[Senate Hearing 108-215]
[From the U.S. Government Printing Office]

                                                        S. Hrg. 108-215
                          OF GSEs TO CONSUMERS


                               before the


                                 of the

                              COMMITTEE ON
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION


                             JULY 21, 2003


      Printed for the use of the Committee on Governmental Affairs

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                   SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska                  JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio            CARL LEVIN, Michigan
NORM COLEMAN, Minnesota              DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania          RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois        MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

           Michael D. Bopp, Staff Director and Chief Counsel
     Joyce Rechtschaffen, Minority Staff Director and Chief Counsel
                      Amy B. Newhouse, Chief Clerk



                PETER G. FITZGERALD, Illinois, Chairman
TED STEVENS, Alaska                  DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio            CARL LEVIN, Michigan
ARLEN SPECTER, Pennsylvania          THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah              MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

                    Michael Russell, Staff Director
              Richard J. Kessler, Minority Staff Director
                        Tara Baird, Chief Clerk

                            C O N T E N T S

Opening statement:
    Senator Fitzgerald...........................................     1

                         Monday, July 21, 2003

Alex J. Pollock, President and Chief Executive Officer, Federal 
  Home Loan Bank of Chicago, Chicago, Illinois...................     4
Peter J. Wallison, Senior Fellow, American Enterprise Institute..     6
Bert Ely, Ely and Company, Inc...................................     8
W. Michael House, Executive Director, FM Policy Focus............    11
James C. Miller III, Senior Fellow, Hoover Institution...........    12
F. Barton Harvey III, Chairman and Chief Executive Officer, The 
  Enterprise Foundation..........................................    14
Susan M. Wachter, Wharton School of Business, University of 
  Pennsylvania...................................................    16

                     Alphabetical List of Witnesses

Ely, Bert:
    Testimony....................................................     8
    Prepared statement with an attachment........................    52
Harvey F. Barton, III:
    Testimony....................................................    14
    Prepared statement with an attachment........................   165
House, W. Michael:
    Testimony....................................................    11
    Prepared statement with attachments..........................    83
Miller, James C. III:
    Testimony....................................................    12
    Prepared statement with attachments..........................   103
Pollock, Alex J.:
    Testimony....................................................     4
    Prepared statement...........................................    41
Wachter, Susan M.:
    Testimony....................................................    16
    Prepared statement...........................................   181
Wallison, Peter J.:
    Testimony....................................................     6
    Prepared statement...........................................    45

                          OF GSEs TO CONSUMERS


                         MONDAY, JULY 21, 2003

                                     U.S. Senate,  
                  Subcommittee on Financial Management,    
                  the Budget, and International Security,  
                  of the Committee on Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 2 p.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Peter G. 
Fitzgerald, Chairman of the Subcommittee, presiding.
    Present: Senator Fitzgerald.


    Senator Fitzgerald. I would like to call this meeting to 
order. Let me first welcome our distinguished panel of experts 
here today. We appreciate all of you making time in your busy 
schedules to be here for this important topic.
    Let me first set forth the purpose of this hearing, as I 
see it. The purpose is, No. 1, to examine the current status of 
Fannie Mae and Freddie Mac and possibly the Federal Home Loan 
Bank Boards, which are also Government-Sponsored Enterprises 
and are involved in housing. At least, the Chicago Federal Home 
Loan Bank is. And two, to engage in a balanced and healthy 
debate about the risks and benefits of these large 
corporations, which were established by Congressional charters.
    Let us stipulate at the outset that the housing GSEs 
fulfill an important public policy mission that is built into 
their government charters, to facilitate home ownership by low- 
to moderate-income families. In my judgment, the housing GSEs 
have contributed meaningfully to this cause, helping to give us 
perhaps the best housing market in the world.
    Second, GSEs, by charter, have prescribed limits on their 
activities. Unlike most companies, GSEs cannot enter into any 
business they want. In the case of Fannie and Freddie, they are 
limited largely to dealing in mortgages and mortgage finance. 
Moreover, the size of the mortgages they can deal in is 
carefully limited in their charters.
    Third, the GSEs have effectively promoted access to 
mortgage credit throughout the Nation, including inner cities, 
rural areas, and underserved areas, by increasing the liquidity 
of mortgage investments and improving the distribution of 
investment capital available for residential mortgage 
    That being said, we cannot ignore continuing news reports 
regarding the size, complexity, and financial status of these 
housing GSEs, in particular, Fannie Mae and Freddie Mac. These 
news reports raise a number of questions. Is there adequate 
market discipline on Fannie and Freddie? Would more competition 
help in ensuring that Fannie and Freddie do not take 
unnecessary risks? Are they adequately capitalized? Are some of 
the features of their special status as GSEs necessary in 
today's sophisticated financial marketplace?
    What are the implications of interest rate volatility? If 
lower interest rates lowered Fannie Mae's earnings, as were 
recently reported, what will happen when the Federal Reserve 
takes away the proverbial punch bowl and starts raising 
interest rates? Are Fannie and Freddie both completely hedged 
against falling and rising rates? And if they are perfectly 
hedged, how is it that they can earn a profit?
    Is it appropriate for us to allow banks and S&Ls to have an 
unlimited amount of GSE debt on their balance sheets? By so 
aggressively promoting housing, are we not artificially sucking 
debt capital away from more productive enterprises, as American 
families move into larger and larger homes in ever-expanding 
metropolitan areas?
    After several weeks of studying Fannie and Freddie, my own 
guess is that they are probably strong enough and sufficiently 
hedged enough to survive a serious downturn in the housing 
market. But perhaps they are not strong enough to survive the 
severest of financial downturns, such as we had in the 1930's. 
But then again, nor are many of our largest companies and 
financial institutions.
    I am pleased to welcome our distinguished panel of 
witnesses, who collectively represent some of the best minds in 
this debate, both for and against. Unfortunately, we do not 
have representatives from Fannie or Freddie testifying today, 
but notwithstanding their absence, we have at least one GSE, 
the Federal Home Loan Bank of Chicago, represented by its 
President, Alex Pollock. My hope is that we can engage in a 
balanced but vigorous debate so that we can ensure the 
continued success of GSEs in fulfilling their mission.
    I would now like to introduce our witnesses before calling 
on each of them for an opening statement.
    Our first witness is Alex J. Pollock, the President and 
Chief Executive Officer of the Federal Home Loan Bank of 
Chicago. Mr. Pollock has had a distinguished financial career 
in my home State of Illinois and has been in his current 
position since 1991. He is known as the architect of the 
innovative Mortgage Partnership Finance program, which has 
grown to over $35 billion in assets since its introduction in 
1997, and is the author of numerous articles on banking, 
financial systems, and management.
    Mr. Pollock will be followed by Peter J. Wallison, Senior 
Fellow of the American Enterprise Institute and Co-Director of 
AEI's program on financial market deregulation. Prior to 
joining AEI in 1999, Mr. Wallison served as General Counsel of 
the U.S. Treasury Department and Counsel to President Ronald 
Reagan and was a partner with Gibson, Dunn and Crutcher.
    Next, we will hear from Bert Ely, who has specialized in 
deposit insurance and banking structure issues since 1981. Mr. 
Ely currently is the principal of Ely and Company, a consulting 
firm devoted to financial institutions and monetary policy. Mr. 
Ely has testified before Congress on numerous occasions to 
share his expertise in banking issues. Prior to the founding of 
his firm, Mr. Ely served as Chief Financial Officer of a public 
company and as a management consultant with Touche Ross and 
Company and was an auditor with Ernst and Ernst.
    I would also like to welcome W. Michael House, Executive 
Director of FM Policy Focus and a partner with Hogan and 
Hartson. In these capacities, Mr. House concentrates on 
regulatory matters before Congress, representing national and 
multinational corporations, trade associations, and coalitions. 
Prior to his current position, Mr. House served as Chief of 
Staff to former U.S. Senator Howell Heflin from Alabama.
    Next, we will hear from the Hon. James C. Miller III, 
Chairman of CapAnalysis Group, LLC, Senior Fellow at the Hoover 
Institution at Stanford University, and counselor to Citizens 
for a Sound Economy. From 1981 to 1985, Mr. Miller served as 
Chairman of the Federal Trade Commission and subsequently was 
named by President Reagan as Director of the Office of 
Management and Budget.
    I would also like to welcome Bart Harvey, Chairman of the 
Board and Chief Executive Officer of the Enterprise Foundation. 
As Chairman and CEO, Mr. Harvey provides seed capital, 
operating funds, financing, technical assistance, and training 
to help rebuild low-income communities. Prior to joining the 
Enterprise Foundation in 1984, Mr. Harvey served in a number of 
domestic and international positions for the investment bank 
Dean Witter Reynolds.
    To close our panel, the Subcommittee will hear from Dr. 
Susan M. Wachter from the Wharton School of Business at the 
University of Pennsylvania. Dr. Wachter is a professor of real 
estate, finance, and city and regional planning at the 
university, a position she has held since 1972. Dr. Wachter 
also serves as a visiting fellow at the Brookings Institution 
and has received numerous awards for her teaching excellence in 
the area of financial management.
    Again, I would like to thank all of you for being available 
today to testify on the risks and benefits of Government-
Sponsored Enterprises.
    In the interest of time, I would ask that you summarize 
your testimony as best you can. I have read all of your 
statements and they are all very good. Some are very brief and 
actually could be read here, but others are much more lengthy, 
and for those of you who have written very lengthy opening 
statements, if you could submit those statements for the 
record, they will be included as part of the permanent record 
of this hearing. If you could just summarize your comments, I 
think that would keep us moving along much more quickly.
    We try to give each of you 5 minutes for your opening 
statement and then we will go for a free-for-all debate, with 
both advocates, pro and con, on the panel and we will all have 
a very lively debate.
    Mr. Pollock, thank you for coming from Chicago, and 


    Mr. Pollock. Thank you very much, Mr. Chairman, and thank 
you for giving us the opportunity to share our views with you. 
We believe your hearings today are very appropriate.
    \1\ The prepared statement of Mr. Pollock appears in the Appendix 
on page 41.
    The American single-family mortgage market is the biggest 
credit market in the world. It seems to us it is socially the 
most important. It is the current version of Thomas Jefferson's 
view that we ought to have a property-owning citizenry to have 
a vibrant republic. Fannie Mae and Freddie Mac are surely the 
most important factors in this extremely large and important 
    We take as the key question for today, in such a market in 
which Government-Sponsored Enterprises play the central role, 
how do we assure that the benefits of the GSE charter are 
passed through the mortgage finance system to benefit home-
buying consumers? Before I give our thoughts on this, I do want 
to note that I am expressing the views of the Chicago Federal 
Home Loan Bank. There are 12 Federal Home Loan Banks. Each is a 
company. Each has its own management, its own board, and most 
distinctly, its own views. So this is the Chicago view, and 
given its market orientation, perhaps we fit in with other 
Chicago views and Chicago schools.
    The Chicago view on today's key question can be summarized 
easily. It is: The best way for Congress to ensure that GSE 
charter advantages are passed through to consumers, is to 
encourage greater competition in the GSE sector.
    Mr. Chairman, in your opening remarks, you mentioned market 
discipline. That is another word for competition, and indeed, 
we believe that the market forces of competition and the 
innovation and efficiency they induce are the best disciplines 
for all enterprises, including GSEs. No amount of regulation or 
redesign in regulators or thinking about regulatory structures, 
however important that may be, can substitute for the effects 
of competition.
    There are, of course, three housing GSEs, as you mentioned, 
Mr. Chairman, Fannie Mae, Freddie Mac, and the Federal Home 
Loan Banks. We are all major sources of housing finance. We are 
all major issuers of debt, and indeed, we were all set up (in 
1932 for us, 1938 for Fannie, and 1970 for Freddie), in times 
of economic stress and problems. The key function of all 
housing GSEs is to link the mortgage market to the bond market, 
so, of course, we are involved with bonds.
    I think it is safe to say all three GSEs have evolved 
differently than their designers would ever have imagined, and 
that is part of the reason why it is a good idea to think about 
them now.
    Of the three, there is no doubt that Fannie Mae and Freddie 
Mac dominate the secondary mortgage market. Last year, 2002, 
they represented more than 80 percent of the conforming loan 
volume. If you look at the outstanding loans of conforming 
size, that is to say, eliminating jumbos and FHA loans and sub-
prime, Fannie and Freddie together have at least a 67 percent 
market share of all the outstanding single-family conventional 
loans, as defined. That is a big share measured in any way. And 
on top of that, they have sustained a remarkable, extremely 
profitable record over many years, with rates of return on 
common equity year after year in the 25 percent range.
    It seems clear to us, as part of this, that lending 
institutions who divest their credit risk to Fannie and Freddie 
by paying guarantee fees, pay very high fees relative to the 
losses involved. For example, last year, those guarantee fees 
averaged 19 basis points per year, but the losses were less 
than one basis point per year. It was a good credit year, but 
lenders are paying what we view as a noncompetitive fee.
    We think that both businesses of the GSEs, that is the 
mortgage funding business and the credit guarantee business, 
are in need of more competition. It is that need which has, at 
the root, generated the debates about Fannie Mae and Freddie 
Mac, in which all of the distinguished panelists here today 
have played a role.
    In our view, there are three possible outcomes to this 
debate. One is continued expansion and even more market 
dominance by Fannie and Freddie. The second is the 
privatization of GSEs and removing all their ties to the 
government. The third is creating a more competitive, 
economically efficient sector. I am not speaking of 
operationally efficient; I am speaking of economically 
efficient, which means the lack of the economic rents which 
today characterize the GSEs.
    As to No. 1, it is easy to imagine continuation of the 
status quo, leading to ever greater market dominance by Fannie 
Mae and Fannie Mae.
    As to No. 2, you can make very strong theoretical arguments 
that privatization is the right answer, and in fact, my good 
friend Peter Wallison has and does make such arguments. 
However, most people think the actual probability of 
privatization is something close to zero. We conclude that, as 
a practical matter, the only available way to improve this GSE 
sector (which has made great contributions, Mr. Chairman, we 
agree), in order to get greater consumer benefit is to increase 
    As an essential fact in the mortgage funding business, only 
a GSE, because of the GSE advantages, can compete with another 
GSE. Therefore, the Home Loan Banks, through our Mortgage 
Partnership Finance business, have set out to compete in the 
mortgage funding business. Through the risk sharing structures 
of Mortgage Partnership Finance, we have put over 500 private 
financial institutions, all Federal Home Loan Bank members, 
into competition with Fannie Mae and Freddie Mac in the credit 
guarantee business. Because of this, credit risk which would 
otherwise be concentrated in Fannie and Freddie is now 
dispersed into hundreds of private institutions.
    So we are making a serious effort to carry out our own 
theory of making the GSE sector more competitive, but I am sure 
there are many other additional pro-competitive possibilities 
which could be considered.
    As Andrew Jackson said in 1832, when vetoing the 
rechartering of the Second Bank of the United States, the GSE 
of its day, if we cannot make our government all that it should 
be, at least we can take a stand against the grants of 
monopolies. I imagine that Andy Jackson would have extended 
that thought to duopolies, as well.
    Mr. Chairman, thanks again for the opportunity to present 
our views.
    Senator Fitzgerald. Thank you, Mr. Pollock. I had never 
thought of the Bank of the United States as a GSE, but I guess 
now that I think about it, you are probably right.
    Mr. Wallison, thank you. You may proceed.

                      ENTERPRISE INSTITUTE

    Mr. Wallison. Thank you, Mr. Chairman. The title of these 
hearings, it seems to me, was quite well chosen, because the 
real question for Congress is whether the benefits provided by 
Fannie Mae and Freddie Mac outweigh their costs and the risks 
they create.
    \1\ The prepared statement of Mr. Wallison appears in the Appendix 
on page 45.
    In my view, the case against Fannie Mae and Freddie Mac is 
very simple. They create enormous risks for the government, for 
the taxpayers, and for the economy as a whole, and yet--if I 
may disagree respectfully with your opening statement, Mr. 
Chairman, provide no significant benefit to homeowners today.
    Fannie and Freddie have been doubling in size every 5 years 
and now have combined liabilities of almost $3.3 trillion. This 
is not a problem that can, in my view, be safely or responsibly 
put off.
    Fannie Mae and Freddie Mac were created for a single 
purpose, to provide liquidity for the housing finance system by 
creating a market for mortgages made by banks and other 
mortgage originators. They did this very well. There is now a 
vibrant and efficient secondary market for residential 
mortgages. The structure will now operate without government 
assistance of any kind and does, in fact, in what is called the 
jumbo market. So Fannie and Freddie are no longer necessary for 
their original purpose. They should be thanked and sent home.
    Fannie and Freddie know all of this, so they have been 
diligent in creating a rationale for themselves that does not 
depend on their providing liquidity to the housing market. They 
now say that they help put people in homes by lowering interest 
rates on home mortgages. They also suggest through their 
advertising that they disproportionately help minority home 
buyers. However, they do not really do these things.
    Many studies have shown that Fannie and Freddie's 
activities reduce rates on home mortgages by a very small 
amount, somewhere in the range of 25 basis points, or one-
quarter of one percent. If I can put this in some perspective, 
every time the Fed raises interest rates one-quarter of a 
point, it has the opposite effect. If that one-quarter point 
were as important as Fannie and Freddie suggest in their 
advertising, thousands and thousands of American families would 
be frozen out of home ownership every time the Fed raises 
interest rates by a quarter-point. I don't think that happens.
    In any event, as shown by a Census Bureau study presented 
at an AEI conference in October, the monthly cost of owning a 
home is not the obstacle that prevents renters from buying 
homes. The obstacle is the down payment. Most renters do not 
have the down payment necessary to buy a home. Accordingly, the 
claim by Fannie and Freddie that they put people in homes by 
reducing interest rates is not true.
    Through their advertising, Fannie and Freddie also suggest 
that they provide special assistance to minority families 
hoping to become homeowners, but they do not do this, either. 
Instead, according to a study by Jonathan Brown of Essential 
Information, a Nader-related group, Fannie and Freddie buy 
proportionately fewer conventional conforming loans that banks 
make in minority and low-income areas than they buy in middle-
class white areas.
    So the U.S. housing finance system gets very little benefit 
from the continued existence of Fannie and Freddie as 
Government-Sponsored Enterprises. What, then, are the costs?
    In 2001, CBO estimated that Fannie and Freddie receive an 
implicit subsidy from the U.S. Government, in effect, an 
extension of U.S. Government credit, with an annual value of at 
least $10.6 billion. But the costs, stated in terms of the 
risks they create, are far greater than this. Because Fannie 
and Freddie are implicitly backed by the U.S. Government, 
financial problems at either of them could require a government 
bailout. The government has done this before for other GSEs.
    Until the recent problems at Freddie, we might have said, 
and I did say, that both were in such good financial health 
that a bailout was not at all likely. Now, because of doubts 
about the accounting of both of them, no one can be sure of 
this anymore. Given their $3.3 trillion liabilities, if even a 
small part of this obligation has to be made up by taxpayers, 
it will make the S&L bailout look insignificant.
    But even that does not end the risks we all face with these 
two companies. Because they are integral to the health of the 
housing market, the failure of either of them could have a 
systemic effect, meaning an adverse effect on the economy as a 
    One of the ways they might do this, incidentally, is 
through the holding of their securities by our financial 
institutions. If their securities decline in value, so does the 
capital of these institutions, reducing the amount that they 
can lend in any area, not just in the mortgage area.
    Thus, since there are only two of these companies, it is 
accurate to say that the continued health of our economy 
depends on decisions by only two corporate managements. If one 
of them makes a grave mistake, the entire economy could suffer. 
And the recent events at Freddie Mac show that management 
judgments are not infallible.
    So what is to be done? Congress can change this calculus in 
a number of ways. Although I favor complete privatization, 
there is a less dramatic way to reduce the risks Fannie and 
Freddie create. Congress should prohibit Fannie and Freddie 
from buying back their mortgage-backed securities or 
accumulating any substantial portfolio of mortgages. Most of 
the limited benefits that Fannie and Freddie provide to the 
mortgage market come from their issuance of mortgage-backed 
securities. Most of their financial risks come from buying back 
these securities and accumulating portfolios of mortgages.
    Yet buying back MBS and holding mortgages in portfolio 
doesn't have any effect, positive or negative, on mortgage 
rates. So Congress, simply by prohibiting them from 
repurchasing their own mortgage-backed securities, can largely 
eliminate the risks they create without affecting mortgage 
interest rates. I respectfully recommend this to you, Mr. 
Chairman, and to the Committee.
    That concludes my testimony. Thank you.
    Senator Fitzgerald. Thank you, Mr. Wallison. Now, we would 
welcome your testimony, Bert Ely. Thank you very much for being 


    Mr. Ely. Mr. Chairman, thank you. I am here to testify 
today with regard to America's Government-Sponsored 
Enterprises. While I will focus on Fannie Mae and Freddie Mac, 
at times, I will touch on three other GSEs, the Federal Home 
Loan Bank System, the Farm Credit System, and Farmer Mac.
    \1\ The prepared statement of Mr. Ely with an attachment appears in 
the Appendix on page 52.
    I will first summarize major problems Fannie and Freddie 
pose and then discuss what we do not know today about the two 
companies. After reviewing underlying problems caused by Fannie 
and Freddie's GSE status, I will comment on proposed GSE 
tweaks, none of which will solve the GSE problem. I will 
conclude by discussing longer-term solutions to the GSE 
problem, including complete privatization.
    The Fannie and Freddie problem today and the broader GSE 
problems stem from their relatively rapid growth, which has 
been facilitated by their numerous privileges. This growth has 
been driven by management desires to enhance the wealth of GSE 
executives as well as the wealth of stockholders in the three 
stockholder-owned GSEs.
    In addition to being unfair competitors, the GSEs pose 
increased systemic risk to the U.S. financial system and, 
therefore, the taxpayers. Fannie and Freddie are too big to 
fail. The financial markets clearly believe Congress will 
rescue any troubled GSE, as it has done twice before.
    The potential for a third GSE rescue has been heightened by 
the troubling revelation of serious accounting problems at 
Freddie. Should those problems worsen, then a Congressional 
rescue of Freddie and its Siamese twin, Fannie, will become 
increasingly likely.
    Particularly troubling is that we don't fully know what we 
don't know about Fannie and Freddie. So far, Freddie's problems 
have been characterized as just accounting problems driven by a 
desire to smooth its earnings. However, the ongoing 
investigation of Freddie's finances may reveal serious problems 
in its risk management practices. Concern about Freddie's risk 
management was expressed quite strongly by Senator Corzine at 
last Thursday's Banking Committee hearing on the GSEs. He is 
better placed than perhaps any other Member of Congress to 
express that concern.
    One reason we don't know what we don't know about Fannie 
and Freddie stems from their inadequate financial disclosures, 
specifically the risk associated with their interest rate 
derivatives. There is also a troubling lack of comparability in 
the disclosures of the two companies.
    OFHEO Director Armando Falcon has tried to soothe 
Congressional and public concerns about Freddie's financial 
condition by stating that the financial restatement process 
should not alter the result of its quarterly risk-based capital 
stress test. However, the test is both outdated and too rigid. 
Neither Congress nor anyone else should take comfort in that 
test today or in the future.
    The special status, privileges, and benefits Congress has 
granted to the GSEs and particularly to Fannie and Freddie 
underlie the GSE problem. First, the GSE's arbitrage the 
interest rate yield curve and their GSE status through maturity 
mismatching on their balance sheets. They partially hedge their 
maturity mismatching through derivatives. A private sector 
mortgage investor could not safely operate today with such a 
high degree of maturity mismatching.
    Second, America has an inefficient housing finance system 
stemming from its reliance upon the secondary mortgage 
marketplace and the creation of mortgage-backed securities.
    Third, by lowering the cost of debt capital for those who 
can borrow from a GSE or whose debt is secured by a GSE loan 
guarantee, GSEs tilt capital flows away from other sectors of 
the economy, notably the productive sector.
    Fourth, the United States is experiencing an unhealthy 
shift toward GSE financing and away from genuine private sector 
financial intermediation. Because GSEs are political creatures, 
it is extremely difficult to correct this shift.
    Fifth, because they are a statutory construct, Fannie and 
Freddie represent relatively rigid features of the American 
financial landscape. They are largely exempt from the market 
forces constantly reshaping the financial institution 
    Sixth, according to CBO, Fannie and Freddie operate quite 
inefficiently in delivering a housing finance subsidy. 
Approximately 30 percent of the subsidy stayed with Fannie and 
Freddie in 2000, which explains the above-market equity rates 
of return Fannie and Freddie consistently earn.
    Seventh, some portion of the Fannie and Freddie subsidy 
goes to the sellers of homes, not purchasers. A slight rise in 
housing prices fully capitalizes the subsidy, thereby shifting 
all of it to sellers.
    Eighth, a substantial portion of the subsidy flows to 
existing homeowners, not to first-time home buyers.
    Numerous proposals have been offered to rectify problems 
and risks Fannie and Freddie pose. These tweaks will not solve 
the Fannie-Freddie problem. Repealing the Fannie and Freddie 
SEC exemption is an easily executed reform, but that will not 
cure the problem.
    Restructuring GSE regulation will be extremely difficult, 
but moving boxes around a government organization chart will 
not address the myriad of GSE problems. It would be better to 
move directly to more fundamental GSE reform.
    Giving OFHEO more money and power will not suffice. 
Repealing the GSE State income tax exemption is highly 
meritorious, but extremely difficult to accomplish politically. 
Repealing the GSE's Treasury line of credit would have symbolic 
value, but would be difficult to achieve.
    Higher capital levels have surface appeal, but they might 
not have the desired effect because of their arbitrary nature. 
Further, the present credit risk leverage ratio for Fannie and 
Freddie may, in fact, be adequate.
    Ending mission creep has been the goal of many, but hard to 
achieve because of the difficulty defining a new financial 
    The greatest public policy challenge facing Congress is 
what to do should one of the GSEs experience serious financial 
difficulties, for those problems could spill over to the other 
GSEs. Freddie's recent accounting problems and management 
shakeup highlight this problem.
    Complete privatization is the only real solution to the GSE 
problem, but first, three points. If they do not exist today, 
would Congress create the GSEs? I doubt it, for the political 
impediments which sparked the creation of the GSEs have largely 
    Second, little can be done to curb Fannie and Freddie's 
growth. Given their enormous political clout, Fannie and 
Freddie will succeed in repelling FM Policy Focus's containment 
    Third, Fannie and Freddie should be barred from owning 
mortgages or MBS, as my good friend Peter Wallison has just 
mentioned, beyond that needed to facilitate ongoing 
securitization activities. This would help mightily to reduce, 
if not eliminate, the systemic risk they pose. Limiting Fannie 
and Freddie to just the credit guarantee business might 
encourage them to seek privatization.
    Privatizing Fannie and Freddie would do five things. First 
of all, it would eliminate GSE risk to taxpayers.
    Second, it would create a much more efficient housing 
finance system.
    Third, it would build a level, competitive playing field 
among all private housing finance firms.
    Fourth, it would create a more flexible and adaptive 
housing finance industry.
    And finally, it would target delivery of the housing 
finance subsidy to just those home buyers on the cusp of home 
    A forthcoming paper will present my Fannie and Freddie 
privatization proposal in great detail. It will explain how 
market forces can restructure the housing finance marketplace 
so that the efficiencies of moving large blocks of debt capital 
to private sector mortgage originators can be fully captured. 
Market forces, not arbitrary capital regulations, will 
determine the amount of capital that institutional mortgage 
owners would hold.
    The paper also will propose a housing finance tax credit 
modeled on the Earned Income Tax Credit that will go only to 
those home buyers on the cusp of home ownership. Finally, it 
will address all-important transition issues as well as the 
privatization of the Federal Home Loan Banks.
    Mr. Chairman, the time is fast approaching when Congress 
must undertake fundamental reform of the GSEs by setting in 
motion the complete privatization of these anachronistic 
entities. I look forward to your questions.
    Senator Fitzgerald. Thank you. Mr. House.


    Mr. House. Thank you, Mr. Chairman. FM Policy Focus is a 
coalition of seven associations of financial services companies 
actively engaged in the mortgage industry. We were pleased to 
be invited to appear before you today and commend you for 
holding this hearing.
    \1\ The prepared statement of Mr. House with attachments appears in 
the Appendix on page 83.
    In 1938, Congress decided to rescue a distressed mortgage 
market. It was a genuine example of Congressional vision and 
we, as an organization, strongly support this vision through 
the continuation of the core mission of the two housing GSEs, 
Fannie Mae and Freddie Mac.
    Our members also believe that more can be done to expand 
home ownership among all Americans and especially among 
minorities and households who find it financially difficult to 
afford a home of their own.
    The GSEs play a vital role in this expansion, and for this 
reason, Congress subsidizes them to the tune of more than $10 
billion annually. However, in order for the GSEs to be in full 
compliance with their charters and fulfill their Congressional 
mandated mission, they need effective government oversight 
founded on three important principles: Effective regulation, 
sound capital, and market discipline from enhanced disclosure.
    From where we sit today, Fannie and Freddie are zero for 
three. They are weakly regulated by an underfunded and 
understaffed agency. They hold far less capital than that 
required by bank regulators, and they are the only two publicly 
traded companies in the Fortune 500 that are statutorily exempt 
from the Nation's security laws. If they were private 
institutions, homeowners and investors alike would be at great 
risk. But since Fannie Mae and Freddie Mac are Government-
Sponsored Enterprises, taxpayers could go from being in the 
dark about their operations to being in the red to bail them 
    The first principle of effective regulation is the 
establishment of a strong single regulator. In 1992, Congress 
created OFHEO as the safety and soundness regulator, and while 
making HUD responsible for overseeing the GSEs affordable 
housing mission and new programs. Unfortunately, this 
regulatory system has failed us in all three categories.
    It took 10 years for OFHEO to produce a complicated and 
inadequate capital rule for the GSEs. Moreover, the GSEs lag 
the private sector in promoting affordable housing. Don't just 
take my word for it: There are 24 separate studies based on HUD 
data that prove it. I have attached the list to my written 
    In 1992, Congress passed an Act that also directed HUD to 
preapprove new programs of the GSEs, but the agency has never 
implemented a meaningful new program review. This failure takes 
on new urgency since many of the new activities that GSEs 
undertake are financial products targeted directly at 
    Therefore, FM Policy Focus recommends that Congress replace 
the existing ineffective regulatory regime with a strong single 
regulator in the Treasury with authority over safety and 
soundness and mission. This structure should have all the 
attributes cited by Chairman Greenspan in his testimony before 
the Senate Banking Committee just last week namely, expertise, 
regulatory authority, and power strong enough to keep the GSEs 
safe and sound.
    The second principle is that the GSEs should be required to 
have capital standards similar to that required of banks, that 
is, bank-like capital. Fannie and Freddie are allowed to 
operate on a razor-thin capital base that doesn't even measure 
up to the capital held by the S&Ls in the 1980's prior to their 
    And the third principle is that the GSEs' exemption from 
the Securities Act of 1933 and the Securities and Exchange Act 
of 1934 should be repealed. At a time when the rest of 
corporate America is subject to stringent review, Fannie and 
Freddie continue to operate as islands unto themselves. It is 
especially dangerous in light of the revelations about Freddie 
Mac and its earnings restatement.
    Mr. Chairman, the GSEs are too big to ignore. These two 
companies alone are larger than the entire S&L industry 
combined, and that is why the stakes of this debate are so 
high. The current regulatory scheme is bifurcated and it is 
weak and subject to undue influence from the GSEs. Fannie and 
Freddie already pose a significant risk to the financial 
markets, a risk that is compounded by their incursions into new 
activities that go beyond their core mission.
    In closing, EM Policy Focus believes that Congress must 
restructure GSE regulation for all players to ensure that the 
GSEs are effectively regulated. I thank the Committee for 
allowing me to testify and ask that my entire statement be put 
in the record. I would be glad to respond to questions.
    Senator Fitzgerald. Thank you. Without objection. Mr. 


    Mr. Miller. Mr. Chairman, thank you for having me here. I 
have a statement with attachments I would ask be included in 
the record.
    \1\ The prepared statement of Mr. Miller with attachments appears 
in the Appendix on page 103.
    Senator Fitzgerald. Without objection.
    Mr. Miller. Thank you, sir. I understand the focus of this 
hearing is on the benefits and risks of the housing GSEs. It so 
happens that over the past couple of years, I have been 
involved in two major studies that are pretty much on target 
here and I would like to describe them briefly for you.
    The first study was prepared by Dr. James Pearce of Welch 
Consulting and myself and it addressed directly the benefits 
and costs of the two housing GSEs of most substantial 
importance here, Freddie and Fannie. And what we did was 
estimate first the benefits to consumers, and the way we went 
about that was, in simplified form, looking at the difference 
between the interest rates paid by consumers in the conforming 
market, which Freddie and Fannie are able to facilitate, and 
the jumbo market, which is above that. Mr. Pollock mentioned 
that jumbo market is, in fact, competitive.
    Well, what we found is that there is a big jump in the 
interest rates paid by consumers, or the mortgage rates paid by 
consumers when you traverse from the conforming rate into the 
jumbo rate. We estimated that the jump was at least 24 basis 
points. We also concluded there was an indirect effect in the 
jumbo market of at least five basis points, and if you multiply 
that by the conforming loans and jumbo loans that are 
outstanding, involving some ranges, because there was some 
discussion about different methodologies, different databases 
give you slightly different answers, we feel very confident 
that the benefits bestowed by the nexus that Freddie and Fannie 
have with the Federal Government generate on the order of $8.4 
billion to $23.5 billion per year.
    Then we looked and tried to measure directly the funding 
advantages these two GSEs realize because of their nexus with 
the Federal Government, and others have talked about the 
reasons for those. We found on short-term debt, there was about 
a 10- to 20-basis point advantage. On long-term debt, between 
10 and 40 basis points. And with respect to MBSs, between 10 
and 30 basis points. Given the amount of debt outstanding, or 
borrowing, this amounts to about $2.3 billion to $7.0 billion a 
    Now, importantly, what this shows is even the high estimate 
of the funding advantages to the GSEs is below the low end of 
our estimate of the advantages to consumers.
    Now, I want to make a point here, Mr. Chairman, and that is 
that our study attempted to measure directly these benefits and 
directly the funding advantage. Others, including CBO, have 
used a model which is basically zero-sum. They estimate the 
funding advantages and take away from that the consumer 
advantages and there is a fee left over, ignoring the fact that 
these GSEs may contribute a great deal of value to the housing 
finance market by virtue of their greater efficiencies, the 
economies of scale, the innovations, and maintaining liquidity 
generally in the marketplace. I think their model is fatally 
flawed because you could find that your estimate of consumer 
benefits exceeded the amount of the funding advantage, which is 
a nonsensical result.
    The second study is one that CapAnalysis, the group that I 
chair, did. As you know and was mentioned here, OFHEO recently 
promulgated a risk-based capital standard for judging the 
capitalization of these two GSEs. What this standard does is 
hypothesize a 4-year period during which there is a dramatic 
fall in housing prices, disruption of housing, and dramatic 
reductions in interest rates. That is one part of the test. The 
other part of the test is a rise in interest rates for a 4-year 
period. And then the question is, would these GSEs survive over 
a 10-year period?
    Now, some questions were raised. Well, this is not just the 
usual kind of capital measures, capital-asset ratios, that 
apply to other federally-regulated financial institutions, and 
while Freddie and Fannie do have to meet certain capital 
requirements, it is not the same. So would this test really be 
very rigorous?
    Well, what we did was hypothesize the thrift industry as 
being a single firm, as if it were a single firm, would it, in 
fact, meet this OFHEO risk-based capital standard?--and we 
applied it and guess what? In the case of the upward interest 
rate scenario, it failed after 7\1/2\ years. The industry 
failed the test. And, in fact, it would have needed $32 billion 
more in capital at the beginning of the period in order to 
survive the 10-year test period. It did pass the interest rate 
reduction scenario, but since it failed one part of the test, 
it failed it in total.
    Mr. Chairman, we have an extraordinarily vigorous housing 
industry that is enabled by a comprehensive mortgage finance 
industry that is facilitated by Freddie and Fannie and other 
GSEs. All institutions, in my experience, can stand 
improvement. I have no doubt that is true of Freddie and Fannie 
and the other housing GSEs. But I think for somebody who has 
looked at a lot of them, it seems to me that these are very 
well-run enterprises and that they have done a substantially 
superior job of facilitating this very important market. Thank 
    Senator Fitzgerald. Thank you, Mr. Miller. Mr. Harvey.


    Mr. Harvey. Thank you, Mr. Chairman, for this opportunity. 
First, just a little bit about Enterprise. Enterprise is a 
national nonprofit organization that provides private capital 
to support affordable housing and economic development in low-
income communities. We have raised and invested $4.4 billion to 
finance 144,000 affordable homes for low- and very-low-income 
families and individuals.
    \1\ The prepared statement of Mr. Harvey with an attachment appears 
in the Appendix on page 168.
    I can say at the outset, we have no more important partners 
in our work than the housing GSEs. Fannie Mae, Freddie Mac, and 
the Federal Home Loan Banks have been indispensable to 
Enterprise's efforts to expand housing opportunities for low-
income and very-low-income homeowners and renters. In many 
cases, the GSEs alone were willing and able to help Enterprise 
meet these needs. Without the GSEs, much of our work simply 
would not be possible.
    Now, we are no experts on macroeconomic benefits. You have 
got many of them here. We are not a research institute. We are 
a practitioner. I think we are the only practitioner on this 
panel. And we are one of the largest and representative of many 
more in the country who provide resources to consumers who are 
often left out of the mainstream housing market. Our testimony 
addresses how we, working with the GSEs, address the needs of 
low-income families and individuals.
    First of all, the GSEs must meet, as you said yourself, 
strong Federal requirements to finance affordable housing. The 
legislation that provides Fannie and Freddie's legal and 
regulatory framework requires them to dedicate substantial 
portions of their business to serving low-income people and 
communities. In fact, as Frank Raines said in his 2002 annual 
report, ``for Fannie Mae, focusing on underserved Americans is 
more than just the right thing to do or something we do on the 
side. It is the center of our business.'' That can be said for 
Freddie Mac, and in its own way for the Federal Home Loan Bank 
    HUD substantially strengthened the public policy 
requirements for Fannie Mae and Freddie Mac in 2000. We 
strongly supported that. We are not aware of any other 
corporations that have such demanding public purpose 
responsibilities as Fannie Mae and Freddie Mac. And similarly, 
the Federal Home Loan Bank Boards are required to dedicate 10 
percent of their net income every year to fund affordable 
housing. That has amounted to more than $1.7 billion that has 
financed $25 billion worth of affordable housing. And billions 
more are available, as Alex Pollock knows, at a slight discount 
for community investment.
    I have served on the board of the Atlanta bank, which went 
beyond the mandatory and reached out voluntarily to serve their 
mission in other ways.
    Enterprise has worked in productive partnerships with the 
GSEs to provide housing for many thousands of low-income 
families and individuals. For example, Fannie Mae, Freddie Mac, 
and the Enterprise Foundation pioneered the use of the 
corporate market for low-income housing tax credits in the late 
1980's. Fannie stepped up to invest when few others would and 
encouraged other corporations to follow suit. Freddie Mac was a 
very early investor, as well. That credit today is the most 
important Federal incentive for the development of rental 
housing for low-income people in the country, and Fannie Mae 
and Freddie Mac are the most important sources of capital for 
    The pictures that you see here show you two examples of the 
kind of housing Fannie Mae and Freddie Mac, working with 
Enterprise, have made possible. I hope it gives a face to this 
sometimes abstract issue of the critical housing benefits that 
the GSEs provide. Ultimately, what we are talking about are 
peoples and families and communities.
    The first here that you see, Sheldon Village in Eugene, 
Oregon, provides 35 homes and numerous supportive services for 
very low-income people, including formerly homeless individuals 
with special needs. It is located to provide easy access to 
educational and recreational facilities and public 
transportation for residents. Freddie Mac was the major 
financial partner.
    The next example is Arbor Park Village with Fannie Mae. 
This is a large-scale development, 282 homes in 28 garden-style 
buildings, all for very low-income people. It is helping 
revitalize a neighborhood near downtown, Cleveland.
    Now, these are just two of many examples that we could give 
you. We use the low-income housing tax credits. We could use 
many other types of financing mechanisms.
    We believe the current statutory and regulatory framework 
for Fannie Mae and Freddie Mac has enhanced their ability and 
willingness to do this kind of work with organizations like 
Enterprise. These partnerships deliver housing resources to 
people and places that cannot take full advantage of our 
Nation's generally well-functioning housing system.
    These companies have consistently met their affordable 
housing responsibilities, even as HUD steadily and 
substantially increased them over the past decade. They have 
the best people, the best technology, enormous access, broad 
partnerships, all working on ways to mainstream new products 
and services. They have the ability to test market ideas that 
people like us bring to them.
    Congress has expressedly provided Fannie and Freddie the 
flexibility to respond to fast-moving market conditions and 
emerging needs. We believe that curtailing Fannie Mae and 
Freddie Mac's flexibility to innovate would undermine these 
gains and limit future progress towards meeting our Nation's 
most serious affordable housing needs.
    Certainly, the safety and soundness of the housing GSEs is 
critical for consumers and the economy. Vigorous regulation is 
essential. But there is no reason that strong safety and 
soundness oversight should chill or constrain the GSEs' vitally 
important affordable housing activities. In fact, the interest 
of affordable housing and safety and soundness are very 
compatible if carried out the right way. Thank you.
    Senator Fitzgerald. Thank you, Mr. Harvey. Dr. Wachter.


    Ms. Wachter. Thank you, Chairman Fitzgerald, for the 
invitation to testify today on Government-Sponsored 
Enterprises. I ask that my full statement be included in the 
    \1\ The prepared statement of Ms. Wachter appears in the Appendix 
on page 181.
    Senator Fitzgerald. Without objection.
    Ms. Wachter. Currently, the United States has one of the 
best housing finance systems in the world. The efficiency of 
this system has been advanced by the Federal chartering of 
Government-Sponsored Enterprises, particularly Fannie Mae and 
Freddie Mac. These institutions have enabled the securitization 
and the development of the secondary market for the funding of 
mortgages. Securitization and the efficient trading of 
mortgages and liquidity in secondary markets have achieved the 
integration of U.S. mortgage markets into national and 
international capital markets.
    The goal of the Federal chartering of Fannie Mae and 
Freddie Mac is to achieve public policy objectives, including 
the promotion of home ownership for all Americans, and economic 
research indicates that this mission is being accomplished. 
Today, I will address how this mission is accomplished, how 
increased access to home ownership for all Americans has been 
accomplished through the Federal chartering of Fannie Mae and 
Freddie Mac.
    In my testimony, I will specifically refer to a research 
paper authored by myself and colleagues, which I request be 
entered into the record.
    Senator Fitzgerald. Without objection.
    Ms. Wachter. In addition, I believe the GSEs have had a 
critical role, through the strength of the U.S. housing market, 
in the recovery of the overall U.S. economy since the 2001 
    Based on my research and that of multiple colleagues, 
Fannie Mae and Freddie Mac have contributed to the expansion of 
home ownership in America, providing affordable residential 
mortgages for households who otherwise would not have had the 
opportunity to become homeowners. Freddie Mac and Fannie Mae's 
efforts have helped to advance gains in overall home ownership 
rates, as well as in home ownership rates among minority and 
low-income households occurring over the past decade. This has 
been a phenomenal decade for home ownership which I do not 
believe would have been as strong without the role of the GSEs, 
a decade resulting in a record high home ownership rate of 68 
percent in 2003.
    GSEs have accomplished this, in part, through their special 
affordable lending programs, of which Bart Harvey has spoken. 
But also, the GSEs have accomplished this through lower 
mortgage interest rates and through lower down payment rates. 
These have been made possible through the innovation and 
technological advances that the GSEs have brought about over 
the last decade.
    The findings of the recently-released research study, ``The 
Impacts of Affordable Lending Efforts on Home Ownership 
Rates,'' by myself, Roberto Guercia, and George McCarthy, which 
was published in March 2003 in the Journal of Housing 
Economics, indicate that affordable lending efforts can 
increase home ownership opportunities overall and for 
underserved populations. For example, they can result in a 30 
percent increase in the relative probability of home ownership 
for younger households, 20 percent increase in the relative 
probability of home ownership for minority households, and a 15 
percent increase for households residing in central cities.
    The potential gains in home ownership are attributable, in 
part, to improved credit risk management, which enables lower 
down payments without an increase in credit risk. Thus, it is 
not just lower interest rates, mortgage rates, but also 
technical innovations, such as automated underwriting, that are 
responsible for increasing home ownership throughout this past 
    The GSEs and a strong secondary market deliver a second 
major benefit, not only to homeowners but to the American 
consumer overall. Their role in accessing global capital 
markets and stabilizing U.S. mortgage markets was evident in 
August 1998 upon the defaulting of Russia's foreign-held debt. 
In the global crisis, interest rates moved sharply higher and 
illiquidity appeared to be a growing concern worldwide. 
Purchasing a record number of mortgages, the GSEs staved off 
crisis by adding liquidity. Therefore, no credit crunch evolved 
in the U.S. residential sector, as opposed to other markets at 
the time.
    This pivotal effect is even more evident in the recent role 
housing has played in stabilizing the overall U.S. economy. The 
role of mortgage market access to global capital markets as an 
automatic stabilizer with the U.S. economy has been 
demonstrated by the strength of the housing sector and its role 
in moving the economy out of the 2001 recession. It is access 
to international capital flows during a period of low and 
falling interest rates that has resulted in additional consumer 
spending, which has supported the U.S. economy.
    This benefit that the GSEs and secondary markets deliver to 
the American consumer is, I believe, a major, if not the major, 
contributing factor to today's housing market, which has helped 
stabilize and grow the U.S. economy. This, together with 
increased access to home ownership for all Americans, I 
believe, is a testimony to the role the GSEs have played and to 
the importance of ensuring that they continue to play this role 
going forward.
    Thank you, Mr. Chairman.
    Senator Fitzgerald. Dr. Wachter, thank you very much.
    What I would like to do now is take a 2-minute recess so 
that you can all stretch and stand for a minute, and then we 
will resume and go quickly into the question and answer 
section. We will be right back.
    Senator Fitzgerald. If we could resume the hearing, I would 
appreciate it.
    I would like to, at the outset, note there is so much money 
involved in the mortgage business, and some of you who are pro 
and some of you who are con, have relations with some of the 
companies involved on either side of the debate. I would like 
to explain any possible conflicts of interest to the media and 
the members of the public before we start going with the 
question and answer session.
    I would start with Alex Pollock. You are President of the 
Federal Home Loan Bank of Chicago. Is it correct that the 
Federal Home Loan Bank of Chicago is trying to compete with 
Fannie and Freddie in the conforming loan market?
    Mr. Pollock. That is very true, Mr. Chairman.
    Senator Fitzgerald. Please pull the microphones close, and 
Mr. House and Mr. Miller, you are going to have to share your 
microphone because we only have six and there are seven 
    But is that correct?
    Mr. Pollock. That is correct.
    Senator Fitzgerald. You are competing with them. You are a 
GSE yourself. You have nothing against GSEs, but you would like 
to compete with them on better terms, which I gather, would be 
a simple way of saying it?
    Mr. Pollock. It is correct. We view anything as an 
advantage for the mortgage market and the country that makes 
the secondary sector more competitive. Clearly, I have an 
interest in this, being a competitor in the market, as you say, 
Mr. Chairman.
    Senator Fitzgerald. And there have been calls, is it not 
correct, to get you out of the mortgage business or the 
mortgage securitization business that you are in?
    Mr. Pollock. I don't want to give a speech on 
securitization. We are not in securitization per se. But 
certainly, a few ill-advised people have thought we shouldn't 
create this competition, yes, sir.
    Senator Fitzgerald. OK. Dr. Wachter, have you been paid for 
any of your research by any party to this debate?
    Ms. Wachter. I have not been paid for my research. However, 
the paper that I have just mentioned has been supported by the 
Wharton Real Estate Center and has also received a small amount 
of funding support from Freddie Mac.
    Senator Fitzgerald. OK. Mr. Harvey, I notice on The 
Enterprise Foundation website you received a $1 million 
contribution from the Fannie Mae Foundation last year, is 
    Mr. Harvey. Let me just say, we solicit funds, loans, 
grants, capital, from all financial institutions and we have 
significant--as I said, we have received grants from Freddie 
Mac, from Fannie Mae, loans and other capital and from all 
financial institutions----
    Senator Fitzgerald. And from a lot of banks?
    Mr. Harvey. From banks, as well.
    Senator Fitzgerald. That maybe are part of the funding of 
FM Policy Focus, possibly. I am not sure.
    Mr. Harvey. That is right. [Laughter.]
    Senator Fitzgerald. We will get to that in a minute.
    Mr. Wallison, your research at AEI, is it funded by 
    Mr. Wallison. No, it is not directly funded by anybody, but 
AEI does get contributions from organizations that are in the 
financial services industry and some of them, although I do not 
know, may be part of any of the organizations that are opposing 
Fannie and Freddie.
    Senator Fitzgerald. OK. Mr. Miller, your study that you 
talked about in your opening statement, that was, am I correct, 
financed by Freddie Mac?
    Mr. Miller. Yes. It was a study commissioned by Freddie 
    Senator Fitzgerald. OK. And you were paid to do that study 
of the benefits?
    Mr. Miller. Yes, but I call them as I see them.
    Senator Fitzgerald. OK. Mr. Ely, have you been paid by 
    Mr. Ely. First of all, the American Bankers Association is 
a client of mine with regard to the Farm Credit System. I have 
done three reports for the ABA on the Farm Credit System.
    Senator Fitzgerald. To the Farm Credit System?
    Mr. Ely. Yes, which, of course, is another one of the GSEs. 
In addition, with regard to Fannie and Freddie, I have received 
modest grants from AEI for several of the papers that I have 
done for AEI and for Mr. Wallison's program.
    Senator Fitzgerald. OK. Mr. House, who funds FM Policy 
Focus, of which you are the Executive Director, and does ``FM'' 
stand for Fannie Mae or Freddie Mac?
    Mr. House. It stands for both. [Laughter.]
    Senator Fitzgerald. It stands for both, OK. Who funds that?
    Mr. House. That is funded, as I said, by people in the 
financial services industry. It is very interesting, because 
the GSEs have characterized our group as a group of 
competitors, and frankly, we are their customers. That is one 
of the reasons we are here today, because if they characterize 
us as competitors, then we have a real problem. That is why 
effective regulation is needed.
    Senator Fitzgerald. OK.
    Mr. Ely. Mr. Chairman, if I can just add one point.
    Senator Fitzgerald. Yes?
    Mr. Ely. Many people have suggested over the years that I 
have done consulting work for FM Policy Focus. As I am sure Mr. 
House will confirm, there has been absolutely no relationship 
between myself and FM Policy Focus.
    Senator Fitzgerald. OK. I just wanted to get that out on 
the table so that everybody knows where everybody else stands.
    Professor Wachter, I have a question for you. You are a 
professor of real estate finance at Wharton?
    Ms. Wachter. I am a professor of real estate and finance at 
the Wharton School.
    Senator Fitzgerald. And finance, OK. Right now, the housing 
industry in America has been very strong with declining 
interest rates. The values of homes have been appreciating very 
rapidly as rates have declined. If we got into a situation 
where rates started to rise, would it not be the case that the 
value of homes themselves could plummet? In other words, a home 
worth $300,000 that is today with low interest rates of 4.5 
percent, let us say, and if mortgage interest rates go back up 
to 7.5, 8, or 9 percent, that $300,000 home, all things being 
equal, may no longer be worth $300,000. Would you agree or 
disagree with that statement?
    Ms. Wachter. I would respectfully disagree with that 
statement. If mortgage interest rates increase, of course, 
there will be other factors that cause this increase. A most 
likely reason that they will increase is increased strength in 
the overall economy, and if that occurs, I do not believe that 
housing prices will plummet.
    It is, I think, quite likely in that situation that housing 
prices will no longer appreciate at the rate that they have 
been appreciating, and in fact, they may appreciate less than 
the inflation rate. There has been no period in the recent 
history of the United States that we have documented where 
housing prices have declined in nominal terms.
    Senator Fitzgerald. Not during the 1930's, during the Great 
    Ms. Wachter. In the database that I have seen post-World 
War II, where we have good data, there has not been a recession 
where housing prices have decreased.
    Senator Fitzgerald. Would anyone else like to comment on 
that? Mr. Wallison or Mr. Ely? What do you think would happen 
to the value of homes if interest rates go up sharply? What I 
am getting at is, right now, the loans that are securitized by 
Fannie and Freddie have strict underwriting requirements. They 
have to have a 20 percent downpayment. If they don't have a 20 
percent downpayment, the borrower has to have mortgage 
insurance. Could not that downpayment or equity, the owner's 
equity in the home, disappear in a scenario where there is a 
substantial general rise in mortgage interest rates?
    Mr. Ely. If I could add some thoughts to that, the question 
comes as to what is driving the increase in nominal interest 
rates. Is it a higher inflation factor, or higher inflation 
premium in the nominal interest rate, in which case the value 
of real assets are going to be increasing in nominal terms? On 
the other hand, if the real interest rate increases, then you 
will not see a plummeting, I wouldn't expect to see that, but 
as Dr. Wachter said, a slowing in the rate of appreciation.
    There is one other thing that we want to keep in mind, too, 
as we look forward that may be somewhat of an overhang on the 
housing market going forward--the ratio of mortgage debt to the 
estimated market value of owner-occupied housing has been 
increasing significantly. We do not yet know what the 
implications are going to be, particularly from a macroeconomic 
standpoint, if the housing price appreciation slows down. As 
has been commented on by the panel, one of the drivers in the 
economy in recent years has been the fact that people have been 
cashing out some of their home equity through refinances. If 
interest rates go up, if the refinance activity slows down, if 
housing starts to get squeezed a little bit, then we may see 
some macroeconomic effects that will certainly not be positive 
for housing.
    Mr. Wallison. May I add something, Mr. Chairman?
    Senator Fitzgerald. Yes.
    Mr. Wallison. I think Dr. Wachter's analysis is probably 
correct, and that is to say interest rates would not likely go 
up unless the economy were recovering and, therefore, housing 
prices might stabilize or not decline. On the other hand, we 
did have, in the 1970's, a period known as stagflation, when we 
had very high inflation and we had very little economic 
growth--indeed some decline in growth--and high unemployment, 
much higher than today. As a result, it is actually high 
unemployment which is the greater danger to Fannie and Freddie, 
and to the mortgage market in general, because that is when 
people can no longer afford to service their mortgages, when 
they are no longer employed.
    So there are all kinds of scenarios that might occur in our 
economy which could result in many more defaults than we have 
seen in the 1990's and the early 2000's, and that is why 
financial institutions are required to maintain high levels of 
capital--financial institutions, I might add, other than Fannie 
Mae and Freddie Mac.
    Senator Fitzgerald. Mr. Pollock, I want to go back to you 
to describe exactly what you are doing at the Federal Home Loan 
Bank of Chicago. You say you aren't securitizing mortgage debt 
per se, and I know in your opening statement, or in your 
written opening statement, you describe that you absorb the 
interest rate risk and allow the financial institution to keep 
the credit risk. How does that work? What exactly do you do?
    Mr. Pollock. Mr. Chairman, what we do, we call ``Mortgage 
Partnership Finance.'' We chose the name seriously because we 
create a partnership with our member institution, which is a 
commercial bank or a savings bank or a savings and loan, and 
each one of those partners takes one of Fannie Mae's or Freddie 
Mac's main businesses. As I said in my testimony, Fannie and 
Freddie have two businesses. The first is a credit guarantee 
business, the one that Peter and Bert want them to have to 
stick to. That happens to be one I think is better done by 
private financial institutions, because if you are the lender 
actually making the loan yourself, you ought to be 
fundamentally advantaged in knowing that credit and being able 
to manage it and bear the credit risk.
    On the other hand, the other business is the mortgage 
funding business, and if you are dealing with 30-year fixed-
rate, freely prepayable mortgages, you must have a long-term 
funding base, in my opinion, which is only available in the 
bond market and in the international hedging markets. In order 
to access that base efficiently with the current structures in 
the United States, you have to be a GSE to compete in the 
funding of long-term fixed rate mortgages. It is not advisable 
for private financial institutions to own 30-year cash flows 
and finance them on their deposit bases. That is a pretty clear 
lesson of our financial history.
    So with Mortgage Partnership Finance, we take these two 
pieces, we put our member, which is a bank or a savings bank or 
a savings and loan, into the credit guarantee business, dealing 
only with loans they have made themselves in which they are 
fundamentally advantaged. Instead of divesting the credit of 
their own customer and paying a guarantee fee to Fannie Mae and 
Freddie Mac, they credit enhance the loan to us and we pay them 
what is in effect----
    Senator Fitzgerald. For guaranteeing it?
    Mr. Pollock. For guaranteeing it.
    Senator Fitzgerald. You pay----
    Mr. Pollock. We put them into a business they ought to be, 
and in fact, are, fundamentally advantaged in. We then provide 
the funding and the interest rate risk management, and if you 
put the two pieces together, you have the entire financing.
    The competitive outcome is that in the credit guarantee 
business, we now have about 550 lending institutions approved 
to participate in MPF. So there are 500 new competitors----
    Senator Fitzgerald. You are growing very rapidly now, 
aren't you?
    Mr. Pollock. We are, yes, sir.
    Senator Fitzgerald. How many billion in assets are you up 
    Mr. Pollock. The Mortgage Partnership Finance Program is 
approximately $70 billion, a little----
    Senator Fitzgerald. Seventy-billion? So the figures I said, 
$35 billion, those are a year or two old?
    Mr. Pollock. They were true when they were printed, Mr. 
Chairman. [Laughter.]
    Senator Fitzgerald. OK, and growing very rapidly.
    Mr. Pollock. Yes.
    Senator Fitzgerald. Now, in talking to bankers in the 
Midwest, I am told that small community banks will have Fannie 
Mae, Freddie Mac, and the Home Loan Bank of Chicago all coming 
in to get their business. But I have also heard that for the 
conforming mortgages, there are private banks that come in and 
try to sell some services for those conforming mortgages to 
small banks, such as someone mentioned, ABN and ROE operating 
in the Midwest. What would those commercial banks do? It 
indicates to me that there is a degree of competition out there 
for Fannie, Freddie, and the Federal Home Loan Bank that isn't 
generally known to the public.
    Mr. Pollock. It is very true for the smaller banks that 
they could deal with a GSE, and, of course, get a better deal 
if they have three bidders for their business compared to two. 
There are also large bank aggregators, as they are called in 
the mortgage business, who will buy loans from smaller 
correspondent banks. This is called the correspondent channel.
    Senator Fitzgerald. OK.
    Mr. Pollock. But those loans, in turn, are generally turned 
into Fannie Mae securities or Freddie Mac securities or also 
financed with us.
    Senator Fitzgerald. So it is hard to see how that would be 
more profitable, to sell it to the correspondent bank which 
then resells to Fannie or Freddie. How could that make sense 
for the small bank?
    Mr. Pollock. It is a question of whether you are a 
retailing or wholesaling part of the business, but I think that 
is a fair question.
    Senator Fitzgerald. Now, Mr. Pollock, you said that the 
guarantee fees charged by Fannie and Freddie were 19 basis 
points and that they are too high. Do Fannie and Freddie both 
charge 19 basis points for guarantee fees?
    Mr. Pollock. Mr. Chairman, guarantee fees are negotiated 
individually. The 19 basis points is the average for 2002 and 
Fannie and Freddie are quite similar in that level, 
    Senator Fitzgerald. Where was that average 10 years ago or 
    Mr. Pollock. In the 20s.
    Senator Fitzgerald. So it has----
    Mr. Pollock. It started off being 25----
    Senator Fitzgerald. It has been coming down.
    Mr. Pollock. Yes.
    Senator Fitzgerald. OK.
    Mr. Pollock. The 19, relative to losses, is still very 
high. A typical, good small bank lender will average losses on 
their mortgage portfolio of perhaps two basis points or less 
per year.
    Senator Fitzgerald. In this kind of a market environment, 
    Mr. Pollock. Even in this market.
    Senator Fitzgerald. But in a bad recession, say, like we 
had in the early 1980's----
    Mr. Pollock. It is cyclical, but I am speaking of the 
averages, Mr. Chairman.
    Senator Fitzgerald. OK.
    Mr. Pollock. The long-term average, if I may just complete 
the thought, for Fannie and Freddie is about four or five basis 
points in their portfolio of annual losses per year. So you can 
think of that as the loss versus the guarantee fee being the 
insurance premium against that loss.
    Senator Fitzgerald. Well, that brings up an interesting 
point, though, because Mr. Wallison recommended that Fannie and 
Freddie not be allowed to hold mortgage-based securities on 
their own balance sheet, and you suggested that there is a 
great deal of risk to having them do so. But as Mr. Pollock 
pointed out, when they are guaranteeing the mortgages of 
others, their losses are very small. My own experience as a 
bank lawyer, prior to being in the Senate, was that home 
mortgages are the safest loans you can make. People will allow 
you to repossess their car, they will put their business in 
bankruptcy, but they will work wonders to come up with the 
money to stay in their home.
    Mr. Wallison. May I respond to that, Mr. Chairman?
    Senator Fitzgerald. Yes.
    Mr. Wallison. There are two kinds of risk, basically. There 
is credit risk, which is what Alex is talking about, and then 
there is interest rate risk. When they issue mortgage-backed 
securities and guarantee them, they are taking only the credit 
    Senator Fitzgerald. Right.
    Mr. Wallison. That is the three or four basis points 
maximum that Alex was talking about. Interest rate risk is the 
risk that they are taking when they buy back their mortgage-
backed securities and when they hold portfolios of mortgages. 
That is where their major risk comes from.
    Senator Fitzgerald. Well, let me tell you what they tell 
me, and I did talk to an executive VP from Fannie. I wish he 
could have been here today to testify, but in fairness to him, 
I did not give adequate notification of this hearing, either.
    But they claim that they are really fully hedged now, that 
they learned the lesson from the early 1980's in which we had 
the case of rising interest rates. They say that now in this 
era of declining rates, about 70 percent of their debt is 
callable, and, in fact, every day they are calling debt issued 
at higher interest rates and replacing it with low-yielding 
debt. And in a situation in which rates were to rise rapidly, 
they would simply keep their low-cost debt in place and not 
call it and that they have derivatives that hedge substantially 
all of their interest rate risk.
    Does anybody care to comment on that? Why would that not be 
    Mr. Ely. Well, first of all, let me provide a couple points 
of information here, not that the risk-based capital 
requirements are magic, but it is important to keep in mind 
that the minimum capital requirement on a strict leverage basis 
for Fannie and Freddie for credit risk is 45 basis points. For 
interest rate risk, it is 205 basis points. So there is in the 
statutes a recognition that there is much greater risk with 
interest rate risk.
    The other thing about interest rate risk is that you can be 
partially hedged, fully hedged, or maybe engaged in 
speculation, which also is risky. The problem that we have with 
Fannie and Freddie is that we are much less certain as to where 
they are in the risk perspective in terms of their hedging 
activities. They may assert that they are fully hedged. As I 
listened to the telephone conference with analysts last week 
that Tim Howard, the Executive Vice President and Chief Finance 
Officer held when Fannie announced its second quarter results, 
he was not talking as if Fannie was fully hedged. Fannie has 
significantly reduced its duration gap, but it didn't strike me 
as being fully hedged.
    So there is still a risk there, but there is also another 
very important factor to keep in mind. It is the assumption of 
interest rate risk by not only buying back MBS but also by 
holding mortgages in portfolio that causes the two GSEs' 
balance sheets to balloon, to loom as large as they do in the 
economy. If Fannie and Freddie were strictly credit guarantors, 
as Freddie was initially back in the 1970's, then they would 
have much smaller balance sheets today and, frankly the concern 
about systemic risk would be much less than it is today.
    But also coming back to a point that Peter made, and I 
might add the Congressional Research Service, among others, has 
made, there is no value added to the housing marketplace and to 
the provision of affordable housing when Fannie and Freddie buy 
back their MBS. Why do they do that? Because there is more 
profit per mortgage dollar, if you are assuming interest rate 
risk. This, therefore, provides them with an avenue for 
maintaining their high earnings growth rate and their high ROE 
than is the case if they were just credit guarantors.
    Senator Fitzgerald. Mr. Miller.
    Mr. Miller. Mr. Chairman, I think we are asking several 
``what if '' kind of questions, sort of pulling them out of the 
air. This OFHEO risk-based capital test is a comprehensive, 
systematic test, a scenario of the sort where you have a lot of 
things going wrong, one in which interest rates rise, one in 
which interest rates fall. This comprehensive test applied to 
Freddie and Fannie show that they both pass for 10 years. They 
do not have a problem.
    Senator Fitzgerald. And you said the S&L industry as a 
whole would not pass that.
    Mr. Miller. Did not pass, and that gives me an opportunity, 
Mr. Chairman, to correct an omission, not in my statement but 
in my oral presentation. I saw the light on. The fact that the 
thrifts failed the test should not really be viewed as evidence 
of a shortcoming of the capital requirements of the thrifts, 
but it should be viewed, I think, as evidence that this OFHEO 
risk-based capital test is a pretty tough test. Now, you can go 
in and change some of the parameters or whatever and you can 
ask a lot of ``what if '' questions----
    Senator Fitzgerald. I would like to give Mr. Ely a chance 
to respond. You foretold the S&L debacle in the 1980's. In one 
of your papers, you point out now that most S&Ls hold variable 
interest rate mortgages only, and I think you cited Washington 
Mutual as 94 percent of their mortgages were floating rate 
mortgages on their books and they weren't holding long-term 
fixed-rate mortgages on their books. You would think if that is 
the case, the S&L industry as a whole would be pretty well 
hedged against rising or declining rates.
    Mr. Ely. Well, two points. First of all, I am very 
skeptical of this finding that the thifts would fail the test 
in a rising interest rate market. One of the problems is, what 
is the database that you are working from? OFHEO has access to 
proprietary, non-public information in running the risk-based 
capital test for Fannie and Freddie. With regard to the thrift 
industry, I assume that Jim has worked with the same data the 
rest of us do, which is the so-called Thrift Financial Report 
or the Quarterly Call Report, which I would not want to try and 
read too much into.
    Let me say something else also about the risk-based capital 
test. As I indicated in my testimony, it is a highly flawed 
test because it is based on the assumption that we are going to 
have a rerun of the interest rate environment of the late 
1970's or early 1980's. It is an unfortunate test because it 
does not reflect present day realities.
    But there is another fundamental problem with it. It is a 
snapshot that is taken four times a year. These two companies 
can look great on December 31 or March 31, but the question is, 
what do they look like on April 1 or March 30? It is dangerous 
to go too far in making judgments just based on how things look 
on a particular date. What is more important is what the range 
of values are over a period of time. We don't see that with the 
risk-based capital test.
    Mr. House. Mr. Chairman, I think if you want to pursue this 
further, if you look at OFHEO, with the recent revelations of 
Freddie Mac, OFHEO has testified before the House and Senate 
and I would think that the members have been somewhat appalled 
by their response. I think if you would want to bring OFHEO 
here and ask them exactly what it is they knew, when they knew 
it, and also on their risk-based capital test, whether or not 
it is adequate, because it seems that from their own testimony, 
even they are not sure what--it took them 9 years, and they are 
still not sure exactly what it is.
    That is important. I think Senator Corzine said last week, 
if we were talking about a $300 million situation here or 
something like that, I could understand it, but I think, if I 
am not mistaken, the quote was it is appalling that we are 
talking about a $3 billion miscalculation.
    So my suggestion is, rather, we can argue all day back and 
forth here about whether it is good, bad, or whatever, but you 
may want to pursue that and really get into that because it may 
be that the test itself is fundamentally flawed, and that is 
important because today, for instance, the Central European 
banks, and this goes to something we were talking earlier 
about, whether or not you want worldwide, be able to have 
access to capital worldwide, the Central European banks said 
that they are looking into the amount that their banks should 
hold Fannie and Freddie on MBSs and when you----
    Senator Fitzgerald. Did they say that or was that just a 
    Mr. House. That was a report today that we heard.
    Senator Fitzgerald. OK.
    Mr. House. That they are looking into it, nothing--but the 
point is, is that having a good, sound regulatory structure is 
important. So anybody that says that you shouldn't have a good 
regulatory structure because it will erode the markets, not 
having one is even worse, and I think with everything going on, 
nobody--Bert said it earlier. Nobody is sure what is going on, 
and I think it is very important that Congress really get in 
and understand exactly what is going on and what needs to be 
set up to make sure it doesn't happen again.
    Mr. Miller. Could I just say, I don't think the record will 
show that anyone here has argued against having a sound 
regulator for Freddie and Fannie. It is an empirical question, 
I guess, whether the risk-based capital test is sufficiently 
severe. But certainly----
    Senator Fitzgerald. Is that test----
    Mr. Miller [continuing]. A test of a major industry, the 
thrift industry, that fails is to suggest it is quite 
significantly stringent.
    Senator Fitzgerald. OFHEO says that Fannie and Freddie did 
well on their risk-based capital stress test. Did they release 
a study to the public or anything or do we just take their word 
for it, that they are fine?
    Mr. Ely. We take their word for it, Mr. Chairman. Most of 
the data that goes into that test is proprietary to Fannie and 
Freddie. OFHEO sees it, but the world in general cannot. So we 
really have to take their word for it.
    The other thing to keep in mind about the risk-based test, 
and this is a very unfortunate circumstance, is that it is 
written into statutory language in quite some detail, and, of 
course, as you know, it takes a little while to get laws 
changed around here. I am very concerned about its relevancy at 
this point in time. In other words, OFHEO is probably doing a 
pretty good job of trying to make this test work, but it is, 
unfortunately, a flawed test.
    Senator Fitzgerald. They are doing the risk test that is 
set forth in a statute, whether or not it is necessarily the--
    Mr. Ely. That is correct.
    Senator Fitzgerald [continuing]. The test that should be 
applied. It is doing that test.
    Mr. Miller. Could I just say, Bert has had enough 
experience in Washington to know that if either one of these 
GSEs actually failed the test but OFHEO leadership went out and 
told the press it passed the test, surely, someone in the press 
would find out and the Nation would find out, so I don't 
    Senator Fitzgerald. But what do you say about the test 
being set in a statute on exactly what the parameters of the 
test should be? Certainly, it could be that the lobbyists for 
those entities have influenced what the test is, then. If it is 
in a statute, the regulator isn't empowered to come up with its 
own test.
    Mr. Miller. Well, you know, I think the regulator did come 
up with a pretty stringent test. At both Freddie and Fannie, 
some people there very much opposed its being implemented so 
soon, wanted to find out more about it, questioned it in some 
ways. But it is, in fact, in place today. But it is an 
empirical question of how stringent it is. You might want to 
have more flexibility, I would suggest, than having each 
element in statute because something may come up of a sort you 
think, well, maybe this is a part that ought to be added, or 
maybe this part of the test really isn't relevant at this time 
or something like that, or less relevant. So you might want to 
    Senator Fitzgerald. OFHEO does have people who came from 
the Controller of the Currency at it, is that not correct? My 
understanding is one of the on-site examiners at Fannie Mae 
actually used to be in charge of the detail at Citibank, so 
from what I am hearing, at least anecdotally, and it hasn't 
been confirmed to me, is that they do have some very good 
people over there. Does anybody wish to challenge that? Or, 
with respect to the effectiveness of the regulator, does 
anybody think that the regulation at the OFHEO--that the OFHEO 
personnel are not up to the task?
    Mr. Wallison. Can I make a general point on that?
    Senator Fitzgerald. Yes.
    Mr. Wallison. I think we put a tremendous amount of stock 
in regulation, but the events of the last 6 weeks should show 
us that we are not fully protected by regulation no matter how 
extensive it is. Ultimately, the major decisions that affect 
the health of a company are made at the very top, and the 
regulators very seldom have access to that. We saw just in the 
case of Freddie Mae that OFHEO did not have access to the 
accounting problems that were roiling the top of the company.
    Senator Fitzgerald. But are not the GAAP accounting 
problems that they had, a somewhat different issue? It may be 
that OFHEO is not necessarily relying on GAAP numbers. GAAP 
numbers are what you need to disseminate to the public for the 
securities reports. Freddie is seeking to voluntarily comply. I 
know from my own experience that bank regulators have a 
different set of accounting numbers that they like to see that 
may not have anything to do with GAAP, that are more stringent 
than GAAP.
    Mr. Wallison. We don't understand everything about what 
happened at Freddie Mac, nor do we actually know anything other 
than what the newspapers have reported. But it does appear that 
they were doing things with their derivatives that caused a 
problem with the reporting of income for certain periods. And 
OFHEO does look at their derivatives That is one of the 
functions that they are supposed to perform. How those 
derivatives are classified, what they are and so forth are 
things that OFHEO should have come across in the course of 
their investigation that would have given them a hint about how 
effectively these companies are operating.
    May I say a couple of other things, Mr. Chairman, while I 
am talking? One is that when the tests were done on Fannie and 
Freddie, all kinds of tests have been run by OFHEO, including 
the stress test that Jim Miller was talking about. Fannie 
always came out very close to the line. Freddie came out way 
ahead most of the time. In fact, people would have said 2 
months ago, if we are going to have any kind of accounting 
problem, we are going to have it at Fannie, because Freddie was 
always very well-managed, it seemed, from an accounting point 
of view. We would never have any difficulty there.
    Well, it turns out, ironically, that it is Freddie with the 
accounting problems. Fannie, which was always very close to the 
line, taking a lot of risks, has not been challenged as yet. I 
think now that investigations have begun, Fannie will get a 
good going over and I think we will find, based on some of the 
stuff you see coming out of the private sector today, that they 
are having their own difficulties.
    But in any event, you can't rely too much on a regulator to 
protect you, especially in a case where these two companies are 
the only two companies involved in this major part of our 
economy. If there is a major error by one of those companies, 
and the regulator does not recognize it, as I suggested in my 
prepared statement, we could have serious systemic problems in 
our economy.
    Also, finally, on the question of whether they are 
profitable after the hedging that they have to do to address 
their interest rate risk, I think, Mr. Chairman, if I heard you 
correctly in your opening statement, you made the fundamental 
and true point that if a company is fully hedged, it is not 
going to be profitable. There is some risk that has to be taken 
in order to make a profit.
    Senator Fitzgerald. I see a lot of witnesses want to 
address that issue. Dr. Wachter, can you get 100 percent hedged 
and still make a profit?
    Ms. Wachter. It does depend on the business that you are 
in. You can make a profit in other elements of your business. 
You could take additional interest rate risk and make profit on 
the interest rate risk. But as a general statement----
    Senator Fitzgerald. But to hedge themselves, they have to 
do a series of things that add to their costs.
    Ms. Wachter. Absolutely.
    Senator Fitzgerald. To hedge themselves on their liability 
side with respect to the debt they have issued, they have to 
make it callable. That requires them to pay higher interest 
rates. Investors who are going to hold callable debt want a 
premium and so forth. To buy all sorts of options and 
derivatives to cover everything in their portfolio, it gets 
very expensive. But you believe it is possible to----
    Ms. Wachter. Mr. Chairman, in an equilibrium setting, I 
absolutely agree with you. It would not be possible to make 
profit on hedging operations alone in equilibrium. But this is 
not necessarily an equilibrium market. That is, there is 
innovation going on. There are economies of scale. And 
separately, you can make money on other aspects of your 
    I also do want to address, if I may, Mr. Chairman, the very 
fact that, of course, regulation is very important here. I 
think it is a great advantage that these are regulated 
institutions. These are private institutions. And for all of 
the concern that has been expressed around this table--I am not 
saying that there shouldn't be concern--I think we also should 
look at the market response to the events of the questions on 
Freddie Mac's accounting and the market response was not very 
    Senator Fitzgerald. Well, does not Freddie have a problem 
of having overstated their earnings as opposed to having 
understated their earnings, which is the opposite of Enron's 
problems? Mr. Miller.
    Mr. Miller. Mr. Chairman, could I first agree with Dr. 
Wachter. You can earn profits when you are fully hedged.
    Senator Fitzgerald. Let me go back and correct myself. 
Freddie has a problem of having understated their earnings----
    Mr. Miller. Right. Right.
    Senator Fitzgerald [continuing]. Whereas Enron overstated 
their earnings. Understating your earnings would be much less 
alarming, I would think, to investors than overstating.
    Mr. Miller. And one explanation of the phenomena that Dr. 
Wachter was just pointing to at the end is that there is a 
difference between, on the one hand, the accounting treatment 
of derivatives, over which there is some dispute, some 
suspicion, or some concern, and I think the jury is still out. 
We just ought not jump to conclusions until we have the 
evidence. That's on the one hand, and on the other hand is 
safety and soundness.
    I think, at least the reports as I have read them, and the 
reaction to the question of the accounting of derivatives, is 
that the market interprets the two quite separately and 
believes in the fundamental safety and soundness of these two 
    Senator Fitzgerald. Mr. House, I want to get back to 
capital requirements. You suggested that Fannie and Freddie be 
required to have bank-like capital. Fannie and Freddie right 
now have to have 2.5 percent capital for the mortgages on their 
books and 0.45 basis points for the guarantees that they make. 
Banks are required to have 4 percent risk-based capital for 
mortgages that they keep on their books. My understanding is 
there is a new Basel round of international risk-based capital 
guidelines that will lower the capital requirements for banks 
holding mortgages. Is it down to----
    Mr. Ely. The so-called Basel II capital standards could 
bring them down, some suggest to a range of 1.4 to 2 percent.
    Senator Fitzgerald. That would be lower than Fannie and 
    Mr. Ely. Well, that is before taking into account maturity 
mismatching. I was just the other night having a hard time 
getting to sleep and so I was reading through some of the Basel 
II discussion. [Laughter.]
    There is an awful lot of judgment that is extended to the 
regulators in terms of how maturity mismatching is to be worked 
in there. So we want to be a little careful about quantifying 
the extent that the capital will be reduced. But in general, 
particularly for the larger banks that opt to go into Basel II, 
it appears that the capital requirement will drop somewhat.
    There is a very important point here to understand, and 
that is that any kind of capital regulation is arbitrary 
because if you take no risk, if you are perfectly hedged, then 
you don't need much capital, if any at all, because you don't 
need a capital cushion to absorb loss. What we have with Fannie 
and Freddie is they have capital levels that, in effect, they 
can arbitrage. At 2.05 percent for interest rate risk, they 
have to take a certain amount of risk in order to be able to 
earn a return on that 2.05 percent. If their ratio is pushed up 
to, let us say, 4 percent, they are either going to have to 
charge higher interest rates, earn a greater spread, or take 
more risk.
    A fundamental problem we have with capital standards, both 
as they apply to the GSEs as well as to the banks, is that they 
don't necessarily reflect the risk that the particular 
institution is taking. Instead, they become a target to 
arbitrage, and frankly, banks do that just as much as GSEs do. 
The difference is the lack of a level playing field. Presently, 
Fannie and Freddie don't have quite as high a capital hurdle to 
clear as the banks and, therefore, they have more room to 
arbitrage on credit risk, but more importantly on interest rate 
    Senator Fitzgerald. Mr. House.
    Mr. House. No matter where the Basel Accords come out, and 
that is--to say that is in flux is probably an understatement, 
and I can't believe--Bert, I will send you a book, a novel, if 
you stayed up reading that---- [Laughter.]
    But I think the key thing--what Bert just said is very 
important. What we are really about is a level playing field. 
So, we think that they are large financial institutions, just 
like any other financial institutions, no matter how you cut 
it. So when it comes to SEC registration, when it comes to 
capital requirements, when it comes to other things, they 
should be treated just like any other financial institution.
    Senator Fitzgerald. OK. So FM Policy Focus mainly wants, 
you have said, effective regulation, sufficient capital, and no 
exemptions from security acts. You don't have a problem with 
their overall mission, is that correct?
    Mr. House. No, we don't. We have said that. As long as they 
are in the secondary market. I mean, the liquidity in the 
secondary market was why they were founded.
    Senator Fitzgerald. It occurs to me that if Mr. Wallison's 
approach of privatization were ever adopted, Fannie and 
Freddie, in return for being privatized, would probably want to 
have restrictions on their operation lifted, too, so that they 
could compete in the jumbo mortgage market with many of your 
members. Would your group be opposed to that privatization and 
unleashing these giants in the areas where they have not 
heretofore tried?
    Mr. House. From day one, we have said that we are opposed 
to privatization. That has been----
    Senator Fitzgerald. So you are opposed to that.
    Mr. House. In fact, I feel very----
    Senator Fitzgerald. Is there self-interest involved in 
    Mr. House. No. I feel very comfortable. I have got 
privatization on my right. I have got business as usual on my 
left. I am sitting right here. [Laughter.]
    So we are fine.
    Mr. Ely. Mr. Chairman, if I could add to that, if there was 
a genuine privatization, it means basically peeling away or 
denying them all of the various special benefits they have now, 
including the implicit government guarantee. In that case, they 
would just be plain old business corporations. And then the 
question is, how well would they be able to compete, lacking 
any kind of meaningful origination capability, which comes back 
to this basic question: Is the secondary market really as 
efficient as we think it is, or does it look efficient only 
because of the GSE advantages that Fannie and Freddie have?
    Senator Fitzgerald. Mr. Wallison.
    Mr. Wallison. The advantages that Fannie and Freddie 
provide, it appears from all the studies, is about 25 basis 
points. It also appears from the CBO study that that 25 basis 
points comes from the support they get from the Federal 
Government. So we don't find that Fannie and Freddie are adding 
very much to the value of the secondary mortgage market.
    Senator Fitzgerald. They have to be adding a lot to the 
mortgage market, though, because of the statutory provision 
that says banks and S&Ls can hold an unlimited amount of their 
debt, and that prefers mortgage debt capital in this country to 
other debt capital, perhaps for more productive uses. Would it 
not be the case that we are putting an incredible, incredible 
emphasis in our country on mortgage financing and it must, at 
the end of the day, be sucking debt capital out of other 
perhaps more productive uses? Does anybody care to comment on 
    Mr. Ely. This is another area where we don't have a level 
playing field in terms of the allocation of capital within the 
economy. And, of course, it also happens through the tax code, 
too, with the favorable tax breaks that owner-occupied housing 
gets. That is why many would suggest that the middle class and 
the upper-middle class are over-housed in this country compared 
to other countries.
    But there are two different issues. One is the competitive 
level playing field, which I think Mike House is addressing. 
And then the other more significant public policy question is, 
to what extent, if at all, do we want to tilt capital flows in 
one direction or another? There is clearly, for a variety of 
reasons, including the housing GSEs, a tilt towards shifting 
capital flows into housing and particularly owner-occupied 
    Senator Fitzgerald. Dr. Wachter, is that a good idea, to 
tilt capital flows into housing as opposed to anything else? 
What about small business?
    Ms. Wachter. The issue of how interest rates overall are 
impacted by this is very complicated and it has to do with 
whether our growing deficit is increasing interest rates. So it 
is that literature that, in fact, needs to be--this needs to 
    In other words, Fannie and Freddie are accessing capital, 
not just in the United States, but global capital. So do they, 
in fact, increase overall interest rates? Do they, in fact, 
increase the share from a limited basket of funds? Do they 
increase the share from that limited basket of funds to housing 
at the expense of others, or is the effect to simply increase 
on the margin funds coming to the United States without any 
impact on other funding in the United States? This is an open 
question, and it may very well be that there is an impact 
drawing capital from small business. It may very well be, and I 
am not saying it isn't. I am saying it is an empirical 
question, to what degree that there is that impact.
    Second, there may very well be, and I do believe it is the 
case that Fannie and Freddie increase the overall efficiency of 
this market. That is, interest rates are lower--mortgage rates, 
that is, are lower than they otherwise would be. Mortgage costs 
are lower than they otherwise would be because of the technical 
efficiencies that they bring to the market. If that is the 
case, then this is not due to their drawing funds from another 
    Senator Fitzgerald. You support the concept of the housing 
GSEs. Would you support the creation of GSEs in other areas 
that would promote equally as worthy sectors of our economy, 
such as small business? In other words, if housing GSEs are a 
good thing, since we all favor home ownership in this country, 
aren't small businesses a good thing and don't we want to 
encourage people to own businesses? Why not then create GSEs to 
securitize loans to small businesses? Do you think that would 
be a good idea?
    Ms. Wachter. No, I do not. See, I think that the 
fundamental--a fundamental factor in our democracy, and I 
believe it was Peter Wallison who started his comments with 
that, is the Jeffersonian concept of ownership, and I believe 
that it is the ability of ordinary American families to have 
substantial ownership in America. This means as America 
prospers, as America expands, as our productivity expands, and 
as a result of that, housing costs go up, that we will not have 
a Nation of ``haves'' and ``have nots.'' And I don't think that 
there is anything more important than economic democracy along 
with political democracy.
    Senator Fitzgerald. Owning your own home. But what about 
economic democracy, everybody owns their own business?
    Ms. Wachter. Well, I do believe that owning your own home 
and having access to capital at low rates is what enables 
people then to go out and start their own small business, what 
enables people to go out and invest in their children's 
education, and what has enabled people to protect themselves in 
their old age.
    Senator Fitzgerald. Well, what about--do you favor 
Government-Sponsored Enterprises to further securitization of 
student loans? We used to have that with the student loan 
marketing GSE, but it has now been privatized.
    Ms. Wachter. Yes.
    Senator Fitzgerald. Do you simply think housing is the most 
important and all other areas of the economy should not have 
any kind of special push, just housing?
    Ms. Wachter. Well, I actually think that home ownership and 
housing, because it is a basic need, but home ownership 
absolutely should. I don't really have a position on these 
others except for the fact that I have in my studies seen what 
happens to economies where home ownership is not equally 
accessed and the political difficulties that so arise.
    And the other side of it is I believe we, in some sense, 
have the best of both possible worlds, which is that we have 
lower cost capital delivered in this very important sector. I 
think it is the ability, in part, to lower the costs of capital 
for housing through the diversification, etc., that comes 
through the secondary markets that wouldn't necessarily be able 
to be delivered to small businesses through secondary markets.
    Senator Fitzgerald. All right. A question for all of the 
panelists. The issue of competition has come up several times, 
first and foremost from Mr. Pollock, who is competing to some 
extent now with Fannie and Freddie. If our country decides that 
GSEs for housing are a good thing, then why just have two of 
them? Why not have four or six of them? Certainly, Mr. Pollock, 
you don't mind being one. I would be interested in your 
thoughts on that. I suppose those who are against GSEs wouldn't 
want any more GSEs. Those of you who are for them, Mr. Miller, 
Mr. Harvey, Dr. Wachter, would you be for more GSEs or just 
limit it to Fannie and Freddie? Mr. Harvey.
    Mr. Harvey. I would just say, we would be for whatever 
competition increases either the efficiency of capital for 
lower-income Americans one way or another, and if you think 
there is a net benefit out of the competition, we would be all 
for it, between the GSEs.
    I just have to point out, we also have a very unfair, or a 
tilted system, however you want to put it, as far as mortgage 
interest deduction goes in this country. It is far more 
favorable to the wealthier Americans than to lower-income 
Americans in this country. So there are a set of policies that 
are in place and you have to look at the totality of them.
    One of the reasons I am for the housing GSEs is that it is 
a means of getting favorable capital and there is a public 
policy objective that is front and center and it makes Fannie 
and Freddie accessible and the Federal Home Loan Bank System 
far more accessible than Wall Street is to those of us who are 
trying to reach down into lower-income communities and to make 
sure that there is equity in the housing in this country.
    Mr. Ely. Mr. Chairman, if I could throw in two points 
there. As you might have inferred from my remarks, I am not a 
fan of Fannie and Freddie and I support the notion of their 
privatization. But if we are going to look at the question of 
whether or not there should be more than two housing finance 
GSEs like Fannie and Freddie, their returns on capital indicate 
that there is clearly a lack of competition. As someone pointed 
out, we are seeing companies that consistently are earning 
returns on equity capital in the mid-20 percent range. That is 
clearly excessive compared to the type of competition and 
returns we see over time in other industries.
    So the fact that their ROEs are so high is an indication 
that what we have is effectively a duopoly in which there is an 
implicit understanding between the two companies to compete but 
not too aggressively or not so aggressively as to reduce their 
return on equity.
    Coming back to the question of the role that Fannie and 
Freddie play in terms of helping to level the playing field in 
favor of lower-income people who pay lower tax rates, if we 
take a look at the current conforming loan limit of $322,700 in 
order to meet that limit, you probably have to be able to buy a 
house worth at least $400,000, if not more. Those are not homes 
being bought by lower-middle-income, or lower-income people.
    Much of the Fannie-Freddie subsidy goes to the middle class 
and the upper-middle class and beyond. A very important public 
policy question should be, to what extent should the middle 
class and upper-middle class be subsidized in this way, given 
the fact that they are already being subsidized tremendously 
because of not only the mortgage interest deduction and the 
deduction of real estate taxes, but also because of the now 
very liberal capital gains treatment with regard to owner-
occupied housing?
    Mr. Pollock. Mr. Chairman, could I take a try at addressing 
the question directly?
    Senator Fitzgerald. Yes, Mr. Pollock?
    Mr. Pollock. I think Bert is right, that if we got to a 
truly competitive GSE sector, we would know it because the 
returns on equity would be at the market competitive cost of 
capital, which in this country now is around 13 or 14 percent, 
as opposed to someplace in the 20s.
    In terms of more GSEs, you could think of the Federal Home 
Loan Banks as one GSE, or you could perhaps more accurately 
think of them as 12, or think of us as 12, which would give you 
    It seems to me that the burden of proof for creating a GSE 
must always fall on those who would wish to create a GSE. We 
have a long history, not always in the form of GSEs, but of 
governmental credit programs. You mentioned, Mr. Chairman, 
student loans. We have Farm Credit. We have the Pension Benefit 
Guaranty Corporation. We had the Federal Savings and Loan 
Insurance Corporation. A very large number of them had rather 
unhappy experiences, or continue to. So to those who would 
create such programs, as I say, I think that the burden of 
proof is on them.
    My point is that if you already have GSEs and you are 
asking what can you do best now and you believe the GSEs will 
continue to exist, it is our view that the best thing you can 
do is to ensure at least that it is a competitive sector so 
that the benefits given to the GSEs, which turn into economic 
advantages, become consumer advantages as opposed to economic 
rents, to use the technical term, in the GSE.
    But that is a ``second-best'' argument.
    Senator Fitzgerald. Well, we have been talking here a lot 
about risk and what is the risk on their balance sheets. If 
they had more competition, would there not be much more risk of 
a financial----
    Mr. Wallison. Actually, Mr. Chairman, if I can respond to 
    Senator Fitzgerald. OK.
    Mr. Wallison If we had to have GSEs doing what Fannie and 
Freddie are doing, it would be better to have more of them than 
fewer of them for the reasons I said in my testimony, and that 
is that the two that we have, if one of them fails, could 
produce a disaster in our economy, whereas a management 
misjudgment at one of six or eight would not have that effect.
    Senator Fitzgerald. The margins of Fannie and Freddie, 
then, would get thinner and thinner----
    Mr. Wallison. Yes, of course, and they should, and that is 
what benefits consumers. In fact, the ROEs that they are 
showing, as Bert suggested, reflect either one of two things. 
Either they are taking the risks that I said they were taking--
they are not adequately hedging--or there is some sort of 
parallelism going on in their pricing.
    Senator Fitzgerald. Well, banks don't ordinarily make that 
kind of return, but they have to have a lot more E, and so 
their R on the E is lower because there is much more E. Because 
Fannie and Freddie have such low levels of required capital----
    Mr. Wallison. That is given to them as a benefit.
    Senator Fitzgerald. Yes.
    Mr. Wallison. Let me just complete a couple of thoughts 
here. So competition would be better than nothing, but why 
would we create more GSEs when we can eliminate the risk, as I 
suggested, simply by not allowing them to buy their own 
mortgage-backed securities which have already been sold to the 
market? We have developed--they have developed, or others have 
developed and they then picked up on--a very good technology in 
offering mortgage-backed securities. Investors will buy these 
instruments and take the interest rate on them. Why are we now 
allowing them to go out into the market, borrow money on the 
Federal Government's credit, and then go out and buy mortgage-
backed securities to take additional risk away from investors?
    Senator Fitzgerald. Mr. Miller, do you want to address 
    Mr. Miller. I am not sure in which order to take these 
things. One reason----
    Senator Fitzgerald. The one I would like you to address is 
Fannie and Freddie holding mortgage-backed securities on their 
balance sheets.
    Mr. Miller. That is the one I was going to start with.
    Senator Fitzgerald. OK. [Laughter.]
    Mr. Miller. They have a comparative advantage in having 
those assets on their balance sheets because they know them 
better than anyone else.
    Senator Fitzgerald. They don't know them better than the 
person or the bank or the S&L that made the loan. . . .
    Mr. Miller. No, but when they consolidate and do the MBS, 
they know what the MBS is.
    Second, I want to get to the competition point, but let me 
return to the--you asked the question, should you establish new 
GSEs for other industries or other areas of economic activity, 
and I would distinguish two things there. One, is that an area 
that is appropriate for promotion? I don't think there is any 
question but that the Congress of the United States and 
administrations from one to another have viewed housing as 
being a priority, and the establishment of the housing GSEs, 
and continuation of the housing GSEs are a reflection of that 
priority. That is something for you to debate.
    The second part, though, is the question of liquidity. If 
you were to establish that in such-and-such an industry there 
was a significant liquidity problem for which there were 
institutional barriers or some such, it might make sense to 
establish something that would increase liquidity there. The 
liquidity problems in the housing industry sources are very 
well known--regional problems, banking, finance that were not 
solved or are not completely solved even today.
    But on the question of competition, I as an economist will 
tell you, yes, maybe rents are being earned, but the rents that 
are flowing are to increased skill at management, innovation, 
other things, not rents that are flowing to the firm because it 
limits competition.
    My impression is, these two GSEs, first, they are very 
competitive with each other. Second, they are run by very smart 
people who are constantly innovating, coming out with new 
things, and that is the reason that the firms are doing well in 
terms of ROE. You find other firms in the economy that do very 
well, and, of course, in some industries, rates of return are 
much, much higher than for the GSEs.
    Now, my own personal view is if you gave an opportunity for 
someone to enter under the same circumstances, that would be 
fine. But I would just caution you that if you established a 
GSE sort of organization, it would take a long time, if ever, 
for them to be competitive with Freddie and Fannie, in part 
because of their scale economy. So if you set something up, you 
might be buying a commitment to engage in a lot of Federal 
promotion and direct subsidy of such an enterprise over time.
    Mr. House. But Mr. Chairman----
    Senator Fitzgerald. We are going to wrap up in a few 
minutes. I will let everybody who wants have a final say here. 
Mr. House.
    Mr. House. To go back, you asked our group how we would 
feel about competition. We would support it if you had proper 
regulation and a level playing field. Something that Mr. Miller 
just said really emphasizes that point. He said nobody 
understands the MBSs better than Fannie and Freddie, and this 
is something that Mr. Wallison talked about on MBS. So when the 
GSEs purchase their own MBS, it is called ``cherry picking'' 
because they do understand their MBS better than anybody else. 
This is exactly why we think they should have to register their 
MBSs under the SEC, so everybody knows, so everybody has the 
same information.
    The next thing is, the GSEs were originally established to 
lead the market in providing for home ownership. And as I said 
earlier in my remarks, 24 studies say they are not leading the 
market. We think it is very important, and I think Mr. Harvey, 
I would hope, would agree that in order to do that--banks have 
to buy CRA loans--and I think the GSEs, which are exempt from 
CPA standards, should be required to invest in community 
reinvestment loans.
    And the second thing is, in applying affordable housing 
standards, it is now done on a national average. We all know 
that you can play all kinds of games with national averages. So 
you say, gosh, I am going to meet my affordable housing 
standards. You can just play with those averages. Take those 
averages and take it down to MSA basis, which is the 
Metropolitan Statistical Area, so it is done by areas. So if 
you really want to increase affordable homeownership, those are 
the kinds of things you can do, instead of taking the GSEs' 
word for it. We think that is very important.
    Senator Fitzgerald. Mr. Ely.
    Mr. Ely. Just a couple of points I wanted to pick up on, 
responding to Jim. First of all, with regard to having more 
competition among the GSEs, you made a point about increased 
risk to these institutions. That is right, there would be 
increased risk and it is increased risk for the taxpayer 
because many of us believe that if a GSE gets into trouble, it 
will be rescued in some fashion by the government. Congress has 
done that twice in the last 16 years, first with the Farm 
Credit System in 1987 and then in 1997 with the FICO bonds, 
which gets back to a key difference between Fannie and Freddie, 
on the one hand, and the banking industry on the other.
    Fannie and Freddie are a ``heads we win, tails you lose'' 
proposition because to the extent they are able to capitalize 
on their implicit Federal guarantee, then their shareholders 
are winners. If, on the other hand, one of them fails, then it 
is the taxpayers who are the loser. Deposit insurance, post-
FDICIA, and post-FIRREA, doesn't work that way anymore. It is 
an industry-financed program, if you will, that is run by the 
government. So as we think about GSE risks, we have to realize 
that the GSEs are getting a free ride off of the taxpayer, 
which is showing up in their high ROE.
    Just one other thing about the liquidity problem. The 
banking industry and the thrift industry have changed 
enormously from the time Fannie and Freddie were set up. Back 
then, and you will remember this very well, we had branching 
restrictions and relatively small banking companies. Today, we 
have large players out there as mortgage originators and as 
aggregators who are operating on literally a nationwide basis--
Washington Mutual, Wells Fargo, J.P. Morgan Chase, Citi, and so 
    And so the private sector, through the consolidation 
process and the lifting of branching restrictions, has been 
able to develop an ability to provide liquidity to the mortgage 
market. That vitiates one of the original reasons for creating 
both Fannie and Freddie.
    Senator Fitzgerald. Mr. Wallison, we are getting to the end 
of the hearing. I do want to ask you if you favor privatization 
of the Federal Home Loan Banks, too.
    Mr. Wallison. By all means. [Laughter.]
    They survive, in my mind, only as competition to Fannie and 
Freddie. [Laughter.]
    Alex and I have talked about this at length.
    Senator Fitzgerald. OK, and you are still friends. 
    Mr. Wallison. If we could not do anything about Fannie and 
Freddie, then it makes a lot of sense to have some competitive 
    Let me mention a couple of things on competition. First of 
all, in my prepared statement, I noted that Fannie and Freddie 
compete against Treasury securities and they thus raise the 
cost of Treasury securities. The Treasury pays more interest 
because foreign central banks and others accessing the foreign 
capital markets are looking at Fannie and Freddie as U.S. 
Government securities, to some extent. So they are buying 
Fannie Mae and Freddie securities instead of buying Treasuries. 
The Treasury has to pay somewhat higher interest. No one has 
done a study--it is probably impossible to do a study of how 
much it is--but it is not insignificant. That is one of the 
costs that they cause the U.S. taxpayer.
    It is certainly true that people have their wealth in 
housing in this country, but that is because of our national 
policy that causes a lot of investment to go into housing, 
Fannie and Freddie and the Home Loan Banks being part of that. 
If we didn't have that direction of funds into housing, people 
would have better jobs. People would have more income from the 
businesses that would have been established here and people 
would have more stock market investments than they have 
investments in their homes.
    So that is the way--our economy is structured that way 
because of government policy. It is not because of any 
particular reason that we should organize our economy that way. 
We ought to realize what the trade-offs are when we push money 
into housing.
    I heard an argument, I thought, that rents, economic rents, 
cause or help innovation. I was always under the impression 
that the more competition there is, the more innovation there 
will be, and that is certainly the lesson of our free market. 
So I can't imagine that we would want to encourage people to 
make profits, rent-type profits, in order to encourage 
innovation when, in fact, what it does encourage is waste and 
inefficiency in the economy.
    And finally, the important thing that we should focus on 
here, what Congress should focus on, it seems to me, is 
eliminating the risk to the taxpayer and the risks to the 
economy. I happen to think that privatization does that more 
effectively than anything else. There is no good reason to have 
these organizations anymore. But if that is too big a bite for 
Congress to take, I do recommend that we look at simply the 
question of forbidding them to buy their mortgage-backed 
securities and accumulate portfolios of mortgages.
    Since Fannie and Freddie were established, the technology 
involved in selling mortgage-backed securities, the 
distribution system, has been developed. It now works 
wonderfully without any government support in the jumbo market. 
It could work for the conforming and conventional market, too, 
if we simply eliminated the government support there, and we 
would then by that Act eliminate the risk. Thank you.
    Senator Fitzgerald. Any final----
    Mr. Miller. Could I just make a correction?
    Senator Fitzgerald. Yes.
    Mr. Miller. My reference to rents was the rent that is the 
return for innovative activity. It is not the way that was 
characterized by Mr. Wallison.
    Senator Fitzgerald. Mr. Pollock.
    Mr. Pollock. Mr. Chairman, I think you have conducted a 
great and a very lively discussion, but I did note there was 
one question you very pointedly asked and it didn't get 
answered, so I would like to try to answer it.
    You discussed the presentation by Fannie Mae about being 
hedged and the different ways you could hedge a mortgage book 
with debt and hedges and you asked, is that reasonable? In my 
opinion, that is very reasonable as long as we don't talk about 
perfect hedging. I have been in the banking business one way 
and another about 34 years now and I have never met anybody who 
was perfectly hedged or even claimed to be perfectly hedged and 
I would greatly distrust anybody who did.
    But if the question is, can you prudently hedge a book of 
mortgages with debt and with hedges, the answer is, you 
absolutely can if you are a GSE under current American 
    I think as a general----
    Senator Fitzgerald. Do you think private companies could 
absorb all those long-term fixed rates in America and hedge 
    Mr. Pollock. Not if they have to compete with GSEs, Mr. 
    Senator Fitzgerald. If they didn't have to, you think they 
    Mr. Pollock. I think the market will always work that out.
    Senator Fitzgerald. OK.
    Mr. Pollock. Embedded in every hedge is somebody's cost of 
operations and cost of capital for providing the risk bearing 
or the risk distribution that the hedge represents. The market 
would work that out.
    I do think it is very clear that every GSE, Home Loan Banks 
and Fannie Mae in particular, was set up with an important 
truth in mind: That is, if you are going to have long-term 
fixed-rate mortgages, you have to link them to the bond market 
in some way. You can't finance them with deposits, which are 
short-term by nature. Whatever system we would end up with, if 
we want to have fixed-rate mortgages, which I think the 
American people should want and do want, then we have to design 
a system that has a highly efficient bond market link. GSEs are 
one way to do that. Obviously, you could imagine others. And 
thank you very much, Mr. Chairman.
    Senator Fitzgerald. Thank you.
    I know you had some comments down here. These will be the 
last two, Mr. Harvey, then Dr. Wachter.
    Mr. Harvey. Great. Thank you, Mr. Chairman. I think one of 
the points that we have missed here is the huge productivity 
gains that have come over the last decade from Fannie and 
Freddie and from the Home Loan Bank System. But if I was to 
take, and this is a negative comparison, where the FHA is and 
Ginnie Mae has been over that period of time versus what has 
happened in Fannie and Freddie, there has been a huge benefit 
that has come out of the GSE system. They have been able to 
access technology, they have been able to have huge through-
puts with the same amount of people. They have been able to 
have dedicated people and resources on their public mission 
goals, and every time the goals have gone up, they have been 
able to meet them or exceed them along the way.
    So as an advocate for low-income people and housing, what 
is there to fix here, because it has been hugely productive. It 
has been a tremendously productive system.
    As far as not leading the market, yes, I would love to 
stretch the GSEs to do more around CRA and other loans. What I 
fear is if you get a capital structure where they can't do that 
or that discourages them from taking the very prudent risk that 
they ought to take, then you are defeating some of the purpose 
as to why you have a GSE in the first place.
    As far as not leading the market, I think you have to 
look--and in minority home ownership, you have got to look at 
the sub-prime market, which is a large part of the lending 
right now that goes to minorities in this country. It has grown 
exponentially over this period of time. Now, there is a sub-
prime market that makes sense and there is a predatory market. 
They are different, but they are sometimes linked together, and 
this will probably horrify everybody on the stage, but I think 
the GSEs getting into that sub-prime market will make it more 
accountable, cleaner, better, with more efficient capital as 
long as you have accountability and oversight on it, and I 
    Senator Fitzgerald. But doesn't that put more risk on the 
GSE's balance sheets?
    Mr. Harvey. As long as they do the business the way the 
business ought to be done, and not in a predatory way, but in a 
way to get capital to those people that don't have perfect 
credit, and that can be done--I applaud every time Citibank 
takes over Associates and Associates has to clean up the way 
that they have been doing their business, and it was a huge 
fight, as you know, or Chase takes over, because they have a 
reputation they have to defend and it allows advocates and 
others to say, look, this hasn't been done the right way. There 
are parts of this business that make no sense at all for low-
income home owners.
    So I think the GSEs have worked remarkably. Of course, we 
believe in public-private partnerships to get to parts of the 
market that you can't get to otherwise.
    Senator Fitzgerald. Thank you. Dr. Wachter.
    Ms. Wachter. Thank you. I believe that it is very much the 
ability to earn profits in the short run before technology is 
widely implemented that encourages innovation, and that is, 
indeed, part of the reason we have had so much innovation in 
this sector.
    The investors will lose, obviously, if these institutions 
take on too much risk. This, too, is a safeguard. So it is, in 
fact, the genius of the private institution with public 
purposes that I think has accomplished so much and there is 
more to accomplish yet.
    Senator Fitzgerald. All of you, thank you very much. This 
has really been a great panel. These are some of the best minds 
in the country on this issue. It was a delight to have all of 
you here.
    Without objection, the hearing record will remain open for 
any additional statements or questions from Senator through 5 
p.m. tomorrow.
    With no further business to come before the Committee, this 
hearing is adjourned. Thank you.
    [Whereupon, at 4:20 p.m., the Subcommittee was adjourned.]

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