[House Hearing, 107 Congress]
[From the U.S. Government Printing Office]

                     OFHEO RISK-BASED CAPITAL RULE



                               BEFORE THE

                            SUBCOMMITTEE ON
                    CAPITAL MARKETS, INSURANCE, AND 

                                 OF THE

                              COMMITTEE ON
                           FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION


                             AUGUST 1, 2001


       Printed for the use of the Committee on Financial Services

                           Serial No. 107-41


74-625                     WASHINGTON : 2001

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                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice      BARNEY FRANK, Massachusetts
    Chair                            PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska              MAXINE WATERS, California
RICHARD H. BAKER, Louisiana          CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama              LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware          NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York              MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California          GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma             KEN BENTSEN, Texas
ROBERT W. NEY, Ohio                  JAMES H. MALONEY, Connecticut
BOB BARR, Georgia                    DARLENE HOOLEY, Oregon
SUE W. KELLY, New York               JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                MAX SANDLIN, Texas
CHRISTOPHER COX, California          GREGORY W. MEEKS, New York
DAVE WELDON, Florida                 BARBARA LEE, California
JIM RYUN, Kansas                     FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama                   JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina      CHARLES A. GONZALEZ, Texas
DOUG OSE, California                 STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois               MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin                HAROLD E. FORD, Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania      RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut       KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona             RONNIE SHOWS, Mississippi
VITO FOSELLA, New York               JOSEPH CROWLEY, New York
GARY G. MILLER, California           WILLIAM LACY CLAY, Missiouri
ERIC CANTOR, Virginia                STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York       MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania         

             Terry Haines, Chief Counsel and Staff Director
            Subcommittee on Capital Markets, Insurance, and 
                    Government Sponsored Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

ROBERT W. NEY, Ohio, Vice Chairman   PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER COX, California          NYDIA M. VELAZQUEZ, New York
PAUL E. GILLMOR, Ohio                KEN BENTSEN, Texas
RON PAUL, Texas                      MAX SANDLIN, Texas
SPENCER BACHUS, Alabama              JAMES H. MALONEY, Connecticut
MICHAEL N. CASTLE, Delaware          DARLENE HOOLEY, Oregon
EDWARD R. ROYCE, California          FRANK MASCARA, Pennsylvania
FRANK D. LUCAS, Oklahoma             STEPHANIE TUBBS JONES, Ohio
BOB BARR, Georgia                    MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, North Carolina      BRAD SHERMAN, California
JOHN B. SHADEGG, Arizona             JAY INSLEE, Washington
DAVE WELDON, Florida                 DENNIS MOORE, Kansas
JIM RYUN, Kansas                     CHARLES A. GONZALEZ, Texas
BOB RILEY, Alabama                   HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York              RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
GARY G. MILLER, California           RONNIE SHOWS, Mississippi
DOUG OSE, California                 JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      STEVE ISRAEL, New York
MIKE FERGUSON, New Jersey            MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania

                            C O N T E N T S

Hearing held on:
    August 1, 2001...............................................     1
    August 1, 2001...............................................    27

                       Wednesday, August 1, 2001

Falcon, Hon. Armando, Jr., Director, Office of Federal Housing 
  Enterprise Oversight (OFHEO)...................................     9


Prepared statements:
    Baker, Hon. Richard H........................................    28
    Oxley, Hon. Michael G........................................    30
    Bentsen, Hon. Ken............................................    33
    Jones, Hon. Stephanie........................................    31
    Kanjorski, Hon. Paul E.......................................    34
    Falcon, Hon. Armando, Jr.....................................    36

                     OFHEO RISK-BASED CAPITAL RULE


                       WEDNESDAY, AUGUST 1, 2001,

             U.S. House of Representatives,
       Subcommittee on Capital Markets, Insurance, 
               and Government Sponsored Enterprises
                           Committee on Financial Services,
                                                    Washington, DC.
    The subcommittee met, pursuant to call, at 2:05 p.m., in 
room 2128, Rayburn House Office Building, Hon. Richard H. 
Baker, [chairman of the subcommittee], presiding.
    Present: Chairman Baker; Representatives Ney, Bachus, 
Lucas, Hart, Kanjorski, Bentsen, J. Maloney of Connecticut, S. 
Jones of Ohio, Capuano, Meeks, Inslee, Ford, Hinojosa, Lucas, 
Israel and Ross.
    Chairman Baker. I would like to call this hearing of the 
Subcommittee on Capital Markets, Insurance, and Government 
Sponsored Enterprises of the Committee on Financial Services to 
    Our hearing today is our continuing oversight of Government 
Sponsored Enterprises, (GSEs), and specifically the Risk-Based 
Capital Rule that the Office of Federal Housing Enterprise 
Oversight, (OFHEO), has recently finalized. And I am looking 
forward to its initial implementation within the next few 
    I am particularly glad to have Armando Falcon, the Director 
of OFHEO here today to explain the impact, direction and intent 
of the new standard, and I want to particularly express my 
appreciation to Mr. Falcon. I have, over the years, made 
comments concerning OFHEO's performance and my frustration 
about their inability to produce the document and to give us 
the tools I feel appropriate to make an appropriate assessment 
about GSE performance. It has been no easy task, Mr. Falcon, 
and I want your professional staff to know that I, for one, 
truly appreciate the commitment made and the intense effort to 
produce this document.
    I will confess to you, I have tried to read it, and admit I 
cannot understand it, but I am told by those who can that it is 
a pretty good piece of work. And so I intend to keep mine close 
by, and as my abilities permit, understand it little pieces at 
a time, but congratulations to you all.
    I do want to read a few lines from the report I think 
important to have in the record.
    Government sponsored enterprises are not immune to failure. 
For most firms, debt markets provide strong capital discipline, 
penalizing a firm that is excessively leveraged with higher 
borrowing costs. That discipline is largely lacking for the 
enterprises because of their status as Government sponsored 
    ``The economic distress of Fannie Mae from 1979 to 1985 was 
significant. But for fortuitous changes in interest rates, 
Fannie Mae might have collapsed, costing investors, or the 
Government, billions of dollars. Because of the growth of the 
enterprises, a failure today could result in much greater loss. 
Depending on the response of the Government to such a failure, 
significant disruption to financial and housing markets, 
significant burdens on the taxpayers, or both would result. The 
enterprises have considerably more dollar exposure than the 
entire savings and loan industry had in 1986.''
    I find these particular provisions of the rule extremely 
important, and I think it is the basis on which the 
subcommittee should begin its understanding of the importance 
of this work. I believe the regulator of Fannie and Freddie 
should be a more bank-like regulator in its structure. 
Specifically, I have looked at moving the regulation of Fannie 
and Freddie to other sites or to the Treasury. Based on a GAO 
study, I want to give this new regulator whatever we ultimately 
decide with regard to regulatory structure, the full set of 
tools necessary to do this work. OFHEO today, in my opinion, 
still lacks some of the similar supervisory resources other 
regulators enjoy. OFHEO has chosen a risk-based capital system 
that is dependent on its ability to field a large team of 
financial market experts. I encourage OFHEO to work 
constructively with GSE management in continuing to improve 
this oversight ability.
    I am particularly interested in exploring how the OFHEO 
rule differs from bank risk-based capital standards. For 
example, it is my understanding that bank regulators take a 
very cautious view of hedging and derivative devices 
specifically, and requiring banks to hold risk-based capital 
regardless of how many hedging devices or derivatives may be in 
place. That is a view which I hope will receive additional 
consideration from the agency.
    I also want to say at the outset today that Fannie Mae and 
Freddie Mac today are very well managed, very profitable and 
very important contributors to the housing market of our 
country, and our actions here today in no way reflect on the 
current financial conditions of the enterprises, but are, in 
fact, forward-looking in our effort to ensure that, in the 
event of a long-term market downturn, we would have in place 
the necessary tools and abilities to minimize adverse 
consequences should we face undesirable economic conditions. 
That is why I am so pleased that OFHEO has come forward with 
the capital standard today, and very much look forward to Mr. 
Falcon's remarks in a few moments.
    Mr. Kanjorski.
    [The prepared statement of Hon. Richard H. Baker can be 
found on page 28 in the appendix.]
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Thank you for the opportunity to comment before we begin 
our hearing to review the final risk-based capital standard 
recently released by OFHEO. Because our subcommittee will hear 
from just one witness, we should probably frame today's hearing 
instead as a briefing. The briefing will help us to better 
understand the contents of the Risk-Based Capital Rule, the 
process of its development and the procedures for implementing 
    OFHEO is the safety and soundness regulator for Fannie Mae 
and Freddie Mac, the Nation's two largest GSEs and two of the 
country's largest financial institutions. Since its creation 
nearly a decade ago, OFHEO has developed and implemented a 
robust and continuous examination program that works to protect 
taxpayers from risk. Each quarter, for example, the regulator 
examination teams review more than 150 separate components of 
safety and soundness to develop a comprehensive account for 
each of the GSEs' financial conditions.
    With the release of this stress test, which the agency 
spent nearly 7 years drafting, OFHEO supplements its existing 
capital standards and complements its already-tough examination 
program. Implemented properly, this rule will ensure that the 
two GSEs remain at the forefront of financial regulation. 
Furthermore, the implementation of this regulation, in my 
opinion, enhances the ability of Fannie Mae and Freddie Mac to 
achieve their mission of helping low- and middle-income 
families to own homes.
    More specifically, this new standard calculates how much 
capital Fannie Mae and Freddie Mac need to hold to withstand a 
10-year period of economic stress. Relying on the parameters 
contained in the 1992 GSE law, OFHEO's stress test simulates 
dramatic changes in interest rates and the highest historical 
declines in property values to determine these capital 
requirements. Notably, the regulator believes its regulation 
will, more accurately tie capital to risk than any other 
current or proposed standard, for any financial institution.
    As you know, Mr. Chairman, our subcommittee has closely 
followed the development and issuance of this innovative rule, 
holding numerous hearings on the subject, and GSE regulation in 
general, since 1997. Some have expressed impatience with the 
amount of time OFHEO has taken to develop this standard, but 
the relatively quick approval by the Office of Management and 
Budget of this complicated regulation demonstrates its 
confidence in OFHEO, its competency, reliability and 
    OFHEO's dedicated experts additionally deserve 
congratulations for their hard work in finalizing this 
intricate rule. In particular, the Director, Armando Falcon, 
has demonstrated leadership in successfully guiding this 
complex standard through the regulatory process. I look forward 
to learning of his thoughts later today during our briefing. It 
is also, in my opinion, especially important that the regulator 
maintain continuity in its leadership in the months and years 
ahead as it works to implement this rule.
    Anticipating the complexity of the GSE stress test, 
Congress further authorized a 1-year transition period 
following the final rule's publication in the Federal Register. 
This interlude will allow OFHEO and the affected parties to 
work through any concerns and address the procedural issues 
likely to arise as the rule becomes operational. Consistent 
with the requirements of the 1992 GSE law and the 
Administrative Procedures Act, our subcommittee should support 
these consultations and reasonable technical modifications.
    As they have done in recent weeks, I also hope that all of 
the involved parties will work constructively with one another 
to implement this rule efficiently. I am also confident that 
the management teams of both Freddie Mac and Fannie Mae will 
swiftly address any changes required by this regulation.
    Finally, I hope that my colleagues will work with me to 
ensure that OFHEO receives the resources it needs to get the 
job done and consider removing the agency from the annual 
appropriations process as we have done with other financial 
    In closing, Mr. Chairman, I continue to share with you your 
desire to conduct effective oversight over the housing GSEs and 
to ensure that we maintain an appropriate and sufficiently 
strong supervisory system for them. The implementation of this 
risk-based capital regulation will provide more immediate 
protection for taxpayers, investors and homeowners than any 
legislation that we could pursue in the 107th Congress. I 
consequently look forward to not only our briefing today, but 
also to working with you to put this long-awaited rule into 
    [The prepared statement of Hon. Paul Kanjorski can be found 
on page 34 in the appendix.]
    Chairman Baker. Thank you, Mr. Kanjorski.
    Mr. Ney, do you have an opening statement?
    Mr. Ney. Thank you, Mr. Chairman, and thank you for calling 
another oversight hearing on the safety and soundness of Fannie 
Mae and Freddie Mac. You are to be commended for your thorough 
work on these two companies. This afternoon marks the eleventh 
hearing in 16 months.
    Today's hearing is on a long-awaited risk-based capital 
standard for Fannie Mae and Freddie Mac. In coming weeks, this 
567-page regulation will be published in the Federal Register. 
One year after the publish date, the regulation will be 
    Mr. Chairman, I know you have worked long and hard pushing 
for the standards and pushing for the conclusion of the work on 
this rule, and today I think the credit is due to both you and 
also the regulatory agency. I would like to take a moment to 
commend Director Falcon for his leadership in bringing this 
risk-based capital stress test to completion. Both he and his 
staff have worked hard to craft this capital stress test, and 
they have worked under tremendous pressure. Mr. Falcon took 
office only 18 months ago, I believe. In that time, he has 
managed to complete this rule in a fair and balanced manner. We 
now have in place a vital component for an effective and 
efficient regulatory program. The new risk-based capital 
standard puts in place a new sophisticated model that more 
specifically aligns capital to risk.
    Because of the length and complexity of this final rule, 
and because it will be another year before the rule is 
enforceable, I would really like to encourage the cooperation 
and work of Mr. Falcon and the agency to work with Fannie Mae 
and Freddie Mac to make any necessary technical changes and to 
ensure the complex regulation conforms to the 1992 Act. This is 
a very complicated, complex and sophisticated rule which will 
help ensure that Fannie Mae and Freddie Mac remain safe, well-
capitalized and able to continue their housing mission.
    However, as with any highly complex Government regulation, 
it is inevitable, I think we all know that, that the rule 
mandates will have unintended consequences, potentially, or 
other problems. So I would encourage Fannie Mae, Freddie Mac 
and Mr. Falcon and the agency and the subcommittee to work 
together to solve these problems to ensure that this rule is 
implemented on time.
    Mr. Falcon, your agency has set out to accomplish a very 
formidable task, creating a sophisticated internal model that 
closely aligns and ties capital to risk. If you consider the 
already-existing minimum capital standard, the new risk-based 
standard and the six voluntary initiatives put forth by Fannie 
Mae and Freddie Mac last October, these two companies really do 
stand at the forefront, I think, of financial services, safety 
and soundness regulation.
    And again, Mr. Chairman, thank you for your diligence on 
the issue.
    Chairman Baker. Thank you very much, Mr. Ney.
    Mr. Israel, you are next by time of arrival.
    Mr. Israel. Thank you, Mr. Chairman, and thank you for 
convening this hearing.
    I am pleased to welcome the Director and join my colleagues 
in welcoming the Director this afternoon.
    Mr. Chairman, if ever there was any evidence of the 
critical need for safe and sound GSEs like Fannie and Freddie, 
it is contained in this morning's edition of Newsday, which is 
my hometown newspaper. The headline is: ``Long Island Named 
Most Expensive Area,'' and it reports on a study done by the 
Economic Policy Institute that indicates that Nassau and 
Suffolk Counties on Long Island are the number one most 
expensive areas to live, more expensive than Boston, than 
Washington, DC., than San Francisco, than San Jose, California 
and others. According to the study, a family of two parents and 
two children would need to make an after-tax salary of $52,000 
a year to afford living in my congressional district. And 
housing costs are cited as the major reason why Long Island is 
ranked as the most expensive area in the country.
    Because of that situation, as I have said in the past, it 
is critically important that we support Fannie Mae and Freddie 
Mac in their mission to provide affordable housing. An article 
in the National Mortgage News states that recent HMDA data 
suggests that Fannie and Freddie are helping to increase 
homeownership numbers for all individuals. By improving their 
underwriting guidelines and adding new loan products, Fannie 
and Freddie are helping to improve the chances that all 
borrowers, particularly low- and moderate-income individuals, 
are approved for a loan and receive affordable housing 
    The new Risk-Based Capital Rule is meant to help the 
companies remain efficient and operational even in times of 
severe economic stress. It may be too early to determine how 
this highly complex rule will affect Fannie and Freddie's 
ability to continue to fulfill their mission, however I hope 
that we will be mindful that anytime greater restrictions are 
placed on the business activities of Fannie and Freddie, it is 
more difficult for them to continue to work to achieve their 
mission and close the home ownership gap.
    I hope that OFHEO will continue to work with this 
subcommittee, the Chairman and the Ranking Member, and Fannie 
and Freddie to ensure that this new risk-based capital standard 
will achieve its intended purpose of helping the two companies 
to operate more efficiently. The more efficient those two GSEs 
are, the more they will be able to continue to fulfill their 
mission and I hope that we will continue to support them as 
they work to successfully implement this rule in the year 
ahead. And I thank the Chairman for my time.
    Chairman Baker. Thank you sir.
    Mr. Lucas.
    Mr. Lucas. Thank you, Mr. Chairman. And I want to 
congratulate both you and Director Falcon for finishing this 
important capital rule. I know it has been certainly your 
priority, both of you, for that matter, priority for several 
    And Director Falcon, I appreciate your appearance before 
this subcommittee and certainly commend you on this monumental 
task. I understand, as the Chairman and a number of my 
colleagues have pointed out, that this is a very complex rule, 
567 pages long in total length, and of course it has not been 
fully evaluated by the two companies that you regulate, or for 
that matter, by this subcommittee. Of course, this rule is 
intended, as has been mentioned, to implement the intent of 
Congress in the 1992 oversight legislation. And it should be 
consistent with that Act and should be appropriate in how it 
aligned capital with risk.
    Because the operation of this capital rule may well have an 
enormous impact on the mortgage markets, on lenders in my 
district, and ultimately on home buyers, I urge you to work 
with Fannie and Freddie to identify any needed clarifications. 
And I also hope that these modifications will be made without 
delay so that certainly any unintended consequences will be 
    With that, Mr. Chairman, I look forward to the Director's 
    Chairman Baker. Thank you very much, Mr. Lucas.
    Mrs. Jones, you would be next.
    Mrs. Jones. Thank you, Mr. Chairman.
    Good afternoon, Ranking Member Kanjorski and other Members 
of the subcommittee.
    To Mr. Falcon, welcome back to our subcommittee.
    I am pleased and would like to congratulate you and your 
organization for the completion of this rule. I guess this is 
about our tenth hearing on safety and soundness. We have a rule 
now. Hopefully, you as a regulatory agency, and Fannie and 
Freddie can walk through this and get things going so that we 
can continue to move on and perhaps have Capital Markets 
Subcommittee hearings on something else as we go along through 
the year.
    I think it is laudable, however, that as we look at safety 
and soundness and to assure the strength of the housing market 
in our communities that we engage in some conversation on the 
issue. I am confident that Freddie and Fannie, having already 
agreed to about six commitments or regulations, are prepared to 
sit with you and make sure that the housing industry is safe 
and sound.
    I have a full statement, Mr. Chairman, that I would seek 
unanimous consent to have submitted for the record so that we 
can allow sufficient time to proceed through the hearing.
    Thank you very much.
    [The prepared statement of Hon. Stephanie Jones can be 
found on page 31 in the appendix.]
    Chairman Baker. Without objection, your statement and all 
Members' statements will be included in the record.
    Thank you, Mrs. Jones.
    Ms. Hart.
    Ms. Hart. Thank you, Mr. Chairman.
    I am pleased that you chose to have this hearing as well. 
Since I am a freshman and have not been long-awaiting this 
rule, I will be just very interested in hearing the testimony 
from Mr. Falcon, and I will reserve the rest of my time for 
    Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Ms. Hart.
    Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman.
    Let me start by welcoming our former staff member, Mr. 
Falcon, who was the General Counsel to the Democratic staff for 
many years on the subcommittee and is also my fellow Texan. And 
we appreciate you being here and we look forward to your 
    Mr. Chairman, I want to commend you for holding this 
hearing which will examine the Office of Federal Housing 
Enterprise Oversight's final regulation related to risk-based 
capital that was released on July 19, 2001. As a Member of this 
subcommittee, I am pleased that OFHEO has released this long-
awaited risk-based capital regulation. As you know, in 1992, 
Congress approved a new law which established OFHEO and 
required OFHEO to draft a risk-based capital regulation within 
2 years. As we know, it has taken some time to develop this 
very complex model, but we believe and we hope that this 
regulation will provide the necessary safeguards to ensure that 
the Federal housing enterprises of Fannie Mae and Freddie Mac 
have sufficient capital to sustain themselves during extremely 
difficult economic conditions, which are described as part of 
the law.
    As you know, this risk-based capital regulation is an 
extremely complex model which requires extensive data input 
from the housing enterprises. Because of the complexity of this 
model, Congress provided additional time before the GSEs must 
comply with the rule. The effective date will be 1 year after 
the publication of the final rule in the Federal Register. I 
believe that Congress and this subcommittee should use this 
time to examine the rule in its entirety to ensure that it is 
both fair and reasonable. By holding additional oversight 
hearings on the rule, Congress will have such time to review 
and make any necessary recommendations for the rule.
    In addition, I believe such hearings should bring forward 
expert witnesses who can discuss this complex model. For 
instance, I believe it would be appropriate, Mr. Chairman, to 
invite some of the major rating agencies, such as Moody's and 
Standard and Poor's, who have familiarity with such complex 
model and will be reviewing this risk-based rule when they make 
their own rating determinations for GSE-sponsored debt 
    In addition, major market participants should be heard 
from, and I think we should also hear from witnesses who can 
provide us more information on other risk-based capital rules, 
particularly the Basel risk-based capital proposals which are 
currently under discussion as they related to derivatives 
    This is an important hearing that we are having today. I 
commend the Chairman for calling this hearing. I commend OFHEO 
and the staff for the work that they have done. But of course, 
as we all know, this will not be the last word, either on this 
rule or the question of the GSEs, and I look forward to 
additional hearings that I am sure our esteemed Chairman will 
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Ken Bentsen can be found on 
page 33 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Bentsen for that 
hearing recommendation. I was not sure whether we would go 
further, but based on your request, we certainly will.
    Mr. Lucas.
    Mr. Inslee.
    Mr. Inslee. I have nothing to add to the brilliance of my 
colleagues. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Ross.
    Mr. Hinojosa.
    Mr. Hinojosa. Yes, thank you, Mr. Chairman.
    I am pleased to congratulate my fellow Texan, Armando 
Falcon, today on finalizing the long-awaited Risk-Based Capital 
Rule and the complex computer code that implements the rule.
    Combined, the rule brings into force any important 
requirement of the Federal Housing Enterprises Financial Safety 
and Soundness Act of 1992, the risk-based capital stress test, 
a simulation that determines the amount of capital Fannie Mae 
and Freddie Mac would need to survive a 10-year period of wild 
fluctuations in interest rates and large credit losses.
    In addition, the 1992 Act requires that the GSEs each 
maintain an additional 30 percent of capital to protect against 
management and operations risk in order to meet their risk-
based capital standard. My message to you today, Mr. Falcon, is 
very concise. It is sincere and based on the physicians' credo: 
``First, do no harm.'' I congratulate you and OFHEO on this 
    The new rule, all 567 pages of it, is extremely technical 
and reflects countless hours of dedicated work by you and your 
staff. But the rule by its nature is long and complex, and the 
enterprises it is created to test are dynamic and they are 
sophisticated. This, combined with the importance of 
homeownership to our economy and the well-being of our people, 
require that you take the time, the energy and the resources 
you need over the next year to get this rule right.
    In closing, I want to say that I fully support OFHEO's 
mission and encourage you to make the corrections necessary to 
improve the rule and its code so that they conform fully to the 
1992 Act and the intent of Congress. The 1992 Act specifically 
gives you significant sole discretion to decide on many aspects 
of the risk-based capital test. Use it. Align risk to capital 
for GSEs in a meaningful, realistic and necessary way.
    Chairman Baker. Thank you, Mr. Hinojosa.
    At this time, I would like to introduce to the subcommittee 
the Director of the Office of Federal Housing Enterprise 
Oversight, OFHEO, Mr. Armando Falcon.
    Welcome sir. I know you have been waiting a long time for 
this day yourself.


    Mr. Falcon. I have. Thank you very much, Mr. Chairman. It 
is a pleasure to be back here in the subcommittee's hearing 
    Mr. Chairman, Ranking Member Kanjorski, and Members of the 
subcommittee, thank you for the opportunity to testify this 
morning on OFHEO's Risk-Based Capital Rule.
    Last year, I appeared before this subcommittee and assured 
you that completing this much-anticipated rule was my highest 
priority as Director of OFHEO. Today, I am pleased to report to 
you that the job is done. On July 19, we formally submitted a 
Final Risk-Based Capital Rule to the Federal Register for 
publication. I am proud of the efforts of the many talented and 
dedicated OFHEO employees who worked tirelessly to complete 
this unprecedented task. I am also grateful for the support of 
this subcommittee, particularly yourself, Mr. Chairman and 
Ranking Minority Member Kanjorski. Your input and encouragement 
certainly kept us, shall we say, focused and motivated.
    As you know, this rule is the final major component of 
OFHEO's comprehensive regime to ensure the safety and soundness 
and capital adequacy of Fannie Mae and Freddie Mac. Once the 
rule is published in the Federal Register, which is estimated 
to occur sometime in early September, Fannie Mae and Freddie 
Mac will be subject to one of the most sophisticated regulatory 
capital standards in the world.
    Yet while the rule represents a state-of-the-art approach 
to tying capital to risk, it in no way makes the other parts of 
OFHEO's regulatory program less vital. Rather, it complements 
our current activities by providing yet another assessment of 
the enterprise risk. When the results of the stress test are 
considered along with other information available to me as the 
Director, I will have the best possible view of the companies 
current and prospective financial health.
    This afternoon, I will provide the subcommittee with 
background on the development of the rule, its contents and 
rationale and the process for its implementation. In addition, 
I will also describe how the test fits into OFHEO's overall 
regulatory program.
    While the Risk-Based Capital Rule has received the bulk of 
attention in recent years, the 1992 Act establishing OFHEO 
directed the agency to establish and enforce two major capital 
tests for the enterprises, a minimum capital test and the risk-
based capital stress test. The minimum capital requirement is a 
leverage standard that is similar to existing capital 
requirements for banks and thrifts. The enterprises have 
satisfied this minimum capital requirement every quarter since 
its implementation.
    To supplement minimum capital, we have a more sophisticated 
measure of risk. The risk-based capital requirement uses a 
stress test to simulate the performance of the enterprises' 
balance sheets during a 10-year period of severe economic 
stress in the Nation's housing and credit markets.
    Mr. Chairman, allow me to provide a brief history of the 
development of the Risk-Based Capital Rule as background for 
the subcommittee.
    After staffing and equipping the agency and completing 
initial study of the issues involved, OFHEO sought public input 
through an Advance Notice of Proposed Rulemaking and two 
Notices of Proposed Rulemaking, or NPR as we call them. The 
first NPR, published in June, 1996, proposed the methodology 
for developing a house price index and identifying a benchmark 
loss experience for use in the stress test. The second NPR was 
published in April, 1999, and described how these stress tests 
would work. At the conclusion of the comment period, OFHEO 
proceeded to analyze and address the comments and finalize the 
rule. On March 29 of this year, OFHEO formally submitted the 
rule to the Office of Management and Budget for clearance. On 
July 16, OMB completed its review and OFHEO sent the rule to 
the Federal Register on July 19.
    With that short history providing context on how we got 
where we are today, I would now like to turn to the rule 
    First, the stress test factors in large moves in interest 
rates, mortgage rates, Treasury rates and enterprise borrowing 
costs. Congress went so far as to specify that the 10-year 
Treasury rate changes by as much as 6 percentage points. Other 
interest rate changes are done in tandem as determined by OFHEO 
using historical experience as a reference point.
    Second, the test provides for loan defaults and loss 
severity on a nationwide basis comparable to the largest 
default and severity rates in any region in recent history.
    Third, the test incorporates no new enterprise business and 
no asset sales to raise cash. It simply runs off their existing 
assets, liabilities and off-balance-sheet activities under 
these stressful conditions. This no-new-business requirement, 
or a wind-down scenario, is explicitly mandated in the 1992 
    If all of these stress conditions were to occur, the 
enterprises would be expected to suffer severe losses as 
homeowners default or pay off the loans early, and the 
enterprises' assets and liabilities go out of balance. OFHEO's 
task is essentially to estimate the losses that would occur in 
the current books of business and determine how much capital 
each enterprise would need to maintain positive capital 
throughout this period. To this amount, an additional 30 
percent is added to compensate for operations and management 
    As compared to other contemporary ``risk-based'' standards, 
which simply apply haircuts to buckets of assets, OFHEO's 
standard determines an enterprise's actual risk exposure as 
measured by the stress test.
    I do not mean to suggest that leverage requirements are 
inappropriate, but like the proposed new Basel Accord, OFHEO's 
risk-based capital standard recognizes the need to more closely 
tie capital to risk. And because both approaches give 
institutions credit for risk mitigation activities, good risk 
management will be rewarded with a lower capital requirement.
    But this is not just a capital standard. It will also serve 
as a valuable analytical tool. It will help us to identify and 
understand the strengths, weaknesses and exposures of the 
enterprises under different scenarios. We will use it to its 
full capacity for this purpose.
    As noted earlier, the risk-based capital standard will be 
published in the Federal Register in September. While the rule 
is ``effective'' immediately, Congress granted the enterprises 
a year to come into compliance before OFHEO can take an 
enforcement action based on noncompliance with the standard. 
However, because the rule is effective upon publication, OFHEO 
will announce in early 2002 how the enterprises fare under the 
standard using 4th quarter 2001 data.
    To achieve compliance, the enterprises will have many 
options. For example, they can raise additional capital, adjust 
hedging practices, offset more of their risk, retain more of 
their earnings or any combination of these. A capital shortfall 
generally can be eliminated at a fraction of the cost of new 
equity capital. Thus, another valuable aspect of this rule is 
that it will allow the enterprises to choose for themselves the 
most efficient means to comply with the rule.
    So while the finalization of the rule is a landmark, it 
certainly does not close the door on work on the rule. The 
standard will not be static. The enterprises will be free to 
innovate. OFHEO will work with the enterprises to assess the 
risk of new activities and appropriately address them within 
the stress test. In addition, the 1992 Act requires us to soon 
consider whether or not to incorporate new business into the 
    As I mentioned earlier, OFHEO's capital regulation is a 
component of an overall regulatory program. We will use the 
stress test in conjunction with other tools, which include 
examination reports and OFHEO's research. OFHEO's examiners 
maintain a physical presence at the enterprises and have 
unlimited access to all levels of management and to highly 
sensitive corporate records. By staying apprised of the 
enterprises' risk and business activities on a timely basis, 
the examiners are able to evaluate an extensive array of risk-
related factors and to assess the enterprises' financial safety 
and soundness.
    As with all financial regulators, research is an area of 
great importance to OFHEO's ability to fulfill its mission. Our 
research provides the independent analysis necessary to 
consider our examination and capital findings in the broader 
context of the economy and the markets in which the enterprises 
    In conclusion, OFHEO is meeting the mission Congress gave 
us. The enterprises are subject to ongoing oversight through 
our examination program, must meet quarterly minimum capital 
requirements, will be the only entities subject to a risk-based 
capital stress test which closely ties capital to risk, and can 
be held accountable if found lacking in any of these areas.
    Mr. Chairman, Ranking Member Kanjorski, you have in OFHEO a 
very talented group of men and women who are dedicated to 
fulfilling the agency's mission ensuring the safety and 
soundness of Fannie Mae and Freddie Mac. I hope you will 
consider that the best investment in safety and soundness 
regulation is an investment in the team and talent we have 
assembled at OFHEO. Toward that end, I would renew my request 
that the Congress consider enacting some enhancements to 
OFHEO's statutory authorities. While those enhancements are not 
essential, they would help ensure that OFHEO has all the tools 
necessary to respond quickly and effectively to any situation.
    Let me again thank you, Mr. Chairman, Ranking Member 
Kanjorski and other Members of the subcommittee for your 
comments and the support you have given this agency.
    I would be pleased to answer any questions you may have, 
Mr. Chairman.
    [The prepared statement of Hon. Armando Falcon Jr. can be 
found on page 36 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Falcon. Again, 
    There is one sort of process question that I would like to 
start with that I think is very important. You have labored 
long. We now have a rule approved by OMB, basically back in 
your area of jurisdiction awaiting final publication. It is 
also my understanding concurrent that our 60-day congressional 
review period would commence beginning the date of July 29, I 
think is correct. And since it has 60 legislative days, that 
would be to expire sometime in October. I do not have the 
correct date.
    Between now and the time that the rule is promulgated 
formally, would it be your intent that the modifications to the 
rule that would be considered would be technical in nature, or 
to ensure conformity of the rule to the agency's intent, as 
opposed to a substantive policy alteration that would depart 
from the original proposal?
    Mr. Falcon. Mr. Chairman, I view the process going forward 
between the time we submitted the rule to the Federal Register 
and the time that it is published as similar to what happens 
with the House when the enrolling clerk takes a bill that has 
been enacted by the House and the clerk makes technical 
corrections to fix punctuation and other things to make sure, 
as you stated, it is consistent with the intent of the 
Congress. Any changes that we would make to the rule between 
now and the date of publication would be consistent with that 
spirit. And if we recognize a need to make any changes in the 
rule, we will do so through probably a notice and comment 
period, perhaps an expedited one, so that we can move quickly 
to make sure that the rule works properly.
    Chairman Baker. Terrific. Because it would be my interest, 
and would intend to do so, to make comment to the agency early 
in the August recess about some areas of concern that, and I 
have regard for your judgment. Whether I am right or not would 
be for you to determine. But for example, in the area of 
hedging, it is my understanding that a financial regulator in 
looking at interest rate risk and let's say credit risk is two 
categories, and where we find an excess of hedge with regard to 
interest rate, but a deficiency on credit risk, that they 
cannot be averaged. So that if you are over a little bit in one 
and under a little bit in the other, the aggregate hedge is 
deemed to be adequate under the risk-based standard, but 
insufficient under financial standards. I want to make sure I 
am understanding it properly, but I will forward that at a 
later date to give you a more detailed explanation.
    And then, generally the whole question of the first step 
being left to the enterprises, let's assume they are modestly 
deficient, and that a relatively small acquisition of hedging 
devices would get them into proper balance. I would be a lot 
more comfortable if rather than having the enterprises manage 
to maintain minimum capital, that we--and there are operative 
reasons for this--minimize the use of hedging devices and 
instead establish a preference for capital, principally because 
of the enormity of their hedging portfolio and, frankly, the 
limited number of counter-parties internationally available for 
these enterprises to be able to acquire those hedging 
instruments. So it is against the international capital markets 
concern that I am worried about the level of their derivatives 
portfolio. Again, I will forward that in a comment.
    And I do not want to get Mr. Bentsen in more trouble with 
his colleagues, but I shared some of his concerns in his 
opening statement about having broader formal comment on the 
applicability of the rule beyond the agencies. So I do not know 
exactly the process by which I will pursue that, but I do want 
to have other financial opinions about the applicability and 
consequences of the rule.
    I also want to compliment you, because I think your 
decision to run the test based on the last quarter of 2001 data 
is very, very important. Many Members of this subcommittee are 
concerned about the volatility in the marketplace, and that 
unanticipated consequence of the rule, either requiring 
significant capital or reducing risk exposure, could 
potentially have some impact on interest rate costs to 
homeowners. I think by taking this step as an early market 
indicator a year out, should give great confidence to everyone 
that if in fact there is a deficiency, that the 12 month 
intervening period can easily be utilized to come into 
conformity with your requirements without any of the adverse 
market consequences some are concerned about.
    Given that general statement, I am sure I am going to come 
back. I do not want to run too far over my own time. I will 
yield my time at this time to Mr. Kanjorski.
    Mr. Kanjorski. Thank you very much, Mr. Chairman, and 
congratulations to you for taking a very strong leadership role 
on this entire issue.
    Congratulations to you and the employees and staff of the 
agency, Mr. Falcon. You have only been there 18 months, but it 
has been a long process, 9 years now, and I am sure the Members 
of the subcommittee, those even that are not here or do not 
know about this event can breathe a little easier today to know 
that we finally do have the regulation ready to go.
    One of the things I have been concerned about all along, 
and intend to support the agency and the GSEs, is that they 
have given a vitality to our economy at this particular point 
in time, the real estate transactions in the country. I hope 
they can maintain that vitality and remain healthy, because I 
see it as one of the two remaining legs to see the economy 
afloat, that and consumer confidence, and consumer confidence 
may start to wane in the latter part now of this year. So it is 
very important that we stabilize and keep a very vibrant real 
estate market in the country. And I think your risk-based 
regulation will help to accomplish that, but also the fact that 
we attended this briefing, and this entire issue, was the fact 
that we are providing tremendous stability for 10 years of 
downturn. There is little worry in the marketplace. We have a 
very secure financing structure in the United States, and not 
only in the domestic market, but the international markets 
should be perfectly willing to buy the securities of these 
entities as we proceed through the rest of this year and the 
following year.
    I want to be a little optimistic. I think by next spring we 
will see a turnaround. We will be turning out of this thing. 
But if we do not, as I understand, the regulation will have a 
capacity to support a 10-year downturn, which no one 
anticipates now, nor should we, since it probably has never 
occurred other than maybe the Great Depression.
    I think it is important that you maintain a relationship 
with the Chairman of this subcommittee and the Chairman of the 
full committee, maybe the Ranking Members, and also on the 
Senate side. If there are technical adjustments or substantive 
adjustments that may have to be made that we are not presently 
aware of, I think to speed that process along, communications 
should be set up between your office and the Congress so that 
they can be attended to and understood, so that we move through 
this process without the need for hearings, without the need 
for even communication by letters of question, but that we are 
only responding to issues that you or the GSEs raise as they 
look at the implementation of this role.
    I join the Chairman in congratulating you on picking that 
quarter at the end of the year to be the base which we will 
gear off of. I hope we do not have a real bad downturn in that 
quarter, and that could always happen, but maybe that is what 
the rule is really promulgated to protect against.
    Again, this has been a long series of hearings and a lot of 
skin has been left on the roadway, so to speak, but I 
congratulate you and the agency for coming to the extent that 
you have, and wish you well. And I certainly offer my 
assistance if there is anything we can do, and I am sure the 
Chairman joins me in that.
    Thank you.
    Chairman Baker. Ms. Hart, did you have questions?
    Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman.
    So to clarify the Chairman's question, the ink is dry on 
the rule now, and any changes you will make will be purely 
technical and the rule will be published prior to or within 
that 60-day legislative period?
    Chairman Baker. It is my expectation that the rule will be, 
I think, printed before the 60-day legislative day comment 
period expires. Is that correct, Mr. Falcon?
    Mr. Falcon. That is out of our control, Mr. Chairman. It is 
subject to the ability of the Federal Register to get the rule 
typeset and proofed within that timeframe. But our expectation 
is that they could do it within 45 days of the day that it was 
submitted to them. So it would be within that 60-day time 
    Chairman Baker. Mr. Bentsen, it is my intent to, believe it 
or not, be the least amount of disruptive element in this 
process. That is the reason for the hearing today, for Members 
to be aware of the rule. And as quickly as we return, if there 
are any issues which we would need to address, do that early in 
September so the agency would have appropriate time, if 
warranted, to respond before the final promulgation.
    Mr. Bentsen. Although I think what Mr. Falcon is saying is 
the final promulgation has occurred, other than really dotting 
``i's'' and crossing ``t's.'' And if that is the case, then 
once the final rule is published, and I do not want to get into 
a long drawn-out discussion of the Administrative Procedures 
Act, as interesting as that would be; but once the rule is 
published, then we go to, what, an APA-type mechanism, which is 
Congress or others have issues that they petition OFHEO and 
OFHEO then takes under advisement can propose a rule or if 
OFHEO itself determines that something needs to be modified, 
and then you go under the standard APA?
    Mr. Falcon. Right. Once the rule was published, it is a 
final rule, and if we saw a need to make any changes to the 
rule, we would utilize the amendatory process of the 
Administrative Procedures Act. And that allows us flexibility 
to move at any point in time to make changes that we thought 
were necessary. We have a wide range of tools from an extended 
notice and comment period to something as quick as an interim 
final rule where changes are effective immediately, subject to 
notice and comment and subject to potential change after that 
notice and comment period.
    So we have the ability to move expeditiously to correct any 
changes that might need to be made. And Congressman, if we 
thought that we needed to make any changes, technical or 
substantive, to get this right as soon as possible, we would do 
so, I think, in an expeditious manner. If we see a need to make 
any changes in this to make it fully operational and to correct 
any problems in it, we could possibly do so very quickly after 
the rule was published. But we have that ability, and I think 
we would want to utilize it to make sure we got this right as 
soon as possible.
    Mr. Bentsen. There has been some concern raised by the 
GSEs, and I am sure there will be lots of concern raised from 
time to time, as is the case with any regulated party, but with 
respect to haircut requirements on hedging instruments, I was 
just looking at an article from the Wall Street Journal from a 
while back regarding the mortgage insurance companies, that 
there is concern that the reserve requirements on that may 
exceed industry standards. Is that an issue that you would see, 
if you were to agree with them, that you would see taking up in 
a subsequent rulemaking process?
    Mr. Falcon. Yes, I am aware of the issue you are talking 
about, Congressman, with respect to the counter-party haircuts 
that are embedded in this rule. Part of the issue there has to 
do with the distinction we have made between AAA, AA, A and so 
forth, and how much of a haircut we give to the securities or 
the counter-parties. Our judgment on the distinctions between 
those various rating levels and the reflection of those 
distinctions in the percentages of the haircuts is grounded in 
a lot of historical analysis and various studies that we looked 
at to come up with the ultimate resolution in the rule.
    However, we are very willing to look at those issues with 
an open mind and take a fresh look at them. If we did not come 
up with the optimal resolution of the issue, we will not 
hesitate to make a correction.
    Mr. Bentsen. If I might, Mr. Chairman, very quickly, given 
that the rule is not fully effective until a year following the 
publication date, or whichever date, do you think that you 
would be able to address issues, and again, you may come down 
and decide that there is no merit in the arguments, in such a 
way that would allow the companies the ability to deal with 
this without having to comply with a rule that might otherwise 
be modified to meet the implementation day?
    Mr. Falcon. I think we would definitely want to, if we 
thought that there were improvements that could be made to the 
rule, I think we would want to act expeditiously to make those 
modifications, certainly well before the end of the 1-year 
transition period, so that it is clear to the enterprises, in 
fairness to them, what rule they will be expected to meet at 
the end of that 1-year transition period, and even more so 
before the end of the quarter when we begin to make public 
pronouncements about how they fare under this rule.
    Mr. Bentsen. Thank you.
    Thank you, Mr. Chairman.
    Chairman Baker. Mr. Ford.
    Mr. Ford. Thank you, Mr. Chairman.
    I think my colleague Mr. Bentsen got at much of what I 
wanted to ask. It is a big thick rule, and I guess it will take 
a lot of us a long time to get through it all. But just so I 
can understand, we will have some flexibility to make changes 
if need be between now and then, Mr. Director?
    Mr. Falcon. Yes, Congressman, you will. And if I can just 
say, I know the Chairman held up a copy of the rule. It is a 
big thick rule. But I think it is important, if I may, to just 
state that the 1992 Act which required the promulgation of this 
rule also required that the agency promulgate a rule which was 
fully transparent and was specific enough so that any 
interested party could replicate the regulation and the code, 
the stress test that implements the rule. So in order to meet 
that requirement of the 1992 Act, we had to put out a rule 
which was very specific and lay out all the details about how 
this model would work. Otherwise, we would not have been in 
compliance with the rule. I would have loved to have a rule 
which is maybe 50 pages long, but then I do not think we would 
have been in compliance with the spirit or the requirements of 
the 1992 Act.
    Mr. Ford. I am not being critical at all.
    Mr. Falcon. I know you are not.
    Mr. Ford. As a matter of fact, it will make for some good 
vacation reading during the August recess. But I appreciate you 
responding to the specificity that, I was not here in the 
Congress in 1992, you were asked to do.
    Mr. Chairman, if it would be appropriate, sir, I know that 
perhaps this is not an appropriate venue to do this, related to 
this, there was an issue or two raised in the July 11 hearing 
on your part, sir, a series of assertions regarding the average 
loan limit and loan-to-value ratios of loans purchased by 
Fannie Mae. And I had some numbers that I would love to submit 
to the record. I certainly do not want to go into those details 
with the Director here and cloud this hearing, but I did want 
to, I was curious about that, and asked Chairman Raines at 
Fannie Mae to respond to some of those issues and have some of 
that. And if it would be OK without objections.
    Chairman Baker. Sure, without objection. Just for the 
record, my comments really in the July hearing were with regard 
to Freddie, but we always welcome Fannie to any fight.
    Thank you.
    Mr. Ford. Thank you.
    Chairman Baker. I am sorry, Mr. Meeks.
    Mr. Meeks. Timing is everything. I just walked in.
    Chairman Baker. Yes, sir. You took me by surprise.
    Mr. Meeks. I apologize in regard to missing your testimony. 
I am on roller skates today. We have various hearings and 
markups going all over the place. And so I only have two quick 
questions. If you have answered of them already, please I 
apologize in advance.
    But this is something that has come up, and I was just 
wondering if there were any conflict between the Final Risk-
Based Capital Rule and the HUD affordable housing goals of 
Freddie Mac and Fannie Mae?
    Mr. Falcon. There will not be, Congressman. We think this 
rule, once it is implemented, will allow them to continue their 
affordable housing activities and remain in compliance and 
exceed the goals of the affordable housing goals as established 
by HUD.
    Mr. Meeks. And let me ask another question that I do not 
know, maybe it is unfair, but I know that there has been a lot 
of discussion regarding OFHEO's ability to properly regulate 
the safety and soundness of the GSEs. And so I guess my 
question is in regards to your capacity, whether there is a 
lack of capacity in your organization to properly regulate GSEs 
in general structure, or are you lacking anywhere in 
legislative authority or resources?
    Mr. Falcon. Thank you. I think the agency fully fulfills 
its mission in supervising the enterprises. I think we could 
use some additional tools to make sure that we can always 
respond adequately to any situation that might arise. I would 
like to have some adjustments to our statutory 
responsibilities. I do not think they are essential to our 
ability to fulfill our mission, but items like exemption from 
the appropriations process that would allow us to adjust our 
budget to our needs on a real-time basis should any situation 
arise. That is an authority that every safety and soundness 
regulator has, and I think OFHEO should be put on par with 
other agencies. And there are other issues related to 
enforcement powers, some independence issues, clarifications 
about our authority. I think those would be nice tools to have, 
but currently I am comfortable that we do a good job with the 
staff we have and that we are able to leverage the technology 
and a very experienced staff to make sure we fulfill our 
mission on a daily basis.
    Mr. Meeks. Thank you.
    That is all from me, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Meeks.
    Let me return to process again, because it is apparently a 
source of concern, and in the brief interim I counseled with 
staff as to the two processes. One is the current 60-day 
comment period in which the subcommittee, if it so chose, could 
only adopt a resolution of disapproval, thereby blocking the 
implementation of the entire rule. That is not likely to 
happen. However, after the rule is formally promulgated and 
published, all changes subsequent to that date would then be 
subject to the provisions of the Administrative Procedures Act, 
which can have an expedited notice and comment period, but 
would in all substantive cases require notice and public 
comment period of some sort, so that the subcommittee would 
then have an opportunity to understand and then again comment 
on any subsequent change that might be considered at the 
agency's request.
    Is that your understanding of the process?
    Mr. Falcon. Yes, that we are subject to all the provisions 
of the Administrative Procedures Act once this is----
    Chairman Baker. Well, I only mention that because there was 
some apparent view that we could get together and work this out 
without going through conformity with the APA. And I think for 
record purposes, we all ought to acknowledge that that is the 
law and we will abide by whatever it provides.
    Mr. Falcon. Right. We could not do anything inconsistent 
within the express provision of the regulation absent an 
amendment to those provisions.
    Chairman Baker. All right.
    And the other minor point is that it is actually effective 
when printed, and it is only enforceable a year later. So that 
is the reason why the APA becomes effective after it is 
printed, and that is just again for the record purposes.
    And I want to return to the issue raised about 
modifications. As you know, I have been available for any 
suggestion by anybody about how to enhance your ability to 
perform this task. Clearly, getting you out of the 
appropriations process based on a fee schedule for the 
regulated enterprises would be something I would strongly 
support, as all other financial regulators are so funded. And 
second, giving you more financial regulatory authority is 
something I have always thought made a great deal of sense 
wherever the agency may land in some future iterations of 
congressional legislation. So for the record, I want to 
acknowledge that you requested funding levels last year in the 
appropriations process higher than you actually received, 
although you did receive an increase in budget. And to a great 
extent, using the OCC model and applying their standards to 
assessments for regulatory purposes, the two enterprises would 
have an assessment of approximately $67 million for regulatory 
compliance, and you are now operating on a $23 million 
    Now, whether or not the people within the agency are 
working very hard or not, on its face there is a regulatory 
mismatch that should be addressed, and for your purposes, I am 
strongly supportive of adjusting that mismatch.
    With regard to the rule, there has been some comment 
expressed that the effect of the rule is to be procyclical in 
that in good times that capital assessment may turn out to be 
excessive, but in bad times the capital assessment may turn out 
to be too little, which would then result in capital swings 
that might be excessive within a short-term duration. Further, 
and this is, I believe, the explanation that OFHEO feels that 
the capital adjustments that will be required will come from 
early warning devices that are now within the agency's ability 
to observe. Don't regular examinations kind of give you leading 
indications without having to wait on the application of the 
stress test? You know, make us feel more comfortable about how 
this capital requirement can and will be adjusted?
    Mr. Falcon. Absolutely. As I said, the stress test is only 
part of our comprehensive oversight program with the 
enterprises. Our examiners are looking at 150 or so different 
examination areas with respect to the enterprises. They are in 
there on a daily basis. They are constantly evaluating the risk 
of the enterprises, how they manage those risks, and certainly 
they work in concert with other areas in the agency. With 
respect to whether or not this rule is procyclical, I think 
what makes this unique from any other capital standard is that 
it incorporates a downward cycle. In a sense, it anticipates a 
downward cycle. That is what happens when you apply stressful 
economic conditions, a 600 basis point swing, whether up or 
down, in interest rates. The worst historical credit losses in 
any region apply to their entire portfolio. So this anticipates 
the worst possible cycle and makes sure that the enterprises 
can survive such a down cycle over a 10-year period.
    And if problems were to occur, the fact is that this rule 
gives the enterprises the flexibility to decide for themselves 
the most efficient means for coming into compliance with the 
capital standard. It would not have, in a true downward cycle, 
the effect of forcing them to find the most inefficient means 
of coming to compliance like raising pure equity capital. They 
would have the flexibility to adjust the risk profile so that 
they would be in compliance with the rule.
    Chairman Baker. Thank you.
    Mr. Bachus has arrived. Mr. Bachus, did you have a comment 
or question?
    Mr. Bachus. I appreciate it, Mr. Chairman. I commend you 
for holding this hearing.
    I have been on the floor of the House debating the energy 
bill, and I apologize for missing your testimony, Mr. Falcon. I 
want to congratulate you. You have only been on the job 18 
months, and yet you and your agency have completed the rule, 
and it is long-awaited, but I appreciate your work.
    This is a very long and complex rule. It is over 600 pages. 
And I would first urge, and I am sort of doing an opening 
statement here too, but I would also urge you to give the GSEs 
an opportunity to work with you and for them to work with OFHEO 
in crafting the final rule. I hope this is not considered a 
final rule.
    Additionally, it is my hope that the final rule will not 
damage the GSEs' mission to increase homeownership in America, 
and at the same time protect the taxpayers' interests from any 
unnecessary exposure from GSEs' debt and mortgage holdings.
    Let me ask you, I have two questions in mind. One is, and 
it goes along with working with the GSEs and their mission of 
creating home ownership, particularly for the less advantaged. 
What impact, if any, will the final rule have on GSEs' efforts 
to finance loans with small down payments? Will these loans 
become more expensive and harder to get?
    Mr. Falcon. Congressman, in order to have a risk-based 
capital stress test, we do look at historical defaults and 
prepayment rates and loss severities for mortgages of different 
types, including various loan-to-value ratios for mortgages. 
But just because a mortgage may have less equity does not 
necessarily mean that it might require greater capital. The 
enterprises can take steps to mitigate their potential risk 
through the use of credit enhancements, offsetting risk, and we 
would certainly give them full credit for those types of 
activities in the Risk-Based Capital Rule. So if the data 
dictates that a certain type of loan has greater risk 
associated with it, that risk can be mitigated through 
activities by the enterprises.
    Mr. Bachus. But to a certain extent, HUD, for instance, has 
asked them to go and make loans in certain areas, and some of 
these loans as a necessity are going to be higher risk loans 
than the premium market.
    Mr. Falcon. Actually, interestingly, the loans that the 
enterprises can count toward compliance with HUD's affordable 
housing goals fall across the spectrum of mortgages. We 
compared those types of mortgages and their spread across 
various LTVs and found that the spread across the LTVs for 
affordable housing mortgages was about the same as it is for 
non-affordable-housing-goal mortgages. And the affordable-
housing-goal mortgage is not quite going to be just a high LTV 
mortgage. In fact, I think the bulk of them have an LTV which 
is 80 percent or less.
    Mr. Bachus. Will it make it harder for the GSEs to buy 
loans from borrowers with poor credit histories? The rule?
    Mr. Falcon. The rule? Perhaps. We have not incorporated 
FICO scores yet through this rule. That is an area of research 
that we are undertaking, and if it is appropriate we will 
incorporate things like FICO scores. I think if it is 
appropriate, we will do it, but as far as what we are now 
taking into account, I guess you could think of things like 
borrowers credit history as embedded in the average default 
rate on that type of mortgage. If it has got a higher default 
rate, it is probably because it was made to someone with a 
higher risk profile. And so in that sense, we do incorporate 
someone with a bad credit history if they receive a mortgage 
that Fannie and Freddie buy, into the stress test.
    Mr. Bachus. I would simply, again, just stress to you that 
their mission being to bring home ownership to the less 
advantaged, and sometimes this requires smaller down payments, 
things of this nature, which does involve greater risk, but 
that is part of what Congress has charged them with a mission 
of doing. And I know that there is probably some tension 
between some of what HUD asks them to do, and then safety and 
soundness considerations, but hopefully you can be aware of 
that. Are you working with HUD in formulating the rule?
    Mr. Falcon. Yes, they have been following the progress of 
this rule. At various points in time, we have discussed it with 
them, that is over many past years. But I am confident that 
this rule will not detract from the ability of the enterprises 
to fulfill their mission, especially with respect to affordable 
    Mr. Bachus. OK, including small down payments and things?
    Mr. Falcon. Yes. Absolutely.
    Mr. Bachus. All right.
    Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Bachus.
    Mr. Bentsen.
    Oh, I am sorry. Mrs. Jones.
    Mrs. Jones. Thank you, Mr. Chairman.
    I want to thank my colleagues for asking questions. My 
questions should not be too lengthy, though, Mr. Chairman.
    Mr. Falcon, as a regulator for Fannie and Freddie, part of 
regulation also is to ensure that these can continue to 
operate, or you do not really have a job to do if they are not 
in operation. Fair statement?
    Mr. Falcon. Yes, ma'am.
    Mrs. Jones. So it is not always an adversarial role. I 
guess that is what I am trying to ask of you. Is that correct?
    Mr. Falcon. Absolutely.
    Mrs. Jones. And someone may have asked this question, but 
in light of the fact that I was not here to hear the answer, I 
am going to ask it again. On page 68 of the regulation, it says 
that OFHEO has the authority to make any changes it deems 
necessary to the code at any time without notice and comment, 
as long as those changes are not inconsistent with the 
technical specification of the RBC rule. This authority allows 
OFHEO to address any technical or other problems that might 
arise in the operation of the code on a timely basis. Any 
change to the code will be made available to the public.
    As the Director of this regulatory agency, do you believe 
that this gives you the ability you need to operate or to have 
oversight over agencies that operate with safety and soundness?
    Mr. Falcon. Yes, Congresswoman. The way the rule will work 
is the rule itself contains various mathematical equations and 
formulas which make up this stress test. And separate and apart 
from that, we have this computer code, this model that we 
constructed using the blueprint of the rule. That code 
implements the rule. It is that code that we will plug various 
quarters' worth of data into and that will produce a capital 
requirement for the enterprises. Now, the code is something 
that is separate and apart from the rule, but code will always 
be consistent with any express provisions, all the policy 
decisions, that are embedded in the rule. If we find ways to 
make the code operate more efficiently, to make it more 
operational from the enterprises' standpoint, we made sure that 
we maintained the discretion to this question to do so.
    Mrs. Jones. So you have what you need?
    Mr. Falcon. Yes.
    Mrs. Jones. But this new program or code will, as you said 
previously, operate in conjunction with the other means that 
you have had to have regulation over Freddie and Fannie. 
    Mr. Falcon. Yes.
    Mrs. Jones. And so it will be, versus two things to judge 
or assess their safety and soundness, you now have how ever 
many there are other than this, as well as this new code that 
came from the law or came from this recent ruling.
    Mr. Falcon. Absolutely.
    Mrs. Jones. Is that correct?
    Mr. Falcon. Absolutely. We have our examination program, 
various other regulations designed to maintain the safety and 
soundness. We have our minimum capital regulation. We have this 
risk-based capital regulation. We have a full array of 
activities that we do.
    Mrs. Jones. Generally, we do not want to allow anyone to 
toot their own horn, but based on what you had available to you 
previously and this new rule, do you believe that you are now 
in a position to help assure the safety and soundness of these 
two Government Sponsored Enterprises?
    Mr. Falcon. Absolutely. And we do a very good job at it, 
Congresswoman, if I may toot our horn.
    Mrs. Jones. Toot, toot, toot, you got the rest of the time.
    Anything else you want to say?
    Mr. Falcon. Yes. I think the 1992 Act which established 
OFHEO gave us a very solid set of tools to work with, very 
similar to the tools that any other financial safety and 
soundness regulator has. We have sought some enhancement to 
that, but basically I think we have a very talented staff, the 
tools. We could always use additional resources, but I think we 
fulfill our mission very thoroughly.
    Mrs. Jones. I yield the balance of my time, Mr. Chairman. 
Thank you very much.
    Chairman Baker. Thank you, Mrs. Jones.
    Just to clarify, with reference to page 69 citation that is 
technical in nature with regard to data and computational 
matters, so that if you are provided new data or you see an 
error in the coding, you can modify those in accordance with 
fairness to reflect an accurate portrayal of the enterprises' 
condition. But we cannot take the 2.5 percent capital standard 
and make it 2.0 percent, as distinguished between substantive 
and technical application. If it is demonstrated by GSEs or 
other interested parties that an outcome of the computations 
are not consistent with the agency's intent, then certainly 
that is viewed, I think, as a technical matter which could be 
changed not subject to the Administrative Procedures Act.
    Mr. Falcon. Right. For instance, if we wanted to change the 
haircuts, we would move through the Administrative Procedures 
Act to make those changes in the rule.
    Chairman Baker. I think I am very comfortable with your 
    Mrs. Jones. Just so the record is clear, Mr. Chairman, it 
is page 68 that I was reading from.
    Chairman Baker. Page 68.
    Mrs. Jones. Yes.
    Chairman Baker. OK.
    Fannie and Freddie will continue to evolve and provide, we 
hope, creative new products to serve homeowners. Your rule as 
constructed today, what affect will it have on new product 
development? Any? None? Any delay for them to proceed? Or how 
will you assess the risk associated with a new product?
    Mr. Falcon. We designed this rule so that it will allow 
full innovation by the enterprises. There is a section of the 
rule that deals with new activities. As the enterprises 
innovate, develop new products that might not be covered by 
this rule, because they just do not exist today, we will work 
quickly to incorporate those new products into the stress test 
as soon as possible. And we will decide whether or not to apply 
some interim conservative treatment to the new activity until 
we are able to fully understand the risk and how they manage 
the risk; decide whether or not we want to incorporate a simple 
application to the stress test; or perhaps do a separate 
modeling of the performance over time of that particular 
    So we allow them full innovation, but at the same time make 
sure that the risks of that innovation are incorporated as soon 
as possible into the stress test.
    Chairman Baker. Thank you.
    I am going to yield back my time to enable other Members to 
ask questions before the break.
    Mr. Bentsen.
    Mr. Bentsen. Thank you, Mr. Chairman.
    Let me say at the outset, I feel a little deficient. I 
studied the Administrative Procedures Act in graduate school, 
but I do not think I can quote from various pages what the regs 
are. But obviously, there is some interest in that.
    There has been some discussion and even I guess some 
criticism in the construct of the rule, both as it relates to 
whether or not it properly addresses the credit quality of the 
assets, and then the question of the use of derivatives as 
hedges. On the first part, and I realize a lot of this came 
straight out of the 1992 Act, is the treatment with the stress 
test of the mortgage portfolios, that is similar to what is 
required in, it is either FIRREA or FDICIA, for the holdings of 
mortgage instruments by federally insured depository 
institutions? Is it the same type of model?
    Mr. Falcon. It is a different type of risk-based capital 
requirement. What we currently have in place for banks and 
thrifts is a risk-based capital requirement that basically 
places assets into different ``buckets,'' and then assigns 
haircuts to those ``buckets'' based on the assessment.
    Mr. Bentsen. No, I understand that. I guess what I am 
asking is, I thought it was either FIRREA or FDICIA that 
requires if a thrift or bank is making a purchase of a 
mortgage-backed security or REMIC or some sort of mortgage 
portfolio. Aren't they required under one of those acts to 
engage in certain stress tests? And if so, is that similar to 
what you do in this rule?
    Mr. Falcon. I am not certain.
    Mr. Bentsen. If you could find out for the record, I would 
just be interested in that.
    Mr. Falcon. Sure. I would be glad to.
    Mr. Bentsen. Second of all, how did you all come up with 
your models for determining risk for the use of derivatives or 
other types of hedge instruments? The reason I ask is, I am 
looking at one, on the one hand, I know there is concern that 
the haircuts are too strict, and on the other, I see where 
someone says you are using the same model as Long-Term Capital 
Management. And I find that hard to believe. So I am curious, 
obviously, this is a new phenomenon in the market used by 
banks, thrifts and other entities. How did you all come up with 
your model?
    Mr. Falcon. Well, first off, on the issue of derivatives, 
and Mr. Chairman, we will certainly work to provide what 
information you would like on the subject that you mentioned 
previously, but the enterprises use derivatives as hedging 
instruments to help manage basically their interest rate risk. 
They do not engage at all in derivative transactions for 
speculative purposes. We would not allow that. So the situation 
with Long-Term Capital Management and the enterprises is vastly 
different. Long-Term Capital Management used its pricing models 
to try to anticipate various swings in foreign currency and 
other types of investments they had. And they lost that bet. So 
you saw what happened with Long-Term Capital Management. The 
enterprises do not engage in derivative transactions for 
speculative purposes. They use them only to hedge their risk. 
They do not take the naked position in the derivative or 
trading position. So we are comfortable that they do use 
derivatives in a prudent manner.
    Now, what we did with respect to haircutting for 
derivatives in the rule, we looked at various studies that had 
been produced as to whether or not to differentiate between 
different rating levels, rating agency levels, and what that 
haircut should be. There were various studies that we looked at 
which everyone cites, Hickman, Moody's, Standard and Poor's, 
Duffs and Phelps, everyone has looked at this. We came out with 
what we thought was a sound judgment, but we are willing to 
take a fresh look to make sure that we properly balanced a rule 
which was appropriately stressful, but at the same time was not 
    Mr. Bentsen. Thank you.
    Thank you, Mr. Chairman.
    Mr. Baker. Thank you very much.
    Mr. Falcon, again, I think every Member has expressed it. 
We want to again say thank you.
    Mrs. Jones. Mr. Chairman, can I just do a quick follow up 
from the question. I would like one second.
    Chairman Baker. Fine.
    Mrs. Jones. Mr. Chairman was talking about the change, or 
new products. But any financial institution or bank or whatever 
may come up with new products. And when you come up with a rule 
or regulation that regulates such a thing, you conceptually 
would include in that the possibility that there would be new 
products that would allow you to still withstand the test of 
time based on your stress test, if I said that right. Did I 
make any sense? Or can you answer that question?
    Mr. Falcon. Yes. If we did not allow for new products in 
this rule, it would be obsolete from the day that it was 
published. And so it does appropriately make sure that the 
enterprises can innovate and put out new products, and we can 
incorporate them on a timely basis into the stress test.
    Chairman Baker. Again, thank you, Mr. Falcon, for your 
agency's work. There is a fair certainty that the application 
of the rule eventually will cause some modification of the 
enterprise business activity, which will yield, I think, 
benefit in the long term for the market and for the taxpayer as 
well. It is my hope that the time available for review, comment 
and implementation will provide us with sufficient flexibility 
to ensure that there are not untoward market consequences of 
the application of the test. That, of course, is everybody's 
desire. But I just want to assure you of my longstanding, 
intense interest in seeing the rule implemented on the best of 
your professional capabilities. And I think the subcommittee 
stands ready to be of assistance.
    We will probably return in the fall for sort of a wrap up 
after the formal implementation of the rule, and perhaps to 
receive comment from others as to the advisability of the rule, 
even the GSEs if they would choose to have some statement on 
the record as to any concerns about the implementation. This 
should be an ongoing dialogue that results in the best public 
policy for all parties concerned.
    With that, I thank you and our hearing stands adjourned.
    Mr. Falcon. Thank you, Mr. Chairman.
    [Whereupon, the hearing was adjourned.]

                            A P P E N D I X

                             August 1, 2001