop using 
Rapidrafts and when we stop using Rapidrafts the problems go 
away. That is not true. And there are certain Rapidrafts or 
vouchers or payments that are going to continue into the future 
that are going to be made to vendors, am I not correct? Nobody 
in their right mind is going to use their travel card to pay 
those. So they are still going to be paid.
    And that is where the problem lies. And the shift to using 
a travel card does not deal with the problem.
    Gelco did not do their job. They were incompetent. And 
there was corruption on the part of staff, without a doubt. And 
we don't know how widespread that corruption was, and we don't 
know how widespread this is here. So you have a checks and 
balances system.
    In fact, Al Gore praised this system in one of his 
statements, saying this is how we reinvent government. We have 
taken care of it because we installed the checks and balance 
system that, if used properly, works.
    And in your testimony--Mr. Mead, you stated, contrary to 
NTSB policy, drafts were paid when they exceeded the $2,500 
limits. It was printed on the check that these Rapidrafts 
should not exceed that amount. Why did Gelco honor these 
checks?
    Mr. Mead. I can't respond to that.
    Mr. Miller. That is what I thought.
    Mr. Mead. The $2,500 is an NTSB order, and it was in the 
agreement with the contractor. But employees internal to NTSB 
wrote letters to Gelco saying for these employees, honor the 
checks over $2,500 all the way up to, in one case, $20,000. In 
another case, under the contract with the contractor, NTSB 
committed to notify the contractor whenever somebody left and 
was no longer an authorized user. They did not do so. Then 
employees internal to NTSB would sign somebody else's name who 
had been an authorized user. Gelco pays the check. So----
    Mr. Miller. The largest checks that were cashed were to 
J.D. Rainbolt Contractors--one for $7,500 one for $16,000, one 
for $20,000, one for $5,000, one for $26,000, one for $13,000--
were by a former employee, not even employed at the time when 
he wrote them. I mean, it is more than Rapidrafts. It is 
internal incompetence on the part of the government and on the 
part of the agency that is supposed to be supervising the 
payment of these.
    It says clearly $2,500. And if you put one of the checks 
up, that shows $2,500 crossed off by the person signing the 
check, and it was paid.
    I guess I have a question. Is Gelco being held accountable 
for paying these? Are they being prosecuted right now? Can 
anybody answer that?
    Mr. Mead. No, not to my knowledge.
    Mr. Miller. Why not? I have a contract right here signed by 
William Park, signed by--I can't read the other name--but one 
by Gelco, and one by part the government, that specifies what 
they are to do. It specifies accountability. It specifies the 
process to go through. This is not new. This has been known.
    In fact, one thing that really bothers me is, when I go to 
the history of events--and this is for Mr. Hall. You became 
aware of this in August of last year. Yet on September 23 we 
did a markup of your authorization bill, and you came before us 
as a committee. You never mentioned it. And on September 30, 
the bill was passed on the House floor, and you never mentioned 
it. And yet you knew about this problem in August.
    Now, trust me, we have always voted for this stuff. Based 
on statements made before us on May, 1999, that you never 
refuted when you found out they were incorrect, one is, I know 
nothing that has caused me any concern.
    In addition, Mr. Keller notified--he was a financial 
officer. He was a problem. ``Eighty percent of our budget is 
dedicated to the people, so there is not a whole lot of 
flexibility as far as abuse or fraud or whatever that can take 
place,'' was stated. And also the statement was made, ``The 
most important job you have given me is responsibility for 
handling taxpayer's money.''
    And, Mr. Hall, you gave me the courtesy of coming by my 
office yesterday, and you told me that you had notified 
everybody when you found out about this, and I took that at 
face value. I am not trying to criticize you. But when I look 
back, because I was responsible for voting for your 
authorization last year, you knew about it a month before we 
voice voted it out of committee. You never brought it up. And 
it went out unanimously on the floor. You never brought it up. 
Why not?
    Mr. Hall. At the time that I learned of this, I notified 
Mr. Mead and attempted to follow every piece of advice Mr. Mead 
gave me, including when to advise our committees, because we 
were dealing with an ongoing criminal investigation. At the 
time that Mr. Mead said we should go and meet with committee 
staff and advise them of this matter, we did so. So that is the 
reason.
    On the matter of those checks, I would like to have a 
chance to check those and respond for the record in terms of 
who signed those checks and their status at the time they were 
signed.
    Mr. Miller. I don't have time. We do have those checks. But 
I do have the sequence of events as they unfolded. We have to 
break.
    Mr. Sununu. I appreciate it, Mr. Miller. We will allow 
Chairman Hall to make that response for the record.
    [The information referred to follows:]

 Chairman Hall's Response for the Record Regarding ``Who Signed Those 
         Checks and Their Status at the Time They Were Signed''

    The checks referred to that exceeded $2,500 were signed by Mr. Don 
Libera, currently the NTSB's Deputy Chief Financial Officer. At the 
time he signed the checks, he was the agency's Budget Officer. Mr. 
Libera had specific written authority from the Chief Financial Officer, 
which also was provided to Gelco, to write checks in excess of the 
$2,500 limit. Because all of the checks were preprinted with the ``NTE 
$2,500 limit,'' Mr. Libera crossed through this note and initialed the 
checks he wrote that exceeded this limit. All of the checks written 
over the $2,500 limit were to expedite payment for legitimate purposes 
and were paid to NTSB employees, primarily for travel-related expenses, 
or to vendors for supplies or services provided. It should be noted 
that when Gelco received a check over the $2,500 limit, they would 
usually call appropriate Safety Board CFO personnel to verify 
authorization to override the established system limit.

    Mr. Sununu. At this time, I would like to yield to Mr. 
Clement and make members aware that at the conclusion of Mr. 
Clement's questioning we will recess for this vote on the rule 
and return back promptly, at which time Mr. Miller will take 
the Chair to complete questioning from the remaining members.
    Mr. Clement.
    Mr. Clement. I don't think I am going to have enough time, 
but I will at least start anyway.
    Mr. Chairman, as you know, I serve on the House 
Transportation and Infrastructure Committee, the jurisdictional 
and oversight congressional committee for NTSB. I am acutely 
aware of the tremendous significance of the National 
Transportation Safety Board.
    Under Chairman Hall's leadership, the NTSB has had to 
address some of the most challenging national transportation 
catastrophes on record. As a fellow Tennesseean, I will say I 
am especially proud of Chairman Hall's commitment to excellence 
and public service.
    Like other members here, I strongly believe that every 
level of the Federal Government should be held accountable for 
its actions. On behalf of American taxpayers, Chairman Hall has 
worked to make improvements in the deficient financial 
accounting system that he inherited from the previous 
administration in 1994. He has indeed worked on behalf of 
taxpayers by reversing NTSB practices that were mismanaged.
    Mr. Hall--Chairman Hall, it is my understanding that NTSB 
does not have an IG of its own. You contacted the Department of 
Transportation's IG to come in and do an audit of the Rapidraft 
check system, payment system. You have also contracted with 
PriceWaterhouseCoopers to do an outside audit as well. Do you 
feel that it would be beneficial to the NTSB to have an 
internal IG instead of having to rely on DOT's IG?
    Mr. Hall. I certainly would have no objection to an 
internal Inspector General in our agency.
    I was told when I first inquired about an IG that our 
agency was too small to have a full-time Inspector General. I 
consulted with a number of people on getting that advice. But I 
think it is imperative that our agency in the future have an 
annual audit of all of our financial activities, and we are 
moving to do that.
    Mr. Clement. Mr. Mead, do you have any comment about the 
question I asked?
    Mr. Mead. Just a point of perspective. When a problem comes 
up like this, you need a critical mass to be able to deploy. I 
think you can make a case for an internal IG. I think you can 
make a case for having a Cabinet-level IG with the critical 
mass that can come in.
    Mr. Hall and I have a very good professional and personal 
relationship, and I think that helps a great deal. You would 
have a problem if--you have a case like this come up--there is 
no way that NTSB could responsibly have a permanent IG staff of 
10 or 15 people. And that is the only perspective I would have. 
If you want us to do it, we will do it. But please don't give 
us any responsibilities that go into the programmatic area or 
the investigative area. Keep it down to the financial 
management.
    Mr. Clement. I may have another question or two when we 
come back.
    Mr. Sununu. We have approximately 4 minutes left in the 
vote. If you would like to ask one of your questions and you 
can resume questioning when we return.
    Mr. Clement. I will wait.
    Mr. Sununu. We will recess at this time. We will reconvene 
as soon as we return from the vote. Thank you, gentlemen.
    [Recess. ]
    Mr. Miller [presiding]. I would like to correct one 
misstatement that I made on the checks that were in the 
individual larger amounts, the individual was still employed. 
But the comment was more directly to the Rapidrafts were not to 
be used for this type of purpose at this amount. And that was 
the issue.
    Mr. Toomey, do you have questions?
    Mr. Toomey. Is Mr. Clement finished?
    Mr. Clement. I am through. And I appreciate what you just 
said, Mr. Chairman; and Mr. Hall may want to comment.
    Mr. Hall. No, that is fine.
    Mr. Clement. Thank you.
    Mr. Toomey. I will be brief, but I did want to just get 
actually maybe both Mr. Mead and Mr. Hall to react to some 
thoughts.
    First of all, if we look at the case of the Rapidraft 
payments that the IG reviewed, there were 1,000. And I take it 
there is no reason to believe that that is not a representative 
sampling. And when we consider that 90 percent of these had 
some kind of noncompliance, one kind or another, it suggests, 
obviously, a routine lack of regard for the rules of 
compliance. And I wonder if it doesn't reveal to some degree 
almost a culture of disrespect for certainly the rules of the 
reimbursement, the whole Rapidraft system, and I wonder how 
much more pervasive that culture would be of disregarding rules 
which are really rather important.
    Now, I take it that your investigation focused more on 
discovering individual and systemic misuse rather than focusing 
on whether there was criminal intent or fraud that went with 
that. But I was wondering, Mr. Mead, if you could clarify that 
for me a little bit.
    Mr. Mead. I will try, yes, sir.
    Inspector General offices are divided into two parts. One 
side is a criminal investigative, looking at quasi-criminal 
administrative violations that get an individual in serious 
trouble. The other side of an IG operation is audit, program 
evaluation, financial audit where you look at the effectiveness 
of the programs.
    And in a case like this, what we had was criminal 
misconduct, and we suspected that from the beginning. But once 
we got in there and saw the type of criminal misconduct and how 
it was allowed to occur, the latter--the unauthorized people 
signing checks, the no-known purpose on them, the no payees, 
going over the limits, things of that nature--we began to see 
that there was an underlying vulnerability to this whole 
program. That triggered the audit side of our office which led 
to the broader audit, sir.
    Mr. Toomey. But as for those broader audits, we had a 
system that we know was extremely vulnerable to abuse. 
Obviously, if you don't need to sign checks, you don't even 
need to write a payee and yet the check will be cashed. And yet 
there are only two cases of fraud and embezzlement that have 
been pursued on a criminal level. With such a high degree of 
noncompliance it strikes me there must be a whole lot more 
flaws that occurred that we don't know about certainly beyond 
those two cases. And that is--you know, I have no direct 
evidence of that, just by the sort of--intuitively seems quite 
likely. So one of my questions is, what do we do about that? 
What can be done?
    Mr. Campbell. If I may respond to that, Congressman, that 
is the first order of business with our contract with 
PriceWaterhouseCoopers. We understood from the nature of the 
investigation that DOT IG did for us that they would not 
necessarily get to the universe of all the difficulties that 
they might see. And so the first order of business we have with 
the independent audit firm is to assess that problem for us and 
give us some advice on how to proceed. The agency has chosen to 
continue to pursue that issue.
    Mr. Toomey. And specifically with respect to the checks 
that were cashed a year ago or 2 years ago with the old 
payments, are they still being investigated or is that the kind 
of thing where that is being given up and we are trying to 
prevent repeat offenses?
    Mr. Campbell. No, sir we are looking at the past.
    Mr. Toomey. In the inspection that you did do, the auditing 
and investigation work that you did, was most of the 
noncompliance that was cited about the handling of the 
Rapidraft system itself and fault in that process? Could you 
also tell me about to what extent do you believe that these 
items that were being paid for were purchasing things that 
either were not intended to be--you addressed those which were 
not intended to be used by the Rapidraft system--but what about 
items that shouldn't be bought at all that were being 
purchased? Any more thoughts on that?
    Mr. Mead. Yes, there is clearly some instances of those 
where you don't really know what the payment was for. You see 
the check behind you to American Express. That is one where 
nobody signed. But even if it was signed, the question occurs, 
well, what about American Express? Why were you writing checks 
to American Express? What was it for? And there are a lot in 
that category. A large number.
    Mr. Campbell. If I could expand on that. The actual Gelco 
book that you write checks from has a check at the top and a 
series of additional documents that--additional parts of the 
document that need to be filled out. What we will attempt to do 
is take some of the difficult, the problematic checks and marry 
them back up with their underlying documents which themselves 
need to be accompanied by the obligating form.
    The check is not actually permission to obligate money. The 
check is just a way of making the payment. Each check needs to 
be accompanied either by a training form, a travel voucher, a 
4400 for purchases and so forth.
    So there is an opportunity to go back and look at these 
checks and ask yourself, one, do we have the documents--of 
course, the ones we don't have the documents for would then by 
themselves be particularly suspicious. But if we have the 
documents you can review the document to give you some sense of 
what the underlying purchase was about and make a determination 
about whether it was for an authorized purpose or not. And that 
is our intention.
    Mr. Toomey. So that is ongoing, that investigation.
    Well, finally, just my last question for the Chairman, are 
you concerned that there may be within the Board a sort of 
culture of disrespect for internal rules and procedures, a sort 
of lax attitude that has been revealed by this whole discovery 
that might pervade both the institution and into other areas 
other than just the finances?
    Mr. Hall. Congressman, I have a great deal of respect for 
all of my employees. Setting the culture of the agency is the 
responsibility of the management of the agency. I can assign 
that responsibility, but I must accept that accountability. In 
this case, the individual that was responsible was not 
enforcing the type of culture that should be in place.
    We are going to, as Mr. Campbell said, look at each and all 
of these transactions. That is one of the things we have asked 
PriceWaterhouseCoopers to do. But, you know, my employee base 
there does an outstanding job, in my opinion, performing their 
mission. And a part of their mission and part of their time was 
supposed to be given and needed to be more directed toward a 
proper accounting of these funds, and so we are going to put an 
emphasis on that. If we had a cultural problem, we are going to 
change that cultural problem.
    I don't know how else to comment on it. I don't choose to 
be in this position. The employees in the agency work very hard 
in their job. It is the responsibility of management to lay 
down that culture and direction for them. In this area we have 
not been as successful as I would like. We have had this 
embarrassing situation, and I intend to do everything we can if 
there is a problem to be sure it is effectively addressed.
    Mr. Mead. I think, just from the observations of my own 
auditors and investigators, there was a culture of looseness at 
the top in the Chief Financial Officer's office. You didn't 
have an IG that every so often did visitations at the agency on 
a routine basis to make sure everything was honest. We found 
that, transcending the Rapidraft program, there were problems 
with the travel vouchers not being reviewed. The computer 
equipment frequently wasn't inventoried properly. The CFO 
should have made sure that employees got periodic ethics 
training. And these things just were not happening.
    And I, too, know a number of NTSB employees and have the 
highest respect for them. But I do think you have to look at 
that CFO for a great deal of leadership. And I don't believe 
the Board, Mr. Hall or NTSB was being well served, sir.
    Mr. Toomey. Thank you, Mr. Chairman. I yield the balance of 
my time.
    Mr. Miller. Chairman Hall, a couple of questions I need to 
ask you, just to clear up some confusion. Under Federal reg 31 
CFR 208, which is under the management of the Federal Agency 
Disbursement Act--can you hear me?
    Mr. Hall. I was having a little difficulty.
    Mr. Miller [continuing]. Which implements the Debt 
Collection Improvement Act of 1996, requires the authority of 
the Secretary of Treasury to grant waivers of all Federal 
payments made after January 1, 1999, when it must be made by 
electronic fund transfer. And 31 CFR 208 permits nonelectronic 
payment for national security interest, military operations, 
national disasters, law enforcement, amounts less than $25, 
certain payments in foreign countries or in emergencies or, 
``mission-critical circumstances that are of such an unusual 
and compelling urgency that the government would otherwise be 
seriously injured.''
    Based on that, under what circumstance did NTSB qualify for 
a waiver of 31 CFR 208 to continue using the Rapidrafts after 
January 1, 1999?
    Mr. Campbell. Congressman, I don't believe that NTSB 
qualified for a waiver under those provisions. And I don't 
believe that we had a waiver under those provisions. I think 
that the program for the Chief Financial Officer, who is, 
unfortunately, not here to answer this question, was to make a 
transition to the purchase card program and the travel card 
program which we have implemented now as of about September of 
1999. And during the period between January 1 and September, I 
have personally asked this question and----
    Mr. Miller. So you are confirming they should not even have 
been using Rapidrafts after January 1.
    Mr. Campbell. It is my understanding that we should have 
gone to electronic transfer.
    Mr. Miller. We need to ask this, because that issue has 
come up and we didn't have clarification. The confusion I had--
there was an ongoing problem with a system that shouldn't even 
have been in existence.
    Mr. Campbell. There would have been a class of transactions 
which would have met the exemption standards, particularly 
those in the field where the actions are--making an electronic 
funds transfer at an accident scene may have been difficult, 
but there was another whole class of transactions which 
probably would not have met the waiver requirement.
    Mr. Miller. Probably the last question I can think of is--
we ran out of colleagues here--is part of the Rapidraft Payment 
System NTSB maintained $350,000 in a non-interest-bearing 
account with Gelco Information Network Inc. Have you made any 
effort to get that money back at this time?
    Mr. Levine. We are, right now, trying to get that money 
back. There are a couple of issues on float and miscellaneous 
charges that my people are trying to reconstruct, but they have 
been in contact with Gelco. That is money that was put in 
deposit, I believe, as far back as 1989. It is basically to 
cover the float. We have been in contact with them, and I have 
been assured that that is being expedited.
    Mr. Miller. Well, Mr. Hall, you have been very courteous 
and kind and forthright, and Mr. Mead, also. I appreciate the 
input.
    We were told that other members are coming, but we are 
going to go check. We will not delay you any longer than you 
have to. Is there any final comment you would like to make?
    Mr. Hall. No, sir.
    Mr. Miller. If somebody doesn't show up in the next 5 
seconds, we will thank you graciously for being here today. Our 
comments were not an attack. I hope they were not taken as 
such. They were not meant to be.
    Mr. Knollenberg, I have been informed, will be here within 
60 seconds, so I will have to wax eloquently for the next 60 
seconds.
    This is probably not the best of times--with Egyptair, what 
is ongoing right now? We just had a hearing in Transportation 
on that issue. It is not the best of times to be here.
    I know your focus is on issues very important to us, very 
important to commuters. I think you are doing an excellent job 
in that area. It is a shame that a situation like this has to 
occur. I know you are a man who probably takes this very 
personal because you are the top. It is not meant to be 
personal.
    From our perspective, it is just an issue that was believed 
should have been discussed publicly, and it sounds like just 
the process we have taken has changed some other agencies from 
the direction they have gone in using these, trying to come up 
with more of an accountable system. It sounds like and it 
appears like the individual now you have put in charge of CFO 
is going to be a thumbs-on individual and he is going to make 
sure something like this never occurs in the future, and I am 
glad to see that.
    But your agency does an excellent job, and this hearing is 
not in any way intended to impugn the quality of work you do. 
Because you do top-quality work. We are not--that is not the 
goal. It is more accountability. And I know that you have taken 
many steps to create accountability, and we thank you for that. 
And, again, I want to say there was nothing personal in the 
questions that had to be asked. I think we are all glad they 
probably were, and we can move forward when Mr. Knollenberg 
shows up to ask his final questions.
    Mr. Clement. Mr. Chairman how do you stay physically in 
shape and be mentally alert? That is what I would like----
    Mr. Miller. You keep me in line. I try very hard, sir.
    Why don't we talk a break for just a minute or so for Mr. 
Knollenberg? We will adjourn the meeting after that.
    [Recess.]
    Mr. Miller. We are going to reconvene the meeting.
    Mr. Knollenberg has walked in. He has 20 seconds worth of 
questions left, because he has used up 40 minutes and 40 
seconds already.
    Mr. Knollenberg. Well, I apologize for being late. Three 
places at the same time doesn't work.
    Let me again welcome everybody, and I appreciate your being 
here. I am sure I might touch on a question that has been 
handled before, and if it has just mention that. Mr. Chairman, 
you obviously may want to reflect on that, too.
    Simple question, and I will get right to the heart, it was 
how many Rapidrafts exceeded 5,000?
    Mr. Levine. $5,000 or $2,500, sir?
    Mr. Knollenberg. I am sorry. Your question was what again?
    Mr. Miller. How many exceeded 2,500?
    Mr. Levine. I sorted it----
    Mr. Knollenberg. I am asking how many exceeded 5,000.
    Mr. Levine [continuing]. I have a list. And the only reason 
I asked for clarification, sir, is my list tells me we issued 
about 169 that were over $2,500. I will have to go back to that 
list and to get you an answer. If I could provide that for the 
record, I will.
    Mr. Mead. I have the answer here, so you won't have to do 
that. There were 70 Rapidrafts totalling $708,000 written for 
amounts between 5,000 and 28,000.
    Mr. Knollenberg. That is fine. What was the maximum 
Rapidraft limit authorized for any user?
    Mr. Mead. Under the Board order, the limit was $2,500.
    Mr. Knollenberg. Who were the persons primarily involved in 
writing the over-limit checks?
    Mr. Mead. Mr. Libera, who was a Deputy Chief Financial 
Officer, and Mr. Mills, who was an Accounting Officer. And I 
should note that administratively they wrote or their 
supervisors wrote to the vendor Gelco and said please authorize 
these people to write checks over $2,500. The NTSB Board never 
approved that.
    Mr. Knollenberg. Another quick question, for what 
purposes--and this is probably general, but what purposes were 
the checks written for and what was the total dollar value?
    Mr. Hall. We have Mr. Libera here.
    Mr. Knollenberg. That question has been raised before. I am 
not trying to duplicate. If you can't do it quickly, would you 
do it for the record?
    Mr. Hall. Be glad to do it for the record. Yes, sir.
    [The information referred to follows:]

                                              RAPIDRAFTS OVER $2500
                                            [Fiscal Years 1997-1999]
----------------------------------------------------------------------------------------------------------------
                                      Cleared
No.    FY    Last Name    First Name    Date    Check Number        Amount           Pay to          Purpose
----------------------------------------------------------------------------------------------------------------
  1   1997  Libera Jr    Donald P.      80697     020001231-9        $2,644.67  North American   Invoice
                                                                                 Van Lines
  2   1997  Libera Jr    Donald P.      81597     020001237-3        $4,703.21  Shane Lack       Travel Voucher
  3   1997  Libera Jr    Donald P.      81897     020001236-4        $3,717.55  Robert Benzon    Travel Voucher
  4   1997  Libera Jr    Donald P.      82697     020001245-4        $5,137.89  Robert Hilldrup  Travel Voucher
  5   1997  Libera Jr    Donald P.      82997     020019002-4        $4,896.93  Ronald Schlede   Travel Voucher
  6   1997  Libera Jr    Donald P.      90297     020019003-3        $3,807.48  Alfred           Travel Voucher
                                                                                 Dickinson
  7   1997  Libera Jr    Donald P.      90497     020001234-6        $3,560.19  Dennis Jones     Travel Voucher
  8   1997  Libera Jr    Donald P.      90897     020019011-4        $8,709.96  Ronald Schlede   Travel Voucher
  9   1997  Libera Jr    Donald P.      90897     020019008-7        $3,819.24  Ronald           Travel Voucher
                                                                                 Wentworth
 10   1997  Libera Jr    Donald P.      90897     020019006-9        $3,176.26  Cynthia Keegan   Travel Voucher
 11   1997  Libera Jr    Donald P.      90997     020019005-1        $3,153.58  Deepak Joshi     Travel Voucher
 12   1997  Libera Jr    Donald P.      91097     020001249-9       $10,729.59  Robert Francis   Travel Voucher
 13   1997  Libera Jr    Donald P.      91097     020019007-8        $3,395.38  George Black     Travel Voucher
 14   1997  Libera Jr    Donald P.      91097     020019009-6        $2,508.58  Gordon Hookey    Travel Voucher
 15   1997  Libera Jr    Donald P.      91297     020019001-5        $3,930.20  Keith D.         Travel Voucher
                                                                                 Holloway
 16   1997  Libera Jr    Donald P.      91297     020019010-5        $2,689.92  Gregory J.       Travel Voucher
                                                                                 Phillips
 17   1997  Libera Jr    Donald P.      91597     020019014-1        $3,815.76  Paul Schlamm     Travel Voucher
 18   1997  Libera Jr    Donald P.      91897     020019015-9        $2,950.35  Matthew M.       Travel Voucher
                                                                                 Furman
 19   1997  Libera Jr    Donald P.      92297     020019025-8        $2,852.08  James Skeen      Travel Voucher
 20   1997  Libera Jr    Donald P.      92997     020019052-8       $10,162.68  Robert Benzon    Reimbursement
 21   1997  Libera Jr    Donald P.      92997     020019018-6        $4,744.42  James R. Jeglum  Travel Voucher
 22   1997  Libera Jr    Donald P.      92997     020019017-7        $2,890.73  Malcolm Brenner  Travel Voucher
 23   1998  Libera Jr    Donald P.      10898     020019283-2        $3,166.52  Richard J.       Travel Voucher
                                                                                 Wentworth
 24   1998  Libera Jr    Donald P.      11498     020019282-3        $2,871.61  Matthew M.       Travel Voucher
                                                                                 Furman
 25   1998  Libera Jr    Donald P.      12198     020019286-8        $4,596.76  Linda A. Jones   Travel Voucher
 26   1998  Libera Jr    Donald P.      12698     020019289-5        $6,106.39  Richard J.       Travel Voucher-
                                                                                 Wentworth        Prehearing
                                                                                                  Prep
 27   1998  Libera Jr    Donald P.      12698     020019288-6        $6,045.76  Ronald Schlede   Travel Voucher-
                                                                                                  Prehearing
                                                                                                  Prep
 28   1998  Libera Jr    Donald P.      12898     020019287-7        $5,194.33  John Goglia      Travel Voucher
 29   1998  Libera Jr    Donald P.      20498     020019290-4        $3,509.67  Robert McGuire   Travel Voucher
 30   1998  Libera Jr    Donald P.      20598     020019292-2        $6,183.51  Robert Hilldrup  Travel Voucher
 31   1998  Libera Jr    Donald P.      20698     020019293-1        $5,442.72  Cynthia Keegan   Travel Voucher
 32   1998  Libera Jr    Donald P.      20698     020019291-3        $4,897.93  Robert Francis   Travel Voucher
 33   1998  Libera Jr    Donald P.      20998     020019295-8        $4,696.18  Jamie Finch      Travel Voucher
 34   1998  Libera Jr    Donald P.      21798     020019296-7        $3,000.20  Robert           Travel Voucher
                                                                                 Macintosh Jr.
 35   1998  Libera Jr    Donald P.      22098     020019303-9        $6,513.41  Robert           Travel Voucher-
                                                                                 Macintosh Jr.    Silk Air
 36   1998  Libera Jr    Donald P.      22398     020019302-1        $7,714.14  Greg Phillips    Travel Voucher
 37   1998  Libera Jr    Donald P.      22398     020019299-4        $4,473.88  Malcolm Brenner  Travel Voucher
 38   1998  Libera Jr    Donald P.      22498     020019301-2        $6,297.40  Scott Warren     Travel Voucher
 39   1998  Libera Jr    Donald P.      22598     020019297-6        $2,938.00  Richard Parker   Travel Voucher
 40   1998  Libera Jr    Donald P.      31098     020019309-3        $6,692.20  Barry Sweedler   Travel Voucher
 41   1998  Libera Jr    Donald P.      31198     020019307-5        $3,411.66  Robert Francis   Travel Voucher
 42   1998  Libera Jr    Donald P.      31198     020019306-6        $3,288.47  Deborah Smith    Travel Voucher
 43   1998  Libera Jr    Donald P.      31298     020019308-4        $2,602.25  Denise Daniels   Travel Voucher
 44   1998  Libera Jr    Donald P.      32598     020019312-9        $5,233.23  James Hall       Travel Voucher
 45   1998  Libera Jr    Donald P.      32798     020019310-2        $4,403.19  Jerome           Travel Voucher
                                                                                 Trachette
 46   1998  Libera Jr    Donald P.      40198     020019311-1        $3,548.83  Paul Weston      Travel Voucher
 47   1998  Libera Jr    Donald P.      40998     020019317-4        $5,326.21  Thomas Haueter   Travel Voucher
 48   1998  Libera Jr    Donald P.      40998     020019314-7        $5,237.61  Deborah Smith    Travel Voucher
 49   1998  Libera Jr    Donald P.      41398     020019319-2        $6,260.06  Robert Hilldrup  Travel Voucher
 50   1998  Libera Jr    Donald P.      41398     020019316-5        $4,918.46  John Goglia      Travel Voucher
 51   1998  Libera Jr    Donald P.      41498     020019320-1        $3,175.35  Thomas Conroy    Travel Voucher
 52   1998  Libera Jr    Donald P.      41798     020019322-8        $4,655.14  Gregory A.       Travel Voucher
                                                                                 Feith
 53   1998  Libera Jr    Donald P.      42098     020019326-4        $9,157.86  Robert Francis   Travel Voucher
 54   1998  Libera Jr    Donald P.      42798     020019321-9        $5,272.43  Evan Byrne       Travel Voucher
 55   1998  Libera Jr    Donald P.      42898     020019329-1        $6,785.50  Scott Warren     Travel Voucher
 56   1998  Libera Jr    Donald P.      42998     020019327-3        $4,387.70  James Pericola   Travel Voucher
 57   1998  Libera Jr    Donald P.      43098     020019332-7        $6,881.87  James Hall       Travel Voucher
 58   1998  Libera Jr    Donald P.      50898     020019331-8        $5,317.69  Gregory          Travel Voucher
                                                                                 Salottolo
 59   1998  Libera Jr    Donald P.      51398     020019335-4        $5,644.60  Robert Francis   Travel Voucher
 60   1998  Libera Jr    Donald P.      51398     020019333-6        $3,395.27  Ronald Robinson  Travel Voucher
 61   1998  Libera Jr    Donald P.      60998     020019337-2        $6,473.44  Gregory Feith    Travel Voucher
 62   1998  Libera Jr    Donald P.      61598     020019340-8        $2,839.83  Robert Francis   Travel Voucher
 63   1998  Libera Jr    Donald P.      62298     020019341-7        $5,000.00  Gregory Feith    Advance for
                                                                                                  Travel
 64   1998  Libera Jr    Donald P.      62998     020019342-6        $3,597.08  Gordon Hookey    Travel Voucher
 65   1998  Libera Jr    Donald P.      81398     020019345-3        $6,309.77  James Hall       Travel Voucher
 66   1998  Libera Jr    Donald P.     100197     020019057-3        $8,816.11  Gary K. Abe      Travel Voucher
 67   1998  Libera Jr    Donald P.     100297     020019059-1       $14,466.36  Gregory Feith    Travel Voucher
 68   1998  Libera Jr    Donald P.     100397     020019058-2        $2,995.47  Gary K. Abe      Travel Voucher
 69   1998  Libera Jr    Donald P.     100797     020019062-7        $3,156.32  American         Airfare RE
                                                                                 Express
 70   1998  Libera Jr    Donald P.     100797     020019064-5        $2,694.00  Rivy Cole        Travel Voucher
 71   1998  Libera Jr    Donald P.     100897     020019063-6        $4,830.44  Peter Goelz      Reimbursement
 72   1998  Libera Jr    Donald P.     100997     020019066-3        $6,476.75  Woodfield        employee
                                                                                 Suites           accomodations
 73   1998  Libera Jr    Donald P.     101097     020019056-4        $4,089.87  Richard parker   Travel Voucher
 74   1998  Libera Jr    Donald P.     101497     020019068-1        $2,822.63  Gregory Feith    Travel Voucher
 75   1998  Libera Jr    Donald P.     102297     020019074-4        $4,089.87  Richard B.       Travel Voucher
                                                                                 Parker
 76   1998  Libera Jr    Donald P.     102497     020019252-6        $8,904.04  Lawrence D.      Travel Voucher
                                                                                 Roman
 77   1998  Libera Jr    Donald P.     102797     020019255-3        $2,709.00  Barry Sweedler   Travel Voucher
 78   1998  Libera Jr    Donald P.     110697     020019258-9        $5,516.21  Robert m.        Travel Voucher
                                                                                 Macintosh
 79   1998  Libera Jr    Donald P.     110797     020019259-8        $3,269.50  Linda Jones      Travel Voucher
 80   1998  Libera Jr    Donald P.     111297     020019260-7        $2,516.60  Richard J.       Travel Voucher
                                                                                 Wentworth
 81   1998  Libera Jr    Donald P.     111897     020019263-4        $5,386.47  Jim Hall         Travel Voucher
 82   1998  Libera Jr    Donald P.     111897     020019261-6        $2,723.47  Gregory          Travel Voucher
                                                                                 Phillips
 83   1998  Libera Jr    Donald P.     112497     020019264-3        $5,176.33  Jamie Finch      Travel Voucher
 84   1998  Libera Jr    Donald P.     120997     020019267-9        $3,577.05  Dennis Grossi    Travel Voucher
 85   1998  Libera Jr    Donald P.     121997     020019273-3        $3,339.19  Jerome           Travel Voucher
                                                                                 Frechette
 86   1998  Libera Jr    Donald P.     122297     020019270-6        $2,821.60  Robert Francis   Travel Voucher
 87   1998  Libera Jr    Donald P.     122397     020019272-4        $3,212.69  Paul Misenick    Travel Voucher
 88   1998  Libera Jr    Donald P.     122697     020019280-5        $3,789.36  Ronald Schlede   Travel Voucher
 89   1998  Libera Jr    Donald P.     122997     020019271-5        $2,699.65  Kenneth Egge     Travel Voucher
 90   1998  Libera Jr    Donald P.     123197     020019278-7        $2,738.41  Deborah Smith    Travel Voucher
 91   1999  Libera Jr    Donald P.     040899       030400001        $8,202.13  James E. Hall    Travel Voucher
 92   1999  Libera Jr    Donald P.     112398       010030512        $2,799.47  Tom Conroy       Travel
                                                                                                  Reimbursement
 93   1998  Mills        William J.     81798     020033326-8        $4,070.00  James V.         Travel Voucher
                                                                                 Roberts
 94   1998  Mills        William J.     81798     020033327-7        $3,232.54  Michael T.       Travel Voucher
                                                                                 Brown
 95   1998  Mills        William J.     82898     020033328-6        $2,979.07  George Black     Travel Voucher
 96   1998  Mills        William J.     90298     020033330-4        $3,003.80  Paul Alexander   Travel Voucher
 97   1998  Mills        William J.     90998     020033331-3        $4,435.76  Paul Misenick    Travel Voucher
 98   1998  Mills        William J.     91198     020033332-2        $2,780.02  Dennis L. Jones  Travel Voucher
 99   1998  Mills        William J.     92298     020033337-6        $4,693.43  Alfred           Travel Voucher
                                                                                 Dickinson
100   1999  Mills        William J.    020599       020033362        $6,474.24  Robert Francis   Travel Voucher
101   1999  Mills        William J.    031799       020033365        $2,980.77  Deepak Joshi     Travel Voucher
102   1999  Mills        William J.    100898       020033343        $3,902.65  Paul Misenick    Travel Voucher
103   1999  Mills        William J.    101398       020033350        $2,737.00  James Hall       Travel Voucher
104   1999  Mills        William J.    101498       020033345        $2,576.77  Ronald Schlede   Travel Voucher
105   1999  Mills        William J.    101998       020033347        $4,720.01  Robert Francis   Travel Voucher
106   1999  Mills        William J.    102298       020033351        $4,571.66  John Goglia      Travel Voucher
107   1999  Mills        William J.    102798       020033352        $3,025.17  Deepak Joshi     Travel Voucher
108   1999  Mills        William J.    111998       020033353        $2,783.64  James Hall       Travel Voucher
109   1999  Mills        William J.    112598       020033357        $2,934.07  Dave Tew         Travel Voucher
110   1999  Mills        William J.    112598       020033356        $3,381.28  Dave Tew         Travel Voucher
111   1999  Mills        William J.    120998       020033360        $3,962.12  Robert Francis   Travel Voucher
112   1999  Mills        William J.    121198       020033358        $2,530.54  Paul D. Weston   Travel Voucher
113   1999  Mills        William J.    122198       020033361        $2,583.54  James Hall       Travel Voucher
114   1999  Mills        William J.    073099       020033372        $3,154.17  James Hall       Travel Voucher
115   1997  Thomas       Laura J.       63097     020018153-7        $2,604.10  American         Airfare RE
                                                                                 Express
     .....  ...........  ...........  .......  ..............      $515,396.10  TOTAL TRAVEL     115 DRAFTS
                                                                                 REIMBURSEMENT
================================================================================================================
116   1996  Caldwell     Alice         100296     020005696-8        $2,772.00  Training 2000    Registration
                                                                                 MITAGS
117   1997  Libera Jr    Donald P.      71897     020001230-1       $14,907.13  Capital Hill     Invoice
                                                                                 Reporting
118   1997  Libera Jr    Donald P.      80697     020001232-8       $23,412.29  Jacksonville     Invoice
                                                                                 Hilton and
                                                                                 Towers
119   1997  Libera Jr    Donald P.      81897     020001240-9       $17,000.00  John Davis       Attorney
120   1997  Libera Jr    Donald P.      81997     020001233-7       $19,723.77  Metrocall        pager bill
121   1997  Libera Jr    Donald P.      81997     020001239-1        $5,785.19  Tharpe Company   purchases
122   1997  Libera Jr    Donald P.      82097     020001238-2       $12,705.00  Dupage Airport   Invoice
                                                                                 Authority
123   1997  Libera Jr    Donald P.      82097     020001241-8        $8,304.31  Proctor          Invoice
                                                                                 Electric
124   1997  Libera Jr    Donald P.      82597     020001244-5       $11,267.20  Paul Schlamm     service
125   1997  Libera Jr    Donald P.      82797     020001242-7       $22,407.00  Tratech          equipment
                                                                                 International
126   1997  Libera Jr    Donald P.      82797     020001243-6        $3,982.17  Nelson           Invoice
                                                                                 Marketing
127   1997  Libera Jr    Donald P.      90297     020001247-2        $7,000.00  Office of        HWY41
                                                                                 Coroner,
                                                                                 Washington Cty
128   1997  Libera Jr    Donald P.      90897     020019004-2        $4,530.46  MicroWarehouse   purchase
129   1997  Libera Jr    Donald P.      90897     020001246-3        $4,500.00  Brave Audio      Hearing
                                                                                 visual, Inc.
130   1997  Libera Jr    Donald P.      90997     020001248-1        $8,721.15  Embassy Suites   Hearing rooms/
                                                                                 Hotel            Audiovisual
                                                                                                  equip
131   1997  Libera Jr    Donald P.      91097     020001250-8       $20,500.00  G.W. Hoch, Inc   Comm Ctr A/C
132   1997  Libera Jr    Donald P.      91097     020019012-3       $20,000.00  J.D. Rainbolt    PO-5th Fl
                                                                                                  renovation
133   1997  Libera Jr    Donald P.      91097     020019013-2        $4,272.00  Spirit           Rewire 5th Fl
                                                                                 Telecommunicat
                                                                                 ions
134   1997  Libera Jr    Donald P.      91597     020019023-1       $13,359.20  KEV Corporation  6th floor
                                                                                                  renovations
135   1997  Libera Jr    Donald P.      91597     020019022-2        $7,000.00  System Safety    Accident
                                                                                 Development      Investigation
                                                                                                  Workshop
136   1997  Libera Jr    Donald P.      91797     020019021-3       $13,000.00  Boeing           Modifications
                                                                                 Commercial       to B-727
                                                                                 Airplane group
137   1997  Libera Jr    Donald P.      91997     020019024-9       $20,000.00  J.D. Rainbolt    5th floor
                                                                                                  renovations
138   1997  Libera Jr    Donald P.      92297     020019051-9       $13,357.00  KEV Corporation  6th floor
                                                                                                  renovations
139   1997  Libera Jr    Donald P.      92997     020019053-7        $2,800.00  Spirit           RE Installation
                                                                                 Telecommunicat   5th&6th
                                                                                 ions
140   1997  Libera Jr    Donald P.      93097     020019054-6        $2,918.16  GES Exposition   Oshkosh Exhibit
                                                                                 Services
141   1998  Libera Jr    Donald P.      10798     020019281-4        $3,996.64  Phillip          Photograph TWA
                                                                                 Humnicky         800 Hearing in
                                                                                                  Baltimore
142   1998  Libera Jr    Donald P.      10898     020019284-1        $3,875.00  Federal          Partition RM
                                                                                 Construction     6100 and paint
                                                                                 contractors
143   1998  Libera Jr    Donald P.      11498     020019285-9        $9,459.00  Mitech Data      NEC Laptops
                                                                                 Systems
144   1998  Libera Jr    Donald P.      21198     020019294-9        $5,055.60  Southwestern     Bill for TX
                                                                                 Bell             Sept-Nov
145   1998  Libera Jr    Donald P.      22098     020019298-5        $9,375.00  Federal          PO
                                                                                 Construction
                                                                                 Contract
146   1998  Libera Jr    Donald P.      30998     020019304-8        $5,000.00  Donald H.        TWA 800
                                                                                 Mershon,PHD
147   1998  Libera Jr    Donald P.      30998     020019305-7        $3,690.00  Ocngressional    PO
                                                                                 Quarterly, Inc
148   1998  Libera Jr    Donald P.      42798     020019324-6        $2,900.00  DOD Joint        Invoice
                                                                                 Spectrum
                                                                                 Center
149   1998  Libera Jr    Donald P.      61198     020019338-1        $5,794.70  Southwestern     Bill for TX
                                                                                 Bell             office
150   1998  Libera Jr    Donald P.      61198     020019339-9        $2,678.70  Southwestern     Bill for TX
                                                                                 Bell             office April
                                                                                                  98-May 98
151   1998  Libera Jr    Donald P.      90898     020019346-2       $11,510.00  J&H Marsh &      Travel
                                                                                 McLennan, Inc    Insurance
152   1998  Libera Jr    Donald P.      93097     020019054-6        $2,918.16  GES Exposition   Oshkosh Exhibit
                                                                                 Services
153   1998  Libera Jr    Donald P.     100397     020019055-5        $2,800.00  General Testing  AZ accident,
                                                                                 Laboratories     Testing of
                                                                                                  school bus
                                                                                                  windows
154   1998  Libera Jr    Donald P.     100697     020019061-8       $17,400.00  Graduate         Procurement
                                                                                 School, USDA     Training
155   1998  Libera Jr    Donald P.     100697     020019065-4       $10,000.00  KEV Corporation  6th Floor
                                                                                                  renovation
156   1998  Libera Jr    Donald P.     101797     020019067-2       $24,461.00  J. D. Rainbolt   5th floor
                                                                                                  renovations
157   1998  Libera Jr    Donald P.     101797     020019071-7        $6,739.75  Campbell Carpet  Install carpet/
                                                                                 Service          GAPAFA
158   1998  Libera Jr    Donald P.     101797     020019073-5        $3,730.75  Spirit           install video
                                                                                 Telecommunicat   cable/GAPAFA
                                                                                 ions
159   1998  Libera Jr    Donald P.     102097     020019072-6       $28,532.25  Loew's L'Enfant  Board Meeting
                                                                                 Plaza
160   1998  Libera Jr    Donald P.     102297     020019075-3        $5,980.00  S.P.Bryant       Refinish
                                                                                                  furniture
161   1998  Libera Jr    Donald P.     102397     020019253-5        $5,657.18  Capital Hill     Invoice
                                                                                 Reporting, Inc
162   1998  Libera Jr    Donald P.     102397     020019070-8        $3,278.50  Graebel          contract movers/
                                                                                 Companies        supplies
163   1998  Libera Jr    Donald P.     102997     020019254-4        $3,912.86  Oceaneering      TWA 800
                                                                                 International
164   1998  Libera Jr    Donald P.     110697     020019256-2       $12,000.00  KEV Corporation  6th Floor
                                                                                                  renovation
165   1998  Libera Jr    Donald P.     111097     020019262-5       $16,403.80  KEV Corporation  6th floor
                                                                                                  renovations
166   1998  Libera Jr    Donald P.     111097     020019257-1        $7,890.00  J.D. Rainbolt    5th renovations
167   1998  Libera Jr    Donald P.     112597     020019265-2        $3,495.00  George           J. Finch CED
                                                                                 Washington       program
                                                                                 University
168   1998  Libera Jr    Donald P.     121897     020019276-9        $3,714.50  American         TWA 800 Hearing
                                                                                 Relocation       Invoice
169   1998  Libera Jr    Donald P.     122497     020019275-1        $3,910.00  American         Invoice
                                                                                 Relocation
170   1998  Libera Jr    Donald P.     123197     020019279-6       $20,917.41  Miami Airport    Invoice
                                                                                 Hilton &
                                                                                 Towers
171   1999  Libera Jr    Donald P.     012799       020019350        $2,957.50  Susan T.         Conduct Psych/
                                                                                 Strahan, MD      Employment
                                                                                                  Examination
172   1999  Libera Jr    Donald P.     100598       020019348       $11,076.00  Hyatt Regency    Speaker's
                                                                                 Hotel            Accomodations
                                                                                                  26 Rooms
173   1999  Mills        William J.    101998       020033344        $3,013.26  Elizabeth        Kinko Cop.
                                                                                 Cotham           Symp98
174   1997  Fenwick      Angela C.      21897     020006368-2        $2,833.92  Digital          VAX Maintenance
                                                                                 Equipment
                                                                                 Corp.
175   1999  Patel        Seema         022699       020032545        $2,826.00  RSPA Mike        Training
                                                                                 Moroney Center   Tuition
     .....  ...........  ...........  .......  ..............      $554,006.51  TOTAL PURCHASES  60 DRAFTS
================================================================================================================
176   1999  Libera Jr    Donald P.     011999       020019349        $3,719.56  Donna M.         Advance payment
                                                                                 Seipler          for amounts
                                                                                                  due
177   1998  Libera Jr    Donald P.      93098     020019347-1        $4,000.00  William P.       Advance for
                                                                                 Fannon           salary
     .....  ...........  ...........  .......  ..............        $7,719.56  TOTAL OTHER      1 DRAFT
================================================================================================================
     .....  ...........  ...........  .......  ..............    $1,077,122.17  TOTAL OVER       177 DRAFTS
                                                                                 $2500
----------------------------------------------------------------------------------------------------------------

    Mr. Knollenberg. How many instances of split invoices are 
you aware of?
    Mr. Mead. We are aware of two.
    Mr. Knollenberg. Two.
    Mr. Mead. Two instances where purchases over $2,500 were 
simply submitted to avoid the Federal regulations. There may be 
more, but these are the ones that turned up in our sample.
    Mr. Knollenberg. There were copies of all the checks that 
were made available. Five checks on one day to--there is five, 
I believe. They were made on the same day, as I remember. That 
is a little bit strange. Was that done obviously to conceal 
exceeding the 2,500 limit?
    Mr. Mead. Yes, well, what was happening here was you buy 
the same thing but to stay under the ceiling you simply write 
multiple checks that, added together, equal the purchase price.
    Mr. Knollenberg. One of these is Tratech. Another one, was 
it Skill--Skillcraft, I believe it was. I think there were five 
made in one day. That is kind of strange.
    Mr. Mead. One was for computers. I think the other was for 
training.
    Mr. Knollenberg. Mr. Chairman, how is my time here?
    Mr. Hall. We will be glad for the record to get you 
whatever information the Board has on those five checks.
    Mr. Knollenberg. I appreciate that.
    [The information referred to follows:]

Response From Director Hall to Query By Mr. Knollenberg About Specific 
                             Split Invoices

    There were a total of four Rapidrafts that were involved in two 
split purchases with Tratech that were reported by the Inspector 
General in their investigative report.
    There were two rapidrafts issued on February 5, 1998, for $1,400 
each to pay an invoice for $2,800 that was dated February 4, 1998.
    There were two rapidrafts issued on July 7, 1999, for $2,047 and 
$2,338 respectively to pay for one facsimile machine purchased on June 
9, 1999, and 3 computers purchased on June 29, 1999.
    With regard to the question concerning Skillcraft, our research did 
not yield any information.

    Mr. Knollenberg. What I found too disturbing, and I am sure 
this has been talked about previously, but what were these 
expenditures for? In the indications of the copied checks, the 
photocopies, there is nothing there to say it was for carpet 
purchase or furniture refinishing or payroll advances. There 
wasn't a lot of disclosure. And I think that it becomes clear 
that there must have been suspicion that it was beyond the 
scope of the authority and for purposes other than what would 
normally be covered in the cost of business. Would you agree 
with that?
    Mr. Mead. Yes, in general, I would.
    Mr. Knollenberg. And I presume that these people that have 
been involved with some of the accounting are no longer on the 
job or are being oversighted in a fashion that would tell you 
that there won't be anymore of this?
    Mr. Mead. The former Chief Financial Officer who was 
incumbent during all times pertinent to this inquiry has 
resigned. Mr. Levine down at the end of the table is his 
successor. He has 35 years of experience. I have confidence 
that he is going to serve the Chairman, the Board and NTSB 
well.
    Mr. Knollenberg. Thank you.
    Just very quickly I will close with this: How did these 
authorized users obtain the Rapidrafts? Were they just about?
    Mr. Mead. Actually, the interesting thing, you think they 
would have to go in to the Chief Financial Officer and get 
them, but under the procedures they had set up you could call 
up the contractor and say, send me some checks, and he would 
send some checks.
    Mr. Knollenberg. We didn't use that in my business. I guess 
I was missing something. But that sounds like a pretty good 
deal do me.
    Well, I think that I will just close with the assurance 
that I am looking for is that those who had access in such an 
open fashion to these checks no longer have that access. Can we 
say that there is 100 percent security on that?
    Mr. Hall. Yes, sir. And we are bringing in an independent 
auditor. I would in a moment's notice bring the IG back in if I 
thought there was any difficulty. Mr. Levine has his orders, 
and his orders are if there is anything improper in any way 
that has been going on in the past is to change it and change 
it immediately.
    Mr. Knollenberg. Any talk about having an IG inside?
    Mr. Hall. We did have that conversation, sir, while you 
were out of the room, but we would be glad to respond depending 
on----
    Mr. Knollenberg. I think that concludes my questions.
    Thank you, gentlemen; and thank you, Mr. Chairman.
    Mr. Miller. Mr. Ryan and Mr. Sununu are headed back. I know 
Mr. Ryan has a few questions, so why don't we take a break for 
a few minutes until they arrive.
    [Recess.]
    Mr. Sununu [presiding]. In the interest of time, I am going 
to reconvene the hearing at this time.
    We have one additional member that would like to ask 
questions. I hope he arrives in a timely way. I am confident he 
will.
    I do have a few additional follow-up questions, and then we 
will try to adjourn the hearing in a timely way, because I know 
all of you gentlemen have important work to do.
    Mr. Mead, we talked a little bit about other agencies that 
are currently using third-party systems, some with Gelco, that 
was a subcontractor to NTSB, some with other third-party draft 
systems. And some discussion was made that perhaps it would be 
appropriate to audit some of those systems.
    My question for you is, given the experience of your 
investigators and auditors with the Rapidraft system at NTSB, 
what kind of an audit--what kind of a scope of an audit might 
you suggest that the committee seek in other agencies or 
departments where we might have questions about the nature of 
the program?
    For example, I am asking your recommendations with regard 
to time period. Is it best to look at a broad period, 2 or 3 
years, at a top-level audit? Should we look in depth at a month 
in the documentation, in the internal controls? What kind of 
guidance might you give this Task Force in making sound 
recommendations for looking at this system in other agencies?
    Mr. Mead. Well certainly we have a methodology that we know 
what questions to ask. And we know what answers you might get.
    I would suggest that if you were to ask other agencies to 
do such an audit, you would go back at least one year and ask 
for a description of the internal controls and whether they 
were in place, and we could actually itemize those for you. For 
example, do people sign the checks, what are they for, so forth 
and so on.
    I would also go back and ask for trend lines, say, going 
back about 4 or 5 years, about program usage so you could see 
the aberrations, if there were sharp aberrations, in program 
usage.
    I would also want to know about the management that was in 
place at all pertinent times for the program going back, say, 5 
years. And I say 5 years because Congress passed a law in 1995 
or 1996 that phased these programs out and said you should go 
to electronic fund transfers only in emergencies and so forth 
should you be using these third party drafts. So 1995 really 
marked a demarcation point. I would not go back before then.
    Mr. Sununu. Thank you.
    Mr. Hall, what kind of internal communication have you 
utilized in trying to make employees aware as appropriate of 
the results of this audit and the concerns regarding financial 
controls and are employees making a best effort to understand 
those controls but also to abide by them?
    Mr. Hall. Mr. Levine has presently underway a training 
program for all Board employees.
    Mr. Levine. Mr. Chairman, on March 2, almost 2 months after 
my arrival, we began training managers and employees. We have a 
power point presentation that I personally give, and I also 
include our labor-management relations specialist.
    We go over the events, we discuss the audit, we review the 
findings, and we go over the two credit card programs. We 
explain the dos and don'ts, and we explain management 
responsibilities.
    The first one I gave was to the office directors. All of 
them are getting management reports. There is no such thing as 
privacy when you use a government credit card.
    We have explained to them how to use it, what to look for. 
We also involved the labor-management relations people because 
there are cases of delinquent debt. But it is not debt owed to 
the government. It is debt owed by our employees who on their 
travel card have incurred charges and are not paying bills 
timely. That has labor-management relations implications as 
well. I have also briefed the employees of several offices.
    Mr. Sununu. If I may, you mentioned delinquent credit 
cards. Is that a problem right now within NTSB? Do you have an 
approximate number or percentage of the cards issued that may 
be delinquent at this time?
    Mr. Levine. Less than 10 percent at the last look. It has 
gotten better, actually.
    Mr. Sununu. I should ask for your definition of 
delinquency.
    Mr. Levine. Per Citibank's terms, it means they are over 60 
days delinquent in paying their bill.
    Mr. Hall. One of the other things I am trying to do is get 
a new travel agency, Congressman. What happens is that we end 
up with people getting things put on their card by hotels or 
because they changed plans because of sudden travel, and then 
it takes forever to get these items reimbursed. I have asked 
Mr. Levine to be very aggressive in that area, and we will be 
glad to provide you information on the record on the total 
amount.
    Mr. Sununu. Thank you.
    [The information referred to follows:]

     Review of Citibank Report On NTSB's Credit Card Delinquencies

    Citibank has issued 367 travel credit cards to our 
employees. A review of the latest Citibank report on 
delinquencies indicates that we have a 7 percent delinquency 
rate. Approximately 75 percent of the delinquencies are just 1 
month overdue. NTSB management officials are working with 
employees to get their accounts current.

    Mr. Sununu. Mr. Levine, how many employees have received a 
power point presentation and how many do you intend to present 
it to? I know that not--every single employee might not be an 
appropriate.
    Mr. Levine. I have made a presentation to the top 
management and the officer directors of every major mode. I 
have also made a presentation to three of the smaller offices, 
and I have presentations scheduled right now for three more. 
The regional directors for aviation are coming in this May, and 
I am scheduled to present to them as well. That is our biggest 
mode and that is where a lot of the travel occurs. To date, I 
can't put a percentage on it, sir, but by office I have had 
three of the seven major offices.
    Mr. Sununu. Will you have all seven completed by June?
    Mr. Levine. Yes sir. That is what the chairman wants, and 
that is what I am going to do.
    Mr. Sununu. I highly encourage to you do your best.
    Mr. Levine. Appreciate your encouragement.
    Mr. Hall. We are trying to move expeditiously, Congressman. 
As you may know, we have nine regional offices, stretching from 
Anchorage to Miami and covering the United States. I won't 
ensure that our new CFO gets to each one of those by June, but 
we have a priority right now in trying to brief our 
headquarters offices.
    Mr. Sununu. I understand. Perhaps you can follow up just 
for the record the detail of that schedule and just so that the 
Task Force has a sense of coverage. Because I think there is a 
great value, even if it is a presentation at a fairly high 
level, so that employees really understand what kind of an 
effort is being made and also they understand the value of the 
oversight that has been provided in this case by the Inspector 
General.
    Mr. Levine. Can I add one point of clarification, Mr. 
Chairman, that you may not be aware of?
    Citibank basically requires us to give very specific 
training on the purchase card and the use of it before that 
card is issued. And I have to say that NTSB--and this occurred 
before I arrived--made sure that all employees who received 
that card had to receive that training as well. So there was 
training in addition to what I have given.
    Mr. Mead. I would like to, in the interest of full 
disclosure in light of the conversation with Mr. Miller earlier 
and NTSB on this credit card delinquency point, this is not 
just an issue with NTSB. We are dealing with it at the 
Department of Transportation, too. We had roughly $3.6 million 
of delinquencies in the serious category a couple months ago; 
and the Assistant Secretary for Budget, the CFO, myself, the 
Deputy Secretary have all thought this is an area we need to 
pay attention to as well. Since February, we have had a marked 
reduction. We are down to $2.9 million, but we still have a 
ways to go. So NTSB is not in this swimming pool all alone.
    Mr. Sununu. I appreciate that clarification, Mr. Mead.
    Mr. Levine, I certainly believe this is a question best 
addressed to you. Can you tell me, before the system that you 
have in place now, and perhaps the system that was or was not 
in place previously, how did you track property and equipment, 
not just furniture but, most importantly, electronic equipment, 
computers and information systems themselves?
    Mr. Levine. I am not sure I have a good answer here, so I 
need to look over to my managing director and check.
    Mr. Campbell. The reason Mr. Levine is hesitating is that 
the inventory system is not within his control, and marrying up 
the inventory system and the financial system is one of the 
projects that we have under way.
    Mr. Sununu. Once the FMS recommendations are implemented, 
will the inventory control system be part of the Mr. Levine's 
jurisdiction?
    Mr. Campbell. It will be part of the same data base. The 
way that the property system works now, when property is 
brought into the building, it is identified as NTSB property 
and tagged as such as it is in an inventory system. What we do 
not presently have is a marrying between the acquisition 
document and the inventory document.
    Mr. Sununu. I believe Mr. Levine gave a rough time line for 
completing the implementation of the goals set out by the FMS 
review and some of the additional goals of the Inspector 
General's recommendations of perhaps completing by the end of 
this year. My question for Chairman Hall is, given that time 
line, when do you expect to and when have you set a goal for 
having a clean audit completed?
    Mr. Hall. I would hope we could have a clean audit at the 
end of fiscal year 2001. That is my goal. I want to do 
everything I can so that my successor at this agency doesn't 
experience the same situation I have. I think the best way to 
do that is to be sure that this agency annually can produce a 
clean audit. And now I have given Mr. Levine all these 
responsibilities, and I have got to get him some more people to 
help him perform his responsibilities.
    Mr. Campbell. If I might, Mr. Chairman, one of the issues 
that we have asked PriceWaterhouseCoopers to look at is the 
degree of readiness that we have for such an audit and to tell 
us what it is that we would necessarily have to do. Depending 
upon what they come back with in terms of readiness or the lack 
thereof, we will probably pick the earliest possible target 
date. If it could be this year, it is this year; if it is next 
year, it is next year.
    But we have to have an independent auditor come to us and 
say these are the deficiencies and these are the needs within 
your existing system that will produce such a possibility. As I 
mentioned once before, the first order of business was to 
relook at the Gelco Rapidraft issue in terms of whether there 
is any continuing liability there; and the second order of 
business is to put us on the path for a clean audit.
    Mr. Sununu. Thank you.
    Mr. Hall. I know you read my testimony. That was where I 
was trying to head with the Treasury in 1997, 1998, because at 
that time I was told we couldn't get a clean audit without 
redoing our financial house. I am committed to that, and I hope 
it will happen very soon.
    Mr. Sununu. Mr. Mead, the various responsive or the various 
remedial actions that NTSB has undertaken and outlined, are 
they responsive to the recommendations in your report? And I 
mean that in two ways.
    One, of course, specifically, are you comfortable with what 
they have outlined and set for goals to respond to the results 
of your audit? More generally, are there any areas that are of 
concern for you that it would be difficult for them to achieve 
the goals of your report even if those remedial actions are 
implemented? In other words, are there objectives or problems 
that you see that--areas where we will need continued oversight 
in any agency? In other words, it is not just necessarily a 
problem with their inventory management system or 
reconciliation process, but they are just, in your opinion, 
going to continue to be problem areas?
    Mr. Mead. I would have to say that the termination of the 
Rapidraft program, the hiring of PriceWaterhouse, the 
installation of a new CFO and the broad front of actions that 
have been articulated as planned are responsive and should take 
care of the problem.
    Now, there is a lot planned, and so the key is going to be 
in their implementation. You know, earlier--I think you were in 
the hearing room--Congressman Miller said, well, it is not just 
the Rapidraft that is the problem, it is a deeper issue. And he 
is right. Because if we don't deal with some of these other 
internal control issues such as reconciling payments you could 
have a recurrence of this sort of thing with credit cards. So I 
think their ship is headed in entirely the right direction. The 
key is going to lie in the implementation. And you are 
absolutely right. This is the type of situation you can find at 
almost any agency.
    Mr. Sununu. Thank you.
    Finally, I believe, as a result of this, it would be in our 
best interest to have you audit the system as it exists or was 
used in FAA and at the Volpe Center within the Department of 
Transportation. And I anticipate that we will be making a 
formal--as a full committee--formal recommendation to you to do 
just that.
    Again, I appreciate all of your time.
    I want to yield to Mr. Ryan for his question period, and 
then we will adjourn forthwith. Mr. Ryan.
    Mr. Ryan. Thank you, Mr. Chairman. I would like to ask 
unanimous consent that my opening statement be included in the 
record.
    Mr. Sununu. Without objection.
    Mr. Ryan. Thank you.
    [The prepared statement of Mr. Ryan follows:]

Prepared Statement of Hon. Paul Ryan, a Representative in Congress From 
                         the State of Wisconsin

    Mr. Chairman, I am perplexed by the apparent financial 
mismanagement that has occurred over the last 18 years at the National 
Transportation Safety Board (NTSB). As I had the chance to read the 
Inspector General's report last night, I was shocked to find some of 
the ways that our tax dollars are being spent.
    In 1982, the NTSB set up the Rapidraft Payment System to provide 
investigators with a mechanism to pay authorized expenses associated 
with on-site investigations. This system allowed NTSB investigators to 
write checks, up to a $2,500 limit, for items such as tow trucks and 
crane rentals. The NTSB's Chief Financial Officer was put in charge of 
the system.
    In 1999, the NTSB's Rapidraft Payment System came under 
investigation by the Inspector General of the Department of 
Transportation. The results of the Inspector General's report were 
startling. By the Inspector General's account, the Rapidraft Payment 
System was turned into the CFO's personal playground at the taxpayers 
expense. In a random sample of one thousand FY99 Rapidrafts, the 
Inspector General found 902 noncompliant drafts. That's over 90 percent 
of the drafts, with many of these checks exceeding the $2,500 limit. 
Worse yet, the audit found that only 5 percent of the $3.6 million in 
allocated funds were used in on-site accident investigations. The 
results of the audit found that Rapidrafts were being used for such 
noncompliant expenses as:
     $731,000 for nonaccident related travel.
     $410,000 for tuition for training.
     $286,000 for nonaccident related equipment office 
supplies.
     More than 100 checks cashed at one DC liquor store.
     And the list goes on from there.
    In 1992, a similar audit of the RPS was conducted by the General 
Services Administration. The GSA audit found that 92 percent of the 
Rapidrafts issued in the first 9 months of Fiscal Year 1991 were 
improperly used. The NTSB took no appropriate actions at or since that 
time.
    All though the 1992 audit found significant weaknesses in the 
system's internal controls, they were not corrected. The Rapidraft 
Payment System may just as well have been called the Rapiddraft 
Profligate System. The Inspector General found that 37 of the 177 
authorized investigators that were approved to write these checks no 
longer work for the NTSB. Checks were paid without signatures, 
authorization numbers or explanations. The CFO did not reconcile these 
checks to ensure payments were authorized.
    Mr. Chairman, I think that any American citizen would find this 
kind of abuse offensive. Americans work hard for their money. As it is 
tax season, we are all reminded of the large portion that we pay in 
taxes every year. The average financial tax burden that the government 
imposes on an individual today is 33.5 percent of their income. In 
1999, Americans worked from January 1st until May 3rd to pay off their 
taxes. That's over 4 months that Americans work just to pay their 
taxes.
    Through the Inspector General's report of the NTSB, we are finding 
today that Americans worked hard to give entertainment money to NTSB 
workers. Americans worked hard to assign blank checks to former NTSB 
workers with no accountability. Americans have worked hard to provide 
computer upgrades to top NTSB officials to download questionable 
material. This is simply unacceptable.
    How does such a system become so poorly managed? Why weren't these 
obvious problems fixed after the 1992 audit? What other government 
agencies are using this Rapidraft Payment System? How many tax dollars 
are being wasted in these agencies because of improper oversight of the 
RPS? These are all questions that I hope are answered today.
    I do appreciate Inspector Meade and Chairman Hall for being here 
and testifying today. I also commend Chairman Hall for his willingness 
to request that Inspector General Meade audit the NTSB when he saw 
deficiencies in the system. I understand that an audit by the Inspector 
General was a voluntary move by Chairman Hall in response to widespread 
abuse of the financial accounting system.
    Mr. Chairman, it has come to my attention that the Department of 
Transportation has recently called for the end of the RPS system--not 
only for the NTSB, but for all related DOT agencies. I am disappointed 
that it took a Congressional hearing to end the eighteen years of fraud 
and abuse. Government agencies like the NTSB should be implementing new 
payment programs that meet its needs with appropriate controls built 
in. It's time for an end to these kind of slush funds.
    Weeding through government waste and abuse is serious business. For 
a government employee to waste taxpayers time is reprehensible, but for 
that employee to waste taxpayer's money is criminal. My staff and I 
take the responsibility of working for the American taxpayer very 
seriously. We work hard not to abuse the awesome power to which we have 
been entrusted. I expect nothing less from the NTSB, or any other 
government agency, than to hold them to that same standard.

    Mr. Ryan. Mr. Hall, I would like to go back to the 1992 GSA 
audit. In 1992, the General Services Administration found 
serious deficiencies in the management of the Rapidraft Payment 
System, including a lack of supporting documentation, that 
Rapidrafts were issued without proper authorization and that 
travel advances made with Rapidrafts were sometimes used for 
nontravel purposes and used to circumvent proper payroll 
procedures. In fact, the GSA found that as many as 92 percent 
of the Rapidrafts issued for travel purposes were not in 
compliance with NTSB internal controls.
    In response, the NTSB Comptroller identified specific 
solutions for correcting those deficiencies that the NTSB 
intended to implement.
    This was 1992. I know you weren't there then, and I know 
the people are new. But GSA did an audit in 1992. Why did it 
take so long for you to take action? What happened in 1992 that 
NTSB didn't do anything to follow up on that audit and why was 
that the case?
    Mr. Hall. Congressman, I want to be responsive to you and 
to this committee on all questions, but I must tell you, in all 
honesty, that I was not aware of that audit. My predecessor did 
not inform me of that. I was not aware of that audit until this 
whole matter came up in this year.
    Mr. Ryan. Who on your staff would have been aware of the 
audit?
    Mr. Hall. Mr. Keller, who is the individual that is no 
longer with us. I am sure there are other individuals. We could 
get that information for the record, but I don't know.
    The office at that time was structured differently, sir. We 
had an Office of Administration, and the Accounting Office was 
under the Office of Administration. The Accounting Office 
reported to the head of that office, who then reported to the 
managing director, who reported to the chairman.
    My concern, when I read the statute in Congress, was I was 
accountable. But there were three people in between me and the 
individual that was responsible for the proper accounting of 
the money. That was when I couldn't get good numbers. The 
second and third year I was there, I tried to move toward a 
reform of the system.
    [The information referred to follows:]

     Response From Director Hall to Queries By Mr. Ryan About 1992 
                              Deficiencies

    In 1992, GSA performed an audit for NTSB to evaluate the adequacy 
of administrative procedures and practices for travel at the agency. 
The audit found that: (1) travel advance documents were signed by 
officials with appropriate authority; (2) expense claims were within 
Federal limits; (3) required receipts were attached; (4) amounts 
claimed were accurate; and (5) travel vouchers were appropriately 
authorized and timely.
    However, the audit found problems with travel advance accounts 
(NTSB no longer uses a travel advance system and has not for some 
time), including a failure by NTSB to undertake periodic reviews of 
travel accounts balances. The audit also found that investigators had 
written rapiddrafts to cover travel expenses, though investigator 
authority was limited to on-scene purchases. Rapiddrafts for travel 
reimbursements were to be written only by NTSB designated imprest fund 
cashiers. Additionally, it was found that rapiddraft booklets were not 
always adequately secured or locked up. No fraud, waste, or theft was 
in any way intimated. Distribution of the GSA audit report indicates 
that three copies were delivered to the then Chairman of the agency, 
since departed.
    At the time of the report, financial management was undertaken by a 
division of the Office of Administration, which in turn reported to the 
Managing Director, a non-career appointee, who reported to the 
Chairman. As a practical matter, the Deputy Managing Director would 
have had day-to-day supervisory responsibility for the Office of 
Administration. None of these individuals are currently with NTSB. 
According to a memorandum dated November 16, 1992, the Chief of the 
Financial Management Division proposed to his immediate supervisor 
several remedial actions, apparently acceptable to the Director of the 
Office of Administration. Whether any of these actions were reported 
further up the management structure, I am unable to say.
    Factually speaking, NTSB did move away from the travel advance 
system that was the principal issue of criticism, and I am unaware of 
any present issue with investigators having subsequently written 
rapiddrafts to cover travel expenses. It would appear that the chief 
deficiencies stated in the 1992 audit resolved themselves, whether as a 
result of precautionary actions or simple changes in circumstances, 
again I cannot say with any certainty.
    I would add that NTSB has undergone an extensive administration 
reorganization that should help to prevent any repetition. All purely 
administrative functions now report directly to Managing Director. (The 
titles of Deputy Managing Director and Managing Director are now 
Managing Director and Executive Director, respectively.) Financial 
management has been removed from administration altogether, and, in 
accord with the principles of the Chief Financial Officer Act, a 
freestanding office reporting directly to the Chairman has been 
established. We did not hesitate to implement the recommendations of 
the DOT IG coming from the recent audit, and I am confident that NTSB 
follow-through will be exemplary.

    Mr. Mead. Here is something that I think--illuminating on 
that. After the General Services Administration filed its 
report back then, it was the IG from GSA, the incumbent, the 
fellow that was the chief financial officer who was then called 
the comptroller, same person, he wrote a memo and in it he said 
that he was going to write another memo reminding everybody not 
to do these things.
    Mr. Ryan. Was the content of that memo notifying employees 
about NTSB Order 46A and 1542?
    Mr. Mead. Yes, sir. And so--but we have been unable to 
establish whether in fact that was actually done. And, 
moreover, it has been our experience, and I am sure yours, that 
just issuing memoranda really doesn't do the trick.
    Mr. Ryan. So the GSA audit was conducted in 1992. They said 
92 percent of the Rapidrafts were for out-of-compliance check 
writing. And then the comptroller at that time, which is also 
the CFO, you are saying, may or may not have issued a memo to 
the staff reminding them of how to comply with the Rapidraft 
system. Is that the gist of what you are saying?
    Mr. Mead. He did write to his boss saying he was going to 
do these things. But we do not know whether in fact he actually 
did.
    Mr. Ryan. Are you looking at--your audit was a 3-year 
audit, from fiscal year 1997 through 1999. Have you looked at 
pre-fiscal year 1997 checks?
    Mr. Mead. No, sir.
    Mr. Ryan. Do you have them?
    Mr. Mead. No.
    Mr. Ryan. Do you know how much money has been appropriated 
within the agency to the Rapidraft system? Just the macro 
numbers of what had been appropriated to the Rapidraft system 
from 1992 to 1997? Because I know you know what money was 
deposited into Rapidraft system for fiscal year 1997, 1998, 
1999. What about 1992 to 1997?
    Mr. Mead. No, I don't know. All I can say is that the 1997, 
1998, 1999 patterns are similar. I do not know if the trend 
existed before that time.
    Mr. Ryan. Mr. Hall, do you have access to the data that 
would show us how much money was ultimately passed through the 
Rapidraft system from 1992 to 1997?
    Mr. Hall. We would be glad to try and obtain that for the 
record, Congressman.
    Mr. Ryan. If you could, that would be helpful.
    [The information referred to follows:]

                TOTAL DOLLARS PAID THROUGH THE RAPIDRAFT SYSTEM AND THE NUMBER OF CHECKS WRITTEN
                                                  [Fiscal year]
----------------------------------------------------------------------------------------------------------------
                                                                                          Number of Rapidrafts
                        Fiscal year                                Dollar value                 written
----------------------------------------------------------------------------------------------------------------
1992......................................................              $1,202,580.57                      5,937
1993......................................................              $2,677,364.18                      7,929
1994......................................................              $1,398,778.13                      6,718
1995......................................................              $2,407,865.42                      7,685
1996......................................................              $2,824,574.71                      7,696
1997......................................................              $4,277,124.64                      8,836
                                                           -----------------------------------------------------
      Total...............................................             $14,788,287.65                     44,801
----------------------------------------------------------------------------------------------------------------

    Mr. Ryan. Mr. Mead, at your entire Department of 
Transportation Inspector General--I came late, so I know these 
questions may have been exhausted already--but it is my 
understanding that yesterday the Department of Transportation 
ceased all Rapidraft procedures as of yesterday, is that 
correct?
    Mr. Mead. Yes, sir. This subject did come up before. And 
based on the NTSB experience, our own audit of FAA previously, 
that Departmentwide instruction was issued yesterday that, as 
of May 10, they will no longer be used in the Department. The 
reason for the 30 days, I hasten to add, is because we have air 
traffic control facilities in the field we want to make sure 
that they have credit cards and they don't say, well, thanks 
for leaving us hanging.
    Mr. Ryan. How many Rapidraft systems were in place within 
the entire Department as of yesterday?
    Mr. Mead. I believe that there were two, FAA and the Volpe 
Center in Boston. The Federal Highway Administration I believe 
had discontinued it. I will correct that for the record if I am 
wrong. FAA had been spending, I think, about $15 million this 
past year; the Federal Highway Administration, $80,000; the 
Volpe Center, about 80 or 90,000. I think 40,000 checks at FAA.
    Mr. Ryan. Forty thousand at the FAA.
    Mr. Mead. In 1999.
    Mr. Ryan. What is the total dollar amount?
    Mr. Mead. About $15 million.
    Mr. Ryan. That is, again, the total budget? You are 
auditing that right now?
    Mr. Mead. No, but we soon will be.
    Mr. Ryan. I hope we look at other areas within the entire 
Federal structure where Rapidraft systems are employed. I think 
that is something that is a challenge for the committee here.
    I want to go back to in 1992. What is the procedure that 
occurs when another government agency like the GSA audits a 
program--what is the procedure that is in place today to make 
sure that those audits are actually recognized, that those 
audits are responded to, that the audits are acknowledged? What 
happens? I am just curious as to what happens when those audits 
come to you.
    Mr. Mead. Within the Department of Transportation over 
which we have jurisdiction, there is a requirement that they 
respond. In this case, where we didn't have the jurisdiction 
over NTSB, there is no requirement for follow through; and in 
the GSA case the GSA never follows up. In this case, there is 
follow up I think largely because of the relationship between 
the NTSB and us. But it is not a legal requirement, if you 
will.
    Mr. Ryan. So in your opinion--and I don't want to 
paraphrase for you, but this was discovered in 1992, these 
inherent flaws: room for embezzlement, over-the-limit 
expenditures, and noncompliant expenditures were known in 1992.
    Mr. Hall, when you found out, you put an end to it just 
this last year. Why do you think it took so long to find this 
out? And what went wrong in 1992? Is it simply that they went 
to one individual, which was at that time the CFO, who just let 
it die by the wayside? Then it cropped back up in 1999? Or what 
do you think, Mr. Mead, was the cause for that?
    Mr. Hall, please feel free to answer as well.
    Mr. Hall. Congressman, in fairness to the people, I don't 
know. Because I wasn't there, I don't know what they did. I 
don't want to respond to a question when I truly do not know 
the answer.
    Mr. Mead. What happens when we travel, we put it on a 
credit card. In order to get paid back, we have to fill out a 
form that says where we traveled, how much we spent. It has to 
be approved, goes into the system. The Department of the 
Treasury eventually cuts an electronic transfer to our personal 
bank account. And there is also a general audit made.
    That is, obviously, a more difficult procedure to get money 
from the U.S. Government than a procedure where you simply 
write a check to yourself and cash it. And if you have a system 
in place where you don't even have to sign the check or you 
don't have to put down the purpose, it is more expeditious. But 
I think we all know that we can't have a system like that in 
place in government and public service. So it is easier.
    Mr. Ryan. This question may have been asked as well, but I 
would like to hear from you Mr. Hall, as part of the Rapidraft 
Payment System NTSB maintained a $350,000 in a noninterest-
bearing account with Gelco. What efforts have NTSB undertaken 
to retrieve the $350,000 deposit since the Rapidraft system was 
stopped?
    Mr. Hall. That matter was covered, and that question 
responded to. I will be glad to have Mr. Levine respond again.
    Mr. Ryan. If you could respond.
    Mr. Levine. I became aware of the deposit about a month and 
a half into my tenure. I directed my people to go after Gelco. 
There are some issues dealing with float charges and 
outstanding charges. We intend to get that money very shortly.
    Mr. Ryan. Thank you.
    That is all, Mr. Chairman.
    Mr. Sununu. Thank you very much, Mr. Ryan.
    I want to thank all of our witnesses today for their time 
and for their candor. Should the Task Force have any additional 
requests for information, I want you to know that we will be 
mindful of the burden that is on you now with the work that you 
do every day. And, again, I appreciate the information that you 
provided that I believe has already made a difference in 
putting important focus on the way we disburse money in 
departments and agencies across the Federal Government; and for 
that you are to be congratulated.
    Thank you, all.
    The Task Force is adjourned.
    [Whereupon, at 12:40 p.m., the Task Force was adjourned.]


   Lack of Income Verification in HUD-Assisted Housing: The Need to 
                         Eliminate Overpayments

                              ----------                              


                         THURSDAY, MAY 25, 2000

                  House of Representatives,
                           Committee on the Budget,
                  Task Force on Housing and Infrastructure,
                                                    Washington, DC.
    The Task Force met, pursuant to call, at 10:05 a.m. in room 
210, Cannon House Office Building, Hon. John Sununu (chairman 
of the Task Force) presiding.
    Mr. Sununu. Good morning. I would like to start by thanking 
Congressman Bentsen and all the members of the Task Force for 
participating in this hearing and supporting the oversight 
hearings for which we are responsible in both housing and 
infrastructure. But also I would like to recognize and thank 
the Special Agents that are here today, Raymond Carolan and 
Emil Schuster of the U.S. Department of Housing's IG Office; 
Deputy Secretary Saul Ramirez, who has testified here before on 
behalf of the Department of Housing and Urban Development; and 
Ms. Sheila Crowley of the National Low Income Housing 
Coalition.
    I know you all have busy schedules. I appreciate your 
taking the time out to testify.
    Since its inception, the Section 8 housing assistance 
program has helped millions of American families find 
affordable housing. Through the Section 8 voucher and 
certificate programs, HUD provides rental subsidies which help 
over 1.4 million households in the United States.
    The subsidies are reserved only for very low-income tenants 
and are based on the amount of income the tenant earns. 
Typically, the tenant pays the rent capped at 30 percent of 
income, and HUD pays the remaining rental cost of the 
apartment.
    Obviously, determining a tenant's true income level is 
essential for the programs to operate not just efficiently, but 
fairly as well, because as we all know, the waiting list for 
these positions can be quite long.
    Unfortunately, there has been a long-standing problem at 
the Department of Housing and Urban Development in assuring 
that subsidy payments are made in the right amount to those 
eligible low-income tenants.
    Both the GAO and the HUD Inspector General's Office have 
determined that the systems in place ``do not provide 
reasonable assurance that subsidies paid under the programs are 
valid and correctly calculated, considering tenant incomes and 
contract rents.''
    Since 1996, the HUD Inspector General has reported that 
HUD's housing subsidy programs do experience improper payments 
when beneficiaries' income status changes and they do not 
notify housing authorities to adjust their benefits.
    HUD itself has estimated that approximately $935 million in 
excessive payments have been made in its Section 8 housing 
program for 1998. Had this $935 million been used to assist 
low-income tenants, it is estimated that approximately 150,000 
families could have been assisted with their housing needs. So 
this is not simply a budgetary problem, but it is also a 
fairness problem.
    We want to make sure within HUD that resources are made 
available to assist those that need help. Again, the waiting 
lists for many of these programs are quite long.
    In 1999, HUD developed an approach to use a large-scale 
computer-matching income verification process that would 
compare IRS and Social Security information and identify 
tenants who had underreported their income. In the first 
quarter of the year 2000, HUD used its new matching methodology 
to identify approximately 280,000 tenant households with income 
discrepancies. HUD then prepared letters to inform tenants of 
their responsibility to disclose their proper income and tax 
data to the Public Housing Authority, as well as notifications 
to the housing authorities themselves.
    Although the Department had originally planned to mail 
notification letters to all of these tenants with income 
discrepancies, it was decided to engage in a pilot program in 
Washington, DC. In February, about 900 letters were sent to 
tenants, which were not received well. As a result, the program 
was temporarily suspended.
    Our goal today is to attempt to shed light on the nature of 
the problems that were encountered early on with the 1995 
problem, understand what efforts the Department of Housing and 
Urban Development has made to solve the problems, and try to 
better understand the scope of the problem that the Inspector 
General's Office has been evaluating.
    We will hear testimony from the Office of Inspector 
General, explaining their understanding of the problem and 
talking about several real-world examples of how and why 
overpayments are made.
    In addition, we will hear testimony from the controller at 
HUD, who has responsibility for monitoring these finances, and 
hear about what steps HUD has taken to bring in the concerns of 
tenants and try to shed additional light on the tenants' 
perspective in these attempts to reduce the significant level 
of overpayments.
    I would like to recognize Congressman Bentsen for any 
remarks he might have.
    [The prepared statement of Mr. Sununu follows:]

Prepared Statement of Hon. John E. Sununu, a Representative in Congress 
                    From the State of New Hampshire

    Good morning. I'd like to start by thanking Congressman Bentsen and 
all the members of the Task Force for being here this morning. I'd also 
like to recognize and thank Special Agents Raymond Carolan and Emil 
Schuster of the U.S. Department of Housing and Urban Development's 
Office of Inspector General, Deputy Secretary Saul Ramirez, U.S. 
Department of Housing and Urban Development, and Ms. Sheila Crowley of 
the National Low Income Housing Coalition. I appreciate your taking the 
time out of your schedules to be here this morning.
    Since its inception the Section 8 housing assistance program has 
helped millions of American families to find affordable housing. 
Through the Section 8 voucher and certificate programs HUD provides 
rental subsidies which help over 1.4 million households in the United 
States. These subsidies are reserved only for very low-income tenants 
and are based on the amount of income the tenant makes. Typically, the 
tenant pays a rent capped at 30 percent of income, and HUD pays the 
remaining rental cost of the apartment.
    Clearly, determining a tenant's true income level is essential for 
the programs to operate properly and fairly. Unfortunately, there has 
been a longstanding problem at the Department of Housing in assuring 
that subsidy payments are made in the right amount to eligible low 
income tenants. Both the General Accounting Office and the HUD 
Inspector General's Office have determined that the systems in place 
now do not ``provide reasonable assurance'' that ''subsidies paid under 
these programs are valid and correctly calculated considering tenant 
incomes and contract rents.'' Since 1996, the HUD IG has reported that 
HUD's housing subsidy programs experience improper payments when 
beneficiaries income status changes and they do not notify housing 
authorities to adjust their benefits. In fact, HUD itself has estimated 
that $935 million in excessive payments have been made in its Section 8 
Housing program for 1998. Had this $935 million been used to assist 
eligible low income tenants, it is estimated that an additional 150,000 
families could have been helped.
    In 1999 HUD developed an approach to use a large-scale Computer 
Matching Income Verification Process to compare IRS and Social Security 
information and identify tenants who had under-reported their income. 
In the first quarter of 2000, HUD used its new matching methodology to 
identify 280,000 tenant households with income discrepancies. HUD then 
prepared letters to inform tenants of their responsibility to disclose 
their proper income and tax data to their Public Housing Authorities, 
as well as notifications to the PHA's themselves. Although the 
Department had originally planned to issue notification letters to all 
tenants with income discrepancies, it was decided instead to use the 
Washington, DC, Housing Authority as a preliminary test area. In 
February 2000, letters were sent to approximately 900 tenants. It is my 
understanding that these letters were received rather negatively, and 
as a result the Department has halted its income verification program.
    The purpose of this hearing will be to attempt to shed light on the 
nature of the problems in the income verification program, and the 
effort of the Department to solve these problems. The Task Force will 
hear testimony from two investigators from the HUD Inspector General 
Office explaining their understanding of the problem and relating real 
world examples of how and why the overpayments are made. In addition, 
we will hear testimony from the Controller at HUD who has 
responsibility for monitoring the finances at HUD. Finally, we will 
hear what steps HUD has taken and plans to take in the future, along 
with testimony from an advocate for tenants to bring light to their 
perspective on recent attempts to bring down these overpayments.
    I would now like to recognize Congressman Bentsen for any opening 
remarks he may have.

    Mr. Bentsen. Thank you, Chairman Sununu. I want to thank 
our panelists for being here, both the individuals from the 
IG's Office, as well as my fellow Texan, the Deputy Secretary, 
who, prior to becoming Deputy Secretary of HUD, had real power 
as the county judge of Webb County, Texas, and gave that up to 
come here to Washington; and also Ms. Sheila Crowley from the 
National Low Income Housing Coalition.
    Let me say, this Task Force of the Committee on the Budget 
is charged with investigating areas where there is either 
fraud, waste, or abuse in government programs. I think that 
there is strong bipartisan support among all members of the 
committee, as well as all Members of the House, that fraud and 
abuse in government programs with taxpayers' money should not 
be tolerated.
    That being said, I think we also--and as a member of the 
Committee on Banking and Financial Services, which has 
jurisdiction over HUD, we also must not lose sight of the fact 
that we do have a low-income housing crisis in America; that as 
strong as our economy has been, we still have tens of 
thousands, or more, Americans who are on waiting lists trying 
to get into assisted homes, assisted living, including in my 
district in the greater Houston area. It is something that we 
should be focused on.
    Additionally, as we have found through hearings on the 
Committee on Banking and Financial Services, while there is 
great concern, and I have great concern with respect to 
overpayments, we also have concerns about underpayments.
    This is a broad problem and a complicated program that has 
probably been somewhat more complicated with the passage of 
H.R. 2 a couple of years ago, which I was involved in drafting 
with Mr. Lazio and Mr. Frank and others, that changed some of 
the income rules and targeting rules and others in the Section 
8 program. So HUD is going through a transition with respect to 
that.
    Finally, I am eager to hear not only about the findings of 
the IGs and the methodology and how we might address this, but 
also about the income verification program that HUD has 
instituted, both in terms of HUD, as to how that is going; but 
also from the IG, your perspective on that as well, and how 
that might be made even better, given that it appears to be the 
first time this is even done.
    Finally, I think we must not lose sight of the fact that 
the clientele that we are talking about here are among the 
poorest of Americans, that there are many who are struggling 
their way up the rungs of the ladder; and we must be cautious 
in our diligence to root out fraud and abuse not to lose sight 
of the fact that many of these individuals may not share the 
technical expertise that those of us in the Washington realm 
do--and we should be cautious in that regard.
    Mr. Chairman, thank you for holding this hearing. I look 
forward to participating in it. I yield back the balance of my 
time.
    Mr. Sununu. Thank you, Mr. Bentsen.
    I would like to begin with the testimony from the Office of 
Inspector General, and once we have completed that testimony, I 
would ask that you gentlemen literally just slide down to one 
side of the table so we can have all of the testimony presented 
from Ms. Crowley and Mr. Ramirez before we get to questions.
    Then if the four of you can participate in the question-
and-answer session, we will have questions from both me and Mr. 
Bentsen, but hopefully in a somewhat informal way; and you 
should feel free during that question period to make any points 
that you think are relevant, even if the questions are not 
necessarily directed to you, because our interest is in 
presenting as much information here as we can in what is, 
unfortunately, a short amount of time.
    Mr. Schuster, I would appreciate your testimony. I yield to 
you for whatever time you might need.

    STATEMENT OF EMIL J. SCHUSTER, SPECIAL AGENT IN CHARGE, 
 SOUTHEAST/CARIBBEAN FIELD OFFICE OF THE HUD INSPECTOR GENERAL

    Mr. Schuster. Thank you. Good morning.
    Chairman Sununu and Congressman Bentsen, I appreciate the 
opportunity to be here before you this morning to provide a 
little bit of insight on what the Office of Investigations for 
the Office of Inspector General of HUD does as far as tenant 
fraud.
    I ask that my full written statement be included in the 
record.
    Mr. Sununu. Without objection.
    Mr. Schuster. My knowledge of this issue is based on the 
9\1/2\ years I have been in charge of the HUD Office of 
Inspector General, Office of Investigations Southeast/Caribbean 
District in Atlanta, Georgia.
    We, like many in the IG community, have limited resources. 
Because of that, it is essential to set strict priorities in 
their use. These priorities are affected in large measure by 
the prosecutorial guidelines set by the various U.S. Attorneys.
    There is generally a minimum dollar threshold on fraud 
charges in each judicial district. For example, it might be 
$10,000, or it could be as high in some districts as $100,000. 
In addition, each district might have their own set of 
priorities, so the priorities in, for example, Miami may be far 
different than in Memphis, Tennessee.
    Nonetheless, there are deviations from these minimums when 
circumstances are so heinous that criminal prosecution is 
called for. Because of these limitations, our investigations 
leading to the prosecution of tenant fraud in the Southeast 
District have averaged approximately only five per year.
    To further clarify our addressing of tenant fraud, I would 
like to use an interview question I pose to recent college 
graduates who are applying for Special Agent positions.
    I explain to the person that a complaint is received and 
that a Section 8 tenant, identified as Mary Doe, is defrauding 
HUD by not disclosing income she is receiving from a part-time 
job. You conduct an investigation and find the following: Mary 
Doe has been working part-time at McDonald's for the past year. 
She has three elementary schoolchildren.
    From the interviews, it appears that she is simply trying 
to earn some extra money to buy new school clothes, shoes, et 
cetera, for her children. She has not disclosed this additional 
income, and thereby has defrauded HUD out of $1,000 this past 
year.
    How do we handle this?
    The answer I look for is that this is not a prosecutable 
criminal case. Rather, this is the type of situation that we 
would refer back to the Housing Authority and/or the HUD 
program staff, recommending that they take some type of 
appropriate administrative action.
    The purpose of this question is to show that not every 
fraudulent act warrants criminal prosecution. Judgment is 
needed, especially with limited resources.
    Now, having identified the type of case that would 
generally not be pursued, I would like to describe several 
specific cases where we have undertaken investigations, alone 
or with other law enforcement agencies, that have led to 
successful prosecutions. We will often work with the Department 
of Health and Human Services IG, or Secret Service, or any of 
the various other IGs in looking at fraud.
    Example number one is Nashville, TN, an IRS employee we 
prosecuted for falsifying her income in order to obtain Section 
8 benefits. She failed to report her income she earned as an 
IRS employee. Her fraud resulted in a loss to HUD of over 
$15,000.
    Example number two, Memphis, TN. A Memphis Housing 
Authority employee conspired with the Shelby County Corrections 
Officer to create a fictitious Section 8 landlord and place the 
property into the Section 8 program. The corrections officer 
became the tenant, receiving the Section 8 assistance. The 
officer would then receive the Section 8 checks and forge the 
fictitious owner's signature, and they would split the money. 
They took in about $11,000 of HUD funds.
    In Campbellsville, KY, during a Safe Home operation--and 
this is our operation for violent crime in public and assisted 
housing; primarily we deal a lot with drug cases--we were 
investigating a situation with two people selling drugs in the 
Housing Authority developments.
    During the investigation, we discovered that one of the 
individuals was a Section 8 landlord who was renting to another 
individual, who was another person who was selling drugs. 
During the search warrant, we found that the landlord was 
living actually in the residence with the tenant.
    Now, this only amounted to fraud of just $1,070, but the 
Assistant United States Attorney [AUSA] decided to include this 
in the prosecution with the drug counts because of the 
heinousness of this situation.
    In Atlanta, GA, the defendant created false birth 
certificates in order to obtain four different Section 8 
subsidized apartments under fictitious names in Tennessee and 
Georgia. In addition, she received food stamps and welfare in 
each of the units. The loss to the government was over $15,000. 
This was one of the situations where we worked with the 
Department of Agriculture IG and the HHS IG.
    Then in Broward County, FL, 35 individuals were prosecuted 
for fraudulently obtaining over $300,000 in Section 8 
subsidies. The tenants were Nigerians, or spouses of Nigerians, 
who were in this country illegally or whose status had expired. 
The defendants were able to create false employers and have 
their verification of income forms sent to the post office 
boxes that they owned or were owned by Nigerian-owned 
businesses.
    Twelve of the defendants were employees of the Florida 
Department of Human Rehabilitation Services, HRS, which is a 
basic State entity which handles welfare payments in the State 
of Florida.
    Another side to this is, these people were making in the 
area of $35,000 to $40,000 per year as salary from the State of 
Florida. In addition, they were also receiving food stamps, 
AFDC, and educational grants that they were not entitled to 
receive.
    There are certain common threads that run through these 
prosecutable-type cases. A subject who is a city, State, or 
Federal employee will spark the interest of an Assistant United 
States Attorney. A subject who is defrauding other government 
programs, like food stamps or AFDC, likewise is seen as a good 
target. Another good subject would be a drug dealer, obviously.
    Of course, there are some whose actions are so flagrant 
that a jury would not hesitate to convict: for example, a 
subject who owns several rental houses, yet still claims 
Section 8 assistance.
    Another important aspect of this case is the deterrent 
value prosecution will bring. For example, if there is some 
notoriety attached to the case, the media will run a story 
which has a positive impact on making an applicant think twice 
about lying. These are all things that we consider before 
opening an investigation.
    We continue to receive allegations from a number of 
sources, and as I said, undertake approximately five 
investigations per year. Over the 9-plus years I have been in 
Atlanta, I have seen the same type of allegations occur and 
recur, understating income or failing to report jobs for the 
purpose of receiving a subsidized unit or a larger subsidy from 
HUD.
    As both resources and prosecutorial appeal exist, we 
investigate the most egregious cases. Any remaining allegations 
are referred to the Housing Authority and/or HUD program staff 
for administrative action, as appropriate.
    Mr. Chairman, that concludes my remarks. I would be happy 
to answer any questions following the testimony.
    Mr. Sununu. Thank you very much, Mr. Schuster.
    [The prepared statement of Mr. Schuster follows:]

   Prepared Statement of Emil J. Schuster, Special Agent in Charge, 
 Department of Housing and Urban Development, Office of the Inspector 
                 General, Southeast/Caribbean District

    Chairman Sununu and members of the Housing and Infrastructure Task 
Force, I appreciate the opportunity to appear before you today to 
provide insight on the investigation of tenant fraud as it relates to 
the Department of Housing and Urban Development, Office of Inspector 
General. I ask that my full written statement be included in the 
record.
    My knowledge of this issue is based on the 9\1/2\ years I have been 
the Special Agent in Charge of the HUD Office of Inspector General, 
Office of Investigations Southeast/Caribbean District in Atlanta, GA. 
We, like many in the IG community, have limited resources. Because of 
that it is essential to set strict priorities on their use.
    These priorities are affected in large measure by the Prosecutorial 
guidelines set by the various U.S. Attorneys. There is generally a 
minimum dollar threshold on fraud schemes for each judicial district. 
It may range from $10,000 to as much as $100,000. In addition, 
jurisdictions have different priorities--Miami's are not the same as 
Memphis. Nonetheless, there are deviations from these minimums when 
circumstances are so heinous that criminal prosecution is called for. 
Because of these limitations our investigations leading to the 
prosecution of tenant fraud in the Southeast District has averaged 
approximately five cases per year.
    To further clarify our addressing of tenant fraud, I would like to 
use an interview question I pose to recent college graduates who are 
applying for Special Agent positions in our office. I explain to the 
person that a complaint is received and that a Section 8 tenant 
identified as Mary Doe is defrauding HUD by not disclosing income that 
she is receiving from a part time job. You conduct an investigation and 
find the following: Mary Doe has been working part time at McDonalds 
for the past year. She has three elementary school children. From 
interviews it appears she is simply trying to earn some extra money to 
buy new school clothes, shoes, etc., for her children. She has not 
disclosed this additional income and thereby has defrauded HUD out of 
$1,000.00 this past year. How do you handle this? The answer that I 
look for is that this is not a prosecutable criminal case. Rather this 
is the type of situation that we refer back to the Housing Authority 
and/or HUD program office recommending that they take appropriate 
action.
    The purpose of this question is to show that not every fraudulent 
act warrants criminal prosecution. Judgment is needed, especially with 
limited resources.
    Now having identified the type case that would generally not be 
pursued, I would like to describe several specific cases where we have 
undertaken investigations, alone or with other law enforcement 
agencies, that have led to successful prosecutions. The reasons, I 
believe, are quite evident.
    Nashville, TN--Evelyn Haggen Hodgins an IRS employee, was 
prosecuted for falsifying her income in order to obtain Section 8 
rental assistance. Ms. Hodgins had failed to report the income she 
earned from the IRS. Her fraud resulted in a loss to HUD of over 
$15,000.
    Memphis, TN--A Memphis Housing Authority employee Donna Dillihunt, 
conspired with a Shelby County Corrections Officer Pamela Allen to 
create a fictitious Section 8 landlord and place a property in the 
Section 8 program. The Corrections Officer became the tenant receiving 
the Section 8 assistance. The officer would receive the Section 8 
checks and forge the fictitious owner's signature. The two defendants 
received over $11,000 in HUD funds.
    Campbellsville, KY--During a Safe Home Operation evidence was 
obtained that Kelly Lee Shipp and Patricia May Wooley were selling 
drugs in the Campbellsville Public Housing Developments. During the 
investigation it was discovered that Mr. Shipp was a Section 8 landlord 
who was renting to Ms. Wooley. Mr. Shipp had moved in with Ms. Wooley 
after he had certified that he did not reside there. The loss to HUD 
was only $1,070. But due to the other criminal activities of the pair, 
the fraud charge was included in their prosecution.
    Atlanta, GA--The defendant Marylin Arinzee, created false birth 
certificates in order to obtain four different Section 8 subsidized 
apartments under fictitious names in Tennessee and Georgia. In 
addition, she received food stamps and welfare at each of the units. 
The loss to the Government was over $15,000.
    Broward County, FL--Thirty Five individuals were prosecuted for 
fraudulently obtaining over $300,000 in Section 8 subsidies. The 
tenants were Nigerians or the spouses of Nigerians, who were in this 
country illegally or whose status had expired. The Defendants were able 
to create false employers and have their Verification of Income forms 
sent to post office boxes that they owned or were owned by Nigerian 
owned businesses. Twelve of the Defendants were employees of the 
Florida Department of Human Rehabilitation Services (HRS). HRS is the 
State Agency that administers welfare payments in Florida. In addition, 
the defendants also received food stamps, AFDC, and educational grants 
that they were not entitled to receive.
    There are certain common threads that run through these 
prosecutable type cases. A subject who is a City, State, or Federal 
employee will spark the interest of an Assistant United States 
Attorney. A subject who is defrauding other Government programs like 
food stamps or AFDC likewise is seen as a good target. Another good 
subject would be a drug dealer. And, of course, there are some whose 
actions are so flagrant that a jury would not hesitate to convict. For 
example, a subject who owns several rental houses yet still claims 
Section 8 assistance. Another important aspect of these cases is the 
deterrent value prosecution will bring. For example if there is some 
notoriety attached to the case the media will run a story which has a 
positive impact on making an applicant think twice about lying. These 
are all things that we consider before opening an investigation.
    We continue to receive allegations from a number of sources and as 
I said undertake approximately five investigations per year. Over the 9 
plus years I have been in Atlanta I have seen the same type of 
allegations occur and recur--understating income or failing to report 
jobs for the purpose of receiving a subsidized unit or a larger subsidy 
from HUD. As both resources and prosecutorial appeal exist, we 
investigate the most egregious cases. Any remaining allegations are 
referred to the Housing Authority and/or HUD program staff for 
administrative action, as appropriate.
    Mr. Chairman, that concludes my remarks, and I would be happy to 
answer any questions you may have.

    Mr. Sununu. Mr. Carolan.

 STATEMENT OF RAYMOND A. CAROLAN, SPECIAL AGENT IN CHARGE, NEW 
          ENGLAND OFFICE OF THE HUD INSPECTOR GENERAL

    Mr. Carolan. Good morning, Mr. Chairman, Mr. Bentsen, and 
members of the committee. I am pleased to appear before you 
today and highlight a few examples of our work in the subsidy 
fraud area.
    I would ask that my comments be entered into the record.
    Mr. Sununu. Without objection.
    Mr. Carolan. Mr. Chairman, I am a career Office of 
Inspector General employee. I have been with the Office of 
Inspector General for 28 years. I have been the Special Agent 
in charge of the New England District for the last 18 years. I 
believe that my district, New England, was the first to present 
subsidy fraud cases for prosecution to the United States 
attorney in the mid-1970's.
    The investigation of these cases today is basically the 
same as it was then. The cases usually fall into four major 
categories: a tenant's failure to report income or assets; a 
tenant's failure to accurately report total family composition, 
which usually results in an underreporting of income; 
conspiracy between tenants and management; and conspiracy 
involving subsidized tenants and property owners.
    Today, I would like to present especially egregious 
examples of subsidy fraud stemming primarily from the last two 
categories, the conspiracy ones.
    My first example involves a 262-unit fully subsidized 
cooperative housing complex in the Charlestown section of the 
City of Boston. In cooperative housing, a tenant board of 
directors oversees all aspects of the property management. In 
this case, tenants were also employed by the management company 
at the site office to administer the annual income 
recertifications and to oversee all of the daily operations.
    Our investigation revealed widespread fraud and conspiracy 
between some of the tenants and the management office 
employees. It also included the board members. The widespread 
fraud at this complex required the cooperation of the office 
staff, members of the board, in order to perpetuate the scheme.
    The investigation indicated that employment verifications 
that were supposed to be independent were false and forged. 
Tenants and management staff conspired to report half of actual 
income and conspired to hide the occupancy of employed family 
members. There was a pattern of this. They also conspired to 
falsify family composition in order to qualify for larger unit 
sizes.
    An example: Section 8 tenants Barbara and Michael failed to 
report total family income, resulting in overpayments of 
approximately $14,000. Michael was related to a project 
manager. The Section 8 forms failed to accurately reflect 
Michael's total income generated from his employment at a 
hospital, and failed to reflect any income generated by 
Barbara, the spouse, through her employment at the same 
hospital.
    The Section 8 forms for 1988 reflected the total family 
income as $9,000, when, in actuality, in 1988 income for the 
gross wages for the entire family was over $57,000.
    In addition, the Section 8 forms incorrectly listed their 
family composition as consisting of Michael, Barbara, and their 
son, Cory. When asked by our agents who Cory was, Barbara 
indicated that Cory was her dog, that she has no children. She 
could not explain how her dog appeared on the Section 8 forms 
as her child.
    Listing a child on the Section 8 forms would entitle the 
Section 8 tenants to a deduction which is formulated into the 
total rent calculation. In addition, the bedroom size allocated 
to a Section 8 tenant family is based upon total family 
composition. In this case, the family qualified for a two-
bedroom apartment. There were a lot of these cases at this 
particular site, where families were overhoused as a result of 
falsification of family composition.
    Once these schemes were crafted, the employment 
verification forms were falsified and formed in order to fit 
each scheme. There was a pattern of this particular type of 
fraudulent activity at varying levels for many of the tenants 
at this complex.
    When we attempted to verify the accuracy of their 
employment forms, the employees reported that the income 
information was inaccurate and that the signatures were all 
forged. The investigation involved the use of Federal grand 
juries and Federal search warrants.
    Twenty-two tenants at the site, including four board 
members, were federally indicted for false statements, 
conspiracies, and other related charges. All defendants either 
pled or were found guilty in 1993. Monetary losses representing 
subsidy overpayments related to these indictments were 
approximately $245,000.
    Following our investigation, the management company was 
required to repay HUD over $366,000, and was removed. A new 
management company was required to recertify all residents at 
this complex. This company's recertification process resulted 
in a $400,000 annual reduction in Section 8 subsidies the next 
year.
    My second example involves a conspiracy between a property 
owner and a subsidized tenant. This case was not prosecuted due 
to evidence and statute of limitations issues. It is, however, 
I believe a good example of this type of scheme.
    Our investigation indicated that a property owner 
transferred ownership of a single-family property to a straw 
buyer just prior to the application to the Public Housing 
Authority for participation in the Section 8 program. What he 
did was reversed his role from a property owner to a tenant.
    From 1981 to 1995, subsidy was paid to the straw buyer in 
the amount of over $74,000. The scheme was disclosed when IRS 
began to investigate the straw buyer for failure to report 
rental income from the property to the IRS. What happened was 
the IRS received a 1099 from the Housing Authority disclosing 
rental income to that straw buyer.
    In response to the IRS, the straw buyer stated that her 
ownership of the subsidized property was ``in name only,'' that 
the rental income reflected on the form 1099 ``was arranged'' 
without her knowledge and was sent in--these payments were sent 
by the Housing Authority, the Public Housing Authority, to a 
post office box rented in her name without her knowledge.
    Furthermore, she stated that the subsidy checks were also 
cashed without her knowledge or her endorsement on the checks. 
An administrative process to recoup this overpaid subsidy is 
ongoing.
    So even though this case was not prosecuted for various 
reasons, the administrative process is ongoing, and I heard 
recently that what this straw buyer is doing is turning the 
deed back to the Housing Authority for that property, so the 
Housing Authority will be the owner, in an attempt to recoup 
the $74,000.
    Some other examples that parallel income issues. An 
investigation was initiated to determine whether Jose and Rose, 
public housing tenants in Manchester, NH, failed to report 
their income. This was a joint investigation with the Social 
Security Administration Office of Inspector General.
    The only income claimed on their public housing 
applications was Social Security and SSI, disability benefits. 
Both Rosa and Jose worked at a variety of jobs during the 
period of overpayment, which was July, 1995, to November, 1996. 
None of this income was reported on the applications.
    Jose was indicted on December 9, 1998, on four counts of 
making false statements, three to HUD and one to the Social 
Security Administration, and two counts of misusing Social 
Security numbers. Jose pled guilty. A Federal judge sentenced 
him on June 30, 1999, to time served, which was 6 months. He 
got 3 years probation and an assessment of $200, and was 
ordered to make repayments in the form of restitution in the 
amount of $25,000.
    In another case, this particular Section 8 tenant received 
Section 8 assistance in Lynn and Lexington, MA, from January 
1987 until August 1998. During the period, they only claimed 
benefits received from Aid to Families with Dependent Children. 
They also held occasional part-time jobs.
    Penny, using another name and another Social Security 
number of a deceased uncle, worked at a computer company from 
December, 1989, to July 1989, and did not report this income. 
On September 13, 1999, a criminal complaint was filed in U.S. 
District Court in Massachusetts, charging Penny with violating 
18 U.S.C. 641, conversion of government funds.
    On January 5, 2000, Penny waived her right to indictment 
and pled guilty to one count, information. The Federal district 
judge sentenced Penny to 6 months' confinement in a halfway 
house, 2 years' probation, a $100 special assessment, and 
$37,000 in restitution to the Federal Government.
    Mr. Chairman, that concludes my remarks. I would be pleased 
to answer any questions you may have following the other 
witnesses's testimony.
    Mr. Sununu. Thank you very much, Mr. Carolan.
    [The prepared statement of Mr. Carolan follows:]

  Prepared Statement of Raymond A. Carolan, Special Agent in Charge, 
 Department of Housing and Urban Development, Office of the Inspector 
                     General, New England District

    Mr. Chairman and members of the committee. I am pleased to appear 
before you today to highlight a few examples of our work in the subsidy 
fraud area. I am a career Office of the Inspector General employee with 
over 28 years of service. I have been the Special Agent in Charge of 
the New England District for the last 18 years.
    I believe that my District was the first to present subsidy fraud 
cases for prosecution to the United States Attorney in the mid 1970's. 
The investigation of these cases today is basically the same as it was 
then. The cases usually fall into four major categories:
     Tenants failure to report income and/or assets.
     Tenants failure to accurately report total family 
composition resulting in understated total family income.
     Conspiracy between tenants and management.
     Conspiracy involving a subsidized tenant and a property 
owner.
    Today I would like to present especially egregious examples of 
subsidy fraud stemming primarily from the last two categories.
               conspiracy between tenants and management
    My first example involves a 262 unit, fully subsidized. cooperative 
housing complex in the Charlestown section of the City of Boston. In 
cooperative housing, a tenant Board of Directors oversees all aspects 
of the property management. In this case, tenants were also employed by 
the management company at the site office to administer the annual 
income recertifications and to supervise daily operations.
    Our investigation revealed widespread fraud and conspiracy between 
the tenants and the management office employees.
    The widespread fraud at this complex required the cooperation of 
the office staff and members of the tenant Board of Directors in order 
to perpetuate the scheme. The investigation indicated that employment 
verifications that were supposed to be independent were falsified and 
forged.
    Tenants and management staff conspired to report half of actual 
income and conspired to ``hide'' the occupancy of employed family 
members. They also conspired to falsify family composition in order to 
qualify for larger unit sizes:
    Section 8 tenants, Barbara and Michael failed to report total 
family income resulting in an overpayment of $14,506. Michael was 
related to a project manager. The Section 8 forms failed to accurately 
reflect Michael's total income generated from employment at a hospital 
and failed to reflect any income generated by Barbara through her 
employment at the same hospital. The Section 8 forms for 1988 reflected 
the total family income as $9,073, when in actuality, the 1988 income 
for gross wages was $57,785.92. In addition, the Section 8 forms 
incorrectly listed their family composition as consisting of Michael, 
Barbara and their son, Cory. When asked by the agents who Cory was, 
Barbara indicated that Cory was her dog, that she has no children. She 
could not explain how her dog appeared on the Section 8 forms as her 
child. Listing a child on the Section 8 forms entitles the Section 8 
tenants to a deduction which is formulated into their total tenant rent 
payment calculation. In addition, the bedroom size allotted to a 
Section 8 family is based upon total family composition. In this case, 
the family qualified for a two bedroom apartment.
    Once the schemes were crafted, the employment verification forms 
were falsified and forged in the management office in order to fit each 
scheme. There was a pattern of this particular type of fraudulent 
activity at varying levels for many of the tenants at the complex.
    When we attempted to verify the accuracy of the forms, the 
employers reported that the income information was inaccurate and that 
the signatures were forged. The investigation involved the use of the 
Federal Grand Jury and Federal Search Warrants. Twenty two tenants, 
including four board members, were federally indicted for false 
statements, conspiracy and other related charges. All defendants either 
plead or were found guilty in 1993. Monetary losses representing 
subsidy overpayments, related to the indictments, were approximately 
$245,000.
    Following the OIG investigation, the management company was 
required to repay HUD over $366,000 and was removed by HUD. A new 
management company was required to recertify all residents. This 
company's recertification process resulted in a $400,000 annual 
reduction in Section 8 subsidies.
              conspiracy between tenant and property owner
    My second example involves a conspiracy between a property owner 
and a subsidized tenant. This case was not prosecuted due to evidence 
and statute of limitations issues. It is however a good example of this 
type of scheme.
    Our investigation indicated that a property owner transferred 
ownership of his single family property to a straw buyer just prior to 
the application to the public housing authority (PHA) for participation 
in the Section 8 program.
    From 1981--1995 subsidy was paid to the straw buyer in the amount 
of $74,508. The scheme was disclosed when the IRS began to investigate 
the straw buyer for failure to report rental income from the property 
to the IRS. The IRS had received a Form 1099 from the PHA disclosing 
payment of this rental income to the straw buyer.
    In a response to the IRS, the straw buyer stated that her ownership 
of the subsidized property was ``in name only"; that the rental income 
reflected on the Form 1099 was ``arranged'' without her knowledge and 
was sent by the PHA to a post office box rented in her name without her 
knowledge. Furthermore she stated that the subsidy checks were cashed 
without her knowledge or endorsement. An administrative process to 
recoup the overpaid subsidy is ongoing.
                             other examples
    An investigation was initiated to determine whether Jose and Rosa, 
Public Housing Tenants, Manchester, NH, failed to report their income. 
This was a joint investigation with the Social Security Administration, 
Office of Inspector General. The only income claimed on their public 
housing applications was SS/SSI. Both Rosa and Jose worked at a variety 
of jobs during the period of overpayment, July 1, 1995 to November 26, 
1996, and none of this income was reported on their public housing 
applications.
    Jose was indicted on December 9, 1998 on four counts of making 
false statements (18 USC 1001; 3 related to SSA and 1 to HUD) and two 
counts of misusing Social Security numbers (42 USC 408, SSA violation). 
Jose plead guilty to counts 1 (18USC1001 re: SSA) and 4 (18USC1001 re: 
HUD) and the other four counts were dismissed. A Federal judge 
sentenced him on June 30, 1999 to time served (6 months), 3 years 
probation, an assessment of $200, and restitution of $25,906.33 
($18,650.33 to SSA and $7,256 to HUD)
    Penelope, a/k/a Penny, received Section 8 assistance in Lynn and 
Lexington, MA, from January 1987 until August 1998 and during that 
period of time Penny only claimed benefits received from Aid to 
Families with Dependent Children and/or an occasional part time job. 
Penny, using another name and a SSN of her deceased uncle, worked at a 
computer company from December 1989 until July 1998 and did not report 
this income on her Section 8 applications.
    On September 13, 1999 a Criminal Complaint was filed in U.S. 
District Court, District of Massachusetts charging Penny with violating 
18USC641, Conversion of Government Funds. On January 5, 2000 Penny 
waived her right to indictment and plead guilty to a one count 
Information charging her with violating 18USC641. On April 10, 2000 a 
U.S.
    District Judge sentenced Penny to 6 months confinement in a halfway 
house, 2 years probation, $100 special assessment, and $37,709 in 
restitution.
    Mr. Chairman, that concludes my remarks, and I would be pleased to 
answer any questions you may have.

    Mr. Sununu. At this time, I would like to ask Ms. Crowley 
and Mr. Ramirez to please have a seat at the witness table.
    Mr. Bentsen.
    Mr. Bentsen. Mr. Chairman, I misspoke. Secretary Ramirez 
was the mayor of Laredo, not the county judge of Webb County. I 
apologize for that. I have found, as you have probably found, 
that the mayor of a city is the most powerful individual you 
can meet. So I want to make sure I got that right.
    Mr. Ramirez. That is OK.
    Mr. Sununu. I appreciate Mr. Ramirez' sacrifice, giving up 
that power for a little bit of public service, and obviously 
serving the needs of those looking for decent, affordable 
housing.
    At this time, I would be happy to yield to Mr. Ramirez for 
his testimony for any time that he may require.

   STATEMENT OF SAUL N. RAMIREZ, JR., DEPUTY SECRETARY, U.S. 
          DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

    Mr. Ramirez. Thank you very much, Mr. Chairman, and Ranking 
Member Bentsen, as well as other members of the committee. I 
would like to submit my written testimony and its exhibits for 
the record, and provide you with just a summary of the key 
points of my testimony to move on to the question-and-answer 
period, if I may, Mr. Chairman.
    First, let me say that it is historic for us at the 
Department to be able to deal with an issue such as tenant 
income verification. Let me just clear up a point. It is not 
just Section 8 that we are talking about when we are talking 
about tenant income verification; that we are actually talking 
about 4.5 million families that include residents of public 
housing, as well, and not just Section 8 subsidized housing.
    What we have done is, we have a tool for assisting the 
Department in furthering our goal of targeting rental 
assistance only to eligible families and ensuring that each 
family pays the correct amount of rent. But we cannot act 
alone; both tenants and our partners who provide the housing 
have a direct responsibility for correcting and actually 
correctly determining the rental assistance, and HUD's new 
income verification program does not alter those roles.
    The complexities associated with providing eligible 
individuals with the correct level of rental assistance are 
numerous. Legislation over the last couple of years has given 
different POAs, or private owners and agents, such as Housing 
Authorities, different types of wide discretion, or discretion 
in the delivery of rental assistance and recovery of excess 
rental assistance.
    The differences include varied recertification policies, 
exclusion of specific income from rent determination 
calculations, the establishment of ceiling rents, and the 
adoption of diverse recovery policies.
    Until now, the Department's past efforts to enhance the 
effectiveness of POAs, efforts to ensure that low-income 
eligible families receive the correct level of rental 
assistance, have been limited. However, the Department is now 
implementing a large-scale computer-matching income 
verification program to dramatically enhance the information 
our partners need to fulfill their income verification 
responsibilities.
    HUD has matched tenant-reported income with Federal tax 
information, and has identified approximately 230,000 tenants 
who have underreported income. At this very moment, letters are 
being sent to these tenants and notifications are being sent to 
the POAs. HUD has worked with the tenant groups, as well as 
industry groups, to obtain the highest level of support for 
this initiative.
    Also, in the interests of fairness to all parties, the 
Department is also addressing the overreporting of income, and 
will be mailing letters as part of this initiative in the near 
future to tenants who might not have received all the 
assistance to which they were entitled.
    HUD's new large-scale computer-matching program achieves 
the delicate balance between the needs of tenants, including 
tenants' rights to privacy and due process, the 
responsibilities and work loads of our private owners and 
agents that are partners out there, and the ultimate goal of 
allocating scarce resources to eligible tenants at correct 
levels of rental assistance.
    For several years, staff from OIG have conducted a sample 
of 1,000 households to estimate excess rental assistance. These 
estimates have ranged from--anywhere between $417 million and 
$935 million.
    There are many reasons why this excess rental assistance 
cannot be fully recovered by HUD. Perhaps many tenants who have 
underreported their income will leave once they are identified, 
before any back rents can be collected. Recovery costs can be 
excessive and often fall way short of any rental assistance 
that could be received. Administrative costs paid by the POAs 
associated with tracking recoveries reduce the amount of any 
potential to us in the long run.
    Moreover, when a tenant vacates after underreporting of 
income is identified, the tenant typically is replaced by 
another eligible family requiring assistance. And, of course, 
we endorse the goal of targeting rental assistance only to 
eligible families. However, we must point out that in cases 
like this, when an eligible family replaces an ineligible 
family, the net amount of rental assistance may not decline and 
may even increase. This is one reason why our program focuses 
on setting current rents correctly to prevent future abuses 
before they happen, when it is much more difficult for us to 
actually go out and collect after the abuses have occurred.
    Through the use of our large-scale computer-matching income 
verification process, HUD is providing our partners, the 
private owners and agents, with an additional tool to help 
identify tenants responsible for program abuses.
    In this first year of large-scale computer-matching income 
verification, HUD is seeking to establish a baseline by which 
to measure the private owners' and agents' income verification 
efficiency and effectiveness at the level at which the tenant 
program abuses can be better detected and better deterred.
    With that, I would like to conclude by saying that our 
efforts to further enhance our abilities to create a more on-
time system of verifying could probably be strengthened by 
seeking a stronger partnership with the Department of Health 
and Human Services quarterly new-hire reports, so that both the 
POAs and HUD can better track incomes, but that would certainly 
take some help on your part with additional legislation.
    That concludes my summary of my written testimony, Mr. 
Chairman. I am prepared to answer any questions when we are 
done.
    Mr. Sununu. Thank you very much, Mr. Ramirez.
    [The prepared statement of Mr. Ramirez follows:]

     Prepared Statement of Saul N. Ramirez, Deputy Secretary, U.S. 
              Department of Housing and Urban Development

    Thank you for allowing us this opportunity to testify on the 
Department's computer matching income verification efforts. For the 
first time in the history of public housing, we have a tool for 
assisting the department in furthering its goal of targeting rental 
assistance only to eligible families and ensuring that each family pays 
the correct amount of rent.
    The Department acknowledges that more could be done to assure only 
eligible low income tenants receive HUD rental assistance and to assure 
that all tenants pay their fair share of rent as required by statute. 
We are aware--indeed we have estimated--the size of possible under-
reporting of income. And, we are moving to do more by implementing an 
income verification program under the authorities given us by the 
Congress.
    We are confident that our computer matching income verification 
efforts will improve the targeting of our scarce rental subsidy 
dollars, make the administration of these programs more fair, and bring 
in additional resources to offset the cost of reaching more of the 5.4 
million low-income families who have severe housing needs.
    The complexities associated with providing eligible individuals 
with the correct level of rental assistance are numerous. First, we 
cannot act alone in this area. As you know, HUD has no direct 
relationship with the tenants who benefit from our programs. Rather, 
both tenants and our partners who provide the housing each have a 
direct responsibility for correctly determining the rental assistance. 
Tenants must accurately and completely report their income to their 
housing managers--the Public Housing Authorities and private owners, 
and agents who administer our rental assistance programs. In turn, the 
housing providers have ultimate responsibility for verifying tenant 
incomes and setting the rents correctly. Our new computer matching tool 
is designed to dramatically improve the information our partners need 
to fulfill their income verification responsibilities.
    In addition, comparing IRS or Social Security data with the income 
reported by tenants is not a straightforward calculation. Great care 
must be taken in drawing conclusions from the matching process because 
there are many reasons that IRS data, for example, might indicate that 
an improper underpayment is occurring when, in fact, it is not. 
Legislation over the years has given different housing providers wide 
discretion or varying directions in how they set rents, calculate 
tenant contributions and go about recovering excess rental assistance. 
These differences include exclusion of specific types of income from 
rent determination calculations and the establishment of rent ceilings 
that do not go up with increases in household income. Recent 
legislation has added additional variables in the form of longer 
intervals between recertifications for tenants under some of the 
Department's programs which means that increases in a tenant's income 
may not be captured in a timely manner by the recertification process.
    Frankly, until now the Department's past efforts to enhance the 
effectiveness of POAs' (Private Owner or Agent) efforts to ensure that 
low income-eligible families receive the correct level of rental 
assistance have been limited. Beginning in the mid-1980's and 
continuing until 1992, the Department performed several narrow matches 
of tenant-reported income with tenant income supplied by State wage 
agencies and the Office of Personnel Management to identify under-
reported income and excess rental assistance. The Omnibus Budget 
Reconciliation Act of 1993 allowed the Department to expand its 
computer matching efforts to include Federal tax information provided 
by the Internal Revenue Service and the Social Security Administration. 
There are a number of laws and other requirements to adequately safe 
guard the privacy of this sensitive data, for example Section 6103 of 
the Internal Revenue Code (IRC) and the Computer Matching and Privacy 
Protection Act of 1988. HUD and its partners have worked diligently on 
these issues and continue to work on ensuring that this sensitive data 
remains protected. The Department used that new authority to complete 
computer matching initiatives focused on individual POAs and on 
sampling the universe of subsidized tenants to estimate overpaid rental 
assistance. This sampling was conducted by HUD's Office of the 
Inspector General with the goal of quantifying under-reported income 
for financial statement purposes.
    The Department is now implementing a large-scale computer matching 
income verification program. HUD has matched tenant-report income with 
Federal tax information and has identified approximately 230,000 
tenants who under-reported income at some fairly large thresholds 
levels set by the Department for this initial effort. At this very 
moment, letters are being sent to those tenants and notifications are 
being sent to all our housing authorities and landlords requesting that 
tenants resolve the potential discrepancies we have identified through 
our income-matching program. The letters to the housing providers do 
not disclose any income data regarding tenants, but only advise the 
housing provider to recertify the income of these particular tenants.
    HUD has worked diligently with tenant and industry groups to obtain 
the highest level of support for this initiative. For example, we 
conducted two training sessions for our partners and stakeholders, soon 
to be followed by a third. We developed an online guide to help our 
housing providers in processing and resolving income discrepancies, and 
we established two call centers to handle both housing provider and 
tenant inquiries. We are also including a fact sheet on the income 
verification program with all mis-match letters that are being sent to 
tenants.
    In the interest of fairness to all parties, the Department is also 
addressing over-reporting of income and will soon be mailing letters as 
part of this initiative in the near future to tenants who might not 
have received all of the assistance to which they were entitled.
    This large-scale computer matching program achieves the delicate 
balance between the needs of tenants, including tenants' rights to 
privacy and due process, the responsibilities and workload of housing 
providers, the responsibility to assure fairness among all tenants by 
assuring that each pays his/her proper amount as require by statute, 
and the ultimate goal of allocating scarce resources to eligible 
tenants at correct levels of rental assistance. HUD is undertaking 
these efforts because of statutory requirements and because it is the 
right thing to do. It is important to recognize, however, that this 
income verification efforts is primarily designed to improve voluntary 
compliance by providing reasonable assurance that tenants pay the 
proper amount in the future. We do not expect a large windfall from 
collections of past underpayments, Indeed, we ask POAs to be work with 
tenants on an prudent payment plan as appropriate that does not 
overwhelm their finances.
    For many years now, the Department's financial statement has 
reflected an estimate that tenant underpayments total some $900 
million. I think it is important to advise the Committee that this 
number is a gross estimate of underpayments and not a net amount that 
could be collected through tenant income verification efforts. For 
several years, staff conducted a sample of 1,000 households to estimate 
excess rental assistance. These estimates were developed under specific 
parameters and assumptions with numerous qualifying statements and have 
a wide statistical range $417 million and $935 million. It is extremely 
important to note that these are estimates of total excess rental 
assistance if all tenants reported income on a retrospective basis. It 
is not a total of recoverable excess rental assistance. Nor are they 
estimates of achievable departmental savings.
    There are many reasons excess rental assistance cannot be fully 
recovered by HUD. First of all, our experience with a pilot income 
verification program indicates that approximately 30 percent of tenants 
who have under-reported their income will leave once they are 
identified before any back rents or future higher rents can be 
collected. In accordance with recent statutory changes, these tenants 
will be replaced by eligble households who are predominately very low-
income households with the end result probably being little or no 
significant increased returns to the housing provider. Indeed, in such 
instances, the rents being paid to the provider for that unit may 
decrease. Our experience also suggests that even where a tenant agrees 
to pay off back rent owed, the average length of the agreed-upon 
payment plan is between 5 and 7 years. Given these circumstances, we do 
not expect big dollar returns to result from back rent collections 
under the income verification effort.
    Second, while HUD has advised housing providers to pursue cases of 
blatant fraud, the recovery costs for the run-of-the-mill tenant 
underpayment can be excessive, and often far exceed any rental 
assistance that could be recovered. These include direct costs 
associated with verifying excess rental assistance and recovering funds 
through the legal system and administrative costs associated tracking 
recoveries. Businesses associated with debt collection have often cited 
20 percent as a reasonable estimate of debt recovery, and recent 
experience with tenant income verification efforts around the country 
have been consistent with this benchmark. For example, in a recent 
computer matching initiative, the Dallas Housing Authority identified 
95 tenants who received excess rental assistance totaling $350,000. The 
housing authority was able to establish repayment agreements with only 
17 of these tenants. The repayment agreements totaled $80,000, or about 
20 percent. The $900 million figure makes no attempt to calculate these 
costs of collection.
    For all of these reasons--tenant move-outs, high administrative 
costs, the administrative payments to our partners--the amount of 
``excess'' assistance paid to tenants cannot be easily recaptured by 
HUD. We believe that more is gained by looking forward than back. In 
the case of the Dallas Housing Authority, the agency terminated rental 
assistance to 42 of the 95 tenants who under-reported their incomes--
freeing up units for eligible families. Through the use of large-scale 
computer matching income verification, HUD is providing housing 
providers with an additional tool to help identify tenants responsible 
for program abuses. In this first year of large-scale computer matching 
income verification, HUD is seeking to establish a baseline by which to 
measure housing provider's income verification effectiveness and the 
level of tenant program abuses. This information will allow HUD to 
effectively target its future enforcement and monitoring efforts to 
those areas where the problem is most acute.
    HUD continues to work to improve its income verification program. 
The Department needs your support to better serve the needs of those 
eligible to receive rental assistance.

    Mr. Sununu. Ms. Crowley, welcome. Thank you for being here. 
I am pleased to yield to you, for testimony, whatever time you 
might need.
    Ms. Crowley. Thank you.

  STATEMENT OF SHEILA CROWLEY, PRESIDENT, NATIONAL LOW-INCOME 
                       HOUSING COALITION

    Mr. Sununu, Mr. Bentsen, I am very pleased to be here. I 
would like to submit my written testimony and attachments for 
the Record.
    Mr. Sununu. Without objection.
    Ms. Crowley. I am Sheila Crowley, the President of the 
National Low Income Housing Coalition. We are a membership 
organization. We represent individuals and organizations around 
the country that are committed to ending the affordable housing 
crisis and assuring decent housing and healthy neighborhoods 
for everyone.
    Our members include nonprofit housing providers, homeless 
service providers, fair housing groups, State and local housing 
coalitions, public housing agencies, private developers and 
private owners, housing researchers, local and State government 
agencies, faith-based organizations, and residents and their 
organizations.
    So on behalf of all our members, thank you for the 
opportunity to offer our perspective on the income verification 
issue and how it fits into the broader picture of housing 
affordability and the Federal response to the affordable 
housing crisis.
    We have worked closely over the last 2 months with our 
partner resident organizations and HUD officials to shape the 
implementation of the income verification program in a manner 
that will achieve the objective of assuring that scarce housing 
assistance is used to help as many eligible families and 
individuals as possible, while preventing unwarranted panic and 
housing destabilization for thousands of public and assisted 
housing residents who have done nothing wrong.
    Everyone, all of us, agree that people who fraudulently 
misreport their income in order to accrue more Federal benefits 
than that to which they are entitled should not be allowed to 
get away with it. As someone who is acutely aware of the severe 
limits of housing choices for poor Americans, I make no excuses 
for people who deliberately deprive others of badly needed 
housing assistance.
    However, we believe that a substantial percent of the 
discrepancy between the rent certifications and the tax returns 
that have been identified in the IG's report have occurred for 
one of a number of legal and legitimate reasons or as the 
result of honest mistakes, or are rooted in errors made by 
Housing Authorities or private owners.
    It is wrong to jump to the conclusion that lots of poor 
people are ripping off the system. The list of possible 
explanations for so-called ``false positives,'' that is, 
leaseholders with legitimate discrepancies, is extensive. Mr. 
Ramirez has reviewed some of those.
    Indeed, Congress has authorized many explanations for this 
discrepancy in order to reduce the disincentives for work that 
have been a problem in Federal housing programs. Further, if 
there are inaccuracies in how a tenant's share of rent is 
calculated that results in overpayment by the Federal 
Government, there are also many cases where residents are 
making overpayments.
    As I understand it, the amount of resident overpayment has 
not yet been determined, so a true picture of what the 
overpayment problem is will emerge once both the false 
positives and the tenant overpayment are factored into the 
equation.
    The concern of residents and their advocacy partners was 
that HUD's initial plan for implementation of the income 
verification program had the effect of accusing many innocent 
people of wrongdoing and then requiring them to prove 
otherwise. While there are some lingering concerns, I am happy 
to report that it is very accurate that HUD leadership has been 
very responsive to the issues raised by residents, and the 
income verification program has undergone significant 
improvements as a result.
    The negotiations have necessarily slowed down the program, 
but we believe that taking the time to do it right is the right 
thing to do.
    We want to solve the income discrepancy problem and 
eliminate the income discrepancy issue as an argument that has 
been raised against increased funding for housing assistance. 
Solving the problem in a way that causes precipitous harm to 
low-income residents for no valid reason is counterproductive 
and simply wrong.
    It is equally wrong for Congress to use this income 
discrepancy analysis as justification for failing to address 
serious housing affordability problems. So I want to put this 
problem into perspective.
    The widely accepted standard in the housing industry is 
that housing should cost no more than 30 percent of household 
income. Our analysis shows that in 1997 10.8 million very low-
income households, that is, households with incomes at less 
than 50 percent of the area median, paid over half of their 
income for their housing. This is nearly 11 percent of all 
households in the United States. That includes 8.4 million 
renters and 2.4 million homeowners.
    A more vivid illustration of the depth and breadth of the 
housing affordability crisis is our analysis of housing costs 
in comparison to wages in every jurisdiction in the country. We 
can say with assurance that nowhere in the country can a full-
time minimum-wage worker afford the fair market rent for a two-
bedroom rental unit. Nowhere.
    The housing wage which we calculate, that is, the hourly 
wage one needs on a full-time basis to afford basic rental 
housing, ranges from $8.02 in West Virginia to $17.10 in 
Hawaii. In the Manchester, New Hampshire, metropolitan 
statistical area, for example, 44 percent of renter households 
cannot afford the two-bedroom fair market rent, and the housing 
wage is $13.20 an hour. One hundred and 2 hours of minimum wage 
work a week is required to afford the fair market rent in the 
Manchester SMA.
    In the Houston SMA, 40 percent of the renters cannot afford 
the fair market rent. The housing wage is $11.56 an hour, and 
one must work 90 hours at the minimum wage in order to afford 
the fair market rent.
    I have attached to my written testimony analysis of the 
housing costs and income gaps in the States that are 
represented by all the members of the Task Force for your 
review. The numbers are stark, but what does it mean to be a 
low-income family and have a severe housing cost burden?
    One or more of the following happens: The family pays a 
precariously high percentage of its income for its housing, and 
then must scrimp on other necessities, like food or medicine; 
or adults in the family work two or three or more low-wage jobs 
and have precious little time left over to devote to family and 
parenting duties; or they are forced into substandard or 
overcrowded housing, paying rent to unscrupulous landlords who 
can take advantage of the severe housing shortage that poor 
people experience; or they simply cannot pay the rent, are 
threatened with eviction, gain poor credit records, and in some 
cases, spiral down into homelessness.
    We are increasingly aware that the high rate of mobility 
among poor families, driven in large part by staying on the 
move to stay a step ahead of the eviction server, contributes 
to poor school performance by children who drift from one 
school to another and just never catch up. In the age of 
standardized tests as the primary indicator of academic 
achievement, these kids do not have a chance at success.
    We all tacitly understand the centrality of stable housing 
in our ability to do our jobs and raise our families. If we 
ponder even for a moment how we would cope if maintaining our 
housing was a daily struggle, we could easily understand the 
human dimensions of the affordable housing crisis.
    We know that receipt of Federal housing assistance 
contributes to housing stability for formerly homeless families 
and is associated with success at moving from welfare to work. 
It is a good investment in American families.
    Federal expenditures on low-income housing are woefully 
inadequate in the face of this challenge, and when examined in 
comparison--and this is an analysis the National Low Income 
Housing Coalition has done for some time--when we examine this 
in comparison to Federal expenditures to subsidize the housing 
of middle- and upper-income households, the lack of investment 
in low-income housing becomes more apparent.
    In 1997, assisted housing outlays were $26 billion, while 
housing tax expenditures, mostly mortgage interest deductions 
and property tax deductions, were $97 billion. In constant 2000 
dollars, the tax expenditure level will go to $123 billion by 
2005. It is going to take much more than fine tuning the 
existing low-income housing programs, which we must continue to 
do, to seriously make a dent in this program.
    The good news is that we know how to solve the affordable 
housing crisis. It is not rocket science. We have a thriving, 
mission-driven, community-based, nonprofit housing sector that 
is only increasing in its capacity to provide safe, decent, and 
affordable housing. We believe strongly that the resources 
exist to intervene at the scale needed to make a difference. 
What we need now is creative and visionary leadership.
    Thank you for your consideration of my remarks. I will be 
happy to answer any questions.
    Mr. Sununu. Thank you very much, Ms. Crowley.
    [The prepared statement of Ms. Crowley follows:]

 Prepared Statement of Sheila Crowley, President, National Low-Income 
                           Housing Coalition

    Mr. Sununu and Mr. Bentsen, I am Sheila Crowley, President of the 
National Low Income Housing Coalition. I would like to submit my 
written testimony and attachments for the record.
    The National Low Income Housing Coalition is a membership 
organization representing individuals and organizations that are 
committed to ending the affordable housing crisis in America and to 
assuring decent housing in healthy neighborhoods for everyone. Our 
members include non-profit housing providers, homeless service 
providers, fair housing organizations, state and local housing 
coalitions, public housing agencies, private developers and property 
owners, housing researchers, local and state government agencies, 
faith-based organizations, and residents of public and assisted housing 
and their organizations. On behalf of our membership, I thank you for 
the opportunity to offer our perspective on the income verification 
issue and how it fits into the broader picture of housing affordability 
and the Federal response to the affordable housing crisis.
    We have worked closely over the last 2 months with our partner 
resident organizations and HUD officials to shape the implementation of 
the income verification program in a manner that will achieve the 
objective of assuring that scarce housing assistance is used to help as 
many eligible families and individuals as possible, while preventing 
unwarranted panic and housing destabilization for thousands of public 
and assisted housing residents who have done nothing wrong.
    Everyone agrees that people who fraudulently misreport their income 
in order to accrue more Federal subsidy than that to which they are 
entitled should not be allowed to get away with it. As someone who is 
acutely aware of the severe limits of housing choices of very poor 
Americans, I make no excuses for people who deliberate deprive others 
of badly needed housing assistance.
    However, we believe that a substantial percent of the discrepancy 
between rent certifications and tax returns that is identified in the 
Inspector General's report has occurred for one of a number of legal 
and legitimate reasons or is the result of honest mistakes or is rooted 
in errors on the part of housing authorities or property owners. It is 
wrong to jump to the conclusion that poor people are ripping off the 
system. The list of possible explanations for so-called ``false 
positives,'' that is, leaseholders with legitimate discrepancies, is 
extensive. Indeed, Congress has authorized many explanations for the 
discrepancy to reduce the disincentives for work that have been a 
problem in Federal housing policy. Further, if there are inaccuracies 
in how tenant share of rent is calculated that results in overpayment 
by the Federal Government, there also are cases where residents are 
making overpayments. As I understand it, that amount has not yet been 
determined. A truer picture of the Federal overpayment problem will 
emerge once both the ``false positives'' and tenant overpayments are 
factored into the equation.
    The concern of residents and their advocacy partners was that HUD's 
initial plan for implementation of the Income Verification Program had 
the effect of accusing many innocent people of wrongdoing and then 
requiring them to prove otherwise. While there are some lingering 
concerns, it is accurate to say that HUD leadership has been responsive 
to issues raised by residents and the income verification program has 
undergone significant improvements as a result. The negotiations have 
slowed down the program, but we believe that taking the time to do it 
right is the right thing to do and is well worth the effort.
    We want to solve the income discrepancy problem and eliminate the 
income discrepancy issue as an argument against increased housing 
funding. But solving the problem in a way that causes precipitous harm 
to low income residents for no valid reason is counterproductive and 
simply wrong. It is equally wrong for Congress to use this income 
discrepancy analysis as justification for failing to seriously address 
the affordable housing crisis of low income Americans. Let's put this 
problem into perspective.
    The widely accepted standard in the housing industry is that 
housing should cost no more than 30 percent of household income. Our 
analysis shows that in 1997, 10.8 million very low income households 
(that is, households with income less than 50 percent of the area 
median) paid over half of their income for their housing. This is over 
11 percent of all households in the United States and includes 6.4 
million renter households and 4.4 million homeowners.
    A more vivid illustration of the depth and breadth of the 
affordable housing crisis is our analysis of housing costs in 
comparison to wages in every jurisdiction in the country. We can say 
with assurance that nowhere in the country can a full time minimum wage 
worker afford the Fair Market Rent for a two bedroom rental unit. The 
housing wage, that is, the hourly wage one needs on a full time basis 
to afford basic rental housing, ranges from $8.02 in West Virginia to 
$17.01 in Hawaii. In the Manchester, NH, Metropolitan Statistical Area, 
44 percent of the renter households cannot afford the two bedroom Fair 
Market Rent and the housing wage is $13.02. One hundred and 1 hours of 
minimum wage work a week is required to afford the Fair Market Rent. In 
the Houston, TX, MSA, 40 percent of renters cannot afford the Fair 
Market Rent, the housing wage is $11.56, and one must work 90 hours a 
week at minimum wage to afford a basic rental unit. I have attached to 
my written testimony analysis of the housing costs and income gap for 
the states of each of the members of the Task Force. I also have 
provided a copy of the complete jurisdiction by jurisdiction analysis 
for your use.
    The numbers are stark. But what does it mean to be a low income 
family and have a severe housing cost burden? One or more of the 
following happens. The family pays a precariously high percentage of 
its income for its housing and must scrimp on other necessities like 
food and medicine. Or the adults in the family work two, three, or more 
low wage jobs and have precious little time left over to devote to 
family and parenting responsibilities. Or they are forced into 
substandard or overcrowded housing, paying rent to unscrupulous 
landlords who can take advantage of the severe housing shortage 
affordable for the poor. Or they simply cannot pay the rent and are 
threatened with eviction, gain poor credit records, and in some cases, 
spiral down into homelessness.
    We are increasingly aware that the high rate of mobility among poor 
families, driven in large part by staying on the move to stay a step 
ahead of the eviction server, contributes to poor school performance by 
children who drift from one school to another and never catch up. In 
the age of standardized tests as the primary indicator of academic 
achievement, these kids do not have a chance at success. We all tacitly 
understand the centrality of stable housing in our ability to do our 
jobs and raise our families. If we ponder even for a moment how we 
would cope if maintaining our housing was a daily struggle, we can 
easily understand the human dimensions of the affordable housing 
crisis.
    We know that receipt of Federal housing assistance contributes to 
housing stability for formerly homeless families and is associated with 
success at moving from welfare to work. It is a good investment in 
American families.
    Federal expenditures on low income housing are woefully inadequate 
in the face of this challenge. And when examined in comparison to 
Federal expenditures to subsidize the housing of middle and upper 
income households, the lack of investment in low income housing becomes 
even clearer. In 1997, assisted housing outlays were $26 billion, while 
housing tax expenditures (mortgage interest and property tax 
deductions) were $97 billion. In constant 2000 dollars, the tax 
expenditure level will go to $123 billion by 2005.
    It will take much more than fine-tuning existing low income housing 
programs, which we must continue to do, to seriously make a dent in 
this problem. The good news is that we know how to do solve the 
affordable housing crisis. We have a thriving mission-driven, 
community-based, non-profit housing sector that is continually 
increasing its capacity to provide safe, decent, and affordable 
housing. We believe strongly that the resources in our country to 
intervene at the scale needed to make a difference. What we need now is 
the creative and visionary leadership to make it happen.
    Thank for your consideration of my remarks.

    Mr. Sununu. I would like to begin the questioning now, 
touching on a few of the points that you raised with Mr. 
Ramirez.
    First, you raised, I think, a very important concern about 
false positives, about trying to approach the verification 
process carefully.
    There is no question when you have the number of letters 
that are going out, the number of discrepancies in income 
reporting that we have, there are going to be some legitimate 
reasons that both of you touched on in your testimony for the 
problem.
    I think we can minimize those issues by putting in place a 
reasonable threshold for income discrepancy. We are not talking 
about a difference of $100 or $500 or even $1,000, as I 
understand it, in the income that is reported. It is at a 
higher threshold than that.
    Mr. Ramirez, can you review for instance what those 
thresholds are?
    Mr. Ramirez. Yes. We have actually two thresholds. One is 
for the multifamily Section 8 subsidized housing, which is a 
$4,000 threshold. Then we have an $8,000 threshold for public 
housing.
    Mr. Sununu. For annual income?
    Mr. Ramirez. Yes, sir, annual income.
    Mr. Sununu. In your testimony on March 8, you suggested 
that there were, I think, 260,000 letters that were about to go 
out. In your testimony today, you mentioned 230,000 letters. It 
is a difference of about 10 percent. I just want to be clear 
for the record; how many letters are being mailed out today?
    Mr. Ramirez. We have two family incomes, so the number has 
shrunk in matching up addresses and individuals in those 
incomes. We anticipate that that will be the case in a bigger 
mailing that will take place after working with the different 
industry groups, as it relates to the overpayments that will be 
discovered as we run the analysis, as well as the notification 
to all residents that are currently receiving some sort of 
subsidy that--in their verification recertification process, we 
are advising them, in the same form that we have advised by way 
of information and handout attached to these letters, what kind 
of income they need to take with them as they get recertified 
for the following year, sir.
    Mr. Sununu. In your testimony, you said those letters are 
being sent as we speak. How many letters are being sent out 
this week?
    Mr. Ramirez. I couldn't tell you exactly how many this 
week. It is a massive mailing of 230,000.
    Mr. Sununu. When is the goal for having completed the 
entire mailing?
    Mr. Ramirez. We should be done mailing all of these letters 
within the next 2 weeks or so, sir.
    Mr. Sununu. Two weeks? That is the initial----
    Mr. Ramirez. This is the initial match of discrepancies for 
underreporting income as it relates to the entire population.
    Mr. Sununu. That is a total of 230,000 notifications?
    Mr. Ramirez. Approximately, yes, sir.
    Mr. Sununu. You talked about the concern of those that may 
be overreporting income, and therefore--and Ms. Crowley touched 
on that, as well. You didn't give an estimate of the number of 
cases of overreporting.
    Has a similar IRS match been done to try to quantify the 
number?
    Mr. Ramirez. Yes. We are currently working on that match. 
But let me, if I may, Mr. Chairman, just bring some perspective 
to where we are and where we were.
    We have over the last several years depended on the 
Inspector General's review of a random sample of 1,000 
residents. We have now gone to matching the entire population 
that is receiving some sort of benefit from public housing or 
subsidized housing.
    We have worked very hard to reduce the false positive 
percentage on the underreporting process, and we feel 
comfortable in saying that we are running at about 20 percent 
in comparison to perhaps up to maybe as much as 50 percent in 
the old sampling method; and we are currently calibrating the 
false positives based on the thresholds that we have for the 
overpayment.
    We run a similar risk in estimating an overpayment, if we 
are not careful, in first getting these false positives, as 
small a number as it can be, because you can imagine someone 
receiving a letter saying, you have something due you, and they 
go in and they then find out that they don't have anything due 
them as a result of us advising them that they have overpaid.
    So we are in the process of doing that. We have gone 
through two runs of getting it. The number has reduced from 
about 55 percent to about 30 right now. We are not comfortable 
yet with where we are on the false positives. We are running 
the systems to see if we can further reduce that.
    We are also working with the different industry groups to 
get together with them in the near future on these 
notifications and to report out to them.
    Mr. Sununu. Ms. Crowley, I don't want to put you on the 
spot, but in the March testimony, Mr. Ramirez talked about 
trying to touch base with industry groups and tenant groups.
    My question is, to what extent have you or your members 
participated in discussions with HUD, and what more do you 
think that HUD can do to make sure that the process they are 
undertaking is fair?
    Ms. Crowley. I would say that our interactions with HUD 
officials have been extensive. My experience was that it did 
take getting it to the attention of the very highest levels to 
get us heard, but once that happened, then we were heard loud 
and clear. So there have been a series of meetings and 
discussions about that.
    There are, as I said, lingering concerns. It is not 100 
percent resolved. There are--my concern, my more than concern 
at this point, is about how it is going to play out at the 
local level and how we are going to assure that what it is that 
we have agreed to at this level actually happens there.
    That is the tricky part, because if everything unfolds the 
way we have been told it will, then it should happen in a fair 
kind of way. But we are talking about the behavior of a large 
number of different people who are going to get communications 
through several layers, and there is always the danger of 
distorted communication.
    So we will be very alert to how it is happening on the 
ground with our members and be prepared to advocate at that 
level as well.
    Mr. Sununu. We don't need to take Mr. Ramirez to task for 
not including you?
    Ms. Crowley. No.
    Mr. Sununu. Good.
    A few final questions about the scope of the problem, 
because there are two large issues here. One is the financial 
issue, which is estimating the size of the underpayments. That 
is important because the demand for the services are high.
    You gave a very stark picture of that, Ms. Crowley. If we 
take the estimate of $935 million that has been presented to 
the Task Force by HUD and the Inspector General's Office, that 
does translate into 150,000 or so certificates, new 
certificates, which is even more than is being requested by the 
administration this year. So it is a significant number.
    If I can finish, the other side of the problem is that if 
there is a case of someone who is ineligible receiving housing, 
then that means someone is on the waiting list, obviously, who 
is in need that would otherwise qualify for a slot. Of course, 
it is worth emphasizing that the vast majority of all of the 
tenants here are completely honest, law-abiding, and deserving 
of the services.
    Even if you take the full figure of $935 million--I think 
you used the total figure of 26 million for low-income 
housing--but just at the Federal level, if you look at a figure 
of 15\1/2\ million for the certificate program, it is well 
under 10 percent. It is probably--that is roughly 7 percent. So 
at the absolute worst, 93 or 94 percent of the people in this 
are not even matched, so there is not an issue there.
    So there are two sides to the problem. The specific 
question I have Mr. Ramirez, is the gross figure of $935 
million--you gave an estimate of $400 million to $935 million--
that is an annual loss; is that correct?
    Mr. Ramirez. Well, that is the estimate that comes out of 
the methodology that was recommended to us to employ in 
partnership with the Inspector General, sampling only 1,000 
of--after taking dual incomes, of about 4\1/2\ million 
families. So it is a broad estimate or a big estimate----
    Mr. Sununu. Based on a sample of 1,000?
    Mr. Ramirez. Yes.
    The other thing is, because of some of the reasons I cited 
as to the difficulty in recapturing these funds, as a result of 
folks moving away and other activities, that the more realistic 
estimate that OMB has come out with in the budget we believe is 
closer to accurate, which is about $80 million. That is taking 
into consideration not just the turnaround that may occur, but 
also remember that there is that category of overpayments.
    It is very preliminary for me to make any real estimate on 
that, but based even on a 50 percent false positive, the number 
is quite substantial on the overpayment side, as well.
    So our goal in the end, Mr. Chairman, is to try to get 
folks qualified at the front end to avoid the back-end 
discrepancies that could lead to any sort of waste, fraud, and 
abuse that we know is occurring, as was highlighted by the 
Office of Inspector General.
    Mr. Sununu. Ms. Crowley.
    Ms. Crowley. I do not pretend to understand all the 
intricacies of these numbers, but my understanding--and Mr. 
Ramirez, correct me if I'm wrong--is that the 935 million is 
the first cut at the analysis, and it is before all the false 
positives have been cleaned out.
    So once--as I said, to get to the true overpayment, you 
have to screen out all the false positives and you have to do 
the overpayment, and then you will get to what that real number 
is. So it is going to be something substantially less than 
that.
    So the 230,000 letters that are going out, the total of 
that does not get up to $935 million because that analysis was 
based on sort of a gross analysis at that point.
    Mr. Ramirez. Yes.
    Ms. Crowley. So that has to be further refined to get at 
some understanding of what the true number is.
    Mr. Sununu. Thank you.
    Mr. Ramirez. May I just say--real quick, just to say that 
what we have done is that this year, for the first time ever, 
we will have an accurate baseline of what that number really 
is, instead of these estimates that are based on a small 
population of a greater population.
    Mr. Sununu. That is the importance of keeping to your time 
line with regard to the issuance of the first 230,000?
    Mr. Ramirez. Yes. On that one, working with the industry, 
because that is also an important piece of correspondence that 
needs to go out, we would anticipate that we could finish up 
our work on that letter and what we need to refine in our 
estimates to get that letter out on the overpayment side by 
June 30, Mr. Chairman.
    Mr. Sununu. Thank you.
    Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman. Mr. Chairman, let me 
talk a little bit about the methodology, and then I want to 
talk a little bit about the broader program.
    Again, in the methodology, this is based upon a--the $935 
million figure is based upon a random sample of 1,000 
households, so it is a sampling-type issue which has questions 
of accuracy, and then is extrapolated out against the entire 
program; but false positives and overpayments by tenants are 
not netted out, so it is still a rather nebulous figure that is 
out there.
    The 230,000 notices that you are sending out, that is not 
net false positives?
    Mr. Ramirez. It is--we have 90 days after they get sent 
out. We anticipate there may be as high as 20 percent false 
positives on the 230,000. That is just based on local policy 
for exemptions of certain incomes. Again, because of the way 
the law is now structured, there is a great deal of discretion 
that is given at the local level.
    The difference between the old methodology and what we are 
employing now is that there is a complete match of income and 
Social Security, and based on that and the tiers we have 
established, we have narrowed down that universe to just 
230,000 where there are these discrepancies.
    Mr. Bentsen. Can the IG's Office tell me, in these cases 
that have been going on for some time--this is a 60-year-old 
program, in effect, and a lot of your cases go back to the 
early 1980's, and have gone on for periods of time, 
unacceptable periods of time. In the IG's study, if you could 
speak to that, is there a preponderance of underpayment by 
tenants in the high-dollar range or the low-dollar range, and 
is it $10 and $20 a month, just outright fraud, or several 
thousand dollars?
    Secondly, is there a preponderance of individual tenant 
abuse through PHAs, or is it with respect to third-party 
private-sector operators?
    Mr. Schuster. Sir, basically, as criminal investigators in 
our little world, we are just dealing with what we would call 
prosecutable criminal cases, so we would not get into the whole 
universe. We could not answer that.
    Mr. Bentsen. On that issue, Mr. Chairman, I will submit for 
the record from the IG's Office--I would be interested to know 
where the mean is and where they come down.
    Let me ask this. From an investigator standpoint, the way I 
understand this, reading through this, Congress in 1993 adopted 
a law allowing, in the famous Omnibus Budget Reconciliation Act 
of 1993--one of the many things that did not get talked about 
in the 1994 elections was a change in the law that allowed for 
the use of IRS data for income verification and match; I 
believe that is correct.
    From the IG's perspective and investigators' perspective, 
do you believe this new income verification will be a 
sufficient tool in trying to root out either outright fraud or 
just inadvertent underreporting of income?
    Mr. Schuster. Once again, I don't know, as a Special Agent, 
whether I am equipped to answer that particular question. I 
think it would give you maybe an idea. But once again, dealing 
with our resources and our priorities and what the U.S. 
Attorney's offices are, in a sense dictating to us, we probably 
would not get into those specific areas unless we had proper 
resources.
    Mr. Bentsen. Mr. Carolan.
    Mr. Carolan. I would say that it is very helpful, and some 
of the things that we talked about around the table, in some of 
the testimony, as long as this information is timely, where it 
is not old information, as long as it is accurate, apples to 
apples, and as long as we are all sensitive to the individual 
circumstances, the case-by-case family----
    Mr. Sununu. If the gentleman would yield for a moment----
    Mr. Bentsen. Yes.
    Mr. Sununu. Specifically, would an income matching program, 
as we are beginning to implement here, would that have assisted 
you in the Charlestown case? Would that have uncovered the 
income discrepancies that were prevalent in that case?
    Mr. Carolan. I would assume that it may have pointed to a 
pattern, multiple cases at a particular site, which would have 
led us to look at something other than individual tenant fraud; 
that there had to be something there that was a common 
denominator. So I think, like I said, it would be helpful.
    We have to remember, most of the cases we look at are the 
egregious ones. They are multiple years of underreporting of 
income, resulting in multiple years of overpayments, usually. 
They have to meet the test of the prosecutor.
    We also look at ability to make restitution.
    Mr. Bentsen. Just a couple more questions. Let me ask, let 
me look at this from a broader perspective in the income 
verification.
    As I understand how the Section 8 assisted housing program 
works, and has for the last long period of time, it has 
somewhat devolved from the Federal Government to local partners 
which--we actually expanded their authority through H.R. 2, or 
whatever the public law is now, back in 1998, and third-party 
contractors to the government who operate project-based housing 
and the Section 8 assistance is made to those entities.
    They are required to verify the income and have that 
approved by a third party, and that is what the Federal 
Government has relied on in the past, for the last 60 years, I 
guess.
    The income verification program, if I understand it, which 
is the first of its kind in HUD, came out of the 1993 act. It 
effectively is designed to try and match W-2, W-3 data of every 
tenant of record in the program against the data that is 
provided by the PHA, that they collect, or the third-party Acme 
Project-Based Housing Corps, whatever third party, to see 
whether that matches up.
    So this will be the first time ever that HUD is basically 
looking over the shoulder of your clients in the field; is that 
correct?
    Mr. Ramirez. It is correct on the income verification side.
    But let me say, it is one more component of our overall 20-
20 management reform. We have always taken the other side of 
oversight seriously, as well, and have reshaped the way we go 
about inspecting the Housing Authorities and the project-based 
owners for housing quality standards, for financial stability, 
for tenant satisfaction, and for management, as well, through 
our real estate assessment system and center.
    So, yes, it is the first time we have ever done that, and 
it is a baseline that we are establishing so that Congress then 
can have a more accurate account of underpayment, overpayment, 
and the real number that is out there, and to assist you in 
providing the funding that we need to provide affordable 
housing.
    Mr. Bentsen. To the IG's, and then I will finish up, and I 
am going to apologize, because I am going to have to leave 
after that; there is another meeting I was supposed to start 
chairing 15 minutes ago.
    In your history of 28 years--and I don't know how long, Mr. 
Schuster, you have been there--is this a problem that you have 
seen throughout your career with HUD in the Section 8 public 
housing; or is this a problem that has just sort of started to 
occur in recent years?
    Second of all--and you may not know the answer to this--but 
how would you compare the potential loss to the program in this 
with the old FHA coinsurance program that was designed to 
create affordable housing, multifamily housing, primarily in 
the late 1970's, but also in the 1980's? I assume you all dealt 
with some of those issues, as well.
    Mr. Schuster. I will start off first by saying, you know, 
is there a history of it? As long as I have been a criminal 
investigator, which is over 30 years, there have been people 
who have been out to defraud the system. So I have always--I 
have never had to worry about work. I have always had a lot of 
work. This has been continually.
    I worked with ATF, I worked with Health and Human Services 
IG, and for the last 11 years I have worked for HUD IG. There 
has been--there has been a problem. There are people who are 
out to defraud the program.
    As I said, we are dealing with a small number of people who 
are really ripping off the system. That is the only way to say 
it. There is no doubt that this is not by accident. They have a 
plan; they are conspiring to do this.
    Mr. Bentsen. This is not just an innocent, ``I didn't 
report--I didn't realize that my minimum wage went up and I was 
getting more money,'' or something?
    Mr. Schuster. Right. This is not an accident. That is why 
in my statement I wanted to point out that there are situations 
where people are not trying to rip off the system, they are 
trying to do for family, or whatever. They might be actually, 
in a sense, defrauding the system, but it is not something 
that, you know, we would be concerned about in our particular 
responsibilities.
    So I think, yes, there have always been problems. To what 
extent, we have no way of knowing. We don't get into that. 
Probably our audit side of the House has made more studies of 
that and may be more able to respond.
    Mr. Bentsen. Thank you.
    Mr. Carolan.
    Mr. Carolan. I would agree. We presented the first cases in 
my district, in the district of Massachusetts, in the 1970's, 
so I believe the problem is there and continues to be there.
    But again, we look at the most egregious cases. We have a 
lot of criteria where we test them, like ability to make 
restitution, multiple years of the problem with one individual 
or family. So there are a lot of ways we screen out those that 
do not meet the standards, and refer them back to the HUD 
program people or to the providers for administrative recovery, 
to look at it and see whether they can recover.
    As far as the second part of your question, the insurance 
programs, back to the 236 program and other programs, the same 
type of things were happening. We had falsification. As my 
associate said, there are people out there that are going to 
beat the system, and will find a way to try to beat the 
matching and everything else. I think it did exist back in some 
of those programs, also.
    Mr. Bentsen. Thank you, Mr. Chairman.
    Mr. Sununu. Thank you, Mr. Bentsen.
    Mr. Miller.
    Mr. Miller. Thank you, Mr. Chairman.
    Deputy Secretary Ramirez, we discussed preventing waste, 
fraud, and abuse from happening in the future. You briefly said 
how the law is now structured.
    Mr. Ramirez. Yes.
    Mr. Miller. That raised a question.
    Is there anything Congress can do to help you?
    Mr. Ramirez. Yes, sir. We believe that to bring the 
accuracy of the system to an even more on-time basis--again, to 
bring a little perspective to the situation--the 1,000 number 
sampling that came out of this population of 4.5 million is 
based the same as we base our current verification process, 
which is prior year returns. So a year has gone by before we 
can actually match up and see if there was any discrepancy in 
what was certified and what income was actually reported.
    If we were to be able to get legislative relief to work in 
greater cooperation with HHS, and in particular, for the 941 
quarterly reports on new hires, that would help enhance the 
ability of the private owners or operators, as well as agents 
and our agency, to be more on time in capturing any 
discrepancies in recertification and underreporting.
    Mr. Miller. Has anybody asked for that legislative relief 
to date?
    Mr. Ramirez. Consider it asked, sir.
    Mr. Miller. OK. I would like to follow up after the hearing 
with you on that.
    Mr. Ramirez. We will be----
    Mr. Miller. If that has not occurred and there is something 
we can do to help you, we need to do that.
    You basically talked about the DC pilot program and the new 
verification program we will be using in the future.
    Can you give me just a brief overview of the difference, if 
you have not already done that? I know I missed part of the 
hearing.
    Mr. Ramirez. The difference between the pilot and what we 
are doing now?
    Mr. Miller. The DC pilot program and the new verification 
program you are going to be using now.
    Mr. Ramirez. What we have done--the biggest difference is 
that the letter, as Ms. Crowley mentioned earlier, what was 
sent in our pilot to the District of Columbia residents was a 
little more menacing then it needed to be. It was pretty 
bureaucratic, and had not really been vetted at the highest 
levels to be able to be a little more descriptive and clear in 
the objective of sending this letter and, also, in outlining 
the facts as to the type of incomes that qualified, did not 
qualify, what kind of rights tenants had in pursuing their--any 
remedial action they felt they needed to take.
    I would like to acknowledge the great work and cooperation 
that we got, not just from Ms. Crowley, but, as well, other 
industry groups both on the private owners' side, the agents' 
side, through the Housing Authorities, and the tenants, which I 
thought was somewhat historic, to be able to get all these 
groups together around a table for the first time.
    This was the issue that brought it. We have worked together 
since then. We will continue.
    We now have a couple of issues that we need to resolve 
together, and now that we have gotten into a rhythm of 
exchanging documentation and corrections in language and 
whatnot, we need to clear up the correspondence that is going 
out to the agents and operators, advising them of what they 
need to do as a result of people receiving--the tenants having 
received these letters for over- or underpayments.
    We have the letter for overpayment that we will be working 
on, and then a bigger mailing that will just lay out what 
qualifies, what does not qualify, and remedies that a tenant 
can pursue that will be going out.
    Again, let me reiterate for the record that our notices--
the way the mail works, and everything else, for underpayments, 
June 30, we are hoping to work with the industry to have the 
overpayment discussion done by that time as well, to get those 
letters out and proceed accordingly, and be able to come back 
with a more defined--because there is a 90-day period; sometime 
by December 1 this process should be concluded for this first 
cycle.
    Mr. Miller. Knowing that you could never eliminate all the 
waste, fraud, and abuse that might exist within any system, 
based on what you are proposing--and you are moving forward 
now--do you believe the next time you come before Congress, you 
will have fairly much resolved this problem?
    Mr. Ramirez. We will have the baseline and an accurate 
number, gross number, of what we believe would be 
underreporting on the part of tenants.
    We need to then, at that point, factor, as we believe is 
correct, the probability of being able to recapture those 
funds, and up to what level, without it becoming overly costly 
for this collection.
    Finally, let me say that what we will have been able to 
accomplish, which is our goal in this process, is to be able to 
have eligible residents that are sitting on waiting lists, that 
have doubled over the last year and a half, into these units, 
and ineligible residents out of those units; and we feel that 
in that regard we will be able to meet that particular area of 
our mission.
    I cannot say that we will be meeting our mission as 
completely as we should. There were some very accurate figures 
brought out by Ms. Crowley as to the real need that is out 
there. There are additional resources we would need to be able 
to create affordable housing opportunities.
    Mr. Miller. As a type of an aside, are you involved in any 
way with down-payment assistance with nonprofits?
    Mr. Ramirez. Yes, sir.
    Mr. Miller. One problem we have noticed in the last few 
years, and I don't know why it is--I have dealt with a couple. 
Some I have looked at and I shake my head; some are doing a 
good job, but it seems like there is vague and ambiguous 
language that HUD keeps putting out. I have written letters to 
try to get this resolved. We have been effective in every 
instance.
    It seems like there is a problem with HUD about putting out 
vague language, whether certain nonprofits' loans are going to 
be approved in the future, with no data to say that they are 
not going to be, no scheduled hearings to say there is going to 
be an overview. I am wondering why that continues to happen. It 
is becoming a problem.
    There are some out there that are providing down-payment 
assistance for groups that are not using any government funds 
and are very successful. It seems like they are repeatedly 
being impacted in some fashion by HUD. It does not make any 
sense to me.
    Mr. Ramirez. There are two issues there that you have 
touched on, Congressman.
    The first issue is that when we put out a regulation to 
create the facilitation of the delivery of whatever programs we 
have, or activities that we have jurisdiction over, we 
purposely try to make sure that this regulation is as flexible 
and as open as possible to create as much local flexibility as 
possible. That may be interpreted as ambiguity, perhaps, in 
some instances.
    We believe that it is better for us to refine it than to 
come out with something that is--that will, in essence, lock 
communities and not-for-profits into doing things a certain 
way, and we have learned that the cookie-cutter approach does 
not work.
    The other side of the equation is that we do have some very 
successful not-for-profits that do not use any government funds 
that provide down-payment assistance to low- and moderate-
income families for home ownership.
    Our concern there, and we are working with the different 
groups, is that there are--there is a negative equity that is 
built as a result of what is brought in at the front end of 
these loans that, in essence, creates a bigger burden through 
the life of a loan for these low- and moderate-income families.
    Mr. Miller. Through inflated appraisals or such?
    Mr. Ramirez. Correct.
    So what we have been doing is, we have been talking to both 
the ones that are effective in doing this and have worked to 
monitor their activity to make sure that this does not occur, 
as well as those that are quite lax in dealing with it.
    We have to step in and make sure that in the end what we 
are doing is that we are truly creating the opportunity for a 
family to realize the American dream and not end up living the 
American nightmare.
    Mr. Miller. One thing--and I think it is really important, 
because we have gone over this, I have done this too many times 
in the last year with nonprofits--that HUD should be a little 
more sensitive.
    There are some that there is absolutely no--even suggestion 
that they are inflating appraisals, they are dealing with 
approved lenders who are providing quality appraisals; and yet 
some of the language comes out that implies that at a future 
date this specific nonprofit might not be an approved HUD agent 
to deal with those types of loans.
    I would ask that you try to create more sensitivity. I 
understand that you try to deal with the problem, but in some 
cases, a problem is being created where there is none. I have 
not tried to be an advocate of any one specific group, but when 
we come back and approach HUD, we find no reason at all that 
they should be using language like that, and they change it. It 
just causes some problems and hurts some people who have tried 
to take advantage of these down-payment assistance programs, 
because their loan has not been recorded or has been delayed 
for some reason. It should not have been.
    If you can just do that, I will appreciate it.
    Mr. Ramirez. Yes, sir. We will get back to you with a 
response.
    Mr. Sununu. Mr. Clement.
    Mr. Clement. Thank you, Mr. Chairman, Mr. Secretary, and 
the panel. It is a pleasure to have you here today.
    Let me ask you this question, first. What percentage of 
households eligible for Federal rental subsidies actually get 
help?
    Ms. Crowley. It is about one-third. That is the number that 
is most frequently cited; that if you defined the eligibility 
under what the law allows now and then you look at how many are 
actually getting assistance, it is about one-third.
    There are other ways of looking at the number. Our number 
is, as I said, 10.8 million households with a severe housing 
cost burden who are low-income people. That includes both 
homeowners and renters. HUD's analysis is that the worst-case 
housing needs is 5.4 million households. Those are renters who 
receive no assistance and have a variety of housing problems.
    Mr. Clement. Of course, we all, Democrats and Republicans, 
want to stop waste and fraud. We should do everything we can to 
stop Federal payments to families who are not eligible.
    If you assume that a $935 million overestimate is accurate, 
and every penny went to eligible families, how many more 
families would be covered?
    Mr. Ramirez. About 150,000. But we don't agree with that 
assumption, Congressman.
    Mr. Clement. I wish you would expand on that.
    Mr. Ramirez. As we went into this subject earlier in our 
testimony and in earlier questioning, the $935 million figure 
that is out there is based on a small sampling of--I hate to 
sound repetitive, but just to be able to clear things up, in 
the past, what we have done is that we would take a sampling of 
1,000 residents in a total population of about 4.5 million. 
Then from there, the methodology that was employed would 
extrapolate to that number that you see up there.
    What we are doing now is that we have actually matched up 
these households through tax returns, Social Security benefits 
that are paid, and their residency, and set thresholds as to 
whether they are underreporting or not. We have gotten down to 
the point of refining that, and have identified, in that 
universe of about 4.5 million, 230,000 households that have 
technically underreported.
    I need to add that within that number, because of the broad 
discretion that has been provided to local Housing Authorities 
and operators, that they do have discretion as to what they 
would allow or disallow as eligible income. So we are going to 
be going through that process of getting down to the final 
number.
    The other circumstance that we run into is that there are 
situations where people overpay in the program. We are 
currently matching up income and payments that get to a number 
that would reflect, as closely as possible, those amounts that 
are being overpaid, to advise those residents as well that they 
need to go in and clear up those overpayments, so they can 
actually be getting what they are entitled to.
    The $935 million number that is out there is a number that 
is--that is, we believe, quite inaccurate in reflecting a true 
picture of what actually exists in the overpayment category.
    Once we have--because this year is a baseline year, 
Congressman, for establishing that number, that baseline then 
is also impacted by certain situations, again allowable 
exceptions plus collection difficulties that occur, to get to a 
real number of actual recovery of any overpayments that are out 
there.
    Our goal in the end, by establishing this system, is to be 
able to better qualify at the inception the residents, number 
one; and number two, that when we do find these discrepancies, 
and someone is living in a unit that is not qualified to live 
in that unit, that that unit then be vacated by that 
individual, or that family, and that it now be occupied by 
someone that is eligible.
    Mr. Bentsen. Mr. Secretary, there is no doubt in your mind 
there is a huge unmet need that exists?
    Mr. Ramirez. I would further add that even after getting to 
this number, we would not be making a dent in the need.
    It was earlier stated that we have over 11 million American 
families out there that--or close to 11 million that are out 
there that are suffering conditions of housing where they are 
paying more than 50 percent of their income in rent. So it is 
an unacceptable condition that exists.
    Even with the current request that the President has 
proposed of 120,000 additional vouchers, it is a baby step in 
trying to resolve this problem, but a step that we feel is 
absolutely necessary, because it is an escalating problem.
    Mr. Clement. Mr. Secretary, these numbers up here on this 
chart, you don't really accept those numbers as true or 
accurate numbers?
    Mr. Ramirez. That is correct. We accept those as rough 
estimates based on the methodology that has been employed in 
partnership with the figure of the Department of Housing and 
Urban Development to come up with a number that needs to be 
included in our financial statements.
    Mr. Clement. All right. Thank you.
    Mr. Sununu. Thank you very much, Mr. Clement.
    I have just a few final questions.
    Mr. Ramirez, has the Department shared the match list of 
the 230,000 tenants that have a significant underreporting of 
income with the Inspector General's Office in order to try to 
identify patterns that might exist there that would be worthy 
of their investigation?
    Mr. Ramirez. No, sir. It is premature for us to share that 
list with anybody, first off, because it has not gone through 
the cycle of it being exempted or not.
    Secondly, it is--the private operators and agents, such as 
the Housing Authorities, it is up to them to assume the 
principal responsibility in rectifying any differences in 
underreporting.
    So the principal obligation of having this reported to the 
Inspectors General throughout the country that serve the 
Department would be based, more than likely, on referrals from 
the Housing Authorities, agents, or private owners, sir.
    Mr. Sununu. As this process moves forward, however, is it 
your intention to share information that HUD might develop 
regarding patterns in income underreporting, or egregious cases 
of income underreporting, to the Office of Inspector General?
    Mr. Ramirez. We are prepared to share information that 
would not violate the Privacy Act and the method in which we 
were able to collect this information, and certainly we are not 
going to be the ones initially to make the call as to whether 
there is fraud or not occurring.
    Inspectors General, as has been my experience through the 
years that I have been with the Department now--they have the 
run of the room. If they so wish to come in and audit these 
numbers, they are certainly welcome to.
    Mr. Sununu. There is nothing that would prevent them 
statutorily from reviewing the income underreporting 
information that you might generate?
    Mr. Ramirez. That would be a question that I would suggest 
be posed to the inspectors.
    Mr. Sununu. Mr. Carolan, is there anything that would 
prevent you from reviewing information to identify patterns or 
egregious cases of underreporting that might be worthy of 
investigation?
    Mr. Carolan. I don't believe there would be any barrier.
    Mr. Sununu. Thank you.
    A final question: Mr. Ramirez, we have talked a lot about 
this process, which I think is important. Mr. Clement mentioned 
the value of determining whether or not $935 million is 
recoverable, identifying what is recoverable. Ms. Crowley 
talked about looking at income overreporting as well.
    These are all issues, though, at the end of the process, 
where we are trying to verify after the fact and match actual 
income to what was initially reported.
    What has been done to deal with the front end of the 
process, to improve the internal control systems of HUD so that 
the Housing Authorities can better determine tenant income up 
front when they first apply, or when they are recertified?
    Mr. Ramirez. One of the things, because of the discretion 
that is written into the law to create greater flexibility at 
the State level and local level, there have been some States 
that have been proactive in trying to get more on-time 
information as it relates to wages. So there are State wage 
reports that now go to Housing Authorities, but it is on a 
State-by-State basis. That is the only way it could be done.
    Mr. Sununu. How many States do that?
    Mr. Ramirez. I think there are three--we are actually using 
two right now. Two.
    Mr. Sununu. Is that something that you are encouraging 
States to do?
    Mr. Ramirez. Absolutely, sir. But that is, again, at their 
discretion.
    Mr. Sununu. Thank you very much.
    Thank you to all the witnesses for your testimony today. 
This is a significant problem, both in terms of the finances, 
but also in terms of the fairness of the program.
    It is important that these programs are viewed by both the 
public that does not benefit from the program and those that 
are in need, that they are fair, in order to ensure the 
credibility of HUD that has a number of other programs that it 
uses to reach out to communities with, and the credibility of 
the Federal Government that is trying to oversee these and 
other programs efficiently and effectively.
    Your testimony has helped us a great deal here today. Thank 
you for your time.
    The committee is adjourned.
    [Whereupon, at 11:41 a.m., the Task Force was adjourned.]


           Government Failure in Disposing of Obsolete Ships

                              ----------                              


                          FRIDAY, JUNE 9, 2000

                  House of Representatives,
                           Committee on the Budget,
                  Task Force on Housing and Infrastructure,
                                                    Washington, DC.
    The Task Force met, pursuant to call, at 10:10 a.m. in room 
210, Cannon House Office Building, Hon. John E. Sununu 
(chairman of the Task Force) presiding.
    Chairman Sununu. Good morning and welcome to the witnesses. 
I want to thank Ken Bentsen and all the committee members for 
participating in the hearing today.
    Today we welcome three witnesses to testify on the problems 
and the failure governmentwide in disposing of obsolete ships. 
Our witnesses today are Thomas Howard, Deputy Assistant 
Inspector General for the Department of Transportation; John 
Graykowski of the Maritime Administration; and Vice Admiral 
James Amerault, Deputy Chief of Naval Operations for Logistics. 
I understand all of you have busy schedules and I appreciate 
your taking the time today.
    The Merchant Ship Sales Act of 1946 created the National 
Defense Reserve Fleet to provide merchant and nonmilitary 
vessels to meet shipping requirements during national 
emergencies. The Maritime Administration, MARAD, administers 
this fleet, and they are responsible for disposing of obsolete 
vessels of 1,500 gross tons or more. DOD provides funding to 
maintain the fleet, and right now there are 114 vessels that 
have been designated for disposal because most of them are no 
longer operational and they do pose problems that are both 
financial and environmental.
    Unfortunately, we have a situation that is beginning to 
develop into a crisis. Over the last 5 years, in a number of 
ways, the government has restricted the ability of MARAD to 
engage in this task. There are current restrictions on MARAD to 
use its own funds to pay for the scrapping of these vessels. 
There have in the past been restrictions on utilizing foreign 
scrap yards, and there is a problem with the domestic supply of 
available scrap yards to handle the disposal of these obsolete 
vessels.
    The vessels are maintained at three locations: James River 
Reserve Fleet in Virginia; Beaumont Reserve Fleet in Texas; and 
the Suisun Bay Reserve Fleet in California. During 1999 the 
cost to maintain this disposable fleet exceeded 4.2 million and 
there was an additional $1 million that we will have Mr. 
Graykowski talk about in some more detail for emergency repair.
    This is really no direct fault of MARAD. These are old 
vessels, in some cases decades old. They have hazardous 
materials in some cases on them. They can leak oil and I think 
this environmental issue has really been undiscussed, at least 
unquantified. That is one of the issues I hope we can touch on 
today to better understand the potential environmental threat, 
the cost of that environmental threat, and the threat it poses 
not just on the river itself or the bay where these boats are 
being held but on local economy, shipping, and local navigation 
safety.
    The estimates to deal with this problem in its entirety 
range from $500 million to over $2 billion. That is a 
significant amount of money. It is an enormous range of costs 
and I think that is simply an indication of how little we 
really understand both the short-term and long-term costs of 
dealing with these problems.
    Since 1995 MARAD has only scrapped 7 vessels. Several were 
sold to contractors in 1999, but a number of the vessels were 
never removed and remain moored with the MARAD fleet. Progress 
has clearly dropped off in the past 10 years; but at the same 
time the longer we wait, the larger this problem becomes. The 
problem grows because over the next year over a dozen 
additional vessels are scheduled to come into the MARAD fleet.
    Now, between 1987 and 1994, MARAD disposed of 130 vessels, 
most of which were exported to China, India, Mexico and Taiwan. 
Problems with the world price of scrap metal has also hindered 
efforts by MARAD to scrap the vessels because when scrap metal 
prices are depressed, there is less likelihood that either a 
foreign or a domestic scrap yard is going to be willing to pay 
to take the vessel off MARAD's hands. Current legislative 
restrictions exist, as I said earlier, that prevent MARAD from 
engaging in contracts to pay for the scrapping of these vessels 
and as a result the problem grows.
    I think it is a problem that is getting worse. The estimate 
is that there would be as many as 155 vessels waiting for 
disposal by the end of 2001. The administration response to 
date, in addition to imposing a moratorium that lasted for some 
time and significantly delayed the scrapping process, was to 
move the date that we required these ships to be disposed of 
back 5 years or at least to request a movement in that date. 
While I understand that this reflects a recognition of the slow 
pace of progress in this area, I don't think that moving the 
date that we require all these vessels to be scrapped in and of 
itself is going to really address the problem. Delaying when we 
have a known environmental crisis before us really is no 
solution.
    I am very interested to hear what our real options are for 
dealing with this problem. I don't think waiting is acceptable. 
I think and I hope Mr. Graykowski from MARAD will be candid and 
even creative in perhaps looking beyond some of the existing 
financial restraints or political restraints and talking 
through with this subcommittee, with this Task Force, what some 
of the potential options might be. And I am sure that members 
on both sides of the Task Force recognize that this is a 
problem that may actually cost money in the short term in order 
to save money in the long term, and certainly it warrants our 
closest attention.
    We don't have a good handle on the costs and the potential 
risks associated with this, with these obsolete vessels, but I 
hope at the end of this hearing today we will have a much 
clearer picture of the options ahead of us.
    [The prepared statement of Mr. Sununu follows:]

Prepared Statement of Hon. John E. Sununu, a Representative in Congress 
                    From the State of New Hampshire

    I would like to start by thanking Congressman Bentsen and all the 
members of the Task Force for being here this morning. I would also 
like to thank and recognize Mr. Thomas J. Howard, Deputy Assistant 
Inspector General, Department of Transportation, Mr. John E. 
Graykowski, Deputy Administrator of the Maritime Administration 
(MARAD), and Vice Admiral James F. Amerault, Deputy Chief of Naval 
Operations for Logistics. I appreciate your taking time out of your 
busy schedules to be here with us.
    The Merchant Ship Sales Act of 1946 created the National Defense 
Reserve Fleet (NDRF), which would provide merchant and nonmilitary 
vessels to meet shipping requirements during national emergencies. The 
Maritime Administration (MARAD) administers the fleet and is charged 
with the responsibility of disposing of vessels of 1,500 gross tons or 
more. The Department of Defense (DOD) provides funding to maintain the 
fleet. At this time, 114 vessels have been designated for disposal 
because many of them are no longer operational and pose serious 
problems both financial and environmental. It is my hope that we can 
explore here today the extent of the problems with scrapping these 
ships and discuss the possible solutions. Furthermore, I would like to 
know what we in Congress can do to help move this potentially costly 
situation forward or at least closer toward a comprehensive resolution.
    These 114 NDRF vessels are maintained at three locations: the James 
River Reserve Fleet in Virginia; the Beaumont Reserve Fleet in Texas; 
and the Suisun Bay Reserve Fleet in California. During fiscal year 
1999, the cost to maintain 110 vessels awaiting disposal exceeded $4.2 
million, and an additional $1 million was spent on an emergency repair. 
The estimates to do away with this problem range from $500 million to 
$2 billion. The yearly costs to maintain an NDRF ship averages $20,000. 
If some of these ships are not disposed of soon, they may sink, causing 
serious environmental problems. Repairing and drydocking these vessels 
could be very expensive and may cost as much as $900,000 per vessel. 
Environmental cleanup and remediation could be even more expensive to 
address, and appears to be very hard to estimate, which is a large 
concern in my mind.
    Since 1995, MARAD has only scrapped 7 vessels. Several vessels were 
sold to contractors in 1999, but the vessels were never removed and 
remain moored with the MARAD fleet. Progress in scrapping vessels has 
clearly dropped off in the past 10 years. The longer we wait the larger 
and more costly the problem becomes.
    Typically, a ship scrapping company buys the rights to scrap a 
government ship and later sells the salvaged metal to recyclers. 
Remediation of hazardous materials takes place before and during the 
dismantling process. If a vessel is taken apart improperly, a ship 
scrapping operation can pollute the land and water surrounding the 
scrapping site and risk the health and safety of the scrapping 
operation's employees.
    Exporting these ships is not an option at present. In 1994, the 
Environmental Protection Agency (EPA) prohibited the Navy and MARAD 
from exporting vessels after determining that the export of government 
ships for scrapping was prohibited by the Toxic Substances Control Act. 
In fact, MARAD has not sold a vessel to overseas markets for scrapping 
since 1994. MARAD disposed of 130 vessels between 1987 and 1994, of 
which 128 were exported to China, India, Mexico, and Taiwan. In 
September 1998, the Clinton administration placed a moratorium on 
overseas scrapping due to concerns about environmental and worker 
health and safety. The moratorium expired October 1, 1999. Currently, 
the administration requires MARAD to request approval from the EPA to 
sell vessels overseas to markets that are capable of scrapping in an 
environmental complaint manner.
    It is apparent that this problem cannot continue to go unresolved. 
The Department of Transportation Inspector General's office indicated 
in its audit report of March 10, 2000, that the number of obsolete 
vessels could be as high as 155 by the end of fiscal year 2001. We can 
surely all agree that this situation is getting worse and something 
must be done soon.
    I am interested to hear what plans are currently being made and 
developed to deal with these issues. I am hopeful that MARAD and the 
Navy can coordinate their efforts to bring about a solution. Solutions 
may range from allowing overseas scrapping of these vessels, creating a 
domestic scrapping industry in the United States to handle the 
workload, or to simply spend the money necessary to dispose of every 
obsolete vessel.
    The bottom line is that the U.S. Government does not have a good 
understanding of the potential long-term cost of scrapping these ships 
or the environmental impact resulting from a ship-related accident. I 
look forward to hearing the thoughts of our panel members. I would like 
to recognize Congressman Bentsen for any opening comments he may have.

    Chairman Sununu. Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman, and I thank the 
members of the panel for testifying today. As the Chairman 
pointed out, this Task Force is charged with holding oversight 
hearings on waste, fraud, and abuse and reporting our findings 
and recommendations to the full House Budget Committee.
    In this, our third oversight committee hearing, we turn to 
disposal of obsolete vessels in the National Defense Reserve 
Fleet by the Maritime Administration, MARAD program. I have a 
dual interest in this, the one which you all are doing; but, I 
also might add, representing the district which includes a 
great deal of watershed in the port of Houston and the ship 
channel.
    I have had my own experience in trying to remove abandoned 
barges from the San Jacinto River, which the Coast Guard was 
kind enough to do with a little nudging from Congress. And, Mr. 
Chairman, we did find that in many cases, the cost of removal 
and decontamination exceeds the scrap value greatly and ends up 
being a net loss situation.
    I am particularly interested in hearing about the Navy's 
pilot project for scrapping obsolete vessels and whether it can 
be used as a model for MARAD. While I am interested in learning 
the magnitude of the inventory excess problem, I am primarily 
concerned about how MARAD plans to economically scrap these 
vessels while complying with safety and environmental 
standards. I understand the issue is the relative feasibility 
of scrapping these vessels in the United States and overseas.
    I might mention that our colleague, Mr. DeFazio of Oregon, 
has introduced a bill, H.R. 4189, which would establish a pilot 
program for the Department of Transportation to carry out the 
vessel scrapping and processing program in the United States. 
At his request, Mr. Chairman, I would ask unanimous consent at 
the appropriate time that his statement regarding his bill in 
this matter be included in the record.
    Chairman Sununu. Without objection. And I would ask also 
unanimous consent that all members be given 5 days to submit 
written statements for the record.
    [The information referred to follows:]

   Prepared Statement of Hon. Peter A. DeFazio, a Representative in 
                   Congress From the State of Oregon

    Thank you very much for the opportunity to testify on the issue of 
how to dispose of the U.S. Government's obsolete ships. As the ranking 
Democrat on the House Transportation and Infrastructure Committee's 
Subcommittee on Coast Guard and Maritime Transportation, I am keenly 
interested in resolving this problem. I have introduced legislation, 
H.R.4189, to address the issue and the Subcommittee has held two 
hearings on this subject.
    As you know, the U.S. used to send its surplus vessels for 
scrapping at overseas facilities, under terrible conditions. Public 
outrage over the U.S. sending its toxic legacies overseas, led the 
Administration to halt this practice several years ago. Since that 
time, virtually no ships have been scrapped. Why? Because the U.S. 
Maritime Administration (MARAD) is statutorily obligated to sell these 
ships, and cannot, under current law, provide funds for their disposal 
here in the United States. No U.S. shipyard can possibly scrap these 
ships in an environmentally responsible and safe manner. So, these 
ships remain rotting at anchor in U.S. harbors.
    The government's current options are to again send its vessels to 
overseas shipyards where third world workers toil in unspeakable 
conditions, or leave them in U.S. harbors where they risk sinking and 
polluting our waters.
    Instead of lamenting over this dilemma, Congress should take the 
initiative to change MARAD's statute and allow the agency to provide 
funding for shipyards in the United States to scrap ships. These ships 
are the responsibility of the U.S. Government and we should take 
responsibility the environmental hazards and safety risks posed by 
these vessels.
    It is time to admit that it will cost money to take care of our 
toxic legacy. I have introduced legislation to do just that. My bill, 
H.R.4189, authorizes funding for a ship scrapping pilot program at 
MARAD, to pay qualifying shipyards to scrap its obsolete vessels.
    I hope that as a result of this hearing, more Members of Congress 
and the public will be aware of this problem and work to enact 
legislation to solve it.

    Mr. Bentsen. I thank the Chairman and with that, I will 
yield back the balance of my time and look forward to hearing 
the testimony today.
    Chairman Sununu. Thank you very much Mr. Bentsen.
    I would like to begin our testimony with Mr. Howard from 
the Inspector General's office and then provide time for Mr. 
Graykowski to talk about his perception of the problem and 
thoughts on ways to deal with the problem. And then we will 
hear from Vice Admiral Amerault about the Navy pilot program 
which I know has met with some success, and even more 
important, I hope has yielded a good deal of information about 
the process, the costs, and the technical and financial 
obstructions to dealing with this problem.
    Mr. Howard, welcome, and we are pleased to hear your 
testimony.

  STATEMENTS OF THOMAS J. HOWARD, DEPUTY ASSISTANT INSPECTOR 
GENERAL FOR MARITIME AND DEPARTMENTAL PROGRAMS, U.S. DEPARTMENT 
    OF TRANSPORTATION; JOHN E. GRAYKOWSKI, ACTING MARITIME 
ADMINISTRATOR, U.S. DEPARTMENT OF TRANSPORTATION; AND VICE ADM. 
 JAMES F. AMERAULT, DEPUTY CHIEF OF NAVAL OPERATIONS LOGISTICS

                 STATEMENT OF THOMAS J. HOWARD

    Mr. Howard. Thank you, Mr. Chairman, members of the Task 
Force. I ask that my statement be submitted for the record and 
I will summarize my remarks.
    Chairman Sununu. Without objection.
    Mr. Howard. My statement is based on our March 10th report 
on MARAD's ship-scrapping program. The Office of Inspector 
General has identified MARAD's ship-scrapping program as one of 
the 12 most pressing management issues in the Department of 
Transportation. The Department, the administration, and the 
Congress face a challenge in determining how to dispose of 
MARAD's fleet of old, environmentally dangerous ships in a 
timely manner.
    The current approach of selling ships for domestic 
scrapping is not working. MARAD will not be able to meet the 
legislative mandate to dispose of its ships by September 30, 
2001. It also will not be able to gain meaningful financial 
returns from these ships.
    As you mentioned, Mr. Chairman, MARAD maintains its ships 
in the water in three locations. The picture being displayed 
shows a few of the ships in Suisun Bay. The one in the 
foreground is the Mission Santa Ynez, which is 56 years old and 
has been awaiting disposal for 25 years. Environmental dangers 
associated with these old, deteriorating ships are increasing 
daily. The so-called worst-condition ships average 50 years old 
and have been awaiting disposal for 22 years.
    These photos show actual conditions on 3 of the 40 worst-
condition ships. The ships contain hazardous materials such as 
PCBs, asbestos, lead-based paint, and fuel oil. Some have 
deteriorated to the point where a hammer can penetrate their 
hulls. If the oil from these ships was to leak into the water, 
immediate and potentially expensive Federal and State action 
would be required.
    MARAD currently has 114 obsolete ships awaiting disposal. 
As shown in the chart being displayed now, this number has 
grown from 66 just 3 years ago. It is expected to reach 155 by 
the end of fiscal year 2001.
    As shown in the next chart, only 7 ships have been scrapped 
since 1995. This represents a significant change from 1991 
through 1994 when 80 ships were scrapped overseas. In addition, 
recent sales to domestic scrappers have only yielded between 
$10 and $105 per ship. This is down from an average price of 
$433,000 per ship during the early nineties.
    MARAD's inability to reduce the backlog of ships awaiting 
disposal is attributable to a couple of factors: the loss of 
overseas sales, current limited domestic scrapping capacity and 
the Navy's pilot program.
    Since 1994 MARAD has been relying on the domestic ship-
scrapping market but its capacity is currently limited. Only 
four companies have passed MARAD's technical compliance reviews 
to scrap ships. Although MARAD sold 22 ships to these domestic 
scrappers since 1995, 13 are still moored in MARAD's fleet. 
Recent contractor delays in picking up ships and a default by 
one contractor raise a question as to whether the ships will be 
removed from the fleet.
    The Department of the Navy experienced a similar inability 
to sell its obsolete combatant ships in the domestic market. In 
1998 Congress authorized and appropriated funding for a pilot 
project allowing the Navy to pay domestic contractors to scrap 
ships. Last year the Navy awarded contracts amounting to $13.3 
million for the scrapping of 4 ships. The contractor that 
defaulted on MARAD is scrapping a ship under the Navy pilot 
program. MARAD is coordinating with the Navy on its initiatives 
and is pursuing alternative disposal methods, but due to 
capacity limitations, no one of those alternatives has the 
potential of significantly reducing the backlog in a timely 
manner.
    In our March report we recommended that the Maritime 
Administrator take several actions:
    First, seek legislative approval to obtain an extension on 
the disposal mandate and eliminate the requirement to gain 
financial returns on vessel sales.
    Second, continue to pursue programs to improve scrapping 
sales and identify alternative disposal methods.
    Third, develop a proposal seeking authority and funding to 
pay domestic contractors to scrap ships, targeting the 40 
worst-condition ships for priority disposal.
    In its authorization request for fiscal year 2001, MARAD 
proposed a 5-year extension to develop and begin implementing a 
plan to dispose of these ships. We do not believe it is 
acceptable to begin disposal within 5 years, considering the 
condition of some of the ships, the environmental risk, and the 
cost to maintain them. In our opinion, the legislation should 
require MARAD to develop a disposal plan and substantially 
dispose of these ships within 5 years. Further, MARAD's plan 
needs to identify viable disposal methods, set milestones, and 
target the worst-condition ships for priority disposal.
    This concludes my remarks. I will be happy to answer 
questions.
    Chairman Sununu. Thank you Mr. Howard.
    [The prepared statement of Thomas Howard follows:]

  Prepared Statement of Thomas J. Howard, Deputy Assistant Inspector 
  General for Maritime and Departmental Programs, U.S. Department of 
                             Transportation

    Mr. Chairman and members of the Task Force, we appreciate the 
opportunity to be here today to discuss the Maritime Administration's 
(MARAD) program for scrapping obsolete vessels. We have identified this 
program as 1 of the 12 most pressing management issues in the 
Department of Transportation. The Department, the Administration, and 
the Congress face a challenge in determining how to dispose of MARAD's 
Fleet of old, environmentally dangerous vessels in a timely manner.
    The current approach of selling obsolete vessels for domestic 
scrapping is not working. There is limited capacity in the domestic 
scrapping market and the Navy is paying contractors to scrap its 
obsolete warships while MARAD is asking contractors to pay to scrap its 
vessels. Further, MARAD has been constrained from selling vessels 
overseas for scrapping, although this had been a key market in the 
past.
    MARAD will not meet the legislative mandate to dispose of its 
obsolete vessels by the end of fiscal year (FY) 2001 in a manner that 
will yield financial benefits. MARAD will need relief from those 
requirements. MARAD will also need authorization and funding for a 
program to pay for the disposal of obsolete vessels if it is to have 
the potential to significantly reduce the Fleet.
    MARAD is pursuing a number of alternatives for disposing of its 
obsolete vessels, but because of capacity limitations, no one has the 
potential to significantly reduce the backlog of vessels in a timely 
manner. MARAD needs to develop a plan and take prompt action to dispose 
of all of its obsolete vessels.
    Our statement is based on our March 10, 2000 report on the 
scrapping program. We will discuss three issues today:
     The environmental threats posed by MARAD's growing backlog 
of obsolete vessels;
     Key factors contributing to MARAD's inability to scrap 
vessels domestically; and
     The need for prompt implementation of a plan that 
prioritizes disposal of the ``worst condition'' vessels and identifies 
methods and milestones for disposing of all obsolete vessels in the 
Fleet.

   Growing Backlog of Obsolete Vessels is a Threat to the Environment

    MARAD currently has 114 obsolete vessels awaiting disposal. This 
number has grown from 66 vessels 3 years ago. Moreover, the inventory 
of obsolete vessels awaiting disposal is continuing to increase, and is 
expected to reach 155 by the end of FY 2001.
    MARAD maintains its vessels in the water at three locations--the 
James River in Virginia; Beaumont, Texas; and Suisun Bay, California. 
Environmental dangers associated with these old, deteriorating ships 
are increasing daily. The so-called ``worst condition'' vessels are 
about 50 years old and have been awaiting disposal for 22 years on 
average.

         Vessels Awaiting Disposal at Suisun Bay Reserve Fleet


    These vessels contain hazardous materials such as polychlorinated 
biphenyls (PCBs), asbestos, lead-based paint and fuel oil. Some vessels 
have deteriorated to the point where a hammer can penetrate their 
hulls. If the oil from these vessels were to enter the water, immediate 
and potentially very expensive Federal and State action would be 
required. For example, MARAD spent $1.3 million on a costly 
environmental cleanup because one of the ``worst condition'' vessels 
deteriorated to a point where oil leaked into the water.

   MARAD's Inability to Scrap Vessels is Attributable to Several Key 
                                Factors

    Since 1995, only seven vessels have been scrapped. This represents 
a significant change from 1991 through 1994 when 80 ships were sold 
overseas at an average price of $433,000 per vessel. Recent sales to 
domestic scrappers have only yielded between $10 and $105 per vessel.

                         MARAD Vessels Scrapped


    MARAD stopped selling vessels overseas for scrapping in 1994 due to 
Environmental Protection Agency (EPA) restrictions. In September 1998, 
the Administration placed a moratorium on all sales of vessels for 
scrapping overseas that remained in force through October 1, 1999. 
MARAD has continued to refrain from exporting obsolete vessels because 
of concerns about the environment and worker safety.
    Since 1994, MARAD has been relying on the domestic ship scrapping 
market, but its capacity is limited. Only four companies have passed 
MARAD's technical compliance review to scrap vessels. Although MARAD 
sold 22 vessels to these domestic scrappers since 1995, 13 of the 
vessels are still in MARAD's Fleet. Recent contractor delays and a 
contractor default raise a question as to whether these vessels will be 
removed by contractors from the Fleet.
    The Department of the Navy experienced a similar inability to sell 
its combatant vessels for domestic scrapping. In 1998, Congress 
authorized and appropriated funding for a pilot project allowing the 
Navy to pay domestic contractors to scrap vessels. On September 29, 
1999, the Navy awarded four contracts amounting to $13.3 million for 
the scrapping of four vessels.
    MARAD cannot compete with the Navy pilot program in the limited 
domestic market because, by law, MARAD is prohibited from paying for 
scrapping services. The contractor that defaulted on MARAD, is 
scrapping a Navy ship under the pilot program.

                  MARAD Needs a Plan and Prompt Action

    To Dispose Of its Obsolete Vessels
    While MARAD has been pursuing alternative ways to dispose of 
vessels, it is constrained by the legislative requirement to maximize 
financial returns. Also, the alternatives MARAD is pursuing have 
capacity limitations and, therefore, no single option has the potential 
to significantly reduce the backlog of vessels in a timely manner. 
These alternatives include: coordinating with the Navy and a west coast 
company on a proposal for a potential scrapping site; participating in 
interagency work groups to look for innovative ways to improve the ship 
scrapping process; and requesting approval from EPA to sell vessels to 
overseas markets.
    The National Maritime Heritage Act of 1994 requires MARAD to 
dispose of its obsolete vessels by the end of FY 2001, which is an 
extension from 1999, the original deadline. MARAD does not have a plan 
to dispose of these vessels.
    We recently recommended that the Maritime Administrator:
    1. Seek legislative approval to obtain an extension on the disposal 
mandate and eliminate the requirement to gain financial returns on 
vessel sales;
    2. Develop a proposal seeking authority and funding to pay domestic 
contractors to scrap vessels, and target the ``worst condition'' 
vessels for priority disposal; and
    3. Continue to pursue programs to improve scrapping sales and 
identify alternative disposal methods for its obsolete vessels.
    In its authorization request for FY 2001, MARAD proposed a 5-year 
extension ``to develop and begin implementing a plan to dispose of 
these vessels.'' We do not believe it is acceptable to begin disposal 
within 5 years considering the condition of some of the vessels, the 
environmental risks, and the costs to maintain them. In our opinion, 
the legislation should require MARAD to develop a disposal plan and 
substantially dispose of these vessels within 5 years. Further, MARAD 
needs to identify viable disposal methods, set milestones, and target 
the ``worst condition'' vessels for priority disposal.

                               Background

    The Merchant Ship Sales Act of 1946 created the National Defense 
Reserve Fleet (NDRF), a Government-owned and administered Fleet of 
inactive, but potentially useful, merchant and non-military vessels to 
meet shipping requirements during National emergencies. MARAD 
administers the Fleet, and the Department of Defense provides the 
funding to maintain the Fleet. The Federal Property and Administrative 
Services Act gave MARAD responsibility for disposing of all Federal 
Government merchant-type vessels of 1,500 gross tons or more. The 
National Maritime Heritage Act of 1994 required MARAD to dispose of 
obsolete vessels in the Fleet by September 30, 1999, in a manner that 
maximizes financial return to the United States, but the Act was 
amended to extend the original disposal date by 2 years, from 1999 to 
2001.
    As of April 30, 2000, 114 obsolete vessels were designated for 
disposal because the majority of them are no longer operational. MARAD 
maintains the inactive vessels in the water at the following locations:
     James River Reserve Fleet (JRRF) at Ft. Eustis, Virginia 
(61 vessels);
     Beaumont Reserve Fleet (BRF) in Beaumont, Texas (9 
vessels); and
     Suisun Bay Reserve Fleet (SBRF) in Benecia, California (42 
vessels).
    The Coast Guard holds two vessels in Mobile, Alabama for fire 
fighting training.
    As shown in the following chart, the average age of the 114 
obsolete vessels is 48 years. These vessels have been in the Fleet for 
an average of 15 years.


     The Number of Obsolete Vessels Awaiting Disposal is Increasing

    The number of obsolete vessels has almost doubled since 1997. MARAD 
expects its inventory of obsolete vessels awaiting disposal will 
increase to 155 vessels by the end of FY 2001, as shown in the 
following chart.

                       Vessels Awaiting Disposal


    This projected increase is due to additional vessel transfers from 
the Navy, downgrades of other NDRF vessels to obsolete status, and the 
inability to sell ships for scrap. Of the 155 vessels, 132 will be 
targeted for scrapping. The remaining 23 vessels will be targeted for 
disposal through the fish reef program, use by a State or Federal 
agency, or held for useful parts and equipment. However, some of these 
vessels may be transferred into the scrapping category in future years 
if they cannot be disposed of through other means.

               Obsolete Vessels Pose Environmental Risks

    The 114 obsolete vessels currently awaiting disposal pose 
environmental risks because they are deteriorating, contain hazardous 
materials, and contain oil that could leak into the water. These 
vessels are literally rotting and disintegrating as they await 
disposal. Some vessels have deteriorated to a point where a hammer can 
penetrate their hulls. They contain hazardous substances such as 
asbestos and solid and liquid polychlorinated biphenyls (PCBs). If the 
oil from these vessels were to enter the water, immediate and 
potentially very expensive Federal and state action would be required.
    In 1999, MARAD identified the 40 ``worst condition'' vessels. These 
vessels were classified as ``worst condition'' due to their severe 
deterioration and threat to the environment. As of April 30, 2000, 3 of 
the 40 had been moved out of the Fleet to domestic scrappers. As shown 
in the following chart, the ``worst condition'' vessels are older and 
have been in the Fleet longer than the other vessels awaiting disposal.


    The ``worst condition'' vessels are in particularly bad condition, 
and may require additional or special maintenance. Our inspection of 11 
of the original 40 ``worst condition'' vessels revealed corrosion, 
thinning, and rusting of the hull; asbestos hanging from pipes below 
deck; lead-based paint easily peeled from the ship; solid PCBs (in 
cabling); and in some instances, remnants of liquid PCBs in electrical 
equipment.

           Deteriorating Vessel at James River Reserve Fleet




    Costs to maintain these vessels will likely increase due to their 
deteriorating condition, leaks, and the need for additional time-
sensitive maintenance. For example, MARAD spent $1.3 million to 
maintain 1 of the 40 ``worst condition'' vessels over the past 2 years. 
This vessel is over 35 years old, contains hazardous substances 
including asbestos, and has deteriorated to the point where oil leaked 
into the water requiring costly environmental clean-up. MARAD has 
applied over 20 patches to leaks, removed hazardous materials, deployed 
containment booms, and pumped oil out of the vessel. The vessel is 
disintegrating to a point where it will not be seaworthy much longer. 
Monitoring efforts for this vessel are ongoing.

                Progress in Scrapping Vessels is Limited

    Although MARAD has sold 22 vessels since 1995, only 7 have been 
scrapped. Two other vessels have been towed to scrapping sites. The 
remaining 13 vessels sold are still moored in MARAD's Fleet, requiring 
continued maintenance at U.S. Government expense.


    Between 1991 and 1994, MARAD sold 80 vessels overseas for scrapping 
at an average price of $433,000 per vessel. During the past year, 
vessel sales yielded between $10 and $105 per vessel. On October 25, 
1999, MARAD sold three vessels for $10 per vessel. The most recent sale 
was for two vessels at $105 per vessel on December 21, 1999.

    Loss of Overseas Markets Contributed to the Decline in Scrapping

    MARAD suspended the sale of vessels to overseas scrappers in 1994 
because the EPA prohibited the export of Government-owned ships 
containing PCBs. In September 1998, an Administration moratorium halted 
all sales of Government-owned vessels for scrapping overseas. The 
moratorium expired on October 1, 1999, but MARAD has refrained from 
exporting vessels overseas for scrapping.
    Based on a 1997 agreement between MARAD and EPA, MARAD is required 
to request EPA's approval to sell vessels to overseas contractors that 
can scrap them in an environmentally compliant manner. The agreement 
requires MARAD to ensure that all liquid PCBs in transformers, 
capacitors, hydraulic and heat transfer fluids and that all ``readily 
removable'' solid PCBs are removed prior to exporting these vessels. 
This agreement also requires EPA to notify countries of import that 
they will be receiving vessels and that these vessels may contain PCBs. 
To date, MARAD has not requested EPA approval to sell any of its 
vessels awaiting disposal to overseas scrappers. However, on April 14, 
2000, the Maritime Administrator sent a letter to the EPA requesting 
its assistance on developing an option for exporting vessels for 
scrapping and implementation of the 1997 EPA/MARAD agreement.

        Limited Domestic Capacity Hampers Progress in Scrapping

    Since 1995 MARAD has been relying on the domestic market, but 
capacity in the domestic market is limited. In the 1970's, there were 
30 U.S. contractors in the ship scrapping industry. Over the past 19 
months, however, only four companies have bid on MARAD's scrapping 
contracts and passed MARAD's technical compliance review to scrap 
vessels. These four companies can only handle approximately one to five 
vessels at a time, depending on the size of the scrap yard and the 
dimensions of the vessel. For example, one company could only scrap two 
or three vessels per year. According to industry sources, it takes 
approximately 4 to 6 months to completely scrap a MARAD vessel.
    Additional companies are not attracted to this industry because of 
the low profits currently available. Scrap steel prices in the United 
States are low and contractors must comply with environmental 
regulations. Most of the domestic scrapping company officials we 
contacted indicated that the profit from scrapping vessels is not worth 
the effort. At a minimum, contractors in this business must pay for the 
towing costs and provide $150,000 as a performance bond to secure a 
vessel after a contract has been awarded. Contractors receive no return 
on a vessel until scrap metal and the equipment removed from the vessel 
are sold.
    Even when it has been able to sell vessels, MARAD has encountered 
problems with domestic contractors. In 1999, MARAD sold 17 vessels to 3 
ship scrapping companies located in Brownsville, Texas. At the time of 
our review, we found that only two companies were actively scrapping 
ships, and only one of these companies was currently scrapping a MARAD 
ship. MARAD has granted a number of extensions to contractors, and in 
one instance, MARAD had to resell vessels because of contractor 
default. During our review, we also found that another company had not 
taken possession of any vessels because of an ongoing dispute with the 
Port of Brownsville regarding contamination of its scrapping site. It 
has since taken possession of its vessels.

             Navy Pilot Project Poses Competition for MARAD

    The Department of the Navy experienced a similar inability to sell 
its combatant vessels for domestic scrapping. In 1998, Congress 
authorized and appropriated funding for a Navy pilot project for the 
disposal of obsolete warships. The Navy and MARAD are coordinating 
efforts to improve ship scrapping programs, as recommended by the 
Interagency Panel on Ship Scrapping and the General Accounting Office. 
The Navy agreed to share its findings from the pilot project with 
MARAD.
    On September 29, 1999, the Navy awarded four cost-plus contracts 
totaling $13.3 million for the scrapping of four vessels under its new 
Pilot Ship Disposal Project. This pilot project departs from the sales 
contracting process by providing for cost plus incentive fees for 
scrapping the first vessels. It guarantees profitability by providing 
for the cost of scrapping the vessels and gives the contractor the 
opportunity to earn incentive fees, which encourages and rewards 
superior contractor performance. If the contractors are successful in 
scrapping the first 4 vessels, they will be given the opportunity to 
scrap more vessels, potentially leading to the disposal of 66 warships.
    One of these contractors was also under contract with MARAD to 
scrap its vessels. The company completed scrapping four MARAD vessels 
during 1998 and 1999; however, it defaulted on a contract for another 
five MARAD vessels in August 1999.
    MARAD cannot compete with the Navy's pilot project while it is 
required by law to maximize financial return on its vessels. If MARAD 
were authorized to implement such a project, it could cost as much as 
$515 million to dispose of the obsolete vessels that MARAD expects to 
have by the end of FY 2001.

           Alternatives Offer Potential But Have Limitations

    While MARAD has been pursuing ways to improve scrapping sales, its 
ability to explore creative solutions for disposing of vessels is 
constrained by the requirement to maximize financial returns. Also, the 
alternatives MARAD is pursuing have capacity limitations, so no one 
single option has the potential to significantly reduce the backlog of 
vessels awaiting disposal in a timely manner. We have identified 
additional alternatives that MARAD has not pursued that may have the 
potential to contribute to the goal of disposing of obsolete vessels.
    Programs to improve scrapping sales and alternatives MARAD is 
pursuing include: coordination with the Navy and a west coast company 
on a proposal for a potential scrapping site; participation in 
interagency work groups to look for innovative ways to improve the ship 
scrapping process and establish consistent procedures; donation of 
vessels designated for disposal for uses such as museums and the fish 
reef program, given legislative or executive approval; and coordination 
with the Navy on its program to sink vessels in deep water after 
hazardous materials are removed.
    MARAD may be able to explore alternatives that have the potential 
to assist in disposing of some of its vessels such as: selling vessels 
to other countries for non-military uses, given legislative approval 
and approval from the EPA to sell vessels to overseas markets that are 
capable of scrapping them in an environmentally compliant manner.
    According to MARAD, selling vessels overseas for non-military uses 
would require a change in the law that only allows MARAD to sell 
vessels for disposal or non-transportation use. However, legislation 
was passed in 1996 for four vessels to be sold on a competitive basis 
for operational use. One vessel was sold in 1999 and bids on two 
vessels are currently under review. The fourth vessel requires an EPA 
approval, which MARAD requested April 1999.
    On April 14, 2000, MARAD sent a memorandum to EPA requesting its 
assistance in facilitating an export option for scrapping based on the 
1997 EPA/MARAD agreement. MARAD also said it would contact the EPA 
staff to discuss recommendations made by the Interagency Panel on Ship 
Scrapping.

               Disposal Plan and Prompt Action Are Needed

    The National Maritime Heritage Act of 1994 requires MARAD to 
dispose of its obsolete vessels by the end of FY 2001, which is an 
extension from 1999, the original deadline. MARAD does not have a plan 
to dispose of these vessels.
    In our March 10, 2000 audit report, MA-2000-067 \1\, we recommended 
that the Maritime Administrator:
---------------------------------------------------------------------------
    \1\ Report on the Program for Scrapping Obsolete Vessels, MARAD, 
March 10, 2000.
---------------------------------------------------------------------------
    1. Seek legislative approval to extend the 2001 mandate to dispose 
of obsolete vessels and to eliminate the requirement that MARAD 
maximize financial returns on the sale of its obsolete vessels.
    2. Continue to pursue programs to improve scrapping sales and 
identify alternative disposal methods that can contribute to the goal 
of reducing the number of obsolete vessels awaiting disposal, to 
include working with the Navy on the results of its studies on the 
environmental impact of sunken vessels.
    3. Develop a proposal for submission to Congress seeking approval 
and funding for a project to pay contractors for vessel scrapping. The 
proposal should include a plan to target the ``worst condition'' 
vessels first, identify funding and staffing requirements, and provide 
milestone dates to dispose of all obsolete vessels.
    MARAD concurred with our recommendations. In its FY 2001 
authorization request, MARAD proposed a ``five year extension [in the 
deadline that] will provide MARAD with additional time to develop and 
begin implementing a plan to dispose of these vessels.'' Considering 
the condition of some of the vessels, the environmental risks, and the 
costs to maintain them, we find the MARAD proposal unacceptable. MARAD 
must develop and implement a disposal plan for its obsolete vessels 
once legislative approval is obtained for an extension.
    As a part of its disposal plan, MARAD must state specific 
milestones and steps it will take to scrap its obsolete vessels within 
the next 5 years. The plan must state how MARAD proposes to dispose of 
these vessels taking into consideration all the available options. 
MARAD must identify viable disposal methods, and target the ``worst 
condition'' vessels for priority disposal.
    Mr. Chairman, this concludes our statement. I would be pleased to 
answer any questions.

    Chairman Sununu. Mr. Graykowski.

                STATEMENT OF JOHN E. GRAYKOWSKI

    Mr. Graykowski. Thank you, Mr. Chairman. And thank you, 
members of the Task Force, for the opportunity today to appear 
before you to talk about what we consider to be a serious and a 
growing problem with national significance.
    By way of background, I am John Graykowski and I am 
currently the Acting Administrator of the Maritime 
Administration, which is a modal administration within the 
Department of Transportation. MARAD is a small Federal agency 
with a large portfolio of responsibilities generally focused on 
the promotion, enhancement, and strengthening of the U.S. 
maritime industries, consisting of vessel owners, maritime 
labor, our shipyards and our ports.
    MARAD performs these duties in direct support of U.S. 
national and economic security objectives, one of which is to 
maintain a commercial sealift capability and shipyard capacity 
to be made available to the Department of Defense in times of 
war, national emergency, or under Presidential directive. In 
effect, MARAD serves as a bridge between the national defense 
apparatus of the country and the commercial maritime assets 
which are critical to support national needs.
    I note the attendance today of one of our major partners in 
our effort to support the United States maritime industry, Vice 
Admiral Amerault, who will, I am certain, concur that our 
current defense posture relies heavily on the commercial 
maritime industry to maintain its readiness and response 
capabilities.
    Mr. Chairman and Members of the Task Force, it is precisely 
this partnership with the Department of Defense that has 
created the situation we have today, where a civilian agency, 
MARAD, has control and title to a large fleet of obsolete ships 
around the country.
    I have submitted written testimony and I will thus simply 
summarize a few points:
    One, the problem is ours, the Federal Government's problem. 
It is our responsibility to fix it. No matter how hard one 
might try to look at it differently, these are government 
ships, they are stored and maintained by the government and 
required by law to be disposed of properly by the government.
    Secondly, the problem will not go away on its own. Indeed 
this problem grows larger with each passing day, both in terms 
of the increasing number of ships that need to be scrapped and 
in the simple and inescapable fact that like all of us, ships 
get old, steel wastes, and structural integrity degrades. We 
simply cannot ignore it. We can't pretend it doesn't exist and 
we can't simply persist in holding our collective breaths each 
time there is a storm near one of these fleets or in the calm 
of the night that something, quote, ``bad'' might happen.
    We are paying considerable amounts of money now, as the 
Chairman noted, and that amount of expenditure will continue to 
grow. For example, we spent around $3 million last year just to 
take care of this fleet. We anticipate spending perhaps five 
times that in the next couple of years unless we resume 
scrapping operations.
    As the Chairman referred to and wanted me to speak to, last 
year with that ship right there, the Export Challenger which is 
some 40 years old, we and the taxpayers spent $1.3 million to 
pump out some oil, to fix it up and return it to site in the 
James River where she sits today. And this, Mr. Chairman, and 
all of you, as all of us who are responsible for managing the 
taxpayers' resources, it is very hard to justify that type of 
expenditure but it is not going to stop with the Export 
Challenger.
    We are going to begin, and it is no secret to Admiral 
Amerault or anybody familiar with this program, we are going to 
begin dry docking these ships, ships such as the Export 
Challenger. Their average age is 48 years old. That is older 
than me, I think it is older than the Chairman and older than 
others here, at the cost of $900,000 apiece minimum, because we 
don't know what it is going to take once they are in the dry 
dock to fix them up.
    We will have 155 ships under our control at MARAD by the 
end of 2001. Anyone here can do the math and see that it will 
cost this country hundreds of millions of dollars in the next 
decade. And what do we end up with? Exactly what we have 
today--155 ships sitting in the James River, Beaumont, Texas, 
and Suisun Bay--unless we resume scrapping.
    How we got here has been chronicled in my written 
testimony. Admiral Amerault will speak to it. Tom Howard just 
spoke to it. I am not going to repeat it. I will say, however, 
that there have been a series of decisions taken within our 
government that have resulted in the current impasse, decisions 
that were well founded in intention and desire but which did 
not address the fundamental and again inescapable fact that 
something has to be done with these vessels.
    In a sense, I think that we have substituted in the last 7 
years an appearance of action on this problem for real action 
while the infinite patience of time continues to take its toll 
on our vessels. But I would caution all of us against leveling 
recriminations against any of the agencies or people who have 
been involved in this matter, since that would, I believe, 
undermine our common purpose and desire to eliminate these 
ships as fast as possible and in the most responsible fashion 
we can.
    Mr. Chairman and members of the Task Force, my agency MARAD 
is forbidden by law to do anything other than sell these ships. 
We did it for quite a number of years and very successfully and 
yielded a lot of money that was used to offset our need for 
appropriations. But because of this situation, MARAD has not 
taken any of the actions that might be necessary to inventory 
the fleet for both the hazardous materials that might exist and 
to estimate possible recoveries from the sale of metals from 
the ships. To do that would require a huge amount of money and 
a devotion of staff resources that we simply don't have at this 
time.
    However, let me stress, if the statutory mandate is 
changed, and MARAD is given the authority to pay for scrap 
vessels domestically, MARAD is fully prepared, equipped and, I 
would submit emphatically, the right agency for the job. We are 
already charged by DOD for these, to take care of these vessels 
and to keep the ready reserve force ready to fight, and we do 
that in an outstanding fashion. We know these vessels, we know 
the shipyards that might be willing to participate in a 
program, and indeed we have a very strong and vibrant 
relationship with those shipyards that is in all senses a 
commercial partnership by virtue of the other programs MARAD 
implements. Thus I am confident that if directed by Congress, 
we, MARAD could establish a program that yields the best value 
to the government. We have proved that elsewhere and I am 
confident we would do it here.
    Finally, Mr. Chairman, members of the Task Force, we all 
need to remove the extensive mystery about ship disposal--and I 
mentioned this to you yesterday--the mystery which leads to 
imposing regulations and treating this situation different from 
disposal situations elsewhere.
    A ship is nothing more in a sense than a building. It 
differs because it floats, but it is a building. Fifty years 
ago, just as buildings were made using materials such as 
asbestos and PCBs, so are ships. But the problems are the same, 
the challenge is identical, and the technical responses to that 
need to be much different, whether it is a ship or a building. 
We have those resources, we have that capability, and we have 
the ability to take care of the problem.
    I thank you for your interest, look forward to working with 
you, and again this is a long overdue opportunity.
    Chairman Sununu. Thank you very much Mr. Graykowski.
    [The prepared statement of John Graykowski follows:]

       Prepared Statement of John E. Graykowski, Acting Maritime 
            Administrator, U.S. Department of Transportation

    Good morning Mr. Chairman and Members of the Task Force. I welcome 
the opportunity to be here today to discuss an issue of great 
importance to the Maritime Administration (MARAD)--the disposal of 
obsolete government vessels. As you know, the Federal Property and 
Administrative Procedures Act of 1949 designates MARAD as the 
Government's disposal agent for merchant type vessels of 1,500 gross 
tons or more. Thus, in addition to MARAD's own National Defense Reserve 
Fleet (NDRF) obligations, the agency has taken title to over 40 
merchant type Navy ships for disposal in the last 2 years.
    Currently, there are 114 vessels slated for scrapping moored at the 
James River Reserve Fleet in Ft. Eustis, Virginia; Beaumont Reserve 
Fleet in Beaumont, Texas; and Suisun Bay Reserve Fleet in Benecia, 
California. This number is expected to grow to 155 by the end of Fiscal 
Year 2001 if additional vessels are not disposed of. MARAD is committed 
to finding an appropriate means of scrapping these vessels safely, 
economically and in an environmentally sound manner.
    Under the National Maritime Heritage Act of 1994, MARAD is required 
to dispose of obsolete NDRF vessels by September 30, 2001, in a manner 
that maximizes financial return to the United States. Fifty percent of 
the amounts received from scrapping are to be used by the Maritime 
Administrator for the acquisition, maintenance, repair, reconditioning 
or improvement of NDRF vessels. Twenty-five percent is to be used for 
expenses incurred by the State or Federal maritime academies for 
facility and training ship maintenance, repair, modernization and the 
purchase of simulators and fuel; the remaining 25 percent is to be made 
available to the Secretary of Interior for maritime heritage grants.
    Historically, MARAD's primary means of disposing of obsolete 
vessels has been to sell them for scrapping. From 1987 to 1994, MARAD 
sold approximately 130 obsolete vessels for scrapping overseas. During 
that period the agency received an average of $108 per ton for those 
ships.\1\ Since an average ship in the NDRF weighs approximately 6,000 
tons, the gross returns for scrapping such a ship overseas have been 
about $600,000.
---------------------------------------------------------------------------
    \1\ All references to tonnage in this statement are to lightship 
displacement tonnage. Lightship displacement tonnage refers to the 
actual weight of the ship.
---------------------------------------------------------------------------
    Since 1995, MARAD has not scrapped any vessels overseas due to 
concerns raised by the Environmental Protection Agency (EPA) about the 
export of hazardous substances. Specifically, the EPA advised MARAD of 
its position that the export of a Government ship for scrapping was the 
equivalent of distributing in commerce regulated quantities of 
Polychlorinated Biphenyls (PCBs) under the Toxic Substances Control Act 
(TSCA). In November 1995, EPA issued a discretionary enforcement letter 
to MARAD allowing the export of two ships for scrapping once all PCBs 
had been removed. That procedure was unworkable since the removal of 
all PCBs could have compromised the watertight integrity of the ships.
    In 1997, MARAD and the EPA signed an agreement allowing foreign 
ship disposal after removal of liquid PCBs and readily removable solid 
PCBs. Prior to implementation of the export agreement, however, the 
Department of Defense formed an Interagency Panel on Ship Scrapping to 
review the process for scrapping Government vessels. Thus, in January 
1998, MARAD agreed to continue to refrain from selling any vessels for 
scrapping abroad until the Panel had completed its review. 
Additionally, in the fall of 1998, an executive memorandum requested 
that MARAD and the Department of Defense observe a moratorium until 
October 1, 1999, on the export of obsolete vessels to be scrapped, to 
ensure that the Panel's recommendations were fully considered. MARAD 
complied with this request.
    The Interagency Panel, composed of representatives from DOD, the 
EPA, the Occupational Safety and Health Administration (OSHA), the 
Department of State, the Department of Justice, the U.S. Coast Guard 
and MARAD reviewed the process and procedures for scrapping ships. The 
Panel made recommendations regarding economic soundness and 
environmental and worker safety. It also concluded that all options for 
ship scrapping, including overseas scrapping, should remain open.
    With regard to exports, the Panel made a number of 
recommendations--such as expansion of the notification process to 
importing countries regarding the presence of hazardous materials, and 
the requirement for bidders to submit a technical compliance plan--
which could be incorporated into the process relatively quickly. 
Nevertheless, developing meaningful technical assistance, and 
determining how to enforce contractual requirements and monitor 
contractual performance overseas could take significant time and 
resources to implement.
    Since 1996, MARAD has been exploring the domestic ship scrapping 
market. The agency has revised its solicitation process for domestic 
sales, incorporating environmental and safety issues as part of the 
award. A bidder is required to submit a technical compliance plan 
including environmental, worker health and safety, business, and 
operational plans that describe the bidder's knowledge and ability to 
address the problems inherent in ship scrapping. Following a review of 
the bidder's technical compliance plan, its compliance history and a 
site visit, MARAD awards vessels to qualified bidders on the basis of 
price. During the scrapping process, MARAD also conducts both announced 
and unannounced visits to the scrapping site to monitor the 
contractor's compliance with the sales contract.
    Unfortunately, the capacity of the domestic market for buying and 
scrapping obsolete MARAD ships is limited, and the drop in the price of 
scrap steel has eroded the profitability of existing scrappers. 
Moreover, only four bidders have satisfied the requirements of MARAD's 
technical review since 1997, and only 9 of the 22 ships sold 
domestically during that time have been removed from the fleet sites. 
Three of these vessels were sold for $10.00 each. One sales contract 
for five vessels was terminated last year because the purchaser did not 
take possession of the vessels. We are likely to continue facing a 
backlog given the number of ships waiting to be scrapped.
    You may be aware that about 40 NDRF vessels are in extremely poor 
condition. Time is critical in this effort. The cost to the Department 
of Defense of maintaining each NDRF vessel is approximately $20,000 per 
year. However, as obsolete vessels in the NDRF continue to deteriorate, 
the costs of upkeep will rise. For example, the Export Challenger, a 
vessel in the James River Virginia Reserve Fleet, experienced a 
relatively minor release of oil in 1998. Due to the deteriorated 
condition of the hull, the remainder of the oil aboard needed to be 
removed. The combined cost of clean up and removal of oil from the 
vessel was $1.3 million. The cost of dry-docking a vessel in order to 
prevent it from sinking is estimated to be about $900,000 per ship. 
MARAD expects to begin dry-docking 16 obsolete vessels in poor 
condition per year beginning in fiscal year 2002 in order to avoid 
environmental problems. In the meantime, these ships are monitored 
closely by MARAD to prevent sinking or a hazardous discharge.
    We are fully committed to working with Congress to find a swift and 
appropriate solution for scrapping obsolete NDRF vessels. MARAD's 
authorization proposal for fiscal year 2001 contains a provision that 
would extend the deadline for the disposal of obsolete NDRF vessels 
from 2001 to 2006. During this period, MARAD intends to develop and 
implement a program to scrap these vessels safely, economically and in 
an environmentally sound manner.
    In addition, Maritime Administrator Clyde J. Hart, Jr. recently 
wrote to Carol Browner, Administrator of the EPA, seeking to explore 
the possibility of resuming exports in a manner consistent with the 
prior agreement negotiated between EPA and MARAD. Although we have not 
yet received a response to our inquiry, we do not believe that this 
option has been foreclosed.
    Mr. Chairman and Members of the Task Force, we appreciate the 
concern that you have shown in this area and want to assure you that we 
are working diligently to resolve the matter as soon as possible. This 
concludes my statement. I would be happy to answer any questions you 
may have.

    Chairman Sununu. Admiral.

            STATEMENT OF VICE ADM. JAMES F. AMERAULT

    Vice Adm. Amerault. Good morning, Mr. Chairman, and 
distinguished members of the Task Force. I am very pleased to 
appear before you today to discuss the Navy's approach to 
reducing our own inventory of excess ships. With your 
permission, I would like to submit my prepared statement for 
the record but take a few minutes here to give you a shortened 
summary version.
    Chairman Sununu. Without objection.
    Vice Adm. Amerault. Thank you sir. The Navy's Inactive 
Fleet has 57 ships designated for scrapping. The decision to 
scrap a Navy ship is made only after carefully evaluating all 
other options, and these include several such as retention as a 
mobilization asset, sale to allied Nations under the foreign 
military sales program, use as a war memorial or historical 
museum, use for training, or use as a weapons development 
asset.
    The Navy's primary interest is to dispose of all of our 
excess ships in a manner that is environmentally sound, 
economically neutral, and worthy of the proud service that 
these ships have performed for this Nation.
    Historically, the scrapping rights to our ships have been 
sold to domestic shipbreakers, very much like what has gone on 
in the MARAD fleet. More recently, environmental concerns, 
worker safety, and changing economic conditions have impacted 
the methods and locations available to scrap our ships. Up 
until the mid-1990's, domestic shipbreakers were willing to pay 
for the rights to scrap Navy ships because the value of metal 
and other equipment in the ships offset their costs and 
provided a profit. This, of course, matched our goals and 
reinforced our expectation that Navy ships could be scrapped at 
no cost to the Navy. However, since 1996 eight scrapping 
contracts have defaulted, causing the Navy to expend over $12 
million to return 28 ships to a safe storage condition. So 
within Navy we faced a dilemma: A backlog of ships to be 
scrapped was growing but there was no domestic market in which 
scrapping could be accomplished at no cost.
    Consequently, we began in 1997 to work with EPA to 
determine the conditions under which scrapping might be 
accomplished overseas. In 1998 increased interest by the 
Congress and the public resulted in both the Vice Presidential 
and Secretary of the Navy moratorium on overseas scrapping. At 
the same time, the Under Secretary of Defense for Acquisition 
and Technology created an interagency panel to explore the 
problems and solutions to disposing of excess Navy and MARAD 
ships. The panel recommended that the Navy conduct a pilot 
program to determine the conditions under which domestic 
scrapping could be made feasible.
    Consistent with this recommendation the Navy developed a 
ship disposal project with a pilot phase that was designed to 
qualify and quantify the technical scope and costs associated 
with ship scrapping. That pilot phase is currently underway. 
The goals of this project are:
    1. To document all processes, costs, revenues and hazardous 
materials generation while demonstrating an environmentally 
sound and cost-effective method for dismantling ships;
    2. To minimize the Navy's net cost of ship disposal by 
realizing a fiscal return on scrap metal and other equipment 
sales; and
    3. Develop a viable domestic capability to scrap additional 
ships from the Navy's inventory after the pilot phase is 
completed.
    A significant feature of the ship disposal project is that 
the Navy, not the shipbreaker, assumes the risks associated 
with the vagaries of the scrap metal market and equipment 
resale. The shipbreaker's profit is set in terms of the 
contract. Proceeds generated by the sale of scrap metals in 
excess equipment are then credited against the cost of the 
contract.
    It is by decoupling this volatile scrap market from the 
contractor's profit or loss that a contractor can establish a 
stable economic model within which scrapping processes can be 
optimized, and hopefully that is our solution to defaulting 
contracts.
    In September 1999 we awarded four indefinite delivery/ 
indefinite quantity contracts for the pilot phase. The initial 
task order under each of these contract is to dispose of one 
ship--and all ships, by the way, all four are exactly the same 
type and model of ship--to dispose of one ship under a cost 
plus incentive fee structure. Progress to date has been 
satisfactory. The data concerning the processes utilized and 
the cost revenue stream is being collected but has not yet been 
completely evaluated. The last of the four ships should be 
completely dismantled and all materials recycled in the fall of 
this year.
    It became obvious to us during the initial performance of 
these task orders that much of the contract cost was 
attributable to process start-up of an infrastructure 
facilitation required for the dismantling process to provide 
further insight into the true cost of shipbreaking. Two 
additional task orders were awarded under the pilot phase on 
May 24th of this year under a fixed price incentive structure.
    Task order awards after the pilot phase will be made 
following careful examination of the data collected and 
dependent upon the availability of Navy funding.
    The Navy has also worked with MARAD on the ship disposal 
problem for several years. Through group participation in 
several joint agency working groups, we have shared our 
technical and process information. We will continue our open 
dialogue and provide the ship disposal project data when it is 
completely available to MARAD.
    In summary, the Navy is committed to dismantling our excess 
ships in a way that is environmentally sound, publicly 
acceptable, and advantageous to the Navy and the government. 
The ship disposal project assists in accomplishing these goals 
while providing empirical data on the processes and costs 
associated with domestic ship scrapping in an environmentally 
safe way.
    Mr. Chairman and member of the Task Force, this concludes 
my remarks. Thank you for your interest in the program. I would 
be happy to answer questions that you may have.
    Chairman Sununu. Thank you, Admiral.
    [The prepared statement of Vice Adm. James Amerault 
follows:]

  Prepared Statement of Vice Adm. James F. Amerault, Deputy Chief of 
                      Naval Operations (Logistics)

    Mr. Chairman and distinguished members of the panel, thank you for 
the opportunity to appear before you to discuss the Navy's approach to 
reducing our inventory of excess ships and how we are working with the 
Maritime Administration on this problem. We sincerely appreciate your 
interest in our program and processes.
    Before going further, I would like to note for the committee that I 
have not included in my testimony any discussion of our process for 
disposing of nuclear powered warships. This is because that work is 
accomplished exclusively in our public shipyards and is subject to 
requirements more stringent than those necessary to dispose of non-
nuclear powered ships.
    I also wish to point out that Navy warships may present a more 
complex dismantling challenge than traditional merchant ships due to 
two facts. First, our warships are constructed to maintain mission 
capability despite battle damage; and second, they have a high density 
in terms of equipment and compartments.
    The Navy's interest is to dispose of our excess ships in a manner 
that is environmentally sound, economically neutral and worthy of the 
proud service they have performed for this nation.
    Let me now briefly explain the process we use to determine the 
manner in which we dispose of our conventionally powered ships. After a 
careful evaluation, the Chief of Naval Operations may declare a ship to 
be ``excess'' to the current operational needs of the Navy. The next 
step is to determine if the ship is required as a Mobilization Asset. 
If the ship is needed, it is placed in a state of preservation such 
that it can be reactivated and returned to active service.
    If the ship is not needed as a Mobilization Asset, then it is made 
available for sale or lease to an allied Navy under the Foreign 
Military Sale/Lease program.
    If the ship is not a candidate for lease, it is stricken from the 
Naval Vessel Register and may then be designated for transfer to a 
nonprofit organization for display as a historical memorial or museum. 
The requirements and mechanics of these transfers are governed by 
statute.
    If not designated as a potential historical museum or memorial, the 
ship may be made available for Navy fleet weapons training or 
developmental testing of weapon systems. If used in this manner, the 
ship is usually sunk as a result of the training or testing. Therefore, 
prior to conducting the training or testing the ship is prepared in 
accordance with requirements set forth by the Environmental Protection 
Agency.
    The ship may also be held as a logistics support asset to fill 
requests by active ships for parts or equipment that are no longer 
manufactured or stocked.
    If the ship is not disposed of or held for any of the 
aforementioned purposes and it is a merchant type ship, then it must be 
transferred to the Maritime Administration (MARAD) in accordance with 
Federal Property and Administrative Services Act of 1949. Navy ships 
transferred to MARAD supplement the National Defense Reserve Fleet.
    If it is not practical to use the ship in any of the ways I have 
mentioned, then the ship is designated for scrapping.
    Ships that are declared to be in excess and are awaiting final 
disposition enter the Navy's Inactive Fleet. Today the Navy Inactive 
Fleet has 144 ships in its inventory, 28 of which are being prepared 
for transfer to MARAD, and 57 of which are designated for scrapping. 
The average age of the ships waiting scrapping is approximately 37 
years and they have been out of active Navy service for an average of 7 
years.
    The traditional method the Navy used to scrap conventionally 
powered ships was to engage the Defense Reutilization and Marketing 
Service (DRMS) as a Government sales agent to sell the scrapping rights 
to a domestic shipbreaker. Proceeds from the sale of these rights were 
deposited with the United States Treasury, not the Navy. The 
shipbreaker's profitability was solely a function of his costs and the 
price of scrap metals on the open market.
    No matter where the shipbreaking is accomplished, the ``Title'' to 
the ship remains with the Navy until the ship is deemed by the Navy to 
no longer be a ship. This generally occurs when the hull is no longer 
floatable. I think it is important to note that while the Navy holds 
the title it is the Navy that is presumed to be responsible for the 
disposition of the ship, even if the shipbreaker defaults on the 
contract.
    Until 1996, DRMS awarded scrapping rights principally to the 
highest bidder. As scrap metal prices began fluctuating in the mid-
nineties, these shipbreakers experienced fiscal difficulties leading in 
many instances to contract defaults.
    In 1996, seeking to address the problem of contract defaults, DRMS 
initiated changes to improve the selection process for scrapping 
contractors. A two-step process was instituted that included an 
evaluation of the contractor's technical plans followed by an 
invitation to bid. Oversight at the contractor's facility was 
increased.
    Under the old sales to the highest bidder process, eight scrapping 
sales contracts were defaulted and five sales contracts were completed 
between 1996 and 1999. The Navy has expended approximately $12 million 
since 1996 to return 28 of the ships from the eight defaulted contracts 
to a safe storage condition. Under the new two-step sales process, only 
two contracts have been awarded. One contract has been satisfactorily 
completed and contract default procedures have been initiated on the 
second contract. The contractor being defaulted has informed DRMS that 
it does not intend to pick up the eight remaining ships under this two 
step sales contract because the company will lose money.
    Since the domestic scrapping industry was not meeting the needs of 
the Navy, the Navy entered into an agreement with the Environmental 
Protection Agency (EPA) in 1997 that identified the conditions under 
which EPA would exercise enforcement discretion against the Navy for 
exporting vessels that may contain regulated levels of PCBs for 
disposal.
    At about that same time, Congress and the media increased their 
interest in both the environmental and safety concerns associated with 
ship scrapping. Overseas scrapping came under scrutiny; and some 
foreign scrappers were identified as not adhering to procedures that 
protected the environment and their workforce, especially when compared 
to the standards required in the United States. In response, on 19 
December 1997, the Secretary of the Navy (SECNAV) suspended all 
initiatives to explore overseas ship scrapping. In addition, 
congressional hearings on ship scrapping were conducted in March 1998 
and June 1998.
    As a result of public and congressional interest, the Under 
Secretary of Defense (Acquisition and Technology) established the 
Interagency Ship Scrapping Panel on 24 December 1997. The panel was 
charged to review Navy and MARAD scrapping programs and investigate 
ways to ensure that Navy ships are scrapped in an environmentally 
sound, economically feasible and occupationally safe manner.
    The panel issued its report in April 1998. One of its 
recommendations was that the Navy carry out a pilot project to quantify 
the scope and costs associated with ship scrapping in private industry. 
This pilot project would also serve as a vehicle for gathering 
information to improve the ship scrapping process.
    On 23 September 1998, Vice President Gore requested both Navy and 
MARAD to observe a moratorium on efforts to award contracts or transfer 
vessels for scrapping overseas. This moratorium expired on 2 October 
1999; however, Navy continues to operate under the previously mentioned 
SECNAV suspension.
    Consistent with the panel's recommendation, the Navy initiated the 
Ship Disposal Project (SDP) in 1999 with three goals in mind. These 
are:
    1. Document all processes, costs, revenues, and hazardous material 
generation while demonstrating an environmentally sound and cost 
effective method for dismantling ships;
    2. Minimize the Navy's net cost of ship disposal by realizing a 
fiscal return on scrap metal and equipment sales; and
    3. Develop a viable domestic capability to scrap additional ships 
from the Navy's inventory after a pilot phase is completed.
    The Ship Disposal Project is structured in two parts. The first 
part, referred to as the ``pilot,'' is underway and is intended to gain 
insight into the process and costs of scrapping warships. Navy will 
gather all revenue and expense data, document quantities and locations 
of hazardous waste that are generated during the scrapping process, and 
develop cost models for future decision making. The domestic 
shipbreaker is required to maximize the value (within a specified time 
period) of the recyclable equipment and scrap metal and sell these 
items as an offset to the Navy costs incurred under the contract. Part 
Two of our Ship Disposal Project is to award additional ships to one or 
more of these same shipbreakers as funds are available.
    A significant feature of our Ship Disposal Project is that the 
Navy, not the shipbreaker, assumes the risk associated with vagaries of 
the scrap metal market and equipment resale. The shipbreaker's profit 
is set in the terms of the contract (i.e., cost contract or fixed price 
contract). Any proceeds realized from the sale of scrap metal or 
equipment are used to offset Navy contract costs. With this decoupling 
mechanism in place the contractor can establish a profitable economic 
model to optimize scrapping processes. The contractor is paid for the 
services he provides. The SDP also features a performance incentive for 
effective environmental and safety programs.
    The Navy's Supervisor of Shipbuilding, Conversion, and Repair 
(SUPSHIP) performs oversight and contract administration for the SDP. 
This allows the contractors to benefit from the Navy's ship repair 
experience and further facilitates the exchange of information between 
the Navy and the contractor.
    Prior to a ship arriving at a contractor's facility for scrapping, 
the Navy accomplishes some environmental remediation of the vessel. 
Nearly all hazardous waste and some other hazardous materials are 
removed from the ship. The Navy also performs limited sampling on each 
vessel to identify the existence and location of other hazardous 
materials.
    On 29 September 1999, Navy awarded four Indefinite Delivery/
Indefinite Quantity (IDIQ) contracts under Phase One of the Ship 
Disposal Project (i.e., the pilot phase). The initial task order under 
each of these contracts is to dispose of one ship under a Cost Plus 
Incentive Fee structure. Progress to date by the four domestic 
contractors has been satisfactory. Data concerning the processes 
utilized and cost/revenue stream are being collected but have not yet 
been evaluated. The last of the four originally awarded ships should be 
completely dismantled and all materials recycled in the fall of this 
year.
    Two additional task orders were awarded under the pilot portion of 
the SDP to provide the Navy with further insight into shipbreaker's 
start-up costs. These additional task orders were offered under a Fixed 
Price Incentive structure to provide additional encouragement to reduce 
dismantling costs.
    Decisions concerning Phase Two task order awards will be made after 
careful evaluation of the data collected during the pilot phase and are 
dependent on the availability of funding.
    The Navy has worked with MARAD on the ship disposal problem for 
several years. Through participation in several joint agency working 
groups, we have shared our technical and process information. We will 
continue our open dialogue and provide the Ship Disposal Project data 
when it is available.
    In summary, our Ship Disposal Project is pursuing the goal of 
dismantling our excess ships in a manner that is environmentally 
friendly, publicly acceptable, and advantageous to the Navy. The 
backlog of ships awaiting disposal presents an increasing burden on the 
Navy's resources and could present an environmental concern as they 
continue to age. We are committed to eliminating our backlog and 
avoiding any environmental risks. The Ship Disposal Project assists in 
accomplishing these goals while providing empirical data on the 
processes and costs associated with domestic ship scrapping. In 
addition, we continue to look for and study other disposal methods that 
may contribute to further reducing our backlog and our costs.
    Mr. Chairman and members of the Committee, I thank you for your 
interest in our program and the opportunity to tell you about the 
Navy's ship disposal goals and programs. I will be pleased to respond 
to any questions.

    Chairman Sununu. Let me begin the questioning with Mr. 
Graykowski. I think you have touched on this in your remarks 
but I want to be clear as to exactly what the problem is. Why 
hasn't MARAD at least put together a plan for disposing of 
obsolete vessels during the period where you have received an 
extension on disposal, a temporary one, from 1999 to 2001? What 
has kept you at least from putting together a strategic plan 
outlining how this might be accomplished?
    Mr. Graykowski. Well, as I mentioned in my opening 
statement, Mr. Chairman, first and foremost, we don't have any 
authority beyond selling the ships at a cost which generates a 
positive cash flow to the government and we have endeavored to 
do that. We have had a number of offerings of ships which you 
know have been taken at low prices and the ships never get 
picked up. We had one instance of contractor default.
    So in one sense we have been sort of struggling to take the 
program into a domestic context. In 1993 we had run an export 
program for years generating tremendous amounts of money. We 
didn't have that much familiarity with domestic scrapping and 
there were constraints which, frankly, resulted in a lot of 
conflicting signals, I think, among various agencies as to how 
we were going to solve this problem. So MARAD tried to respond 
that way. We have never really explored or had the opportunity 
to explore with the Navy with respect to a pilot project but I 
don't think it is fair to say----
    Chairman Sununu. Do you have any legislative mandate to 
develop such a plan?
    Mr. Graykowski. No, we do not have a legislative mandate to 
develop any plans.
    Chairman Sununu. Do you think it is, despite the fact that 
you don't have a plan in place now, do you think that we really 
can afford to wait 5 years before we begin the disposal 
process? I was struck by the request by the administration to 
move that date back 5 years and that the disposal process would 
have been required to begin then. That would seem to be far too 
much time, given the condition of the vessels. Would you agree 
with that?
    Mr. Graykowski. I think that the perception that was 
created by the legislation was that we were going to somehow 
take all 5 years, and then at the end of 60 months we are going 
to sort of start doing what we came up with to do; and I think 
that a fairer assessment is give us a reasonable amount of 
time. We could have, I think, done what we did several years 
ago, which was asked for 2 years, knowing that that was 
unrealistic, from our perspective. The 60 months was an outside 
date.
    I don't think in our hearts and minds at MARAD it was going 
to take that long or be that long and, quite frankly, looking 
at the development of the interest level within the Congress, 
both House and Senate, I think it is going to be overtaken by 
events. I am confident there is going to be some action and 
directives from the Congress which will both shorten the time 
and increase the pace of activity.
    Chairman Sununu. I would tend to agree and very much hope 
that it is overtaken by proactive events rather than defensive 
events. And to that point, could you talk a little bit more 
about the problems associated with the Challenger? Was it a 
single leak, a single fracture, or a series of problems? And 
again, could you summarize the total cost associated with that 
one vessel?
    Mr. Graykowski. I will do that, Mr. Chairman, and I will 
also--I would like to submit a better answer for the record.
    All of these ships, or many of them, have pockets of oil, I 
mean, for want of a better term. In some cases there are 1,000 
barrels and in other cases 20 barrels. But we have surveyed 40 
ships and I think I came up with a ballpark figure of some 
40,000 barrels of oil that are scattered around the country, 
which would cause a problem in anybody's district, anybody's 
river.
    On the Challenger there were small leaks and the Coast 
Guard notified us, as I recall, and I may be wrong on this, 
that this was a problem. And we had to boom it by putting 
containment booms around her, and were sort of--``directed'' is 
too strong a word--encouraged and supported by the Coast Guard 
to sort of remediate the potential for additional oil to leak 
and this is oil deep in tanks. The ships are just laid up in 
some cases.
    Chairman Sununu. Are you unable to pump it?
    Mr. Graykowski. Yeah. You have got to see it to believe it. 
In some cases, this is bunker oil, if any of you are familiar 
with the thick, heavy, sludgy stuff which over the years 
hardens into tar-like road tar. So just the process of peeling 
open the tanks and heating up the oil, if you will, to the 
point where you can pump is extensive and a very arduous 
process. So that is what we went through on her, to the cost of 
$1.3 million.
    Chairman Sununu. All of the effort was done while it was 
still on the water?
    Mr. Graykowski. Yes, sir. She still remains there, and 
indeed we spent some more money down at the James River when 
Hurricane Floyd came through and we were very concerned. That 
was the reference I made there, additional funds we didn't 
anticipate having to spend.
    Chairman Sununu. How many of the vessels, approximately, of 
the 40 worst-condition vessels are at or near the condition of 
the Export Challenger?
    Mr. Graykowski. We have triaged it or identified sort of a 
priority list and we have got sort of--not a new term--but the 
``dirty dozen.'' There are 12 ships that really, Mr. Chairman, 
are--Export Challenger, she is our poster child, but she has a 
lot of siblings. And so I say there are 12 that really are 
approaching the condition of the Export Challenger.
    Chairman Sununu. Was it ever in danger of sinking?
    Mr. Graykowski. I don't think so. I mean, I don't want to 
impart--it is a tough question to answer.
    Chairman Sununu. I don't know if that is an encouraging 
answer or discouraging answer from my perspective.
    Mr. Graykowski. I could say none of them sunk yet. No, we 
monitor them carefully, we do the best we can, and I don't 
think they are in danger of imminent sinking and hulling, 
absent sort of major storm and waves and conditions that don't 
exist today. These are calm waters. Congressman Bentsen, I 
think if he is familiar with where Beaumont sits, is a very 
well protected area. Over time will they sink? I think it is 
unavoidable, yes, but not imminent. I would like that message 
to be there.
    Chairman Sununu. Has any effort been made to quantify what 
the potential costs would be of a catastrophic accident, either 
a sinking or a serious hull rupture of one of these vessels?
    Mr. Graykowski. I am getting no encouragement from the 
folks behind me. My bench is weak here. Well, to quantify the 
costs, fine; what kind of accident, we would have to remediate 
whatever leakage problem or environmental damage that occurs. 
And frankly as a lawyer, I have always looked at it as I have 
got the ultimate strict liability here. I am a generator under 
EPA, under TSCA, under CERCLA, under Fish and Wildlife and 
Migratory Birds; there are a whole number of acts out there. 
And the Federal Government is the ultimate deep pocket, so 
quantification depends on the extent of damage to a certain 
extent, but the checkbook is going to be open for a long time.
    Chairman Sununu. OK. What kinds of marine wildlife are 
there in the James River, and was there any damage to the 
ecosystem or the wildlife with the Export Challenger accident?
    Mr. Graykowski. The answer is an emphatic no. There was no 
damage. We contained very limited minor leaks. We have got a 
containment boom pretty much around the fleet now in terms of 
where that is. There are State certified oyster beds. I 
understand there are a couple of wildlife refuges. Indeed we 
have ospreys building nests on our ships, and certain times of 
the year we can't go near them. They are wildlife habitat 
wetlands which we have got to protect as best we can.
    Chairman Sununu. Your predecessor, Mr. Hart, wrote at least 
twice to the EPA requesting a meeting with the Administrator to 
resolve the issues that are preventing the timely scrapping of 
government vessels. Has there been any response from Ms. Brown 
or the EPA today?
    Mr. Graykowski. Mr. Chairman, there hasn't. I think that 
recently Deputy Administrator Bonnie Green, who testified in 
front of Congressman Gilchrest, has written the Administrator 
of the EPA, and I intend on writing her today to tell her once 
again that we have testified and we need to work in an 
interagency fashion.
    To date, no sir, there has not been a response.
    Chairman Sununu. Has the EPA put together guidelines for 
you or for the Navy, that you are aware of, for the disposing 
of obsolete vessels?
    Mr. Graykowski. We have got a memorandum of understanding, 
if you will, or agreement with EPA on certain conditions that 
have to be conformed with before we can scrap a ship, so that 
is in place. However, there are still some of the guidelines--I 
was just getting to that. While we have this memorandum, the 
particulars in terms of the regulations, for instance PCBs, and 
that the guidelines that we would employ to scrap and to 
monitor are not in place, sir.
    Chairman Sununu. Would you explain that in a little more 
detail? What do you mean, the guidelines aren't in place?
    Mr. Graykowski. I think that EPA, and I am going to have to 
elaborate for the record if I could, EPA, we have got this 
memorandum of understanding, but it lacks sort of--that says we 
are going to cooperate, and here's the basic structure of that: 
Before MARAD scraps a ship, you have to clean out all the PCBs, 
for example, but in terms of the exact procedures and the 
quantities that would be allowed or not, they are still under 
development at EPA.
    Chairman Sununu. I am confused. Does the memorandum, does 
the agreement that you signed, lay out what you need to do 
before you can move forward with a scrapping--is that valid or 
invalid? Either those are the guidelines you need to follow or 
the EPA has changed their minds and is walking away from this 
agreement and saying we are going to come up with different 
guidelines.
    Mr. Howard. Mr. Chairman, may I speak to the agreement?
    Chairman Sununu. Please.
    Mr. Howard. The agreement contains three conditions: one, 
that all liquid PCBs be removed; that solid PCBs be removed to 
the extent possible; and that the country that is accepting the 
vessel be notified that the PCBs were on board and attempts 
were made to remove them. That is what the agreement covers.
    Chairman Sununu. Those sound like reasonable guidelines.
    Mr. Howard. MARAD received authority in 1997 or 1998 to 
sell two ships under those guidelines. When they attempted to 
put together a plan that complied with the guidelines they 
found that once they had removed the PCBs, that the ship 
wouldn't be seaworthy and it wouldn't be able to be towed to 
the foreign country that was willing to purchase it.
    Mr. Graykowski. So we are still waiting for final guidance, 
if you will, out of EPA to avoid this conundrum.
    Chairman Sununu. I understand. So you are looking for a 
little additional guidance so that you won't have to destroy 
the seaworthiness of the vessel in an effort to scrap it 
efficiently and economically.
    Mr. Graykowski. Yes, sir; and I don't know what the status 
of the guidelines are at this point in time.
    Chairman Sununu. Has MARAD or anyone else evaluated EPA's 
environmental concerns to determine whether they are 
supportable on an environmental or economic basis?
    Mr. Graykowski. The short answer would be no. I guess it 
would be very difficult for the Maritime Administration to 
second guess the Environmental Protection Agency on a 
determination of environmental----
    Chairman Sununu. I understand that is not your expertise, 
but there has been no other outside or independent evaluation.
    Mr. Graykowski. No. We are sort of leaning--we as a country 
by approaching it this way are way ahead of, if you will, the 
rest of the world. Scrapping practices vary worldwide, and what 
we are trying to impose as standards and that the Admiral has 
worked with, for example, is where I believe sincerely the 
world is going to end up. But it is going to be several years 
before it gets there, but we will be the first to get there.
    Chairman Sununu. Thank you very much. Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman. I have a few 
questions. First of all, I am familiar with the Beaumont area, 
even though I am in Houston. But let me tell you, when a 
hurricane comes up the Gulf Coast, and a lot of times they head 
toward an island in the Beaumont area, you can be in that 
protected part of the Sabine River and still get some pretty 
good surf over there. In my district back in 1994, as well as 
just last year, when you get either a storm or a hurricane or 
heavy rainstorm, you move the current on that river and you can 
lose control of operating ships.
    Plus we had in 1994 a situation with these abandoned 
barges, some that were beached, that got moved off the beach, 
off the banks, and smashed into the I-10 bridge, was involved 
in part setting off an explosion in a pipeline.
    So even though you are in a protected water area, the force 
of nature can sometimes change it, and that is something that 
we have to be concerned about, particularly in--at least I am 
most familiar with the Texas areas. And I do understand the 
environmental hazard related to these with, again, my own 
experience in going through it with these barges and most of 
the working ships in the Texas area.
    Again, though, it is--and I know you have been having this 
discussion with Mr. Sununu about this--but it is my 
understanding that EPA has said that you could--if MARAD would 
remove the hazardous waste, be it PCB or whatever, then you 
could direct the vessel for scrapping. And I guess what you are 
saying is in some cases the vessel becomes unseaworthy and you 
can't do it. Why not salvage the vessel on site? I mean, we do 
that. I don't, but the organizations along the Houston ship 
channel do that from time to time, where they just do an onsite 
salvaging instead of trying to tow something in and take it 
apart.
    Mr. Graykowski. Well, number one--and probably you don't 
have to go farther than number one--we don't have the money for 
it, Mr. Bentsen.
    Number two, the EPA agreement--let me correct myself if I 
could, please. And the Admiral was kind enough to tell me this. 
It pertained to exports, OK and it is very dicey at this point 
in time politically as well as I think practically, if you 
will, to be exporting these ships. And so while we have turned 
our attentions domestically as I have indicated----
    Mr. Bentsen. Can I say that, for a second, on EPA, on the 
exports, they were opposing the export of the ships because of 
PCB content?
    Mr. Graykowski. Primarily; and other what they consider to 
be toxic waste, they viewed it as----
    Mr. Bentsen. It is an interesting notion, and I only add 
that because I have had a small battle with the EPA over the 
last several years changing what has been the position for the 
last 15 years to allow for the export of PCBs for disposal and 
incineration abroad, which we believe violates the TSCA act, 
although EPA seems to believe that it doesn't. EPA has taken 
the position that they would like to export PCBs to Mexico and 
Latin America and other countries where they can be disposed 
of. Some would argue that this is because the volume of 
American PCBs is declining and there continues to be industry 
demand.
    So it sounds to me like EPA may have a--the left hand may 
not know what the right hand is doing at the EPA. I would 
encourage you all to go back and talk to them.
    Now they are under court order precluding them from doing 
that, from the California circuit, the West Coast circuit and 
we have tried to block them from doing that through the defense 
bill in the past. Again, EPA has taken this position that in 
some cases, at least, you would export PCBs for incineration.
    Mr. Graykowski. I am incredulous, frankly. This is news to 
me because when I leaf through, this is the agreement that I 
signed with EPA in 1997, it specifically links PCBs, the 
vessels and TSCA and the prohibition against introducing PCBs 
into international commerce and that is what ground the 
exporting to a halt.
    Mr. Bentsen. Maybe instead of offering up the ship for 
scrap metal you should have offered it up for PCB 
consideration. I would encourage you to revisit that, and that 
is in the courts, I think the 9th Circuit.
    Let me ask you this. The chairman mentioned that the range 
of cost for addressing this problem would be between half a 
billion to $2 million. Why is there that amount of fluctuation 
or band in the cost? Is it because you don't know necessarily 
what you have out there until you get into the ship?
    Mr. Graykowski. We have not inventoried, and I told the 
chairman this yesterday, we have not really conducted the 
inventory necessary to say we have 5 pounds or 5,000 pounds of 
PCBs, I don't know, liquid versus solid. My impression is that 
most of the liquids have been removed except those transformers 
and capacitors that are buried in the bowels of the ship. We 
don't know approximately how much we can get off of the ship. I 
think the admiral can speak to the fact that--it is a net 
outlay when you pay to have someone scrap it, but there is a 
return that we would anticipate having a similar experience 
with.
    Vice Adm. Amerault. Assuming you will ask about this 
anyway, but our program is based on the fact that we are paying 
someone to scrap the ships. Heretofore that was very difficult 
to do because they would default, there being no longer a 
viable market for the scrap material which used to finance the 
whole venture. So what we do is we reduce their risk of making 
nothing by paying their workforce and facilitization and other 
costs, by paying the cost of doing business, if you will, just 
the labor and so forth.
    Any materials that come off the ships that then can be sold 
in the scrap market are, by contract, used to net the total 
cost in our favor.
    Now, we don't know exactly how well that is going to do and 
I think it is going to depend on some things, one being 
facilitization that is taking place up front, and we have paid 
for that in the four pilots, the four yards that we have used 
as pilot program participants. Part of what we pay for is the 
facilitization to be able to handle the environmental and the 
other things. Once that is done, then you have learning curve, 
which can reduce the cost of their operation, and you have of 
course the value of that material. As you get a good steady 
throughput and the learning curve comes into play, their costs 
will go down and you will have a volume of material that you 
can sell for scrap. And the net, if things were to work out, 
might, and I say might because we don't have the final 
information and we don't have this--we don't know how scalable 
this is, but it could be that the net cost of this whole thing 
equals the cost of living up to the EPA agreements of taking 
out the PCBs and making the ships environmentally safe for 
export. So that is our hope.
    Then you would have at least two processes that you could 
look at and compare. I would think that we would want to try to 
export a few ships so we could test that hypothesis to see if 
doing it domestically with a net value, if you will, approach, 
that we have done in this pilot program is indeed better or if 
you can still beat it overseas even if you pay the up front 
environmental costs.
    Mr. Bentsen. It seems to me there would be a couple of 
factors between domestically and overseas, the laboratory input 
and the capacity, but also there are some transportation costs 
associated as well. I am sure that these ships are not cheap to 
move around.
    Vice Adm. Amerault. There is a cost of getting them there. 
That could work in our favor domestically.
    Mr. Bentsen. There are two bills, one being Mr. DeFazio's 
bill, and I would be interested in your comments on that. I 
don't know if MARAD has taken a position on that.
    The other, in the Senate, the chairman of the Senate 
Commerce Committee, Senator McCain, has introduced a bill which 
gives DOT the authority to scrap 39 foreign vessels under terms 
determined by the agency. Is this an effective way to deal with 
the problem or do you have a position on that bill?
    Mr. Graykowski. No, we have not taken a position on any of 
the legislation. There are four bills in total. We don't have 
an administration position on any of the bills introduced.
    Mr. Sununu. If I could interject there, Mr. Howard, those 
two alternatives, correct me if I'm wrong, were part of the 
recommendations that you made, one, to release the restriction 
on these exports, and, two, to authorize MARAD or get rid of 
the restriction on MARAD from being able to pay to scrap, and 
that is what Mr. DeFazio's bill does. He includes an 
authorization amount but of course in order to do that he needs 
to eliminate that restriction?
    Mr. Howard. Yes, sir, that is consistent with what we 
recommended.
    Mr. Bentsen. It seems to me that this is a situation that 
there isn't going to be much of a market for and we just need 
to get a handle on this and how much it is going to cost and 
deal with it because again I realize these ships are docked and 
they are in somewhat secure waters most of the time, but I 
guarantee you there will be another storm that will come up 
high island and there will be more water in Suisun and Beaumont 
and everywhere else you have these and it is going to become a 
problem. It would be worthwhile for us to get a handle on this 
now and address this and figure out a way to do it. This is not 
unlike a Superfund situation or any other hazardous waste 
disposal, we just have to deal with it.
    Mr. Graykowski. Mr. Bentsen, I didn't mean to imply in my 
statement that the calm waters are always calm. Hurricane Floyd 
caused us some sleepless nights. The first report indicated 
that some of the nests had not broken but they were drifting 
apart, had hurricane Floyd been stronger and hit differently, 
our lives would have been differently. These ships cannot 
withstand heavy water.
    Number two, I might take issue with you. I do see a 
potential for this country. There are 10,000 commercial ships 
operating around the world. If indeed we set the standard as we 
have consistently through the years on environmental matters 
and the rest of the world does catch up and I would point to 
the Basel Convention, which is part of the U.N. Process, if you 
will, moving toward declaring obsolete ships as a hazardous 
waste, the country of the Netherlands, which is a major world 
shipowner, there was one conference, they are pushing for 
another one, Norway has been talking about incorporating 
scrapping into the life cycle cost of the vessel, imputing to 
owners this notion that you are going to have to pay to scrap.
    I would pose to you if we put a program together now with 
these government ships, quite possibly we are in a position to 
take advantage of it in a commercial sense when the rest of the 
world says, oh, my gosh, we are going to have to.
    Mr. Bentsen. That is a legitimate point. I had a discussion 
last week with some people in the maritime industry in Houston, 
where there is a discussion going on both in Texas and I think 
somewhat through the international maritime organization 
regarding emissions controls. Houston, of course has a serious 
ozone problem. One idea--and part of the contribution of that 
comes from the ships that go up and down the Houston ship 
channel. We can't impose a Houston emissions control policy on 
ships calling on our port because they will go somewhere else. 
There probably needs to be a national standard, but it is 
difficult to impose a national standard with respect to WTO and 
other international agreements that we have, and perhaps it 
needs to go through the International Maritime Organization. I 
do appreciate that.
    However, surely you have some ships that are decaying to 
the point where we may not be able to wait for an international 
convention to--you know, necessarily get an agreement. We may 
be talking something more prospective than retroactive.
    Mr. Graykowski. The imminence is undeniable. I think long 
term there are benefits to be gained by sort of creating this 
new industry just as we have seen in other environmental 
recovery operations. Right now, Mr. Bentsen, we have to do 
something with, as I said, these 12 or the 40. I mean there are 
other benefits. We have not really looked at it in a broad 
perspective. If we attack it, we ought to attack it in a 
comprehensive fashion. We are dying for people to work in basic 
shipbuilding industries and trades. The shipyards are essential 
to the national defense. This is the type of program that can 
help support them different than building brand new ships. We 
have a source of labor to keep people coming in because this is 
another problem that has not been looked at.
    Mr. Bentsen. I agree with that. In order to get there, it 
may be something that has to be subsidized initially. The 
chairman doesn't always like to hear that word, but I think he 
understands as well this may be a situation where the need is 
great to deal with this problem, and I understand the need and 
the idea of maintaining shipyard operations. You might be able 
to match the two. Perhaps in the long run you are right. As in 
other environmental services which we have seen grow in waste 
disposal, this may be applicable also.
    Mr. Graykowski. Yards that I have talked with this about 
comment that there is a crossover point. If we guarantee a 
certain feedstock at some point, however many ships, the 
economies become such that it becomes a positive situation for 
the company or in this case the joint venture between 
government and industry. You are running so many ships, 
ostensibly you get the efficiencies down and the yields up in 
terms of the metals. And the projections that I have seen show 
a definite crossover point from subsidy to a revenue generating 
or certainly a wash situation referred to by the admiral. Until 
we start it, we are not going to know and we right now don't 
know much other than our ships are getting old and the problem 
is getting bigger.
    Mr. Bentsen. Thank you.
    Mr. Sununu. Thank you.
    Ms. Hooley.
    Ms. Hooley. I am sorry that I missed your testimony but I 
have the written statements.
    Having gone through your information, Mr. Graykowski, do 
you think we have the capacity to dismantle the ships today in 
a domestic market?
    Mr. Graykowski. Nope.
    Ms. Hooley. You do not?
    Mr. Graykowski. No.
    Ms. Hooley. Let me ask the vice admiral if we have enough 
capacity in domestic market to dismantle the ships?
    Vice Adm. Amerault. I don't think now. It could possibly be 
generated but again as Mr. Graykowski said, I think one of the 
problems in trying to get it generated is what will be the 
throughput so that when it is capitalized there will be a 
continuous throughput to pay off that capitalization. So if we 
were to generate it, it would either have to be subsidized, or 
there would have to be some feeling that in an economic or 
business model, that there will be throughput to keep it going.
    Ms. Hooley. When you say that we don't have the capacity, 
that has nothing to do with that we may have to pay to get this 
dismantled, it is simply that there are not enough shipbuilders 
or facilities?
    Vice Adm. Amerault. There are people in the ship 
maintenance business and shipbuilding business and public 
yards.
    Ms. Hooley. Which have the capability?
    Vice Adm. Amerault. Yes. This is not rocket science. You 
need basically a berm or a dry dock or some sort of containment 
and metal workers and the new part of it is the environmental 
sense or the ability to deal with the environmental issues.
    Ms. Hooley. Don't you think on the domestic side that we 
have much greater ability to deal with the environmental 
issues?
    Mr. Graykowski. Yes, ma'am. I was trying to get at that. I 
think export ought to be looked at as almost a last resort 
option. We will have 155 ships by the end of fiscal year 2001 
and the Navy has----
    Vice Adm. Amerault. We have 57 that are in excess category 
that will be disposed of in some way or another, and an 
additional 28 of which we will turn over to MARAD, so we will 
add to their problem.
    Mr. Graykowski. Exporting is almost giving up on the notion 
that we can do it better. I believe we can do it better here in 
America. Our standards are higher, but we have proven that is a 
better way to go. We have yards that are interested. When I say 
there is not the capacity, today there is not. People are not 
bidding on our ships because they have to pay us.
    Ms. Hooley. As long as they have to pay you, they can't 
afford to do it?
    Mr. Graykowski. If we turn it around, I am confident that 
we can put a program together and there will be sufficient 
people to do it. But we need to do 12 to 15 ships a year, not 
onesies and twosies.
    Ms. Hooley. Right now does MARAD have to maximize the 
economic value of the ships, and is that a problem?
    Mr. Graykowski. Absolutely. I mean, we went from selling 
ships in 1993 or so at $108 a ton which netted us several 
hundred thousand dollars, netted to the government, so we 
didn't have to ask for appropriations to the last bid we had 
accepted was $10 a ship for the whole ship that people paid us 
and even those contracts ran into problems.
    Ms. Hooley. Most of those were foreign; is that right? The 
bids?
    Mr. Graykowski. No, the $10 ship bid was domestic.
    Ms. Hooley. OK. OK. How much does it cost for you to store 
these ships? Wouldn't we be better off to pay somebody to 
dismantle them than storing them?
    Mr. Graykowski. Well, I have the statutory problem which 
precludes that. Intuitively, logically, and as a taxpayer, 
absolutely; but the money that we are spending to care take, 
which was $3 million last year, isn't enough to address the 
problem in a substantive and dramatic fashion. We would still 
have to increase the amount of money. The admiral spent a lot 
of money last year just on four ships. But we--you missed the 
part of the testimony regarding the dry dock. We are projecting 
that it is going to cost us $900,000 per ship times 155, and 
that is sort of a benchmark level of expenditure to just take 
it into the garage, if you use the analogies of a car. That is 
every single ship. That is a nonavoidable cost. We are going to 
spend that irrespective of a scrapping problem or not, but if 
we have a scrapping problem, we don't have to do it, we can 
devote the money to scrapping and we will have to do that with 
fewer ships. That is a function of time.
    But your point remains. We are spending the money now and 
we are going to spend more and more money and end up exactly 
where we are today with ships sitting in the James River and 
elsewhere.
    Ms. Hooley. Didn't the Navy have a pilot project and what 
happened with that?
    Vice Adm. Amerault. Yes, ma'am. We still have the pilot 
program underway.
    Ms. Hooley. It has been going what, a couple of years?
    Vice Adm. Amerault. We had a 1999 contract for four ships. 
We have some money in 2000 that we are applying to two other 
ships, four contractors. So that ship breaking is underway. All 
four contractors are working on ships. All four ships are 
frigates. So if you look at this as a pilot or experiment, the 
control variable is the same. We had some money in 2000 which 
we asked for bids to continue. The best value bids were taken 
up on two of the contractors. So we basically are scrapping two 
more. We will learn a little more with those two.
    What we are hoping to do is find out some data with regard 
to what are the costs of facilitizing a yard to take care of 
the environmental aspects of this and other things that they 
might need to create an efficient ship breaking process that is 
environmentally safe, by paying for their labor, and then 
finding out how much the value is in a typical ship in terms of 
the scrap material and scrap metals. Copper alloys, aluminum, 
steel, these are all in abundance. That would then net against 
the cost, and we would like to find out what the net value is 
and then subtract the initial facilitization, and then we would 
have some data to say if you create a steady stream and apply a 
learning curve. Maybe that net cost could go down over time and 
approach zero, or at least we would know what it would be and 
we can compare it to exactly the costs that are you talking 
about. If we do spend money on these ships in both the reserve 
fleet and in our own reserve fleet or in active fleet to keep 
them from sinking and having these environmental disasters, and 
in fact if eventually there is a cost of dry docking at a lot 
of money, considerable cost, it could be that your present 
value one-time costs are cheaper than your annualized costs of 
keeping all of that going.
    So I think that is where you are going and that is what the 
project is all about to some degree. It is not the same kind of 
ships in their reserve fleet but there should be lessons----
    Ms. Hooley. But MARAD cannot do a pilot project?
    Vice Adm. Amerault. They are still enjoined to produce a 
scrap ship at no cost to the government. It is impossible for 
them to do that under statute. We are giving them all of the 
information that we find, or will, and there will be some--I 
don't know how scalable this is. There are lessons to be 
learned.
    Ms. Hooley. Mr. Graykowski, Peter DeFazio from Oregon has 
introduced a piece of legislation that would allow you to do 
that. Are you supporting that?
    Mr. Graykowski. No, we have not taken a position as the 
administration on that legislation. But I am aware of it and 
following it with great interest.
    Ms. Hooley. Why haven't you taken a position? It would seem 
to me that here is an opportunity for you to do a pilot 
project, to try this out. You are spending a ton of money 
keeping the ships, you know. Tell me why.
    Mr. Howard. If I might comment on that, ma'am, Mr. 
DeFazio's bill is consistent with the recommendation that we 
made in our March 10 report. We recommended that the Maritime 
Administration develop a proposal for a pilot program and seek 
legislation and funding for that program. In order to do that, 
the Maritime Administration has to work that proposal through 
the Department of Transportation and through the Office of 
Management and Budget. What they told us in response to our 
report is that they would work that in next year's 
authorization bill.
    Mr. Sununu. Ms. Hooley, recognizing that it wouldn't be 
good form, to say the least, for Mr. Graykowski to lobby for or 
against any single piece of legislation, I think it probably 
does bear emphasizing Mr. DeFazio's bill would be consistent 
with the goal of helping to build a domestic capability to do 
this work.
    Ms. Hooley. Thank you. I am sorry that I put you on the 
spot.
    Mr. Graykowski. No, I am not on the spot. Look at--when I 
say----
    Ms. Hooley. It just seems to me that it seems stupid. I 
don't know any other way to put it. It seems stupid that we 
don't develop our own program in this country based on some of 
the information that was in your testimony not only to keep our 
shipyards going and the workers there and trained workers, but 
it is costing us so much money to store these ships right now 
and we could be dismantling them in an environmentally sound 
way and put people to work, and we need to do that in this 
country. I am hoping that that can be something that we can 
look at this year, frankly, to begin at least if nothing else a 
pilot project on figuring out how do we do this the best way 
possible.
    Thank you, Mr. Chairman.
    Mr. Sununu. Thank you very much.
    Let me take some time to ask one final round of questions 
and begin with the issue of subsidies, foreign or domestic. Mr. 
Graykowski, your predecessor Mr. Hart attended an international 
ship scrapping conference in the Netherlands last year, you are 
probably aware of that. One of the issues they discussed was 
providing international assistance to improve the working 
conditions or environmental conditions at ship breaking 
facilities in third world countries.
    My first question, is the U.S. Government to your 
understanding considering providing any type of assistance to 
foreign countries or foreign ship breaking facilities?
    Mr. Graykowski. I am unaware of any efforts. We are not 
aware of anything at MARAD.
    Mr. Sununu. Is that something that MARAD would support or 
oppose?
    Mr. Graykowski. Hmm. I am trying to be diplomatic here 
because we are talking about international things.
    It strikes me if there is going to be a decision made to 
subsidize foreign companies and we are not willing as a country 
to spend the same tax dollars on a domestic program, that that 
might be hard to sustain politically in the body in which you 
serve and others serve. That is a gut reaction.
    Mr. Sununu. EPA's moratorium on exporting vessels, was it 
based solely on the hazardous materials issue or was it also 
based on concerns for environmental and labor standards abroad?
    Mr. Graykowski. Yeah. I am just confirming that.
    The moratorium, so-called, we are sort of confusing a 
number of different events. EPA was concerned about TSCA, as I 
discussed with Mr. Bentsen, and in 1993-1994 began to look at 
ships covered by TSCA and, therefore, restricting its exports. 
The moratorium was imposed by the administration, by Vice 
President Gore, to enable this DOD interagency panel to come up 
with a solution. So in a sense one may have fed into another, 
and the moratorium was extended until October 1999.
    Mr. Sununu. Has the government done anything to express 
concerns, to discuss guidelines or objectives with any foreign 
ship breaking facilities since these discussions and the panel 
was convened and the memorandum of understanding was signed?
    Mr. Graykowski. I know we have maintained contacts. We had 
relationships with foreign scrapping facilities because we had 
dealt with them in the past, but let me give you an update in 
terms of our conversations with them.
    Mr. Sununu. Has MARAD inspected any overseas facilities 
since 1994?
    Mr. Graykowski. No, we have not.
    The notion of us imposing our standards on other countries 
around the world is difficult.
    Mr. Sununu. Without question. Mr. Bentsen touched on those 
points, and the imposition of any number of requirements would 
be a violation of the regulations or the guidelines that we 
agree to abide by as part of the WTO.
    Mr. Graykowski. Furthermore, any requirements that we levy 
on the exports of our ships would require--would raise the cost 
to the scrap and lower the yield to the government, thereby 
making our ships less competitive with others.
    Mr. Sununu. Are there any limits on the use of foreign 
scrap yards that are imposed on privately owned U.S. vessels?
    Mr. Graykowski. No, sir.
    Mr. Sununu. None at all?
    Mr. Graykowski. They can take a ship any time, any way up 
to these foreign scrap yards and sell it without restriction.
    Mr. Sununu. At this point under the memorandum of 
understanding that has been signed with the EPA, given those 
guidelines, you have the ability to utilize those breaking 
yards as well?
    Mr. Graykowski. Well, you mean under the EPA agreement? 
Theoretically if we clean up all of the PCBs, we are in that 
loop, but we have to make the ship unstable.
    Mr. Sununu. The remaining issue is seaworthiness.
    Mr. Graykowski. You have to tell the country formally as 
the United States, we are going to send you a ship that might 
contain stuff, PCBs and other stuff, which in a political 
context is hard for a country to say no problem because every 
country has an environmental movement or green party, however 
you want to characterize it.
    Mr. Sununu. It doesn't seem to me that the notification 
that a vessel going to a breaking yard might contain lead paint 
or PCBs or residual asbestos would surprise anyone in this 
country or abroad.
    Mr. Graykowski. Actually, I think our experience--actually, 
Mr. Chairman, we did run into a problem in India, which is 50 
percent of the world market in scrapping. Because of that we 
are notifying you, Mexico is another outlet that--you know, I 
suppose in a lot of ways people don't know what they don't want 
to know, if you will. So private people take the ships and run 
them up on the beach and life goes on. But formal notification 
to the government, we are sending stuff that might be bad for 
you, do you mind?
    Mr. Sununu. I am confident that your technical presentation 
could be a little more detailed on that.
    Let me ask about the growth of the fleet. Do you have the 
option to object to or reject any additions to the reserve 
fleet?
    Mr. Graykowski. There are no additions. We don't have the 
money.
    Oh, no. We have to take them under contract.
    Mr. Sununu. Why have you never included funds in your 
budget request to cover the costs of domestic scrapping?
    Mr. Graykowski. Because we do not have the statutory 
authority to do anything other than sell them.
    Mr. Sununu. That has never been part of the budget request 
either? You have never requested a repeal of that statutory 
limitation?
    Mr. Graykowski. No, because we had this DOD interagency 
panel. So we saw the panel in place and so there was no impetus 
to develop that legislative position.
    Mr. Sununu. Admiral, could you run through the costs of the 
pilot program? You talked about the initial vessels, the two 
that were done using 2000 money. What have been the gross costs 
of the contracts that were let, the number of ships for each, 
and then the amount of scrap credits that have come?
    Vice Adm. Amerault. I don't have the scrap credit yet, but 
I can tell you what we have paid so far. There have been four 
contractors and thus four contracts. Metro Machine Corporation 
in Philadelphia and Chester, PA, we paid $3.5 million for the 
initial phase, that is for one ship. That includes some 
facilitization, as I mentioned, the cost of labor, and we have 
yet to get a full accounting of the sales, and thus the net 
costs.
    Mr. Sununu. So that is $3.5 million gross. Then anything 
they get through the sale of scrap will be credited against 
that. Do you split it 50/50?
    Vice Adm. Amerault. No, sir, it always comes to us because 
again the insurance for them is that their costs will be borne. 
We are taking the risk, and that is what we are paying for.
    Mr. Sununu. These are aluminum hull?
    Vice Adm. Amerault. These are steel hull with aluminum 
superstructure.
    Mr. Sununu. So the scrap value is a little higher?
    Vice Adm. Amerault. I can't say with authority. Aluminum is 
one of the more saleable commodities, however. And I think 
warships tend to have more copper. There are other things that 
are good about those in a sense; however you determine 
goodness, I guess.
    Baltimore Marine Industries, the cost is $4 million. The 
variance in this is mostly facilitization, what they were 
prepared and able to do to start with.
    Again when we come out of this, we will have four 
facilitized contractors.
    International Shipbreaking in Brownsville, Texas, $2.7 
million. They are fully facilitized. This is a contractor that 
once defaulted on I think MARAD as well as us. And the reason 
that they are working out now is again, we have removed the 
risk. The reason that they defaulted was they bought the ship 
from us expecting to make money and didn't. So that puts them 
back in the business in a sense.
    Ship Dismantling and Recycling, which is a consortium 
working in San Francisco, that is $3.9 million. So the ones 
that have to be facilitized are roughly about the same amount.
    Mr. Sununu. Which were the two that were let with 2000?
    Vice Adm. Amerault. We added a ship to Metro Machine and we 
added a ship to Ship Dismantling and Recycling.
    Mr. Sununu. What were the incremental costs for adding each 
of those?
    Vice Adm. Amerault. $2.7 million and $3.2 million. Again, 
that doesn't have the cost reduction that will come.
    Mr. Sununu. The 2.7 was let to whom?
    Vice Adm. Amerault. Metro Machine, and the other was 3.2. 
That is to Ship Dismantling and Recycling, which is a joint 
venture----
    Mr. Sununu. That is six ships that have been placed?
    Vice Adm. Amerault. Four contractors. Two of them have two 
ships.
    Mr. Sununu. In the case of Metro Machine, the difference 
between the 2.7 and the 3.5 represents the start-up costs and 
the facilitization costs?
    Vice Adm. Amerault. It will be that, yes, sir. And what we 
will find out is again how much this will all be reduced 
because none of these figures have the reduction for the sale 
of scrap.
    Mr. Sununu. Did Metro Machine complete the scrapping of the 
first vessel?
    Vice Adm. Amerault. They are almost done.
    Mr. Sununu. But you don't have the cost figures?
    Vice Adm. Amerault. Not yet, but that is part of the 
deliverable on the contract.
    Mr. Sununu. To what detail will those cost figures be 
provided?
    Vice Adm. Amerault. I think to great detail. It will almost 
have to be a CPA like accounting because it is contractual. I 
don't think that we will get it until some of these sales----
    Mr. Sununu. There is a joke in here about whether or not 
DOD's books meet FASB standards, but----
    Vice Adm. Amerault. Yes, I have been involved in that 
previously.
    Mr. Sununu. Will all of that cost information be shared 
with MARAD?
    Vice Adm. Amerault. It is open. Since I have been in this 
job, I have tried to engage MARAD in this problem. So I feel 
like a partner. I don't particularly want to have the Navy bear 
the cost of the problem they have.
    Mr. Sununu. There are obviously economies of scale in the 
numbers that we are dealing with here. To the extent that there 
is cooperation or a long-term solution to the problem with 
MARAD, it is going to help both groups.
    Are there any issues or concerns that you have, Mr. 
Graykowski, with regard to information sharing, either 
administrative problems or legislative problems, that somehow 
inhibit you from getting information that you think might be 
helpful?
    Mr. Graykowski. No. You are too modest. I told the admiral 
that. When he took over, he was the first person who really 
took ahold of this, not only on behalf of the Navy, but reached 
out to MARAD.
    I don't see any impediments. We all have the same problem 
here, and I think we all want a solution.
    Mr. Sununu. Admiral, do you have even a rough estimate for 
the scrap credit?
    Vice Adm. Amerault. Let me just say that it is encouraging.
    Mr. Sununu. Give me a range.
    Vice Adm. Amerault. Any figures I had seen were rough and I 
don't want to pin them down to anything.
    Mr. Sununu. Give me a wild range?
    Vice Adm. Amerault. Well, it could be that say--say a 
million dollars a ship. $800,000 to a million dollars.
    Mr. Sununu. If I were you testifying to me, I probably 
would have said something like well, between $200,000 to a 
million five.
    Vice Adm. Amerault. That is my answer.
    Mr. Sununu. If we have the opportunity, we will correct the 
record.
    Vice Adm. Amerault. The reason is that I would be hesitant 
to create a program based on that figure would not be in either 
ours or your best interests.
    Mr. Sununu. I understand. If we look at the gross numbers, 
it is 1,300 a ton to scrap the ships and that is an enormous 
figure at 10 times the scrap value. There seems to be a 
disconnect, so I would expect the credits to be significant in 
just trying to gauge where we might be at the end of this 
process.
    Vice Adm. Amerault. I think the other thing is that this is 
a one-time venture, too. I think again their costs will come 
down and that probably affects it almost more than the price of 
the market.
    Mr. Sununu. How much of their costs are driven by EPA 
mandated directives and environmental concerns?
    Vice Adm. Amerault. I would say that is the second most 
significant thing. Labor is the most, and then the 
environmental concerns.
    Mr. Sununu. Thank you.
    The Navy received $284 million in fiscal year 2000 for 
environmental restoration. What is that funding directed for 
and why would the Navy need a new program for disposal of 
vessels if it could utilize that funding for this program?
    Vice Adm. Amerault. Sir, the environmental remediation Navy 
is the appropriation or the line item, and it is for 
remediation. So I would say in our case, our ships that are 
scrappable, if you will, are not yet needing remediation. So I 
would have to find out whether those funds--we have 
appropriation lawyers, would tell us whether we can spend those 
funds on this.
    Also in terms of the MARAD fleet, it is not just a Navy 
fleet. I am not so sure we would be spending our ERN funds on 
their fleet.
    If we--and I think part of the answer might be in what Mr. 
Graykowski mentioned in terms of this has not yet--or these 
ships have not yet been declared as environmental hazards. So 
environmental restoration Navy is for declared environmental 
hazards.
    Mr. Sununu. Who makes that declaration?
    Vice Adm. Amerault. I am not sure.
    Mr. Graykowski. We have to find out what the scope of the 
ERN program is. I am guessing that it is SECNAV, but I don't 
know.
    Mr. Sununu. If you would provide any clarification for the 
record, I would appreciate it.
    Vice Adm. Amerault. We have not had difficulty in paying 
for the scrapping of ships that need to be scrapped. We are not 
running into an environmental problem with the ships that are 
in our Navy controlled inactive fleet.
    Mr. Sununu. Would the Navy consider holding onto those 
vessels that are scheduled to be transferred to MARAD in order 
to dispose of them through the pilot project?
    Vice Adm. Amerault. We are enjoined by statute to transfer 
them.
    Mr. Sununu. Mr. Graykowski, putting aside political 
constraints and financial constraints, what do you think would 
be an ideal path forward for your agency?
    Mr. Graykowski. Give me a moment to sort of bask in this 
new found freedom that you have sort of given me.
    Mr. Sununu. Believe me, it is very temporary.
    Mr. Graykowski. You don't know how temporary. I have to go 
back to my office.
    The answer is obvious. You have picked up on it and you 
know it. Your colleagues have as well. We need, A, to have the 
statutory constraints lifted. We have to recognize reality and 
pay people.
    B, I think we can set up a real partnership with the 
shipbuilding industry and create a ship breaking industry which 
focuses on breaking them in an efficient and economically and 
environmentally responsible way, and that is going to take 
money. I think we should start with, as the Navy has done with 
a pilot program, although I would suggest perhaps a bit more 
ambitious, and guarantee to a yard we will give you 12 ships. I 
have 40 to work with and so we could give them to 2 or 3 
different yards. We can say here is the results, it is going to 
work or not.
    I suggest that we hold off on exporting until we have a 
chance to get a program up and running, and I think we could do 
that in fairly short order if we have got the money and if the 
statute changes.
    Mr. Sununu. What other alternatives are there for dealing 
with this that we haven't discussed? I will also editorialize 
by emphasizing that it seems to me that there is a problem 
where we probably want to take multiple approaches, where there 
is no single solution that is going to be ideal or best for 
every single vessel that we are talking about. There is the--I 
think the need to deal with the 40 vessels that are in the most 
serious condition and I think with the memorandum of 
understanding in place, foreign breaking yards ought to be an 
alternative. I think there is the very promising prospects of 
the Navy's pilot program and I think we need to continue to 
have discussions about the statutory requirement that hinders 
you, whether or not that means that we authorize a 12-ship or 
40-ship pilot or we simply get rid of the requirement and allow 
you to use your annual maintenance budget more creatively.
    But outside of those alternatives that we have discussed, 
are there any other opportunities that you see as strong 
alternatives for disposing of these ships?
    Mr. Graykowski. I am really racking my brain here. Because 
of the criticality of the problem, we have to focus. We cannot 
chase different options. To me we are going to export it or do 
it here. If we need to do it here we need to come up with a 
decision tree and come up with money. Limited capability and 
you have to ship everything out of the ship. Other than that, I 
mean knowing the ships as I do, I don't see anything other than 
getting them out of the water and cut up and disposed of as 
soon as possible. That is scrapping, either domestic or 
foreign.
    Mr. Sununu. Thank you very much. Thank you, gentlemen. We 
are adjourned.
    [Whereupon, at 11:46 a.m., the Task Force was adjourned.]


   Implications of Debt Held by Housing-Related Government-Sponsored 
                              Enterprises

                              ----------                              


                         TUESDAY, JULY 25, 2000

                  House of Representatives,
                           Committee on the Budget,
                  Task Force on Housing and Infrastructure,
                                                    Washington, DC.
    The Task Force met, pursuant to call, at 10 a.m. in room 
210, Cannon House Office Building, Hon. John Sununu (chairman 
of the Task Force) presiding.
    Members present: Representatives Sununu, Bentsen, Miller, 
Smith, Ryan, Toomey, Hoekstra, Minge, and Clayton.
    Chairman Sununu. Good morning. The purpose of today's 
hearing is to discuss recent trends in the issuance and 
accumulation of mortgage-backed securities at government-
sponsored enterprises and other financial institutions.
    As the internal portfolio is held by the GSEs continues to 
grow, a number of questions have been raised by Federal 
regulators, Members of Congress and others regarding the change 
in the risk profiles and the ability of GSEs and others to 
appropriately manage these risks.
    This hearing will focus on the economic implications of 
this GSE debt, but, most important, it is meant to provide 
information. We intend to shed light on the nature of these 
portfolios, their size and their economic implications, rather 
than engage in extended policy debate over potential 
legislative prescriptions.
    These questions are made even more timely by the current 
trends in the growth of the Federal budget surpluses and the 
projected pace of debt retirement over the next 3 years. Today, 
the GSEs play a central role not only in the housing finance 
market, but also in the global debt markets.
    According to the Treasury Department, the GSEs' debt of 
$1.4 trillion is roughly the size of the municipal bond market 
and more than half of the outstanding amount of privately held 
Treasury debt.
    Given that the Treasury Department forecasts that GSEs may 
well double over the next four to 5 years, it will likely 
surpass the level of privately held, marketable Treasury debt 
by 2004.
    GSE debt also represents a significant portion of the 
assets of the banking system. Federally-insured deposit 
institutions hold around one-fifth of all GSE debt. Naturally, 
the strength, the safety, the soundness of this GSE debt is 
going to have an impact on financial institutions around the 
country.
    Today, our budget Task Force will hear from witnesses who 
will describe the structure of GSE held debt in mortgage-backed 
portfolios, the nature of the financial risks involved in GSE 
debt and mortgage-backed securities, and the degree to which 
interest rate risk, credit risk, prepayment risk and other 
risks exist under different economic scenarios.
    I think it is essential for policy-makers to better 
understand the nature of these risks and their relative sizes 
and the strategies for managing these risks before making 
assumptions or commitments regarding policy initiatives.
    The housing GSEs continue to operate very successfully in 
today's marketplace. They are literally the backbone of 
America's residential mortgage system that is the most liquid 
and competitive in the world.
    Moreover, GSE regulators in the most recent reports have 
offered clear opinions supporting the safety and soundness of 
the GSEs. However, these institutions are enormous and complex 
entities and we should understand the impact that an economic 
downturn might have on the GSEs themselves and the holders of 
their securities.
    In the 1980's, Congress learned a difficult lesson when the 
American taxpayers were called upon to provide a financial 
backstop for the savings and loan industry. Despite the fact 
that GSE debt securities clearly disclose that they are not 
guaranteed by the United States, some analysts and investors do 
believe that GSE debt is implicitly backed by the Federal 
Government's moral obligation to support these important 
institutions.
    Our goal is to better understand this potential liability 
as investors look toward GSE debt as a potential benchmark 
security.
    The markets will ultimately decide whether or not to confer 
such a benchmark status, but as policymakers we will determine 
whether such a status is based upon safety and soundness alone 
or precipitated by Federal regulation, sponsorship or subsidy.
    I look forward to the testimony of our witnesses and am 
pleased to yield to Representative Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman. I thank you for 
calling this hearing. As the members of the panel know, this 
Task Force is charged with holding oversight hearings on waste, 
fraud, and abuse and reporting our findings and recommendations 
to the full House Budget Committee.
    This is our fourth oversight hearing and in this hearing we 
turn to the economic implications of debt held by government-
sponsored enterprises. This is an issue which, as I think 
members of the panel know and I would imagine the rather large 
audience we have today for this task farce knows, has been a 
subject of numerous hearings before the House Banking Committee 
Subcommittee on Capital Markets, of which I am a member. I 
appreciate those who are testifying today.
    I think in talking with the chairman this is an interesting 
subject which we are embarking upon. It is one that we should 
look at more from, I think, an academic perspective rather than 
whether or not GSEs in and of themselves are a good or bad 
thing.
    I think the focus ought to be on the question of GSE debt, 
in particular, the issuance of GSE corporate debt, the issuance 
of GSE conduit debt in the form of mortgage-backed securities 
and the repurchase of such conduit debt and whether or not that 
constitutes either a secondary market function, taking 
advantage of an arbitrage function or both.
    I look forward, Mr. Chairman, to the testimony of our panel 
and the ability to question them on their expertise of this 
subject. I would say that this is a subject, the question of 
the GSEs themselves is a subject that will go on for quite some 
time.
    Let me just close in saying this. The GSEs have without 
doubt contributed tremendously to a very stable housing market 
in the United States, along with the Federal Housing 
Administration. We know this has been of great benefit. It is 
something that was jump started by the Congress and the Federal 
Government.
    The question before us on the House Banking Committee at 
least at this point is to what extent is a continued Federal 
involvement still necessary, have the GSEs grown too large and 
rather than aid the market now distort the market and is the 
answer to curtail the activities of the GSEs.
    I am not sure that is the right question that is being 
asked or is the answer to unleash the GSEs and have the Federal 
Government get out of the business all together.
    I am not sure that is the answer that those who are asking 
the question want. So this is an issue that is going to be 
around for a couple of years and I think, Mr. Chairman, that 
you are on point in having this hearing.
    I yield back the balance of my time.
    Chairman Sununu. Thank you, Mr. Bentsen.
    Our witnesses today on our first panel are Barbara Miles of 
the Congressional Research Service, Thomas McCool of the GAO, 
and Bert Ely of Ely & Company.
    We would like to try to keep our testimony to 5 minutes, 
and once we have taken testimony from each of the panelists, we 
will have questions from the members.
    Ms. Miles, we will begin with you. Welcome, and thank you 
for being here.

     STATEMENTS OF BARBARA MILES, SPECIALIST IN FINANCIAL 
 INSTITUTIONS, GOVERNMENT AND FINANCE DIVISION, CONGRESSIONAL 
    RESEARCH SERVICE; THOMAS J. McCOOL, DIRECTOR, FINANCIAL 
   INSTITUTION & MARKET ISSUES, GENERAL GOVERNMENT DIVISION, 
   GENERAL ACCOUNTING OFFICE; AND BERT ELY, PRESIDENT, ELY & 
                         COMPANY, INC.

                   STATEMENT OF BARBARA MILES

    Ms. Miles. Good morning. Mr. Chairman and members of the 
committee, I am Barbara Miles, a specialist in financial 
institutions in the Congressional Research Service of the 
Library of Congress. Thank you for inviting me to appear this 
morning to discuss the housing-related government-sponsored 
enterprises and the implications that their activities may pose 
for the economy and the Federal budget.
    At the end of the first of quarter of this year, the three 
housing GSEs--Fannie Mae, Freddie Mac and the Federal Home Loan 
Banks--had outstanding debt of $1.47 trillion. For comparison, 
publicly held marketable Treasury debt was about $2.7 trillion.
    The current and projected declines in the publicly held 
debt of the U.S. Government imply that at current growth rates, 
GSE debt could surpass Treasury debt as early as 2003.
    When Fannie Mae and Freddie Mac's outstanding guarantees of 
mortgage-backed securities are added in, the GSE presence in 
capital markets is very nearly equal to the size of the 
Treasury market today.
    Both the absolute size of the debt and its rapid growth 
have raised questions and concerns about the risks that the 
GSEs' activities pose for the economy and for the government. 
In this regard, I will discuss briefly two fundamental 
questions.
    The first is what is the Federal Government's 
responsibility to and for the housing GSEs?
    And, second, what are the specific risks that these 
companies' activities pose?
    GSEs are a special class of financial institutions in our 
economy. They are government in that they serve as instruments 
of public policy for influencing credit allocation in our 
economy--in this case, into the housing sector. Their 
sponsorship means that they have congressional charters that 
assign them narrow lending powers, but that also grant them 
exemptions and privileges that lower their costs, in part by 
implying a guarantee that is formally denied. That they are 
enterprises means that they operate as private sector 
institutions for the benefit of their owners.
    The public policy purpose of the housing GSEs is reasonably 
clear. They all provide liquidity to mortgage markets by 
lending to primary lenders or by buying and selling mortgages 
in a secondary market that crosses geographic and institutional 
boundaries that for many years characterized our banking 
system.
    The charter benefits of sponsorship are significant. They 
are arrayed in the table that I attached to my written 
testimony.
    Some of the benefits are clear subsidies, exemption from 
State and local income taxes, for example. Others accord 
preferential treatment, granting GSEs securities agency status. 
The main value resides, however, not in the individual benefits 
but in the nature of the charter itself. Even though there is 
no explicit Federal backing, the benefits and public policy 
importance of the mission denoted by the charters leads market 
participants to infer that the GSEs would not be allowed to 
fail such that creditors would lose their money.
    This is the implied guarantee. It effectively lowers 
funding costs for the GSEs and lowers the capital requirements 
below those of other private companies in otherwise similar 
financial conditions.
    The risks that the GSE operations pose fall into two 
categories.
    The normal business risks experienced by any intermediary 
in mortgage markets include interest rate risk, credit risk, a 
variety of business and market risks. All of these risks can be 
managed. They cannot be made to disappear, but they can be 
managed by a prudent company and by all accounts they are being 
managed well.
    Ordinarily, the private market can be expected to exercise 
discipline over any excessive risk taking, but the market 
discipline is weakened by the implied guarantees in the case of 
the GSEs. As a result, all three GSEs have safety and soundness 
regulators to examine and to test the companies and control for 
those excessive risks.
    The Office of Federal Housing Enterprise Oversight is 
responsible for safety and soundness regulation of Fannie Mae 
and Freddie Mac, while HUD oversees their mission, and the 
Federal Housing Finance Board has responsibility for the Home 
Loan Banks. Both OFHEO and FHFB have proposed risk based 
capital standards, although they are not yet in effect.
    OFHEO, HUD and the FHFB are, in an important way, the last 
line of defense against the larger risks to the economy. And 
those greater risk to the financial system and the economy are 
systemic risks and a kind of systematic risk.
    Systemic risk is the likelihood that a failure of a GSE 
would cause widespread failures of other financial institutions 
and result in severe damage to the financial system. In this 
case, it is partly a direct result of the charter provision 
that allows depository institutions to hold GSE securities 
without the normal limits that would be imposed on banks by 
their safety and soundness regulators.
    According to the Treasury, banks currently hold GSE debt 
that is equivalent to one-third of bank capital and many banks 
have sufficient holdings that a GSE failure could wipe out 
their capital. A failure of a GSE under these circumstances 
could create a domino effect and seriously strain the deposit 
insurance funds.
    Systematic risk is risk that cannot be controlled by 
diversification. It is the problem of having all your eggs in 
one basket, but there is only one basket. Portfolio theory 
holds that diversification makes for better management of risk, 
but by law GSEs can only diversify so far. Ultimately, they 
build and grow on a single sector of the economy--and actually 
only a large part of that sector--and that sector therefore 
poses systematic risks for the companies. Beyond some point, 
they cannot continue to grow in their current path without 
``breaking out'' of their assigned market.
    For the government, this same risk is one of having an 
entire sector of the economy more or less identified with the 
GSEs. So long as the GSEs have their benefits fully operating, 
the sector becomes dependent upon the companies and cannot 
diversify away from them. If, on the other hand, GSEs are 
allowed into other sectors, they are better diversified, but 
the economy is not.
    The growth in GSE debt has also led to consideration of GSE 
debt as the ``risk-free'' benchmark for pricing in securities 
markets. But for a benchmark asset to function properly, it 
should reflect risks that are inherent to the economy overall. 
These clearly do not. Yet because of their inferred safety, the 
private sector could turn to them and, as a result, there could 
be pressures on the GSEs other than their announced growth 
plans and, as a result, also on their regulators to allow them 
to expand their missions further to fill that kind of benchmark 
role.
    This completes my prepared statement and I would be pleased 
to answer any questions you may have.
    [The prepared statement of Barbara Miles follows:]

     Prepared Statement of Barbara Miles, Specialist in Financial 
 Institutions, Government and Finance Division, Congressional Research 
                                Service

    Mr. Chairman and members of the committee, I am Barbara Miles, 
Specialist in Financial Institutions in the Congressional Research 
Service of the Library of Congress. Thank you for inviting me to appear 
before you to discuss the housing-related government-sponsored 
enterprises (GSEs) \1\ and the implications their activities may pose 
for the economy and the Federal budget.
---------------------------------------------------------------------------
    \1\ There are five GSEs in our financial system. Two operate in 
farm credit markets--the Farm Credit System and ``Farmer Mac.'' A sixth 
GSE, Sallie Mae, provides student loans and is currently in the process 
of converting to a fully private company.
---------------------------------------------------------------------------
    At the end of the first quarter of this year, the three housing 
GSEs--Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System--
had outstanding debt totaling $1.47 trillion. \2\ For comparison, 
publicly held, marketable Treasury debt was about $2.7 trillion. \3\ 
The current and projected declines in the publicly held debt of the 
U.S. government imply that, at current growth rates of about 20 to 25 
percent per year, GSE debt could surpass Treasury debt outstanding by 
2003. When Fannie Mae and Freddie Mac's outstanding guarantees of 
mortgage-backed securities (MBS), $1.21 trillion (net of the $508 
billion of MBS the GSEs have repurchased), are added in, the GSE 
presence in capital markets is very nearly equal to the size of the 
Treasury market.
---------------------------------------------------------------------------
    \2\ Sources: quarterly statements of Fannie Mae, Freddie Mac and 
the Office of Finance of the Federal Home Loan Banks.
    \3\ This excludes non-marketable debt which, by definition, does 
not trade in capital markets and is, therefore, not an indicator of 
market size.
---------------------------------------------------------------------------
    Both the absolute size of the GSE debt, and its rapid growth have 
raised concerns about the risks the GSE's activities pose for the 
economy and the U.S. Government. In this regard, I will discuss two 
fundamental questions:
    First, what is the Federal Government's responsibility to and for 
the housing GSEs?
    Second, what are the specific risks that these companies' 
activities pose?
                 what are gses and why do we have them?
    The answer to the first question is tied up in what GSEs are, why 
we have them, how they are perceived by investors and why. GSEs are a 
special class of financial institutions in our economy. They are 
government in that they serve as instruments of public policy for 
influencing credit allocation in the economy--in this case into the 
housing sector or, more accurately, into mortgage finance. Their 
sponsorship means that they have congressional charters that assign 
them narrow lending powers, but also grant special exemptions and 
privileges that lower their costs, in part by implying a guarantee that 
is formally denied. That they are enterprises means that they operate 
as private sector institutions for the benefit of their owners.
    Public Policy Purpose. The initial government purpose of the three 
housing GSEs is reasonably clear. The 12 regional Federal Home Loan 
Banks were chartered in 1934 as a collective GSE in order to provide 
liquidity to savings and loan associations so that they could continue 
lending for home mortgages, or at least not be forced by depositor 
withdrawals to call in mortgage loans already made. There was only very 
limited private sector ability to take the risks associated with 
assisting thrifts facing liquidity problems; and nothing, short of the 
commercial banks' Federal Reserve or the Federal Government itself, 
could fill the financing gaps on a scale sufficient to deal with the 
widespread problems of the 1930's. The Banks were chartered to be owned 
by the S&Ls themselves, and given a series of benefits that lowered 
their costs. In turn, the Banks made low-cost loans (called 
``advances'') to the S&Ls on the strength of their mortgage lending, 
and turned a profit for their member-owners in doing so.
    Fannie Mae and Freddie Mac were both started to assist in providing 
liquidity to lenders by developing a secondary mortgage market. A 
series of problems--including Federal and state laws restricting 
depository institutions--impeded nationwide flows of mortgage funds and 
made tapping the resources of general capital markets difficult. As a 
result, funds did not flow in a normal market response from areas with 
high savings or from investments with low returns into the regions and 
mortgages where rates and yield were higher. Fannie Mae, originally a 
government agency in 1938, but rechartered as a GSE in 1968, and 
Freddie Mac in 1970, were to help solve these problems by doing what 
the primary lenders could not do: act as national intermediaries to 
first, move funds across the country by borrowing where funds were 
cheap to invest in mortgages where rates were high, and second, develop 
appropriate securities to tap into non-traditional investment sources. 
Both actions made mortgages funds more uniformly available.
    The charter benefits. The benefits that have been granted to the 
GSEs are significant and valuable. (See Table, attached.) Some of the 
benefits directly and explicitly lower the costs of operation of the 
GSEs below those of any other private-sector company. Exemption from 
State and local income taxes, for example, was worth about $490 million 
to Fannie Mae and Freddie Mac last year. \4\ The SEC registration 
exemption, according to the U.S. Treasury, was worth another 
approximately $280 million. CBO estimates that, were all five GSEs 
required to register, the Federal budget would gain $313 million in 
2001, and about $1.5 billion for 2001-2005.
---------------------------------------------------------------------------
    \4\ This assumes a state tax average of about 8 percent and 
cooperation under the state tax compacts. See Zimmerman, Dennis. 
Unfunded Mandates and State Taxation of the Income of Fannie Mae, 
Freddie Mac, and Sallie Mae: Implications for D.C. Finances. CRS Report 
95-952 E.
---------------------------------------------------------------------------
    Other benefits accord GSE debt preferential treatment, including 
the eligibility for unlimited investment by depository institutions--
circumventing the normal safety and soundness limits on loans to a 
single borrower--and the eligibility of their debt and MBS as 
collateral for public deposits. Still others simply provide links that 
signal that these companies are more ``important'' than ``normal'' 
corporations as a matter of public policy.
    Implied Guarantee. The charter value resides not simply in the sum 
of the individual preferences but in the nature of the charter itself. 
Even though there is no explicit government backing, because of the 
benefits and because of the public policy importance of the GSE mission 
as demonstrated by their special charters, market participants infer 
that the Federal Government would not allow the GSEs to fail such that 
creditors would lose their money. \5\ This is usually referred to as 
the ``implied guarantee,'' and it effectively lowers funding costs for 
the GSEs below those of other private companies in similar financial 
condition. A series of studies since 1990 have generally put the 
funding advantage at about 30 basis points (or 0.3 percentage point) 
below what is available to triple-A companies and about 40 basis points 
below double-A companies. While there appears to have been some 
narrowing of this advantage in the past few months, the advantage is 
still significant.
---------------------------------------------------------------------------
    \5\ All GSEs are required to inform investors that their securities 
do not carry full-faith-and-credit guarantees. Yet the statutory 
equivalence of GSE and Federal debt for a variety of purposes reassures 
investors that the government in some way stands behind the debt. 
Investors are probably correct in their assessments: when the Farm 
Credit System was in trouble in the late 1980's, it was rescued so that 
no investors lost.
---------------------------------------------------------------------------
    The implied guarantee also allows for high leverage on the part of 
GSEs. That is, less capital is needed to assure investors of safety for 
any given level of assets. Relatively low financial capital allows a 
higher rate of return for the company so that there is an incentive 
toward toward maintaining minimum levels consistent with investor 
comfort and low borrowing costs. Capital provides a kind of cushion 
against losses for investors. But the implied guarantee replaces, to 
some extent, the normal market discipline that would take into account 
the actual risks of the business operations of the company.
    Market power. By most accounts, the problems that gave rise to 
creation of the housing GSEs have been corrected. \6\ Correction is 
generally measured in terms of the degree to which housing finance is 
integrated with general capital markets. Mortgage rates are effectively 
uniform across the country, and mortgage markets tap funds in the rest 
of the capital market with relative ease. Further, many sources of 
liquidity are now available to primary mortgage lenders, although they 
would generally be more expensive than the terms available from the 
GSEs. The charters continue, however, and now contribute to 
considerable market power.
---------------------------------------------------------------------------
    \6\ Jud, G. Donald. Regional Differences in Mortgage Rates: An 
Updated Examination. Journal of Housing Economics, June 1991. 
Hendershott, Patrick, and Robert Van Order. Integration of Mortgage and 
Capital Markets and the Accumulation of Residential Capital. Regional 
Science and Urban Economics, May 1989.
---------------------------------------------------------------------------
    Because their costs are lower than for non-favored companies, many 
private sector observers are particularly concerned that GSEs can reap 
greater-than-competitive profits, even while undercutting pricing of 
potential competitors. They need only price their products a little 
below what fully private companies would have to charge. And GSEs 
control the value of their charters, because increasing business volume 
increases the extent of the benefits conferred by the charter, while 
increasing risk adds to the depth of the gains. In short, the special 
charters confer benefits on the GSEs that increase in value as a 
company's business volume and risk increase. This arguably provides 
incentives not only to dominate the assigned market but also to seek 
ways to continue to grow even after the market to which the GSEs are 
constrained by charter is saturated. This, in turn, gives rise to new 
risks for the government.
                      the risks of gse operations
    The risks that GSE operations pose fall into two separate 
categories: the normal business risks of the GSEs' operations, and the 
larger risks to the financial system and the economy.
    Normal business risks. Normal risks are those that would be 
experienced by any intermediary in mortgage markets and include the 
following.
     Interest rate risk: that changes in interest rates will 
result in a loss of economic value.
     Credit risk: that borrowers will default on (not repay) 
loans or other obligations.
     Business risk: that factors beyond a firm's control could 
result in unanticipated loss of earnings, or capital.
     Management risk: losses arising from decisions made (or 
not made) by managers.
    Ordinarily, the private market can be expected to maintain 
discipline over risk-taking by assessing the riskiness of a company's 
operations and acting in accordance with what it sees. If leverage were 
high enough (capital were low enough), for example, to raise concerns 
about insolvency, creditors would demand prompt payment or attempt to 
accelerate principal repayment where possible, and new credit would 
become costly. This market-imposed discipline means that a company has 
every reason, so long as it is solvent, to control its own risk-taking 
in order to avoid the costs that would be imposed by creditors. GSEs, 
like other companies, have an incentive to maintain their shareholder 
value.
    In the case of GSEs, however, the market discipline is weaker 
because of the implied government-backing. Creditors, so long as they 
continue to infer that GSE debt is near-equivalent to Treasury debt, 
will allow greater risk and countenance lower capital. GSEs can borrow 
at preferential rates in good times, and in bad times. While this is 
supposed to be a strength, it is also a problem if matters get out of 
hand because once capital is lost, the GSE may have reason to take 
greater risks in the pursuit of rewards large enough to work itself 
back out of difficulty.
    A case of not-well handled interest rate risk did create severe 
problems for Fannie Mae. The secular rise in interest rates that 
occurred in the 1970's and the sharp rise in 1979 presented major 
problems for all mortgage lenders who had basically lent for long-term 
mortgages at fixed rates while financing at shorter term rates. Fannie 
Mae was such a lender at that time and its high leverage exacerbated 
its problems. The spread between interest rates on mortgages and the 
rates required on new debt turned negative. At the same time, fewer 
mortgages were being prepaid as home buyers either assumed the 
mortgages of the sellers, or homeowners simply did not move, both 
reactions to high interest rates that prolonged the expected life of 
loans held by Fannie Mae and prolonged their losses. According to a 
1986 study by HUD (then the sole regulator for Fannie Mae), the GSE was 
insolvent on a mark-to-market basis every year from 1978 through 1984. 
The worst year was 1981 when estimated net worth fell to minus $11 
billion and the corporation actually booked losses. Ultimately, Fannie 
Mae was allowed to grow its way out of difficulty, although it required 
regulatory forbearance, some tax adjustments, and declining interest 
rates to return to health after 1985.
    All three housing GSEs have safety and soundness regulators who are 
specifically charged with examination and testing to keep these risks 
in check. The Federal Housing Finance Board oversees the Banks. The 
Office of Federal Housing Enterprise Oversight (OFHEO) oversees Fannie 
Mae and Freddie Mac for safety and soundness, while HUD has 
responsibility for mission oversight. Both the FHFB and OFHEO have 
proposed risk-based capital standards that are intended to test the 
GSEs for excessive interest rate and credit risk and would require 
capital holdings accordingly. If the tests work as intended and are 
timely, it should be possible for regulators to require sufficient 
capital at all times to avoid a repeat of the 1980's experience. Those 
tests are not yet in effect.
    Repurchase of mortgage backed securities. The repurchase of their 
own MBS by the GSEs can be thought of as a case of repatriating 
interest rate risk. When mortgages are securitized and sold, the GSE 
retains the credit risk on the loans, but sells to investors the 
interest rate risk. MBS are less profitable than portfolio holdings as 
a result. Repurchase restores profits along with risk. Fannie Mae and 
Freddie Mac are the largest holders and purchasers of their own MBS, 
holding nearly 30 percent of their own issuances and in some recent 
periods repurchasing a volume equal to or greater than what they 
issued.
    While it is clear that this increases shareholder value, it is 
difficult to understand what, if anything, it does for mortgage 
markets. In order to repurchase the securities, the GSEs must issue new 
debt. Given that U.S. capital markets are highly integrated, mainstream 
economic theory holds that there should be no lasting change in yields 
required by the market on either the debt or the MBS. As a result there 
should be no benefit to pass through to housing markets. \7\
---------------------------------------------------------------------------
    \7\ The exception would be if GSE debt and MBS were not good 
substitutes for one another, i.e., the products were not well 
integrated in capital markets.
---------------------------------------------------------------------------
    Larger Risks. The larger risks to the financial system and the 
economy are systemic risk and systematic risk.
    Systemic risk. Systemic risk is the likelihood that a failure of 
one institution would cause widespread failures of other institutions 
and result in severe damage to the financial system. In the case of the 
GSEs, the potential for systemic risk is a direct result of the charter 
provision that allows depository institutions to hold their debt and 
MBS without limit. Normally, depositories are restricted to no more 
than 15 percent of capital in loans to a single borrower. According to 
the Treasury, banks held over $210 billion in GSE debt 1 year ago, 
which constituted one-third of bank capital, and over $355 billion in 
MBS. These holdings have raised concern among banking regulators. A 
failure of a GSE could create a domino effect if it resulted in the 
sudden loss of capital at banks and thrift institutions, and could 
strain the deposit insurance funds were the situation unanticipated or 
severe enough.
    Systematic risk. Systematic risk is basically that risk that cannot 
be controlled by diversification. This kind of risk brings to mind the 
old adage about the dangers of putting all your eggs in one basket: it 
is generally a very risky thing to do. In the case of the GSEs, there 
are two sides to the risk: first, portfolio theory holds that 
diversification makes for better management of risk. But by law, the 
GSEs can only diversify so far. Ultimately, they build and grow on a 
single sector of the economy, one that because of their dominance and 
ability to increase dominance, poses systematic risks for the 
companies. They cannot diversify away from residential mortgages 
without a change in mission. Beyond some point, they cannot continue to 
grow without ``breaking out'' of their assigned market. One recent 
study estimates that by 2003, Fannie Mae and Freddie Mac will have to 
control (retain or guarantee) better than 90 percent of all outstanding 
conventional/conforming mortgage loans, and essentially all of new 
loans originated. \8\
---------------------------------------------------------------------------
    \8\ Wallison, Peter J. and Bert Ely. Nationalizing Mortgage Risk: 
The Growth of Fannie Mae and Freddie Mac. AEI Studies on Financial 
Market Deregulation, 2000.
---------------------------------------------------------------------------
    On the other side, if the GSEs take over the housing sector, the 
government runs systematic risk with respect to the housing sector. So 
long as the agencies have their benefits fully operating, the sector 
becomes dependent upon these companies and cannot diversify away from 
them. If the GSEs are allowed into other sectors, they are better 
diversified, but the economy is not.
    Recall now the data on Treasury and GSE debt. The growth in GSE 
debt, combined with the projected declines in Treasury debt, has led to 
consideration of GSE debt as the ``risk-free'' benchmark for pricing 
debt in securities markets. Indeed, the GSEs have been positioning 
themselves to fill such a function by regular issuances of debt in a 
manner that creates an alternative to the Treasury yield curve. The 
possibility that the Federal Reserve might use GSE securities for 
conducting monetary policy has also arisen. But a major economic 
drawback of using GSE securities--or the securities of any other 
corporation--is that for the benchmark asset to function properly, it 
should reflect only risks inherent to the economy overall. GSE 
securities, on the other hand, include risks specific to their 
corporations, in this case housing sector risks, which are very 
different than risks to the overall economy. Yet, because of their 
inferred safety, the private sector could use them as a benchmark 
anyway. Thus, the problem arises again that the GSEs may have cause to 
expand their missions to fill the benchmark role.
    The point behind creating GSEs is to increase efficiency by 
improving the allocation of credit in the economy. But the risk to the 
economy from introducing what is effectively a subsidized entity into a 
new market is that current competition will be displaced and economic 
inefficiency increased.
    That completes my prepared statement, Mr. Chairman. I will be 
pleased to respond to any questions you may have.

                                        TABLE 1.--GOVERNMENT-SPONSORED ENTERPRISE LINKS TO THE FEDERAL GOVERNMENT
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                         Federal
                                         Federal National  Federal Home Loan  Federal Home Loan     Farm Credit        Agricultural       Student Loan
                Feature                      Mortgage           Mortgage            Banks              System            Mortgage          Marketing
                                           Association        Corporation                                              Corporation        Association
--------------------------------------------------------------------------------------------------------------------------------------------------------
Chartered by Act of Congress..........               Yes                Yes                Yes                Yes                Yes                Yes
Form of Ownership.....................     Publicly held      Publicly held                   Cooperative        Cooperative        CooperPublicly held
                                                                                                                       publicly held
President or Presidential Appointees          Yes (5/18)         Yes (5/18)      Yes (6/14)\1\                 No         Yes (5/15)         Yes (7/21)
 Name Some Board Members..............
Treasury Lending Authorized...........     $2.25 billion      $2.25 billion       $4.0 billion              No\2\    $1.5 billion\3\       $1.0 billion
Treasury Approval of Debt Issuance....               Yes                Yes                Yes                 No                 No                Yes
Securities Eligible for Federal                      Yes                Yes                Yes                Yes                N/A                Yes
 Reserve Open Market Purchases........
Use of Federal Reserve as Fiscal Agent               Yes                Yes                Yes                Yes                Yes                Yes
Debt Eligible to Collateralize Public                Yes                Yes                Yes                Yes                Yes                Yes
 Deposits (All U.S. Government; Most
 State and Local).....................
Exempt from SEC Registration (1933                   Yes                Yes                Yes                Yes                 No                Yes
 Act).................................
Government Securities for Purposes of                Yes                Yes                Yes                Yes                 No                Yes
 the SecuritiesExchange Act of 1934...
Securities Eligible for Unlimited                    Yes                Yes                Yes                Yes                Yes                Yes
 Investment by NationalBanks and State
 Bank FR Member.......................
Securities Eligible for Unlimited                    Yes                Yes                Yes                Yes                Yes                Yes
 Investment by Thrifts Regulated by
 FDIC or OTS..........................
Exemption of Corporate Earnings from                  No                 No                Yes             Yes\4\                 No                 No
 Federal Income Tax...................
Exemption of Corporate Earnings from                 Yes                Yes                Yes                Yes                 No                Yes
 State and LocalIncome Tax............
Exemption of Interest Paid from State                 No                 No                Yes                Yes                 No                Yes
 Income Tax...........................
Subject to GAO Audit..................            Yes\5\             Yes\5\                Yes                 No                Yes                 No
Federal Regulator.....................      HUD/OFHEO\6\       HUD/OFHEO\6\            FHFB\7\                  FCA\8\             FCA               ED
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Each bank.
\2\ Treasury is authorized to guarantee up to $4 billion of Financial Assistance Corporation bonds.
\3\ Upon required certification from FAMC, borrowing from Treasury authorized to make payments under guarantee.
\4\ Federal Land Banks, Farm Credit Banks and Financial Assistance Corporation.
\5\ Mortgage transactions may be subject to GAO audit under rules that may be prescribed by the Comptroller General.
\6\ HUD regulates mission and program; the Office of Federal Housing Enterprise Oversight regulates safety and soundness.
\7\ Federal Housing Finance Board.
\8\ The Farm Credit System Assistance Board also has certain powers with respect to the Financial Assistance Corporation and the System institutions
  needing financial assistance.

Source: Statutes and regulations pertaining to the GSEs as compiled in Report of the Secretary of the Treasury on Government Sponsored Enterprises, May
  1990, updated by CRS.

    Chairman Sununu. Thank you very much.
    Mr. McCool.

                 STATEMENT OF THOMAS J. McCOOL

    Mr. McCool. Thank you, Mr. Chairman.
    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 to promote home 
ownership in the United States. The enterprises fulfill their 
mission by borrowing funds or issuing mortgage-backed 
securities 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.
    Most analysts agree that the enterprise's 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, in 
particular, the cost of any financial assistance the Federal 
Government might decide to provide in an emergency situation.
    In recent years, GAO has issued several reports that assess 
the enterprises' role in the housing finance system and Federal 
oversight of their activities. My testimony today will briefly 
discuss topics covered in these reports, including the benefits 
and costs of the enterprises' housing finance activities, 
Federal efforts to ensure the enterprises' safety and soundness 
and Federal efforts to ensure the enterprises promote home 
ownership opportunities for all Americans.
    Now, I will shorten my discussion of the benefits, since 
Barbara has already gone through some of the benefits that the 
GSEs obtain.
    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 private sector 
companies. Again, the most important of these benefits is the 
perception in the financial markets that the government would 
not allow the enterprises to fail, which allows the enterprises 
to borrow and issue MBS to finance mortgage purchases at 
relatively lower cost than fully private firms.
    These and other benefits, again, which have been discussed 
already, are to some extent passed on to home buyers in the 
form of lower mortgage interest rates.
    In our report on privatization, which we issued in 1996, we 
gave an example of a reduction in mortgage interest rates for a 
$100,000 mortgage would add up to about $10 to $25 a month. So 
again, there are substantial benefits passed on to homeowners.
    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.
    Second, opportunity costs are generated when the perceived 
backing of the 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 of 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.
    This act established the Office of Federal Housing 
Enterprise Oversight, OFHEO, to ensure that the enterprises are 
adequately capitalized and operating safely and provide the 
Department of Housing and Urban Development with additional 
regulatory authority to ensure that the enterprises fulfill 
their housing finance mission.
    The 1992 act established OFHEO as an independent agency 
within HUD to monitor the enterprises' financial safety and 
soundness. The act provided OFHEO with two essential 
responsibilities to carry out its mission: first, to establish 
capital standards for the enterprises and, second, to establish 
an examination program.
    As required by the 1992 act, OFHEO established minimum 
capital standards for the enterprises, which are capital ratios 
applied to certain on balance and off balance sheet 
obligations.
    The act also mandated that OFHEO develop a stress test to 
serve as the basis for more sophisticated risk-based capital 
standards. The purpose of the stress test is to help manage 
taxpayer risks by simulating situations where the enterprises 
are exposed to adverse credit and interest rate scenarios.
    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 
conditions. At the time of our 1997 report, 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 
opportunity for all Americans. The 1992 act required HUD to 
development, implement and enforce a comprehensive housing 
mission regulatory framework. This included setting housing 
goals which required the enterprises to meet specified criteria 
each year for the purchase of mortgages serving targeted 
groups.
    In our work, we found that HUD generally adopted a 
conservative approach to setting the housing goals that placed 
a high priority on maintaining the enterprises' safety and 
soundness.
    In March of this year, HUD proposed a new rule setting 
housing goal requirements for the period 2000 through 2003 
which are higher than the previous goals. 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. 
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 to ensure that the enterprises' 
activities are consistent with their housing mission and its 
new mortgage program approval authority to review new mortgage 
programs proposed by the enterprises to ensure the programs are 
consistent with the enterprises' charters and not contrary to 
the public interest.
    In giving HUD this mission oversight authority, Congress 
correctly recognized that the enterprises face a natural 
tension between maximizing profitability for their shareholders 
and fulfilling their housing mission. For example, we have 
pointed out that the enterprises have incentives to use the 
funding advantage associated with their government sponsorship 
to make non-mortgage investments, some of which may result in 
arbitrage profits.
    While our reports found that HUD had not acted promptly to 
ensure that the enterprises' non-mortgage investments were 
consistent with their housing mission, in 1997, HUD initiated a 
rulemaking process designed to develop criteria that would help 
ensure that the enterprises' non-mortgage investments are 
consistent with their housing mission and Federal charters. 
However, HUD has yet to develop criteria for overseeing the 
enterprises' non-mortgage investments.
    Enterprises have also engaged in other complex financial 
activities whose relation to their housing mission is not 
always clear. We reported on HUD's approval of a new mortgage 
program by Fannie Mae that would have involved Fannie Mae 
purchasing cash value life insurance. More recently, the 
enterprises' involvement in other activities 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.
    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 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 the enterprises 
would focus on and fulfill their public mission 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.
    As large sophisticated institutions, the enterprises have 
become engaged in complex financial activities that may serve 
multiple purposes. 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. I will be happy 
to answer any questions.
    [The prepared statement of Thomas J. McCool follows:]

      Prepared Statement of Thomas J. McCool, Director, Financial 
      Institutions and Markets Issues, General Government Division

    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 benefits and costs of the enterprises' housing finance activities
    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 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 
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.
         ofheo monitors the financial safety of the enterprises
    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 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 responsibility for overseeing the enterprises' fulfillment of 
                         their housing mission
    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 
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.
    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.
    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.
                              conclusions
    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.
                                endnotes
    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.
    3. Federal Housing Enterprises: OFHEO Faces Challenges in 
Implementing a Comprehensive Oversight Program (GAO/GGD-98-6, Oct. 22, 
1997).
    4. Federal Housing Enterprises: HUD's Mission Oversight Needs to Be 
Strengthened (GAO/GGD-98-173, July 28, 1998).
    5. 12 U.S.C. Sec.  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.
    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.

    Chairman Sununu. Thank you, Mr. McCool.
    Mr. Ely.

                     STATEMENT OF BERT ELY

    Mr. Ely. Mr. Chairman and members of the Task Force, I am 
pleased to testify this morning on the economic implications of 
debt issued by government-sponsored enterprises, or GSEs. I 
request permission to submit additional material to the 
committee for inclusion in the record of this hearing.
    Also, I am testifying today on my own behalf. The 
statements I will make and the opinions I will offer are mine 
alone and do not necessarily reflect those of any client.
    I will begin by addressing the issue of the systemic risks 
posed by the GSEs and specifically Fannie Mae and Freddie Mac. 
Within that context, I will then discuss the amount of GSE 
obligations federally-insured banks and thrifts hold relative 
to their capital. GSE obligations include mortgage-backed 
securities the GSEs have guaranteed as well as the debt they 
have issued. I will close by offering a recommendation.
    Systemic risk arises when the failure of a large financial 
institution threatens the stability of the financial markets. 
While the failure of a small institution would not threaten 
financial stability, the failure of a large institution could. 
Hence, size matters.
    Because stable financial markets are essential to the 
smooth functioning of the economy overall, systemic risk must 
be treated extremely seriously. Systemic risk also can arise 
when a large financial institution begins to suffer funding 
problems. That is, it experiences difficulty and high costs in 
rolling over its debt because the financial market fears that 
the institution might be sliding toward insolvency.
    That situation arose in the fall of 1998 when a large, 
highly leveraged hedge fund, Long-Term Capital Management, 
experienced a funding problem. Although LTCM apparently never 
was actually insolvent on a mark-to-market basis, there were 
grave doubts about its solvency in the aftermath of the Russian 
debt market default in the summer of 1998.
    Due only to the intervention of the New York Fed, Long-Term 
Capital Management was able to keep rolling over its debt in 
sufficient quantities to enable it to shrink itself in an 
orderly manner.
    Had LTCM been forced to sell its assets at fire sale prices 
in order to pay its maturing debts, chaos would have reigned in 
the financial markets. Those fire sale prices would have caused 
tremendous mark-to-market losses for other financial firms, 
possibly rendering some of them insolvent. A cascade of losses 
could have wracked global economic havoc.
    I mention LTCM because as big as it was, its outstanding 
debt at the time of its troubles was less than one-seventh of 
the amount of debt Fannie and Freddie combined had outstanding 
at the end of last year. Adding in their MBS, the total 
outstanding obligations of Fannie and Freddie at the end of 
1999, $2.125 trillion, was 17 times LTCM's obligations when it 
crashed. Unquestionably, Fannie and Freddie pose serious 
systemic risks. Clearly, they are too-big-to-fail institutions.
    The fact that Fannie and Freddie are GSEs makes it nearly 
certain that the Federal Government will rescue them should 
they experience financial problems. History bears out this 
statement. In 1988, Congress threw a $4 billion life ring to 
the much smaller Farm Credit System, even though it was solvent 
on a book value basis, after yields on FCS debt over longer 
Treasuries went above 100 basis points, signalling that new FCS 
debt might become virtually unmarketable.
    In 1996, Congress averted a possible default on FICO bonds 
by extending the FICO interest bond assessment from S&Ls to all 
federally-insured depository institutions. And, of course, 
Congress coughed up approximately $160 billion drawn from 
various sources to ensure that the Federal deposit insurance 
commitment would be met for all failed S&Ls.
    Much has been made in hearings held earlier this year by 
the Capital Markets Subcommittee of the House Banking Committee 
that a statutorily required stress test will prevent Fannie or 
Freddie from reaching insolvency. Although OFHEO has strived 
valiantly to implement this stress test, the test will not 
prevent either Fannie or Freddie from creating systemic risk.
    This is a most important point that Representative Richard 
Baker, chairman of the Capital Markets Subcommittee, made in a 
hearing last Thursday. This is the case because any meaningful 
deterioration in the financial condition of either Fannie or 
Freddie, even if neither is insolvent, will create funding 
problems for both GSEs since they are, for all practical 
purposes, Siamese twins.
    According to a recent American Banker article, over two-
thirds of federally-insured banks and thrifts hold more GSE 
debt and MBS, relative to their capital, than would be 
permissible for them to hold if GSE obligations were held to 
the same loan-to-one borrower and investment-per-company rules 
that apply to credit extensions by banks and thrifts to 
genuinely private organizations.
    Due to data limitations, it is not possible to identify the 
specific GSEs for which banks and thrifts have exceeded the 
credit limits applicable to private entities. However, given 
their enormous size relative to the other GSEs, most banks and 
thrifts are overexposed to Fannie and Freddie obligations.
    This overexposure has undoubtedly created solvency concerns 
about banks and thrifts heavily invested in GSE debt and MBS 
should Fannie or Freddie get into trouble. This is the case 
because if funding problems drove down the market value of GSE 
debt, that drop would cause capital reductions in banks and 
thrifts that would trigger regulatory sanctions that in turn 
would force banks and thrifts to reduce their lending to 
consumers and businesses. The resulting credit crunch could 
easily cause a recession, which would magnify the downward 
spiral.
    If banks and thrifts continue to hold a proportionate share 
of the total amount of Fannie and Freddie obligations, then 
Fannie's and Freddie's continued growth will increase the 
systemic risk they pose to America's banks and thrifts.
    Ironically, the growing presence of Fannie and Freddie 
obligations on bank and thrift balance sheets further increases 
the likelihood that the Federal Government will rescue the GSEs 
should they experience funding problems because of the adverse 
effects that those problems would have on federally-insured 
depository institutions.
    Although the reforms Congress enacted in the early 1990's 
have essentially eliminated the taxpayer risk posed by Federal 
deposit insurance, Congress would still understandably be 
concerned about the credit crunch effects of Fannie and 
Freddie's funding problems.
    While GSE obligations owned by banks and thrifts should be 
subject to the same loan and investment limitations applicable 
to the obligations of private sector firms, forcing banks and 
thrifts to trim their Fannie and Freddie obligations would 
merely shift systemic risk elsewhere in the financial system, 
not eliminate it. In any event, the GSE exception to these 
limitations should be of less concern to Congress than the 
enormous and increasing size of these two undercapitalized 
GSEs.
    Until such time as Fannie and Freddie can be transformed 
into genuinely private sector firms by eliminating their 
special privileges, Congress must ensure that a reliable 
mechanism is in place to rescue Fannie or Freddie should one of 
them stumble financially. Because there are innumerable reasons 
why they might stumble, some of which lie outside the U.S. 
financial system, it would be pointless to try to prevent an 
external event. Instead, if needed, a rescue mission should be 
executed as quickly and smoothly as possible.
    It would be foolhardy to rely upon ``market discipline'' to 
prevent a stumble because the exercise of market discipline 
could collapse the financial markets. We got a whiff of that 
potential effect in the aftermath of Treasury Under Secretary 
Gary Gensler's testimony in March before the Capital Markets 
Subcommittee when yields on Fannie and Freddie debt shot up at 
the mere suggestion that they are not government-backed 
institutions.
    The two existing rescue mechanisms are grossly inadequate. 
First, Fannie's and Freddie's Treasury lines of credit, at 
$2.25 billion for each institution, pale in light of the total 
amount of their outstanding debt in MBS. Fannie's line of 
credit is less than .2 percent of its outstanding obligations. 
The comparable figure for Freddie is about 2.5 percent, or in 
effect one-four-hundredth of its outstanding obligations.
    Second, if Congress were out of session and the Treasury 
lines of credit had been fully drawn down, then presumably the 
Fed could lend to Fannie and Freddie or buy their securities. 
But to do so, the Fed would have to sell a like amount of 
Treasury securities. Massive sales of Treasury debt could be 
highly disruptive to the financial markets.
    Key, therefore, to dealing with a Fannie or Freddie funding 
crisis would be congressional enactment of a line of credit 
comparable to the life ring Congress tossed to the Farm Credit 
System in 1988 that the Treasury Department could draw upon to 
keep the financial markets funding Fannie and Freddie even if 
these GSEs were experiencing financial difficulties.
    That action would give Congress time resolve their problems 
in a manner that would minimize the cost of any rescue. As 
distasteful as this recommendation may seem, going forward with 
the present limited rescue resources is playing Russian 
roulette with the U.S. economy.
    Mr. Chairman and members of the Task Force, I thank you for 
your time, and I welcome your questions.
    [The prepared statement and other submitted materials of 
Bert Ely follows:]

            Prepared Statement of Bert Ely, Ely & Co., Inc.

     economic implications of debt issued by government-sponsored 
                              enterprises
    Mr. Chairman and members of the Task Force on Housing and 
Infrastructure, I am pleased to testify this morning on the economic 
implications of debt issued by government-sponsored enterprises, or 
GSEs. I request permission to submit additional material to the 
Committee for inclusion in the record of this hearing, specifically a 
monograph I co-authored recently, titled ``Nationalizing Mortgage Risk: 
The Growth of Fannie Mae and Freddie Mac.'' Also, I am testifying today 
in my own behalf. The statements I will make and the opinions I will 
offer are my alone and do not necessarily reflect those of any client.
    I will begin by addressing the issue of the systemic risk posed by 
the GSEs, and specifically Fannie Mae and Freddie Mac. Within that 
context, I will then discuss the amount of GSE obligations federally 
insured banks and thrifts hold relative to their capital. GSE 
obligations include mortgage-backed securities, or MBS, the GSEs have 
guaranteed as well as the debt they have issued. I will close by 
offering a recommendation.
                             systemic risk
    Systemic risk arises when the failure of a large financial 
institution, due to its actual or apparent insolvency, threatens the 
stability of the financial markets. While the failure of a small 
institution would not threaten financial stability, the failure of a 
large institution could. Hence, size matters. Because stable financial 
markets are essential to the smooth functioning of the economy overall, 
systemic risk must be treated extremely seriously.
    Systemic risk also can arise when a large financial institution 
begins to suffer funding problems; that is, it experiences difficulty 
and high cost in rolling over its debt because of financial market 
fears that the institution might be sliding toward insolvency. That 
situation arose in the fall of 1998 when a large, highly leveraged 
hedge fund, Long Term Capital Management, or LTCM, experienced a 
funding problem. Although LTCM apparently never was actually insolvent, 
on a mark-to-market basis, there were grave doubts about its solvency 
in the aftermath of the Russian debt default in the summer of 1998.
    Due only to the intervention of the Federal Reserve Bank of New 
York, LTCM was able to keep rolling over its debt in sufficient 
quantities to enable it to shrink itself in an orderly manner. Had LTCM 
been forced to sell its assets at fire-sale prices, in order to pay its 
maturing debt, chaos would have reigned in the financial markets. Those 
fire-sale prices would have caused tremendous mark-to-market losses for 
other financial firms, possibly rendering some of them insolvent. A 
cascade of losses could have wracked global economic havoc.
    I mention LTCM because as big as it was, its outstanding debt at 
the time of its troubles was less than one-seventh of the amount of 
debt Fannie and Freddie combined had outstanding at the end of last 
year. Adding in their MBS, the total outstanding obligations of Fannie 
and Freddie at the end of 1999, $2.125 trillion, was 17 times LTCM's 
obligations when it crashed. Unquestionably, Fannie and Freddie pose 
serious systemic risks. Clearly, they are too-big-to-fail financial 
institutions.
    The fact that Fannie and Freddie are GSEs makes it nearly certain 
that the Federal Government will rescue them should they experience 
financial problems. History bears out this statement. In January 1988, 
Congress threw a $4 billion life ring to the much smaller Farm Credit 
System, or FCS, even though it was solvent on a book-value basis, after 
yields on FCS debt over longer term Treasuries went above 100 basis 
points, signalling that new FCS debt might become virtually 
unmarketable. In September 1996, Congress averted a possible default on 
the so-called FICO bonds by extending the FICO bond interest assessment 
from savings-and-loans, or S&Ls, to all federally insured depository 
institutions. And of course, starting in 1989, Congress coughed up 
approximately $160 billion, drawn from various sources, to ensure that 
the Federal deposit insurance commitment would be met for all failed 
S&Ls.
    Much has been made in hearings held earlier this year by the 
Capital Markets Subcommittee of the House Banking Committee that a 
statutorily required stress test will prevent Fannie or Freddie from 
reaching insolvency. Although the Office of Federal Housing Enterprise 
Oversight, or OFHEO, has strived valiantly to implement this stress 
test, the test will not prevent either Fannie or Freddie from creating 
systemic risk. This is a most important point that Rep. Richard Baker, 
Chairman of the Capital Markets Subcommittee, made in a hearing last 
Thursday. This is the case because any meaningful deterioration in the 
financial condition of either Fannie or Freddie, even if neither is 
insolvent, will create funding problems for both GSEs since they are, 
for all practical purposes, Siamese twins.
          investments by banks and thrifts in gse obligations
    According to a recent (April 14, 2000) American Banker article, 
over two-thirds of federally insured banks and thrifts hold more GSE 
debt and MBS, relative to their capital, than would be permissible for 
them to hold if GSEs obligations were held to the same loan-to-one-
borrower and investment-per-company rules that apply to credit 
extensions by banks and thrifts to genuinely private organizations. Due 
to data limitations, it is not possible to identify the specific GSEs 
for which banks and thrifts have exceeded the credit limits applicable 
to private entities. However, given their enormous size, relative to 
the other GSEs, most banks and thrifts are most overexposed to Fannie 
and Freddie obligations.
    This overexposure has understandably created solvency concerns 
about banks and thrifts heavily invested in GSE debt and MBS should 
Fannie or Freddie get into trouble. This is the case because if funding 
problems drove down the market value of GSE debt, that drop would cause 
capital reductions in banks and thrifts that would trigger regulatory 
sanctions that, in turn, would force banks and thrifts to reduce their 
lending to consumers and businesses. The resulting credit crunch could 
easily cause a recession, which would magnify the downward spiral. If 
banks and thrifts continue to hold a proportionate share of the total 
amount of Fannie and Freddie obligations, then Fannie's and Freddie's 
continued growth will increase the systemic risk they pose to America's 
banks and thrifts.
    Ironically, the growing presence of Fannie and Freddie obligations 
on bank and thrift balance sheets further increases the likelihood that 
the Federal Government will rescue the GSEs should they experience 
funding problems because of the adverse effect those problems would 
have on federally insured depository institutions. Although reforms 
Congress enacted in the early 1990's have essentially eliminated the 
taxpayer risk posed by Federal deposit insurance, as I explain in a 
paper titled ``Banks Do Not Receive a Federal Safety Net Subsidy,'' 
Congress would still understandably be concerned about the credit-
crunch effects of Fannie's and Freddie's funding problems.
    While GSE obligations owned by banks and thrifts should be subject 
to the same loan and investment limitations applicable to the 
obligations of private-sector firms, forcing banks and thrifts to trim 
their Fannie and Freddie obligations would merely shift systemic risk 
elsewhere in the financial system, not eliminate it. In any event, the 
GSE exception to these limitations should be of less concern to 
Congress than the enormous and ever increasing size of the two 
undercapitalized GSEs.
      what to do about the systemic risks fannie and freddie pose
    Until such time as Fannie and Freddie can be transformed into 
genuinely private-sector firms by eliminating their special privileges, 
Congress must ensure that a reliable mechanism is in place to rescue 
Fannie and Freddie should one of them stumble financially. Because 
there are innumerable reasons why they might stumble, some of which lie 
outside the U.S. financial system, it would be pointless to try to 
prevent an external event. Instead, if needed, a rescue mission should 
be executed as quickly and smoothly as possible.
    It would be foolhardy to rely upon ``market discipline'' to prevent 
a stumble because the exercise of market discipline could collapse the 
financial markets. We got a whiff of that potential effect in the 
aftermath of Treasury Under Secretary Gary Gensler's testimony in March 
before the Capital Markets Subcommittee when yields on Fannie and 
Freddie debt shot up at the mere suggestion that they are not 
government-backed institutions.
    The two existing rescue mechanisms are grossly inadequate. First, 
Fannie's and Freddie's Treasury lines of credit, at $2.25 billion for 
each institution, pale in light of the total amount of their 
outstanding debt and MBS. Fannie's line of credit is less than .2 
percent of its outstanding obligations; the comparable figure for 
Freddie is about .25 percent. Second, if Congress were out of session 
and the Treasury lines of credit had been fully drawn, then presumably 
the Fed could lend to Fannie and Freddie or buy their securities, but 
to do so, the Fed would have to sell a like amount of Treasury 
securities. Massive sales of Treasury debt could be highly disruptive 
to the financial markets.
    Key, therefore, to dealing with a Fannie or Freddie funding crisis 
would be congressional enactment of a line of credit, comparable to the 
life ring Congress tossed to the Farm Credit System in 1988, that the 
Treasury Department could draw upon to keep the financial markets 
funding Fannie and Freddie even if these GSEs were experiencing 
financial difficulties. That action would give Congress time to resolve 
their problems in a manner that would minimize the cost of any rescue. 
As distasteful as this recommendation may seem, going forward with the 
present limited rescue resources is playing Russian roulette with the 
U.S. economy.
    Mr. Chairman and members of the Task Force, I thank you for your 
time. I welcome your questions.

                               Ely & Company, Inc.,
     Financial Institutions and Monetary Policy Consulting,
                                     Alexandria, VA, July 29, 2000.
Hon. Eva M. Clayton,
U.S. House of Representatives, Washington, DC.
    Dear Ms. Clayton: I am writing to clarify an answer I gave to a 
question you posed to me at the Budget Committee's Housing and 
Infrastructure Task Force hearing on Tuesday about the GSEs. I stated 
something to the effect that I do not believe that the lower interest 
rates Fannie Mae and Freddie Mac provide are necessarily beneficial to 
housing finance. However, I am not an advocate of high mortgage 
interest rates. Instead, I fear that the interest rate subsidy Fannie 
and Freddie deliver may actually harm housing affordability if that 
subsidy gets overcapitalized in housing prices. Let me explain.
    At present interest rate levels, a .25 percent reduction in the 
rate on a 30-year fixed-rate mortgage enables a borrower to finance a 
mortgage approximately 2.4 percent larger than the borrower could 
finance without that interest rate reduction; a .375 percent rate 
reduction will finance an approximately 3.6 percent larger mortgage. 
While that may seem desirable, if the existence of the Fannie/Freddie 
subsidy causes housing prices to rise by more than 2.4 percent to 3.6 
percent, then it is the seller of a house, rather than the buyer, who 
receives the benefit of the mortgage subsidy. My research suggests that 
at times, and perhaps much of the time, Fannie and Freddie's interest 
rate subsidy has been overcapitalized in housing prices, thus making it 
more difficult for moderate income people to buy a home. In my opinion, 
a more much effective and lower cost housing finance subsidy would 
target the subsidy to just those homebuyers on the cusp of home 
ownership.
    I would welcome the opportunity to meet with you to discuss in 
greater depth the issues you raised at the hearing.
            Very truly yours,
                                                  Bert Ely.

 Nationalizing Mortgage Risk: The Growth of Fannie Mae and Freddie Mac

                     Peter J. Wallison and Bert Ely

                            1. introduction
    Fannie Mae and Freddie Mac are today the largest financial 
institutions in the United States. Many economic studies, including one 
by the Congressional Budget Office (CBO), have concluded that these 
government-sponsored enterprises (GSEs) receive an implicit government 
subsidy arising out of the statutory benefits they retained at the time 
they were ``privatized'' (Fannie in 1970, Freddie in the 1980's). In 
1996, the CBO estimated the value of that subsidy at $6.5 billion for 
the previous year, and the subsidy has grown substantially larger since 
then.
    According to the CBO, only a portion of that subsidy is actually 
passed along to the mortgage markets.\1\ The balance, almost a third, 
is retained for the share-holders and managements of the two companies, 
accounting for more than 40 percent of their 1995 profits (which ranked 
them among the most profitable publicly held companies in the United 
States).
---------------------------------------------------------------------------
    \1\ In its 1996 report, Assessing the Public Costs and Benefits of 
Fannie Mae and Freddie Mac, CBO concluded that the GSEs reduced 
interest rates in the conventional/conforming market by passing along 
about two-thirds of the implicit subsidy they received from the 
government, while retaining the balance for themselves. CBO estimated 
that subsidy as $6.5 billion in 1995, a figure that was derived by 
estimating the GSEs' funding cost savings as a result of their implicit 
government backing. Prior assessments of the GSEs' credit quality had 
concluded that, without government backing, Fannie and Freddie would 
have private-sector credit ratings in the Aa range. That permited CBO 
to estimate the savings attributable to the government's implicit 
credit enhancement by computing the difference between the costs the 
GSEs would have faced without government backing and the costs they 
actually paid. That savings was estimated at about 50 basis points for 
each dollar of funds acquired. CBO then noted that the difference 
between interest rates in the jumbo market and those in the 
conventional/conforming market amounted to approximately 35 basis 
points, and concluded that the GSEs were retaining about 15 basis 
points, or about one-third of their implicit subsidy.
---------------------------------------------------------------------------
    The lower interest rates that Fannie and Freddie can command 
because of their government backing permit them to out-compete any 
private-sector rival and to dominate any market they are permitted to 
enter. Although their charters are supposed to limit their activities 
preventing them from competing with companies that must raise their 
funds without government backing the vagueness of the charters and the 
political power of Fannie and Freddie have enabled them to expand with 
few constraints. That they can and do make soft-money political 
contributions, hire legions of lobbyists, and employ people with close 
ties to Congress as top management further ensures their insulation 
from scrutiny.
    Meanwhile, their dominance of the residential mortgage markets 
grows ever greater. Reasonable projections based on statements by 
Franklin Raines, the chairman of Fannie Mae, suggest that, by the end 
of 2003, the two companies will have assumed the risk associated with 
almost half of all the residential mortgages in the United States. That 
means that the taxpayers, who ultimately stand behind the obligations 
of these two companies, will have unwittingly become responsible for 
almost $3 trillion of residential mortgage risk that should be on the 
books of private sector firms.
    An important decision point lies immediately ahead. As shown in 
this analysis, in 4 years, Fannie and Freddie will have either acquired 
for their portfolios or guaranteed more than 91 percent of all the 
conventional/conforming mortgages in the United States. Those are the 
high-quality loans on middle-class homes that have until now been 
virtually the only mortgages the GSEs would purchase. As they grow 
beyond their traditional market segment, Fannie and Freddie will have 
to purchase increasing amounts of lower-quality loans and hold more of 
those loans in portfolio, increasing their risks. If they fully hedge 
those risks, their extraordinary profitability will decline.
    The question is whether Fannie and Freddie will (1) slow their 
growth to reduce the risks they take on; (2) continue their growth at 
the rate Franklin Raines predicted, but accept reduced profitability by 
hedging those risks; or (3) continue the growth in both those assets 
and risks in order to achieve high profitability. The evidence is that 
they are pursuing the third course.
    To be sure, there is nothing wrong with growth, risk, or 
profitability. But the growth of the GSEs--aided as it is by government 
support--creates enormous risks for taxpayers only a decade after the 
savings and loan bailout, and it threatens to drive a whole sector of 
the private financial community out of the residential mortgage market. 
Those factors raise serious policy issues. The purpose of this study is 
to examine the implications of that growth for the mortgage market, for 
those who compete with Fannie and Freddie, and for the nation's 
taxpayers.
    Chapter 2 provides background on the GSEs and the mortgage markets. 
It outlines the statutory links to the Federal Government that have led 
the financial markets to conclude that Fannie and Freddie will not be 
allowed to fail, describes the mortgage market in the United States, 
and summarizes both the functions and growth of the GSEs.
    Chapter 3 contains detailed information on the structure of the 
residential mortgage market today, the growth of Fannie and Freddie's 
share of that market since 1995, and (if the forecasts of Fannie's 
chairman are correct) the share they will hold together and separately 
at the end of 2003. It shows that the GSEs' total risk including both 
the mortgages they will own and those they have guaranteed will 
increase from somewhat more than a third of the market today to almost 
half of a much larger market 4 years hence.
    The growth of Fannie and Freddie in relation to the growth of the 
conventional/conforming sector of the market is examined in chapter 4. 
It shows that, beginning in 1998, they were already acquiring more net 
mortgage assets in each year than the total net principal amount of the 
conventional/conforming loans made in that year. The data presented in 
chapter 4 also show that, by the end of 1998, Fannie and Freddie were 
holding in portfolio or had guaranteed more than 73 percent of all 
conventional/conforming mortgages, and that figure could reach almost 
92 percent by 2003.
    The implications of that growth are addressed in chapter 5, which 
discusses the possibility that to make up for the absence of sufficient 
conventional/conforming mortgages--Fannie and Freddie will have to 
drive deeper into the subprime markets, taking more risk and displacing 
more of the genuine private-sector lenders who have traditionally made 
these loans. The chapter also discusses other financial services that 
Fannie and Freddie might be preparing to offer if their charters are 
not more strictly interpreted.
    Chapter 6 continues the analysis of the implications of GSE growth, 
focusing on the risks to taxpayers that will be associated with the 
nationalization of almost half the residential mortgage market by 2003. 
The chapter points out that Fannie and Freddie have a choice--to hedge 
the greater risks they will be taking and reduce their profitability, 
or to maintain their level of profit growth by taking greater risk. It 
suggests that the incentives of management and the pressures of the 
financial markets will push the two GSEs toward greater risk-taking.
    The study's conclusion notes that there is an inherent conflict 
between the GSEs' status as private, profit-making companies and the 
government mission they are expected to perform. There is ample 
evidence that their government mission is no longer necessary, and that 
they are using the subsidy they receive primarily to enhance their 
profitability and to dominate their market. Even if that were not true, 
the risks they are creating for taxpayers and the threat they represent 
to non-subsidized private-sector competitors would argue strongly for 
more strictly confining them to limited areas of activity, eliminating 
their links to the government, or taking steps toward recapturing their 
subsidy through a complete privatization.
                             2. background
    The Federal National Mortgage Association (popularly known as 
Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie 
Mac) are two government-chartered and government-sponsored corporations 
that have been assigned the statutory mission of improving liquidity in 
the middle-class residential mortgage markets by buying and selling 
residential mortgages.
    Fannie Mae and Freddie Mac carry on their functions in two ways--by 
purchasing and holding mortgages originated by mortgage lenders, and by 
placing their guarantee on securities (mortgage-backed securities, or 
MBSs) that represent an interest in pools of mortgages they have 
assembled. Whether they are holding mortgage loans or MBSs in their 
portfolio or are guaranteeing MBSs that are then sold to investors, 
they are assuming the credit risk associated with those loans.
    Although initially established to enhance liquidity in the mortgage 
markets, it is doubtful that Fannie and Freddie are necessary for that 
purpose today. Many private organizations are now capable of purchasing 
mortgages from originators and selling them--either directly or through 
securitization--into the capital markets. However, Fannie and Freddie 
now argue that they perform their public mission by reducing interest 
rates on the mortgages they are permitted to buy, and thus help 
homebuyers to obtain lower-cost financing. That claim is dubious; 
economists believe that the lower rates attributable to the GSEs' 
subsidized borrowing are simply capitalized into the cost of the homes, 
thus benefiting developers and home sellers rather than buyers.
    Fannie and Freddie were originally government agencies but were 
``privatized'' when they were permitted to sell shares to the public. 
Today, both companies are among the largest and most profitable 
financial institutions in the world, with their securities listed on 
the New York Stock Exchange.
    The unusual thing about their privatization, however, is that 
Fannie and Freddie continue to retain a large number of connections to 
the government, as well as various privileges and immunities that no 
genuinely private company can claim:
     The president appoints up to five members (a minority) of 
their boards of directors.
     The secretary of the Treasury is authorized to invest up 
to $2.25 billion in their securities, and to approve their issuance of 
debt.
     They are exempt from state and local income taxes and from 
the requirement to register their securities with the Securities and 
Exchange Commission.
     Their debt securities are eligible for open-market 
transactions by the Federal Reserve Board and for investment by insured 
banks.
     Their debt securities are eligible collateral for the 
Federal Government's deposits of tax revenues in banks.
     Their securities require only a 20 percent risk weighting 
(versus 100 percent for the securities and debt of private companies) 
under the Basel risk-based capital standards applicable to banks.
    Those extraordinary advantages have convinced the capital markets 
that the Federal Government will never allow Fannie and Freddie to 
fail. Thus, they are able to sell their debt securities at interest 
rates that are consistently better than any AAA-rated corporation in 
the world and just slightly above the rate paid by the Treasury itself. 
Moreover, that favored position allows them to operate with capital 
levels that are much lower than those of other financial 
intermediaries, since the capital markets are not concerned that those 
low capital levels will ever mean losses to the holders of their debt 
or their MBSs.
                  the market in which the gses operate
    The residential mortgage market is composed of a number of 
segments--government-guaranteed Veterans Administration (VA) and 
Federal Housing Administration (FHA) loans; multifamily housing loans; 
middle-class mortgages (known as conventional/conforming mortgages, the 
basic loans that Fannie Mae and Freddie Mac purchase or guarantee); 
subprime loans (loans with credit deficiencies); home equity loans; and 
so-called jumbo loans, which exceed the size limit on conventional/
conforming loans.
    According to Federal Reserve data, FHA and VA loans constitute 
about 11 percent of the total market. Although similarly authoritative 
numbers are difficult to obtain for jumbo loans, most observers agree 
that those mortgages constitute another 15 percent of the market. 
Fannie and Freddie cannot compete for most FHA and VA loans, since 
those are purchased and marketed by the Government National Mortgage 
Association (known as Ginnie Mae), an on-budget government agency that 
obtains its funds at Treasury rates and thus can offer lower rates than 
can Fannie and Freddie.\2\ Nor can Fannie and Freddie compete for jumbo 
mortgages, which have initial loan amounts above $252,700, the limit on 
the size of the loans Fannie and Freddie can purchase in the year 
2000.\3\
---------------------------------------------------------------------------
    \2\ Although Ginnie Mae can borrow at a lower rate than Fannie and 
Freddie, the GSEs have been able, from time to time, to offer a lower 
mortgage rate to many subprime borrowers eligible for FHA and VA loans. 
That may be a consequence of the fact that Fannie and Freddie's MBSs 
have greater liquidity than Ginnie Mae's, and perhaps shorter duration. 
It may also be attributable to better underwriting skills at Fannie and 
Freddie, which might leave Ginnie with higher credit losses. It remains 
to be seen whether Fannie and Freddie will be able to maintain a 
permanent beachhead in the FHA/VA market.
    \3\ The limit, which is keyed to housing prices, was $240,000 in 
1999.
---------------------------------------------------------------------------
    That leaves 74 percent of the total residential market in which 
Fannie and Freddie can invest. Of that portion, most are conventional/
conforming loans; the balance are subprime, home equity, and 
multifamily housing loans.
    In the past, the GSEs purchased almost exclusively conventional/
conforming loans, because those are the best credits available in the 
middle-class market. But increasingly in recent years--as they have 
foreseen that their need for assets will outstrip the conventional/
conforming market--the GSEs have entered the market for subprime, home 
equity, and multifamily housing loans. Those assets are riskier middle-
class credits, since they represent loans to borrowers with impaired 
credit (subprime loans), subordinated debt (home equity loans), and 
rental housing (multifamily).
                               gse growth
    In a statement to a September 1999 financial conference, Franklin 
Raines predicted that by the end of 2003 Fannie Mae will have 28 
percent of the U.S. residential mortgage market, and that its 
profitability will have doubled. Raines's forecast implies an 11.3 
percent annual rate of growth in risk and a 15 percent annual rate of 
growth in profitability during 1999 and over the following 4 years.\4\
---------------------------------------------------------------------------
    \4\ Not to be outdone, in a November 1999 statement to securities 
analysts, Leland Brendsel, the chairman of Freddie Mac, also predicted 
a mid-teens growth in profitability, without specifying the period over 
which that would occur.
---------------------------------------------------------------------------
    The Raines statement provides a valuable benchmark for assessing 
both the steps that Fannie Mae must take to achieve that goal and the 
shape of the residential mortgage market in 2003, if the goal has then 
been achieved.
    At the end of 1999, the residential mortgage market--that is, all 
outstanding residential mortgage loans in the United States--had an 
aggregate book value of just over $5 trillion. In 1998 and 1999, that 
market grew strongly--by more than 8 percent each year. But its long-
term growth rate has been about 6 percent. If we make the conservative 
assumption that the residential mortgage market will grow at that rate 
for the next 4 years, it will have a total value of about $6.4 trillion 
in the year 2003.
    Thus, when its chairman predicts that Fannie Mae will have 28 
percent of the residential mortgage market in 2003, he is saying that 
it will in that year have assumed the risk of mortgage loans with an 
aggregate value of more than $1.8 trillion. At that size, Fannie Mae 
may or may not be the largest financial institution in the world--
depending on the size of future mergers among the world's largest 
banks--but it will unquestionably be the largest S&L the world has ever 
seen.
    And in second place will be Freddie Mac, which in 1999 was about 
two-thirds the size of Fannie. If we assume that that relative size 
differential will continue through 2003, then Freddie Mac will hold in 
portfolio, or will have guaranteed, mortgages with an aggregate value 
of more than $1.2 trillion, a growth rate of 11.4 percent between 1998 
and 2003.
    Together, then, the GSEs in 2003 will be bearing the risk 
associated with more than $3 trillion in residential mortgages, or 
almost 48 percent of all home mortgages in the United States. The 
balance of the market--barely more than half--will be left to the 
thousands of private, non-subsidized lenders who have traditionally 
provided mortgage finance in the United States.
    Those extraordinary facts have a number of equally startling 
corollaries:
     Since the U.S. government stands behind the obligations of 
the GSEs, the nation's taxpayers--rather than the shareholders of 
private sector mortgage lenders--will ultimately bear the risks 
associated with almost half of all the residential mortgage debt 
outstanding in the United States.
     If the total residential mortgage market is growing at 6 
percent a year, and Fannie and Freddie are growing, respectively, at 
11.3 percent and 11.4 percent a year, then the GSEs cannot achieve 
their growth goals solely within their traditional segment of the 
residential mortgage market. They will have to strike out into other 
areas.
     The current private-sector sources of mortgage finance 
will be forced to consolidate and will gradually be squeezed out of the 
residential market; in effect, half of that sector of the economy will 
have been nationalized.
     Just as ominously, achieving a 15 percent annual rate of 
profit growth will require that Fannie and Freddie take on and retain 
more financial risk--in a process reminiscent of the S&L industry's 
ultimately fatal effort to achieve high levels of profitability only 
fifteen years ago.
                            3. market shares
    Table 3-1 shows the growth of the residential mortgage markets 
since 1995. The data for the size of the FHA/VA market (line 3), 
multifamily mortgages (line 5), and the mortgage market as a whole 
(line 6), during the years 1995 through 1998, are taken from reports 
published by the Federal Reserve Board. Information on the size of the 
jumbo market (line 1) and the conventional/conforming market (line 2) 
was derived from industry sources. Other one-to-four-family mortgages 
(line 4), a residual figure, consists primarily of subprime and home 
equity loans. For the purpose of this study, those loans and 
multifamily loans (loans for apartment buildings) have been combined 
into a category called ``all other.''
                          assumptions and data
    The projections for 1999 through 2003 are based on our judgment 
that the very strong residential real estate market during 1998 and 
1999 will return gradually over the next 4 years to its historical 
pattern. Thus, although the market grew by 9.3 percent in 1998, we 
project that it will have grown by about 8 percent when all the data on 
1999 are in, by 7 percent in 2000, and by 6 percent in each of the 3 
years thereafter.
    Historically, total residential real estate mortgage debt has grown 
slightly faster than nominal gross domestic product (GDP). In that 
context, residential mortgage debt's extraordinary growth in 1998 
cannot be expected to continue. If we assume that the market will 
gradually return to its historic growth pattern in relation to GDP, 
that would reinforce the projection of a gradual return to a 6 percent 
growth rate beginning in 2001.

                                                  TABLE 3-1.--SIZE OF THE RESIDENTIAL MORTGAGE MARKET, PAST, PRESENT, AND PROJECTED, 1995-2003
                                                                                     [Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  History (year-end)                                   Projection (year-end)                      Annual     Annual
                                                   ------------------------------------------------------------------------------------------------------------   growth     growth     Growth
                                                                                                                                                                  rate:      rate:       rate
                                                       1995        1996        1997        1998        1999        2000        2001        2002        2003     1995-1998  1998-2003  difference
                                                                                                                                                                   (%)        (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Composition of outstanding mortgage market:
    1. Jumbo mortgages............................     568,008     602,069     639,797     699,485     755,444     808,325     856,825     908,234     962,728       7.2        6.6        -0.6
    2. Conventional/conforming....................   1,969,096   2,087,172   2,217,961   2,424,882   2,618,873   2,802,194   2,970,326   3,148,545   3,337,458       7.2        6.6        -0.6
    3. FHA/VA mortgages...........................     466,620     497,684     525,000     524,354     546,377     566,456     584,300     602,705     621,690       4.0        3.5        -0.5
    4. Other 1- 4-family mortgages................     505,997     532,085     572,096     673,732     747,556     818,051     883,279     952,928   1,027,281      10.0        8.8        -1.2
    5. Multifamily: all kinds.....................     277,002     294,783     310,456     340,782     368,045     393,808     417,436     442,482     469,031       7.2        6.6        -0.6
    6. Total residential mortgages................   3,786,723   4,013,793   4,265,310   4,663,235   5,036,294   5,388,834   5,712,164   6,054,894   6,418,188       7.2        6.6        -0.6
    7. Annual growth rate (%).....................         4.3         6.0         6.3         9.3         8.0         7.0         6.0         6.0         6.0
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: For all tables, historic data sources are as follows: Federal Reserve Bulletin, December 1999; periodic financial reports issued by Fannie Mae and Freddie Mac; and industry
  nestimates. Projected data are the projections of Peter J. Wallison and Bert Ely.

    The division of the market into four subcategories--jumbo, 
conventional/conforming, FHA/VA, and all other (subprime, home equity, 
and multifamily loans)--is necessarily somewhat arbitrary. There are no 
official or government estimates of the size of key market segments; 
apart from FHA/VA and multifamily mortgages, there are no formally 
recognized and defined subcategories into which the market has been 
divided for purposes of official reporting.
    Although official figures are lacking, there is a wide variety of 
unofficial market breakdowns.\5\ The data we have received from market 
sources, however, indicate that jumbo loans account for about 15 
percent of the market and FHA-VA loans for about 11 percent. 
Accordingly, conventional/conforming plus all other loans--the loans in 
which Fannie and Freddie can invest--account for about 74 percent.\6\
---------------------------------------------------------------------------
    \5\ In a recent statement, Fannie chairman Franklin Raines divided 
the residential mortgage market into seven subcategories: conventional/
conforming (49 percent), FHA/VA (11 percent), jumbo (19 percent), 
subprime (6 percent), home equity loans (6 percent), seller-financed (2 
percent), and multifamily (7 percent).
    \6\ If Mr. Raines is correct that the jumbo market is 19 percent of 
the total, that would indicate that Fannie and Freddie have an even 
larger percentage of the total eligible market.
---------------------------------------------------------------------------
                    fannie and freddie market shares
    Table 3-2 contains data on the respective market shares of Fannie 
and Freddie. The information on their shares between 1995 and 1998 was 
derived by comparing the information in their financial statements to 
known market totals. For the years after 1998, we assumed a growth rate 
in market shares that would permit Fannie Mae to reach the 28 percent 
market share projected by Franklin Raines for the year 2003. We then 
assumed that Freddie's growth rate would be such as to maintain its 
market share in relation to Fannie. That means that Fannie, which had 
grown at a rate of 11.2 percent annually between 1995 and 1998 (line 
11), would have to grow at a slightly greater rate, 11.3 percent, from 
1999 through 2003, and that Freddie would have to increase its growth 
rate from 9 percent to 11.4 percent (line 17).

                                                  TABLE 3-2.--FANNIE MAE AND FREDDIE MAC MARKET SHARES, PAST, PRESENT, AND PROJECTED, 1995-2003
                                                                                     [Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  History (year-end)                                   Projection (year-end)                      Annual     Annual
                                                   ------------------------------------------------------------------------------------------------------------   growth     growth     Growth
                                                                                                                                                                  rate:      rate:       rate
                                                       1995        1996        1997        1998        1999        2000        2001        2002        2003     1995-1998  1998-2003  difference
                                                                                                                                                                   (%)        (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Fannie/Freddie retained portfolios, total
 mortgages outstanding:
    Fannie Mae:
        8. Retained portfolio:....................     252,868     286,527     316,592     415,434     528,811     635,882     754,006     877,960   1,020,492      18.0       19.7         1.7
        9. Total residential (%)..................         6.7         7.1         7.4         8.9        10.5        11.8        13.2        14.5        15.9
        10. Conventional/conforming & all other            9.2         9.8        10.2        12.1        14.2        15.8        17.7        19.3        21.1
         (%)......................................
        11. Retained + guaranteed:................     766,098     834,700     895,730   1,052,577   1,208,711   1,347,209   1,485,163   1,634,821   1,797,093      11.2       11.3         0.1
        12. Total residential (%).................        20.2        20.8        20.9        22.5        24.0        25.0        26.0        27.0        28.0
        13. Conventional/conforming & all other           27.8        28.6        28.9        30.6        32.4        33.6        34.8        36.0        37.2
         (%)......................................
    Freddie Mac:
        14. Retained portfolio:...................     107,706     137,826     164,543     255,670     337,432     420,329     506,383     605,489     712,419      33.4       22.7       -10.7
        15. Total residential (%).................         2.8         3.4         3.8         5.5         6.7         7.8         8.9        10.0        11.1
        16. Conventional/conforming & all other            3.9         4.7         5.3         7.4         9.0        10.5        11.9        13.3        14.7
         (%)......................................
        17. Retained + guaranteed:................     566,751     610,891     640,528     734,021     846,097     943,046   1,039,614   1,144,375   1,257,965       9.0       11.4         2.4
        18. Total residential (%).................        15.0        15.2        15.0        15.7        16.8        17.5        18.2        18.9        19.6
        19. Conventional/conforming & all other           20.6        21.0        20.7        21.3        22.7        23.5        24.3        25.2        26.0
         (%)......................................
    Fannie + Freddie:
        20. Retained portfolio:...................     360,574     424,353     481,135     671,104     866,243   1,056,212   1,262,388   1,483,449   1,732,911      23.0       20.9        -2.1
        21. Total residential (%).................         9.5        10.6        11.2        14.3        17.2        19.6        22.1        24.5        27.0
        22. Conventional/conforming & all other           13.1        14.6        15.5        19.5        23.2        26.3        29.6        32.6        35.9
         (%)......................................
        23. Retained + guaranteed:................   1,332,849   1,445,591   1,536,258   1,786,598   2,054,808   2,290,255   2,524,777   2,779,196   3,055,057      10.3       11.3         1.1
        24. Total residential (%).................        35.2        35.9        35.9        38.2        40.8        42.5        44.2        45.9        47.6
        25. Conventional/conforming & all other           48.4        49.6        49.5        51.9        55.0        57.1        59.1        61.2        63.2
         (%)......................................
        26. Conventional/conforming only (%)......        67.7        69.3        69.3        73.7        78.5        81.7        85.0        88.3        91.5
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

    Table 3-2 displays market share data in two ways: (1) the 
respective mortgage portfolios of Fannie and Freddie as a percentage of 
the market as a whole, and (2) those mortgage portfolios plus the 
principal amount of the mortgage-backed securities that Fannie and 
Freddie have guaranteed--again, as a percentage of the market as a 
whole. We show those data separately for two reasons.
    First, while there is no significant difference between the credit 
risk of guaranteeing MBSs and the risk of holding whole mortgages, 
there is a substantial difference in profitability. Fannie and Freddie 
earn considerably more from retaining mortgages in their portfolios 
than from receiving guarantee fees on MBSs. That is because they assume 
an additional risk--interest-rate risk--when they retain mortgages. 
Accordingly, as Fannie strives to meet Franklin Raines's forecast of 15 
percent annual profitability growth, we would expect to see greater 
proportional growth in its mortgage portfolio than in its guarantees of 
MBSs.\7\ That differential is reflected in our projections.
---------------------------------------------------------------------------
    \7\ Serious questions arise if Fannie and Freddie are now meeting 
their growth objectives by purchasing MBSs that are already outstanding 
in the market. If their purchases of MBSs are made in sufficient 
amounts to increase prices and decrease yields on outstanding MBSs, 
then Fannie and Freddie will be reducing the spread between their 
borrowing costs and the yield they receive on their MBS portfolios. 
That in itself will raise their risks. If their purchases do not 
substantially affect yields in the MBS market, however, it is 
questionable whether that activity has any salutary effect on mortgage 
rates for homebuyers. Unless they can show such an effect, Fannie and 
Freddie will be hard put to explain why that use of subsidized funds 
qualifies as anything more than a strategy to maintain their targeted 
earnings growth rate. Indeed, it seems unlikely that Fannie and 
Freddie's purchases will appreciably influence MBS market yields. If 
they reduce homebuyers' interest rates by only about 30 basis points 
when they transfer two-thirds of their annual subsidy directly into the 
mortgage markets, the indirect effect of their purchase of outstanding 
MBSs in the $3 trillion MBS market should be even smaller.
---------------------------------------------------------------------------
    Indeed, just such a trend is visible between 1995 and 1998, when 
Fannie's mortgage portfolio grew by 18 percent (line 8), while its 
total risk (mortgages plus MBSs it had guaranteed) increased by only 
11.2 percent (line 11). We believe that trend will continue and will 
become more pronounced from 1999 to 2003, with Fannie's portfolio of 
mortgages increasing by 19.7 percent on an annualized basis during that 
period.
    We project a different trend for Freddie, which (starting at a much 
lower base than Fannie) grew its portfolio at the unsustainable rate of 
33.4 percent annually between 1995 and 1998. Since we are assuming that 
for 1999 and the next 4 years Freddie will remain about two-thirds the 
size of Fannie, we are projecting that Freddie will reduce the rate of 
growth of its retained mortgage portfolio to 22.7 percent (line 14)--a 
rate that will still be higher than Fannie's but will bring Freddie in 
2003 to a position at which its retained mortgage portfolio will be 
roughly 70 percent the size of Fannie's.
    Second, making a distinction between mortgages retained in 
portfolio and mortgages guaranteed through MBSs reveals that Fannie and 
Freddie have only a limited range of options available to them. When 
Franklin Raines predicted that Fannie Mae would reach 28 percent of the 
total residential mortgage market in 2003 (line 12), he could have been 
referring to substantial growth in Fannie's issuance of MBSs, with much 
lower growth in the company's mortgage portfolio. However, when he 
forecast that Fannie would double its profitability during that period, 
he could only have been talking about a substantial increase in 
Fannie's mortgage portfolio, since only by enlarging that portfolio can 
a 28 percent market share be consistent with a 15 percent year-over-
year rate of profit growth.
    Fannie's options are further limited by the fact that the GSEs are 
permitted to purchase or guarantee only those mortgages with an initial 
principal amount that (in 2000) does not exceed $252,700. As noted 
above, that limitation essentially confines them to 74 percent of the 
total residential market, which for ease of reference we shall call the 
middle-class mortgage market. Accordingly, table 3-2 also shows the 
growth in the GSEs' risk (mortgages and MBSs) as a proportion of that 
market.
    Those data indicate that by 2003, Fannie is likely to hold in its 
portfolio 21 percent of all mortgages in that segment (line 10), and it 
will have assumed the risk (through holding mortgages in its portfolio 
or guaranteeing MBSs) of 37 percent of that market (line 13). In that 
same year, Fannie and Freddie together will hold in their portfolios 
about 36 percent of all middle-class mortgages outstanding (line 22), 
and will bear the risk (through ownership of the underlying mortgages 
or guarantees of MBSs) of 63 percent of that entire market segment 
(line 25).
    The numbers are even more dramatic if we consider only the 
conventional/conforming portion of the market. In that case, by the end 
of 1998, Fannie and Freddie had purchased and retained or guaranteed 
almost 74 percent of all the conventional/conforming mortgages 
outstanding (line 26). We project that by 2003 they will have assumed 
the risk of virtually all these mortgages--91.5 percent. It is no 
wonder, then, that Fannie and Freddie are advertising their efforts to 
acquire loans in the subprime categories. They are making a virtue of 
necessity, since their growth requirements leave them no choice.
    Thus, if Fannie remains on the growth path forecast by Franklin 
Raines and if Freddie keeps pace, by the end of 2003 they will hold in 
their portfolios more than one-third of all middle-class residential 
mortgages in the United States (line 22), and more than a quarter (line 
21) of all residential mortgages of any kind. Moreover, if we include 
their guarantees of MBSs, these two companies will be bearing the 
credit and other risk that is associated with almost half of all the 
mortgages outstanding (line 24), almost two-thirds of all middle-class 
mortgages (line 25), and more than 91 percent of all conventional/
conforming mortgages (line 26).
    In chapter 4 of this study, as those percentages suggest, we show 
that Fannie and Freddie can meet their growth objectives in the years 
ahead only by purchasing the riskier loans in the subprime, home 
equity, and multifamily categories. There will simply not be a 
sufficient amount of the higher quality, conventional/conforming 
mortgages to meet their needs. So in addition to assuming a greater 
degree of risk simply through their growth over the next 4 years, the 
GSEs will also be increasing their overall risk by going more deeply 
into the lower-quality sectors of the market that until now have been 
served satisfactorily by non-subsidized lenders. We explore the nature 
and possible consequences of the GSEs' growing risk profiles in chapter 
6 of this study.
    Also, as the GSEs move into the lower-quality market sectors they 
have previously shunned, they will reduce the portfolio assets, 
revenues, and profits of thousands of mortgage lenders now active in 
that market. Although some might think that mortgage lenders will have 
a choice whether to sell the mortgages they originate to Fannie and 
Freddie, that is not really the case. Because the GSEs can offer lower 
government supported rates for the mortgages they are willing to buy, 
no lender can offer a competitive rate against another lender who is 
willing to sell the resulting loan to Fannie or Freddie. Their lower 
rates also permit Fannie and Freddie to skim the cream from the 
mortgage markets, leaving other lenders with riskier loans to weaker 
borrowers. That problem will become more severe as Fannie and Freddie 
drive deeper into the subprime market.
    In other words, if Fannie and Freddie are permitted to continue 
their growth, even if they don't move outside the secondary mortgage 
market itself, they will gradually strangle the other participants in 
the mortgage markets. Those markets will become more concentrated and 
less diverse than any other financial market in the United States and, 
increasingly, an obligation of the Federal Government rather than of 
the private sector. The impact on competition of Fannie and Freddie's 
growth is discussed in detail in chapter 5 of this study.
                               4. growth
    Table 4-1 presents data on the year-to-year growth in the mortgage 
assets of Fannie Mae and Freddie Mac since 1995. The information for 
the years 1995 through 1998 is taken from their financial statements; 
the projections for the years 1999 through 2003 are derived from the 
assumptions that were used in chapter 3 to project their asset totals 
for those years.
    The data show Fannie and Freddie's growth as a percentage of the 
growth of: (1) the entire residential mortgage market (line 29); (2) 
the conventional/conforming portion of the market (line 32); and (3) 
the conventional/conforming plus ``all other'' portion of the market 
(line 35).
    By presenting the information in that way, we are able to show 
that, as Fannie and Freddie grow in the year ahead, they will have to 
drive deeper and deeper into the subprime loan categories in order to 
find the assets their growth requires. Clearly, Fannie and Freddie 
cannot continue to grow indefinitely by purchasing and guaranteeing 
conventional/conforming mortgages. If the conventional/conforming loan 
market grows at the same rate as the market as a whole in each of the 
next 4 years, conventional/conforming mortgages outstanding will 
increase by $720 billion. But to maintain their projected growth rates, 
Fannie and Freddie will have to increase their mortgage investments and 
guarantees by $1 trillion. At the end of 1998, they had retained in 
their portfolios or guaranteed 74 percent of those loans, and we 
project that by 2003 they will have retained or guaranteed almost 92 
percent.
    Thus, beginning in 1998, Fannie and Freddie together, to meet their 
combined growth goals, were required to add new assets at a rate that 
exceeded the growth in conventional/conforming mortgages that year. 
Line 30 of table 4-1 shows that in 1998, the total amount of 
conventional/conforming mortgage debt outstanding increased by $207 
billion. But in that same year, Fannie and Freddie together added $250 
billion in new mortgage assets and guarantees to their balance sheets, 
so that their increase in mortgage credit risk was 121 percent of the 
net increase in the conventional/conforming market (line 32). By 2003, 
Fannie and Freddie's need for new assets will equal 146 percent of all 
net new conventional/conforming loans.
    Accordingly, unless they can break into the jumbo market through a 
change in law, or out-compete Ginnie Mae for a substantial share of the 
FHA-VA market, the only recourse for Fannie and Freddie is the subprime 
market.
    However, the subprime market, as its name implies, involves 
considerably greater credit risk than does the conventional/conforming 
market. By entering that market, Fannie and Freddie will be taking on 
more risk than they have in the past--risk that may be only partially 
compensated by the higher interest rates and guarantee fees those 
mortgages generally yield. We cover that issue more fully in chapter 6.

                           TABLE 4-1.--GROWTH IN RESIDENTIAL MORTGAGES: FANNIE MAE AND FREDDIE MAC VERSUS THE MORTGAGE TOTALS, PAST, PRESENT, AND PROJECTED, 1995-2003
                                                                                     [Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  History (year-end)                                   Projection (year-end)                      Annual     Annual
                                                   ------------------------------------------------------------------------------------------------------------   growth     growth     Growth
                                                                                                                                                                  rate:      rate:       rate
                                                       1995        1996        1997        1998        1999        2000        2001        2002        2003     1995-1998  1998-2003  difference
                                                                                                                                                                   (%)        (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
27. Annual growth in residential mortgage market--     227,070     251,517     397,925     373,059     352,541     323,330     342,730     363,294        32.4      -1.8      -34.2
 total............................................
28. Growth in GSE portion.........................     112,742      90,667     250,340     268,210     235,447     234,522     254,420     275,861        49.0       2.0      -47.1
29. GSE portion of total (%)......................        49.7        36.0        62.9        71.9        66.8        72.5        74.2        75.9
30. Growth in conventional/conforming--total......     118,076     130,789     206,921     193,991     183,321     168,132     178,220     188,913        32.4      -1.8      -34.2
31. Growth in GSE portion.........................     112,742      90,667     250,340     268,210     235,447     234,522     254,420     275,861        49.0       2.0      -47.1
32. GSE portion of total (%)......................        95.5        69.3       121.0       138.3       128.4       139.5       142.8       146.0
33. Growth in conventional/conforming & all other      161,945     186,473     338,882     295,077     279,580     256,987     272,915     289,814        44.7      -3.1      -47.7
 mortgages--total.................................
34. Growth in GSE portion.........................     112,742      90,667     250,340     276,079     236,348     235,420     255,394     276,917        49.0       2.0      -47.0
35. GSE portion of total (%)......................        69.6        48.6        73.9        93.6        84.5        91.6        93.6        95.5
36. Nominal GDP--4th quarter......................   7,529,300   7,981,400   8,453,000   8,947,600   9,394,980   9,864,729  10,357,965  10,875,864  11,419,657       5.9        5.0        -0.9
37. GDP annual growth rate (%)....................         6.0         5.9         5.9         5.0         5.0         5.0         5.0         5.0
38. Assumed growth rate after 1998 (%)............         5.0
39. Total mortgages outstanding/GDP (%)...........        50.3        50.3        50.5        52.1        53.6        54.6        55.1        55.7        56.2
40. Change in mortgage/GDP ratio (%)..............         0.6         0.0         0.2         1.7         1.5         1.0         0.5         0.5         0.5
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

                5. threat to private-sector competitors
    Since Fannie and Freddie are growing faster than the mortgage 
market itself, their growth comes from taking market share, revenue, 
and profits from genuinely private-sector mortgage lenders. As shown 
earlier, to maintain the rate of profit growth on which their stock 
price depends, Fannie and Freddie must encroach further and further on 
the private sector. Although they had previously concentrated on the 
best and most creditworthy loans within the conventional/conforming 
sector--leaving to the banks, S&Ls, and other non-subsidized lenders 
the subprime, home equity, and multifamily loans that represent greater 
default risks--they are now compelled to wade into that market and 
begin to take market share from the companies that are already there.
    The figures in table 3-2 illustrate quite well the problem that 
confronts Fannie and Freddie's private sector competitors. As shown by 
line 22, the GSEs' share of all residential mortgages (conventional/
conforming and ``all other'') will grow from 19.5 percent at the end of 
1998 to almost 36 percent at the end of 2003. That increase of 16.4 
percentage points would equal approximately $800 billion, or 12.4 
percent of the aggregate principal amount of all mortgages outstanding 
at the end of 2003. In other words, in 4 years, $800 billion in 
principal amount of mortgages--which would otherwise be in the 
portfolios of private-sector lenders now operating in those markets--
will instead be in the portfolios of Fannie and Freddie. That will 
substantially reduce the mortgage supply for the lenders now in the 
market, and will force many of them to leave the mortgage lending 
business entirely.
    In effect, the growth of Fannie and Freddie is leading to a steady 
nationalization of the residential mortgage markets in the United 
States, without any debate--or even apparent awareness--by Congress.
    As shown by lines 29, 32, and 35 of table 4-1, Fannie and Freddie 
must take most of the growth in mortgages outstanding if they are to 
meet their market share, revenue, and earnings growth objectives. Since 
they cannot meet their needs for product solely out of the 
conventional/conforming mortgages that will come to market between 1999 
and 2003, they must look elsewhere for product.
    One easy target would be the jumbo market, which will become 
available if Congress can be induced to eliminate the ceiling on 
conventional/conforming mortgages. Opening the door for Fannie and 
Freddie to enter the jumbo mortgage market would, by 2003, give them 
access to almost $1 trillion of mortgages that are now off-limits.
    Other mortgage markets beckon to Fannie and Freddie, including 
those to be accessed by dipping deeper into the subprime loan pool and 
assuming the higher credit risks associated with those loans; by 
expanding more aggressively into the financing of multifamily housing 
designed for renters, not homeowners; and by acquiring home equity 
loans in addition to first mortgages. But those can be merely stopgaps. 
Our projections extend only through 2003; if the growth of Fannie and 
Freddie continues beyond that year at the rate Frank Raines has 
forecast, they will at some point acquire all the available residential 
mortgage product in the United States. As the practical limits of the 
residential mortgage market are reached, one can easily envision Fannie 
and Freddie arguing that they should extend their skills and cost 
advantages into the commercial mortgage market. After all, many office 
building and shopping center owners would welcome the taxpayer subsidy 
Fannie and Freddie can deliver.
    Fannie and Freddie's other opportunity for growth outside the 
residential mortgage market is to provide financial services generally, 
especially consumer credit services. Home equity loans, for example, 
provide a ready entry into consumer financial services. Once the GSEs 
hold a home equity loan, they have the opportunity to use it as a 
revolving loan fund with which Fannie and Freddie would be able to 
supply credit directly to the homeowner/borrower. Although in one sense 
that might be considered loan origination, such a determination would 
have to be made by the Department of Housing and Urban Development 
(HUD)--which in the past has shown little appetite for challenging 
Fannie and Freddie's expansion. If in fact that activity goes 
unchallenged by HUD, the GSEs could become very large sources of 
consumer credit, and through their implicit government subsidy they 
would be able to offer consumers better rates than banks and other 
consumer lenders.
    Perhaps the greatest competitive threat, however, remains in the 
mortgage origination process. Although Fannie and Freddie vigorously 
deny that they have any intention to originate mortgages, pointing out 
that they lack the statutory authority to do so, what exactly 
constitutes origination of a mortgage is a matter of interpretation. If 
Fannie and Freddie were to open their automated underwriting facilities 
to direct borrower access over the Internet, it might be possible for 
them to provide the prospective homebuyer with a certification that his 
or her mortgage would qualify for purchase by Fannie or Freddie. At 
that point, the actual lender would have little to do except to perform 
the ministerial acts necessary to fund the loan and deliver it to one 
or another of the GSEs. The compensation for that role would, of 
course, be small.
    In a November 1999 speech to securities analysts, Leland Brendsel, 
the chairman of Freddie Mac, referred in rather vague terms to major 
changes in the offing for the mortgage market:
    I can safely predict that within a few short years, the mortgage 
industry will change dramatically. When the dust settles in the 
mortgage market, we will be left with an industry structure where 
investor funds flow to consumers with little drag from antiquated, 
inefficient processes. Consumers will be able to tap global capital 
markets at even lower cost than they can today.
    And later in the same statement he was even more explicit. Citing 
the potential of technology ``to streamline the entire mortgage process 
and eliminate inefficiency in the housing finance system,'' he 
continued:
    Freddie Mac has brought tremendous efficiency to the mortgage 
market, but the industry still generates significant costs from 
redundant operations and expensive transfer of information through all 
the steps in the mortgage process. As technology wrings out remaining 
inefficiencies, Freddie Mac's role will be enhanced, as we deliver low-
cost funds to consumers even faster and more effectively.
    There can be little doubt that Mr. Brendsel was describing a 
mortgage industry in which, through technology, Freddie Mac would be 
dealing directly with borrowers and perhaps with consumers generally.
                                6. risks
    It is impossible to understand the risks that Fannie and Freddie 
create for the government and taxpayers without understanding their 
similarities to the S&Ls that collapsed at the end of the 1980's. Like 
the S&Ls,
     their principal investments are home mortgages, long-term 
assets that can abruptly become short-term assets when a home is sold 
or refinanced;
     they can borrow at government-assisted rates that do not 
substantially increase as they take on more risk;
     they are unable to manage risk through asset 
diversification because virtually all their assets are home mortgages.
    But Fannie and Freddie are like 1980's S&Ls in another significant 
way. Scholars reviewing the S&L collapse have shown that it came about 
in substantial part because the industry was seeking high profits in 
order to recover the capital depleted by losses during the high-
interest-rate period at the beginning of the 1980's. To achieve that 
profitability, through a process ultimately called ``gambling for 
resurrection,'' the S&Ls reached for greater and greater risk. Although 
the debt market usually requires much higher interest rates from 
companies that are taking on increased risk--if those companies can 
access the debt market at all--that was not true for the S&Ls. Because 
their deposits were backed by the government, weak and failing S&Ls 
were able to raise the necessary funds to keep on gambling--ultimately 
causing immense losses to the government and the taxpayers.
    Of course, Fannie and Freddie are not weak companies, and they have 
no need to take risks to restore their capital. But they have strong--
indeed, compelling--reasons to continue increasing their profitability. 
That circumstance creates the same incentives to take on risk that the 
managements of weak S&Ls confronted fifteen years ago.
    The incentives are clear. Fannie and Freddie are public companies; 
their shares are listed on the New York Stock Exchange and are closely 
monitored by the investment community. The value that investors place 
on their stock at any given moment is not only a vote on their earnings 
growth prospects and the quality of their management, but also directly 
affects management's compensation. Like the managements of most large, 
publicly held companies, the managements of Fannie and Freddie are 
compensated in part through stock options, which in turn acquire 
increasing value only if the price of their stock increases.
    That creates a strong incentive for the managements of the GSEs, 
like those of conventional private firms, to increase their profits and 
to impress investors with their potential for profit growth. For 
example, at the Merrill Lynch investor conference in September 1999, 
Fannie Mae chairman Franklin Raines projected that Fannie Mae would 
achieve annual earnings growth of 15 percent in 1999 and over the next 
4 years. But profit growth at that rate is highly unusual. Fannie 
already boasts that it is one of only eight companies in the S&P 500 
that can claim to have had a double-digit rate of earnings growth for 
twelve straight years. Continuing that growth in profitability--and 
indeed increasing it--would be extraordinary for any company in today's 
low-inflation environment.
    We can only speculate why Mr. Raines would place such a burden on 
himself and his management. Possibly it is because he wants to be seen 
as a highly capable manager, or he feels an obligation to match the 
success of his predecessors. However, the fact that his compensation 
and that of the top managers at Fannie Mae are tied to increases in 
Fannie's stock price also provides a substantial incentive to impress 
the financial markets.
    Once we look at Fannie and Freddie as gigantic S&Ls that are 
seeking an almost unprecedented rate of profitability growth, we can 
begin to see why they create risks for the government and the taxpayers 
that parallel the risks created by the S&Ls in the 1980's. Because of 
their government backing, they are essentially exempt from debt market 
discipline--just like the insured S&Ls of the 1980's.
    The incentives may be different, but the objectives are the same--
to increase profitability by issuing debt at a government-backed rate, 
while achieving higher profitability through taking on greater risk. In 
the 1980's, S&Ls tried to do that to replenish their capital; Fannie 
and Freddie are doing it to maintain the profit growth that sustains a 
growing market valuation of their stock.
    To be sure, Congress has attempted to address the question of GSE 
risk, using the familiar device of a regulatory agency. In 1991, 
Congress established the Office of Federal Housing Enterprise Oversight 
(OFHEO), a regulatory agency charged with supervising the GSEs the way 
banking regulators supervise banks and S&Ls. Given the experience of 
the 1980's--not only with the S&Ls but with banks themselves--we should 
be skeptical about the effectiveness of regulators in controlling the 
risks of the companies they regulate.
    For one thing, there is always the question of asymmetric 
information--the regulated company knows more than its supervisor about 
the risks it is taking on. For another, as demonstrated in the case of 
the S&L industry, the regulated companies frequently have more power to 
influence Congress than has the regulatory agency, and they are 
frequently successful in limiting the agency's resources. It is useful 
to recall that Congress repeatedly supported the S&L industry's efforts 
to avoid regulatory restriction on its activities. As it happens, in 
the case of OFHEO, that phenomenon was clearly demonstrated in 1999, 
when a Senate committee initially capped OFHEO's appropriation at the 
previous year's $16 million level--despite an administration request 
for a 20 percent increase. Although an increase to $19 million was 
ultimately voted, the special effort that was required sent a signal to 
OFHEO about how much congressional support it will receive if it 
seriously attempts to control Fannie and Freddie's behavior.
    Even without those negative signals, there are good reasons to 
believe that OFHEO will not act to reduce the GSEs' risk-taking. For 
example, if Fannie or Freddie's capital ratios slipped too low, OFHEO 
could direct the troubled GSE to reduce its assets as part of a plan to 
strengthen its capital position. Shrinkage, however, implies that the 
GSE in question would sharply reduce its buying and guaranteeing of 
mortgages. It might even be required to sell assets. That would improve 
its capital ratios, but the cutback and asset sales could force an 
increase in mortgage interest rates and a sudden, sharp reduction in 
housing construction, with secondary effects throughout the economy.
    The possibility that there might be severe macro-economic 
consequences as a result of an OFHEO regulatory action should raise 
both systemic--risk concerns about OFHEO's new capital regulations and 
doubts about the likelihood that they will ever be effectively applied. 
If OFHEO's capital regulations are believed to threaten severe 
macroeconomic consequences--and certainly Fannie and Freddie will not 
be shy about pointing that out--it is easily foreseeable that Congress 
will act to prevent the enforcement of the regulations. That example, 
not at all far-fetched, suggests how difficult it will be for OFHEO to 
be an effective source of discipline over Fannie and Freddie. And 
without OFHEO, there is effectively no means of controlling their risk-
taking.
    Nevertheless, OFHEO has proposed a regulation intended to control 
the riskiness of Fannie and Freddie--including a risk-based capital 
requirement that imposes capital penalties when risks are not 
adequately hedged. Undoubtedly, Fannie and Freddie will cite those 
regulations as a basis for quelling congressional concerns. The 
question, however, is whether it is reasonable to believe that Fannie 
and Freddie can achieve the extraordinary rates of growth they are 
projecting while keeping their risks within tolerable levels. If they 
do so, they will be unusual companies indeed.
    The GSEs' sagging stock prices demonstrate that Wall Street is 
skeptical on that score. As shown on lines 52 and 55 of table 6-1, both 
GSEs have experienced a significant decline, per dollar of portfolio 
investment, since 1995. We project that that trend will continue 
through 2003. On January 12, 2000, Fannie's common stock closed 20 
percent below its twelve-month high, while Freddie closed down a more 
troubling 28 percent for the same period. That development seems to be 
puzzling to Fannie Mae chairman Raines, who asked at the Merrill Lynch 
conference, ``So why does the market trade Fannie Mae at a discount to 
the other companies with similar growth rates?''
    There are two possible reasons.
    First, some investors may have recognized that Fannie and Freddie 
are simply running out of room to grow by purchasing the high-quality 
conventional/conforming mortgages that have been their traditional 
assets, and that the cost of hedging the risks of lower-quality product 
may reduce their profitability.
    Second, and more ominously, Fannie and Freddie's lagging stock 
prices may reflect a growing concern in the equity markets that the 
GSEs are not adequately hedging their risks, so that their future 
earnings may be hit by losses on the riskier mortgages they are 
purchasing or guaranteeing today.
    In addition to their inherent lack of diversification, Fannie and 
Freddie face a number of other risks as guarantors of MBSs and as 
holders of large portfolios of mortgages and MBSs. Those risks include 
credit risk, interest-rate risk, counter-party risk, and spread-
compression risk, all of which are discussed more fully below. As we 
will show, each of those risks can be reduced or hedged, but doing so 
is costly and will inevitably reduce Fannie and Freddie's 
profitability. To compensate for those costs--while trying to maintain 
and surpass their past levels of profitability--they must take on still 
more risk, always keeping one step ahead of their regulator.
    Credit Risk. In common with all housing lenders, the GSEs have 
enjoyed a substantial decline in their credit losses in recent years. 
Fannie's pre-tax losses, per mortgage dollar owned or guaranteed, 
dropped from 5.3 basis points in 1996 to 2.9 basis points in 1998 
(table 6-2, line 59); Freddie's pre-tax credit losses dropped from 10.5 
basis points in 1996 to 5.1 basis points in 1998 (line 65).
    But the housing market is historically volatile, and it regularly 
passes through boom and bust periods related to national economic 
conditions, interest rates, and other factors. Completely exogenous 
factors--an example might be a change in the tax system that alters the 
deductibility of mortgage interest in a significant way--could have 
seriously adverse effects, for which the participants have no effective 
way to prepare. It is important to keep in mind that Fannie and Freddie 
will be more exposed to the risks of the housing market than any 
lenders in history, since their already unprecedented market shares 
will--as discussed earlier in this study--grow even larger in the 
future.

                                         TABLE 6-1.--FANNIE MAE AND FREDDIE MAC NET INCOME BY LINE OF BUSINESS, PAST, PRESENT, AND PROJECTED, 1995-2003
                                                                                     [Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  History (year-end)                                   Projection (year-end)                      Annual     Annual
                                                   ------------------------------------------------------------------------------------------------------------   growth     growth     Growth
                                                                                                                                                                  rate:      rate:       rate
                                                       1995        1996        1997        1998        1999        2000        2001        2002        2003     1995-1998  1998-2003  difference
                                                                                                                                                                   (%)        (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Net income by line of business (basis points):
    Fannie Mae:
        41. Portfolio investment..................       1,369       1,694       1,894       1,878       2,219       2,621       2,988       3,346       3,702      11.1       14.5         3.4
        42. Credit guarantee......................       1,003       1,031       1,162       1,540       1,583       1,661       1,770       1,872       1,973      15.4        5.1       -10.3
        43. Total.................................       2,372       2,725       3,056       3,418       3,802       4,282       4,758       5,218       5,675      12.9       10.7        -2.3
        44. Federal tax rate (%)..................        28.0        29.5        29.3        25.9
    Freddie Mac:
        45. Portfolio investment..................        N.A.         785         892       1,021       1,305       1,591       1,857       2,116       2,372      14.0       18.4         4.3
        46. Credit guarantee......................        N.A.         458         503         679         751         760         793         819         841      21.8        4.4       -17.4
        47. Total.................................       1,091       1,243       1,395       1,700       2,055       2,352       2,650       2,935       3,213      15.9       13.6        -2.4
        48. Federal tax rate (%)..................        31.2        30.0        29.0        27.8
    Fannie + Freddie:
        49. Portfolio investment..................        N.A.       2,479       2,786       2,899       3,524       4,212       4,846       5,462       6,074       8.1       15.9         7.8
        50. Credit guarantee......................        N.A.       1,489       1,665       2,219       2,333       2,422       2,563       2,691       2,814      22.1        4.9       -17.2
        51. Total.................................       3,463       3,968       4,451       5,118       5,857       6,634       7,409       8,153       8,888      13.9       11.7        -2.2
Net income per $ of business (basis points):
    Fannie Mae:
        52. Portfolio investment..................                    62.8        62.8        51.3        47.0        45.0        43.0        41.0        39.0
        53. Credit guarantee \1\..................                    13.3        14.0        16.9        14.0        13.0        12.5        12.0        11.5
        54. Total.................................        34.0        35.3        35.1        33.6        33.5        33.6        33.4        33.1
    Freddie Mac:
        55. Portfolio investment..................                    63.9        59.0        48.6        44.0        42.0        40.0        38.0        36.0
        56. Credit guarantee \1\..................                     7.9         8.2        10.2         9.5         8.5         8.0         7.5         7.0
        57. Total.................................                    21.1        22.3        24.7        26.0        26.3        26.7        26.9        26.7
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Assumes no credit risk on GSE/government-guaranteed debt held in portfolio.
N.A. = Not available.

    Obviously, credit risk is closely related to conditions in the 
general economy. In recent years, a sustained economic expansion, soon 
to be the longest in U.S. history, has brought unemployment to record 
lows while boosting incomes. Both of those factors have led to a steady 
rise in housing prices. Rising prices in turn have given homeowners 
more equity in their homes, which protects mortgage lenders and 
guarantors, notably Fannie and Freddie. However, an economic down-turn 
could depress housing prices while causing a jump in mortgage 
delinquencies as the unemployment rate rises. Mortgage foreclosures 
would increase, substantially raising Fannie and Freddie's credit 
losses.
    As Fannie and Freddie are also diving deeper into the pool of 
subprime mortgages, they will be in largely uncharted waters. Although 
Fannie and Freddie claim that technology has greatly increased their 
loan-underwriting capabilities, thereby lowering their risks in sub-
prime lending, that assertion has not been tested by a recession. 
Further, because of lower down payments from more financially 
challenged borrowers on properties that may not hold their values well 
during an economic downturn, losses on subprime lending could be much 
higher than on higher-quality loans.
    Unlike their deep knowledge of and databases on conventional/
conforming loans, the GSEs' relative inexperience with the subprime 
market makes their judgments concerning the risks they are assuming 
much less sure. Thus, Fannie and Freddie face not only higher likely 
losses in subprime loans per dollar lent or guaranteed but also greater 
uncertainty as to how high those losses will be. To cover their risks 
in those cases, Fannie and Freddie have in the past relied in part on 
private mortgage insurance, but recently they have been exploring 
various devices that would enable them to assume more of the mortgage 
insurer's risk and thus keep more of the profit for themselves. That is 
consistent with their desire to increase their profits, but obviously 
it will also increase their risks of loss in the event of a market 
turndown.

TABLE 6-2.--CREDIT-RELATED EXPENSES FOR FANNIE MAE AND FREDDIE MAC, 1995-
                                  1998
------------------------------------------------------------------------
                                          History (year-end)
                             -------------------------------------------
                                 1995       1996       1997       1998
------------------------------------------------------------------------
Fannie Mae:
    58. Pre-tax credit-                        409        375        261
     related expenses ($, in
     millions)..............
    59. Pre-tax credit cost                    5.3        4.5        2.9
     (B.P.).................
    60. Credit guaranty tax                   31.4       31.1       24.3
     rate (%)...............
    61. After-tax credit                       281        258        198
     cost ($, in millions)..
    62. After-tax credit                       3.6        3.1        2.2
     cost (B.P.)............
    63. Credit income before                  16.9       17.1       19.1
     credit expense (B.P.)..
Freddie Mac:
    64. Pre-tax credit-                        608        529        342
     related expenses ($, in
     millions)..............
    65. Pre-tax credit cost                   10.5        8.6        5.1
     (B.P.).................
    66. Credit guaranty tax                   28.2       28.4       28.2
     rate (%)...............
    67. After-tax credit                       437        379        246
     cost ($, in millions)..
    68. After-tax credit                       7.5        6.2        3.7
     cost (B.P.)............
    69. Credit income before                  15.4       14.4       13.9
     credit expense (B.P.)..
    70. Difference: line 63                    1.5        2.7        5.2
     1 line 69 (B.P.).......
        Fannie Mae ($, in        22,200     29,200     43,200     83,600
         millions)..........
            % of total              8.8       10.2       13.6       20.1
             portfolio......
        Freddie Mac ($, in        7,665     10,056     12,567     29,817
         millions)..........
            % of total              7.1        7.3        7.6       11.7
             portfolio......
------------------------------------------------------------------------
B.P. = Basis points. 1 B.P. = .01%.
Memoranda data--government/GSE securities in portfolio. They presumably
  have no credit risk.

    Finally, Fannie is seeking substantial loan growth in the 
multifamily housing market, specifically to meet affordable housing 
goals. Multifamily mortgages can be much riskier than those for owner-
occupied, single-family homes, as Freddie learned to its regret a few 
years ago, because tenant income is more vulnerable to economic 
downturns and rental property deterioration can be more severe than 
owner-occupied housing.
    Credit-guarantee fees, per dollar of risk assumed, declined during 
1999 for both Fannie and Freddie, reflecting lower credit costs as well 
as increased competition between them for the business of large 
mortgage originators. A decline in fees is probably only the visible 
portion of the competition between the GSEs for that business. It is 
likely that they are also placing their guarantees on MBSs that are 
backed by somewhat riskier pools of mortgages, for which they are also 
attempting to assume more of the risk previously taken by mortgage 
insurers. A sharp and largely unpredictable upswing in credit losses a 
few years hence could therefore result in substantial losses in their 
guarantee business.
    Interest-Rate Risk. Fannie and Freddie's potential interest-rate 
risk is growing rapidly as they grow their mortgage portfolios. Those 
portfolios consist of both whole mortgages and MBSs. In just twenty-one 
months, from the end of 1997 to September 30, 1999, Fannie increased 
its mortgage investments by 59 percent, or $188 billion; Freddie's 
increase was 91 percent, or $150 billion.
    Like the S&Ls before them, Fannie and Freddie are heavily dependent 
on short-term funding to finance the long-term, fixed-rate mortgages 
they own. That is the classic borrow-short-to-lend-long strategy that 
S&Ls pursued, with disastrous consequences, when interest rates 
skyrocketed in the early 1980's. On September 30, 1999, 41 percent of 
Fannie's debt matured within 1 year. Freddie was worse off on that 
date, with 51 percent of its debt due within 1 year. The two GSEs have 
tried to lessen their maturity mismatching through various devices, 
such as callable debt and interest-rate hedging. But such devices are 
costly, as discussed below, and their extensive use will reduce the 
GSEs' profitability.
    Theoretically, Fannie and Freddie can minimize their interest-rate 
risk in two ways. First, they can ``match fund'' their mortgage 
portfolios. That is, they can sell debt that matches the maturity of 
their mortgage investments. Maturity matching is complicated, though, 
by mortgage prepayments, which are not as predictable as risk managers 
would like. Because the ease and cost of mortgage refinancing have come 
down in recent years, mortgage prepayments accelerate dramatically 
whenever longer-term interest rates decline even moderately.
    Prepayments create a maturity mismatch because longer-term funding 
now exceeds longer-term assets. To some extent, Fannie and Freddie can 
neutralize maturity mismatching by issuing debt that can be called, or 
repaid, before maturity. But callable debt carries a higher interest 
rate than non-callable debt, so Fannie and Freddie pay a price for that 
form of interest-rate risk protection.
    The reverse form of interest-rate risk occurs when interest rates 
rise. In that case, there is likely to be a sharp slowdown in home 
sales and mortgage refinancing, so that low-rate mortgages remain on 
the GSEs' books longer than anticipated and have to be supported with 
higher-rate liabilities. That can result in substantial losses or 
profit reduction and is exactly what happened to the S&L industry when 
interest rates spiked in the late 1970's and early 1980's.
    Second, Fannie and Freddie have reduced their exposure to higher 
rates through the use of various financial derivatives, largely 
interest-rate swaps. That is, for a fee, the two GSEs shift some of 
their interest-rate risk to third parties. That practice enables them 
to increase their reliance on cheaper short-term funding. But 
derivatives can be costly, particularly when interest-rate volatility 
causes significant changes in the shape of the interest-rate yield 
curve.
    Counterparty Risk. Hedging interest-rate risk through derivatives 
raises a separate risk--counterparty risk, which is essentially a form 
of credit risk. That is, will the counterparty be able to pay when 
called on to do so under a swap agreement or other form of derivative 
contract? Counterparty-risk assessment is not a simple process, though, 
particularly when the counterparty is another financial institution 
that has entered into many other financial contracts.
    The increasing challenge Fannie and Freddie face as they grow 
larger is finding sufficient counterparty capacity among highly rated 
potential counterparties: that is, firms with AAA or AA credit ratings. 
At the end of 1998, 32 percent of Fannie's counterparty risk was with 
entities rated less than AA; 7 percent of its counterparty risk was 
with entities rated less than A. Freddie is less forthcoming about its 
counterparty risk, merely stating that at the end of 1998, its five 
largest counterparties, which accounted for 60 percent of its total 
counterparty exposure, were rated at least A+. Consequently, as Fannie 
and Freddie's risk-hedging needs grow, they may have to pay steadily 
higher fees for a given amount of protection while relying increasingly 
on less creditworthy counterparties.
    Spread-Compression Risk. In terms of their desire to maintain their 
profitability, the most serious risk the two GSEs now confront is 
spread compression: that is, a narrowing of their interest margins. 
Spread compression has become quite evident at both companies, as 
reflected in the net income they earn on their portfolio investments 
per dollar of investment. In 1996, Fannie's net income (excluding the 
cost of credit risk) per dollar of portfolio investment was 62.8 basis 
points (table 6-1, line 52); for the first half of 1999, that profit 
margin had declined to 49.3 basis points. Freddie has experienced a 
similar reduction--its net income, per dollar of portfolio investment, 
declined from 63.9 basis points in 1996 (table 6-1, line 55) to 46.6 
basis points during the first half of 1999. During the third quarter of 
1999, Freddie's interest margin declined seven points from the second 
quarter, which suggests that its net income per dollar of portfolio 
investment declined again.
    Spread compression is occurring for two reasons. First, as Fannie 
and Freddie continue to grow, their sheer size and the demands they 
impose on the financial markets will force up their cost of obtaining 
credit and interest-rate protection, per dollar of protection obtained. 
Second, Fannie and Freddie's purchases of mortgages and MBSs will drive 
up mortgage prices, thereby reducing mortgage yields, as their mortgage 
portfolio growth reaches and then exceeds the growth in those portions 
of the mortgage market where they can lawfully participate. That spread 
compression will negatively affect Fannie and Freddie's earnings growth 
and return on equity capital. For Fannie, those data will be found in 
table 6-1, line 43, and table 6-3, line 85; the comparable data for 
Freddie are in table 6-1, line 47, and table 6-3, line 100. Lower 
mortgage and MBS yields in the face of rising risk-protection costs 
will squeeze Fannie and Freddie's net interest margins. Unless they can 
trim their operating costs to fully offset that squeeze, which is 
unlikely, they will experience even less net income per dollar of 
portfolio investment. That decline will lower their return on equity 
capital and slow their earnings growth. In the face of that inevitable 
spread compression, Fannie and Freddie's managements will 
understandably be tempted to take greater risks--specifically, greater 
credit risk and increased interest-rate risk.

                                              TABLE 6-3.--FANNIE MAE AND FREDDIE MAC CAPITAL REQUIREMENTS, PAST, PRESENT, AND PROJECTED, 1995-2003
                                                                                     [Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  History (year-end)                                   Projection (year-end)                      Annual     Annual
                                                   ------------------------------------------------------------------------------------------------------------   growth     growth     Growth
                                                                                                                                                                  rate:      rate:       rate
                                                       1995        1996        1997        1998        1999        2000        2001        2002        2003     1995-1998  1998-2003  difference
                                                                                                                                                                   (%)        (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Fannie Mae:
    71. Core capital (OFHEO-defined)..............      10,959      12,773      13,793      15,465      18,668      22,109      25,811      29,456      33,602      12.2       16.8         4.6
    72. Required minimum capital..................      10,451      11,466      12,703      15,334      18,168      21,359      24,811      28,456      32,602      13.6       16.3         2.7
    73. Core-required minimum.....................         508       1,307       1,090         131         500         750       1,000       1,000       1,000
    74. Mortgage portfolio (net)..................     252,588     286,259     316,316     415,223     528,811     635,882     754,006     877,960   1,020,492      18.0       19.7         1.7
    75. Other assets..............................      63,962      64,782      75,357      69,791      61,007      73,360      86,987     101,287     117,730       2.9       11.0         8.1
    76. Total assets on B/S.......................     316,550     351,041     391,673     485,014     589,818     709,242     840,993     979,247   1,138,222      15.3       18.6         3.3
    77. Other assets/total assets (%).............        20.2        18.5        19.2        14.4        10.3        10.3        10.3        10.3        10.3
    78. Calculated minimum capital: Assets on B/S        7,914       8,776       9,792      12,125      14,745      17,731      21,025      24,481      28,456      15.3       18.6         3.3
     (2.5%).......................................
    79. MBS, other off-B/S (.45%).................       2,310       2,467       2,606       2,867       3,060       3,201       3,290       3,406       3,495       7.5        4.0        -3.4
    80. Other capital requirement.................         228         223         305         342         363         427         496         569         652      14.5       13.8        -0.7
    81. Other/total capital required (%)..........         2.2         1.9         2.4         2.2         2.0         2.0         2.0         2.0         2.0
    82. After-tax income for dividends, stock buy-                     911       2,036       1,746         599         841       1,056       1,573       1,529
     backs, other.................................
    83. Net income (%)............................                    33.4        66.6        51.1        15.7        19.6        22.2        30.1        26.9
    84. Dividend payout rate (%) \1\..............                    31.5        30.9        30.9
    85. After-tax return on core capital, before                      23.0        23.0        23.4        22.3        21.0        19.9        18.9        18.0
     preferred dividends (%)......................
Freddie Mac:
    86. Core capital (OFHEO-defined)..............       5,829       6,743       7,376      10,715      12,229      14,728      17,248      20,019      23,062      22.5       16.6        -5.9
    87. Required minimum capital..................       5,584       6,517       7,082      10,333      11,829      14,228      16,748      19,519      22,562      22.8       16.9        -5.9
    88. Core-required minimum.....................         245         226         294         382         400         500         500         500         500
    89. Mortgage portfolio (net)..................     107,424     137,520     164,250     255,348     337,432     420,329     508,383     605,489     712,419      33.5       22.8       -10.7
    90. Other assets..............................      29,757      36,346      30,347      66,073      37,492      46,703      56,487      67,277      79,158      30.5        3.7       -26.8
    91. Total assets on B/S.......................     137,181     173,866     194,597     321,421     374,924     467,632     564,870     672,766     791,577      32.8       19.8       -13.1
    92. Other assets/total assets (%).............        21.7        20.9        15.6        20.6        10.0        10.0        10.0        10.0        10.0
    93. Calculated minimum capital: Assets on B/S        3,430       4,347       4,865       8,036       9,373      11,676      14,122      16,819      19,789      32.8       19.8       -13.1
     (2.5%).......................................
    94. MBS, other off-B/S (.45%).................       2,066       2,129       2,142       2,153       2,289       2,352       2,391       2,425       2,455       1.4        2.7         1.3
    95. Other capital requirement.................          89          42          75         145         167         200         236         275         318      17.7       17.0        -0.7
    96. Other/total capital required (%)..........         1.6         0.6         1.1         1.4         2.0         2.0         2.0         2.0         2.0
    97. A-T income for dividends, stock buy-backs,                     329         762     (1,639)         542       (148)         131         164         170
     other........................................
    98. Net income (%)............................                    26.5        54.6       196.4        26.4        16.3         4.9         5.6         5.3
    99. Dividend payout rate (%) \1\..............                    26.0        26.5        26.3
    100. After-tax return on core capital, before                     19.8        19.8        18.8        17.9        17.4        16.6        15.8        14.9
     preferred dividends (%)......................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Common + preferred dividends as a percentage of net income.
B/S = balance sheet.

    That temptation is troubling, given their extremely thin capital 
cushions. Under existing regulations, Fannie and Freddie must have, at 
a minimum, equity capital (common stock, permanent preferred stock, 
paid-in capital, and retained earnings) equal to 2.5 percent of on-
balance-sheet assets plus .45 percent of outstanding MBS and other off-
balance-sheet obligations. The on-balance-sheet capital ratio is one-
half the leverage capital ratio equired for commercial banks considered 
to be well capitalized for regulatory purposes. Worse, as is clear from 
table 6-3, lines 73 and 88, Fannie and Freddie operate much closer to 
their minimum capital ratio requirement than is generally true for 
well-capitalized banks, which generally have risk-based capital of 10 
percent. Therefore, increased risk-taking, which might not be 
immediately evident to regulators and stock market analysts, could set 
up either company--or both--for serious financial difficulties.
    Systemic Risk. As Fannie and Freddie continue to grow, they will 
pose increased systemic risk to the U.S. financial markets. They had 
$866 billion of debt outstanding as of September 30, 1999. By the end 
of 2003, that amount will increase by almost $1 trillion, rising to 
$1.8 trillion (table 6-4, line 105). At that point, or shortly 
thereafter, the combined debt of the two GSEs may exceed the Treasury 
debt held by the general public--if budget surpluses continue to shrink 
the amount of Treasury debt outstanding.
    Recently, Fannie and Freddie have been attempting to emphasize the 
similarity of their debt to Treasury securities, by mimicking 
Treasury's frequent, regular issuances of new debt. Indeed, at one 
point Fannie Mae's website contained the statement that its debt 
securities ``will often provide investors with a spread pickup to the 
Treasury structure.'' In other words, investors can receive 
substantially the same security as Treasury debt with an interest-rate 
premium. If those marketing efforts are successful, actual losses at 
either of the GSEs--or a perception in the markets of a sudden increase 
in their riskiness--could result in a serious systemic problem for the 
economy as a whole.

                                        TABLE 6-4.--FANNIE MAE AND FREDDIE MAC INTEREST-BEARING DEBT OUTSTANDING, PAST, PRESENT, AND PROJECTED, 1995-2003
                                                                                     [Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  History (year-end)                                   Projection (year-end)                      Annual     Annual
                                                   ------------------------------------------------------------------------------------------------------------   growth     growth     Growth
                                                                                                                                                                  rate:      rate:       rate
                                                       1995        1996        1997        1998        1999        2000        2001        2002        2003     1995-1998  1998-2003  difference
                                                                                                                                                                   (%)        (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Fannie Mae:
    101 Interest-bearing debt O/S.................     299,174     331,270     369,774     460,291     560,327     673,780     798,943     930,285   1,081,311      15.4       18.6         3.2
    102 O/S debt as percentage of total assets....        94.5        94.4        94.4        94.9        95.0        95.0        95.0        95.0        95.0
Freddie Mac:
    103 Interest-bearing debt O/S.................     119,328     156,491     172,321     287,234     337,432     420,329     508,383     605,489     712,419      34.0       19.9       -14.1
    104 O/S debt as percentage of total assets....        87.0        90.0        88.6        89.4        90.0        90.0        90.0        90.0        90.0
    105 Total O/S interest-bearing Fannie and          418,502     487,761     542,095     747,525     897,759   1,094,109   1,307,326   1,535,774   1,793,730      21.3       19.1        -2.2
     Freddie debt.................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
O/S = outstanding.

    Despite their efforts to present their securities as substitutes 
for Treasury securities, Fannie and Freddie are not the Treasury. Their 
securities are only implicitly backed by the U.S. government; they do 
not carry the full-faith-and-credit promise of the United States. 
Indeed, the GSEs' securities are by statute required to state that they 
are not obligations of the United States. They are able to obtain 
favorable financing because the markets do not believe--given the GSEs' 
many connections with the U.S. government--that they will be allowed to 
fail.
    But it is important to understand that that condition still leaves 
some room for doubt. Ultimately the GSEs' ability to fund themselves in 
the financial markets depends on their ability to manage their risks as 
well as on conditions in the U.S. housing markets. The housing markets, 
in turn, are subject to risks--such as changes in the tax code--that 
cannot be anticipated. An adverse change in the GSEs' financial 
condition could lead to an increase in the yield spread of the GSEs' 
debt over Treasury debt. That could be a gradual rise, as the market 
worries about whether their implicit backing will turn into a bailout, 
or it could reflect a sudden shift in market perceptions. In the case 
of Farm Credit System (FCS) debt in 1987, a gradual rise was followed 
by a sudden tipping point, when the market fled to quality. In the case 
of the Farm Credit System, the yield spread over longer-term Treasuries 
went above 100 basis points, signaling that new FCS debt might become 
unmarketable.\8\
---------------------------------------------------------------------------
    \8\ Bert Ely and Vicki Vanderhoff, ``The Farm Credit System: 
Reckless Lender to Rural America'' (Alexandria, Va.: Ely & Company, 
Inc., November 1990).
---------------------------------------------------------------------------
    If a similar phenomenon should affect Fannie or Freddie's 
securities, the financial intermediaries that are currently holding 
that debt instead of Treasuries may find that they can sell only at 
substantial losses; the losses would then raise questions about their 
own financial stability, and a systemic crisis would arise. To be sure, 
Congress could resolve the crisis, but a great deal of damage would 
then have been done to the economy as the market fled to quality and 
credit sources dried up. The U.S. financial markets experienced that 
phenomenon during the fall of 1998, in the aftermath of the Russian 
debt crisis and the Long-Term Capital Management debacle.
    Of course, the effect of a Fannie and Freddie crisis would be even 
more calamitous for the housing markets. If those GSEs were to face 
substantially higher interest costs in marketing their debt, the costs 
would be transmitted immediately to the housing market--slowing home 
purchases and new home construction dramatically. That in itself would 
have a severely adverse effect on the general health of the U.S. 
economy.
    Fannie and Freddie can contain their risks, but at the cost of 
reduced profitability. There is no indication in their behavior thus 
far that they are willing to accept that result.
                             7. conclusion
    Fannie Mae and Freddie Mac are fast becoming a problem that can no 
longer be ignored. By 2003, they will have assumed the risk--either 
through ownership or guarantees--of almost one-half of all residential 
housing mortgages in the United States. In effect, the residential 
mortgage market will have been partially nationalized, with the 
taxpayers bearing a risk that should be borne by private stockholders 
and creditors.
    Moreover, we project that in 2003, Fannie and Freddie will own or 
have guaranteed 91.5 percent of all conventional/conforming mortgages, 
justifying the concern of private mortgage lenders throughout the 
United States that they will gradually be squeezed out of their 
traditional markets, and that Fannie and Freddie are planning to extend 
their activities to some form of direct relationship with the public.
    It seems clear that the problem here is the peculiar structure of 
Fannie and Freddie--profit-seeking companies that have been granted 
special status to pursue a public mission. Those objectives are 
contradictory. Whatever balance Congress initially thought could be 
achieved between them has been lost.
    What are the benefits that Fannie Mae and Freddie Mac claim to 
provide, and are those benefits worth the cost in taxpayer risk and 
competition for non-subsidized mortgage lenders?
    Although the GSEs do contribute to liquidity in the mortgage 
markets, they are no longer necessary for that purpose; private firms 
now routinely acquire and securitize portfolios of jumbo mortgages--
which exceed the size that Fannie and Freddie may purchase--and those 
private firms could certainly do the same for conventional/conforming 
loans.
    Recognizing the validity of that argument, Fannie and Freddie now 
claim that their purpose is to reduce middle-class mortgage rates, and 
point to the fact that those rates are about 30 basis points lower than 
rates in the jumbo market. However, many economists have noted that 
that saving for homebuyers is an illusion: the lower interest rate is 
immediately capitalized into the cost of the home, so that the real 
benefit of the implicit subsidy goes to developers and home sellers 
rather than to the homebuyers whom congress presumably intended to 
assist.
    Weighed against those highly conjectural benefits are the real 
taxpayer risks that Fannie and Freddie create, and the real danger that 
they will eventually evict private non-subsidized lenders from the 
residential mortgage market.
    Policymakers have a number of appropriate potential responses: true 
privatization of Fannie and Freddie through cutting their links to the 
Federal Government; tighter statutory and regulatory restrictions on 
their efforts to expand their activities; limitations on their use of 
lobbyists, their political contributions, and their other efforts to 
manipulate the legislative process; free sale of identical GSE 
franchises, or the imposition of special taxes, affordable housing 
burdens, or other costs that would enable the government to recapture 
their implicit subsidy; forbidding the tying of management compensation 
to their stock price; and even returning them to their former status as 
on-budget Federal agencies.
    Whatever the course ultimately adopted, it is important to 
recognize that options are foreclosed and solutions become more 
difficult as Fannie Mae and Freddie Mac continue their de facto 
nationalization of the residential mortgage market.

Banks Do Not Receive a Federal Safety Net Subsidy: A Paper Prepared for 
        the Financial Services Roundtable by Bert Ely, May 1999

    For several years, the Federal Reserve, and its chairman, Alan 
Greenspan, have argued with extreme forcefulness that banks benefit 
from a substantial, but apparently unquantifiable taxpayer subsidy. Mr. 
Greenspan contends that in order to minimize the competitive 
distortions caused by this alleged subsidy, expanded powers for banking 
companies should be exercised only through non-bank affiliates of bank 
holding companies regulated by the Fed and barred for operating 
subsidiaries of national banks regulated by the Treasury Department's 
Office of the Comptroller of the Currency.
    The Fed cannot quantify the amount of this alleged subsidy because 
there is, in fact, no such subsidy. Instead, a subsidy of at least $1.5 
billion annually flows in the opposite direction, in the form of non-
interest-bearing loans banks have been forced to make to the Federal 
Government through the Fed and the Federal Deposit Insurance 
Corporation.
    What some contend is a Federal subsidy to banks in fact is not, for 
two reasons. First, deposit insurance delivers genuine economic value 
to banks due to its inherent risk-spreading nature which is common to 
all insurances. That is, deposit insurance protects deposits against 
bank failure because, through the premium charged for it, deposit 
insurance effectively spreads bank insolvency risk over a far broader 
equity capital base than just the capital of the bank holding those 
deposits. Deposit insurance therefore permits each insured bank to 
utilize expensive equity capital more efficiently than it otherwise 
could; that is, a bank with deposit insurance can operate with higher 
leverage than it could without it. The fact that the Federal Government 
currently operates the deposit insurance system does not negate this 
inherent value of deposit insurance. Non-bank firms must, of necessity, 
operate with lower leverage because they do not have insolvency 
protection for their creditors comparable to deposit insurance.
    Second, taxpayers do not subsidize Federal deposit insurance 
because over the last decade Congress has made deposit insurance as 
risk-free as possible to taxpayers by creating mechanisms which impose 
all deposit insurance losses on the banking industry, even in 
circumstances far worse than the S&L crisis. Because of the reforms 
Congress enacted, deposit insurance is no longer simply a government 
guarantee, as it was during the S&L crisis--it has been transformed 
into a genuine insurance mechanism which can stand on its own without 
Federal backing. Ironically, these taxpayer safeguards have greatly 
magnified the highly undesirable cross-subsidy within deposit insurance 
which flows from sound, well-managed banks to poorly capitalized and 
badly run banks. Unfortunately, the existence of this cross-subsidy has 
been masked by Mr. Greenspan's false assertion that taxpayers subsidize 
Federal deposit insurance. Worse, his false assertion has inflicted 
significant and possibly lasting harm on the banking industry by making 
it more politically vulnerable to the imposition of yet more social 
welfare obligations beyond those which already burden it, but not its 
non-bank competition.
    Interestingly, this analysis of the subsidy argument reveals that 
non-banks, and specifically securities firms, receive a significant 
taxpayer subsidy--free access to the Fed's discount window during times 
of economic duress. Arguably, permitting this access achieves a public 
good--systemic stability, but that good does not warrant a subsidy for 
securities firms any more than the public good of Federal deposit 
insurance would warrant a taxpayer subsidy for banks.
    Although banks do not receive a taxpayer subsidy, the Fed's amazing 
success in propounding this fiction has raised the question of how best 
to contain the alleged subsidy. Careful analysis indicates that even if 
a subsidy existed, it would flow with equal ease to operating 
subsidiaries of banks and non-bank subsidiaries of holding companies. 
Therefore, whether there is a subsidy or not, there is no rationale for 
limiting the organizational flexibility of banks by requiring that 
certain activities be conducted only in non-bank subsidiaries of Fed-
regulated holding companies. Mr. Greenspan's argument that the holding 
company structure better contains the fictional subsidy is entirely 
without merit.
                              introduction
    Contrary to frequent assertions by Federal Reserve Chairman Alan 
Greenspan, banks do not receive a so-called Federal ``safety net 
subsidy,'' as this paper will demonstrate. Instead, banks pay all costs 
of banking's Federal safety net, including the Federal Government's 
cost of regulating banks. What is alleged to be a safety net subsidy, 
specifically that banks can operate with higher leverage than non-
banks, in fact represents the consequence of the risk-spreading nature 
of deposit insurance. That is, banks can operate with higher leverage 
ratios than their non-bank competitors because banks participate in, 
and pay for the entire cost of, a risk-spreading mechanism that safely 
permits higher leverage.
    This paper will first explain what a Federal safety net subsidy 
would be if banks did receive such a subsidy. It will then explain the 
structure of banking's Federal safety net to demonstrate that any 
taxpayer risk, and therefore any subsidy flowing from this safety net, 
is concentrated in Federal deposit insurance. The next portion of the 
paper will describe various actions Congress has taken over the last 10 
years to eliminate taxpayer risk from deposit insurance by imposing all 
of that risk on the capital of the entire banking system. The paper 
will then explain how deposit insurance works as a risk-spreading 
mechanism so as to permit higher leverage for banks insured by the 
Federal Deposit Insurance Corporation (FDIC). At the same time, as the 
paper will demonstrate, the banking industry pays what amounts to a 
subsidy to the Federal Government of at least $1.5 billion annually. 
Unfortunately, as the paper will explain, Federal deposit insurance has 
created an unhealthy cross-subsidy within the banking industry which 
flows from healthy, well-managed banks to weak, poorly managed banks. 
At the same time, large non-bank financial firms receive an important 
Federal safety net subsidy in the form of free access to the Federal 
Reserve's discount window. Finally, the paper will conclude that while 
banks do not receive a Federal safety net subsidy, if there were one it 
would be equally well contained in a bank-operating subsidiary 
structure as in a holding company-affiliate structure.
    Two other points regarding this paper are in order. First, the term 
``banks'' refers, unless otherwise indicated, to all FDIC-insured 
institutions, including savings-and-loans and savings banks. However, 
the term does not encompass credit unions. Second, the paper assumes 
that the alleged Federal safety net subsidy ultimately is paid by 
taxpayers. It is highly unlikely that there is another source for such 
a subsidy.
       what a safety net subsidy would be if there were a subsidy
    The threshold question in the debate over whether or not banks 
receive a Federal safety net subsidy is what would constitute a 
taxpayer subsidy to banks if a subsidy actually existed. That is, how 
would banks actually reap that subsidy? There appear to be four ways in 
which a taxpayer subsidy could be transmitted to banks--direct payment 
of taxpayer funds to banks, using taxpayer funds to protect depositors 
and others from bank insolvency losses, using taxpayer funds to pay the 
cost of banking regulation, and higher interest rates on the Federal 
debt because of the contingent taxpayer liability posed by Federal 
deposit insurance. None of these potential sources of a Federal safety 
net subsidy exist, as will be discussed shortly. The absence of any 
subsidy is reinforced by the fact that the Fed has never quantified the 
dollar amount of this subsidy. As recently as April 28, 1999, when Mr. 
Greenspan contended that permitting operating subsidiaries to engage in 
non-bank activities as a principal would lead to ``greater Federal 
subsidization'' (Greenspan, 1999), he did not quantify the amount of 
that increased subsidy. Surely, if a subsidy existed, Fed economists 
could at least estimate its size.
               direct payment of taxpayer funds to banks
    The Federal Government does not directly subsidize banking 
activities by making explicit payments to banks. For example, the 
government does not pay banks to maintain branches in low-income 
communities nor does it subsidize banks operating in remote locations. 
Further, any services which the Federal Government purchases from banks 
are priced at competitive market rates.
       using taxpayer funds to protect depositors in failed banks
    Although the S&L crisis cost general taxpayers $125 billion, \1\ 
steps Congress has taken since then, notably the 1991 enactment of the 
Federal Deposit Insurance Corporation Improvement Act (FDICIA), have 
effectively eliminated the risk Federal deposit insurance poses to 
taxpayers. These protections are summarized below, starting on page 6, 
in the discussion of Federal deposit insurance.
   using taxpayer funds to pay the cost of federal banking regulation
    Federal banking regulation cost almost $1.7 billion in 1997; \2\ 
figures are not yet available for 1998. The Office of the Comptroller 
of the Currency (OCC), the regulator of national banks, is supported 
entirely by examination and application fees paid by banks. The same is 
true for the Office of Thrift Supervision (OTS), the Federal regulator 
of thrift institutions (savings-and-loans and savings banks). As will 
be discussed further below, the expenses and insurance losses of the 
FDIC are fully covered by deposit insurance premium assessments and 
interest earned on the fund balance of the FDIC's two deposit insurance 
funds, the Bank Insurance Fund (BIF) and the Savings Association 
Insurance Fund (SAIF). The expenses of the Federal Financial 
Institutions Examination Council, the regulators' coordinating body, 
are charged to the regulatory agencies.
    At the Fed, the income value of non-interest-bearing reserves which 
banks maintain on deposit at the Fed was approximately $653 million in 
1997, \3\ or $136 million more than the cost of the Fed's supervision 
and regulation activities in 1997. As is widely recognized, the present 
reserve requirement on checkable deposits is simply a tax on those 
deposits. The Fed does not use these reserves to execute monetary 
policy since it long ago elected to instead be an interest-rate 
signaler (Ely, 1997a). Although reserve balances are declining because 
of bank sweep accounts (average reserve balances declined 11 percent in 
1998), the income value of reserve accounts should continue to exceed 
the cost of Fed supervision and regulation for the foreseeable future. 
Any shortfall, though, at the Fed will be more than covered by the 
FDIC's net income, as noted below in the discussion, starting on page 
12, of the banking industry's forced loan to the FDIC.
              increased cost of financing the federal debt
    Although it cannot be proven, it is highly unlikely that the 
Federal Government's contingent liability under Federal deposit 
insurance has raised the cost of financing the Federal debt, for two 
reasons. Arguably, any increase in this financing cost could be viewed 
as a subsidy to the banking industry. First, the Federal Government's 
debt has unambiguously been rated AAA for many years. In fact, Treasury 
securities, despite any contingent Federal deposit insurance liability, 
are widely viewed as the closest thing to risk-free debt that exists 
anywhere in the world. Therefore, it is difficult to imagine that 
Federal deposit insurance has raised yields on Treasury securities.
    Second, as will be discussed below, starting on page 6, over the 
last decade Congress has made Federal deposit insurance essentially 
risk-free to Federal taxpayers. Any perceived cost advantage banks have 
in obtaining insured deposits therefore is a product of the soundness 
of banking's self-financed insurance safety net. Also, bank deposits 
appear to be a relatively cheap source of bank funding largely, if not 
entirely, because of the expense banks incur in gathering deposits 
through branch offices and in the substantial regulatory costs banks 
must pass through to their depositors.
             the structure of banking's federal safety net
    Banking's Federal safety net has three components--banks' ability 
to borrow at the Fed's discount window, the Fed's guarantee of payment 
finality on payments transmitted through the Fed, and Federal deposit 
insurance. As a practical matter, if banks receive a safety net 
subsidy, it comes only through Federal deposit insurance because the 
Fed operates the other two components of this safety net on a risk-free 
basis to itself and therefore to the taxpayer.
                        the fed discount window
    The Fed discount window does not provide banks with a safety net 
subsidy although it does provide banks, and especially small rural 
banks, with a very slight funding subsidy comparable to the funding 
subsidy that the Federal Home Loan Banks deliver to their members. For 
the 1992-98 period, discount window loans outstanding averaged $208 
million--$74 million for adjustment loans (used to meet reserve 
requirements and other short-term liquidity needs) and $134 million for 
seasonal loans to small agricultural banks; for 1998, the comparable 
numbers were $162 million, $67 million, and $95 million.\4\ Given that 
the Fed's lending or discount rate for adjustment and seasonal loans is 
a below-market rate, this funding subsidy would equal approximately $2 
million annually if a market rate was 1 percent higher and $4 million 
if it was 2 percent higher. Although indefensible, in the larger scheme 
of things, this is an extremely modest subsidy.
    The Fed should not suffer any losses as a lender since it lends to 
banks only on a fully collateralized basis; acceptable collateral is 
specified in the Fed's Regulation A.\5\ Further, because the Fed can be 
a very demanding lender, it can insist on substantial 
overcollateralization of its loans and can demand the posting of 
additional collateral should the posted collateral lose market value. 
Any losses the Fed did experience as a lender would be borne by 
taxpayers because these losses would reduce, dollar-for-dollar, the 
earnings the Fed sends back to the Treasury every year. Any loss the 
Fed experienced on its discount window lending would occur only because 
Fed officials failed to monitor the market value of the Fed's loan 
collateral in a timely manner. Also, under Sec. 142 of FDICIA, the Fed 
could be liable to the FDIC in a failed bank situation for any 
increased loss to the FDIC as a result of the Fed failing to demand 
payment of outstanding discount window loans within 5 days after the 
failed bank became ``critically undercapitalized.'' However, such a 
loss should be a fairly easy bullet for the Fed to dodge.
    Therefore, because of its essentially risk-free nature and the 
modest amount lent, the Fed's discount window does not gift a safety-
net subsidy to the banking industry. Even its funding subsidy, a few 
million dollars per year at most, is extremely modest compared to the 
funding subsidies provided by the Federal Home Loan Banks.
                        the fed's payment system
    The Fed provides payment finality on interbank payments made 
through the Fed, thereby eliminating interbank credit risk for those 
banks which directly access the Fed's payment system. These interbank 
payments generally take the form of checks deposited in the Fed for 
collection from other banks, automated clearinghouse (ACH) payments, 
and Fedwire funds transfers. In effect, when the Fed grants payment 
finality to a bank for a payment the Fed has not yet collected from 
another bank, the Fed has assumed a credit risk on the bank upon which 
the payment was drawn while the payment is being processed through the 
Fed's payments system. However, this credit risk is extremely short-
term, lasting just a few minutes to a few hours for any single payment. 
The Fed has recognized this payment system risk by establishing 
daylight overdraft limits; that is, a limit on the amount that a bank 
can be overdrawn at any point in time in its reserve or clearing 
account at the Fed. Further, the Fed can charge interest on intraday 
overdrafts; that interest effectively compensates the Fed for the 
intraday credit risk it assumes by providing payment finality at the 
time a payment is presented to it for collection.\6\
    Operating in a real-time environment, the Fed can effectively 
eliminate its payment system risk in two ways. First, it can refuse to 
accept payment requests presented to it which are drawn on weak banks. 
Second, it can accept such payment requests only to the extent to which 
a weak bank has covered any intraday overdraft at the Fed by borrowing 
at the discount window on a fully collateralized basis. In other words, 
through proper, timely management, the Fed can eliminate its payment 
system risk and therefore any subsidy that direct access to the Fed's 
payment system would provide to the banking system. As a practical 
matter, the Fed has always operated its payment system on a risk-free 
basis, which means that the Fed has not subsidized the banking system 
in this manner.
    Contrary to the Monetary Control Act of 1980, which bars the Fed 
from subsidizing the priced services (principally collecting checks, 
processing ACH payments, and executing Fedwire transfers) it offers to 
banks, the Fed in fact does subsidize these services by using a portion 
of its annual ``pension cost credit'' to lower its service prices. In 
1997 (the most recent year for which figures are available), the Fed 
recognized a pension cost credit of $200.8 million.\7\ While $138 
million of this cost credit was turned over to the U.S. Treasury, the 
Fed retained approximately $62.8 million of this credit to subsidize 
its priced-services activities.\8\ However, this subsidy is not a 
safety net subsidy. Instead, it represents a conscious effort by the 
Fed to use funds that would otherwise go to the U.S. Treasury to gain a 
competitive edge, through lower prices, over private-sector providers 
of payment services.\9\ An amendment to S. 900, the financial services 
modernization bill passed by the Senate on May 6, 1999, will bar the 
Fed from using any portion of its pension cost credit to subsidize its 
priced services activities.
  the federal reserve portion of the safety net poses no taxpayer risk
    Clearly, Fed operations, and specifically its discount window 
lending and the operation of its payment system, are designed to 
operate on a risk-free, and therefore loss-free, basis. To the best of 
the author's knowledge, the Fed has never incurred a loss from a bank 
failure. The run on and subsequent failure of Continental Illinois in 
May 1984 best dramatizes the ability of the Fed to avoid losses in 
failed banks. Fed advances to Continental Illinois peaked at $7.6 
billion in August 1984 (Continental Illinois Corporation, 1984, p. 2), 
yet the Fed did not lose a penny on that loan, or at least the Fed has 
never admitted to any such loss, yet the FDIC spent $1.1 billion \10\ 
protecting depositors and other Continental creditors against any loss 
whatsoever. Clearly, losses incurred under banking's Federal safety net 
are focused on Federal deposit insurance and the FDIC.
                       federal deposit insurance
    Federal deposit insurance for banks, which is offered exclusively 
through the FDIC, represents the third component of banking's Federal 
safety net. Federal deposit insurance is a contingent liability of the 
Federal Government; as a practical matter, though, numerous safeguards 
Congress has enacted since the S&L crisis have eliminated any risk 
Federal deposit insurance might otherwise pose to taxpayers.
    Federal deposit insurance creates the potential for a taxpayer 
subsidy only to the extent that the FDIC incurs losses in protecting 
depositors of failed banks. If banks never failed or always failed 
without losses to the BIF or SAIF, then there would be no losses to be 
subsidized. Banks do fail, though, even in good times, and sometimes 
with substantial losses. However, those losses will not be borne, or in 
effect be subsidized, by taxpayers if they instead are paid by healthy 
banks through deposit insurance premiums. Despite suffering $37.1 
billion in losses from 1934 to 1997,\11\ the BIF and its predecessor, 
the FDIC fund, have not received a single dollar of taxpayer 
assistance. Instead, all BIF/FDIC losses as well as FDIC operating 
expenses have been covered by deposit insurance assessments, which 
totaled $46.4 billion through the end of 1997,\12\ and earnings of the 
BIF/FDIC fund. Even the Federal Government's initial $289 million 
capitalization of the FDIC was repaid in 1947 and 1948, with 
interest.\13\ At the end of 1998, BIF had a fund balance (unaudited) of 
$29.6 billion (Federal Deposit Insurance Corporation, 1998a, p.17). 
SAIF, the successor to the Federal Savings and Loan Insurance 
Corporation (FSLIC), which has had a comparable experience since 1989, 
reached an unaudited fund balance of $9.8 billion at the end of 1998 
(Federal Deposit Insurance Corporation, 1998a, p.17).
    Stung by the S&L crisis, and its enormous cost to taxpayers, as 
well as by the commercial banking problems of the 1980's and early 
1990's, Congress enacted numerous reforms which directly or indirectly 
have eliminated the taxpayer risk in Federal deposit insurance. These 
reforms were intended, and to date have performed, to minimize deposit 
insurance losses while ensuring that all such losses will be imposed to 
the maximum extent possible on banks which do not fail. By eliminating 
the taxpayer risk previously posed by Federal deposit insurance, 
Congress transformed Federal deposit insurance from a government 
guarantee program into a genuine insurance mechanism, albeit a 
mechanism with serious cross-subsidy problems discussed below in the 
section on mispriced deposit insurance premiums, which starts on page 
13.
    The seven principal reforms divide into two broad categories--
minimizing deposit insurance losses and imposing all deposit insurance 
losses on bank capital.
                  minimizing deposit insurance losses
    Cross-guarantees among affiliated banks (1989) The Financial 
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 
which launched the resolution of the S&L crisis and FSLIC's bankruptcy, 
included a ``cross-guarantee'' provision (Sec. 206, enacting 12 U.S.C. 
1815(e)). This provision made all ``commonly controlled'' banks liable 
for the FDIC's share of an insolvency loss in any one of the commonly 
controlled institutions. That is, the FDIC experiences an actual loss 
in a failed bank only to the extent that it cannot recover its 
potential loss from affiliated banks of the failed bank. As a practical 
matter, the amount of this potential recovery is limited to the market 
value of the affiliated banks. Hence, for deposit insurance purposes, 
all banks in a multi-bank holding company or otherwise under common 
ownership or control are treated as if they were one bank for the 
purpose of absorbing at least some portion of the FDIC's share of a 
failed bank's insolvency loss. To some extent, the value of this 
provision to the FDIC has been diminished by interstate branching, 
which was authorized in 1994 (and is discussed on the next page). 
Nonetheless, it was an important first step which Congress took to 
minimize FDIC losses and remains an important loss-minimization tool 
for the FDIC.
    Prompt regulatory action/least-cost resolution (1991) In many ways, 
prompt regulatory action (often referred to as prompt corrective 
action, or PCA) and least cost resolution (LCR), are the heart of 
FDICIA,\14\ which Congress enacted on November 27, 1991. Together, PCA 
and LCR represent the most important tool the Federal Government has to 
minimize deposit insurance losses in banks which have sunk into 
insolvency. At the same time, they reflect a fundamental and 
understandable congressional distrust of the bank regulators in the 
aftermath of the S&L crisis and problems in the commercial banking 
industry. Briefly, regulations issued under the authority of PCA set 
trigger points in a bank's slide toward insolvency. These triggers are 
intended to force regulators to take timely corrective action in a 
failing situation or, barring a turnaround, to force the closure of a 
bank before it becomes insolvent. LCR is designed to minimize the 
FDIC's use of purchase-and-assumption transactions in failed bank 
situations because such transactions can protect the uninsured portion 
of deposits, which has the effect of raising the cost of a bank 
failure. Although not fully tested during a severe economic crisis, in 
theory PCA and LCR should minimize deposit insurance losses even during 
a crisis. A discussion of the workings of PCA and LCR lies beyond the 
scope of this paper.
    Depositor preference in failed banks (1993) Although enacted as 
part of the 1993 budget reconciliation bill as a spending reduction 
measure and with no debate whatsoever over its deposit insurance 
implications, the depositor preference provision of the Federal Deposit 
Insurance Act \15\ serves as a potentially significant legal device for 
reducing FDIC losses in failed banks. Briefly, depositor preference 
gives both insured and uninsured deposits in domestic branches of a 
bank a liquidation preference over deposits in that bank's foreign 
offices as well as all other general, unsecured claims on that bank. 
Consequently, general unsecured claims which are not domestic deposits 
will absorb all of a failed bank's insolvency loss before the first 
dollar of loss will be borne by domestic deposits, and specifically by 
the FDIC as the insurer of the insured portion of domestic deposits. 
Depositor preference already is playing a role in reducing the FDIC's 
loss in the relative handful of banks which have failed in recent 
years.
    Interstate banking and branching (1994) Although intended primarily 
to improve the operating efficiency and customer service of commercial 
banks, the Interstate Banking and Branching Efficiency Act of 1994 
greatly improved the safety-and-soundness of the banking system by 
permitting large banks to operate regionally or nationally. The banking 
problems in Texas and other states during the 1980's as well as the 
banking crisis of 1930-33, during which time 9,000 mostly small, single 
office banks failed (Federal Deposit Insurance Corporation, 1983, table 
on p. 41) were greatly aggravated by state and national banking and 
branching restrictions and prohibitions. It is highly unlikely that 
even a future regional banking crisis, such as that which struck the 
Southwest in the mid-1980's or the New England banking crisis of the 
late 1980's and early 1990's, would be as severe, in terms of deposit 
insurance losses, as those crises were.
             imposing all deposit insurance losses on banks
    Recapitalizing the deposit insurance funds Sec. 104 of FDICIA 
established the framework for building the BIF to a ``designated 
reserve ratio'' (presently 1.25 percent of insured deposits) and 
maintaining that ratio. FIRREA, which created the BIF and SAIF, 
established similar requirements for the SAIF. Under the guise of the 
designated reserve ratio, the FDIC was able to levy a substantial tax 
on banks to build the BIF and SAIF to a 1.25 percent reserve ratio. 
Although not used solely to build the BIF to a 1.25 percent ratio, the 
FDIC levied $27.9 billion of premiums on BIF-insured institutions from 
1990 to 1995 (Federal Deposit Insurance Corporation, 1997, p. 105). 
From 1991 to 1996, the FDIC levied $8.5 billion of premiums, including 
$5.2 billion in 1996, on SAIF-insured institutions to build that fund 
to a 1.25 percent ratio (Federal Deposit Insurance Corporation, 1997, 
p. 107). These huge assessments cannot be tapped to pay future deposit 
insurance losses, as is discussed in the next paragraph. Hence, they 
form a permanent investment base which generates the interest savings 
on financing the Federal debt that provides much of the special subsidy 
discussed below, starting on page 12, which flows from the banking 
industry to the Federal Government.
    Unlimited FDIC assessment power Of particular importance to 
taxpayers, Sec. 103 of FDICIA gave the FDIC a blank check, through the 
authorization of emergency special assessments, on the capital of all 
of the institutions insured by a particular fund to quickly rebuild 
that fund to the designated reserve ratio should prior losses have 
driven that ratio below the designated minimum. This unlimited 
assessment power gives the FDIC the power to draw heavily on the 
capital of the banking industry to cover deposit insurance losses 
should cross-guarantees, PCA, LCR, and depositor preference fail to 
minimize those losses. To the extent that the FDIC has to draw upon its 
$30 billion line-of-credit at the U.S. Treasury to meet short-term 
liquidity needs, those interest-bearing borrowings will effectively be 
repaid from future FDIC assessments.\16\ At December 31, 1998, the book 
value of the equity capital of all FDIC-insured institutions was $556.7 
billion (Federal Deposit Insurance Corporation, 1998, p. 16), almost 
three times the amount of the insolvency losses suffered by Federal 
deposit insurance since the S&L crisis first erupted in the early 
1980's.
    Special ``systemic risk'' or too-big-to-fail assessments In 
addition to the emergency special assessment powers of FDICIA's Sec. 
103, FDICIA's Sec. 141 codified the concept of too-big-to-fail (TBTF) 
and provided the means to pay for it. Specifically, this systemic risk 
provision (the so-called ``systemic risk exception '') authorizes the 
Fed and FDIC, with the concurrence of the Secretary of the Treasury and 
the President, to declare a bank TBTF. The FDIC may then protect, if 
necessary, all the liabilities of that bank against loss in order to 
``avoid or mitigate'' the ``serious adverse effects on economic 
conditions or financial stability'' if the bank were liquidated under 
FDICIA's LCR provisions. The systemic risk provision of FDICIA also 
authorizes the FDIC to levy one or more emergency special assessments 
on the other members of the insurance fund to which the failed TBTF 
bank belonged to cover the cost of protecting the failed institution's 
creditors. Because of this provision, healthy banks, not taxpayers, 
will bear the cost of protecting uninsured creditors of TBTF banks from 
any loss.
   federal deposit insurance permits higher leverage, which is not a 
                                subsidy
    Integral to the contention that banks receive a deposit insurance 
subsidy is the argument that this subsidy permits banks to operate with 
higher leverage than non-bank institutions. Kwast and Passmore (1997, 
pp. 16-27) present substantial evidence that non-banks, with the 
possible exception of large investment banks, operate with less 
leverage than banks. They close the discussion of their leverage 
contention by opining that ``these differences [in leverage ratios] are 
quite likely due, in substantial part, to the fact that banks have 
direct access to the Federal safety net'' (Kwast and Passmore, 1997, p. 
27) without explaining the linkage between this direct access to the 
safety net, the subsidy the safety net allegedly provides, and the 
higher leverage banks enjoy. Interestingly, they ignore the fact that 
non-bank firms can access one important element of the safety net, the 
Federal Reserve discount window, as will be discussed below, starting 
on page 13. What is especially intriguing about the Kwast/Passmore 
paper is that it ignores an explanation as to why banks can safely 
operate with higher leverage--the insurance value of deposit 
insurance--that this author explained in the American Banker (Ely, 
1997b) 3 months prior to the publication of the Kwast/Passmore paper.
             all forms of insurance permit higher leverage
    A central element in the subsidy debate is the indisputable fact 
that all forms of insurance permit an insured to operate with higher 
leverage than the insured could enjoy without insurance. That is, 
higher feasible leverage is an inherent byproduct of the risk-spreading 
nature of any form of insurance. This statement holds true for 
businesses, which banks are, as well as for individuals. In effect, 
insurance prevents the bankruptcy of businesses and individuals who 
have partially financed their assets with debt if their assets suffer 
an insurance-covered decline in value which exceeds the insured's net 
worth. Viewed from another perspective, insurance is a credit 
enhancement device an insured obtains in exchange for a fee called an 
insurance premium.
    A simple example will illustrate this crucial point. An individual 
with a net worth of $100,000 purchases a home for $200,000 that is 
partially financed with a $160,000 mortgage. Having used $40,000 of her 
net worth to make a down payment on the house, she has $60,000 worth of 
other assets. Hence, she has total assets of $260,000 which have been 
financed by a $160,000 mortgage and her $100,000 of net worth. If her 
home then suffers a $150,000 uninsured fire loss, she will now have 
assets worth $110,000 and a negative net worth of $50,000 (assets of 
$110,000 minus the $160,000 mortgage). Personal bankruptcy will occur, 
which means the mortgage holder will incur a loss of at least $50,000. 
The risk of this type of loss is precisely why lenders insist that 
borrowers insure mortgaged assets for at least the amount of the 
mortgage. Consequently, a person who cannot obtain property insurance 
cannot leverage herself as highly as someone who can obtain such 
insurance. In effect, insurance exists not just to protect the net 
worth of the insured, but equally important to protect lenders against 
loan losses. In the context of this paper, a depositor is a lender to a 
bank.
    Insurance works properly, from the perspective of ensuring insurer 
solvency, if the risks of loss it has assumed are diversified 
sufficiently; insurance premiums are priced properly so as to cover the 
insurer's losses, operating expenses, and profits (thereby deterring 
moral hazard on the part of insureds); and the insurer has enough net 
worth of its own to absorb extraordinarily high or unanticipated losses 
and pricing errors. In effect, insurance pools the risk of loss of many 
insureds in return for a premium. Consequently, by using insurance to 
shift the risk of a substantial loss to an unrelated party, an insured 
can own more assets than she otherwise could own since her net worth 
will not become negative if she suffers an insured loss. Put another 
way, an insurance contract is an option contract which give the insured 
an option on its insurer's net worth and loss reserves should the 
insured suffer an insured loss. An insurance premium therefore is the 
price of that option contract.
             insurance theory applied to deposit insurance
    This theory of insurance, which reflects the reality of insurance, 
is applicable to all types of financial institutions. The creditors of 
banks and insurance companies are, to some extent, protected by 
insurance mechanisms. The creditors of other types of financial firms, 
such as investment banks and finance companies, generally speaking do 
not enjoy similar insurance protection.\17\ Therefore, all other things 
being equal, firms with insurance which protects their creditors 
against loss can operate with greater leverage than firms without that 
type of insurance. Claims on insurance companies are protected by state 
guaranty funds; a discussion of these funds lies beyond the scope of 
this paper. Instead, the balance of this paper will focus only on 
Federal deposit insurance and the protection it provides to bank 
creditors, specifically depositors.
    Although deposit insurance is characterized as protecting 
depositors, or at least the first $100,000 of a depositor's balance in 
a bank, against loss, in actuality Federal deposit insurance works in a 
slightly different manner. A bank fails because it becomes insolvent; 
that is, it has a negative net worth because the book value of its 
liabilities exceeds the market value of its assets. A bank becomes 
insolvent, and therefore a failed bank, when asset losses and operating 
losses (current expenses exceed current income) consume any positive 
net worth it had. When the FDIC takes over a failed bank, it places it 
in a receivership. The FDIC then advances to the receivership 
sufficient funds to ensure that insured deposits are made whole, either 
through a direct payment to depositors or a transfer of the insured 
deposits to another bank. The FDIC then assumes, under the law of 
subrogation, a claim on the failed bank's receivership in proportion to 
the amount of insured deposits it protected to the total amount of 
domestic deposits. The payment the FDIC makes into the failed bank's 
receivership is functionally equivalent to the payment an insurance 
company makes to a homeowner who has suffered a fire loss or, if so 
specified in the insurance contract, to the holder of the mortgage on 
the home.
    Insured deposits permit a bank to operate with higher leverage than 
it could without deposit insurance because deposit insurance shifts to 
other banks, through FDIC premium assessments, the bank's insolvency 
risk that otherwise would be borne by the insured deposits. Unlike a 
money market mutual fund, though, a bank cannot operate with infinite 
leverage, that is zero capital. Instead, it must hold some capital 
which effectively operates as an insurance deductible that provides 
some insolvency risk protection for the FDIC and therefore for other 
banks. The fact that most banks today are not paying explicit premiums 
to the FDIC does not negate the fact that they are paying for their 
FDIC insurance, as will be discussed below, starting on the next page. 
This insolvency risk protection potentially extends to all liabilities 
in banks that most likely are TBTF although the uncertainty as to which 
banks are TBTF (the so-called ``constructive ambiguity'' favored by 
regulators) undermines the credit-enhancing value of TBTF protection.
    Like any insurance entity, the FDIC must have sufficiently 
dispersed risks in order to be a sound, viable insurance mechanism. The 
FDIC is a very viable insurer given that it insured 8,554 banking 
companies at the end of 1998 (Federal Deposit Insurance Corporation, 
1998b, p. 62).\18\ The fact that the FDIC operates two insurance funds, 
the BIF and the SAIF, does not threaten the FDIC's viability as an 
insurer since Congress intends to merge the two funds and in any event 
would quickly merge them if one of them began to suffer high losses.
    The largest individual FDIC insurance risk, BankAmerica, accounted 
for just 5.9 percent ($163.5 billion) of the FDIC's insured deposits at 
September 30, 1998 (the latest date for which this data is 
available).\19\ BankAmerica's insured deposits equaled just 29.6 
percent of the total capital of FDIC-insured banks on that date ($163.5 
billion/$556.7 billion). Given its size, the diversity of its assets, 
and its geographical spread, in the extremely unlikely event that 
BankAmerica should become insolvent, the FDIC's loss in resolving its 
subsidiary banks would be a tiny fraction of their insured deposits. 
For example, if BankAmerica incurred an insolvency loss equal to 5 
percent of its liabilities, it would cost the FDIC $8.2 billion ($163.5 
billion x .05) to protect BankAmerica's insured deposits against any 
loss; that amount equals just 1.5 percent of total bank capital ($8.2 
billion/$556.7 billion). If BankAmerica were declared to be TBTF, which 
almost certainly would be the case, a loss equal to 5 percent of the 
total amount of liabilities to be protected might be as high as $27-$28 
billion, or approximately 5 percent of total bank capital. While 
enormous (and reflective of massive regulatory failure), a loss of that 
magnitude nonetheless could be borne entirely by the banking system.
    Creditors of a non-bank financial firm operating without creditor 
insurance do not have a third-party standing by to make them whole if 
the firm becomes insolvent. Therefore, creditors of such a firm can 
look only to the net worth of the firm itself to protect them against 
insolvency. Accordingly, without that third-party protection, creditors 
properly insist that an uninsured firm operate with less leverage. 
However, there is nothing to prevent non-bank financial firms from 
establishing insurance mechanisms comparable to deposit insurance if 
their managements desired to operate with higher leverage.
     the bank safety net actually subsidizes the federal government
    Contrary to Mr. Greenspan's assertion that Federal deposit 
insurance provides banks with a Federal taxpayer safety net subsidy, 
the reverse is true--banks effectively provide a special subsidy to the 
Federal Government and hence to taxpayers. This subsidy takes three 
forms--two financial and one non-financial.
             banks' low-interest-rate loans to bif and saif
    The Federal Deposit Insurance Act effectively bars BIF and SAIF 
from dropping below a designated reserve ratio, which the FDIC Board 
has set at 1.25 percent of insured deposits. That is, if the fund 
balance in the BIF or the SAIF drops below 1.25 percent of insured 
deposits, either because of deposit insurance losses or growth in the 
total amount of insured deposits, then the FDIC Board of Directors must 
adopt a recapitalization plan for that fund. Key to raising a fund 
above a 1.25 percent reserve ratio is levying higher deposit insurance 
premium assessments on the members of that fund. This recapitalization 
requirement effectively means that the entire fund balance below the 
1.25 percent requirement is not available to absorb deposit insurance 
losses, except over the very short term. In effect, then, the required 
reserve balance in each fund represents what is tantamount to a forced, 
low-interest-rate loan from the banking industry to the Federal 
Government. Banks extended that loan to the Federal Government through 
the high deposit insurance assessments they paid in the early and mid-
1990's that built the BIF and SAIF to their 1.25 percent reserve 
ratios. These premium payments constituted a permanent loan to the 
Federal Government because the FDIC is ``on budget,'' \20\
    A portion of the interest on this loan, which accrues to the FDIC 
as income earned on its portfolio of Treasury securities, pays for FDIC 
losses and expenses in excess of its deposit insurance premium 
assessments and other sources of income from outside the Federal 
Government. The portion of its interest income the FDIC spends 
effectively constitutes interest banks earn on the forced loan. That 
interest, which banks never collect, in turn, is in lieu of making cash 
premium payments to the FDIC.
    The unspent portion of the FDIC's interest income on its Treasury 
securities represents the net income value to the Federal Government of 
the banking industry's forced loan. Banks receive absolutely nothing in 
return for this foregone income. In 1997, this loan lowered the cost of 
financing the Federal debt by approximately $1.4 billion; \21\ 1998 
figures are not yet available. If Congress had put the FDIC on a pure 
pay-as-you-go financing basis, banks would not have had to pay heavy 
premium assessments to build the essentially untouchable portion of the 
BIF and SAIF fund balances. That portion, at the designated reserve 
ratio of 1.25 percent, reached $35.6 billion at the end of 1998.\22\
    Arguably, the banking industry delivers another $800 million 
annually to Federal taxpayers in the form of the interest banks pay on 
the FICO bonds issued during the 1987-89 period to finance a limited 
disposal of failed S&Ls. This interest is paid entirely by a special 
assessment on bank and S&L deposits. Because the S&L crisis was rooted 
in numerous failed public policies reaching back to the 1930's (Ely and 
Vanderhoff, 1991), the case can be made that FICO bond interest should 
be paid from general taxpayer funds rather than with a special 
assessment on bank deposits.
                  banks' non-interest bearing reserves
    As noted on page 2, the income value of required reserves actually 
on deposit at the Fed exceeded the Fed's bank supervision expenses by 
$136 million in 1997. Given that banks probably hold more vault cash 
than they would if interest was paid on reserves on deposit at the Fed, 
the excess of the Fed's income on required reserves over Fed 
supervision and regulation expenses is somewhat higher. However, 
reserves on deposit at the Fed have been dropping due to sweep 
accounts, so the income value of these reserves has been declining and 
would disappear if the Fed opted to pay interest on reserves (contrary 
to popular belief, the Fed is not explicitly barred by law from paying 
interest on reserves).\23\ The time may arrive when the Fed's 
supervision and regulation expenses will exceed the income value of 
required reserves. However, even if the Fed held no non-interest-
bearing reserves, its supervision and regulation expenses would be 
substantially less than the interest savings the Federal Government 
enjoys by virtue of the forced loan the banking industry has made to 
the FDIC, and hence to the Federal Government.
                        non-financial subsidies
    Because Congress views Federal deposit insurance as a great benefit 
to the banking industry, it has imposed social welfare obligations on 
banks that effectively save the Federal Government substantial sums. It 
lies beyond the scope of this paper to quantify those sums. The 
Community Reinvestment Act (CRA) is one obvious obligation. While there 
is great debate over whether banks make or lose money when meeting 
their CRA obligations, it is highly unlikely that CRA lending and 
service obligations earn the target rates of return that banks set for 
other products and services, especially when considering the 
substantial administrative costs banks incur in complying with the CRA. 
Other laws, such as the Bank Secrecy Act, which impose obligations on 
banks but not on other types of financial institutions, effectively 
represent a special tax on banks and therefore a subsidy to the 
government.
    Adding it all up, the banking industry effectively provided a cash 
subsidy to the Federal Government of $1.5 billion in 1997 plus payment 
of FICO interest and an incalculable amount of social welfare services, 
specifically in the form of CRA lending.
 federal deposit insurance creates an undesirable cross-subsidy within 
                                banking
    While banks do not, contrary to Mr. Greenspan's assertion, receive 
a Federal safety net subsidy, Federal deposit insurance has created a 
highly undesirable cross-subsidy within the banking industry which 
flows from healthy, well-managed banks to weak, poorly managed banks. 
This cross-subsidy takes three forms--mispriced deposit insurance 
premiums, excessive capital requirements for low-risk assets and well-
managed banks, and excessive regulatory compliance costs.
                  mispriced deposit insurance premiums
    Although it may seem odd to contend that healthy banks pay too much 
for their deposit insurance while weak banks pay too little given that 
almost 95 percent of the banks will pay no deposit insurance premium 
for the first half of 1999,\24\ that in fact is the case, for this 
reason: The annual income foregone by banks on the deposit insurance 
premiums they paid to the FDIC to build the BIF and SAIF to a 1.25 
percent reserve ratio, as discussed above, effectively is an implicit 
deposit insurance premium. Assuming banks could earn a 6 percent yield 
on this forced loan to the government, this foregone income is 
equivalent to almost a 6 basis point deposit insurance premium.\25\ 
Hence, effective premiums for FDIC-insured deposits range from 6 basis 
points to 33 basis points since explicit premium rates presently range 
from zero to 27 basis points. In the author's opinion, based on his 
substantial research on the pricing of deposit insurance, this premium 
range is too narrow. The safest banks should pay no more than two basis 
points for insurance of all of their deposits while the riskiest banks 
should pay as much as 70-100 basis points.
    The very serious problem caused by mispriced deposit insurance 
premiums is that they do not deter bad banking while also causing a 
misallocation of credit. Thus, the pernicious nature of mispriced 
deposit insurance reaches far beyond banks to the functioning of the 
entire economy, as became evident in the aftermath of the S&L crisis 
and the commercial banking difficulties of the 1980's and early 1990's. 
Unfortunately, the very real problem of the cross-subsidy within the 
banking industry caused by mispriced deposit insurance has been masked 
by the debate over whether or not banks, taken as a whole, receive a 
Federal safety net subsidy.
    The FDIC itself has acknowledged the shortcomings of its premium 
rate structure. Earlier this year, it considered charging a higher 
premium rate to as many as 573 banks, almost all of which did not pay 
any premium in 1998. The premium increase would have been levied on 
banks with CAMELS ratings of 3, 4, or 5 for bank management or asset 
quality (Barancik, 1999a) However, in response to a strong negative 
reaction to this proposal, the FDIC quickly announced that it was 
backing off from its initial proposal, having ``decided to revise and 
delay until next year a plan to make more institutions pay for deposit 
insurance'' (Barancik, 1999b). This retreat by the FDIC does not negate 
the fact that deposit insurance premiums are underpriced for riskier 
banks. The FDIC's problem is that as a government monopoly it cannot 
properly price deposit insurance premiums because prices can be 
properly established only in private, competitive marketplaces where 
both buyers and sellers, or insureds and insurers, have a choice as to 
whom they do business with.
                      excess capital requirements
    Implicitly acknowledging that neither government banking regulation 
nor government pricing of deposit insurance will prevent unwise 
banking, Congress effectively mandated the Basle risk-based capital 
standards with regulations which tie prompt regulatory action, 
discussed above, to various measures of bank capital. Yet like FDIC 
insurance premiums, risk-based capital standards only very crudely 
reflect the actual riskiness of bank assets. This is particularly 
evident for loans to private-sector firms where no distinction in 
capital requirements is made between firms which are AAA-rated and 
those which have a junk bond status. Worse, capital ratios have been 
set high enough to minimize banking failures caused by a combination of 
inept management and regulatory failure,\26\ which means that capital 
ratios are too high for well-managed banks. Undifferentiated capital 
requirements for private-sector credit risks, coupled with the 
inability of regulators to sufficiently differentiate good banking from 
bad in establishing risk-based deposit insurance premiums, are the 
principal reasons why banking has steadily lost market share as a 
channel of financial intermediation. In effect, regulatory 
inefficiencies have created substantial regulatory arbitrage 
opportunities which financial services entrepreneurs, utilizing 
electronic technology, have increasingly capitalized upon, at banking's 
expense.
                   excess regulatory compliance costs
    Because of the regulatory shortcomings cited above and 
congressional distrust of the competency of the banking regulators, as 
FDICIA effectively proclaimed, Congress and the banking regulators have 
geared regulatory compliance burdens to the lowest common denominator 
in banking; that is, the poorly managed banks which are most likely to 
fail. This compliance burden is made worse by the inherent, one-size-
must-fit-all nature of government banking regulation. This burden, 
which imposes higher operating costs on banks as well as regulatory 
straitjackets which impair the managerial flexibility of bank managers, 
further harms banking's competitiveness. All of these costs are borne 
by banks and are in no way subsidized by the Federal Government.
 large non-bank financial firms receive an implicit safety net subsidy
    While banks pay for the entire cost of their Federal safety net, as 
demonstrated above, large non-bank financial firms do not pay for their 
Federal financial safety net, which is the ability to borrow at the 
Fed's discount window in ``unusual and exigent circumstances.'' \27\ 
Although the Fed has not lent in such circumstances for at least fifty 
years, it can lend to a large insurance company or investment banking 
firm facing severe liquidity problems. The importance of this standby 
lending authority for the Fed was evidenced by a little-noticed 
provision in FDICIA (Sec. 473, Emergency Liquidity) which effectively 
broadened the types of collateral which the Fed could accept in lending 
to non-bank firms to include marketable securities. This amendment 
reportedly was sparked by the liquidity problems some securities firms 
faced in the aftermath of the 1987 stock market crash. The report 
accompanying the Senate version of FDICIA made clear that this 
amendment to 12 U.S.C. Sec. 343 was intended to make it easier for the 
Fed to lend to temporarily illiquid investment banking firms.
    Unpublished reports also indicate that there have been times, 
specifically in the mid-1970's and the late 1980's, when insurance 
companies suffering liquidity problems approached the Fed about 
borrowing at the discount window. According to these reports, the Fed 
did not lend to these insurers, but that does not mean the Fed could 
not have lent to them. That insurers occasionally face liquidity crises 
illustrates one of the great weaknesses of the state guaranty funds for 
insurers--the lack of an equivalent to the Fed's discount window.
    Another close call for the Fed may have been Long Term Capital 
Management (LTCM). Although the New York Fed did lean on LTCM's 
principal creditors to provide additional liquidity to LTCM during its 
late-summer crisis last year, had that liquidity not been forthcoming, 
the Fed might have been forced to lend directly to LTCM in order to 
prevent a liquidity freeze-up in the global capital markets.
    While the Fed theoretically would demand sufficient collateral when 
lending to a non-bank to protect itself against any loss, there is the 
danger that the Fed could not obtain enough collateral fast enough if 
the market value of the pledged securities was falling rapidly, as 
occurred during the 1987 stock market crash and again last summer 
following Russia's domestic debt default and LTCM's subsequent 
problems. This collateralization problem is compounded by the fact that 
most marketable securities of investment banking firms already have 
been pledged as collateral for the loans financing the purchase of 
those securities. In such a case, the Fed can only obtain a junior, and 
very thin, lien on such securities. Consequently, the Fed's risk of 
loss on discount window lending to non-bank firms may be much greater 
than it is on loans to banks which have substantial unobligated assets. 
Far worse in the case of non-bank firms, the Fed does not have an FDIC 
to look to for a bailout. As the Continental Illinois caper discussed 
on page 5 so clearly illustrates, the Fed can hide behind the FDIC when 
lending to a troubled bank. Sec. 142 of FDICIA further exaggerated this 
difference by limiting the length of time the Fed can lend to a 
troubled bank; \28\ no comparable limit applies to non-bank discount 
window loans.
    Non-bank financial firms which have legal access to the Fed's 
discount window do not have to pay a commitment fee in advance for that 
right of access nor has Congress established an after-the-fact 
mechanism, comparable to the FDIC's unlimited assessment powers, to 
assess surviving non-bank financial firms for any losses the Fed might 
incur in lending to non-bank firms. The absence of a commitment fee and 
assessment power effectively has gifted non-bank financial firms with a 
valuable Federal financial safety net subsidy that has been denied to 
banks through their forced participation in an unsubsidized Federal 
deposit insurance scheme. Arguably, a public good--systemic stability--
flows from non-bank access to the discount window. However, that good 
does not warrant this subsidy any more than the public good of Federal 
deposit insurance would warrant a taxpayer subsidy for banks.
   if there were a bank safety net subsidy, the operating subsidiary 
     structure would be preferable to the holding company structure
    As should be clear by this point, banks do not receive a Federal 
safety net subsidy financed by taxpayers. Consequently, it should be a 
moot question as to whether the ``op-sub'' or the ``holding company'' 
structure of a banking organization can better contain a safety net 
subsidy. Unfortunately, this is not a moot question because of the 
amazing success Mr. Greenspan has had in promoting the fiction that 
banks receive a safety net subsidy. Therefore, the balance of this 
paper will examine the containment issue.
        organizational differences underlying the op-sub debate
    The op-sub organizational structure is one in which a banking 
company conducts what have traditionally been viewed as non-bank 
activities in an operating subsidiary of the bank; hence, the term op-
sub. Notable among these non-bank activities are securities and 
insurance underwriting and brokerage. An op-sub, because it is owned 
by, and therefore is capitalized by, its parent bank, is subject to the 
regulatory oversight of the bank's regulator. In effect, the op-sub's 
equity capital, and therefore its capacity to absorb losses, flows from 
the bank's owner or owners through the bank to the op-sub.
    Under rules proposed by the OCC, for the purpose of measuring a 
national bank's compliance with its regulatory capital requirements, a 
bank's equity capital investment in an op-sub must be fully deducted 
from the bank's capital. This deduction will eliminate any double-
counting of capital and therefore any ``double-leveraging'' whereby 
debt of the parent is counted as equity capital in a subsidiary. Some 
degree of double-leveraging is still evident in capital arrangements 
between bank holding companies and their subsidiary banks, but not to 
the extent it once was. Still, the OCC's proposed rule represents a 
more conservative approach to op-sub capitalization than now governs 
the capitalization of banks by Fed-regulated bank holding companies.
    In the holding company structure, non-traditional activities, 
specifically securities and insurance underwriting, are conducted in a 
direct subsidiary of the bank holding company. Therefore, such a 
subsidiary is a side-by-side, non-bank affiliate of the bank. That is, 
the bank and its non-bank affiliate have a common parent, which is 
regulated by the Fed as a bank holding company. The capital invested in 
the non-bank affiliate comes from the holding company, possibly with 
some degree of double-leverage. This structural alternative is referred 
to as the non-bank affiliate structure.
    In addition to its equity capital investment, a bank can engage in 
other types of financial transactions with an op-sub, specifically 
lending to it or buying assets from it. Likewise, a bank can engage in 
similar transactions with a non-bank affiliate. In the latter case, 
Sec. 23A and 23B of the Federal Reserve Act limit the financial 
dealings between a bank and its non-bank affiliates; the OCC has 
proposed to apply the same restrictions to dealings between a bank and 
its op-subs. Therefore, the op-sub debate focuses on equity capital 
issues and not on debt or other types of financial transactions.
                greenspan's safety net subsidy assertion
    Mr. Greenspan, with almost no support outside of the Fed, asserts 
that banks receive a safety net subsidy which banking companies can use 
to greater competitive advantage in the op-sub structure than in an 
affiliate structure. The fact that the OCC becomes the key banking 
regulator of a banking company opting for the op-sub structure while 
the Fed is the key banking regulator of a banking company electing the 
affiliate structure has no bearing, of course, on Mr. Greenspan's 
position in this debate.
    There are two sequential pieces to Mr. Greenspan's safety net 
subsidy assertion. First, he contends that banks generate ``subsidized 
equity capital.'' Apparently, based on a conversation the author had 
with a Fed economist familiar with Mr. Greenspan's thinking on this 
subject, subsidized equity capital represents the above-market rate of 
return banks earn on their equity capital by virtue of their safety-net 
access. There apparently are two sources for this additional rate of 
return.
    The first source is that banks can lower their weighted average 
cost-of-funds by operating on a more highly leveraged basis than non-
banks. This favorable cost-of-funds differential generates the 
additional return on equity that banks supposedly earn. It is true that 
banks can operate on a more highly leveraged basis than non-banks, but 
that advantage does not constitute a taxpayer subsidy. Instead, as was 
explained above, it represents the insurance value of any form of 
insurance. As noted above, if non-banks want to capture the risk-
spreading benefit of insurance, they should create private insurance 
vehicles comparable to Federal deposit insurance. As the author has 
explained in numerous fora, the cross-guarantee concept can be utilized 
to privatize bank deposit insurance and can be broadened to insure the 
liabilities of non-bank firms.\29\
    The second source of above-market returns that banks supposedly 
earn stems from the Federal Government's guarantee of the FDIC's 
insurance obligation. Because of this guarantee, Mr. Greenspan 
contends, interest rates on bank deposits do not reflect a sufficient 
FDIC insolvency risk premium; that is, depositors would demand higher 
interest rates if the FDIC's insurance obligations were not federally 
guaranteed. Presumably this absence of an FDIC risk premium extends to 
the non-deposit liabilities of TBTF banks implicitly protected under 
the FDICIA systemic risk exception discussed above. However, there is 
no need for such a risk premium because the congressional reforms 
discussed above, starting on page 6, have essentially eliminated the 
FDIC insolvency risk.
    The author readily agrees that deposit insurance is mispriced on a 
bank-by-bank basis, and grievously so in some cases, but the FDIC's 
unlimited assessment powers, which underpin the substantial cross-
subsidy in deposit insurance pricing discussed above, readily trump the 
effect of the bank-by-bank mispricing of Federal deposit insurance. 
That is, while some banks may benefit competitively for a time by being 
undercharged for their deposit insurance, eventually their sins will 
sink them, as we saw most recently in the BestBank failure.\30\ Over 
time, though, the competitive damage of mispriced deposit insurance 
falls most heavily on the stronger banks which are hurt by the 
overpriced deposit insurance premiums they pay, excessive capital 
requirements, and the regulatory burdens discussed above. Hence, while 
mispriced deposit insurance and banking regulation adversely distort 
the financial marketplace, the net effect of these distortions is far 
more detrimental than helpful to well-managed banks.
    The second sequential piece of the Greenspan assertion is that 
having once captured extraordinary profits, thereby creating subsidized 
equity capital, banks can then more easily downstream that subsidized 
capital into op-subs than it can funnel that capital up to the bank's 
parent holding company, which would then invest that capital in non-
bank affiliates. However, that argument simply does not wash because it 
is just as easy, given the tax neutrality of moving earnings around 
within a banking company, for the management of the banking company to 
invest bank earnings downstream into an op-sub as it is to dividend 
bank earnings up to the holding company for reinvestment in a non-bank 
affiliate. This equality will be strengthened by the OCC's proposed 
rule to require that all capital a national bank invests in an op-sub 
be deducted from the bank's capital for regulatory purposes.\31\
             other arguments favoring the op-sub structure
    Other arguments favor the op-sub structure over the non-bank 
affiliate structure, including the inherently greater operating 
efficiency of op-subs. Also, op-subs will strengthen banks, if the 100 
percent capital deduction rule is in place, while non-bank affiliates 
could harm affiliated banks, particularly if the corporate veil between 
a bank and a non-bank affiliate can be pierced if the affiliate becomes 
insolvent. These arguments lie beyond the scope of this paper. However, 
an article by Longstreth and Mattei (1997) does an excellent job of 
demonstrating the legal superiority of the op-sub structure.
                               conclusion
    The contention that banks receive, and therefore benefit 
competitively, from a Federal safety net subsidy, is simply false. 
There is no subsidy because banks are subject to FDIC assessments which 
will pay for the full cost of the banking industry's safety net even in 
circumstances far worse than the S&L crisis. Further, various reforms 
enacted by Congress over the last decade have so dramatically reduced 
the potential for such a crisis that the reoccurrence of a crisis of 
that magnitude would represent unconscionable regulatory failure, 
partly by the very agency which argues that banks enjoy a Federal 
safety net subsidy.
                               references
Barancik, Scott. (1999a) ``FDIC Staff is Developing A System to Make 
            Some
Well-Capitalized Banks Pay.'' American Banker, January 4, p. 2.
----. (1999b) ``FDIC Puts Off Charging Riskier Banks More.'' American 
            Banker, February 16, p. 4.
Board of Governors of the Federal Reserve System. (1997) 84th Annual 
            Report.
Committee on Banking and Financial Services. (1997) U.S. House of 
            Representatives, Subcommittee on Domestic and International 
            Monetary Policy, Federal Payment System, Hearing, 105th 
            Congress, First Session, Serial No. 105-31, September 16, 
            Washington, D.C.
Continental Illinois Corporation. (1984) Annual Report.
Ely, Bert. (1997a) ``Let the Market Set Interest Rates.'' The Wall 
            Street Journal, May 20.
----. (1997b) ``Greenspan's Deposit Insurance Subsidy Argument is 
            Nonsense.'' American Banker, June 6.
----. (1997c) ``Regulatory Moral Hazard: The Real Moral Hazard in 
            Federal Deposit Insurance.'' A paper presented on November 
            22, 1997, at the annual meeting of the Southern Finance 
            Association. Forthcoming in The Independent Review: A 
            Journal of Political Economy.
---- and Vicki Vanderhoff. (1991) ``Lessons Learned from the S&L 
            Debacle: The Price of Failed Public Policy.'' The Institute 
            for Policy Innovation, Lewisville, Texas.
Federal Deposit Insurance Corporation. (1980) Annual Report.
----. (1983) Annual Report.
----. (1997) Annual Report.
----. (1998a) FDIC Quarterly Banking Profile. Fourth Quarter 1998.
----. (1998b) FDIC Quarterly Banking Profile Graph Book. Fourth Quarter 
            1998.
----. (1999) ``Material Loss Review: The Failure of Best Bank, Boulder, 
            Colorado.'' Audit report No. 99-005, January 22.
Greenspan, Alan. (1999) Testimony before the Subcommittee on Finance 
            and Hazardous Materials, Committee on Commerce, U.S. House 
            of Representatives, April 28.
Kwast, Myron L. and S. Wayne Passmore. (1997) ``The Subsidy Provided by 
            the Federal Safety Net: Theory, Measurement and 
            Containment.'' Board of Governors of the Federal Reserve 
            System, September, Mimeograph.
Longstreth, Bevis and Ivan Mattei. (1997) Columbia Law Review 36 (4) 
            October, pg. 1895.
Petri, Tom, and Bert Ely. (1995) ``Better Banking for America: The 100 
            Percent
Cross-Guarantee Solution.'' Common Sense, Fall 1995.
                                endnotes
    1. Author's calculation.
    2. These costs, which totaled $1.692 billion, break down by agency 
as follows: Federal Reserve System--$517 million; Federal Deposit 
Insurance Corporation (including administrative costs of the deposit 
insurance funds)--$677 million; Office of the Comptroller of the 
Currency--$350 million; Office of Thrift Supervision--$148 million.
    3. Reserves on deposit at the Fed in 1997 (excluding compensating 
balances for services provided by the Fed) averaged $10.792 billion 
(calculated from the monthly Federal Reserve Bulletin, Table A6). The 
average yield on the Fed's securities portfolio in 1997 was estimated 
to be 6.05 percent (calculated from Board of Governors of the Federal 
Reserve System (1997), Statistical Tables 6 and 14). $10.792 billion x 
.0605 = $653 million.
    4. Calculated from data published in the monthly Federal Reserve 
Bulletin, various issues, Table 1.12, ``Reserves and Borrowings.''
    5. Codified as 12 CFR 201.
    6. It is not necessary for the Fed to include a cost-of-funds 
element in its intraday interest rate since it pays no interest to 
banks which accumulate positive intraday account balances at the Fed.
    7. Board of Governors of the Federal Reserve System (1997), Pg. 
288, Table 6, footnote 1.
    8. Ibid., p. 264, footnote 2 to the financial statements for priced 
services provided by Federal Reserve banks.
    9. The pension cost credit is describe more fully in a report by 
the author, titled ``An Analysis of the Fed's Priced Services 
Activities,'' appended to testimony by Mr. Eric Roy, on behalf of the 
Association of Bank Couriers (Committee on Banking and Financial 
Services, 1997, pp. 249-250). This report also discusses other ways in 
which the Fed effectively utilizes taxpayer funds to subsidize the 
services which it provides to banks.
    10. This estimate was obtained in a March 31, 1999, telephone call 
to the Division of Finance at the Federal Deposit Insurance 
Corporation.
    11. Federal Deposit Insurance Corporation (1997), Table on 
Recoveries and Losses for All Cases, p. 104.
    12. Ibid., Table of Income and Expenses, p. 105.
    13. Federal Deposit Insurance Corporation (1980), p. 299, Table 
127, Footnote 3.
    14. Prompt Regulatory Action constitutes Subtitle D of Title I of 
FDICIA (Sec. 131-133) while Least-Cost Resolution follows in Subtitle E 
(Sec. 141-143).
    15. Depositor preference was enacted as Sec. 3001 of Public Law 
103-66 and is codified as 12 U.S.C. ?1821(d)(11).
    16. This line of credit is authorized by 12 U.S.C. Sec. 1824(a). In 
addition, Sec. 1824(b) authorizes the FDIC to borrow from the Treasury 
Department's Federal Financing Bank.
    Sec. 1824(c) governs the repayment schedule for any such 
borrowings. Presumably, the interest rate on these borrowings will not 
be less than Treasury's borrowing rate given that, in setting the 
interest rate on Treasury loans to the FDIC, the Secretary of the 
Treasury will take ``into consideration current market yields on 
outstanding marketable obligations of the United States of comparable 
maturity.'' This provision in Sec. 1824(a) should bar any taxpayer 
subsidy to banks through this borrowing channel. Given the capital 
strength of the banking industry today, this line of credit could 
safely be canceled.
    17. One exception: the Securities Investor Protection Corporation 
(SIPC), which is a creature of the Federal Government. It protects the 
cash and securities account balances of customers of insolvent broker/
dealers against fraud, up to statutorily specified limits.
    18. Although there were 10,461 FDIC-insured banks at the end of 
1998 (Federal Deposit Insurance Corporation, 1998b, p. 63), the cross-
guarantee provision of FIRREA discussed on page 6 effectively 
consolidates the banking industry into a smaller number of institutions 
for deposit insurance purposes.
    19. Calculated from call reports filed with the FDIC by 
BankAmerica's ten subsidiary depository institutions.
    20. The FDIC is ``on-budget'' for this reason: for the purpose of 
calculating the Federal Government's revenues, spending, and therefore 
its annual surplus or deficit, the FDIC's revenues from outside the 
government, such as the premiums it collects, count as Federal revenues 
while its cash outlays count as Federal spending. It is this inclusion 
of the FDIC's revenues and spending in the government's financial 
statements which makes the FDIC an on-budget Federal agency. The 
interest the FDIC earns on its portfolio of Treasury securities does 
not count as Federal revenue because it is merely a bookkeeping 
transfer within the Federal Government, from the Treasury to the FDIC.
    21. BIF and SAIF combined net income of $1.918 billion ($1.438 
billion for BIF plus $480 million for the SAIF) for 1997 minus a non-
cash reversal of prior years' loss provisions of $506 million equals 
$1.412 billion.
    22. Total insured deposits of BIF and SAIF equaled $2.85 trillion 
at the end of 1998 (Federal Deposit Insurance Corporation, 1998a, p. 
17). 1.25 percent of that amount equals $35.63 billion.
    23. According to several observers on the scene at the time, in 
1978, when interest rates were rising, the Fed proposed to pay interest 
on required reserves so as to arrest a decline in Fed membership as 
state-chartered banks dropped their Fed membership. Because the Federal 
Reserve Act does not specifically bar the Fed from paying interest on 
reserves, the Fed opined that it could pay that interest. However, 
members of the House and Senate Banking Committees strongly opposed 
this proposal, partly because payment of interest on reserves would 
have added substantially to the Federal budget deficit. The banking 
committees reportedly backed up their position with a legal opinion 
from the Congressional Research Service of the Library of Congress 
stating that the Fed did not have statutory authority to pay interest 
on reserves; the author has not yet located that document. Faced with 
this extremely negative congressional reaction, the Fed backed off from 
its proposal. Congress later solved the Fed's membership problem by 
mandating, in the Monetary Control Act of 1980, that all depository 
institutions maintain reserves at the Fed regardless of whether they 
belong to the Fed. Congress's views in 1978 were set forth in a June 5 
letter to then Fed Chairman G. William Miller from Henry S. Reuss, then 
chairman of the House Banking Committee, and William Proxmire, then 
Chairman of the Senate Banking Committee, and in a June 28 letter from 
Reuss to Miller.
    24. For the first semiannual assessment period in 1999, 95.0 
percent of all BIF-insured institutions will not pay an insurance 
premium while that will be the case for 93.4 percent of all SAIF-
insured institutions. Just eleven FDIC-insured institutions will pay 
the highest premium rate of 27 basis points (Federal Deposit Insurance 
Corporation, 1998a, p. 19).
    25. FDIC-insured deposits equaled 74.7 percent of total domestic 
deposits at the end of 1998 ($2.85 trillion/$3.814 trillion), as 
calculated from Federal Deposit Insurance Corporation (1998a), pp. 4, 
16, and 17. The FDIC earned approximately a 6 percent yield on its 
Treasury securities in 1997 (1998 data is not yet available), as 
calculated from Federal Deposit Insurance Corporation (1997), pp. 47, 
48, 63, and 64. Assuming a minimum reserve ratio of 1.25 percent: .0125 
x .06 x .747 = 5.6 basis points.
    26. The shortcomings of government banking regulation are the real 
moral hazard in Federal deposit insurance (Ely, 1997c).
    27. 12 U.S.C. Sec. 343, second paragraph. Unlike banks, which can 
borrow at the discount window of a Federal Reserve bank without prior 
approval by the Board of Governors of the Federal Reserve System, loans 
to non-bank firms require an affirmative vote of five members of the 
Board of Governors.
    28. 12 U.S.C. 347b(b)(1), as amended by Sec. 142 of FDICIA, 
provides that ``[e]xcept as provided in paragraph (2), no advances to 
any undercapitalized depository institution by any Federal Reserve bank 
under this section may be outstanding for more than 60 days in any 120-
day period.''
    29. See for example, Petri and Ely (1995). Other articles and 
papers on the cross-guarantee concept are posted on the Ely & Company 
website at http://www.ely-co.com.
    30. On July 23, 1998, the BestBank of Boulder, Colorado, failed 
with total assets of $314 million. The FDIC's estimated loss in 
BestBank, as of the end of 1998, was $171.6 million, or 55 percent of 
assets; that loss percentage may go higher. As spelled out in a 74-page 
report issued by the FDIC's Inspector General (Federal Deposit 
Insurance Corporation, 1999), BestBank represents an extremely serious 
regulatory failure by the FDIC.
    31. An amendment to H.R. 10, as reported by the House Banking 
Committee on March 11, 1999, would require that this capital deduction 
include all retained earnings in the op-sub.

    Chairman Sununu. Thank you very much to each of our 
witnesses.
    Let me begin with Ms. Miles.
    Could you please talk in slightly more specific terms about 
the trends in the size of the portfolios held by the GSEs, both 
whole loans and their own mortgage-backed securities?
    In relative terms, what has been the size of the increase 
over the past decade? Is it a new trend or are the portfolios 
they hold essentially the same size as they have held 
historically?
    Your comments.
    Ms. Miles. You have two separate trends going on. 
Historically, until about the middle 1980's, Fannie Mae was a 
portfolio holder and they did not start issuing mortgage-backed 
securities until about 1980 and they were not a significant 
size until a few years after that.
    Freddie Mac, by contrast, started life as a mortgage-backed 
securities issuer and held very small portfolios. That started 
changing.
    Chairman Sununu. Started changing when?
    Ms. Miles. Again in the 1980's and significantly in the 
1990's. At this point, I am going to have to check my memory 
here. I know Tom has some numbers in front of him. I believe 
that Freddie Mac is up to about--not quite one-third of its 
assets in the form of its portfolio or repurchased mortgage-
backed securities and about two-thirds in mortgage-backed 
securities.
    Chairman Sununu. Mr. McCool, did you want to offer some 
specifics?
    Mr. McCool. That is about what we have. For Freddie Mac, it 
is about one-third in portfolio and two-thirds as MBS 
outstanding and for Fannie Mae it is about 43 percent in 
portfolio.
    Chairman Sununu. Let's stay focused on their portfolios, 
when you say 43 percent in portfolio.
    Mr. McCool. That means that they hold either as whole 
mortgages or as repurchased mortgage-backed securities about 43 
percent of the total outstanding obligations are in their 
portfolio rather than as outstanding mortgage-backed securities 
that somebody else holds.
    Chairman Sununu. And for Fannie Mae in particular, that 
amount would be approximately $550 billion currently? Is that 
right?
    Mr. McCool. Well, 522 at the end of 1999.
    Chairman Sununu. You mentioned both whole loans and 
mortgage-backed securities. What are the differences in risks 
that the holder of those securities are exposed to? In other 
words, from the standpoint of systematic risk, interest rate 
risk, prepayment risk, is there any difference in whether or 
not the GSEs or any other financial institution chooses to hold 
whole loans versus mortgage-backed securities?
    Ms. Miles. Would choose to hold them?
    Chairman Sununu. Yes.
    Ms. Miles. If you are holding them, you have all the risks. 
The advantage of mortgage-backed securities, when you sell 
them, you are selling mortgages off your books. You are 
retaining the credit risk, but you are pushing off onto someone 
else the interest rate risk.
    One of the reasons they are less profitable than holding 
whole loans is that in the process of giving someone else the 
interest rate risk you also have to give them the profitability 
that attaches to that. But when you buy them back on your 
books, you are essentially repatriating all that risk.
    Chairman Sununu. My question is: For the purposes of us 
assessing a change in the risk profile, should it matter to us 
whether Fannie Mae, say, previously held $100 billion in whole 
loans and today holds $100 billion in mortgage-backed 
securities? They are still taking the credit risk on both and 
because they choose to hold them, they are holding interest 
rate risk and prepayment risk, correct?
    Mr. McCool. Interest rate and prepayment risk. Right.
    Mr. Ely. Mr. Chairman, if I could add to that, there is 
cause for concern because when they do take back the interest 
rate risk, particularly if they buy back mortgage-backed 
securities that they or someone else has previously issued, 
they take back the interest rate risk and they bring back the 
prepayment risk. This gets to what is, I think, of concern with 
regard to their balance sheets. That is, they become like the 
traditional S&L of the 1960's and 1970's, that is, they 
significantly maturity mismatch on their balance sheet in terms 
of how they fund themselves.
    Now, they hedge a lot of that risk by buying interest rate 
swaps and other forms----
    Chairman Sununu. If you could hold up there, believe me, I 
will get to hedging, but for the purposes of laying out 
information, I want to proceed with a little bit of order, 
whether it is order in my own mind only.
    Mr. McCool, you talked a little bit about new product 
issuance and about HUD's proposed regulations regarding new 
products to make housing more available to lower income people.
    Question one is how do new products that might be offered 
by the GSEs affect their risk profile and their credit risk 
profile in particular. And maybe comment regarding the 3 
percent down payment product which is just one new product that 
has been in the news and been marketed pretty heavily.
    Mr. McCool. The effect on the risk profile would obviously 
depend on the product, but in cases where, you know, you are 
moving toward lower down payment products, then it would tend 
to increase the credit risk, to the extent it is not hedged.
    Chairman Sununu. You also discussed investment in, I guess, 
non-mission-related vehicles, cash value life insurance and 
other investments. Why has there been a delay in issuing 
regulations regarding those investments?
    Mr. McCool. Well, you would have to ask HUD that. We have 
been sort of--we have recommended that HUD issue regulations to 
establish criteria, as I said, in our 1998 report and they did 
put out an advance notice and they did get some comment back 
but they have not actually gone forward with the regulations to 
set forth criteria.
    Chairman Sununu. Is it your contention, as you addressed 
those issues in your testimony, that those investments in non-
mission-related securities increases the risk profile of the 
GSEs?
    Mr. McCool. Well, actually, some of them might be quite 
safe and sound, let's put it that way. For example, some of the 
non-mortgage investments that Freddie Mac purchased were 
actually from a safety and soundness perspective probably 
pretty good, but they had nothing much to do with what Freddie 
Mac was in business from the GSE perspective.
    So that is part of the issue, are they mission-related in 
the sense that the GSEs were given privileges to achieve a 
mission and the question is whether they are doing that. So 
they could be safe and sound and not mission-related, they 
could be both risky and non-mission related, I guess. We have 
not seen too many examples of that, but that is also feasible.
    Chairman Sununu. Ms. Miles, Mr. Ely mentioned mismatch, the 
concern that long-term liabilities might be funded with short-
term assets. Have you made any effort to quantify the degree to 
which the portfolios held by the GSEs are well matched and how 
do we as policy makers better understand whether or not there 
is an appropriate level of matching in these portfolios?
    Ms. Miles. I have not attempted to do that recently. We 
have some horrendous examples from the past, including one that 
I gave you in my written testimony about what happened when 
Fannie Mae in the late 1970's and early 1980's was in fact our 
largest savings and loan association. They were not well 
matched at that point.
    They did what every S&L did. They used the relatively short 
end of the yield curve in order to fund mortgages at the longer 
end and according to a study done by HUD in 1986, on a mark-to-
market basis, they were insolvent every single year from 1978 
through 1984 and only came out of trouble in 1985, generally 
because of regulatory forbearance.
    Having said that, I do not think anyone sees anything quite 
like that now and the best people to ask that question are here 
today. I would ask OFHEO and also the Federal Housing Finance 
Board what those matches are.
    Chairman Sununu. Mr. Ely, you raised the case of Long-Term 
Capital Management and I would like to address that a little 
bit, in a little bit more detail.
    You mentioned that their debt was only one-seventh of the 
GSEs'. Does that include their exposure as a result of their 
trading on margin?
    Mr. Ely. Yes, because this was a very highly leveraged 
institution. In effect, it largely financed its asset portfolio 
with, if you will, margin debt. It may not have been called 
that as such, but effectively it was very highly leveraged.
    Chairman Sununu. But they do not actually hold their margin 
exposure on their books as debt, correct?
    Mr. Ely. I have never seen their financial statements. I am 
not sure they have ever been published. But as I understand it, 
they owned assets, a variety of securities, that were financed 
with debt that was on their balance sheet. They also had some 
off balance sheet exposures, too. As I understand it----
    Chairman Sununu. But this is a not insignificant point. 
They had debt obligations to a number of financial institutions 
that eventually came and were willing to roll over their debt 
in order to facilitate the orderly liquidation. And I assume 
that is the debt that you talk about being one-seventh the size 
of the GSE debt.
    Mr. Ely. That is correct.
    Chairman Sununu. It would seem to me that that would not 
include, however, their exposure to margin calls which a margin 
call does not necessarily require the entry of a debt or an 
obligation on your books. So it would seem to me that there is 
at least something of a difference here and there was an 
enormous exposure to margin calls in the case of Long-Term 
Capital Management that I hope, assuming that the non-mission 
related-investments are more or less focused, the GSEs are not 
exposed to. I do not know of any GSE being exposed to a margin 
call, do you?
    Mr. Ely. I am not aware of that.
    Chairman Sununu. Long-Term Capital Management, they also, I 
know, traded quite heavily in currencies and currency futures. 
That is obviously a very volatile market that GSEs are not 
really exposed to. Is that correct?
    Mr. Ely. Except that they do raise funds in foreign 
markets, so whether or not any of that is in foreign 
currencies, I do not know, but they do sell their debt on a 
global basis so that the extent to which we worry about 
systemic risks, we have to think not only in terms of how U.S. 
investors are reacting, but also about foreign owners of their 
debt.
    Chairman Sununu. If they were effective at managing their 
risk exposure, I assume they would just swap out of any 
exposure to foreign currencies, correct?
    Mr. Ely. That is a reasonable assumption.
    Chairman Sununu. In the same way that they would swap out 
of exposure to short-term rates if they wanted to balance their 
portfolio appropriately.
    Mr. Ely. That is correct. But what that does is create 
counterparty risk, which is a form of credit risk. In other 
words, the underlying assumption in any kind of swap or 
derivative arrangement is the counterparty will be able to 
perform if and when called upon to do so. One of the things 
discussed in the report I co-authored on nationalizing mortgage 
risk is that the footnote disclosures by both Fannie and 
Freddie, in my opinion, do not provide enough insight into the 
counterparty risk that they have under all of their swap and 
derivative arrangements.
    Chairman Sununu. What is riskier, holding a whole loan or 
holding a mortgage-backed security? To an individual, for 
example to me. Let's start with that.
    Mr. Ely. It depends on who issues the mortgage-backed 
security. If the mortgage-backed security is issued by one of 
the GSEs, by Fannie or Freddie, then I would argue that that is 
less risky than holding a whole mortgage because of the 
implicit backing of the Federal Government.
    Chairman Sununu. I mean, it says pretty clearly that it is 
not backed, so let's assume that to be the case.
    What about for a financial institution? What is riskier for 
the bank in my hometown, Bedford or Manchester, New Hampshire, 
what would be riskier, holding a whole loan or holding a 
mortgage-backed security?
    Mr. Ely. If you leave aside even the Federal guarantee, 
presumably it is riskier to hold a whole mortgage if the bank 
has a large concentration of mortgages it has originated 
locally because one of the benefits of mortgage-backed 
securities, whether they are issued by a GSE or privately, is 
that they provide geographical risk dispersion.
    Chairman Sununu. Should we be concerned, and should we 
include in these discussions, then, the fact that the whole 
loans held by the bank and thrift industry still dwarf the 
number of mortgage-backed securities held by the bank and 
thrift industry, I think by a factor of two to one or three to 
one?
    Mr. Ely. Well, again, that also is a function of what the 
capital levels are at the banks and thrifts. In other words, 
there may be risk in the form of a geographical concentration, 
but if the bank or thrift holds enough capital, then that can 
offset the risk. That is the tradeoff. And basically, banks and 
thrifts are held to a higher capital standard to reflect the 
fact that they have some degree of concentration of risk.
    Although it is not widely used, there is an instrument, 
known as a credit derivative that represents another tool for 
trying to diversify geographical risk concentrations.
    Chairman Sununu. Thank you.
    Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman.
    Let me go back just for a second to this question of risk. 
It seems to me there are two types of risk related to a 
mortgage, whether it is in the form of a whole loan or 
mortgage-backed securities, and you all have said this, but 
just to clarify, there is credit risk related to the asset 
itself and there is interest rate risk. Both entities, both 
instruments, carry some form of that type of risk.
    But I think we need to also consider the fact it is not--I 
do not think we can just say because Fannie and Freddie have 
the implicit guarantee of the Federal Government, which I 
totally concur with, that we also have to give some credit to 
underwriting standards, whether they be Fannie and Freddie's 
underwriting standards or the bank's underwriting standards or 
whoever's underwriting standards. So I think there are other 
factors that come into play as to what the risk is.
    I also need to say, and I think the chairman was commenting 
on this, I realize we like to use Long-Term Capital Management 
as a comparison. I think that is a red herring.
    And, Bert, you made this clear in your comments in response 
to the chairman, that the types of investments that LTCM was 
in, which I do not have objection with them doing that, are far 
different in most respects with the types of investments that 
the GSEs are in, just as the GSE investments are different in 
many respects to the types of asset investments on the part of 
banks, on the part of mutual funds, et cetera.
    Now, the question is the concentration, which I think is 
where you make a bigger point and the question of is there too 
much concentration in the mortgage market on the part of the 
GSEs with a potential for systemic risk and how that flows back 
to the taxpayer.
    Now, let me ask a couple of questions. One issue that we 
have sort of talked around which I think was sort of the 
initial focus of this hearing and that is what is the risk to 
the taxpayer compounded by the fact that the GSEs in addition 
to issuing corporate debt with which they use the proceeds to 
purchase whole loans and then the corpus of which is pledged 
against that corporate debt, is that risk compounded when the 
GSEs enter the secondary market and purchase back mortgage-
backed securities which they issued?
    And, second of all, how much of that purchase is for the 
purpose of supporting the primary market price of the 
securities itself that they are issuing and how much of it is, 
for lack of a better term, an arbitrage play because their 
ability to--because of both the price of the security in the 
market and the cost of their capital?
    And if it is such a play, how much of that--and I am not 
going to ask you to quantify the difference today, but how much 
of that spread, if you will, enures back to the benefit, if 
any, to the homeowner in terms of lower mortgage costs? Or does 
it all go to the shareholder? Or do you know?
    Mr. Ely. Well, to address a couple of points, in my 
opinion, you do not have to have Fannie and Freddie to maintain 
liquidity in the secondary market. That market is big enough 
that private sector firms, specifically broker dealers, could 
do that job.
    In my opinion, the MBS buyback is to take advantage of 
arbitrage. It is an arbitrage play. Driving it, in my opinion, 
is that Fannie and Freddie have made a commitment to the 
financial markets, Fannie more strongly than Freddie, to grow 
their earnings at 15 percent a year, to double their earnings 
every 5 years.
    The mortgage market is not growing that fast and so they 
have to figure out how to grow their revenues faster than the 
market is growing. A good way to do that is to buy back MBS, to 
get the interest rate spread, which is significantly greater 
for carrying interest rate risk than carrying credit risk.
    Our assessment is that on a net profit basis, depending on 
which GSE you are looking at, they get about four to six times 
as much net profit, per mortgage dollar outstanding, if they 
assume the interest rate risk which they get by buying back the 
MBS. So ultimately their MBS buybacks are driven by the 
earnings growth commitment that they have made to Wall Street.
    Now, in terms of where that benefit goes, that is something 
I have not assessed. It would be a good question to pose to CBO 
in the context of the study that they are doing to update their 
1996 report on Fannie and Freddie. At that time, CBO made an 
estimate as to how much of the overall subsidy that Fannie and 
Freddie have flows through to homeowners and how much of it 
stays with stockholders and management.
    Mr. Bentsen. And I want to hear your comment, but I want to 
follow up with Bert here because we----
    Is the reason, in your opinion, that Fannie and Freddie--
let's say Fannie, is the commitment to the capital markets of 
the 15 percent annual return because the structure of the 
entity is such that the Federal Government wanted to jump start 
the secondary market and ease the ability to gain a mortgage 
and in effect leverage private capital, that the entities have 
to be able to raise private capital at a competitive rate of 
return and the fact that, criticism notwithstanding, the 
ability for the GSEs to expand into non-mortgage investments in 
any marked way, as opposed to a nominal sense, is limited by 
the fact that HUD oversees them and there may be legislation, 
et cetera, has this created sort of a Hobson's choice for us of 
whether we want to have--of the type of entity that we have 
here?
    Is this part of our own creation, that they are forced to 
earn returns where they can in order to meet their mission and 
satisfy those who are putting capital into it?
    Mr. Ely. Well, there are two issues here. First, in terms 
of the rate of return, they clearly are earning above-market 
rates of return on their equity capital. ROEs of 22 and 24 
percent are earned on a steady basis, which are quite handsome 
compared to genuine private sector firms.
    What is the motivation here is that it is the promise of 
such significant growth in earnings, that is 15 percent a year, 
doubling earnings every 5 years, that is key to driving up 
their stock price. That is what motivates Fannie and Freddie--
not so much the striving for high ROE as it is the earnings 
growth rate.
    And, again, the problem they face, and maybe it is their 
Hobson's choice, is that they have made a commitment to the 
financial markets to grow their earnings faster per year than 
the mortgage market as a whole is growing, which means they 
have to assume a larger and larger market share, if you will, 
of the total interest spread that exists in the mortgage 
market.
    This is increasingly a dilemma for them. My sense is that 
the stock market is increasingly skeptical of their ability to 
maintain that earnings growth rate, which is again separate 
from the ROE question.
    Mr. Bentsen. But without sufficient capital, they are 
unable to purchase more mortgages in the secondary market at a 
rate competitive enough to meet the missions that Congress set 
out when they were created in the 1930's and in the 1960's. Is 
that correct?
    Mr. Ely. Well, that is true, except that a lack of capital 
has not been a problem for them. At times, Fannie particularly 
has been buying back stock. Given what their stock prices have 
been, at least until very recently, they would certainly have 
no problem in issuing additional capital stock. So I do not 
think----
    Mr. Bentsen. So it is not that stock buyback--it is not 
necessarily a bad thing. I mean, we would expect in a 
corporation that has sufficient capital that it ought to 
support a stock price at a relatively good price through a 
buyback. I mean, that would be something--that would be 
considered a good corporate practice in most cases, right?
    Mr. Ely. That is true, but a stock buyback suggests that a 
corporation has more capital than it needs rather than being 
short of capital, so I do not think that Fannie and Freddie 
have suffered from a lack of capital.
    Mr. Bentsen. Do you all have any comment?
    Ms. Miles or Mr. McCool?
    Mr. McCool. Well, I think just getting to your question, I 
think it is fairly clear that holding mortgages in a portfolio, 
whether it be MBS or whole loans, is both more profitable and 
riskier than issuing MBS. I think that is true. What is done 
with the profits is something that is very difficult to know.
    I think that the question about a Hobson's choice, in our 
work on mission regulation, we talk about it as the tension 
between increasing shareholder value and fulfilling the mission 
and I think it is fairly clear that that tension exists. That 
is why mission regulation is so important.
    Ms. Miles. I think as far as the repurchase of mortgage-
backed securities goes, it is difficult for me to understand 
what that is supposed to do for housing markets because if you 
believe that capital markets are well integrated, then what you 
are talking about is a GSE taking one form of its means of 
financing mortgages and simply substituting it for another form 
of financing mortgages. In other words, issuing general GSE 
debt in order to buy back mortgage-backed securities, which are 
the other way of financing them, and you should end up with a 
wash.
    Mr. Bentsen. Thank you, Mr. Chairman.
    Chairman Sununu. Thank you.
    One brief point to clarify. A wash in terms of both 
interest cost and liquidity?
    Ms. Miles. In terms of what it is that the GSE has actually 
done. I mean, if you finance the mortgages by buying them 
through GSE debt or if you finance them through selling 
mortgage-backed securities, those are both means of financing 
mortgages. And if you simply substitute one for the other while 
you change who is holding the risk, you still have the same 
amount of mortgage money sitting out there in the market.
    Mr. Bentsen. Mr. Chairman, if you will yield, that is true 
except for the ability, I think, to buy--if you are able to go 
back into the market and buy the MBS at a discount, at a deeper 
discount than the issuance price, the question is what do you 
do with the spread on the discount.
    We know that MBSs fluctuate in price based upon interest 
rate changes which are obviously beyond the control of Fannie 
and Freddie, or I think they are, and the guy who is doing that 
is testifying over at the banking committee now, they are over 
there.
    And the question comes back to, again, is taking advantage 
of that spread doing one of two things: is it supporting the 
initial issuance price of the future MBS or the current MBS and 
that may or may not be the case, although issuers do do that 
from time to time, support their product in the secondary 
market, both private and Fannie and Freddie, but the other is 
what are you doing with the spread and is the spread somehow 
affecting the price of the future issuance and thus the price 
of the mortgage to the consumer, which is the original mission.
    Ms. Miles. Again, that depends on what you believe about 
the substitutability of these instruments.
    Chairman Sununu. Thank you.
    Mr. Hoekstra.
    Mr. Hoekstra. I thank the chairman. I thank you for doing 
this hearing.
    Ms. Miles, I would just like to go to some testimony on 
page 3 of your testimony and I want to get an elaboration or 
expansion of your comments at the bottom of the page where it 
talks about market power.
    ``By most accounts,'' and I am quoting, ``By most accounts, 
the problems that gave rise to creation of the housing GSEs 
have been corrected. Correction is generally measured in terms 
of the degree.''
    So are you saying that the circumstances and conditions 
that gave rise to GSEs in this area are no longer out there, 
that the need no longer exists?
    Ms. Miles. The academic studies that have been done on this 
would say yes, that is correct. The argument then becomes one 
of does the market failure reappear if you remove GSE status 
from the market and that is where most of the argument would be 
today.
    Mr. Hoekstra. OK.
    Mr. Ely. If I could add something to that?
    Mr. Hoekstra. Yes.
    Mr. Ely. We have a substantial amount of asset 
securitization in this country that has nothing to do with the 
GSEs, in the jumbo mortgage market, credit cards, and auto 
loans. The markets have learned how to securitize assets. If 
Fannie and Freddie went away, the markets would still be able 
to securitize mortgages.
    Mr. Hoekstra. Thank you.
    Ms. Miles. And if I could pick up on one thing there. I do 
not know of anyone who is actually advocating that Fannie and 
Freddie go away. I have heard a lot of advocacy that they 
simply graduate out of their GSE status, which is a different 
question.
    Mr. Hoekstra. Right. And they graduate out of GSEs to move 
them away from the benefits that I think all three of you 
talked about in your testimony that they receive as being 
identified as a GSE.
    And I would also assume if we moved them away from a GSE we 
would also perhaps move away some of the risk that is 
associated with the taxpayer. Would that be safe to say?
    Mr. Ely. Yes.
    Mr. Hoekstra. OK. Because I think where I then start 
getting some concerns, I think, again, Ms. Miles, on page 5 of 
your testimony, you talk about them repurchasing their 
mortgage-backed securities and it is toward the bottom of the 
page.
    ``While it is clear that this increases shareholder value, 
it is difficult to understand what, if anything, it does for 
mortgage markets.''
    So this really--what I see at least I think all three of 
you talking about in your testimony, you are seeing behavior 
out of these GSEs that is not associated with their primary 
mission, but is associated with their mission to their 
shareholders of meeting the commitments that they have made to 
their financial markets.
    Is that what you are saying here on page 5?
    Ms. Miles. That is correct. And one of the things to bear 
in mind is when we set up GSEs, I tried to make clear right up 
front, we set up something that has an inherent contradiction 
in it. Because while it has a public purpose and those charters 
are intended to be tools to take care of that public purpose, 
we also set them up as private enterprises with a fiduciary, a 
legal responsibility to their shareholders. There is a tension 
there.
    Mr. Hoekstra. That is right.
    And then, Mr. McCool, in your testimony on page 6, you are 
using the same type of examples. ``We pointed out that the 
enterprises have incentives to use the funding advantage 
associated with their government sponsorship to make non-
mortgage investments, such as corporate bond purchases, that 
may result in arbitrage profits.''
    Again, you conclude, ``However, our report concluded that 
the relationship between long-term non-mortgage investments and 
the enterprise housing mission is not entirely clear.''
    So you are saying the same thing, that there is not--
activity that the GSEs are engaged in may or may not be 
directly related to their primary mission.
    Mr. McCool. There are cases where that is very true. There 
are cases where non-mortgage investments are necessary to 
maintain liquidity and there are other cases, we suggest, where 
that relationship is not clear.
    Mr. Hoekstra. And then at the bottom of page 6, you go on 
to talk about, ``For example, in our March 1998 report, we 
pointed out that HUD approved a new mortgage program Fannie Mae 
that would involve Fannie Mae in purchasing cash value life 
insurance, which is essentially a non-mortgage investment. HUD 
officials told us that they lacked expertise in cash value life 
insurance when they approved the Fannie Mae program.''
    We are seeing these organizations move into an area where 
it may be higher risk to the taxpayer, it gets to be even 
higher risk if the people that have oversight over them do not 
understand the activities that they are engaging in. Is that 
what you are saying in this section?
    Mr. McCool. Well, part of the issue there was we thought it 
would have been prudent for HUD to talk to, in this case, 
Treasury, who actually does understand cash value life 
insurance and, in particular, the tax treatment thereof, which 
was one of the issues. But in this case, that discussion did 
not occur.
    Mr. Hoekstra. Well, what you are saying is that for an 
organization whose debt approaches that of Treasury and in some 
form is overseen by HUD, HUD is approving activities and 
actions that it does not understand.
    Mr. McCool. In this particular case, I think that was true.
    Mr. Hoekstra. Mr. Chairman, I have no more questions. Thank 
you.
    Chairman Sununu. Thank you, Mr. Hoekstra.
    Mrs. Clayton.
    Mrs. Clayton. Thank you, Mr. Chairman. I also think this is 
a significant hearing. I would also ask if my opening statement 
may be a part of the record.
    Chairman Sununu. Without objection.
    [The prepared statement of Eva M. Clayton follows:]

Prepared Statement of Hon. Eva M. Clayton, a Representative in Congress 
                    From the State of North Carolina

    Chairman Sununu, this is the latest in a series of hearings and 
other activity that have focused on this important subject.
    On July 18, our colleague, Congressman Peter Hoekstra, issued a 
``Dear Colleague'' calling for ``A Healthy Debate on the Future of 
GSEs.''
    That call came on the heels of five hearings on GSEs that have been 
conducted in Congress, this session.
    Those hearings centered around a Bill, H.R. 3703, that has been 
introduced by our colleague, Congressman Richard Baker.
    Despite those hearings, it appears that we are still searching for 
the right thing to do in this situation--There is no emerging 
consensus.
    I believe it is important and useful that Congress exercise its 
oversight authority, especially on a matter--housing--that affects all 
of our citizens.
    Home ownership rates in the United States have reached historic 
levels.
    One of the questions I hope this hearing will help answer is 
whether the role of the GSEs has substantially and significantly 
contributed to this desirable rise in home ownership?
    And, if so, will the call for reform help or hurt this role?
    No one likes debt.
    But, another question I hope this hearing will answer is whether 
the debt of GSEs is something about which we should be concerned to the 
point of panic.
    It is fair to say that, while comparison of GSE debt to Treasury 
debt is of some use, the comparison is not exact.
    They are not the same.
    Still another question I hope this hearing will help to answer is 
whether the GSEs, by their activities, are exposing our Government to 
unreasonable and unacceptable risk?
    Not all risk is unreasonable and unacceptable.
    A related question is whether the GSEs, through their debt, are 
adding to or contributing to the debt of the United States.
    We have worked hard to eliminate the national debt, and we are on 
track to do just that by 2013, and activity that impedes that progress 
must be closely scrutinized.
    What is the fundamental role of the GSEs, and can that role be 
better performed by some other entity?
    Is the current arrangement with the GSEs in need of repair, 
restructuring, radical change?
    And, finally, I hope this hearing will help us to answer the 
question, what is best for the consumer--- what is best for the 
American people?
    Can we have home ownership, without debt?
    Can we ensure that every citizen, regardless of their station in 
life, with hard work, determination and careful budgeting, has a chance 
to own a home, without the involvement of the GSEs?
    While home ownership has reached historic levels in America, still, 
for many, it is out of reach.
    Like home ownership generally, minority home ownership has grown.
    Yet, despite that growth, home ownership among African- Americans 
today stands at just over 47 percent.
    And home ownership among Hispanics stands at roughly the same 
amount.
    Yet, the home ownership rate among whites is close to 75 percent.
    Home ownership, Mr. Chairman, is the backbone of this Nation's way 
of life.
    Whatever we do, we must promote that important goal.
    Before we change anything, we must be clear as to whether what we 
have now is a benefit or a burden.
    And, even if it is a burden, when weighed against the good it does, 
is it a necessary burden.
    Under current law, Fannie Mae and Freddie Mac face strict 
supervision and examination by OFHEO, which has a staff of 95, whose 
full-time responsibility is to oversee these two entities.
    Fannie Mae and Freddie Mac will argue that they employ 
sophisticated interest-rate and credit risk management strategies, 
strategies, they will say, which provide more than adequate protection.
    Fannie Mae will argue that it is limited by charter to investing in 
residential mortgages only
    They will point out that In the 1980's, most S & Ls failed because, 
through deregulation, they were allowed to invest in endeavors far 
beyond home mortgages.
    Most of the S & Ls that stayed with their traditional mortgage 
business recovered, they say.
    And, finally, Fannie Mae will argue that any increase in its debt 
does not in any way increase the indebtedness of the U.S. government.
    Their obligations, they say, are not in any way backed by the full 
faith and credit of the United States Government.
    In fact, they argue, the law requires that the front page of all 
their debt and mortgage-backed securities state that they ``are not 
guaranteed by the United States and do not constitute a debt or 
obligation of the United States.
    Indeed, I have heard nothing to this point to suggest that the GSEs 
are not doing a good job.
    Moreover, I have seen no evidence that they are not well managed.
    Indeed, for example, the OFHEO 2000 Report concludes, ``At year- 
end 1999, Fannie Mae exceeded safety and soundness standards in all 
examination program areas.
    Mr. Chairman, I believe first and foremost, we must maintain our 
ability to encourage home ownership opportunities in America--for 
everyone.
    I look forward to the testimony of our witnesses.

    Mrs. Clayton. I guess I want to pick up on Mr. Hoekstra's 
remarks. Let me just make a statement also.
    I think we are indeed enjoying historical highs in terms of 
people enjoying the American way of home ownership, and I think 
that is a good thing. I think indeed people have calculated 
making debt no one likes but taking a risk and having access in 
their homes, they think that is a worthwhile activity. And so 
we are having historical highs right now where people are 
making the calculation, buying a home, and I certainly 
encourage that, but I think I would be remiss to suggest that 
the issue has been addressed sufficiently.
    When you look at those historical highs, there is a 
disproportional benefit. Minorities are not increasing their 
homes at the same rate. Working middle class are now having 
stress. There is a recent article, I guess about 3 weeks ago, 
in the high tech areas where working people who are making 60 
and $75,000 a year are finding it difficult to afford homes. So 
there is a constraint in the market.
    I think we acknowledge great things are happening for many 
Americans, but to suggest that there is not a need for these 
entities that provide for an easy way for most Americans to get 
housing I think is inaccurate, so I want to challenge that.
    And I do not know if you are saying that you feel that 
there is no longer any problem in the marketplace, I want to 
suggest there is a problem in the marketplace. Contrarily, I 
think because we are indeed enjoying great prosperity in 
certain areas, you ask people in Silicon Valley, you ask people 
in Oakland, you ask people in the Washington area, you ask 
people where there is opportunity for growth, they are not able 
to afford a home. So that prosperity has almost driven the 
value of the land itself and house to move and there is great 
genderfication going on right now, so I do not want it to be 
missed in this hearing or any other hearing that we have 
addressed all the housing areas.
    Having said that, also, the testimony for all three of you 
seemed to suggest that the risk of the debt is not--well, I 
take exception, Mr. Ely, you do not suggest that because your 
very point is indeed that debt is a risk--but it would seem to 
me that you are--both of you have indicated, the GAO as well, 
tell us that the debt itself is not as much of a risk.
    Am I right in assuming that?
    Mr. McCool. Well, we have not actually made an explicit 
statement about that, I do not think. I mean, I guess----
    Mrs. Clayton. Well, let me ask you----
    Mr. McCool. The issue really comes down----
    Mrs. Clayton. Is the debt that Fannie Mae and Freddie Mac 
hold implied to be risky and therefore we should indeed think 
about restructuring, changing the structure drastically? Is 
that a sufficient concern we ought to look at it? Is it fair to 
compare the debt of those entities with the United States? The 
debts are quite different, so is it really a serious problem?
    Mr. McCool. Well, again, the debt or the securities and 
mortgages that Fannie and Freddie hold are somewhat more risky 
than issuing mortgage-backed securities, but the point is that 
OFHEO is charged with overseeing their activities to make sure 
that the risks are managed well, hedged well, and that they 
have a risk-based capital standard in place that would protect 
the interests of the government. So the risks are relative.
    Mrs. Clayton. The risks are relative to the management and 
having instruments----
    Mr. McCool. And being well regulated.
    Mrs. Clayton. How different is that, Mr. Ely, since you 
think that Fannie Mae and Freddie Mac debt is really troubling 
and how different is the risk of the banks that have this 
same--they buy back securities, they have whole loans. My 
understanding, you represent them. How are you advising them 
about their debt?
    Mr. Ely. Well, I am not advising banks with regard to that. 
I just----
    Mrs. Clayton. No, you advise the banks.
    Mr. Ely. I am a student of what their practices are. What 
concerns me about the GSEs, particularly relative to the banks, 
is twofold. Number one, they are more thinly capitalized, 
particularly with regard to credit risk. The second thing is 
that they are less diversified. This is a point that the other 
witnesses made. Fannie and Freddie are focused on just one 
sector of the economy.
    Mrs. Clayton. Let me stop you there. They are less 
diversified. I thought they were chartered for an explicit 
mission, to encourage their instruments, and the advantage they 
had of being chartered to direct most of their attention to the 
mortgage financing of homes. So their less diversification is 
consistent with their mission.
    Mr. Ely. Well, that is true, but we have to understand that 
there is a down side to that and that is the lack of asset 
diversification, the concentration in housing finance.
    The fact that they are buying mortgages and guaranteeing 
mortgages from all over the country helps to diversify that 
risk, but we cannot lose sight of the fact that they are 
focused strictly on housing finance whereas commercial banks 
generally have a broader range of assets. That is why, when you 
combine the higher capital levels of banks and thrifts with 
their greater asset diversification and their balance sheets--
and also the fact that Federal deposit insurance has been 
essentially set up as an industry self-insurance mechanism, the 
banking and thrift industries do not pose the taxpayer risk 
that Fannie and Freddie do.
    Mrs. Clayton. Banks do have some subsidy. I do not want you 
to suggest that they do not have some. I think it is a matter 
of judgment as to which of the ones pose a risk, but banks do. 
That is part of what we give the depositor, that the government 
does indeed back some of their deposits to a certain level. So 
to suggest that only the entities that are GSEs are posing a 
great risk, I think that is inappropriate.
    Mr. Ely. Well, if I could address that question, I would 
like to file a paper with the committee which argues that 
actually the banking industry, the nation's banks and thrifts, 
do not receive any Federal subsidy at all. If anything, the 
subsidy actually flows the other way.
    Chairman Sununu. Thank you, Mrs. Clayton.
    Mr. Toomey.
    Mr. Toomey. Thank you, Mr. Chairman.
    I would like to follow up on a question that is 
tangentially related to what we were just discussing. Certainly 
if you look at the cost of funds relative to capitalization, 
there is a subsidy going on for the GSEs. I think that is 
pretty clear.
    I am interested in pursuing a point that Ms. Miles raises 
in her testimony on page 4 in particular, where there seems to 
be a dynamic here that I was hoping you would comment and 
elaborate on a little bit and that is as follows.
    The magnitude and the value of the subsidy, the implied 
guarantee, the various government benefits conferred upon the 
GSEs, clearly grows with their size and that creates an added 
incentive for these institutions to grow, arguably above and 
beyond the normal incentive that every corporation has to grow.
    When any company grows, certainly a publicly traded 
company, certainly a company that issues debt, there are a 
number of market forces that put a check on that growth, that 
that growth be prudent and that there be sufficient capital to 
sustain that growth. And if a company does not have--if there 
are concerns, then the market will impose costs on a company 
such as a higher cost of funds, a lower price of its share, 
various mechanisms that the market has to keep that growth in 
check in a sustainable level.
    When we have an implied government guarantee and when the 
market is convinced that the government is backing these 
institutions and it would not be allowed to fail, you raise the 
point that maybe that normal market discipline is weaker than 
it would be with another company, a company without such an 
affiliation.
    So my question is have we created an inherently unstable 
dynamic, where we have created extra incentives to grow and we 
have reduced the market discipline that normally holds that 
growth in check and requires that to be done in a prudent 
fashion? Is that not an inherently long-term unstable 
situation?
    Ms. Miles. It certainly can be. Bear one thing in mind. As 
long as the GSEs do have positive shareholder value, they have 
plenty of reason to exercise their own discipline and not go 
into an area where they would jeopardize that. If, however, 
they lose that value, they then have no reason not to gamble 
and go in for very big risks, knowing that they have lost 
everything they can lose. A big risk gives you the opportunity 
of getting back out of trouble and restoring shareholder value, 
but if you lose everything, you basically put it back on 
somebody else.
    That is where it becomes very unstable and that was 
essentially what did happen with the savings and loan industry 
in the 1980's.
    Mr. Toomey. So if I could sort of summarize what you are 
saying, in good times and when things are going well, this 
dynamic may not be very dangerous. The problem is sort of----
    Ms. Miles. When things do not go well.
    Mr. Toomey.--leveraging up and doubling up your bet when 
things are looking rather grim.
    Ms. Miles. That is correct. The less capital you are 
carrying the more quickly that kind of situation can come upon 
you.
    Mr. Ely. If I could add something to that, there is a 
second form of discipline and that is credit market discipline. 
In other words, the debt markets. One of my real concerns is 
that the credit markets are not providing the discipline over 
Fannie and Freddie that they should, which is very important 
given how highly they are leveraged, because of their implicit 
Federal guarantee.
    Mr. Toomey. Al right.
    Mr. Ely, you mentioned, if I recall, during your testimony 
that there are numerous reasons why Fannie Mae or Freddie Mac 
might run into financial problems, including events outside the 
U.S. financial system.
    Did I understand you correctly? If so, could you elaborate 
on what some of those exogenous events might be?
    Mr. Ely. Well, you know, I could sit here all day long and 
come up with examples and not hit the mark. One of the problems 
with the world is that problems can come out of left field that 
no one anticipated and yet they have a disruptive effect on the 
market.
    The impact of the Russian debt crisis in the summer of 1998 
is a very good example. It caught a lot of people unawares. It 
did have magnification effects in the U.S. financial markets.
    Mr. Toomey. Specifically did it have any impact on interest 
rates associated with mortgage-backed securities? Or the whole 
loan market for that matter?
    Mr. Ely. In that particular case, there was a flight to 
quality, and Fannie and Freddie were beneficiaries----
    Mr. Toomey. It was actually a good thing for the mortgage-
backed securities market.
    Mr. Ely. At that time, but there were other credit markets 
that suffered quite a bit, particularly the junk bond market. 
Next time, it could play differently.
    I will give you one example that I worry about a lot and 
have written about and that is the Japanese financial 
situation. You have a country that is increasingly indebted, 
and with very weak financial institutions.
    If there is some kind of accident in Japan, I could see 
global effects of that. And next time, it may not inure to the 
benefit of Fannie and Freddie. So we just cannot expect the 
same kind of reactions to the next crisis that we have had in 
the past.
    Mr. Toomey. Thank you.
    Thank you, Mr. Chairman.
    Chairman Sununu. Thank you, Mr. Toomey.
    Mr. Minge.
    Mr. Minge. I would like to ask two questions. First, to 
what extent do you believe the interest rates on residential 
mortgages are lower because of Fannie Mae and Freddie Mac and 
the Federal Home Loan Bank institutions?
    And I would ask this of any of you.
    Mr. Ely, I will start with you.
    Mr. Ely. They may be lower, but that is only half the 
equation. The other question is, and this is one again I have 
explored a little bit, to what extent are the lower interest 
rates capitalized or possibly even overcapitalized in housing 
prices? In other words, you can afford to pay more for a house 
because the interest rate is lower?
    Some work I have done with Fed Flow of Funds Data suggests 
that at times we have possibly had an overcapitalization of the 
subsidy in housing prices. Specifically, overcapitalization is 
reflected in the residual value of land underlying owner-
occupied housing.
    So it is not enough to say that rates are lower. You also 
have to look at what the effect of lower rates is on housing 
prices because if lower interest rates have been capitalized in 
housing prices, then the beneficiaries of the subsidy, if you 
will, are the sellers of homes, not the buyers.
    Mr. Minge. I assume that observation, then, would apply to 
the availability of housing credit generally, that if we have 
housing programs we might make it easier for people to finance 
housing which in turn would drive up the price of housing 
because of greater demand.
    I do not want to debate this, except to say that I think 
that you can take that to its logical extreme.
    Mr. Ely. Well, you have put your finger on a fundamental 
policy issue. The broader a subsidy is the more likely it is to 
be capitalized in the price of assets. A targeted subsidy is 
less likely to have that effect, which is why I believe that 
one of the issues that needs to be addressed in the housing 
finance area is to what extent the subsidy is misdirected and 
going to people who do not need it, versus those who are 
presumably at the cusp of home ownership and therefore warrant 
a subsidy.
    Mr. Minge. So maybe we should have high interest loans so 
we do not have a lot of competition for housing and we keep the 
price of housing down.
    Mr. Ely. No, I am not arguing for that at all.
    Mr. Minge. Mr. McCool, let me direct that same--not the 
little exchange that we have just had, but the question of 
whether or not----
    Mr. McCool. We estimated in our privatization report of 
1996 that the housing enterprises probably reduced mortgage 
rates by something in the range of a quarter--about 25 basis 
points, about a quarter of a percent.
    Mr. Minge. Ms. Miles.
    Ms. Miles. I pretty much agree with that. One of the ways 
to measure that is to look at the difference between the jumbo 
market where Fannie and Freddie cannot purchase mortgages and 
the conforming market, and it is generally 25 to 30 basis 
points. That might not be the whole story.
    In fact, I would argue that the great success story that is 
involved here is that we have far better integration of housing 
finance markets and capital markets generally and that is 
something that has occurred for a variety of reasons. You no 
longer get the great curtailments of mortgage financing 
whenever interest rates rise, but you will get some arguments 
as to whether that was all Fannie and Freddie's doing.
    Mr. Minge. Another question I would like to ask, if I can, 
and this guy is sitting here with a clock, so I get just a 
little sliver of this time----
    Chairman Sununu. I will be as generous as possible.
    Mr. Minge. Well, thank you.
    I am concerned with Fannie Mae and Freddie Mac and the 
others, when they issue their securities and the collateral is 
series of mortgages that they are holding on residential 
property, with a right of prepayment under certain 
circumstances, there may be generally, then the question is do 
they match that up with the right to call those bonds without 
penalty?
    What have you observed in that respect? And I guess the 
interest rate risk that we are talking about to some extent is 
whether or not there is a match between the prepayment risk 
that occurs and the ability to call bonds so as to issue new 
bonds at a lower interest rate or more competitive interest 
rate to keep these interest rates in synch.
    Mr. Ely.
    Mr. Ely. Well, both agencies do issue callable debt which 
helps to protect them if rates are going down. They also enter 
into interest rate swaps to protect themselves if interest 
rates are going up. If interest rates are going up, the 
prepayment rate drops off. But what is important to realize 
here is that these mechanisms do not work perfectly. While 
callable debt is a good way to handle the increased prepayment 
rate due to a decline in rates, if rates are moving up, I have 
a greater concern because that introduces counterparty risk 
into the equation.
    Mr. Minge. OK. But if the interest rates are moving up, 
then I suppose that Fannie Mae or Freddie Mac would decide not 
to call those bonds, leave those bonds out there and homeowners 
are not going to go out and refinance under those 
circumstances, so you would have a level of stability just 
based upon the nature of the market in that setting.
    Mr. Ely. That is correct.
    Mr. Minge. I am also quite intrigued with the advantage 
that you have identified, sort of an arbitrage advantage to 
Fannie Mae and Freddie Mac investing in their own securities 
for the purposes of internalizing the interest rate risk is, I 
believe, how you described it.
    Now, maybe I have mis-identified this. To those of us that 
do not come from such rarified financial backgrounds, it has a 
certain mysterious side to it and I am wondering if you can 
offer any additional explanation that would help us better 
understand how this creates profitability and, secondly, how it 
increases risk.
    Mr. Ely. Well, if you take a look at the two basic risks, 
the credit risk and the interest rate risk, when mortgages get 
securitized, mortgage-backed securities are issued and the 
interest rate and prepayment risks are shifted to whomever buys 
the mortgage-backed securities.
    When Fannie or Freddie buy back their own MBS, they take 
that risk back in or to use Ms. Miles' term, they repatriate 
the risk. So they have brought the interest rate risk back on 
their balance sheet, but they are earning additional interest 
income spread to compensate for that risk.
    The great question is are they earning enough additional 
spread to compensate for the interest rate risk that they have 
reassumed.
    Chairman Sununu. Thank you, Mr. Minge.
    Mr. Ryan.
    Mr. Ryan. I think that this has been a very helpful 
hearing. I am on the relevant banking subcommittee which goes 
over these issues and I do not think I have heard a more in 
depth discussion about GSE debt per se. So I am intrigued with 
the depth that we have gone into in this.
    Mr. Bentsen basically asked precisely the question that I 
was going to ask, but I would like to go back to this issue of 
repurchasing mortgage-backed securities and ask each of you a 
question.
    Number one, I think when you look at GSE debt, and that is 
the scope of this hearing, you can kind of divide it into two 
areas, mission critical debt which is used to securitize the 
secondary market, which would obviously grow as the mortgage 
market grows, then you have what some people call excessive 
debt, which is the debt that is issued solely for the 
repurchasing of mortgage-backed securities or retaining 
mortgage-backed securities on the books. It involves a new kind 
of risk, an interest rate risk or a prepayment risk. There is 
an arbitrage activity that is occurring which clearly is profit 
derived. I think we have established that here.
    I would like to ask you does the repurchasing of mortgage-
backed securities, specifically the alarming pace of the 
repurchasing of mortgage-backed securities, I think 4.6 percent 
in 1992 was retained, now it is about 30 percent of mortgage-
backed securities are retained by both Freddie and Fannie, does 
that in any way notably extend and advance home ownership?
    Does it put a new person in a home? Is it mission critical? 
And then I have a follow-up, but if you can answer that quickly 
I would appreciate it.
    Barbara, why don't we start with you?
    Ms. Miles. How brief can I be? I would say no, I do not 
think so.
    Mr. Ryan. That is great. Thanks.
    Mr. McCool. We would, I think, agree that there is no clear 
advancement of the mortgage market by repurchasing mortgage-
backed securities.
    Mr. Ely. Mortgage repurchases are not mission critical.
    Mr. Ryan. OK. So repurchasing the mortgage-backed 
securities you would then say is clearly done for the ROE, for 
profit, for the shareholder directive. Would you concur with 
that?
    Barbara.
    Ms. Miles. By and large.
    Mr. McCool. Again, we have not really studied that 
specifically, but I would suspect that, again, it is a risk/
return tradeoff that is probably driving it.
    Mr. Ely. Yes.
    Mr. Ryan. OK. So if we are establishing that repurchasing 
mortgage-backed securities is done with an arbitrage activity 
for the ROE, it kind of goes down to the issue that we have a 
contradictory mandate, a structure that is inherently 
contradictory, Hobson's choice, whatever you may say, mission 
critical housing mandate by Congress overseen by OFHEO which is 
to securitize the secondary market, but now you have the 
repurchasing of these mortgage-backed securities which clearly 
adds to the ROE, something you cannot really fault a company 
that has shareholders as well, but something that raises very 
interesting questions because there is an implied guarantee. 
Our job is to steward and watch over taxpayer risk.
    Do you believe that this prepayment risk is sufficient 
hedged against? Do you believe that the mortgage-backed 
security risk, the interest rate risk is sufficiently addressed 
or do we even know whether it is sufficiently addressed and do 
you think OFHEO is capable of calculating whether or not that 
risk is sufficiently hedged or offset?
    We will start with you, Barbara.
    Ms. Miles. That is really a question I hope you ask OFHEO. 
They have what looks to me to be a very nice capital standard 
model. It is not yet in effect, there are a lot of questions 
about it. By and large, it appears to handle within certain 
bounds the kinds of limits you would want it to handle.
    The question I would have is will it give you a signal 
quickly enough if things really go badly. And given that we are 
talking about relatively low capital levels, I cannot give you 
a good answer to that.
    Mr. Ryan. Mr. McCool.
    Mr. McCool. Again, I think that that is a question for 
OFHEO, as Barbara has suggested. And, in fact, I mean, again, 
this whole idea of the GSEs buying back mortgage-backed 
securities and having more risk on their portfolio should be 
certainly into account by their risk-based capital standard. 
And it is. So a lot of that should all be played out in their 
risk-based capital standard and in OFHEO's examination process. 
But that is a question, as I said, to ask them.
    Mr. Ely. In my opinion, outsiders cannot judge how well 
Fannie and Freddie are managing that risk based on the 
information that is publicly available. I find it troubling 
that there is not sufficient information available to the 
public, specifically to the investment community, to judge that 
risk and its management.
    Mr. Ryan. Thank you. I think it is important, and I will 
briefly summarize here.
    Did you want to interject?
    Chairman Sununu. No, I just wanted to ask specifically can 
you give an example of what information is not available that 
would enable that judgment to be made?
    Mr. Ely. In my opinion, based on the footnote disclosures 
that I read, that we get kind of bits and pieces of 
information. We are not presented with a total picture in a 
comprehensive way, even though it may be summarized, as to how 
they are managing the risk and what the risk characteristics 
are particularly of their counterparties.
    Mr. Ryan. If I could interject, I think it also goes to the 
question that we really do not know how reliable the hedging 
techniques are. Hedges have obviously advanced since the early 
1990's, but no one including OFHEO or any of us know if this is 
properly hedged, how well the hedges would work and, you know, 
we had a similar problem where we had paper insolvency of 
Fannie Mae in the 1980's where you had an interest rate 
problem, you had an interest rate risk, Freddie did not engage 
in the same kind of activity and also missed out on having the 
paper insolvency. So I think it is an interesting issue.
    What is interesting that I think we have established here 
in this hearing is that the debt which is relative to mortgage-
backed securities in retaining or repurchasing the mortgage-
backed securities, repurchasing is a term that has been in 
question, but it is a term that is used in Freddie Mac's annual 
report, so I will use the repurchasing of mortgage-backed 
securities, the debt associated with that is by and large it 
seems like our panel has agreed to is excessive debt, non-
mission-related debt and debt that is more or less used for 
profit.
    Thank you. I yield back my time.
    Chairman Sununu. Thank you, Mr. Ryan.
    Mr. Ely, for clarification, the example you gave of 
information that is not disclosed to the extent that you would 
like it to be to render judgment about risks is counterparty 
risk. I assume you are talking about the counterparty risk 
involved in primarily the interest rate swaps that the GSEs use 
to hedge their debt.
    Can you give an example or are there examples of other 
publicly traded companies that disclose counterparty exposure 
in their hedging strategies?
    Mr. Ely. One could argue that there is no such thing as 
enough disclosure. It has been my experience, as I read their 
footnote disclosures, that I do not get as much and I do not 
get as complete a picture as I would like to see.
    Chairman Sununu. Is there a difference between getting as 
much information as you would like and getting as much 
information as you would get from a comparable firm or from a 
firm that is not regulated or sponsored in any way by the 
mortgage-backed securities?
    Mr. Ely. In my opinion, bank holding companies basically 
provide a more complete disclosure than Fannie and Freddie do.
    Chairman Sununu. Bank holding companies disclose 
counterparty exposure in interest rate swaps?
    Mr. Ely. They provide more insight into the nature of the 
risks, into the nature of their counterparties, and in other 
regards to the swaps. You basically get more numbers, you get 
more detail. Although I will say this, it is not comparable 
across the different companies. You can find fault with any one 
company's disclosure.
    One difference is that the bank holding companies and other 
financial firms issue financial statements that are subject to 
SEC oversight, which is lacking in the case of Fannie and 
Freddie.
    Chairman Sununu. Fair point. Thank you.
    Mr. Smith.
    Mr. Smith. Mr. Chairman, just briefly.
    Again, would you give me your impression of the assumed 
liability of the Federal Government in terms of what is 
anticipated from those buying these bundles from Fannie Mae or 
Freddie Mac? Is there implied liability of the Federal 
Government in terms of expectations of the government somehow 
bailing out Freddie Mac or Fannie Mae if they were to go into 
trouble?
    Ms. Miles. I always try to be really careful how I answer 
that because we officially deny that there is any 
responsibility at all. But if you take a look at the list of 
ties, links to the Federal Government, they clearly imply 
something and the market infers something. The market believes, 
obviously, in the way they price Fannie Mae and Freddie Mac 
paper, and for that matter the Federal Home Loan Banks as well, 
that there is a sufficient nexus that the government would do 
something. And any time the market believes that relationship 
is being challenged, things change. We had an example of that 
in March.
    We had a little bit of a decrease in spreads between GSE 
paper and triple-A paper. Not a big one, but it is still there.
    So there is something that is being inferred. I do not want 
to be in a position of measuring it, but something is there. 
Beyond some point, presumably, the market perception may also 
break. At that point, the government might decide to step in. 
Again, Bert's example of the Farm Credit System.
    Mr. Smith. And Tom and Bert?
    Mr. McCool. Well, again, I would echo Barbara's idea that 
clearly the market perceives there is some connection. But, I 
mean, the extent to which there is or is not a government 
bailout should that ever arise is up to the administration and 
Congress to decide. I mean, that would be a decision for you 
folks.
    Mr. Ely. As I said in my testimony, we have two clear cut 
examples of a GSE rescue: the Farm Credit System back in 1988 
and then the FICO bonds in 1996. When I talk to people in the 
Wall Street community and ask them this question, they have no 
doubt in their minds whatsoever that if there was a problem 
with any of the GSEs, the Federal Government, in one way or 
another, would ride to the rescue to protect creditors, that is 
holders of debt and MBS, against any kind of loss.
    There is a totally different story for stockholders. 
Stockholders might get wiped out, but the belief in the credit 
markets is the Federal Government would ride to their rescue. 
Given their size today, the government would ride to the rescue 
sooner rather than later.
    Mr. Smith. It just seems based on your answers, Mr. 
Chairman, maybe there are two alternative actions of the 
Federal Government, either to charge Freddie Mac and Fannie Mae 
a fee for this underwriting, if you will, or to somehow take 
action to make it clear that they are independent organizations 
and even though they are a government-sponsored enterprise, the 
Federal Government is not underwriting any liability that might 
develop.
    If we were to do the latter, what kind of action might the 
Federal Government take to send out a signal to the marketplace 
that we are not going to underwrite them if they have problems?
    Mr. Ely. I will jump into that. I do not think there is any 
credible action the Federal Government could take. Fannie and 
Freddie are government-sponsored enterprises. As long as they 
are creatures of Congress, they are subject to special Federal 
oversight. In my opinion, you cannot credibly say that they are 
not backed by the U.S. Treasury and the U.S. taxpayer.
    Mr. Smith. Then, Mr. Chairman, I would come down on the 
side of starting to charge them a 1 percent fee for that 
insurance that probably is more real than implied and, again 
thank the witnesses and yield back.
    Chairman Sununu. Thank you, Mr. Smith.
    Mr. Bentsen had some follow-up questions.
    Mr. Bentsen. Thank you, Mr. Chairman.
    My colleague will probably be getting some mail as a result 
of this.
    Mr. Ely made a good point, we need to remember this, that 
the fact that the GSEs are in this position today did not just 
happen out of the blue. It happened because Congress 
established this with a purpose in mind in the 1930's and with 
a purpose in mind in the 1960's.
    And I know there has been discussion about the fact that 
banks and thrifts hold a GSE debt in a greater proportion than 
they would be allowed to hold the debt of a single corporate 
interest or if it were a loan to an individual. But that is 
also because Congress in the Bank Holding Company Act and other 
subsequent acts included GSE debt as a qualified investment, I 
believe, if I am correct about that.
    There are reasons why we did that. We, being the royal we, 
did that because we believed that through the GSE structure we 
were in effect establishing a subsidy for the benefit of the 
American people to get into home ownership.
    Has that worked, is the first question.
    Second of all, if it could have been done without, which I 
am not sure that it could have, that you could have had the 
same stable mortgage market at least up until the 1980's when 
the mortgage-backed securities market came about in the extent 
that we see it today, would you have had the same stable 
interest rate environment for mortgage finance and the ability 
of Americans to get into homes?
    And if that were the case, if in fact we did not need to do 
this at all, if you can make that argument, would the risk 
still exist because the ultimate risk we are talking about here 
is the risk to the American mortgage market.
    The systemic risk that might--and I say might--come from 
Freddie and Fannie has to come from the standpoint that--in two 
instances, it seems to be, one would be bad management practice 
on the part of the GSEs themselves, and we assume through 
shareholder vigilance and OFHEO's job and HUD's job and 
Congress ultimately that that is watched.
    The other is the credit risk associated and interest rate 
risk associated with the general economy. If we were to 
eliminate the GSEs tomorrow and assume that there were still 67 
percent home ownership rate in the United States, somebody 
would have to hold that paper, including the banks and thrifts 
who might not be holding as permitted or qualified investments 
GSE debt or MBS, but would be holding a very high level of 
whole loans and portfolios or privately issued MBSs. So the 
risk would still exist.
    Would the systemic risk still exist as well as a result of 
that, that U.S. banks and thrifts might be more susceptible to 
a meltdown in the mortgage market?
    Mr. Ely. Well, I will stick my neck out on that one.
    Obviously, the market would be different. We would see, 
first of all, a lot of privately issued MBS, just like we do in 
the jumbo mortgage market now, so there would be at least a 
geographical spreading of the credit risk.
    What we might see is possibly a somewhat less leveraged 
investment in housing and finance. I, for one, am troubled by 
the fact that as part of the overall debt build-up in the 
economy, we are seeing steadily increasing leverage in housing 
finance. That in itself is potentially destabilizing. So I 
think we might see greater equity in homes.
    But I would like to come back to your point about the 
subsidy. The question is: should there be a subsidy and, if so, 
what is the best way to deliver it? This question should be 
addressed in the coming years in Congress. Do the GSEs 
represent the best way to deliver the subsidy or are there 
alternative mechanisms for delivering the subsidy that focus it 
on those who, for whatever reason, are most deserving of the 
subsidy?
    The CBO study in 1966 suggested that in effect Fannie and 
Freddie were not very efficient in delivering the subsidy. What 
they did not say, and I am sorry they did not----
    Mr. Bentsen. Excuse me, in 1996 or 1966?
    Mr. Ely. I am sorry, 1996. I misspoke. The study from 4 
years ago. What CBO did not get into is the extent to which the 
subsidy that Fannie and Freddie deliver is going to people that 
do not need a subsidy. They are middle income and above.
    So there really are two policy issues that have to be dealt 
with here, one of which you touched on and that is the whole 
issue of financial stability generally, no matter how the 
financial markets are structured. The other is the issue of 
what is the best, most efficient, fairest way to deliver 
whatever housing finance subsidy is needed in this country in 
order to promote home ownership.
    Mr. Bentsen. Bert, can I just ask you to follow up on that? 
Would we have achieved the same home ownership rate, say, by 
1980 without the GSEs compared to what we did achieve, in your 
opinion?
    Mr. Ely. Sheer speculation, I could not have an answer on 
that, but I do not believe we had to have the GSEs in order to 
get home ownership to where it is today. For instance, if we 
had a subsidy targeted to just those people who are on the cusp 
of home ownership, where they need a subsidy in order to move 
from being a renter to a buyer or homeowner, then you would get 
that increase.
    The problem with much of the subsidy today is it is going 
to people who are going to be homeowners anyway. They may end 
up being able to afford a somewhat more expensive, larger home, 
but they still would be homeowners.
    So, again, the question is: are there alternatives for 
delivering the subsidy other than through the GSEs?
    Mr. Bentsen. Thank you.
    Thank you, Mr. Chairman.
    Chairman Sununu. Thank you, Mr. Bentsen.
    I am sure we could question or badger, depending on your 
terminology, this panel all day, but that would not be fair to 
our remaining witnesses.
    I want to thank our witnesses on this panel for their 
testimony and remind members that they have 5 days to submit 
written testimony for the record and call forward our second 
panel: Armando Falcon, the director of OFHEO, and William 
Apgar, the HUD designee to the Federal Housing Finance Board.
    Thank you for being here, gentlemen.
    Mr. Falcon, since the phrase ``That would be a good 
question for OFHEO'' was uttered more than ``That would be a 
good question for the Finance Board,'' we will be pleased to 
begin with your testimony whenever you are prepared.
    Again, welcome.

STATEMENTS OF ARMANDO FALCON, JR., DIRECTOR, OFFICE OF FEDERAL 
HOUSING ENTERPRISE OVERSIGHT; AND WILLIAM C. APGAR, HOUSING AND 
URBAN DEVELOPMENT DESIGNEE TO THE FEDERAL HOUSING FINANCE BOARD

                STATEMENT OF ARMANDO FALCON, JR.

    Mr. Falcon. Thank you, Mr. Chairman. I did catch most of 
those references to OFHEO. I am pleased to begin.
    Thank you, members of the Task Force. As you are aware, the 
Office of Federal Housing Enterprise Oversight, or OFHEO, was 
established in 1992 as an independent entity within the 
Department of Housing and Urban Development. OFHEO's primary 
mission is to ensure the capital adequacy and safety and 
soundness of the two government-sponsored enterprises, Fannie 
Mae and Freddie Mac.
    To fulfill this mission, OFHEO has regulatory authority 
similar to those of other Federal financial regulators, such as 
the FDIC and the Federal Reserve. Those authorities include 
annual examinations, broad rulemaking authority, setting 
capital standards, enforcement actions and research.
    Fannie Mae and Freddie Mac were established to create a 
secondary mortgage market to ensure a ready supply of mortgage 
funds for affordable housing for American home buyers.
    To assist Fannie Mae and Freddie Mac in achieving their 
public mission, they receive numerous explicit benefits from 
the Federal Government. The most important benefit the 
enterprises receive is the special treatment the market bestows 
on their securities. Because of investors' belief in an implied 
U.S. Government guarantee on their securities, the enterprises 
have been able to borrow money more cheaply and without the 
practical volume restrictions faced by any fully private 
triple-A rated company.
    This market perception allows the enterprises to safely 
operate with a higher degree of leverage than fully private 
firms are able to do. There is no doubt that the GSEs are large 
and rapidly growing. As they grow, the implications to the 
economy, if they were to fail, also increases. However, the 
actual likelihood of any failure depends critically on how they 
are managed and supervised.
    I want to assure you, Mr. Chairman, and members of the Task 
Force, that Fannie Mae and Freddie Mac are currently in 
excellent financial condition and OFHEO has a strong regulatory 
program in place to ensure their continued safe and sound 
operation. If the need ever arose, OFHEO would move quickly and 
forcefully to correct any financial problems at the 
enterprises.
    OFHEO supervises the enterprises primarily through its 
extensive and continuous examination work. Our experts maintain 
a physical presence at the enterprises at all times and have 
unlimited access to all levels of management and highly 
sensitive corporate records. By staying apprised of the 
enterprises' risk and business activities on an almost real 
time basis, the examiners are able to evaluate an extensive 
array of risk related factors and assess the enterprises' 
financial safety and soundness.
    Each quarter, OFHEO examinations staff issue conclusions 
related to more than 150 separate components of financial 
safety and soundness and thereby provide me with a 
comprehensive picture of the enterprises' financial condition.
    Examiners meet frequently with management to discuss and 
assess business strategies and plans, financial performance 
results, risk management structure and practices, and each 
enterprises' overall risk profile.
    Through our risk focused examination work, OFHEO constantly 
evaluates such critical areas as the enterprises' overall risk 
management practices, the composition of the risk profile and 
significant trends in the enterprises' retained and guaranteed 
mortgage portfolios, the enterprises' ability to effectively 
manage interest rate risk and other key financial exposures, 
the enterprises' ability to efficiently issue debt and hedge 
financial exposures and the quality of financial performance-
related information and market-related information on which the 
enterprises' board and management rely in reaching key 
decisions.
    In summary, the examination group provides us with an 
accurate and timely understanding of the enterprises' financial 
condition.
    Fannie Mae and Freddie Mac have two major lines of 
business. First, they guarantee mortgage-backed securities, 
which are, of course, securities backed by pools of residential 
mortgages. Enterprise mortgage-backed securities are highly 
regarded by investors and can be issued at interest rates very 
close to those of mortgage-backed securities with an explicit 
government guarantee.
    This guarantee business has been quite profitable for the 
enterprises, but mortgage borrowers receive most of the benefit 
from these lower borrowing costs. While there is no precise way 
to measure these savings, recent estimates have generally 
centered around 25 to 30 basis points, I think as was mentioned 
by the previous panel as well.
    The enterprises' second major line of business is portfolio 
investment in mortgage-backed securities and, to a lesser 
extent, in whole mortgages. The enterprises fund these 
investments primarily by issuing debt.
    Both of these business lines have been growing at the 
enterprises, particularly their portfolio investment business. 
Since the end of 1991, the enterprises' mortgage assets have 
swelled from $155 billion to $900 billion, an increase of 
approximately 475 percent. A majority of the increase reflects 
purchases of mortgage securities they had previously 
guaranteed.
    Now, to fund the growth of these assets, the enterprises 
have increased their debt outstanding at a comparable rate from 
$164 billion to $963 billion over the same time period.
    The guarantee business has also increased significantly. 
Total mortgage-backed securities guaranteed, both those held 
privately as well as those held in portfolio, has more than 
doubled from $731 billion 1991 to over $1.76 trillion today.
    Enterprise debt and mortgage-backed securities outstanding 
now amounts to $2.2 trillion. Adding in the debt of the other 
GSEs, the total debt of all GSEs rises to $3 trillion.
    Federal reserve estimates for holdings of what is known as 
agency debt, about 85 percent of which is issued or guaranteed 
by GSEs, shows the following breakdown:
    Depository institutions hold 27 percent.
    Households, mutual funds, trusts and estates hold 21 
percent.
    Public and private retirement funds hold 16 percent.
    Foreign investors, which includes over 60 central banks, 
holds 12 percent.
    Insurance firms hold 9.
    State and local governments hold 5.
    The balance remaining is 10 percent.
    As should be apparent from this data, a financial crisis at 
the enterprises could have a disruptive impact on investors and 
the economy. Accordingly, OFHEO has developed and continues to 
improve upon a strong supervisory program.
    OFHEO is aggressively fulfilling its obligation as a strong 
and effective regulator. By fulfilling our core mission well, 
OFHEO protects against systemic risk posed by Fannie Mae and 
Freddie Mac.
    As I have stated before, OFHEO takes a three-pronged 
approach to accomplish this goal: examinations, capital 
regulation and research. I have already spoken about our strong 
examination program, so I will address our capital standards.
    OFHEO's minimum capital standard, one that is built on 
traditional ratio based approaches, ensures a base level of 
enterprise capital to protect against risk.
    Also, we are on track to complete our risk-based capital 
standard by the end of the year. This standard will be the 
first to explicitly link capital and risk through the use of a 
model that simulates financial performance of the enterprises 
under stress. Let me say here we will complete this rule by the 
end of the year, Mr. Chairman. While we will have a final 
capital rule, let me differentiate here between a final capital 
and a final stress test.
    The stress test will be by its nature evolving and 
constantly changing to take into account the different risk 
profile of the enterprises at any point in time. The risk-based 
capital standard has to adjust itself to reflect different 
activities, different programs of the enterprises, to make sure 
it always accurately ties capital to risk, given what the risk 
profile of an enterprise is at any particular point in time.
    Any risk-based capital standard like this would be obsolete 
if it was not constantly evolving, so part of OFHEO's job is to 
ensure that we consistently and constantly update the risk-
based capital requirement, although at the same time 
accommodating the enterprises' uncertainty as to what their 
capital requirement will be and how it is calculated. It will 
be a state of the art capital regulation and I look forward to 
having it in place, as I am sure the committee does.
    Finally, OFHEO is continuing to strengthen its research and 
analytical capability. We must stay on top of the changes 
taking place in the quickly evolving secondary and primary 
mortgage markets. This important research and analysis serves 
to better inform our examination and capital regulation 
efforts.
    In summary, the enterprises' rapid growth raises important 
policy issues regarding their mission and the risk they pose to 
the financial system. However, because OFHEO is fulfilling its 
responsibilities, this discussion takes place not in a climate 
of urgency, but at a time when the enterprises are financially 
sound and well regulated.
    Thank you, Mr. Chairman.
    [The prepared statement of Armando Falcon, Jr. follows:]

  Prepared Statement of Hon. Armando Falcon, Jr., Director, Office of 
                 Federal Housing Enterprise Oversight*

    Thank you Chairman Sununu, Ranking Member Bentsen, and members of 
the Task Force. As you are aware, the Office of Federal Housing 
Enterprise Oversight (OFHEO) was established in 1992 as an independent 
entity within the Department of Housing and Urban Development. OFHEO's 
primary mission is to ensure the capital adequacy and safety and 
soundness of two government-sponsored enterprises (GSEs)--Fannie Mae 
and Freddie Mac. To fulfill this mission, OFHEO has regulatory 
authority similar to other Federal financial regulators such as the 
Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve 
Board. Those authorities include annual examinations, broad rulemaking 
authority, setting capital standards, enforcement actions, and 
research.
---------------------------------------------------------------------------
    *This testimony represents the view of the OFHEO Director, which 
are not necessarily those of the President or Secretary of Housing and 
Urban Development.
---------------------------------------------------------------------------
    The Task Force has taken an important step in convening this 
hearing to consider the economic implications of the size and scope of 
the housing GSEs activities. Because Assistant Secretary Apgar is here 
today representing the Federal Housing Finance Board, I will focus my 
discussion on the two entities within my jurisdiction.
    In considering these issues, it is important to understand what the 
GSEs do and how they operate.
                  who are fannie mae and freddie mac?
    Fannie Mae and Freddie Mac are publicly-held companies chartered by 
Congress. They were established to create a secondary mortgage market 
to ensure a ready supply of mortgage funds for affordable housing for 
American homebuyers. They fulfill this very important public mission by 
buying mortgages from commercial banks, thrift institutions, mortgage 
banks, and other primary lenders, and either hold these mortgages in 
their own portfolios or package them into mortgage-backed securities 
(MBS) for resale to investors. They have become two of the world's 
largest financial institutions.
    To assist Fannie Mae and Freddie Mac in achieving their public 
mission, they receive numerous explicit benefits from the Federal 
Government, including an exemption from state and local taxation, an 
exemption from the registration requirements of the Securities and 
Exchange Commission, and each firm has a potential credit line with the 
U.S. Treasury.
    However, the most important benefit the Enterprises receive as a 
result of their GSE status is the special treatment the market bestows 
on their securities. Because of investors' belief in an implied U.S. 
government guarantee on their securities, the Enterprises have been 
able to borrow money more cheaply and without the practical volume 
restrictions faced by any fully-private triple-A rated company. This 
market perception allows the Enterprises to safely operate with a 
higher degree of leverage than fully private firms are able to do.
    There is no doubt that the GSEs are large and rapidly growing. As 
they grow, the implications to the economy if they were to fail also 
increases. However, the actual likelihood of any failure depends 
critically on how they are managed and supervised. I want to assure you 
that both Fannie Mae and Freddie Mac are currently in excellent 
financial condition, are well-managed, and have exceeded minimum 
capital requirements every quarter that the requirement has been in 
place. And OFHEO has a strong regulatory program in place to ensure 
their continued safe and sound operation. If the need ever arose, OFHEO 
would move quickly and forcefully to correct any financial problems at 
the Enterprises.
    OFHEO supervises the Enterprises primarily through its extensive, 
and continuous, examination work. Our examiners possess impressive 
skills and backgrounds, and came to OFHEO from banking and thrift 
regulatory bodies and from the mortgage industry itself. Our experts 
maintain a physical presence at the Enterprises at all times, and have 
unlimited access to all levels of management and to highly-sensitive 
corporate records. By staying apprised of the Enterprises' risks and 
business activities on an almost real-time basis, the examiners are 
able to evaluate an extensive array of risk-related factors and to 
assess the Enterprises' financial safety and soundness.
    Each quarter, the OFHEO examination staff issue conclusions 
relating to more than 150 separate components of financial safety and 
soundness, and thereby provide me with a comprehensive picture of the 
Enterprises' financial condition. These conclusions pertain to such key 
risk management areas as credit risk, interest rate risk, liquidity 
risk, information technology, internal controls, business process 
controls, internal and external audit, management information and 
process, and board of director governance and activities.
    Examiners meet frequently with management to discuss and assess 
business strategies and plans, financial performance results, risk 
management structure and practices, and each Enterprise's overall risk 
profile. These discussions include future trends and management's 
controls and practices to anticipate and prepare for potentially 
adverse trends in any risk areas, or combination of risk areas.
    Examination teams identify opportunities for improvements in 
existing Enterprise risk management practices and work directly with 
management to address identified opportunities to enhance financial 
safety and soundness. Through our risk-focused examination framework, 
OFHEO constantly evaluates such critical areas as:
     The Enterprises' overall risk management practices
     The composition, risk profile, and significant trends in 
the Enterprises' retained, and guaranteed, mortgage portfolios
     The Enterprises' ability to effectively manage interest 
rate risk and other key financial exposures
     The Enterprises' ability to efficiently issue debt and 
hedge financial exposures
     The quality of financial performance-related information 
and market-related information on which the Enterprises' boards and 
management rely in reaching key decisions
    In summary, the examination group provides us with an accurate and 
timely understanding of the Enterprises' financial condition.
                      what do the enterprises do?
    Fannie Mae and Freddie Mac have two major lines of business. First, 
they guarantee mortgage-backed securities: securities backed by pools 
of residential mortgages. When investors purchase a mortgage-backed 
security they are entitled to the principal and interest payments made 
by the mortgage borrower, except for portions earned by mortgage 
servicers and by the Enterprise which guarantee the payment of 
principal and interest. In return for the portion the Enterprise earns, 
they agree to protect investors against losses caused by borrower 
defaults. Enterprise mortgage-backed securities are highly regarded by 
investors and can be issued at interest rates very close to a mortgage-
backed securities with explicit government guarantees. This guarantee 
business has been quite profitable for the Enterprises, but mortgage 
borrowers receive most of the benefit from these lower borrowing costs. 
While there is no precise way to measure these savings, recent 
estimates are generally centered around 25 to 30 basis points.
    The Enterprises' second major line of business is portfolio 
investment in mortgage-backed securities and, to a lesser extent, whole 
mortgages that are purchased directly from lenders and are not parts of 
pools backing mortgage securities. The Enterprises fund these 
investments primarily by issuing debt. The characteristics of the debt 
issues are designed so that, in combination with a variety of 
derivatives contracts and other hedges entered into by the Enterprises, 
the values of the debt and the mortgage securities will be similarly 
affected by interest rate changes. This help protect the Enterprises 
from a mismatch between the cost of funding its operations and the 
income derived from those operations.
    Another risk in the portfolio business is that changes in 
borrowers' prepayment behavior, often in response to interest rate 
changes, are not fully predictable and may affect mortgage security 
values differently than expected.
    Portfolio investment has been more profitable than the guarantee 
business. This activity may create additional interest savings for 
mortgage borrowers, though such savings would be much smaller than 
those created by the guarantee business. Because empirical data on this 
issue is scarce, OFHEO intends further study of this topic.
    Both of these business lines have been growing at the Enterprises, 
particularly their portfolio investment business. Since the end of 
1991, the Enterprises' mortgage assets have swelled from $155 billion 
to $900 billion, an increase of approximately 475 percent. The majority 
of the increase reflects purchases of mortgage securities they had 
previously guaranteed. To fund the growth in these assets, the 
Enterprises have increased their debt outstanding at a comparable rate 
from $164 billion to $963 billion over the same period.
    Their guarantee business has also increased significantly. Total 
mortgage-backed securities guaranteed--both those held privately as 
well as those held in portfolio--has more than doubled from $731 
billion in 1991 to over $1.76 trillion today. Although the Enterprises 
purchased roughly half of the increase in their guaranteed mortgage 
securities in recent years, the amounts held by other investors has 
still grown 73 percent to $1.2 trillion over that period.
    The Enterprises debt and mortgage-backed securities outstanding now 
amounts to $2.2 trillion. Adding in the debt of the other GSEs, the 
total debt of all GSEs rises to $3 trillion, substantially above the 
total privately held, marketable debt of the U.S. Treasury. (Further 
detail about Enterprise mortgage portfolios, debt, and mortgage-backed 
securities outstanding can be found in the attached tables.)
                          who holds the debt?
    Federal Reserve estimates for holdings of what is known as agency 
debt, about 85 percent of which is issued or guaranteed by GSEs, shows 
the following breakdown:

Depository Institutions...........................................   27%
Households, Mutual Fund, Trusts & Estates.........................   21%
Public & Private Retirement Funds.................................   16%
Foreign Investors (including 60+ central banks)...................   12%
Insurance Firms...................................................    9%
State & Local Governments.........................................    5%
Others............................................................   10%

    As should be apparent from these data, a financial crisis at the 
Enterprises could have a disruptive impact on investors and the 
economy. OFHEO has developed and continues to improve upon a strong 
supervisory program.
    The Enterprises' business lines will likely continue to grow. 
Recently Fannie Mae announced its continued desire to double earnings 
per share over the next 5 years. Freddie Mac has predicted double digit 
earnings growth over a similar period. These earnings targets will only 
lead to increased pressure to generate new revenues. The prudence and 
competence with which the Enterprises manage and balance their assets 
and liabilities becomes that much more important, the larger they grow.
    In order for the Enterprises to continue to grow their asset 
portfolios, they have expanded the markets for their debt securities, 
and built demand for debt instruments, such as callable debt, that help 
them manage interest rate risk. They have expanded their domestic and 
international investor base, developing new products to appeal to 
different investor profiles. The introduction of debt issuance programs 
modeled after those of the U.S. Treasury is the most recent development 
in these efforts.
                         what is ofheo's role?
    OFHEO is aggressively fulfilling its obligation as a strong and 
effective regulator. By fulfilling our core mission well, OFHEO 
protects against systemic risks posed by Fannie Mae and Freddie Mac. As 
I have stated before, OFHEO takes a three-pronged approach to 
accomplish this goal-examinations, capital regulation, and research.
    I have already spoken about our strong examination program, so I 
will next address our capital standards. OFHEO's minimum capital 
standard, one that is built on traditional, ratio-based approaches to 
regulation of insured depository institutions, ensures a base level of 
Enterprise capital to protect against risk.
    Since our inception, we have imposed and enforced a minimum capital 
standard on the Enterprises. The Enterprises have met that standard 
every quarter and we are reviewing the necessity of updating the 
standard.
    We are on track to complete our long-awaited Risk-Based Capital 
Standard by the end of the year. This standard will be the first to 
explicitly link capital and risk through use of a model that simulates 
the financial performance of the Enterprises under stress. This is my 
top priority and we will meet my deadline.
    Finally, OFHEO is continuing to strengthen its research and 
analytical capability. We must stay on top of the changes taking place 
in the quickly evolving secondary and primary mortgage markets. This 
important research and analysis serves to better inform our examination 
and capital regulation efforts. In summary, the Enterprises' rapid 
growth raises important policy issues regarding their mission and the 
systemic risks they pose. However, because OFHEO is aggressively 
fulfilling its responsibilities, this discussion takes place not in a 
climate of urgency, but at a time when the Enterprises are financially 
sound and well regulated.
























    Chairman Sununu. Thank you, Mr. Falcon.
    Mr. Apgar.

                 STATEMENT OF WILLIAM C. APGAR

    Mr. Apgar. Thank you. Since the resignation of Chairman 
Bruce Morrison on the 4th of July, I hold the delegated 
authority of Chairman of the Finance Board, and I testify today 
in that role. I would like to emphasize my intention to 
maintain the continuity of the Finance Board's recent actions 
with respect to safety and soundness oversight, as well as 
actions to foster innovation in the Home Loan Banks and 
competition among the various GSEs.
    I should point out, however, that the board of directors of 
the Federal Housing Finance Board has not reviewed my 
testimony, nor does it represent the administration's position.
    As you know, Congress created the Federal Home Loan Bank 
System in 1932 to improve on the availability of funds to 
support home ownership. The Federal Home Loan Banks are 
cooperatively owned by their member bank stockholders and they 
operate by enhancing member lending at the local level.
    The Home Loan Banks offer as their primary product a 
readily available, low cost source of funds, called an advance, 
to member institutions and housing associates. Advances enhance 
the lending of members both by passing through the Home Loan 
Banks' cost-of-funds advantage in the debt markets and by 
having the Home Loan Banks manage interest rate risk. To the 
Finance Board, activities that assist and enhance lending by 
members are consistent with the Home Loan Bank mission.
    Congress originally granted access to the Home Loan Bank 
advances primarily to thrift institutions. In response to the 
thrift crisis of the 1980's, Congress enacted FIRREA in 1989 to 
change the Federal Home Loan Bank System, most significantly by 
expanding membership eligibility to include commercial banks 
and credit unions.
    In 1989, Congress also imposed a $300 million per year 
assessment on the Home Loan Banks to help pay for the cost of 
the thrift bailout. In addition, Congress imposed a requirement 
that 10 percent of Home Loan Bank net earnings go to support 
the Affordable Housing Program each year. Last year, the system 
made $199 million in AHP contributions and grants nationwide.
    In November 1999, with the enactment of the Gramm-Leach-
Bliley legislation, Congress in a singular vote of confidence, 
made many changes to enhance the capacity of the Home Loan 
Banks to carry out their housing finance and community and 
economic development mission.
    Gramm-Leach-Bliley charged the system with supporting 
access to low cost funds for community financial institutions 
to support small businesses, small farm and small agri-business 
lending.
    Moreover, by changing the fixed $300 million REFCORP 
assessment to one based on a percentage of Home Loan Bank 
income by reforming the Home Loan Banks' capital structure, 
this legislation has truly positioned the Home Loan Bank System 
to promote competition in housing finance, serve as a central 
bank for community institutions, and serve under served 
populations.
    I would also stress that through both proposed and final 
regulation including the recently proposed regulation on a new 
risk-based capital structure, the Finance Board has implemented 
all the statutory requirements of Gramm-Leach-Bliley.
    As of June 30, 2000, the assets of the Home Loan Bank 
System totaled $621 billion. There were more than 7500 members 
on that date.
    The bonds issued to support the assets of the bank system 
are expressly not obligations of the United States, but they do 
benefit from the favorable investor perception associated with 
the Home Loan Banks' status as a government-sponsored 
enterprise.
    The Home Loan Bank Act makes it clear that it is the 
Finance Board's primary duty to ensure the safety and soundness 
of the bank system and, consistent with that primary duty, to 
ensure that the Home Loan Banks carry out their housing finance 
mission.
    To control the Home Loan Bank System's risk exposure, the 
Finance Board has established regulations and policies that 
Home Loan Banks must follow to evaluate and manage their credit 
and interest rate risk. The principal defenses against credit 
interest rate risk are sound risk-based management policies and 
practices, vigilant supervision, and over $30 billion in Home 
Loan Bank System capital.
    Among the most notable regulatory requirements are:
    Collectively the Home Loan Bank must maintain a triple-A 
credit rating on their consolidated debt.
    Each individual Home Loan Bank must maintain a double-A 
credit rating.
    Each Home Loan Bank must establish and implement risk 
management policies and controls consistent with Finance Board 
requirements, file compliance reports and have external and 
internal auditors.
    Each Home Loan Bank and the office of finance must be 
subject to an annual on-site examination by the Finance Board.
    And, finally, the Finance Board has recently articulated a 
new set of state-of-the-art duties and responsibilities of the 
audit committee of each of the Home Loan Bank boards of 
directors along with standards for corporate governance and 
internal controls that the boards must comply with.
    Risk management is central to this oversight. For example, 
the Finance Board limits the interest rate risk of mortgage-
backed securities owned by the Home Loan Banks. Moreover, the 
size the Home Loan Banks' mortgage-backed securities holdings 
is limited to no more than three times Home Loan Bank capital 
or less than $90 billion today.
    The general approach of the Home Loan Banks toward managing 
interest rate risk is to acquire and maintain a portfolio of 
assets and liabilities, which, together with their associated 
interest rate exchange agreements, limit the exposure to future 
interest rate changes.
    With respect to credit risk, it is important to note that 
in the 68-year history of the Home Loan Bank no Home Loan Bank 
has ever experienced a credit loss on an advance to a member.
    While the Home Loan Banks face minimal credit risk on 
advances, they are subject to credit risk on some investments. 
Each Home Loan Bank must comply with limits established by the 
Finance Board and its directors on the amounts of unsecured 
extensions of credit, whether on or off balance sheet.
    The Finance Board also limits the amounts and terms of 
unsecured debt exposure to any counterpart other than the 
United States Government. Unsecured credit exposure to any 
counterparty is limited by the credit quality and capital level 
of the counterparty and the capital level of the bank.
    The Finance Board views these risk management requirements 
to be more than adequate to protect against any potential loss 
exposure to the taxpayer.
    In exchange for public support, of course, the American 
taxpayer has the right to expect responsible behavior by the 
GSEs. It is critically important to protect the taxpayer from 
any potential loss by monitoring and regulating GSE financial 
risk. It is also critically important to ensure that the low 
cost-of-funds and other advantages bestowed on the GSEs are 
well directed and ultimately reach their intended 
beneficiaries.
    There is a risk that much of the government-owned benefit 
could be absorbed as profits within the GSE conduit. But one of 
the unique factors and features of the Home Loan Bank System, 
namely, its cooperative structure, inherently protects against 
such an event. Because the members and shareholders are one and 
the same and because the public benefit of the Federal Home 
Loan Bank System is delivered by members' retail lending, the 
members' financial incentives to get the lowest cost of funds 
is entirely consistent with maximizing public benefit. In 
addition, mission regulation helps ensure this valuable GSE 
benefit is focused on assisting member lending.
    Mission regulation is closely linked to safety and 
soundness regulation. Many assets are perfectly safe and sound 
from a financial point of view, but because the GSEs were 
created for specific purposes and GSEs are supported by agency 
debt, only some assets are consistent with the mission of those 
GSEs.
    The Finance Board has been focusing on the Home Loan Bank 
core mission activities. In the past, some level of non-mission 
investments were necessary for the banks to meet their REFCORP 
obligation of $300 million per year and to fund the Affordable 
Housing Program.
    This activity where the Home Loan Banks borrow at close to 
Treasury rates to purchase higher yielding assets in the 
capital markets such as MBS and earn a profit from the spread 
has been the subject of bipartisan criticism for many years. 
Indeed, the arbitrage issue has been at the top of the list of 
many Members of Congress and the Treasury Department, and 
rightfully so.
    Five years ago, approximately 40 percent of Home Loan Bank 
assets reflected core mission activities as we defined here. I 
am pleased to report that through a combination of advances, 
growth and Finance Board actions, the ratio is now 
approximately 75 percent.
    Recently, Finance Board actions along with reforms passed 
in Gramm-Leach-Bliley that eliminated the major drivers of 
arbitrage, such as the flat REFCORP assessment and 
subscription-based capital, provide the best opportunity in a 
decade to focus the activity of the Home Loan Banks on their 
mission and reduce their dependence on arbitrage investment.
    On June 29, the Finance Board passed the Core Mission 
Assets/Acquired Member Assets rule. This rule establishes a 
framework for the Home Loan Bank System to pursue a totally 
mission-related balance sheet. The rule has two parts.
    It makes permanent Acquired Member Assets, or AMA programs, 
such as the so-called Chicago pilot or the Mortgage Partnership 
Finance, which is the most prominent of acquired mortgage 
assets. As you know, this as proved to be a very successful 
program to date involving over $10.5 billion worth of assets.
    Each of the 12 member banks is now offering or will soon 
offer an MPF or similar program that will divide the risk of 
the mortgage between a member bank and a Home Loan Bank 
partner. Simply stated, the member bank manages the credit risk 
and the Home Loan Bank, experts at hedging interest rate risk, 
will assume and manage that risk.
    These partnerships provide true competition with the 
secondary market GSEs. Instead of credit risk being 
concentrated in those two housing GSEs, the risk can now be 
dispersed through over 7500 Home Loan Bank members.
    These programs serve to de-concentrate the risk of a $4 
trillion housing finance market and put the rewards in the 
right place, with those who take the risk, to offer what is 
truly a third way home for member institutions.
    The rule also defines Core Mission Assets as assets 
including advances, Acquired Member Assets and certain smaller 
classes of securities. If there is any meaning to the mandate 
that the Finance Board must ensure mission achievement, it is 
incumbent on the Finance Board to state in regulatory form 
which activities and assets actually advance that mission.
    The development of the Acquired Member Asset programs will 
help the Home Loan Banks to develop Core Mission Assets to 
replace arbitrage investments and at the same time increase 
competition in the secondary market.
    Of course, these new activities must be supported by a 
strong capital base. For this reason as well as for purposes of 
capitalizing other new Home Loan Bank activities, Gramm-Leach-
Bliley has mandated the establishment of a new risk-based 
capital structure that will allow the banks to adjust their 
capital to the actual risk that they have on their balance 
sheet.
    I am pleased to report that on July 13th the Finance Board 
proposed a state-of-the-art risk based capital rule as required 
by Gramm-Leach-Bliley which is currently out for a 90-day 
comment period. The legislation requires the Finance Board to 
issue its final capital rule in November and we are making 
progress toward that goal.
    In summary, as a result of Gramm-Leach-Bliley and the 
regulatory initiatives that I have described, the Home Loan 
Banks can play an even broader and more important role in the 
future than they have in the past and do so in a way that is 
mindful of the financial interests of the American taxpayers.
    Thank you.
    [The prepared statement of William C. Apgar follows:]

  Prepared Statement of William C. Apgar, HUD Designee to the Federal 
                         Housing Finance Board

    Good morning Mr. Chairman, and members of the Task Force. I would 
like to thank you for the opportunity to appear today to testify before 
the Task Force on Housing and Infrastructure of the House Budget 
Committee on the subject of economic implications of debt held by 
government sponsored enterprises. I should point out that the Board of 
Directors of the Federal Housing Finance Board has not reviewed my 
testimony nor does it represent the Administration's position.
    The Federal Housing Finance Board (Finance Board) is an independent 
agency in the Executive Branch. It is both the mission and safety and 
soundness regulator for the 12 regional Federal Home Loan Banks 
(FHLBanks) and the regulator of the Office of Finance, which serves as 
the debt issuance facility for the consolidated obligations of the 
FHLBanks. The Finance Board is funded through assessments made on the 
FHLBanks and is not subject to the congressional appropriations 
process.
    Since the resignation of Bruce Morrison as Chairman on July 4, 
2000, I have held the delegated authority of Chairman of the Finance 
Board as Secretary Cuomo's designee. I would like to emphasize my 
intention to maintain the continuity of the Finance Board's recent 
actions with respect both to safety and soundness and to innovation by 
the FHLBanks and competition among the government sponsored enterprises 
(GSEs) as a means of maximizing their public benefit.
    Congress created the FHLBank System in 1932 to improve the 
availability of funds to support homeownership. The FHLBanks are 
cooperatively owned by their member-bank stockholders and they operate 
by enhancing member lending at the local level. The FHLBanks offer as 
their primary product, a readily available, low-cost source of funds, 
called an advance, to its member institutions and housing associates. 
Advances enhance lending by members both by passing through the 
FHLBanks' cost-of-funds advantage in the debt markets, and by having 
FHLBanks manage interest rate risk. To the Finance Board, activities 
that assist and enhance lending by members are consistent with the 
FHLBanks' mission.
    Congress originally granted access to FHLBank advances primarily to 
thrift institutions. In response to the thrift crisis of the 1980s, 
Congress enacted FIRREA in 1989 to change the FHLBank System, most 
significantly by expanding membership eligibility to include commercial 
banks and credit unions.
    In 1989, Congress also imposed a $300 million per year assessment 
on the FHLBanks to help pay for the costs of the thrift bailout. In 
addition, Congress imposed a requirement that 10 percent of FHLBank net 
earnings go to support an Affordable Housing Program (AHP) each year. 
The AHP is designed to enhance the availability of affordable housing 
for very low- to moderate-income families. Last year the FHLBank System 
made $199 million in AHP contributions and grants nationwide. The 
combination of these new financial obligations, the decline in the 
thrift population, and the time lag for commercial banking institutions 
to join the FHLBank System and take down advances, understandably drove 
the FHLBanks in the 1990s to supplement earnings by increasing 
arbitrage activities.
    In November 1999, by enacting Title VI of the Gramm-Leach-Bliley 
Act--the first comprehensive legislation since FIRREA to affect the 
FHLBank System--Congress, in a singular vote of confidence, made many 
changes to enhance the capacity of the FHLBanks to carry out their 
housing finance and community and economic development mission as part 
of the modernized financial services world of the 21st century. 
Significant, among other changes, is that the FHLBank System has now 
been charged with supporting access to low-cost funds for community 
financial institutions to support small business, small farm and small 
agri-business lending. Moreover, by changing the fixed $300 million 
REFCORP assessment to one based on a percentage of FHLBank income and 
by reforming the FHLBanks' capital structure, this legislation has 
truly positioned the FHLBank System to add value to consumers and to 
the financial system in three critical areas: providing competition in 
housing finance; serving as central bank to community institutions; and 
serving underserved populations. I would also stress that, through both 
proposed and final regulations, including a recently proposed 
regulation on the new risk-based capital structure, the Finance Board 
has implemented all the statutory requirements of Gramm-Leach-Bliley--
as well as exercising its discretionary authority to strengthen mission 
regulation--in a timely and expeditious fashion, and I would like to 
commend the Finance Board staff on their efforts in this regard.
    As of June 30, 2000 the assets of the FHLBank System totaled $621 
billion. There were more than 7500 members as of that date. The bonds 
issued to support the assets of the FHLBank System are expressly not 
obligations of the United States, but they do benefit from the 
favorable investor perception associated with the FHLBanks' status as a 
GSE. The Federal Home Loan Bank Act makes clear that it is the Finance 
Board's primary duty to ensure the safety and soundness of the FHLBank 
System and, consistent with that primary duty, to ensure that the 
FHLBanks carry out their housing finance mission.
    As noted, the fundamental business of the FHLBanks is to provide 
member institutions with advances and other credit products in a wide 
range of maturities and terms to meet member demand. Lending and 
investing funds and engaging in off-balance-sheet interest-rate 
exchange agreements have the potential for exposing the FHLBanks to 
credit and interest-rate risk. The principal defenses against credit 
and interest-rate risk are sound risk-management policies and 
practices, vigilant supervision, and the over $30 billion of FHLBank 
System capital.
    To control the FHLBank System's risk exposure, the Finance Board 
has established regulations and policies that FHLBanks must follow to 
evaluate and manage their credit and interest-rate risk. Among the most 
notable regulatory requirements are:
     The FHLBanks must have, and take whatever actions are 
necessary to maintain, a triple-A credit rating on their consolidated 
debt.
     Each FHLBank must have, and take whatever actions are 
necessary to maintain, a double-A credit rating that is a meaningful 
measure of the individual FHLBank's financial strength and stability.
     Each FHLBank must establish and implement risk management 
policies and controls that comport with Finance Board requirements and 
conduct periodic assessments of these controls.
     Each FHLBank and the Office of Finance must be subject to 
an annual on-site examination by the Finance Board, as well as off-site 
analyses.
     Each FHLBank must file periodic compliance reports with 
the Finance Board.
     Each FHLBank must have both an external and an internal 
auditor, and the Finance Board has recently articulated a new set of 
state-of-the-art duties and responsibilities of the audit committee of 
each FHLBank's board of directors along with standards for corporate 
governance and internal controls that the boards must comply with.
    Managing Interest-Rate Risk. Interest-rate risk is the risk that 
relative and absolute changes in interest rates may adversely affect an 
institution's financial condition. The goal of an interest-rate risk 
management strategy is not necessarily to eliminate interest-rate risk 
but to manage it by setting appropriate limits.
    The Finance Board has adopted comprehensive policies that strictly 
limit the amount of interest-rate risk a FHLBank may assume. Most of 
the FHLBanks have adopted internal interest-rate risk limits that are 
even more conservative than the strict limits required by the Finance 
Board. To further limit interest-rate risk that could arise when a 
member prepays an advance, the Finance Board requires that each FHLBank 
generally charge a prepayment fee that makes it financially indifferent 
to a member's decision to prepay an advance.
    The Finance Board limits the interest-rate risk of mortgage-backed 
securities (MBS) owned by the FHLBanks by restricting the types of MBS 
to those with limited average life changes (and hence limited price 
change) under certain interest-rate shock scenarios. Moreover, the size 
of the FHLBanks' MBS holdings is limited to no more than three times 
the FHLBanks' capital (or less than $90 billion today).
    The general approach of the FHLBanks toward managing interest-rate 
risk is to acquire and maintain a portfolio of assets and liabilities, 
which, together with their associated interest-rate exchange 
agreements, limit the exposure to future interest rate changes.
    Managing Credit Risk. Credit risk is the risk of loss due to 
default. The FHLBank System protects against credit risk through 
collateralization of all advances. In addition, each FHLBank can call 
for additional or substitute collateral during the life of an advance 
to protect its security interest. In the 68-year history of the FHLBank 
System, no FHLBank has ever experienced a credit loss on an advance to 
a member.
    While the FHLBanks face minimal credit risk on advances, they are 
subject to credit risk on some investments. Each FHLBank must comply 
with limits established by the Finance Board and its board of directors 
on the amounts of unsecured extensions of credit, whether on- or off-
balance sheet. The Finance Board also limits the amounts and terms of 
unsecured credit exposure to any counterpart other than to the U.S. 
Government. Unsecured credit exposure to any counterparty is limited by 
the credit quality and capital level of the counterparty and by the 
capital level of the FHLBank.
    The Finance Board views these risk management requirements to be 
more than adequate to protect against any potential loss exposure to 
the taxpayer. Even so, the taxpayer has a right to expect certain 
benefits for taking any potential risk and for bestowing certain 
advantages on the GSEs.
    Congress long ago decided that promoting homeownership is desirable 
and worth the cost of granting special advantages to homebuyers, such 
as the mortgage interest tax deduction, and the establishment of 
specially advantaged GSEs to facilitate housing finance and other 
socially desirable activities. In exchange for public support, the 
American taxpayer has the right to expect responsible behavior by the 
GSEs. It is obvious that it is critically important to protect the 
taxpayer from any potential loss by monitoring and regulating GSE 
financial risk. It is also critically important to ensure that the low 
cost-of-funds and other advantages bestowed upon the GSEs are well 
directed and ultimately reach their intended beneficiaries. There is a 
risk that much of the government-bestowed benefit could be absorbed as 
profits within the GSE conduit.
    One unique characteristic of the FHLBank System--namely, its 
cooperative structure--inherently protects against such an event. 
Because members and shareholders are one and the same, and because the 
public benefit of the FHLBanks System is delivered by members' retail 
lending, the members' financial incentives to get the lowest cost of 
funds is entirely consistent with maximizing the public's benefit. In 
addition, mission regulation helps to ensure that this valuable GSE 
benefit is focused on assisting member lending.
    Congress created GSEs to accomplish statutorily prescribed missions 
and provided them with advantages, including a U.S. Treasury line of 
credit, which enables them to benefit from a lower cost of funds and 
operations. It is up to the regulator to ensure that the public, in 
turn, receives the benefits of that lower cost and to ensure, 
consistent with safety and soundness, that the public mission of the 
GSE is achieved.
    Mission regulation, while controversial, is closely related to 
safety and soundness regulation. Many assets are perfectly safe and 
sound from a financial point of view. But because the GSEs were created 
for very specific purposes, and GSE assets are supported by agency 
debt, only some assets are consistent with the mission of those GSEs.
    The Finance Board has been focusing the FHLBanks on core mission 
activities. In the past, some level of non-mission investments were 
necessary for the FHLBanks to meet their REFCORP obligation of $300 
million per year and to fund AHP. This arbitrage activity, where the 
FHLBanks borrow at close to Treasury rates to purchase higher yielding 
assets in the capital markets, such as MBS, and earn a profit from the 
spread, has been the subject of bi-partisan criticism for many years. 
Investments supported by agency debt and ultimately guaranteed by the 
taxpayer simply to earn a profit are much less useful than activities 
that would more directly benefit members and their borrowers.
    Indeed, the ``arbitrage issue'' has been at the top of the list of 
concerns of many Members of Congress and the Treasury Department, and 
rightly so. Five years ago approximately 40 percent of FHLBank assets 
reflected Core Mission Activity as we have recently defined the term. I 
am pleased to report that through a combination of advances growth and 
Finance Board actions, that ratio is now approximately 75 percent.
    Recent Finance Board actions along with the reforms passed in 
Gramm-Leach-Bliley that eliminated the major drivers of arbitrage, such 
as the flat REFCORP assessment and subscription based capital, provide 
the best opportunity in a decade to focus the activities of the 
FHLBanks on their mission and reduce their dependence on arbitrage 
investments. On June 29, the Finance Board passed the ``Core Mission 
Assets/Acquired Member Assets'' rule. This rule establishes the 
framework for the FHLBank System to pursue a totally mission-related 
balance sheet. The rule has two parts:
    1. It makes permanent the Acquired Member Assets, or AMA programs, 
and removes the $9 billion cap on the ``Chicago Pilot'' (MPF), which is 
the most prominent of acquired member asset programs. MPF has proven to 
be very successful and has to date acquired over $10.5 billion of 
assets. Each of the 12 FHLBanks is now offering, or will soon offer, 
MPF or a similar program that will divide the risks of mortgages 
between a member bank and its FHLBank partner. Rather than sell the 
mortgage and all its attendant risks in the secondary market, a FHLBank 
member will have the option of retaining the credit risk and being 
rewarded for good underwriting by receiving a credit enhancement fee. 
The FHLBanks, experts at hedging interest rate risks, will assume and 
manage the market risk.
    These partnership programs provide true competition with the two 
secondary market GSEs. Instead of credit risk being concentrated in 
these two housing GSEs, the risks can now be dispersed through the 
FHLBanks to their 7,500 members. These programs de-concentrate the 
risks of a $4 trillion housing finance market and put the rewards in 
the right place--with those who take the risk--to offer what is truly a 
``third way home.''
    Rather than rail against the housing GSEs and the advantages they 
have been afforded, I believe we should instead focus on how to 
introduce competition among them, decrease risk to the public sector, 
and focus mission to maximize the public benefit. The FHLBanks' AMA 
programs accomplish these objectives.
    2. The proposed rule defines Core Mission Assets (CMA) as assets 
(including advances, AMA and certain smaller classes of targeted 
assets) that the FHLBanks are encouraged to hold. If there is any 
meaning to the mandate that the Finance Board ``ensure'' mission 
achievement, it is incumbent on the Finance Board to state in 
regulatory form which activities and assets actually advance that 
mission. Rather than imposing a constraint, the definition of Core 
Mission Assets simply specifies what we consider to be the most 
productive, value-added assets as tools for business and capital 
purchase purposes.
    The development of Acquired Member Asset programs will help the 
FHLBanks to develop core mission assets to replace arbitrage 
investments and, at the same time, increase competition in the 
secondary market. By doing so, AMA should increase mortgage market 
share for depository institutions, help disperse the credit risk of the 
$4 trillion mortgage market from the two large secondary market GSEs to 
the more than 7,500 FHLBank member institutions and, most importantly, 
reduce mortgage costs for American homebuyers.
    These new AMA activities must be supported by a strong capital 
base. For this reason, as well as for the purposes of capitalizing 
other new FHLBank activities, and creating consistency with rules 
applied to other regulated financial institutions, Gramm-Leach-Bliley 
has mandated the establishment of a new risk-based capital structure, 
that will allow the FHLBanks to adjust their capital to the actual 
risks that they have on their balance sheets.
    Currently, members are required to buy an amount of FHLBank stock 
based on the size of their balance sheets and the amount of their 
advance borrowings from the FHLBanks. This has resulted in systematic 
over-capitalization of the FHLBanks. The FHLBanks have been servicing 
this excess capital with arbitrage-derived profits. Risk-based capital 
will match required capital to actual acquired risk and therefore 
alleviate the need for extraneous arbitrage earnings. Risk-based 
capital offers greater protection to the System and therefore greater 
protection to the taxpayer. Another way of looking at the issue of 
capital is as follows: member institutions can think of the FHLBanks as 
their capital markets affiliate and make a rational decision as to how 
much capital they wish to put up for the FHLBanks to be able to conduct 
members' business. The size of the balance sheet need be no larger than 
what is actually required for business, not for arbitrary, non-mission 
related arbitrage. Again, this is another vital tool to minimize risk 
while assuring maximum pass-through of public benefit. The Finance 
Board on July 13 proposed a state-of-the-art risk-based capital rule as 
required by Gramm-Leach-Bliley, which is currently out for a 90-day 
comment period. The legislation requires the Finance Board to issue its 
final capital rule by November 12 of this year, and we are making 
progress toward that goal.
    In summary, as a result of both Gramm-Leach-Bliley and the 
regulatory initiatives that I have described, the FHLBanks can play an 
even broader and more important role in the future than they have in 
the past. The FHLBanks have new authority to expand into small business 
and agricultural lending to their smaller members, to expand non-
mortgage lending to all members and to offer new mortgage products that 
enhance competition among the housing GSEs and disperse the credit 
risks of mortgage finance. The FHLBanks now have a regulatory incentive 
to focus on activities that create value for members and thus for 
consumers, and have the prospect of more permanence in the FHLBank 
capital base than has previously been the case. In all these ways, the 
FHLBanks are extraordinarily well-positioned to work with their rapidly 
growing membership base. Consumers of financial services all across 
America will benefit if we stay this public policy course and authorize 
the FHLBanks to play these important roles in the future.

    Chairman Sununu. Thank you very much, Mr. Apgar.
    Mr. Falcon, a lot of discussion in the previous panel 
centered around matching the GSE portfolios in order to 
minimize their exposure to risk. To what extent are the long-
term assets within the GSE portfolios funded by short-term 
debt? How well matched are the portfolios?
    Mr. Falcon. Right now, Mr. Chairman, we consider the 
portfolios to be very well matched. The majority of the debt 
that they issue is long term and the short-term debt that they 
do have is through the use of derivatives converted to 
effective long-term debt and then the majority of that long-
term debt has callable or adjustment features in it which 
protect the enterprises from changes in interest rates.
    Chairman Sununu. How do you quantify or how do you measure 
the degree to which the portfolio might be mismatched, that 
there might be some gap in duration?
    Mr. Falcon. Well, you have to take into account, Mr. 
Chairman, the prepayment risk associated with mortgages and 
there is a well established body of research about prepayment 
speeds on mortgages. And it depends on the various state of 
interest rates as to whether or not mortgages will be prepaid 
at a certain rate, as opposed to earlier rather than later.
    Chairman Sununu. In trying to forecast prepayment risk, do 
you benefit from the GSEs' considerable database of 
information? I would guess that no one has better historical 
records than the GSEs. Do you benefit from that information in 
trying to estimate yourself what the potential for prepayment 
is?
    Mr. Falcon. Yes. Absolutely. In fact, we have a broader 
base than either one of the GSEs, since we have both GSEs' 
databases. We can look at them in the aggregate in addition to 
individually.
    Chairman Sununu. Could you for a little bit of history 
describe the mismatch that occurred in the early 1980's that 
was mentioned by the previous panel and the degree to which 
that could or could not happen again due to changes in the 
policy at the GSEs?
    Mr. Falcon. Certainly I would never say that anything could 
never happen again, Mr. Chairman, but I think through our 
supervisory program I am comfortable with the way they are 
managing their interest rate risk at the current time.
    Certainly--and I worked for the House Banking Committee for 
8 years, Mr. Chairman, and worked with that committee to help 
deal with the savings and loan crisis, so I am well aware of 
what is required of a regulator in order to try to prevent that 
from ever happening again with any financial institution.
    So I think what you had there was basically, as the 
previous panel described, you had long-term assets funded with 
short-term sources of funds. And that is why it is so critical 
to the enterprises to ensure that there is a match in duration 
of assets and liabilities.
    Chairman Sununu. Who had responsibility for oversight at 
that--and that's before S&Ls even existed, correct?
    Mr. Falcon. Yes, Mr. Chairman.
    Chairman Sununu. So who was primarily responsible for 
oversight or for trying to help identify whether or not a 
mismatch existed in the early 1980's?
    Mr. Falcon. With the enterprises?
    Chairman Sununu. Yes.
    Mr. Falcon. At that time, I think HUD had some general 
regulatory responsibility, but I think that was the extent of 
it.
    Chairman Sununu. Could you talk a little bit about the 
risk-based capital stress test? What are the principles that 
are at the core of that test that you have developed and are in 
the process of implementing?
    Mr. Falcon. I certainly enjoy talking about risk-based 
capital because I think it would be a very valuable tool for 
OFHEO in achieving its responsibilities.
    It is intended to complement our examination program and 
our research program. They are all, I think, critical 
components to OFHEO achieving its mission.
    Risk-based capital is simply placing the enterprises' 
balance sheets under stressful economic conditions, both 
stressful credit losses as well as big swings in interest rates 
and then seeing how their balance sheets would fare under a 10-
year scenario at those stressful levels.
    We are in the process right now of combing through the 
comments. In fact, we have concluded review of all the comments 
on the proposal and we are in the process right now of writing 
a final rule to reflect any changes that have been made and we 
will also have to make changes to the computer model.
    This involves not just writing the rule, but involves 
writing very sophisticated computer code to make sure that we 
adequately and properly model the assets and liabilities of the 
enterprises.
    Chairman Sununu. What elements of risk cannot be adequately 
captured in this kind of a model?
    Mr. Falcon. I think management and operations risk is 
certainly one of them, but that is why the risk based capital 
requirement will have a 30 percent add on in addition to 
whatever is produced by the stress test. So there is a very 
generous add on that is included to the stress test capital 
requirement.
    Chairman Sununu. Is that 30 percent intended to cover bad 
management?
    Mr. Falcon. No, just to--well, to ensure that if there were 
any lapses in management or unforeseen circumstances, this is 
just an add on to ensure that to the next something cannot be 
modeled in the risk-based capital regulation there is a cushion 
in addition to that requirement which is produced by the stress 
test.
    Chairman Sununu. How does OFHEO deal with oversight of risk 
management strategies in hedging?
    Mr. Falcon. Our examination staff, which I think consists 
of very talented and experienced examiners, look at the 
policies of the enterprises and not just their policies but the 
actual practices of the enterprises in trying to hedge against 
risk. They will look at very specific transactions that are 
entered into, to accommodate changes in interest rate.
    I think, Mr. Chairman, this will be complemented by our 
risk-based capital standard, but as great as the risk-based 
capital standard will be when we get it completed at the end of 
the year, I do not ever want to downplay how important it is 
for our examiners to be there at the enterprises, understanding 
everything that the enterprises do.
    We never substitute our business judgment for what they 
have decided to do in running their businesses, but we 
certainly look at everything that they do and try to make 
certain that the risk is properly managed.
    Chairman Sununu. As the size of the portfolio held by the 
GSE grows, the GSE needs to engage in a greater volume of 
interest rate swaps and utilization of option-embedded 
securities in order to keep that portfolio in balance. Is that 
correct?
    Mr. Falcon. Yes. As they add mortgage-backed securities 
into their portfolio, their retained portfolio, they do take on 
the interest rate risk.
    Chairman Sununu. Does the increase in the utilization of 
derivatives in that situation in and of itself require a higher 
level of capitalization or reserves?
    Mr. Falcon. I think any increase in the use of derivatives 
certainly requires increased supervision because you then have 
to deal with counterparty risk and counterparty risk is dealt 
with in our risk-based capital standard as well as in our 
examination program. We will look at the nature of the 
counterparties, we will try to make sure that there is not any 
concentration in any one or two counterparties, but, yes, it is 
an important part of our supervision.
    Chairman Sununu. Mr. Ely was disappointed that he did not 
have access to more information regarding that counterparty 
exposure but for the purposes of regulation, is there any 
information regarding counterparty exposure that you do not 
have access to?
    Mr. Falcon. No, sir.
    Chairman Sununu. Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman, and thank our panel 
for being here. I am sorry I missed your testimony.
    I want to say I am always happy to see Mr. Falcon testify 
because a lot of what we are talking about with respect to the 
GSEs and whether or not there is sufficient oversight and risk-
based capital rules and all is sitting on Mr. Falcon's front 
doorstep and we eagerly await the publication of the final 
rules with respect to that and I, for one, am eager to see 
Congress allow Mr. Falcon and the agency that he represents the 
ability at least to carry out what we passed in 1992 before we 
go and change it all again, maybe at least for a month or two, 
if not longer.
    Let me ask just a couple of questions.
    One, to Mr. Ely's question on derivative information, when 
OFHEO conducts its analysis of the GSEs, in which case you will 
be looking at counterparty risk and the like, will that 
information, will your final analysis including some of that 
information, become part of the public domain and thus be 
available to the public, whether it is the general public, 
concerned investors or whatever?
    Mr. Falcon. I think generally I would like to foster 
greater understanding of the GSEs and the secondary mortgage 
market. To the extent we can provide any increased transparency 
to their operations, especially in this area, I think it would 
be of benefit to the mortgage market and to the public. 
However, we have to balance that against the requirements of 
the Trade Secrets Act and ensure that we do not release any 
proprietary information of the enterprises, but certainly I 
think that that is a very worthwhile goal.
    Mr. Bentsen. It is tough in the area of derivatives, there 
is no real Federal standard as it relates to disclosure of 
derivative investments, even in the banking industry we have 
had a battle going on over FASB rules and how derivatives 
should be handled and disclosure rules, but I would hope that 
OFHEO's analysis that it is disclosed to the public is useful 
analysis, I guess is the best way to put it.
    How would you compare in establishing your risk-based 
capital standards and your stress test to those that were 
established under FIRREA for savings and loans? You were 
involved in the passage of both pieces of legislation as 
counsel on the banking committee. FIRREA sought to impose 
tighter investment standards on thrifts both in the purchase of 
mortgages, mortgage securities, and other types of non-mortgage 
investments. Do you think the standards you are establishing 
are comparable to that?
    Mr. Falcon. The standards which eventually resulted from 
FIRREA and FIDCIA were risk-based capital standards, but they 
were more of a ratio or leverage type risk-based capital 
standard, where assets were placed in buckets and the buckets 
had a risk weighting and the resulting capital would be their 
risk-based capital standard.
    This was in addition to the straight forward leverage 
capital standard that the banks and thrifts have applied to 
them.
    What OFHEO is doing under the 1992 act is something which 
is entirely different. I do not mean to imply that one is 
better than the other. I think that comparing banks and thrifts 
and the enterprises, it may be that one is appropriate for 
banks and thrifts and this is appropriate for the GSEs. What we 
do is we actually place the balance sheets of the enterprises 
under stressful conditions, big interest rate swings, severe 
credit losses, we give them credit for hedging activities, and 
we make sure that they can remain solvent over that entire 10-
year period under those stressful conditions.
    If at any point in any quarter during that 10-year period 
they do not have sufficient capital to remain solvent, then we 
will increase their capital requirement to make sure that they 
always maintain that level of minimum capital.
    So we try to simulate through this risk-based capital 
regulation and the stress test what would happen under severe 
economic times and I think that is an entirely different way of 
imposing a risk-based capital requirement and, in fact, we have 
been educating the banking regulators on how this would work. 
There may be some aspects of it that they are trying to 
understand better to see if there is any applicability.
    Mr. Bentsen. Do you take into consideration geographic 
economic dislocation and how it affects the mortgage portfolio? 
I know a lot has been talked about the farm crisis and the 
impact it had on the Farm Credit System in the mid 1980's. 
Obviously, there was an economic problem broadly in the farm 
system.
    Do you all take into account--I mean, short of just an 
overall economic decline in the United States, the geographic 
changes in the real estate market?
    Mr. Falcon. Well, the worst credit losses that are built 
into the stress test actually are the worst credit losses for a 
specific region of the country, so to the extent that we did 
pick the severest credit losses for a geographic region of the 
country and implied those losses and that experience to the 
entire portfolio of the enterprises, so Congressman, I think in 
that sense we are trying to not just take a national average of 
credit experience, but actually a more focused worst case 
scenario.
    Mr. Bentsen. I just have a couple more questions, Mr. 
Chairman.
    If you find that there is under capitalization or potential 
under capitalization or non-adherence to stress test risk out 
there, your examiners are in the GSEs and they find there is a 
problem with the portfolio or a systemic problem, what 
authority do you have to correct that problem?
    Mr. Falcon. We have pretty broad authority in our statute 
and we have adequate authority, I believe, to step in and 
require the corrective action to address the problem and we 
will move quickly to do that. I would never want to place this 
committee, this Congress, in any position where they have to 
consider a deteriorating condition of the enterprises. So we 
would move quickly, we would move forcefully, utilizing all the 
authorities we have to ensure that we exercise prompt, 
corrective action.
    Mr. Bentsen. Do you have similar sort of cease and desist 
authority in the same way the Comptroller of the Currency or 
the Federal Reserve has in bank regulation?
    Mr. Falcon. Yes.
    Chairman Sununu. Finally, for Mr. Apgar and Mr. Falcon, 
there has been a lot of discussion about GSE debt and we will 
just talk about aggregate debt, both GSE corporate debt and 
mortgage-backed security debt, and how fast it is growing.
    Is GSE debt--the vast majority of which is mortgage debt, I 
believe, in one way or the other--is it growing more rapidly 
than housing debt would grow as a whole to meet housing market 
demand?
    The point is--and this is sort of where I think the big 
question we are leading to is--do the GSEs have access to so 
much cheap money out there that they have issued a dramatic 
amount of debt far greater than the demand they have for buying 
mortgages, either through direct purchase or through the MBS 
function?
    Mr. Apgar. Well, you heard earlier that the mortgage market 
is a mature market, growing only so fast, and the GSEs for a 
variety of reasons, the secondary market GSEs particularly, are 
growing even faster in their purchase of debt.
    I think the more relevant question is is it growing faster 
than maybe Congress or anybody anticipated when they laid down 
the regulatory frameworks in 1992. And so I think it is a fair 
question to review whether the oversight mechanisms are 
appropriate. I have high confidence that in the case of the 
Federal Housing Finance Board we are doing an adequate job.
    I have testified earlier concerning the job that OFHEO and 
HUD is doing in its oversight of Fannie and Freddie, but I do 
think it is an appropriate question given the fact that it is 
growing, I believe, faster than people would have anticipated 
that would review these regulatory structures.
    Mr. Bentsen. I would just add--and that is a fair question, 
I agree with you, that is a question we need to be focusing on. 
But my initial question is a risk-related question.
    The argument is that there is substantial risk associated 
with the rise in GSE debt. The question is is that debt rising 
to meet housing market demand or is it rising faster than 
housing market demand would otherwise require?
    And if there is a spread there, then is that where the risk 
would be?
    Mr. Apgar. Well, it is clearly----
    Mr. Bentsen. Assuming that the housing market is relatively 
stable.
    Mr. Apgar. It is what does housing market demand require, 
which is the question of how much do the GSEs need in order to 
maintain their operations and that is the important question 
that we have been discussing.
    Clearly, in order to maintain their role as secondary 
market activity, they need to do some purchasing of securities 
to maintain price and other things. The question is whether 
they have been involved in excessive purchases, some way 
defined, and I do not have a specific answer on that.
    Mr. Bentsen. Thank you.
    Thank you, Mr. Chairman.
    Chairman Sununu. Mr. Smith.
    Mr. Smith. Thank you, Mr. Chairman.
    I happen to chair one of the science subcommittees in 
research and we have been looking at the effect of the new 
technology and our ability through computers and websites to 
communicate and I am somewhat familiar with a couple of 
innovations such as the muniauction.com and other websites that 
tend to make sure that the market is in place as far as buyers 
and sellers in terms of trying to make this system a little 
more efficient.
    What do you see as the impact of this kind of advance 
communication in terms of bringing the lowest possible interest 
rates or the lowest possible--the best possible service to the 
ultimate homeowner?
    Mr. Apgar. Well, as was noted earlier, capital markets are 
emerging, they are integrated into the world, housing finance 
markets into the world, capital markets. The innovations in 
delivery of mortgage products are astounding. And so I think 
that all enures to the benefit of the American home buyer.
    Mr. Smith. Mr. Falcon, any comments?
    Mr. Falcon. I agree generally with what Secretary Apgar 
said.
    Technology as it evolves, and I would recommend to you our 
annual report which discussed this at some length, could change 
the way the mortgage delivery system is used right now. I think 
you are seeing some efforts by the enterprises to try to 
position themselves accordingly. They are developing 
relationships with others such as the Freddie Mac-Microsoft 
joint venture to have a single delivery mechanism for mortgages 
through the Internet.
    So I think it is an area that we are studying carefully.
    Mr. Smith. And, Mr. Falcon, let me ask you a question about 
hedging. When asked about the credit risk and interest rate 
risk as a result of mortgages and MBSs in the portfolio, GSEs 
are quick to point out that they have a great hedging system 
and so my question is is there an adequate framework in place 
for OFHEO to assess and review these hedging systems to look at 
what is going to be the best way to do it? How do you assess 
it? Are you assessing them?
    Mr. Falcon. Absolutely, Congressman. We look at their 
overall policies with regards to how they use hedging, 
derivatives for hedging purposes. They engage in derivative 
usage for hedging purposes and do not engage in the use of 
derivatives for speculative purposes. And we do look closely at 
how they use hedges to deal with any possible interest rate 
risk that they have with respect to their portfolio or any 
other line of business that they have.
    Mr. Smith. And another question is Fannie Mae has stated on 
several occasions that a bank or a thrift institution would 
require much more capital if they were going to meet the risk-
based capital requirements of OFHEO. Give me your reaction.
    Mr. Falcon. You really cannot compare them, Congressman. 
They are two entirely different types of capital regulations, 
the risk-based capital we are working on versus the risk-based 
capital regulation that banks and thrifts have applied to them. 
And the nature of their businesses are very different as well. 
So I do not know that you could readily compare the capital 
requirements of banks and thrifts to the capital requirement 
that we will have for Fannie or Freddie under a risk-based 
capital regulation.
    Mr. Smith. And maybe a final question would be each of your 
assessment or your evaluation of the ultimate responsibility of 
the Federal Government, how much of a real obligation would 
there be for the Federal Government to underwrite, would it be 
a political obligation?
    Do you see anything that is implied in any of the laws or 
any of the regulations that might go further in implying some 
underwriting by the Federal Government if the GSEs run into 
trouble?
    Mr. Apgar. Well, as was noted, we are starting with 
securities that say in plain English that these are not 
guaranteed by the Federal Government, but that does not undue 
the 60, 70-year history of Federal involvement in each entity. 
And so clearly there is an investor perception.
    What it would take to change investor perceptions is 
difficult to assess, but among other things, investors could 
perceive that because of the size of these organizations alone, 
independent of this history of Federal involvement, that any 
substantial financial difficulties because of the magnitude and 
number of people that would be affected by that would require 
some Federal action.
    Mr. Falcon. I agree totally, Congressman. You could remove 
the enterprises' line of credit and you could take away their 
Federal charter, you could subject them to State and local 
taxation, you could take away all the explicit Federal 
benefits, but you still have the question before you of would 
they be considered too big to fail.
    This is a question that Congress has before it, not just 
with respect to Fannie or Freddie or the Federal Home Loan Bank 
System, but with respect to any large financial institution.
    So would repealing the explicit benefits they receive 
address the issue of the implied Federal guarantee? I am not 
certain it would because of the issue of too big to fail.
    Mr. Smith. And so to what extent does this implied 
responsibility of the Federal Government add to the profits of 
Fannie Mae and Freddie Mac?
    Mr. Falcon. It certainly makes our jobs all the more 
important, to make sure that we are adequately supervising the 
enterprises. The benefits they receive, as I outlined in my 
testimony, there is benefit that enures to homeowners. If you 
look at the comparison of the conforming mortgage interest rate 
to jumbos, there is certainly a difference in what it would 
cost the homeowner to get a home loan.
    Chairman Sununu. If you could elaborate on that, to what 
extent is that disparity driven by the participation of the 
GSEs and to what extent is it driven by market liquidity at the 
sort of higher end and the larger size mortgages that might be 
less common?
    Mr. Falcon. Well, I think certainly the enterprises' lower 
cost of funds by virtue of the GSE status is what results in 
some of that differential. Whether or not all of the 
differential gets passed on to homeowners is a question. I 
believe it was CBO several years ago opined that roughly half 
of it was passed on to the homeowners and the rest was for the 
benefit for shareholders.
    I would like to do some more research on the subject, Mr. 
Chairman, on your specific question.
    Mr. Smith. Mr. Chairman, can I just do a quick final 
question?
    Chairman Sununu. Sure.
    Mr. Smith. To what extent is this implied support and 
underwriting by the Federal Government jeopardizing additional 
competition or participation in the secondary mortgage market 
by other totally private organizations?
    Mr. Falcon. Well, there is a healthy amount of business 
done by private label mortgage-backed securitizers and Ginnie 
Mae certainly engages in mortgage-backed securities of FHA 
loans. There is an issue here about competition. I am not 
prepared to say a lot about it, but it is one that I think is 
appropriate for Congress to consider.
    Generally, I think competition is good.
    Mr. Smith. So are you saying it does to some extent give 
Fannie Mae and Freddie Mac somewhat additional advantage?
    Mr. Falcon. Without a doubt, Congressman. The existence of 
the GSE status on Fannie and Freddie does give them a 
competitive advantage over any competitor that does not have 
GSE status. That is certainly true.
    Chairman Sununu. Thank you, Mr. Smith.
    Mrs. Clayton.
    Mrs. Clayton. Thank you.
    To follow up, I think that the reason and the rationale for 
creating and giving the advantage was that indeed there was a 
need for generating tools that would enhance the affordability 
for housing. Is that not right?
    Mr. Falcon. Yes. That was Congress' purpose in establishing 
the GSEs.
    Mrs. Clayton. And knowingly they gave it an advantage 
because there was a public good for which there was a need, 
otherwise, they would not have done that.
    Mr. Falcon. Yes, that is right.
    Mrs. Clayton. All of the previous panelists indicated that 
the buying back of mortgage-backed securities is perhaps not 
mission driven and one, I think Ms. Miles, said it may be a 
wash, yet Mr. Ely argued that the absence of a diversified 
portfolio increased the risk exposure of the GSEs.
    Can it be said that to buy back mortgage-backed securities 
really decreases or increases the risk?
    Mr. Falcon. I think certainly buying back mortgages does 
help the enterprises in the sense that it increases the 
liquidity for their mortgage-backed securities. Whether or not 
that is--it is Congress' judgment to consider whether or not 
that is or is not a mission-related right of the enterprises to 
do that, but certainly it is a sound business practice to 
increase the liquidity of the securities and to the extent that 
this does increase the liquidity, I do not have a concern about 
it from a safety and soundness standpoint.
    Now, as a mission-related standpoint, that is something I 
think is appropriate for Congress to consider.
    Mrs. Clayton. But you do not have any questions about it 
undermining the mission?
    Mr. Falcon. No, ma'am.
    Mrs. Clayton. You do not question that the buying back 
would undermine the mission. You do see the value in that it 
strengthens the liquidity of the GSE and therefore reduces the 
risk which is the opposite of what Mr. Ely said.
    Mr. Falcon. Yes, Congresswoman. It does not undermine the 
mission of the enterprises.
    Mrs. Clayton. On the matter of the implied obligation of 
the U.S. Government to the creditors or the investors of the 
GSEs, the fact is that the line of credit that has been argued, 
again, Mr. Ely, really is very low as it relates to the 
portfolio, so indeed of that being an issue to undermine the 
government's debt, can you comment on that?
    Mr. Falcon. The two and a quarter billion dollars line of 
credit which each enterprise has is symbolic. Given their size, 
that amount of money would not really do them much good if they 
were to experience some severe economic troubles.
    Chairman Sununu. Mrs. Clayton, if you would yield on that 
point for a moment?
    Mrs. Clayton. Yes.
    Chairman Sununu. That begs the question what does it 
symbolize?
    Mr. Falcon. I remember this came up, Mr. Chairman, in the 
hearing before Congressman Baker as well. And I think it is a 
matter for discussion and debate by this Task Force, by the 
Congress, as to whether or not Congress wants to begin to take 
away some of the explicit benefits that the GSEs have.
    Removing it would take away some of the aura of the implied 
government guarantee. Would it have any adverse effect on 
homeowners? That remains to be seen and it might be an avenue 
for further search.
    Mrs. Clayton. The implied obligation on the part of the 
government, is that enforceable?
    Mr. Falcon. It is enforceable only by Congress. If 
something were to happen to the enterprises----
    Mrs. Clayton. What about a court? Is it enforceable by a 
court order?
    Mr. Falcon. No, ma'am. The statute--in fact, the 1992 act 
which created OFHEO explicitly says that the liabilities of the 
enterprises are not backed by the full faith and credit of the 
Federal Government. It would take an act of Congress to step in 
and bail out the creditors of the enterprises if it wanted to 
do so.
    Mrs. Clayton. Follow on. Should we really be concerned with 
GSEs, their debt or about their safety and soundness if the two 
are not the same?
    Mr. Falcon. I'm sorry?
    Mrs. Clayton. Should we really be concerned about the 
extent of their debt or we should we be concerned about their 
safety and soundness, the security of the GSEs, since the two 
are not necessarily the same?
    Mr. Falcon. Right. Two issues here. One is the size of 
their debt. Certainly you would be more concerned about 
entities like this which have $2.2 trillion in debts and MBS 
outstanding as opposed to whether or not it was $10 million. So 
size is important here with respect to the implications to the 
financial system, should one of the enterprises ever become 
insolvent.
    However, equally or more important is the nature to which 
those risks are managed and supervised. That is why OFHEO has a 
very extensive examination program, that is why we have a 
minimum capital regulation, we will soon have a risk-based 
capital regulation in place.
    I think with the tools and adequate regulation we can 
ensure that those risks are properly managed and that there is 
not an undue risk to the financial system. That is OFHEO's 
role.
    Mrs. Clayton. You say you can, but you have found that. 
Haven't you found that they are sound?
    Mr. Falcon. Yes, ma'am. Absolutely.
    Mrs. Clayton. OK. And so the structure or the soundness of 
the management has been established and you have evaluated that 
to be the case. Is that correct?
    Mr. Falcon. Yes. They are financially healthy. They are 
well managed institutions.
    Mr. Apgar. Excuse me. Just with respect to the Home Loan 
Bank System, I would echo the same thing. I think today, there 
is no reason for concern about risks that the system poses to 
the American taxpayer.
    Mrs. Clayton. I think also, Mr. Chairman, that the implied 
advantage given to the GSEs is also an implied advantage given 
to the consumer and I would just question what the interest 
rate would be for our loans generated if we did not have that.
    So I do not know, since we are looking for studies, we may 
want to look at what that implication would be and how the 
interest rate would be somewhere else if we did not have the 
intervention of GSEs in the marketplace. So I think there is 
great value in having them there.
    Thank you.
    Chairman Sununu. Thank you very much, Mrs. Clayton.
    A few final questions.
    Mr. Falcon, you seemed to suggest just a few minutes ago 
that safety and soundness was not related to the size of the 
mortgage portfolio held by one of the GSEs. Now, it would seem 
to me that by purchasing mortgage-backed securities or whole 
loans and holding them that GSEs expose themselves to the risks 
we have talked about, interest rate risk and the prepayment 
risk, that they were not exposed to before they held those 
securities on their own balance sheet.
    So that would impact their safety and soundness, with the 
appropriate caveat that they would hedge and manage those risks 
in an appropriate way. But clearly the existence of the 
portfolio does have an effect on and is intertwined with safety 
and soundness in your evaluation of that in support of the 
safety and soundness.
    Mr. Falcon. Yes. You are right. What I meant to say, if I 
did not say it clearly, was the existence of a retained 
portfolio and their purchase of mortgage-backed securities is 
not in and of itself unsafe and unsound. It is more a question 
of how they manage the risk inherent with that activity.
    Chairman Sununu. And at least in your most recent report, I 
think it is a 2000 report, you certainly took those increased 
risks and risk management strategies into consideration in 
issuing the support for their safety and soundness that you 
did, correct?
    Mr. Falcon. Yes, Mr. Chairman.
    Chairman Sununu. Could you comment briefly on whether you 
think there would be some efficiencies to be gained if we 
combined your mission regarding safety and soundness with the 
mission regulation of the GSEs?
    Mr. Falcon. I am not sure what efficiencies would be 
gained. There could be some. But I would say that having 
mission regulation is not essential to an effective safety and 
soundness regulation. We work well with HUD. We are under the 
HUD umbrella as an independent agency within HUD and we are 
constantly discussing GSE issues amongst ourselves.
    Chairman Sununu. One case, though, where there would seem 
to be an interrelationship is in the discussion of appropriate 
investment vehicles and, in particular, the case of the whole 
cash value life insurance policies. There was a well publicized 
example, I think, several years back of investment in some 
equities, tobacco securities or equities or something along 
those lines.
    Those investments are reviewed, as I understand it, by 
those looking at mission, but they would ultimately have an 
effect on safety and soundness as well. Could both of you 
comment on that?
    Mr. Apgar. Yes. With respect to non-mortgage investments, 
you know, clearly, we need to look at the safety and soundness 
implications and so as we do our non-mortgage investments 
review, which take place on the HUD side of the ledger, we 
coordinate very carefully with OFHEO.
    Chairman Sununu. Why not allow OFHEO to have jurisdiction 
over those issues as well?
    Mr. Apgar. Because there are other issues with respect to 
non-mortgage investment in terms of what types of--as well as 
with mortgage investments as to whether or not they enhance the 
overall effectiveness of the mission, whether they are in the 
broad public value, we have a three-part test of which safety 
and soundness is just one of the criteria we use.
    Mr. Falcon. And HUD does approach us on these issues and we 
do offer a very thorough analysis to them about the safety and 
soundness implications of any activities of the enterprises, 
Mr. Chairman.
    Chairman Sununu. There was some discussion on the previous 
panel about global market disruptions such as the Russian 
devaluation, the series of Asian currency devaluations, and the 
fact that these kinds of global economic disruptions or 
downturns could have an impact on the safety and soundness of 
the GSEs.
    Now, it seems to me in considering both of those crises 
that the market reaction would be one of a flight to quality, 
which would have the effect of lowering interest rates or at 
least supporting demand for both GSE debt and perhaps mortgage-
backed securities that are viewed as a generally less risky 
investment as compared to many others that are in the 
marketplace.
    Mr. Falcon, could you comment on whether or not there are 
international economic disturbances that have been seen to have 
a negative impact on the risk profile of the GSEs, one, and, 
two, are the potentials for global economic disruptions, 
international disruptions included in the risk-based capital 
standard that you are soon to release?
    Mr. Falcon. Let me start with the risk-based capital 
standard. We have very lengthy historic data that we use that 
we built into our risk-based capital regulation, issues like 
the credit risk where you might have defaults associated with 
mortgages of the enterprises.
    That is built into those numbers that we use to model the 
likelihood of default and the severity of credit losses in the 
event that there were defaults on mortgages.
    Chairman Sununu. Just to be clear, you include historical 
information about international interest rates and currency 
values as well?
    Mr. Falcon. We think--not specifically international 
currency values or international economic scenarios. We think 
that is all built into the historical averages that we use on 
default rates and loss severities on mortgages that the 
enterprises are involved in.
    We could look at whether or not we would want to include 
specific international economic problems, but that would 
require us to get into a lot of speculative modeling on how 
much of an impact a crisis in Asia might have on mortgage 
performance in the United States, that kind of very 
hypothetical exercise. We try to stay away from that and make 
sure that this rule matches known risk to capital.
    On the first part of your question, with respect to the 
risk to the enterprises from possible international crises and 
the flight to quality, in 1998 there was such an event and 
there was a flight to quality and, in fact, Fannie Mae and 
Freddie Mac used their mortgage portfolio to be the market 
essentially for their securities. That helped their MBSs, their 
debt remain very liquid and part of a quality investment.
    Chairman Sununu. Are there any financial instruments that 
you are aware of aside from treasuries that have the level of 
market liquidity that the GSEs' mortgage-backed securities do? 
I mean even outside of that extraordinary case in 1998.
    Mr. Falcon. Sure. Sure. Some would point to some triple-A 
rated corporate debt of some very large companies.
    Chairman Sununu. That have higher liquidity, similar 
liquidity or nearly the same liquidity?
    Mr. Falcon. That are regarded as nearly as risk--that have 
the same risk level as the enterprises. But they trade closely 
to GSE debt. But none of those come to mind really.
    Chairman Sununu. Thank you very much.
    We thank both witnesses again. And the good news--the bad 
news, rather, is you are not Alan Greenspan, but the good news 
is you were able to keep a room full for about 3 hours.
    Thank you for your patience and for all of the information 
you provided the Task Force.
    We are adjourned.
    [Whereupon, at 1 p.m., the Task Force was adjourned.]

                                
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