[Senate Hearing 111-435]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 111-435
 
     THE FUTURE OF THE MORTGAGE MARKET AND THE HOUSING ENTERPRISES 

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

EXAMINING WHETHER RESPONSIBLE HOMEOWNERS WILL HAVE ACCESS TO THE LOANS 
     THEY WILL NEED TO REALIZE THE AMERICAN DREAM OF HOME OWNERSHIP

                               __________

                            OCTOBER 8, 2009

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia             JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

              William D. Duhnke, Republican Staff Director

                     Marc Jarsulic, Chief Economist

               Jonathan Miller, Professional Staff Member

                Misha Mintz-Roth, Legislative Assistant

                      Matthew Green, FDIC Detailee

                Mark Oesterle, Republican Chief Counsel

            Chad Davis, Republican Professional Staff Member

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)



















                            C O N T E N T S

                              ----------                              

                       THURSDAY, OCTOBER 8, 2009

                                                                   Page

Opening statement of Chairman Dodd...............................     1
        Prepared statement.......................................    49

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     3
        Prepared statement.......................................    49
    Senator Gregg................................................     4

                               WITNESSES

Edward J. DeMarco, Acting Director, Federal Housing Finance 
  Agency.........................................................     5
    Prepared statement...........................................    50
    Responses to written questions of:
        Chairman Dodd............................................   100
        Senator Menendez.........................................   102
        Senator Kohl.............................................   105
        Senator Corker...........................................   107
William B. Shear, Director, Financial Markets and Community 
  Investment, Government Accountability Office...................    34
    Prepared statement...........................................    57
    Responses to written questions of:
        Chairman Dodd............................................   109
Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy 
  Studies,
  American Enterprise Institute..................................    35
    Prepared statement...........................................    76
Susan M. Wachter, Richard B. Worley Professor of Financial 
  Management, Wharton School of Business, University of 
  Pennsylvania...................................................    37
    Prepared statement...........................................    81
    Responses to written questions of:
        Chairman Dodd............................................   113
Andrew Jakabovics, Associate Director for Housing and Economics, 
  Center for American Progress Action Fund.......................    39
    Prepared statement...........................................    84
    Responses to written questions of:
        Chairman Dodd............................................   114

                                 (iii)


     THE FUTURE OF THE MORTGAGE MARKET AND THE HOUSING ENTERPRISES

                              ----------                              


                       THURSDAY, OCTOBER 8, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 9:36 a.m. in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order. Let me 
welcome our guest witnesses this morning, as well as my 
colleagues. The title of this morning's hearing is ``The Future 
of the Mortgage Market and the Housing Enterprises,'' and this 
is a subject matter on which there has been a tremendous amount 
of Committee interest and others over time. And we have had--
Richard, I counted up last night. I think we have had just this 
year alone 70 hearings.
    Senator Shelby. I believe it.
    Chairman Dodd. I looked at the number, just on the various 
subject matters. Most of it has been focused on reg reform 
issues, and almost everything----
    Senator Shelby. I do not know of any other committee----
    Chairman Dodd. That had this many.
    Senator Shelby. Because we both serve on other committees. 
We would not have any sleep, would we?
    Chairman Dodd. It has been a lot. I know yesterday Jack 
Reed had a hearing as well. Judd, I think you participated in 
that hearing that Jack had.
    So we have covered a lot of ground, and there are so many 
things, we could be just having--we could literally have a 
hearing a day on the subject matters that the Committee has 
jurisdiction over. And this is a subject matter Bob Corker, 
others, obviously Richard--we all have a great interest in this 
issue of the Government-sponsored enterprises and where we are, 
where we are going, what is the future of all of this. And so 
it is an important subject matter, and, therefore, I am glad we 
have some time this morning to spend on this.
    Let me share a few opening comments. I will turn to the 
former Chairman, Senator Shelby, for his opening thoughts and 
comments on it, and then we will get right to our witnesses, 
unless any of the Members feel compelled that they want to 
share a thought or two on all of this.
    Well, today we meet to discuss the Government-sponsored 
enterprises--Fannie Mae and Freddie Mac--and the role they will 
play as we seek to restore normalcy to the mortgage market. But 
let us not forget what we are really talking about here. We are 
talking about whether responsible homeowners will have the 
access to home loans they need to realize the American dream of 
home ownership.
    Last year, when the mortgage market collapsed, the Director 
of the Federal Housing Finance Authority put Fannie Mae and 
Freddie Mac into conservatorship. At the same time, Secretary 
Paulson exercised the authority he was given by last year's 
bipartisan Housing and Economic Recovery Act to provide back-up 
funding for the two companies, ensuring that they would 
continue financing mortgages during the housing crisis.
    Today we are going to consider where we need to go from 
here. Now is the time to look forward as well as looking back, 
but with so much damage done by this financial crisis, the role 
of the GSEs in that crisis is still hotly debated, as we all 
know.
    Let me just say Fannie and Freddie were neither the 
villains that caused the crisis, in my view, as some claim, nor 
the victims of that crisis, as others would make them out to 
be. They did not create the subprime and exotic loan market, 
but they did chase it into the general--to generate profits, 
rather. And like many of the supposedly private financial 
institutions that ended up becoming equivalent to GSEs, Fannie 
and Freddie enriched their shareholders and management while 
the public took the losses.
    We cannot let that happen again, in my view, and as we look 
forward, we must start by setting benchmarks to determine 
whether the mortgage market is healthy so that American 
families can once again begin to build wealth--not the kind of 
wealth that buys mansions and yachts, but the kind of wealth 
that sends a child to college or ensured an affordable 
retirement.
    First, the mortgage market must remain liquid and stable, 
especially in times of stress. Otherwise, rates are driven up, 
prices are driven down, and the American family loses.
    Second, we must encourage product standardization such as 
widespread availability of that unique American opportunity, 
the 30-year fixed-rate mortgage, without prepayment penalties. 
This helps both borrowers and lenders.
    Third, mortgage credit must remain consistently available 
and affordable. Home ownership remains part of the American 
dream, as we all know. That dream should be accessible to as 
many people as possible and sustainable for as many people as 
possible as well.
    Today the market is meeting these tests, but only through 
massive Government intervention. The Federal Reserve, for 
example, has committed to pumping more than $1 trillion into 
the mortgage market. That cannot go on, as we all know. 
Therefore, it is time to begin the conversation about how we 
can re-create a functional market that stands on its own two 
feet and to decide what role, if any, the GSEs or their 
successors should play.
    I want to start that conversation by posing a number of 
questions. Can the market function with no Government 
involvement? Should, on the other hand, the Government 
completely and explicitly take over the job previously done by 
Fannie and Freddie? Do we want a model where there is some 
private capital at risk but only under strict Government 
control, such as a utility? Hank Paulson and others have raised 
this possibility or idea.
    There are other important questions. The answers, in my 
view, are critical to ensuring that American dream that we all 
embrace, and I look forward to considering these questions with 
our distinguished panel today that we are fortunate to have 
with us.
    Before turning to Senator Shelby, I want to quickly add 
that I am hopeful that the higher GSE and FHA loan limits, 
which were first established in HERA, will be extended again in 
the HUD appropriations bill currently being negotiated. These 
higher loan limits are helping many borrowers in States like 
mine and others, frankly, where it is critical, to purchase 
homes or refinance their mortgages. And I think we need to keep 
this support in place. It is a controversial item, but I wanted 
to mention that as a side item here this morning as well.
    With that, let me turn to my good friend and colleague from 
Alabama, Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    As we consider the future of the GSEs, I believe we would 
be wise to remember the disastrous consequences that poorly 
regulated GSEs can have on our financial markets. Just 1 year 
ago, Fannie Mae and Freddie Mac were placed into 
conservatorship when they could not cover billions of dollars 
in losses.
    Despite repeated warnings by me and other Members of this 
Committee about the risk that GSEs presented, they were allowed 
to accumulate more than $5 trillion--$5 trillion--in financial 
obligations with only minimal amounts of capital. The 
Congressional Budget Office now estimates--and this is probably 
conservative--that resolving the GSEs will cost American 
taxpayers $389 billion, perhaps more. We must ensure that this 
never happens again, but the question is: Will we?
    This hearing, therefore, comes at an opportune time as this 
Committee is considering financial regulatory reform. There is 
no doubt that the failure of Fannie and Freddie was a 
significant actor in the financial crisis because their 
activities touched nearly every aspect of our financial system. 
In addition, their debt is among the most widely held in the 
world. They are also major counterparties to our most prominent 
financial institutions. Accordingly, regulatory reform, I 
believe, must involve the GSEs.
    But the Administration made no effort to include the GSEs 
in its financial regulatory reform proposal. Instead, the 
Administration has said that it will not propose how to deal 
with the GSEs until next year. Why? I believe that this is a 
grave mistake that will make it more difficult to reform our 
financial system that will potentially expose taxpayers again 
to even greater losses.
    I believe what we need is a clear path that addresses both 
the GSEs' ongoing financial difficulties and the role that the 
GSEs should play in our economy in the future. I fear that the 
longer we wait, the more it is going to cost the American 
taxpayer. Certainly the question of what to do with GSEs is 
very difficult and complex. Yet it is a question that we ignore 
at our peril.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Do either of my two colleagues here have any comments at 
all?

                STATEMENT OF SENATOR JUDD GREGG

    Senator Gregg. Well, Mr. Chairman, I know you want to get 
to the witnesses, but I do not think the moment should pass 
when we are taking up this issue to not acknowledge the fact of 
the extraordinary work that you two did last summer--the summer 
before last, to basically address this issue. The chaos which 
would have occurred would have even been more severe if you two 
had not joined and pulled together a very aggressive resolution 
of the Fannie Mae/Freddie Mac issue and led the Congress in 
this area. So I just wanted to acknowledge that.
    Chairman Dodd. I thank you, Senator, very much for those 
comments. Let me just say--I know people hear me say these 
things, but it is a tremendous pleasure working with Richard 
Shelby, and this Committee has been tremendous. We have got a 
lot of work in front of us, but I am more than confident we are 
going to do well at it as we move forward.
    I want to introduce our panel, not only Mr. DeMarco but let 
me introduce the second panel as well so we can just move 
through and so we have a sense of everyone.
    Edward DeMarco, Acting Director of the Federal Housing 
Finance Agency, has served with the FHFA, the successor of the 
Office of Federal Housing Enterprise Oversight, since 2006 when 
he came on as Chief Operating Officer and Deputy Director. 
Previously he served in various capacities with the Social 
Security Administration and the Department of the Treasury. Mr. 
DeMarco, we thank you very much for joining us.
    Let me briefly introduce the second panel quickly as well.
    Mr. William Shear is the Director of Financial Markets and 
Community Investment at the U.S. Government Accountability 
Office. In this capacity, Mr. Shear has conducted important 
research on the Government-sponsored enterprises, including a 
recent report published in 2009, and we all look forward to 
hearing about that in your testimony.
    Peter Wallison is the Arthur F. Burns Fellow in Financial 
Policy Studies at the American Enterprise Institute. He serves 
as cochair of the Pew Financial Reform Task Force and has held 
a number of Government positions, including General Counsel at 
the United States Treasury. He is the author of numerous books 
and articles about the housing enterprises, and we welcome you 
as well to our Committee.
    Dr. Susan Wachter is a professor of real estate and finance 
at the Wharton School. Dr. Wachter is the former Assistant 
Secretary at the Department of Housing and Urban Development 
for Policy Development and Research and has served on numerous 
review and research boards in the public and private sectors.
    And, last, Mr. Andrew Jakabovics--did I pronounce that 
correctly?
    Mr. Jakabovics. Close enough.
    Chairman Dodd. Close enough? Thank you very much. Andrew, 
welcome. Mr. Jakabovics is the Associate Director for Housing 
and Economics at the Center for American Progress Action Fund, 
and prior to this, he served as the research chief of staff for 
the MIT Center for the Real Estate Housing Supportability 
Initiative.
    So we have a very distinguished group of witnesses to hear 
from this morning as well, and I am very honored that all of 
you agreed to appear before us this morning to talk about this 
important subject matter.
    With that, Mr. DeMarco, we welcome you and I am going to 
just ask all of you--I am going to take all of your full 
statements, by the way. I presume they are probably fuller 
statements than what you are prepared to give publicly in the 
statement, and any supporting documents and information you 
think would contribute to our knowledge of this issue is 
welcomed as well. And so if you would try and keep your remarks 
in that 5- to 7-minute range, I would appreciate it so we can 
get to questions.
    Welcome.

   STATEMENT OF EDWARD J. DeMARCO, ACTING DIRECTOR, FEDERAL 
                     HOUSING FINANCE AGENCY

    Mr. DeMarco. Good morning, Chairman Dodd, Ranking Member 
Shelby, Committee Members. Thank you for the opportunity to be 
here today. My written statement details FHFA's key activities 
and accomplishments, the challenges facing the housing GSEs, 
and their response to those challenges. I will summarize now 
the GSEs' financial condition and key challenges, and I will 
close with some thoughts about the future of our housing 
finance system.
    I will begin with the current financial condition of Fannie 
Mae and Freddie Mac, or as I will refer to them, ``the 
enterprises.'' In the first 2 years of this housing crisis, 
combined losses at the enterprises totaled $165 billion. Their 
financial performance continues to be dominated by credit-
related expenses and losses stemming principally from purchases 
and guarantees of mortgages originated in 2006 and 2007.
    Since the establishment of the conservatorships, the 
combined losses at the enterprises depleted all their capital 
and required them to draw $96 billion from the Treasury under 
the Senior Preferred Stock Purchase Agreements. With continuing 
uncertainty regarding economic conditions, employment, house 
prices, and mortgage delinquency rates, the short-term outlook 
for the enterprises remains troubled and likely will require 
additional draws.
    The Treasury and the Federal Reserve have made sizable 
purchases of housing GSE securities to instill confidence in 
their securities, provide stability to mortgage markets, and 
lower mortgage rates. This combined support exceeds $1 trillion 
and has allowed the enterprises to continue providing liquidity 
to the mortgage markets.
    The enterprises face four key challenges. First is 
staffing. Both enterprises have filled vacancies at the 
executive management level. However, several key vacancies 
remain below that level. Moreover, uncertainties about the 
future of the enterprises make staff retention a key concern. 
As we see improvements in the economy, opportunities for 
employees and officers to seek other employment will increase, 
adding to the current retention challenge.
    Second is credit risk. The credit risk in their mortgage 
books remains a supervisory concern. While a few positive signs 
of housing recovery have emerged, we recognize the risk 
associated with the increasing number of seriously delinquent 
loans and the uncertain path of the market's recovery. In 
addition, the multifamily market is experiencing declining 
property values and record vacancy rates.
    Market risk. The enterprises' investments in mortgage 
assets expose them to market risk that is challenging to manage 
in today's environment.
    And, finally, operational risk. The systems and models upon 
which the companies have relied in the past have been greatly 
stressed in this market, and the new management teams are 
working on appropriate remediation. The implementation of the 
new consolidation accounting standard, which will require the 
enterprises to bring off-balance-sheet mortgage-backed 
securities onto their balance sheets in January, is a 
substantial operational challenge.
    Turning to the home loan banks, Federal home loan banks 
have not been immune from mortgage-related losses. Most notable 
is the deterioration in the value of private label mortgage-
backed securities held by many Federal home loan banks.
    In the first 6 months of this year, the home loan banks 
collectively saw impairment charges of $8 billion in the 
private label MBS portfolio. However, a change in accounting 
rules resulted in only $1 billion of that being charged against 
income.
    Net income for the first half of 2009 was $1.4 billion, 
compared to $1.2 billion for all of last year. This improvement 
reflects in part these new accounting rules.
    The home loan banks have two key challenges of note: First 
is working through the issues associated with their private 
label MBS, and the other is the failure or consolidation of 
system members has shifted business volumes among the banks and 
increased concentration of ownership by, and advances to, a few 
large institutions.
    Mr. Chairman, you asked me to address the future of the 
housing finance system. The mortgage market in this country is 
a $12 trillion market, yet this massive size is attained 
through millions of individual transactions that have an 
average size of about $200,000. In its broadest terms, then, 
the housing finance system connects $12 trillion on the one 
hand to these $200,000 transactions on the other. It connects 
capital markets to local mortgage lending transactions.
    Going forward, we might begin with the following simple 
goal: to promote the efficient provision of credit to finance 
mortgages. An efficient system would have characteristics such 
as allowing for innovation, providing consumer choice, 
providing consumer protection, and facilitating transparency in 
the marketplace. While these characteristics provide a broad 
framework, policymakers must determine the Government's role in 
the following areas: ensuring adequate liquidity, absorbing 
credit risk, and affordable housing.
    Now, ensuring liquidity in this context addresses periodic 
disruptions in credit markets that cause investors to 
temporarily exit from holding or purchasing mortgages. During 
such episodes, do we need to ensure there is a balance sheet of 
last resort?
    Second, markets have relied upon an implicit Government 
guarantee of enterprise securities. Going forward, though, what 
level of Government credit support is needed to have an 
efficient mortgage market? One approach is having the 
Government take a limited catastrophic credit insurance 
position backing certain mortgage assets. Another approach 
could be a combination of enhanced private sector market 
discipline and regulatory oversight.
    Third, the Government has long promoted credit availability 
for low- and moderate-income homeowners and renters. The 
subsidies granted the enterprises were exchanged for 
requirements, including housing goals, to ensure the 
enterprises did not ignore these segments of the market. Going 
forward, though, policymakers may consider alternative 
approaches to targeting such subsidies.
    Finally, we should remember the benefits of our current 
system. Notable are the standardization of conventional 
mortgages and a highly liquid forward market for mortgage-
backed securities that allows mortgage applicants to lock in 
interest rates. We should strive to maintain those benefits as 
we plan for the future.
    I think we are in the early stages of an important national 
discussion, one that the Administration has committed to 
addressing in the coming months. I also believe that private 
capital, properly regulated, has a critical role to play in the 
housing finance system. But we need clear rules of the road for 
private risk capital to fully return to this market. As for the 
enterprises and the home loan banks, they each may well have 
important roles to play in this future system. But the place to 
begin the discussion is outside the existing framework of 
institutional arrangements.
    Thank you for the opportunity to be here today, and I would 
be pleased to answer questions.
    Chairman Dodd. Thank you very much, Mr. DeMarco, and let me 
begin.
    First, let me begin with something we do not do often 
enough and, that is, to thank you and your staff and other 
personnel at the Federal Housing Finance Agency. These are the 
most difficult economic circumstances that any of us have had 
to grapple with in our tenure here in the U.S. Congress. There 
have been other periods of downturn, but nothing like what we 
have been through. You have got to go back to the period of our 
parents or grandparents to encounter a time that has been as 
difficult. So I want to begin by thanking you and the staff. 
You have had the equivalent of sort of an economic gun at your 
head and have performed very, very well, in my view, and we 
thank you.
    Mr. DeMarco. Thank you very much, Mr. Chairman. On behalf 
of the very hard-working staff at FHFA, I really appreciate 
that.
    Chairman Dodd. They do not get recognized and these 
alphabet letters, most people do not understand there are 
people behind those letters that show up every day and do a 
tremendous job on their behalf.
    Let me begin by--there is one of our witnesses in the 
second panel is going to testify, and let me quote part of that 
testimony to you. The witness says that, ``Perhaps the biggest 
question policymakers face is whether U.S. housing finance can 
attract sufficient capital to meet its needs without a 
significant Government role, particularly in the wake of 
massive failures in the private securitization market.''
    What is your answer to this question? Will the United 
States be able to attract the capital necessary to meet our 
housing needs without a role of the Federal Government?
    Mr. DeMarco. Mr. Chairman, as I said at the close of my 
statement, I actually think that private risk capital can and 
should return in a more fulsome fashion to the U.S. housing 
finance system.
    In terms of the role of the Government as a credit 
backstop, there are multiple dimensions to that. Clearly, the 
Government is playing a direct guarantee role through the FHA, 
through the VA, through rural housing. So there already are 
various mechanisms in which the Government is providing direct 
credit guarantee to certain targeted mortgage activity. The 
question becomes really, with the conventional mortgage market, 
what sort of role the Government ought to play going forward 
there. There are various options, but I think this actually is 
a bit of the rub in terms of what should be done.
    I would say that the system that we have had has attracted 
a great deal of global capital investment, but it appears to 
have done so with this much discussed perception of an implied 
Government guarantee. And so I would hope, however policymakers 
end up deciding on this question of the Government's role in 
providing or not providing credit support to a broad swatch of 
the mortgage market, that we not leave this hanging uncertainty 
because this has the tendency to privatize the gains and put 
the losses on taxpayers.
    So I would hope for something that is either clear about 
what the limit of Government support is, if there is going to 
be some, or clarity in the fact that we are looking to private 
financial institutions to be well capitalized and for private 
market discipline to be the controlling influence on mortgage 
credit risk.
    Chairman Dodd. I do not begin with the presumption that we 
ought to. In fact, I begin with the presumption that I would 
like to figure out how we could do it without doing that. It 
seems to me that ought to be the charge. Tell me how we can 
achieve this without that role. The question I have is, in a 
sense: Is that a realistic conclusion? I mean, looking down the 
road, can it be done that way? Otherwise, we are trying to--
whether or not we deal with this in the reg reform proposal or 
whether or not we deal with it after the fact, we are going to 
have to deal with issue, and sooner rather than later. And the 
question is: What do we do? We would all kind of like to know 
the answer to the question as we proceed.
    As policy setters, I begin, as I say, with the presumption 
I would like to figure out a way we could do it without that.
    Mr. DeMarco. Right.
    Chairman Dodd. But if I am being unrealistic about that and 
am going to destroy a great wealth creator, job creator, all of 
the other things that we associate with home ownership, I would 
like to get some sense of whether or not that is realistic.
    Mr. DeMarco. Certainly. Mr. Chairman, I believe that we, in 
fact, can develop structures and a framework by which this can 
be managed in the private sector. So if the question is can it 
be done, my response is, yes, sir, I believe it can be done. I 
think that it requires structures in which there is competition 
in the marketplace, that there is freedom of entry and exit for 
market participants who would be engaging in secondary mortgage 
market activity. There ought to be suitable regulatory 
oversight of those functions, as there is for most aspects of 
our financial system. But I think that with clarity in the 
rules of the road, that will happen.
    In any event, this is one aspect of a larger issue, Mr. 
Chairman, about returning to a more traditional set of 
underwriting so, in fact, we are being more honest with 
ourselves about the risk of mortgages and the differential in 
risk from one mortgage to another.
    And so I think that, in fact, if we have appropriate 
transparency in the marketplace so that investors know, if we 
distribute risk appropriately so that there is good credit risk 
management, global capital market investors will want to 
purchase mortgages. They are not going to know about the 
individual credit characteristics of any individual mortgage of 
$200,000 if they are investing in securities in the millions. 
Private mortgage insurance is one aspect today of where there 
is other private capital at risk assessing that very issue of 
what is the credit risk of this mortgage.
    And so I think that our financial system can build upon 
what we have today so that that credit risk can be, in fact, 
managed and capitalized in the private sector. That is a 
workable model.
    Chairman Dodd. Let me ask you, the Case-Shiller Index has 
shown that housing prices in most large American cities have 
stabilized or turned around. At least that is according to the 
Case-Shiller Index. Your own house price index shows some gains 
at FHFA for the first time in many months.
    On the other hand, we have millions of mortgages that are 
in delinquency and heading to foreclosure. I saw a number the 
other day, and I do not--I always see numbers on a TV screen, 
but it talked about even an 18-percent increase this year over 
last year in the number of foreclosures in the country. Now, 
probably more of that is associated at this juncture with the 
unemployment rates maybe than subprimes, since we seem to have 
run through that a little bit. But, nonetheless, those numbers 
seem pretty high.
    I would like to ask what your expectations are regarding 
housing prices and what impact that will have on the 
performance of the enterprises, in your view.
    Mr. DeMarco. Mr. Chairman, I do not have a forecast for 
national house prices. I will affirm what you said, that FHFA's 
own house price index, which is based upon repeat mortgage 
transactions of mortgages that flow through Fannie Mae and 
Freddie Mac, has been pretty stable this year. In fact, it is 
up very slightly for the year. So that is one indicator that on 
a nationwide basis there may be some bottoming out of house 
prices.
    The Case-Shiller number is more recent--it is the first 
time in 3 years Case-Shiller has shown an uptick in house 
prices.
    These are, in fact, positive signs that perhaps were in 
some sense bumping along the bottom. But if you had not, I 
would have very much added I am concerned about the continued 
increase in serious delinquency rates in mortgages around the 
country, including in, you know, what have been considered to 
be prime mortgages that Fannie Mae and Freddie Mac have 
purchased and guarantee.
    It is troubling to me to see that the serious delinquency 
rates are continuing to rise, and the employment situation is 
one factor that is certainly affecting that. But I think that 
that is a very clear reason why it is too early to declare 
victory.
    Chairman Dodd. Let me just ask a couple of quick ones here 
as well. You have pointed out that the enterprises are playing 
a central role in carrying out the Administration's foreclosure 
prevention plan in your testimony. Why did you turn to the 
enterprises to perform this function, number one? And to date, 
the loan modification effort has focused largely on payment 
modifications. We have been through a lot here, Senator Shelby 
and Members of the Committee, in trying to fashion a way that 
would help out. And I think all of us wished it would have 
worked better than it has.
    I for one believe that principal reduction probably would 
have done more than interest rate reduction. That was a view 
taken by some, but we have not embraced that view nationally.
    Is there any more that Fannie and Freddie can do to 
encourage principal forgiveness? Is this the kind of thing you 
are prepared to explore, or has it been rejected?
    Mr. DeMarco. To start with the first part of that question, 
Mr. Chairman, before the Obama administration took office, late 
last year FHFA, in conjunction with Treasury and with HOPE Now, 
a group of some of the largest mortgage lenders and servicers 
in the country, developed a streamlined modification plan.
    What we, collectively, the GSEs and many of these mortgage 
servicers with their own mortgage books, as well as mortgages 
that were in private label securities, faced was this 
incredible increase in delinquent mortgages and the challenge 
of how to mitigate the losses from those mortgages.
    And so what we first tried to do last fall with the 
streamlined modification program was to come up with a national 
program that servicers could implement regardless of whose 
mortgage it was, so there would be a consistent framework for 
engaging in a massive-scale loan modification program. That was 
set, what could be done voluntarily at that time, at a payment 
rate of about 38 percent of a homeowner's monthly income.
    When the Obama administration came into office, they looked 
at the very early results from the streamlined program with us, 
with the GSEs, and with industry, and we all collectively 
concluded that more needed to be done here. And so the Obama 
administration did lead an effort to develop the Making Home 
Affordable program.
    The reason for the enterprises' involvement in this is 
twofold: One, the enterprises currently own or guarantee in 
rough order about half the mortgages in this country. So 
anything that brings liquidity and stability to the general 
mortgage market goes directly to the financial benefit of 
Fannie Mae and Freddie Mac in terms of stabilizing their credit 
exposure.
    The second thing is Fannie and Freddie, with all these 
mortgages, their mortgages are actually serviced by several 
thousand servicers around the country. Most of the servicing is 
being done in these same large servicing shops that do private 
label securities.
    So to engage in a large-scale national loan modification 
effort, it really made a lot of sense for there to be one 
program that servicers had to learn the rules and had to 
implement, regardless of whether it was a Fannie Mae loan, a 
Freddie Mac loan, or a loan on some other balance sheet.
    And so the reason that the enterprises do this is they have 
the direct commercial relationships with these servicers, and 
it allowed for this consistency, which was good for the 
servicers, good for the borrowers--they get treated equitably 
that way--and certainly facilitated loss mitigation for Fannie 
and Freddie.
    Chairman Dodd. Thank you very much.
    Senator Shelby.
    Senator Shelby. Thank you, Mr. Chairman.
    Mr. DeMarco, on June 18th, the day after the Administration 
released its regulatory reform plan, Secretary Geithner said to 
this Committee, and I quote, ``We wanted to make sure we were 
focusing on those problems that were central causes of this 
crisis.'' Those are his words.
    While I agree that we should address the problems that were 
the central causes of this crisis, I am at a loss as to why the 
Administration does not or did not consider the GSEs to be a 
central cause meriting immediate consideration in regulatory 
reform. Maybe it is something we have got to do; the 
Administration did not understand or maybe looked the other 
way.
    Do you know why the Administration determined that Fannie 
and Freddie were not central causes of the crisis when 
everybody else knows better?
    Mr. DeMarco. Senator Shelby, I am sorry, I cannot speak for 
the Administration's view on this or why they did or did not--
--
    Senator Shelby. But you are part of the Administration.
    Mr. DeMarco. Well, I am running an independent Federal 
regulatory agency, so in that sense, I really do not think I 
am----
    Senator Shelby. You cannot speak on that subject.
    Mr. DeMarco. I cannot speak on that subject for Secretary 
Geithner, no.
    Senator Shelby. Do you have an opinion, if we do our job 
well, if we do--and I hope we will--on reforming financial 
services regulation, can we do that job really without 
addressing the Fannie and Freddie problem? And if so, I wish 
you would tell us all, both sides of the aisle, because that 
would be an interesting statement.
    Mr. DeMarco. Senator, there is no question that the U.S. 
Congress needs to deal with Fannie and Freddie and more 
largely, as I have tried to set out in my testimony, with the 
housing finance system. And I think that that needs to be done. 
I do not mean to be trite in saying this, Senator, but I think 
it needs to be done expeditiously, but not hastily.
    Senator Shelby. I agree we should not hastily do anything, 
especially regulatory reform.
    Mr. DeMarco, the General Accounting Office found, and I 
will quote, that ``The enterprises' ''--meaning GSEs, Fannie 
and Freddie--``structures undermine market discipline and 
provided them with incentives to engage in potentially 
profitable business practices that were risky and not 
necessarily supportive of their public missions.''
    Do you disagree with that statement?
    Mr. DeMarco. Senator, I think it is quite clear that the 
GSE structure had flaws in it, and that has been widely 
discussed and reported. GAO has been reporting on that for many 
years. I know the Treasury Department in multiple 
Administrations has reported on that.
    The structure in which Fannie and Freddie were allowed to 
operate under for many years really did allow for excessive 
leverage and risk taking and sending mixed signals to the 
marketplace about just what the Government's stand with respect 
to them was. And it is something that I think we all ought to 
regret was not addressed earlier.
    I would also acknowledge the Congress' enactment of HERA in 
2008 that finally, after many years, created a single housing 
GSE regulator and gave that regulator----
    Senator Shelby. It helped some, did it not?
    Mr. DeMarco. It helped some, but, frankly, Senator it would 
have certainly been helpful to have had that earlier.
    Senator Shelby. You referenced that--but I will bring it up 
again--while the conservatorship itself would reduce incentives 
to some degree--and we brought that up in the legislation 
there--what other steps has your agency taken to bring Fannie 
and Freddie practices in line with sound lending standards?
    Mr. DeMarco. Senator, I think that clearly we are limiting, 
and they are themselves limiting, their mortgage activity to a 
more prudent approach to the credit quality of borrowers and 
the realistic pricing of credit risk. That itself is subject to 
some criticism, but I think that, in fact, we have for a long 
time underpriced mortgage credit risk, and there is an ongoing 
return to a more sensible price----
    Senator Shelby. We have underpriced it at our own peril, 
have we not?
    Mr. DeMarco. Yes, sir.
    Senator Shelby. What measures would you suggest through 
your agency be adopted to ensure in the future that GSEs--
Freddie and Fannie--do not return to such bad practices that 
they have had in the past after they emerge, assuming they do--
I hope they do and are privatized--from conservatorship?
    Mr. DeMarco. Well, Senator, it would certainly be my 
expectation that you have two institutions that have tremendous 
expertise, personnel and otherwise, in servicing the U.S. 
mortgage market. And so I do envision that there is some post-
conservatorship realm for them. But there is a certain 
difficulty in answering that question because one does not know 
what the model is that this post-conservatorship world is 
operating in.
    So I think that the sort of questions that I set forth in--
--
    Senator Shelby. Do you envision a hybrid model like a GSE 
or a totally private Fannie and Freddie or something like that?
    Mr. DeMarco. Senator I know the GAO will testify in the 
next panel, they have set out several broad ways this can be 
done, of which privatization is one. Something that moves it 
more into the Government is another.
    As I have already said, in my view, whichever way we go 
here, I would urge that we avoid the key pitfalls of the 
current arrangement where there is this uncertainty or this 
implied Government backing, and a set of exclusive charters 
that are given a set of subsidies operating in this rather 
unique fashion. That model does not work. And so I think those 
are the things we need to fix.
    Senator Shelby. I know I am over my time, but basically 
what lessons have we learned? And that is important. Have we 
learned anything from the debacle that went through Fannie and 
Freddie? You testified, Mr. DeMarco, and I will quote your 
words, ``To properly consider the future of the housing GSEs, 
one should first consider the goals policymakers have for the 
U.S. housing finance system, and specifically the secondary 
market.'' I agree with that.
    And as you consider this, what lessons do you see from our 
past experiences related to Fannie and Freddie that should help 
us shape, all of us, policymakers, those goals in the future? 
And do you believe that the GSEs' housing goals may have 
contributed to the buildup and subsequent fall of these 
institutions?
    Mr. DeMarco. Senator Shelby, I will try to hit on all the 
different things that were in that question.
    I think in terms of the lessons learned, I have already 
talked about the model here. I think that we had a system 
driven by statute where we ended up with different regulatory 
capital requirements for a mortgage, depending upon where that 
mortgage was held or how it was being financed. I think there 
needs to be far greater regulatory harmony there.
    I would extend that point to also say that, as a general 
proposition, I think that, in whatever financial regulatory 
reform we end up with, there will be multiple agencies of 
Government with responsibility for some aspect of housing 
finance. And I think creating mechanisms whereby those various 
agencies are themselves in some coordination with each other so 
that, as a Government, we are taking a more consistent approach 
of analyzing what is going on in the mortgage market, how are 
consumers being protected, and are we creating sort of 
regulatory arbitrages someplace in the market, that we ought to 
have mechanisms that address that in whatever regulatory reform 
we end up with.
    Senator Shelby. Mr. Chairman, you have been very generous 
with me on the time, but if I could follow up on this. As we 
get into regulatory reform, we are talking about and a lot of 
the regulators are talking about more capital for banks, for 
financial institutions. Yet if we deal with the GSEs in the 
future, they are going to have to have a lot of capital 
considering the risks out there in the marketplace. How do we 
do that?
    Mr. DeMarco. Well----
    Senator Shelby. Because you cannot--I do not believe you 
can have one institution or two institutions this big with very 
thin capital, because you are waiting for the time bomb to go 
off.
    Mr. DeMarco. Well, absolutely, Senator. And I think that 
OFHEO for many years testified to that very point, as have 
other Government agencies that have studied this risk. So, 
think about where we were statutorily. Since 1992, the 
requirement was that Fannie and Freddie hold 45 basis points of 
capital for the credit risk of mortgages that were in mortgage-
backed securities. That creates leverage----
    Senator Shelby. Now, just tell the audience--and you are 
talking to the American people here.
    Mr. DeMarco. Sure.
    Senator Shelby. ----what 45 basis points is. It is not even 
a half of a percent, right?
    Mr. DeMarco. That is correct, Senator.
    Senator Shelby. Fifty would be----
    Mr. DeMarco. Would be half a percent.
    Senator Shelby. That would be the most thinly capitalized 
financial institution in the world, would it not?
    Mr. DeMarco. That is remarkably thin, Senator.
    Senator Shelby. Would it be the most thinly capitalized 
financial institution you ever heard of?
    Mr. DeMarco. I am guessing so.
    Senator Shelby. Thank you, Mr. Chairman.
    Mr. DeMarco. But, I mean, Congress did address this last 
year.
    Senator Shelby. I know that.
    Mr. DeMarco. But, unfortunately, it was just 6 weeks before 
we were faced with the necessity to put them in 
conservatorship.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you very much.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Can you give me an idea of the balance sheets today of the 
two GSEs in terms of the category of assets they have, direct 
mortgages, guarantees, mortgage-backed securities? Not with 
numbers, but just a rough approximation.
    Mr. DeMarco. Sure. Just roughly speaking, about $750 
billion in mortgages on their balance sheet.
    Senator Reed. And these are individual mortgages that they 
are holding?
    Mr. DeMarco. Mortgages and mortgage-backed securities.
    Senator Reed. And what is the breakdown between the 
mortgage-backed securities and----
    Mr. DeMarco. It differs between the two companies, Senator. 
I can give you the precise figures. But Freddie Mac tends to 
hold more mortgage-backed securities. And then they each have 
on the order of a couple trillion dollars in mortgage-backed 
securities that are outstanding.
    Senator Reed. And some of these mortgage-backed securities 
were essentially--as I understand the process, they would put 
the mortgage-backed securities together themselves. They would 
buy the loans and then--is that correct?
    Mr. DeMarco. There are a couple different ways in which the 
transactions actually take place. But in simple terms, Senator, 
yes. There is a pool of individual mortgages that are collected 
and put in trust, and then there is a security issued that is 
backed by the mortgages in that trust.
    What Fannie Mae and Freddie Mac provide the holder of that 
security is a corporate guarantee that if the borrower, if any 
of the borrowers fail to make payment on any of the underlying 
loans, that as a company they will make sure that the payment 
of principal and interest is made to the holder of the 
mortgage-backed security.
    Senator Reed. But then they would go in and buy in the 
market mortgage-backed securities that were put together by 
other entities. Is that correct?
    Mr. DeMarco. They did do that, Senator, yes.
    Senator Reed. And to what extent do you think the due 
diligence was done and underwriting was done on those purchases 
by Fannie and Freddie?
    Mr. DeMarco. Well, certainly in hindsight, Senator, not 
enough. I think that, like other market participants, there was 
a reliance upon the tranching that was done in these private 
label securities whereby there were subordinate pieces or 
tranches in the security class that were to absorb the initial 
losses that might take place on individual mortgages. And so 
the rating agencies were used to identify how much of that 
needed to be done in order for the most senior class to be 
rated AAA. And so not just Fannie and Freddie, but the home 
loan banks as well, all the housing GSEs were engaged in 
purchasing these private-label mortgage-backed securities, 
almost all purchasing the AAA-rated pieces of it.
    But as we have seen during this crisis, many of those, if 
not most of those, AAA-rated securities have, in fact, been 
downgraded.
    Senator Reed. I understand also that they were given credit 
by the regulators for their affordable housing goals with the 
purchase of much of these market private label securities.
    Mr. DeMarco. That is correct, Senator.
    Senator Reed. Was there any way that they assured 
themselves that these loans were actually, you know, providing 
affordable housing for--in fact, I would assume that the 
package of loans in the overall pool ranged from upper-income 
people buying second homes all the way down to someone buying a 
first home.
    Mr. DeMarco. Well, Senator, the pools themselves or the 
pieces of it that they purchased had to, of course, be 
structured to satisfy the requirements of their charter. So the 
loans could not exceed a certain size. And, in fact, there is a 
review done--the Department of Housing and Urban Development 
was the agency responsible for this until last year when FHFA 
was created. But HUD did go in and review what the enterprises 
reported in terms of what were the actual underlying mortgages 
and did they satisfy the requirements of various housing goals.
    And so, for example, a private label mortgage-backed 
security backed by subprime loans might, in fact, be fairly 
goals rich, and that, in fact, is one of the ways in which the 
enterprises satisfied their housing goals. For other types of 
private label securities backed by Alt-A loans where there was, 
say, limited or no income documentation, in fact, those loans 
would not qualify for at least some of the goals because 
without income documentation, there was no way to verify 
whether they met the income requirements of those goals. So 
there was no goals credit given in that area.
    Senator Reed. So you are confident that HUD actually went 
in and credited those--looked at the mortgages underlying these 
securities, gave credit where credit was due?
    Mr. DeMarco. Well Senator, I was not at HUD. The HUD staff 
that have come over to FHFA have told me that there was a 
review process to look at what were the mortgages that were 
being stated as backing these goals.
    Senator Reed. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator, very much.
    Senator Johanns.
    Senator Johanns. Mr. Chairman, thank you.
    Mr. DeMarco, thank you for being here. Do not take offense 
at this, but I have listened to all of this and the challenges 
you are facing, and I wonder what makes you tick. Why would you 
take a job like this?
    [Laughter.]
    Senator Johanns. It is a temptation to revisit the past, 
and I think that is important. But in my questions I would like 
to focus on kind of a way forward and where do we go from here, 
because this is important and I am one of those people that 
believe unless we get some stability in the housing market, it 
is going to be hard to build an economy that works.
    In getting my head around this--and I would like your 
reaction to this--it seems to me that we are kind of dealing 
with two things in a global sort of ways, maybe a 50,000-foot 
way. And the first thing is that we have got this book of 
business that you have got to deal with, and it just sounds 
overwhelmingly horrible, to be very blunt about it. You have 
said, you know, we are about into this, from the standpoint of 
the Federal Reserve, to the tune of about $1 trillion plus. You 
anticipate additional draws will have to be made. Unemployment 
is rising, so that is now impacting foreclosures. It is not 
just the subprime phenomenon. It is almost like a snowball 
coming down the hill. So we have got that book of business and 
how to deal with that.
    Then we have got the issue of the way forward. What do we 
do? What is the right model in terms of looking at the 
Government's role in the housing industry in the future?
    First of all, is that a fair way of looking at it, number 
one? And, number two, give me some thoughts on an idea that, 
relative to that book of business, somehow some way we just 
have to deal with that, bite the bullet, find the best way to 
get out of that, deal with foreclosures, et cetera. Is that a 
resolution trust authority? Talk me through that a little bit, 
if you would.
    Mr. DeMarco. OK. I think as a general framework, Senator, 
that is about right, and I think it fairly accurately depicts 
what not just our agency but others that are involved in the 
current housing crisis are, in fact, doing.
    The effort certainly since the creation of the 
conservatorships to now has really been focused on bringing as 
much liquidity and stability back to the mortgage market as we 
can and working through those books of business where all these 
losses are embedded. You mentioned about taking this job. I 
think the thing that motivates our agency, our staff, is 
motivating a lot of what is going on at Fannie and Freddie 
right now and the folks that are working there. There is an 
opportunity to try to help as many people in troubled mortgages 
as we can. It is good for those people, it is good for their 
neighborhoods, and it is good business sense to do everything 
we can to prevent avoidable foreclosures. And so the efforts 
that have been taken under the loan modification program is a 
key aspect of bringing stability to the mortgage market.
    Another part of it that has not been discussed yet at this 
hearing is mortgage refinance activity, and there have been a 
number of things done in that way, and that also is good. It is 
good for individual households. It allows households to 
strengthen their own balance sheet by being able to refinance 
into a lower-rate mortgage. That makes them more committed to 
their neighborhood, their home, and that helps stem future 
delinquencies and foreclosures. And it improves, frankly, the 
credit quality of the mortgage guarantee book that Fannie and 
Freddie are running.
    So I think that the effort today is focused where it needs 
to be. This is a huge, huge problem, and it affects many, many 
people. And so it has been a huge undertaking to address it. 
And it cannot be fixed overnight, but I do, in fact, think that 
the conservatorships have accomplished their basic goal of 
getting the enterprises so that they can remain active in the 
marketplace, so we can have some restoration of liquidity and 
stability.
    Clearly, the support provided by the Treasury and the 
Federal Reserve have been essential to that. While we work 
through this remaining book of business and, frankly, the 
larger macroeconomic issues in the country, it is also the time 
to be considering the future of the housing finance system and 
what sort of institutional arrangements and regulatory 
oversight is going to be most effective and efficient in 
ensuring going forward that we have robust, liquid, and stable 
capital market financing of these trillions of dollars' worth 
of mortgage credit across the country.
    Senator Johanns. You know, I do not know--my time is up 
already, but I do not know how we accomplish all of this, and 
that is what we are trying to figure out through this hearing 
process. But just in terms of an ongoing relationship with this 
Committee and maybe even individual Senators, it would be very, 
very helpful to me to kind of understand how the current mess 
is being cleaned up and the progress there and whether there is 
something missing in your authority or whatever that would be 
helpful on that.
    Second, any advice you can give on the way-forward piece of 
this problem, what role should Government have in the future 
and how should that be executed.
    But then I am going to add a third piece that is really 
important to me, and if you could just give us a quick 
observation on that. Fannie and Freddie are out there still 
doing business. Are they further compounding the problem? Or is 
it a new world for them? In other words, help assure me that a 
year from now somebody will not be in here saying, ``Oh, man, 
all of that work we did since January of 2009 has just created 
a further mess.'' Assure me that that is not happening, if you 
can.
    Mr. DeMarco. Certainly, Senator. First, thank you for the 
offer. I would be most pleased, as would my staff, to follow up 
directly with you and with all the Members of this Committee on 
an ongoing basis. As I said earlier, this really is the start 
of a national discussion here, and we would be most pleased to 
make ourselves available to talk individually about how we are 
progressing in that way.
    With respect to the assurance that you are seeking, 
Senator, I can assure you that as conservator of each of these 
companies, we are very focused on ensuring that we are, in 
fact, conserving the assets of the companies and that the 
companies' continued participation in the marketplace is done 
in a way in which it serves its core mission of ensuring 
liquidity and stability to the mortgage market. And so 
everything that they are doing going forward is prudent, sound, 
safe and sound business that is adding to the stability of the 
market and not bringing additional risk to it. And that is very 
much our focus.
    And I would like to say that we have got new boards of 
directors at each of these companies, new executive management 
teams, and I do appreciate the effort that they have been 
bringing to this effort. They see the companies' role in the 
same fashion, and that is why I think we have had a good, 
cooperative effort on the Making Home Affordable program, 
because they realize it is good for borrowers, it is good for 
communities, and it is good business sense all the way around. 
And so that is going to help us get through this housing 
recovery.
    Senator Johanns. Great. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator, very much.
    Senator Johnson.
    Senator Johnson. Excuse me for having gone to the Energy 
Committee to participate in the markup.
    Mr. DeMarco, how have private label securities affected the 
stability of the GSEs?
    Mr. DeMarco. Senator, the private-label security 
investments that the housing GSEs have made have been damaging 
to their financial condition. They have all--both Fannie and 
Freddie as well as the home loan banks that had sizable 
private-label security investments--suffered impairments from 
those investments, and those impairments have certainly had a 
negative effect on their balance sheets.
    With respect to Fannie and Freddie, a tremendous amount of 
those securities, I think on the order of 90 percent--have been 
downgraded. And so this has not been a pretty financial picture 
for the housing GSEs.
    Senator Johnson. Your statement includes two sentences 
about market risk. Can you elaborate on your strategies 
available to mitigate market risk and how they would impact 
liquidity in the mortgage market?
    Mr. DeMarco. Certainly, Senator. The combination of the 
volatility and severe episodes of illiquidity that we have had 
in financial markets--and not just in terms of debt markets but 
with derivatives as well--have made it an increasing challenge 
to finance and retain a portfolio of mortgages. There is added 
complication for the enterprises in conservatorship.
    On the one hand, there is something very positive, and that 
is the Treasury Department's Senior Preferred Stock Purchase 
Agreement with each company that established a very sizable 
taxpayer backstop to the companies, and that continues on with 
new debt issues that the companies have.
    At the same time, the market is quite cognizant of what is 
going on with the enterprises, that they are in 
conservatorship, that there is public discussion, which is 
quite necessary that we are having today, about the future of 
the enterprises. And that goes to concerns or questions in the 
marketplace about how much longer will they be around or 
issuing debt in the form and fashion in which they have. And so 
those sorts of uncertainties add some unique challenges to the 
market risk activities that the enterprises' folks have.
    Senator Johnson. In a relatively stable mortgage market 
like South Dakota, there are families underwater. What steps 
are being taken to assist those families, particularly in rural 
areas?
    Mr. DeMarco. Senator, I would immediately note two things. 
One is the refinance program I alluded to a few minutes ago. 
You know, with mortgage rates being down around 5 percent, or 
perhaps even lower, it is a terrific opportunity for households 
to strengthen their balance sheet and be able to take advantage 
of that by refinancing the mortgage.
    But there are many homeowners that took out very prudent, 
sensible loans. They might have had 20 percent down and not 
even needed mortgage insurance when they first got their 
mortgage. But they happen to live in a community in which over 
the last 2 years there has been a tremendous decline in house 
prices. And so for them to be able to refinance their mortgage, 
they, in fact, might be underwater today.
    So one of the things we did with this refinance program is 
we allowed for mortgages that are owned or guaranteed by Fannie 
Mae or Freddie Mac, for those loans to be able to be refinanced 
even if the current loan-to-value ratio on that property is up 
to 125 percent. And so that gives these borrowers that are 
underwater an opportunity to, in fact, take advantage of these 
low rates.
    The reason we did that is that this credit risk is already 
on the books of Fannie and Freddie. They already own the 
mortgage, so they already own that credit risk. So if there is 
something that can be done to make that a more creditworthy 
mortgage, that is good for the borrower, and it is good 
business for the credit risk exposure that the enterprises have 
to that. So that is one thing that has been done to help 
underwater borrowers.
    You asked particularly about rural housing, Senator. One of 
the things that Congress did last year in enacting HERA is it 
made a number of changes to the housing goals for Fannie and 
Freddie going forward that our agency is supposed to implement 
beginning next year. And one of those is a duty-to-serve 
requirement for the enterprises, and Congress said that we want 
to see--in addition to the housing goals, we want to have 
expressed in regulation a duty-to-serve responsibility for 
Fannie and Freddie to serve manufactured housing, certain 
targeted multifamily housing, and rural housing.
    So, Senator, what we have done in the path of implementing 
congressional intent here is this summer, earlier this year, we 
issued an Advanced Notice of Proposed Rulemaking to get broad 
public comment on how to go about developing this duty-to-serve 
requirement. My team literally has gone out and hit the road to 
see what is actually going on across the country in these 
areas. So we have gone out and visited manufactured housing 
parks. We have gone out and visited with participants in the 
manufactured housing industry. We have done likewise with 
respect to rural housing and have been meeting with advocates 
for and folks with direct knowledge of what is going on in 
rural housing markets in this country. And we are trying to 
gather that information so that as we develop our proposed rule 
later this year, we will be informed by what we learn from 
market participants so that we can implement congressional 
intent with respect to these duty-to-serve requirements.
    Senator Johnson. Thank you, Mr. DeMarco. My time has 
expired.
    Chairman Dodd. Thank you, Senator, very much.
    Senator Gregg.
    Senator Gregg. Mr. Chairman, I----
    Chairman Dodd. I am sorry? We try to do it first to arrive 
and----
    Senator Gregg. Yes, but yesterday Senator Corker was nice 
enough to yield to me after he had left and come back, so I 
would yield to Senator Bunning or Senator Corker.
    Chairman Dodd. I am not going to intervene here.
    [Laughter.]
    Senator Gregg. No, no. I am yielding to you guys. You stuck 
around. I will go after the----
    Chairman Dodd. Senator Bunning actually was next.
    Senator Bunning. Thank you, Senator Gregg.
    Chairman Dodd. Senator Bunning, you are on.
    Senator Bunning. Thank you. Thank you, Mr. Chairman.
    It has been over a year since the creation of your agency, 
yet you still do not have an Inspector General. Why is that 
critical job still vacant? And when will it be filled?
    Mr. DeMarco. Senator, when Congress enacted HERA, it did 
establish--it did state in that law that there shall be 
established an Office of Inspector General at FHFA. As the 
Acting Director of FHFA, I would like to be very clear, I want 
an Inspector General. I would like it, and I would like it now, 
because I believe, Senator, that Inspectors General can be very 
important elements of the functioning of a Federal regulatory 
agency.
    But, Senator, the answer to your question of why we do not 
have one is that there is a requirement in the statute that the 
Inspector General be Presidentially appointed and Senate 
confirmed. So this position is awaiting a Presidential 
nomination for the IG.
    Senator Bunning. Well, I understand that, but you as the 
acting head of it, you could at least make a suggestion to the 
Administration that this is a critical position that needs to 
be filled. It would really help your relationship with the 
Congress of the United States, I can tell you, and with this 
Committee if that position were filled.
    Mr. DeMarco. Senator, I have had that communication with 
the Administration multiple times.
    Senator Bunning. Others have asked questions about Freddie 
and Fannie. This one I do not believe has been asked. How many 
more dollars, how much more money are we going to have to put 
in Freddie and Fannie?
    Mr. DeMarco. I do not know the answer to that question, 
Senator, but I can tell you that from the time we created the 
conservatorships, FHFA has been regularly evaluating that 
question and working with both the Treasury Department and the 
Federal Reserve to undertake various stress test approaches to 
analyze under various scenarios what might be needed. And so 
this has been an ongoing effort, and it is an effort that 
continues today to assess where the losses are heading and what 
future draws might look like. But it depends upon so many 
variables about the future, not just of house prices but of the 
economy.
    Senator Bunning. Do you think there is any chance of us 
getting taxpayers' money back?
    Mr. DeMarco. To date, Senator, there has been about $96 
billion drawn from the Treasury under the Senior Preferred 
Stock Purchase Agreement. I do not envision any near-term way 
in their current form for that money to be paid back.
    Senator Bunning. Thank you. I agree with that.
    Do you know how much profit mortgage banks are making off 
new Government-guaranteed loans right now?
    Mr. DeMarco. I am sorry, Senator. Would you repeat that?
    Senator Bunning. Do you know how much profit mortgage banks 
are making off new Government loans right now?
    Mr. DeMarco. No, sir, I do not.
    Senator Bunning. You do not have any idea?
    Mr. DeMarco. What mortgage bankers are making? No, sir.
    Senator Bunning. Mortgage banks.
    Mr. DeMarco. No, sir.
    Senator Bunning. OK. According to what I have been told by 
people in the industry, recent profit margins are 2.5 to 3 
percent per loan. Not that long ago, profits were more like 1 
percent per loan. Does that seem fair to you that originators 
are making that much money when all the risk is being taken by 
the taxpayers? What are you going to do to bring those unfair 
profits back down to a more reasonable risk to the originators?
    Mr. DeMarco. Senator, I do not have oversight over mortgage 
originators, so I believe that that would be a question for 
other regulatory agencies. I am certainly concerned about what 
is going on with Fannie Mae and Freddie Mac and their 
earnings----
    Senator Bunning. But you do have regulatory power over the 
agencies.
    Mr. DeMarco. Yes, sir.
    Senator Bunning. That is the basic question.
    Mr. DeMarco. So with respect to Fannie Mae and Freddie Mac, 
I am concerned about the money they are still losing, Senator.
    Senator Bunning. Me, too, since it is my money.
    Mr. DeMarco. All of us, sir, as taxpayers.
    Senator Bunning. Yes, everybody. I mean ``us.''
    Mr. DeMarco. Yes, I understand that.
    Senator Bunning. ``My'' being plural.
    Mr. DeMarco. We are very cognizant of that at FHFA, 
Senator.
    Senator Bunning. Is it true that refinanced loans that you 
were speaking about have better than a 50-percent failure rate?
    Mr. DeMarco. Refinanced loans? No, sir.
    Senator Bunning. Is that right? Would you like to----
    Mr. DeMarco. The default rate of a mortgage that has been 
refinanced?
    Senator Bunning. Yes.
    Mr. DeMarco. No, sir.
    Senator Bunning. Do you have a figure?
    Mr. DeMarco. Senator, are you actually asking me about loan 
modifications as opposed to refinanced? To me, there is a very 
important difference here. A modified loan is one where the 
lender has redone the terms of the mortgage because the 
borrower is failing to make payment. A refinanced mortgage is a 
different animal.
    Senator Bunning. OK. Let us take the first type.
    Mr. DeMarco. OK. So on loan modifications, Senator, it had 
been common practice, before we really got into the depths of 
this housing crisis, that when an individual borrower got into 
trouble, they would certainly have the opportunity to work with 
their lender. There were times in which the loans would be 
modified, the payment would be modified to help keep the 
borrower from defaulting.
    But the way that was done, Senator, is that the majority of 
time that resulted actually in an increased payment to the 
borrower. And so the performance rate or, if you will, the 
redefault rate on modified loans had been quite high.
    The approach that is being taken now is much, much 
different than the way loan modifications were made even a year 
ago. A year ago, a year and a half ago, there were very few 
modified loans that resulted in a material decline in mortgage 
payments. Today the loan modifications that Fannie Mae and 
Freddie Mac are doing, over 80 percent of them are resulting in 
a decline in the borrower's payment, and over 50 percent of 
them are resulting in a decline of more than 20 percent.
    Now, because this activity----
    Senator Bunning. You are not answering my question.
    Mr. DeMarco. Well, because----
    Senator Bunning. You are evading my question.
    Mr. DeMarco. No, Senator, I am trying to give you an honest 
answer that says that, in fact, loan modifications that were 
done 18 months ago did have high default rates, and I would not 
transfer that experience, that data point as a presumption of 
what we are going to see about loan modifications that are 
being done today, because those modifications are fundamentally 
different from the perspective of the borrower.
    Senator Bunning. Well, but aren't the fees that have been 
added to those loans, the loan level price adjustments, making 
those loans more expensive?
    Mr. DeMarco. Senator, the loan level price adjustments are 
things that are affecting new loans, so that might be an 
issue----
    Senator Bunning. That is why I asked the question.
    Mr. DeMarco. ----with the refinance, but that is not an 
issue with the modified mortgages.
    Senator Bunning. Then you did not answer the percentage for 
me.
    Mr. DeMarco. Senator, I can go back, and I would be glad to 
try to get a percentage for you on redefault rates for 
refinanced loans. And I would do that for the modified as well.
    Senator Bunning. I would appreciate that, if you would give 
it to the Committee.
    Mr. DeMarco. Yes, Senator, I would be happy to do that.

    Response: I am pleased to provide responses to questions you asked 
me during the October 8, 2009, Committee on Banking, Housing, and Urban 
Affairs hearing on the future of the mortgage market and the housing 
enterprises. Your questions focused on redefault rates for refinanced 
and modified mortgages.
Redefault Rate for Refinanced Loans
    Fannie Mae and Freddie Mac eligibility requirements do not allow 
for loans that are significantly delinquent or in default to be 
refinanced. Loans in that condition would be more appropriate for 
modification. The most significant benefit of the Home Affordable 
Refinance Program (HARP) and other refinance programs is a reduced 
payment, which increases affordability for the borrower, leading to 
fewer defaults. Most of the borrowers refinancing their mortgages are 
reducing their interest rates, reducing their housing payments, and 
potentially substituting a new fixed rate mortgage for their original 
adjustable-rate mortgage. All of these changes increase their 
probability of successful long-term home ownership.
    The Federal Housing Finance Agency (FHFA) reports on the 
performance of refinanced loans in its monthly Refinance Report, based 
on Enterprise data. The Enterprises have begun tracking the performance 
of loans refinanced under HARP, but it will be several months before 
they have sufficient information to establish a valid default rate. As 
of September 30, 2009, of the 116,677 loans with loan-to-value ratios 
over 80 percent to 125 percent that have been refinanced under HARP 
over the last 9 months, only one loan is categorized as more than 90 
days delinquent. For refinance loans originated in the first and second 
quarters of 2008 and purchased by the Enterprises, (the most recent 
period with enough data to establish a redefault rate), the early 
payment default rate for refinance loans is approximately half the 
early payment default rate of purchase loans. Based on the early 
default data and the design of the program, FHFA does not expect a high 
default rate for refinanced loans.
Redefault Rate for Modified Loans
    The Home Affordable Modification Program (HAMP) was established in 
March 2009, with the first trial modifications under HAMP in place in 
May 2009. HAMP requires a 3 month trial period where homeowners can 
adjust to the modified payment before the modification is final. The 
first trial modifications just completed their trial period in August 
2009. There has not yet been enough time to establish a valid redefault 
rate for this program.
    As I mentioned in my testimony, redefault rates for modified loans 
have been an area of concern for policymakers focused on keeping 
homeowners in their homes. Modified loans are more at risk for 
redefault than refinanced loans because the borrower was experiencing 
financial hardship. However, FHFA expects lower redefault rates for 
loans modified under HAMP than older modification programs developed by 
individual servicers for one key reason: HAMP loan modifications 
generally result in lower monthly payments for homeowners. Prior 
modification programs focused on ``catching up'' the loan and, with 
fees rolled in, often resulted in higher monthly payments. This is a 
significant difference, making the HAMP loans more sustainable over the 
long term.
    FHFA's most recent monthly Foreclosure Prevention Report  
demonstrates this difference. In the first quarter of 2008, 82 percent 
of modified loans resulted in an increase in the monthly payment made 
by the homeowner. In the second quarter of 2009, after HAMP was 
established, only 12 percent of modifications resulted in an increased 
payment. Although not all borrowers qualify for HAMP modifications, 
some homeowners seeking a modification may still qualify for the older 
programs.
    FHFA will continue to publish and share with Congress information 
on the performance of both refinanced and modified loans through the 
agency's Foreclosure Prevention Reports and Refinance Reports, 
available on the FHFA Web site, www.fhfa.gov. These reports are 
submitted to the Committee monthly as part of FHFA's Federal Property 
Manager Report.

    Senator Bunning. Thank you.
    Senator Johnson [presiding]. Senator Reed.
    Senator Reed. I have already gone.
    Senator Johnson. Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair, and thank 
you for your testimony. In your written testimony, you note 
that important features of the mortgage system include 
innovation and consumer choice but also consumer protection. 
There is sometimes some tension between those goals.
    I was wondering if you would elaborate on your 
perspectives, if you will, how two of the features of mortgage 
practices that developed might have impacted this overall 
puzzle, those being prepayment penalties and steering payments. 
If you could kind of give us some sense of how those practices 
reverberated through the markets.
    Mr. DeMarco. Senator, steering payments? I want to make 
sure I understand what you are meaning by that.
    Senator Merkley. Yield spread premiums.
    Mr. DeMarco. Oh, I am sorry. Yes. So on the issue of 
consumer protection, prepayment penalties, it seems as though 
prepayment penalties on subprime mortgages have been one of the 
very detrimental features of those mortgages for borrowers. 
That is an issue. I would say that the enterprises have little 
or no mortgage activity that involves prepayment penalties.
    I would not be quite so blanket as to say that there is not 
opportunity for where some of the various features in subprime 
loans, in fact, could not be sensible for a particular borrower 
in a particular circumstance and with the financial 
sophistication to know what it is that they are undertaking. 
But what we saw is that when some rather tailored mortgage 
products with certain features that might make sense to a 
sophisticated borrower with a particular situation got 
generalized in mortgage lending, and then offered to and 
encouraged for borrowers that were not the strongest credits or 
did not have the characteristics for which those specialized 
features were originally developed that has been a cause of a 
great deal of the problem here. A lot of that has taken place 
sort of outside of the normal regulated mortgage lending 
channels, but, nonetheless, I think we all share a concern that 
this activity really went too far and needed an appropriate 
response.
    With respect to yield spread premiums, Senator, this is 
something that has been the object of a great deal of debate 
and discussion at HUD and the Fed and other regulatory agencies 
with responsibilities in this area, and I think that it is 
really kind of unfortunate we cannot get to having that 
resolved once and for all.
    Senator Merkley. Well, that was not exactly an answer on 
yield spread premiums on either the role they played or your 
opinion on them.
    Mr. DeMarco. I do not have information specific to the role 
yield spread premiums played on mortgage defaults.
    Senator Merkley. Well, let me enlighten you a little bit 
then. Ordinary families went to their mortgage brokers. They 
saw on their spread sheets that they were paying their broker a 
certain amount of money. What they did not know is that their 
broker was being paid a separate fee off the books to steer 
them into a subprime. So if you have a broker system where the 
brokers who are presenting themselves as the financial adviser 
to the American consumer on the most important transaction that 
an American family faces are actually being paid separately 
with an undisclosed conflict of interest payment to put people 
into something that is not in their best interests, not only 
does that result in tons of people being steered into subprime 
loans, but it also means that any sort of good advice that the 
customer is paying for, they are not getting because they are 
being outbid on the back side. That had a huge impact on the 
multiplication of the subprime switch. Fannie and Freddie then 
began to purchase.
    So when I go through this, it puzzles me that you would not 
have any insight or thought on the role that this played, 
because it was a massive part of the increase in subprime 
lending.
    Mr. DeMarco. Senator, fair enough. I think it perhaps was a 
misunderstanding of the question, because, in fact, yield 
spread premiums are an issue there, but they are also an aspect 
of normal or more prime transactions as well. And it has been a 
focus of a great deal of regulatory discussion.
    So I think, Senator, that what I would say is that yield 
spread premiums, prepayment penalties, and a whole array of 
characteristics of what was going on in the subprime market are 
characteristics that need to be either removed from the 
marketplace or restored to the limited usage where, as a 
tailored aspect of a mortgage product, it makes sense for that 
borrower.
    But, clearly, Senator, I share with you the concern that we 
had a lot of activity here steering borrowers into mortgages 
that perhaps either were not suited for them or they were, in 
fact, qualified for something else, of which yield spread 
premiums may well be part of that explanation. But I would not 
go so far as to say that was the only thing that was going on 
here. But I do share your concern with this.
    Senator Merkley. Thank you.
    Senator Johnson. Senator Gregg.
    Senator Gregg. I think Senator Corker is next.
    Senator Johnson. Senator Corker.
    Senator Corker. Thank you, Senator Gregg and Mr. Chairman, 
and, Ed, for your testimony. You know, I know we need to focus 
on the future. I want to make just one statement before we do.
    When you listen and you watch what has occurred with Fannie 
and Freddie and the GSEs, you really could not make up a 
scenario that is as strange and has such a competing undoable 
goal. So, you know, to have an entity that has under 45 basis 
points in capital, had a Government guarantee, that was 
actually keeping mortgages in order to juice up its profits, 
and then we had target groups that the Government was telling 
had to be lent to, really an odd model that hopefully is going 
away very quickly, and certainly numbers of things happened 
during this last crisis that would be hard to make up, again.
    So hopefully as we do regulation we will make sure that 
this is something that we deal with, that this is not left to 
the side.
    Mr. Chairman, I want to say I think we have a tremendous 
opportunity to do the right thing having this gentleman at the 
helm. This is a person that, you know, does not have a fiefdom 
he is trying to protect. The fact is he stated here that these 
GSEs should not exist, that the private sector can deal with 
this issue perfectly adequately. And so I hope this Committee 
will move ahead with whatever regulation is necessary to do 
away with the GSEs, move it to the private sector, and ensure 
that that is part of our regulation.
    Let me just ask you, how do we do that? I read the GAO 
report--which, by the way, I thought they did a very good job. 
I know they are coming up on the next panel. We talked about 
some good bank/bad bank. You know, it seems to me that they 
exist as basically entities that are going to continue to lose 
money and there is no reason to really separate those.
    Walk me through how we go from having this mortgage 
portfolio and the insurance, how we move from there to moving 
this to the private sector. And what are some of the pitfalls 
that might exist along the way? But thank you again for your 
service and for your testimony. Again, I think we are very 
fortunate to have someone like you in this position.
    Mr. DeMarco. Thank you, Senator. That is very kind. I hope 
I do not now disappoint you with this answer, but I do not have 
a fully developed model for how one does this, but I think I 
can at least help move it along the way.
    One of the things is that if Congress does decide on a 
model going forward that really relies on private capital and 
market discipline to be the core functioning of our housing 
finance system for conventional--that is, non-Government-
guaranteed--mortgages, the transition point that is done with 
Fannie and Freddie is going to have to be very clear to market 
participants about what is old and what is new. Because we have 
clearly told the market that activity that is going on now is 
backed by this Senior Preferred Stock Purchase Agreement of the 
Treasury Department, and so there is an important 
responsibility that we have made to make sure that we carry 
that through.
    So there are different ways of actually doing that 
separation, but I think being crystal clear about what that 
separation looks like is an essential element to the transition 
that you are talking about. So an investor knows if they are 
purchasing something from an old Fannie, old Freddie that has 
this Government support to it, they know what that is and what 
that means separate from any going-forward entity that comes 
out of a post-conservatorship realm for the enterprises and 
that the Government is stating its intention that this is a 
fully private activity or it is private with this amount of 
support from the Government.
    There are models out there. I think that as we have done in 
other times, looked to the FDIC, which has certainly over its 
history come up with various approaches to doing these sorts of 
splits between institutions. That is one place that I would 
look to for lessons on how actually one can go about 
structuring these kinds of splits. But, honestly, Senator, 
beyond that I am sorry to say that I have not thought through a 
whole lot of the mechanics of this. I think I am a little too 
focused on working with what we have got right now.
    Senator Corker. So let me ask you, what--so you cannot walk 
through the transition at the present. I hope you will help us 
walk through that in our next meeting.
    Mr. DeMarco. I would be glad to. Sure.
    Senator Corker. What is it that a private entity that said, 
hey, look, you know, these entities are going to sunset. We 
know the oldco still has its various Government guarantees in 
place. But what would a newco private entity--what are some of 
the components that they would have to think about to, in 
essence, take up the vacuum that the oldco was going to leave 
on a go-forward basis?
    Mr. DeMarco. So I think to get into details of where I 
think we would need to go is we actually come up with a future 
system.
    One of the benefits of the current system is the 
standardization of mortgage products. So if we create some new 
companies and we get rid of the barriers to entry and exit so 
that they are a non-Fannie or a non-Freddie entity that might 
come into existence that also wants to participate in this 
mortgage market, how do we go about appropriate standardization 
of mortgages and mortgage documents so that no matter which 
company we are talking about, we can continue to have the 
benefit of that standardization to lower the costs to consumers 
and to provide greater transparency to investors?
    I think that we are going to need to think through how 
exactly we make sure that happens with non-GSE entities that 
are providing a mortgage securitization activity. It certainly 
can be done, but, again, it is one of these things where all I 
can do for you this morning, Senator, is note that these are 
some of the issues I think we need to make sure we have 
answered. And I am sure that there are answers there. I just do 
not have them this morning.
    Senator Corker. Mr. Chairman, thank you for the time, and, 
Mr. DeMarco, for your service and testimony. I would like to 
say that I would like--our office would very much like to be 
involved in a step-by-step process with you as to how we unwind 
oldco and move this function over the private sector. This is 
really not that--housing loans are not that complicated. And, 
in essence, by virtue of creating the huge entities that we 
have, we really have taken away from community banks an 
opportunity that exists for them to actually be able to make 
money on something that is less complex than commercial loans 
and other kinds of things where they are getting ready to take 
a bath.
    So I look forward to working with you, and I thank the 
Chairman for having this Committee meeting.
    Senator Johnson. Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman. Thank you, 
Director.
    Let me ask you, in your testimony you have presented 
challenges that your agency faces in regulating and monitoring 
the progress of the GSEs. But the one thing I have heard time 
and time again from critics is that Fannie and Freddie were the 
catalysts of the mortgage collapse and not the unregulated 
mortgage actors.
    Is it fair to say that your own agency's data indicates 
that Fannie and Freddie only held a small share of subprime 
mortgages and never originated a single subprime mortgage? 
Which is inconsistent with the explanation of what some people 
are alleging the crisis is all about.
    Mr. DeMarco. Senator, all the housing GSEs--Fannie, 
Freddie, and the home loan banks--were clearly important 
investors in subprime private label mortgage-backed securities, 
so they clearly provided support to that market through their 
purchases of it.
    I think each enterprise had various programs in which they 
purchased mortgages directly that one would say would have some 
of the characteristics or features of subprime mortgages. So I 
think that----
    Senator Menendez. How big a share of them would they be?
    Mr. DeMarco. Well, Senator, for their direct purchase, I do 
not have those numbers directly.
    Senator Menendez. If you could get that for the Committee, 
I would like to see it, because my understanding is that they 
held a rather small share of those subprime mortgages. I would 
like to be able to quantify it.
    Mr. DeMarco. Senator, we will get something for you.

    Response: I am pleased to provide responses to questions you asked 
me during October 8, 2009, Banking, Housing, and Urban Affairs 
Committee hearing on the future of the mortgage market and the housing 
enterprises. Your questions focused on historical information on the 
participation by Fannie Mae and Freddie Mac in the market for subprime 
single-family mortgages.
    There is no common industry definition of a subprime mortgage, so 
it is not possible to indicate the volume of subprime loans acquired by 
the Enterprises. However, most industry participants would consider a 
mortgage made to a borrower whose credit score is below 620 to be a 
subprime loan. Both Freddie Mac and Fannie Mae have reported that, as 
of September 30, 2009, loans to borrowers with credit scores below 620 
comprised 4 percent of the unpaid balance of their respective 
portfolios of conventional single-family mortgages. From 2002 through 
2008, each Enterprise's acquisitions of such loans accounted for 3-6 
percent per year of their total single-family acquisitions.
    During the mortgage lending boom of the middle years of this decade 
private-label mortgage-related securities often were backed by pools of 
mortgages that issuers designated as subprime loans. The table below 
provides information on issuance and Enterprise purchases of such 
securities in 2002 through 2008. The data on securities issuance were 
obtained from Inside Mortgage Finance Publications. The data on each 
Enterprise's purchases in each year and combined Enterprise purchases 
in 2006 through 2008 were obtained from the Enterprises and published 
in FHFA's 2008 Report to Congress. The data on combined Enterprise 
purchases for 2003 through 2005 were obtained from Inside Mortgage 
Finance Publications and previously reported in annual research reports 
published by the Office of Federal Housing Enterprise Oversight, one of 
FHFA's predecessor agencies.

    Table: Issuance and Enterprise Purchases of Private-Label Mortgage-Related Securities Backed by Subprime
                                              Mortgages, 2002-2008
                                 (dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
               Issuance of            Fannie Mae                  Freddie Mac                  Combined
                 Subprime    -----------------------------------------------------------------------------------
    Year      Private-Label
                   MBS          Purchases      Share*       Purchases      Share*       Purchases      Share*
----------------------------------------------------------------------------------------------------------------
    2002        $122,680.9       $5,143.9          4.2%          n.a.          n.a.          n.a.          n.a.
    2003         194,958.5       25,768.6         13.2%          n.a.          n.a.     $81,000.0         41.5%
    2004         362,549.3       67,003.6         18.5%          n.a.          n.a.     176,000.0         48.5%
    2005         465,036.3       24,468.8          5.3%          n.a.          n.a.     169,000.0         36.3%
    2006         448,599.6       35,606.1          7.9%     $74,761.0         16.7%     110,367.1         24.6%
    2007         201,546.7       15,970.5          7.9%      43,667.0         21.7%      59,637.5         29.6%
    2008           2,261.4          637.4         28.2%         106.0          4.7%         743.4         32.9%
----------------------------------------------------------------------------------------------------------------
n.a. = not available.
Sources: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications.
* Reported ``share'' is Enterprise purchases of subprime private-label MBS in each year expressed as a
  percentage of total subprime MBS issued during the year. It cannot be assumed that the subprime private-label
  MBS purchased by an Enterprise in a given year were issued in that year.


    Mr. DeMarco. I think there has always been in this arena a 
difficult definitional question of what constitutes a subprime 
mortgage. The most traditional approach to this has been to 
look at the lending channel through which the mortgage was 
actually originated. But, in fact, there can be mortgages that 
were originated through other channels. As I said, I used the 
term they had some of the characteristics----
    Senator Menendez. Well, you cannot have a universe of 
people saying that Fannie and Freddie are the cause of the 
crisis because they were the entities that created the mortgage 
collapse and because they got largely involved in subprime 
mortgages and not be able to quantify it. You know, so we have 
to have some sense of being able to quantify it.
    Mr. DeMarco. So we will be glad to do that, Senator.
    One other thing I would point out, just because I think it 
is germane to what you are asking me--and we will provide the 
actual data to you, but I will just try to describe it--is to 
look at the shifting share of secondary market activity with 
mortgages over the course of this decade. You know, in the 
early part of this decade, you see a real trend downward in 
Fannie and Freddie's share of mortgage securitization activity, 
because there was an increasing share of mortgage 
securitization activity taking place through the private label, 
private conduit system, and that is where most of the subprime 
and the Alt-A and the other nontraditional mortgage activity 
was taking place.
    So there was a clear shift of market share away from the 
enterprises and their normal underwriting through these other 
channels. That has clearly and sharply reversed itself in the 
last 2 years, such that today Fannie and Freddie are providing 
the financing or mortgage guarantee on three out of every four 
mortgages that are made in this country. But we will make----
    Senator Menendez. But those are not subprime mortgages.
    Mr. DeMarco. Those are not subprime mortgages, Senator.
    Senator Menendez. OK. Just so we have the record clear. 
Which of the policy options in the GAO report do you believe 
are worthy of support in terms of the future of the GSEs? And 
are any of the GAO options particularly troublesome to you?
    Mr. DeMarco. Senator, I think GAO has done a very fair job 
of presenting to the Committee three broad ways in which 
policymakers and which the U.S. Congress can decide to go with 
respect to not just Fannie and Freddie, but really in terms of 
the secondary mortgage market and housing finance. This can 
come more into the Government with a more direct Government 
role. You can use the GSE model or various alterations to or 
enhancements to the GSE model. Or you can move to something 
that is more fully private.
    I would offer two things about that. I do not have a 
particular preference or recommendation to offer the Committee. 
But I think that there are hybrids among each of these three 
classes that GAO lays out. In my testimony, I tried to identify 
three areas where I felt in particular policymakers needed to 
think about what role they thought the Government ought to 
have. That has to do with ensuring liquidity, credit backstop, 
and affordable housing. But I think any of that can be worked 
into any of these three models. Those issues can be addressed.
    The one thing that I would caution against, as I have 
earlier this morning, is this notion of trying to have it both 
ways with an implicit guarantee where we say we want market 
discipline, but, in fact, the Government is still standing 
behind it there, because I think that creates a very difficult 
position for the taxpayer.
    If we want the Government to be providing credit support, I 
think we ought to do it in a more sort of direct fashion and 
say this is what we are doing, this is how we are limiting it, 
this is how we are pricing for it, and so forth.
    Senator Menendez. All right. Thank you.
    Senator Johnson. Senator Vitter.
    Senator Vitter. I think Senator Gregg may have been in 
line.
    Senator Johnson. Senator Gregg.
    Senator Gregg. Thank you.
    The way I look at this is it is sort of an inverted 
pyramid, and you have got all this structure and everything 
like that. But at the bottom of the pyramid is the person who 
borrowed money on a house, and until you can get that done 
correctly, until the underwriting of that loan is done 
correctly, you are really not going to solve the problem.
    So the Congress has set up a lot of incentives to lend to 
that person even though the person may not be able to afford 
the house. The guarantees are out there that say, well, maybe 
the person cannot afford the house, but we are going to 
guarantee the loan, anyway.
    All of these create incentives for bad underwriting. Is 
there some way to create some incentives for good underwriting? 
Should we require recourse loan? Should we require a percentage 
of--that there be 10, 15, 20 percent that cannot be loaned to, 
such as they do in Australia? Should we have covered bonds? 
Should we require covered bonds?
    Is there something at that entry point in this process that 
we can do that does not undermine the public policy, which is 
that we want everybody in America to own a house? I mean, the 
two conflict, right? Do you have any thoughts on that?
    Mr. DeMarco. A couple, Senator. First, I believe in 
diversification and diversity. I think that is one of the 
things that impresses me in the work I do. Look at mortgage 
lending, and on the one hand, there is a tremendous benefit 
that American households get from standardization of mortgage 
products. On the other hand, the American household is a very 
diverse entity. It is different ages, different structures, 
different income patterns, and so forth.
    And so I would hope that whatever system we come up with, I 
would actually not look for one answer, but, in fact, a market 
system that is as robust as this country is which would allow 
for--covered bonds might be an approach. There may be--recourse 
lending is an approach. I would note that the Federal home loan 
bank system, which we have not talked about, for a number of 
years have had a mortgage purchase program. It is actually 
shrinking a lot right now, but one mark of that program was, in 
fact, the initial credit risk on the mortgage actually went 
back to the original lender. And the mortgages in that 
portfolio have performed better than sort of the average in the 
country these past several years.
    But I would look to more than one solution to this, because 
I think that that we have got households in different 
situations that have different needs. And the richness that I 
think having multiple sort of conduits, if you will, between 
capital markets and these individual lending transactions 
allows for diversification of credit risk and allows for 
greater opportunity for individual households.
    Senator Gregg. OK. Accepting that--and I do accept that as 
a very reasoned approach to this--you still have the problem 
that we have created these massive incentives in our system to 
undermine good underwriting. I mean, basically our guarantees 
undermine good underwriting. This idea that the originator is 
just out there for a fee really undermines good underwriting.
    So what do you do to put back in the structure that does 
some discipline on the underwriting side?
    Mr. DeMarco. Senator, I think that is a very fair question, 
and it is one we all have to grapple with. If I could in some 
sense add to it with some additional information, we sent up to 
the Congress a couple months ago a study that we were required 
to do on guarantee fees by the enterprises, and one of the 
striking things about that study is what it reflects about the 
cross-subsidization of mortgage credit risk that was going on 
with the GSEs' credit book. And so you have borrowers that are 
in 15-year mortgages that are, in fact, effectively paying more 
relative to their risk than someone in a 30-year mortgage. You 
have someone that is a high credit quality borrower relatively 
speaking paying more than a less creditworthy borrower.
    Now, the model that was put out there that we have operated 
under accepted and in some ways encouraged this sort of thing. 
And yet when you do that, it does not create the best 
incentives for people to have the most sound approach to taking 
credit.
    So I think, in fact, there are good incentives to have 
credit risk properly priced to borrowers, and this gets 
directly at your question, I think, about underwriting.
    But while I would acknowledge and share your view that this 
is something that needs to be addressed, I think that I do not 
have a particular answer. I think the answer does lie somewhere 
in the decisions that policymakers make about what kind of role 
they want for the Government in the future operation of the 
housing finance system.
    Senator Gregg. Well, clearly, that is the problem. I was 
sort of hoping you had a solution for it.
    Thank you.
    Senator Johnson. Senator Vitter.
    Senator Vitter. Thank you very much, Mr. Chairman, and 
thank you, Mr. DeMarco. And this sort of goes to Senator 
Menendez's lines of questions.
    On June 30th of this year, at a Banking Committee hearing 
Secretary Geithner agreed that ``Fannie and Freddie were a core 
part of what went wrong in our system.'' A core part. Would you 
agree with that?
    Mr. DeMarco. Clearly, Senator, the failure of these two 
companies, the need to put them into Government 
conservatorship, and the amount of taxpayer money that has been 
injected into them to assure that they can continue to keep a 
secondary market operating is a sign that their failure was a 
central part, a key part of the broader financial crisis that 
this country has been facing.
    Senator Vitter. Well, I know you are not responsible for 
any of these broad regulatory reform proposals, but given that, 
don't you think it is odd that Fannie and Freddie reform is 
nowhere on radar, basically no part of those broad proposals? I 
am not saying they should be the only part or they are the only 
problem, but isn't it logical for them to be a big part of that 
discussion?
    Mr. DeMarco. I clearly think, Senator, that the 
Administration and the Congress need to deal directly with the 
issues of Fannie and Freddie, their current status, and do that 
in the context of the broader housing finance system.
    With respect to regulatory reform, I may have said it 
earlier this morning, but in any event, no matter what sort of 
path reform takes and what sort of system or set of entities 
that exists when Congress is done, whatever that looks like, it 
strikes me as though there is still going to be multiple 
Government agencies with key responsibilities for some aspect 
of our housing finance system. And so I think that it would be 
a prudent and wise thing to have arrangements whereby whatever 
that collection of agencies is--and not just regulatory 
agencies but places like HUD and the Veterans Administration 
and so forth--that there be sort of a systematic way for 
agencies with some responsibility for aspects of our housing 
finance system to themselves be coordinated and be sharing 
views on what is going on in the mortgage market, risks that 
are out there, whether they have to do with financial risks to 
investors or consumer protection issues where borrowers are at 
risk.
    So wherever that reform discussion goes, I hope that given 
the huge size of the mortgage market as a particular credit 
market and how important it is to so many households around the 
country--and I would say not just homeowners. This is very 
important to renters as well. So this covers all the American. 
I think that we ought to be making sure we consider how we are 
addressing that kind of coordination.
    Senator Vitter. Right. Apart from Freddie and Fannie as 
institutions, it seems to me that the sort of perverse 
incentives in terms of safety and soundness that Senator Gregg 
was describing was clearly part of the problem as well. Is that 
fair to say?
    Mr. DeMarco. Sure.
    Senator Vitter. And, again, maybe I am missing something, 
but it seems to me there is little to nothing addressing that 
in these broad regulatory reform proposals. I know those 
proposals are not from you. They are not your responsibility. I 
am just asking for a reaction to that.
    Mr. DeMarco. Well, the Administration has put forward a 
regulatory reform proposal and has pledged to have its ideas on 
the future of the housing GSEs early next year. So that really 
is for the Administration to answer in terms of their thought 
process on this. I am sure that they see the connections that 
are here. But Secretary Geithner and the rest of the 
Administration--I am not going to speak for them in terms of 
the timing or staging of how they develop this.
    I will say that this is a challenging--not as a challenging 
issue, but there has been so much effort focused on trying to 
get stability into the mortgage market right now and to assess 
kind of where we are to give that a little time to figure out 
where they want to go is, I suspect, part of what may be going 
on.
    Senator Vitter. Well, this is just a statement on my part. 
It seems to me we are delving into regulatory reform and, in 
doing so, in terms of the big proposals put forward, there are 
a lot of things being proposed which, as I see it, have little 
to nothing to do with what went wrong, and there are whole gaps 
in the proposals, including Fannie and Freddie, where a lot of 
what went wrong is not addressed, is not being changed in any 
way, including the perverse incentive Senator Gregg was talking 
about.
    So I hope as the Committee works hopefully in a bipartisan 
way on this, we sort of use as a starting point what the real 
problems were that developed over the last several years.
    Mr. DeMarco. Senator, if I may, just a couple of things 
from the standpoint of my agency.
    First we are working on developing and implementing the 
authorities that were given to our agency last year in HERA, so 
that is a step along the way. And I would just like to offer to 
you, as I have offered to all the Members of the Committee, we 
would be glad to continue to meet with you all individually and 
collectively to have discussions along this way, as we are 
working and having discussions with the Administration.
    I mean, I do know the Administration cares deeply about 
wanting to tackle this and are working on that, and we are 
having discussions with them as well along the lines of the 
things that I presented in my testimony this morning. But I 
think at least we all can enter this sharing a sense that this 
is a challenging but important issue for the country and we all 
want to see it done right. And we are prepared to work with 
you, Senator.
    Senator Vitter. Great. Well, I thought the Administration 
was virtually always for comprehensive reform. I guess that 
breaks down when it comes to Fannie and Freddie in terms of 
doing it together with these other pieces.
    A final quick line of--one question. The CBO estimates that 
the conservatorship will cost taxpayers $389 billion. Would you 
roughly agree with that figure as of now?
    Mr. DeMarco. Senator, I cannot comment on that. It was 
actually just this morning that someone on my staff alerted me 
that CBO had come up with some new numbers, and I have not had 
any opportunity to look at them or assess what that is supposed 
to reflect.
    Senator Vitter. Whatever those numbers are, they clearly 
are going to be very significant. What is the taxpayer exit 
strategy from that type of liability?
    Mr. DeMarco. Well, Senator, I think that is what we are 
working on and what we are talking about right now. The 
immediate strategy is to bring as much liquidity and stability 
to the mortgage market today as we can, to try to prevent as 
many avoidable foreclosures as we can, because those 
foreclosures are only going to add to the tab. And so I think 
that is where our immediate efforts are, to bring liquidity 
back to the market and to try to stem this rising tide of 
foreclosures so that we can keep individual homeowners 
committed to their home, in their house, stabilize 
neighborhoods, and start to see a curtailment in the credit 
losses that are widespread in our housing finance system right 
now. So that is where the immediate focus is.
    Senator Vitter. But beyond that, shouldn't there be a 
strategy for exiting out of that type of liability for the 
taxpayer in the future?
    Mr. DeMarco. Yes, Senator, there should, and I think that 
is very much what we are talking about when we are talking 
about the future of the housing finance system and the post-
conservatorship framework for Fannie and Freddie. How do we 
exit and how do we then create a structure that is more robust 
so that we do not end up in this kind of a situation again. I 
would agree entirely. And that is what I hope my agency has 
been able to contribute in some way to that this morning, and 
we very much look forward to continuing the dialogue so that we 
can achieve just that, Senator.
    Senator Vitter. Great. Thank you.
    Senator Johnson. Thank you, Mr. DeMarco, for your public 
service. I appreciate your thoughtful testimony and welcome 
Members to submit additional questions for the record. You may 
be excused.
    Mr. DeMarco. Thank you very much, Mr. Chairman.
    Senator Johnson. The second panel will take its place.
    [Pause.]
    Senator Johnson. Mr. Shear, will you proceed?

STATEMENT OF WILLIAM B. SHEAR, DIRECTOR, FINANCIAL MARKETS AND 
     COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY OFFICE

    Mr. Shear. Mr. Chairman, Members of the Committee, I am 
pleased to be here this morning to discuss the results of our 
recently issued report on options for restructuring Fannie Mae 
and Freddie Mac. This report provides information on the roles, 
benefits, and risks associated with the enterprises' activities 
over time. Our intent is to help inform forthcoming 
deliberation on their future structures.
    Here I will discuss our first three objectives: first, to 
summarize the enterprises' performance in achieving key housing 
mission objectives; second, to identify various options for 
revising the enterprises' long-term structures; and, third, to 
analyze these options in terms of their potential capacity to 
achieve key housing mission and safety and soundness 
objectives.
    With respect to key housing mission objectives to support 
the secondary mortgage market, the enterprises' contributions 
include the establishment of standardized underwriting 
practices for conventional mortgages that in turn helped to 
develop a liquid MBS market. However, it is not clear to what 
extent the enterprises have been able to support a stable and 
liquid secondary mortgage market during periods of economic 
stress, nor whether enterprise efforts to facilitate mortgage 
credit opportunities for targeted groups have materially 
benefited such groups.
    Over the years, we have been particularly concerned with 
how the enterprises' structures as for-profit corporations with 
Government sponsorship undermined market discipline and 
provided incentives to engage in potentially profitable but 
risky business practices that did not necessarily support their 
public missions. Given this concern, we have consistently 
called for establishing a single regulator for the housing GSEs 
with all the regulatory oversight and enforcement powers 
necessary to address unsafe and unsound practices, assess the 
extent to which the GSEs' activities benefit home buyers and 
mortgage markets, and otherwise ensure that the GSEs comply 
with their public missions.
    Given the mixed records of the enterprises, researchers and 
others believe a range of options for the enterprises' 
structure could better achieve housing objectives, help ensure 
safe and sound operations, and minimize risks to financial 
stability. Basically, these options generally fall along a 
continuum, with some overlap among key features and include, 
first, establishing a Government corporation or agency; second, 
reconstituting the enterprises as for-profit GSEs in some form; 
and third, privatizing or terminating them.
    Here I would like to draw attention to the section 
beginning on page 9 of my statement, particularly to Table 2 on 
pages 10, 11, and 12, where tradeoffs are summarized.
    Let me highlight one challenge associated with each 
proposed reform option. If a Government corporation or agency 
is adopted, it could face greater challenges than private 
sector entities in obtaining the human and technological 
resources needed to manage complex processes, or it might lack 
the operational flexibility to do so.
    With reconstituted GSEs, the incentive concern I raised 
would be reestablished, which in turn could lead to even 
greater moral hazard and safety and soundness concerns and 
increase systemic risk. While we recognize that FHFA is in a 
better position to effectively regulate the enterprises than 
its predecessors were, its role in this function has not been 
tested.
    And with respect to privatization, privatization could lead 
to a situation where the resulting mortgage finance entities 
are considered too big to fail.
    Finally, regardless of any enterprise structural reforms 
that are adopted, we urge Congress to continue to actively 
monitor the progress of such implementation and to be prepared 
to make legislative adjustments to ensure that any changes are 
as effective as possible. And we stand ready to assist this 
Committee and the Congress in its oversight capacity and in 
evaluating the progress that is being made in implementing any 
changes.
    It is a pleasure to be here. I would be pleased to answer 
any questions.
    Senator Johnson. Mr. Wallison.

   STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN 
    FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE

    Mr. Wallison. Thank you, Senator. Fannie and Freddie are 
now central to the housing finance system in the United States. 
This is especially true since the advent of the financial 
crisis. Because of the collapse of the securitization market, 
other sources of financing--jumbo loans, available through 
banks or private label securitization--are very expensive, and 
that is holding down recovery in markets that Fannie and 
Freddie cannot access.
    For this reason, any reforms that make private credit 
sources more expensive will create pressure for Fannie and 
Freddie, as GSEs--or as Government agencies, if that is what 
ultimately happens to them--to remain in existence and 
eventually to take over the entire housing finance market. I 
believe that the ultimate solution to the housing finance 
question is a private one. However, there is a very difficult 
transition problem here.
    Realistically, for a long while, Fannie and Freddie will 
continue to exist, and any comprehensive financial reform 
adopted now must take into account how a private housing 
finance system will be able to develop as long as Fannie and 
Freddie continue to operate.
    As GAO suggests, there are really only three likely 
outcomes for Fannie and Freddie: nationalization, 
privatization, or a return to GSE status. I discuss these 
issues, the pros and cons--mostly cons, I might say, about 
nationalization and GSE status--in my prepared testimony. 
However, GAO did not consider how current regulatory reform 
proposals will affect how Fannie and Freddie, while they exist, 
will compete with and impede the development of the private 
sector financial system.
    As an example, the Administration has proposed that both 
originating lenders and securitization sponsors retain some 
interest in securitized mortgages. Banks will also be required 
to hold more capital. These proposals may improve mortgage 
underwriting and financial soundness. But they will also 
increase the cost of private credit, especially for securitized 
mortgages.
    As long as Fannie and Freddie exist in the conservatorship, 
they will not be subject to the new capital and securitization 
rules. Accordingly, there will be a very large gap in cost 
between mortgages securitized by these Government agencies and 
mortgages securitized in the private sector.
    The housing market will be seriously bifurcated in this 
case, and pressure will develop for Fannie and Freddie to 
securitize all mortgages, including jumbo mortgages. The same 
thing will certainly be true if Fannie and Freddie are 
ultimately nationalized.
    Similarly, if Fannie and Freddie are allowed to survive as 
GSEs, they will be subject--or they may be subject, or not, to 
new securitization rules and capital requirements. If so, if 
they are subject to those requirements, we will have authorized 
them again to hold a portfolio of interests in mortgages, this 
time the retained interests in securitizations. And that in 
turn will require them to borrow more with the Government's 
backing and to hold substantial capital in order to protect the 
taxpayers against losses.
    If they will not be subject to the new securitization rules 
and capital requirements--and that will be true as long as they 
are in the conservatorship--the bifurcation of markets problem 
will arise again, and again there will be pressure to let them 
securitize mortgages of any size. If this happens, they will 
likely assume the credit risk of virtually the entire mortgage 
system.
    Then there is the question of whether the GSEs or a 
Government agency will have an affordable housing mission. 
Their former regulator noted that, in retrospect, their 
affordable housing goals caused them to do things they should 
not have done. When Fannie and Freddie were taken over, they 
held or had guaranteed $1.6 trillion of subprime and Alt-A 
mortgages, about 85 percent of which met the goals set by HUD. 
These loans are now defaulting at unprecedented rates and will 
probably cost the taxpayers somewhere between $200 and $400 
billion.
    There is little doubt that Fannie and Freddie bought and 
guaranteed these mortgages and mortgage-backed securities 
because of HUD's affordable housing regulations and because of 
demands that, as GSEs, they had to ``lead the market'' in 
increasing home ownership. These weak loans were a major part 
of the housing bubble, the mortgage meltdown, and ultimately 
the financial crisis.
    The problems associated with nationalization or renewed GSE 
status suggest to me that the best long-term solution is 
privatization. This means that if the securitization system is 
improved and investor confidence returns to the securitization 
market, Fannie and Freddie should be privatized. I do not 
believe that a Government-backed structure and a private system 
can coexist. The Government system, as Fannie and Freddie have 
shown, will always drive out private competitors because of its 
financing advantages. Accordingly, if the Committee wants to 
retain any role for private sector financing in the housing 
system, it will have to consider the future of Fannie Mae and 
Freddie Mac and how they will eventually be privatized.
    Thank you.
    Senator Johnson. Thank you.
    Dr. Wachter.

 STATEMENT OF SUSAN M. WACHTER, RICHARD B. WORLEY PROFESSOR OF 
FINANCIAL MANAGEMENT, WHARTON SCHOOL OF BUSINESS, UNIVERSITY OF 
                          PENNSYLVANIA

    Ms. Wachter. Thank you, Mr. Chairman and Members of the 
Committee. I appreciate the invitation to testify at today's 
hearing on the ``Future of the Mortgage Market and the Housing 
Enterprises.'' It is my honor to be here.
    Historically, home ownership for Americans has served as 
bedrock of social prosperity. As we consider the future of the 
mortgage market, we need to step back and understand the 
sources of the global financial debacle. This is essential as 
we evaluate the broad options before us of nationalization, 
privatization, and a public/private system.
    While Federal support of the mortgage system is now 
necessary, nationalization I do not believe is a long-run 
solution as it ultimately expands taxpayer exposure, while 
privatization without a stabilizing public role also leads to 
the inevitable socialization of risk, as this crisis has 
demonstrated.
    This crisis resulted from the explosion of risky mortgages, 
made in the USA, the result of a lethal race to the bottom for 
short-term profits, enabled by regulatory failure. This 
explosion can be traced to the issuance of private label 
securities. These private label securities were neither 
standardized nor transparent; they were not traded, and, 
therefore, they were not subject or accountable to private 
sector forces of market discipline. The common-sense-defying 
loans they funded, including interest only, negative 
amortization, zero equity, and teaser rate ARMs, were not 
designed to be affordable when full rates came into effect; and 
these loans drove housing markets to an episode of irrational 
exuberance of historic proportions that have brought down the 
entire financial system.
    As these loans were pushed into the market, overall 
household debt to GDP rose, with the increase coming from 
mortgage debt and these risky loans.
    As nonstandard mortgages proliferated, the market share of 
traditional mortgages declined. From 2000 to their peak in 
2006, nontraditional mortgages grew in origination market share 
from 10 percent in 2000 to almost 50 percent at their height in 
2006. In particular, the housing enterprises' share of the 
market dropped, as did the market share of the long-term 
standard fully amortized fixed-rate mortgage that they fund, 
which I note protects borrowers against interest rate risk, a 
risk which is likely to be rising.
    The fundamental problem in the proliferation of these 
nonstandard loans was the lack of accountability to the long-
run risks they generated. Due to the illiquidity of markets, 
private label mortgage-backed securities did not trade. Because 
they did not trade, this meant that market discipline could not 
prevail. They continued to be supplied, eroding mortgage 
lending standards and artificially pushing up housing prices.
    Before private label securities, securitization did work 
well, supporting sustainable home ownership. Historically, the 
GSEs were regulated to support sound underwriting. Contrary to 
popular misconception, they were not allowed to securitize 
subprime or Alt-A mortgages. After they started losing market 
share to private label securities, however, shareholder and 
other pressures led them to purchase private label securities 
backed by nonstandard mortgages for their portfolio. To be 
clear, they did not create the risky mortgage-backed securities 
that caused the crisis, but they did become a burden to the 
taxpayer because they were allowed to purchase them for their 
portfolio after private institutions had manufactured them. My 
fellow panel member Peter Wallison elsewhere has documented how 
several GSE observers suggested Congress put limits on the 
portfolios, but to no avail.
    To ensure the safety and long-term sustainability of a 
reenvisioned mortgage finance system, we should pursue policies 
that embody three principles.
    First, policies and procedures are needed to identify and 
prevent out-of-control housing asset bubbles and systemic risk. 
Loan-to-value ratios, in particular, must be maintained over 
time.
    Second, borrowers must have effective, informed choice: 
safe mortgages should be the presumed mortgage vehicle for 
borrowing. The standard mortgage must be a safe mortgage, and 
mortgage regulation should favor safe products. Consumer choice 
is inconsistent with heterogeneous nonstandard options that 
cannot be compared by the consumer.
    Third, we need a structure that promotes and provides safe 
and standard mortgages through liquidity and standardization. 
Effective borrower choice is impacted by the structure of the 
system. Standard mortgages should be the cost-efficient 
mortgage. Liquidity in funding sources can assure this.
    Securitization should be the way to bring liquidity and 
cost efficiency to bear on the provision of safe, transparent, 
and standard 30-year fixed-rate mortgages which banks cannot 
fund. This can assure effective choice and support for a 
mortgage system that once again becomes the bulwark of 
sustainable home ownership in the U.S.
    Thank you for the opportunity to be here today, and I will 
be pleased to answer questions.
    Senator Johnson. Thank you.
    Mr. Jakabovics.

STATEMENT OF ANDREW JAKABOVICS, ASSOCIATE DIRECTOR FOR HOUSING 
    AND ECONOMICS, CENTER FOR AMERICAN PROGRESS ACTION FUND

    Mr. Jakabovics. Thank you, Mr. Chairman and other Members 
of the Committee, for giving me the opportunity to share a 
series of principles that describes the essential functions of 
the housing finance system that it must serve, and several of 
which were touched upon by Chairman Dodd in his opening 
remarks.
    I also want to take this opportunity to touch upon 
important lessons to be learned from the subprime crisis in an 
effort to prevent us from drawing the wrong lessons from it. In 
short, the systemic failures we have seen stemmed from the 
proliferation of poorly underwritten mortgages channeled 
through the so-called ``shadow banking system'' of unregulated 
private label securities.
    Any discussion of the housing finance system's future 
should start from a clear sense of what we expect the system as 
a whole to accomplish. But if the Committee restricts its 
analysis of the past and prescriptions for the future simply to 
the GSEs, it will miss the most significant points of origin of 
the current crisis, leading possibly to a system that is 
inadequate to support the essential role of housing finance in 
our economy. The real question for the Committee's 
consideration should be what the goals of the system are and 
what combination of public, private, and hybrid arrangements, 
if any, will deliver those objectives.
    I want to note that the core principles that I will lay out 
are the result of collaborative efforts and discussions of a 
group of experts and stakeholders in mortgage finance convened 
by the Center for American Progress that have been meeting for 
more than a year, which we call our ``Mortgage Finance Working 
Group.'' And while we have benefited tremendously from those 
members' insights and expertise, my remarks this morning should 
not be construed as their personal or institutional endorsement 
of my testimony, and any errors, of course, are my own.
    I point you to my written testimony where I go into the 
principles in greater detail, but the key principles to 
consider are access to credit and liquidity, 
countercyclicality, risk management and oversight, 
standardization, transparency, and accountability, systemic 
stability, and consumer protection.
    The first concern of policymakers in contemplating any 
redesign in the U.S. mortgage finance system must be ensuring 
sufficient credit liquidity at all times to meet the Nation's 
housing needs. In thinking about liquidity, two important 
aspects must be considered: first, the need for consistent 
credit liquidity through booms and busts; and, second, the need 
for broad availability of credit across places and housing 
types, including multifamily housing, which is not easily 
securitized or underwritten as single-family mortgages are, and 
in which the GSEs have played a critical role, particularly in 
times of stress.
    Reform efforts must consider the importance of ensuring 
sufficient credit liquidity during down times and who might 
provide that liquidity. Private mortgage securitization 
certainly played a procyclical role during the bubble years, 
but institutions with the capacity and responsibility for 
countercyclical activity are a requirement for a well-
functioning system. This countercyclical role is one that will 
require some measure of Government backing as the private 
sector has proven itself unable or unwilling to independently 
provide sufficient and necessary capital during periods of 
retrenchment.
    Consumers, including in underserved communities, must 
continue to be able to receive access to credit on terms that 
reflect their actual not perceived credit risk and not on 
predatory terms. We should be careful to ensure that tightened 
underwriting standards are based on criteria empirically tied 
to credit risk while remaining sensitive to the true costs of 
providing that credit.
    Level playing fields are necessary, particularly when it 
comes to affordable credit provision. Safe, affordable, and 
well-underwritten loans must compete against unregulated exotic 
mortgage products priced without regard to underlying asset 
value or risk marketed by brokers with misaligned incentives, 
and the results have been disastrous, both for homeowners and 
the larger economy. Parallel systems must not again emerge that 
put soundly underwritten loans in competition with unregulated 
and nontransparent products.
    Susan Wachter has already mentioned the importance of 
consumer protection in a well-designed system and 
standardization closely linked to it, so I refer you to my 
written testimony for those points.
    But exotic products should have a higher not lower 
obligation for transparency and consumer protection, both at 
the point of origination as well as securitization.
    Finally, there are principles of risk management and 
systemic stability to consider. It is clear that the 
unregulated private securitization markets caused this crisis 
through poor underwriting and misaligned incentives that 
ultimately because toxic MBS whose losses infected seemingly 
invincible institutions. And so we believe that any efforts to 
reform the housing finance system that focus exclusively on the 
GSEs or maintain unregulated private securitization markets are 
destined for failure. We must ensure a level playing field.
    All modern banking systems have a prudential oversight 
regime, but when regulators fail to use their authorities or 
loopholes are created that allow certain products and market 
participants to avoid oversight, the stability of the entire 
system is threatened. The problem of regulators being 
philosophically opposed to regulation was an even more critical 
failing in light of the problem of misaligned incentives 
throughout the system. Put simply, virtually none of the 
participants in the private mortgage securitization process had 
the incentive to originate and sell loans that were viable over 
the long term.
    The unregulated private MBS market, free from any direct 
safety and soundness supervisory oversight, was held as a 
paradigm for efficient markets, with the result that the 
regulatory playing field was tilted to the advantage of private 
securitization, with the lack of regulation allowing the shadow 
banking system to enjoy cost advantages over other sources of 
housing finance, allowing it to dominate the marketplace and 
bring it to the point of collapse.
    A reformed system must ensure that all market participants 
play by the same rules. My written testimony offers a 
suggestion for how this may be accomplished, but the key take-
away from this hearing should be the principles I laid out as a 
metric for evaluating any proposals.
    I urge the Committee to ask of any proposal coming forth: 
Will institutions of any size in any market have access to 
capital and liquidity in all markets at all times? How well 
will it do in ensuring a steady supply of 30-year fixed-rate 
mortgages, in ensuring a steady supply of financing for 
affordable housing, specifically multifamily? Will it support 
and speed innovation, encourage transparency? Will all 
communities, especially those devastated by this particular 
crisis, have access to credit on fair and nondiscriminatory 
terms? And, finally, how can we transition to a new system 
without disruption?
    I thank you for your time and look forward to taking your 
questions.
    Senator Johnson. Thank you. Mr. Shear, how would each 
option that you suggest affect borrowing costs? Could there be 
a geographical disparity in unavailability or cost under any of 
these proposals?
    Mr. Shear. You raise a very good question, because 
historically when the GSEs were established, we had large 
regional disparities in mortgage rates because of the nature of 
unit banking and other aspects of our financial services 
industry.
    The GSE structure addressed that, and now we have more of a 
financial system where you have very large, diverse, nationwide 
types of financial service firms. So the return with either 
privatization or a Government corporation or with reconstituted 
GSEs, a return to regional disparities in interest rates that 
are not related to risk, we think would be unlikely to occur.
    In terms of just affordability, part of the question--I 
will pose it in terms of just going back even a decade ago when 
we were addressing the privatization question. Government 
support for Fannie Mae and Freddie Mac did cause mortgage 
interest rates to be slightly lower on conforming conventional 
mortgages than other mortgages, such as jumbo mortgages. But 
what we pointed out, there were benefits to borrowers and there 
were risks to other entities, including the Federal taxpayer.
    We still have that dichotomy today. Part of the question 
for this Committee and the Congress is what you want to 
achieve, how much risk you are willing to take to achieve a 
certain outcome.
    So I think that answer is consistent with what we were 
saying a decade ago.
    Senator Johnson. Thank you.
    Mr. Jakabovics, in the Chicago Sun Times article this 
summer, you noted that at the end of last year, half of all 
seriously delinquent mortgages were improperly issued mortgage-
backed securities, despite being only 15 percent of the 
outstanding mortgages. By way of comparison, Fannie Mae and 
Freddie Mac had a combined 56-percent market share, but only 20 
percent of the delinquencies.
    Are there tools at the Administration's disposal to address 
this disparity in refinanced or modified mortgages held in 
private label securities?
    Mr. Jakabovics. I think that there are two aspects to that, 
and one is focusing, I think, on the efforts that this 
Committee in particular led to establish the Hope for 
Homeowners program and other modification efforts, where 
working with the owners of--or the servicers of mortgages both 
controlled by Fannie Mae and Freddie Mac as well as those 
serviced on behalf of private entities, an effort to bring 
those mortgages more in line with payment standards that the 
existing borrowers can make or to refinance borrowers out of 
loans that are unsustainable or underwater into a mortgage--
refinance into a mortgage that is, in fact, sustainable because 
they are originated based on the current value of the property. 
A lot of the problems that we have seen have been a function of 
the fact that house price declines have been severe, and so 
borrowers who may otherwise be creditworthy lack the ability to 
refinance into safer loan products.
    Senator Johnson. Dr. Wachter, would the market be able to 
maintain the 30-year fixed-rate mortgage without the 
enterprises?
    Ms. Wachter. There are very few countries in the world that 
have access to 30-year fixed-rate mortgages without prepayment 
penalties. The only other two that have systems that do provide 
it, Germany and Denmark, have a securitization system which is 
heavily regulated by their governments. And, in fact, only 
Denmark has a system where you have a prepayable mortgage, and 
their system has regulations over time which maintain 
underwriting and which maintain standardization of the mortgage 
system.
    So much of the world has a banking system supported 
adjustable--and they support adjustable-rate mortgages. Our 
trading partners--U.K., Australia--all have adjustable-rate 
mortgages. And while adjustable-rate mortgages are, in fact, 
useful mortgages for some people, they do expose borrowers to 
interest rate risk and, indeed, the entire economy to interest 
rate risk, which I am at this moment very concerned about going 
forward.
    So your question is: Can you have a 30-year fixed-rate 
mortgage without GSEs? GSEs are a particular securitization 
entity which achieves standardization. In that respect, I 
believe the answer is if the entities that replace GSEs or 
carry on the mission of GSEs are similar to the GSEs in 
offering standardized mortgage-backed securities as well as 
standardized 30-year fixed-rate mortgages, the answer is yes.
    If indeed we have securitization which requires banks to 
keep securities on their portfolios, that is a risk to the 
banks, to the banking payment mechanism, and to the stability 
of the overall economy, and that I do not believe is consistent 
with the long-term provision of the 30-year fixed-rate 
mortgage.
    Senator Johnson. Thank you.
    Mr. Wallison, you have been a strong supporter of 
privatizing the enterprises. Could you discuss the transparency 
available to investors in the private label MBS?
    Mr. Wallison. Yes, Senator. In a private label structure, 
the investors should get quite a lot of information if they ask 
for it. There is no reason why the transparency of a private 
label system should not be as complete as the transparency that 
occurs in any securities market--particularly in our securities 
markets--as overseen by the SEC. So I do not see any 
inconsistency between a private label system in terms of its 
transparency and a system that uses a Government structure for 
doing securitizations. The difference turns out to be that in 
the Government system, I believe, whether it is through a 
nationalized structure or a GSE-type structure, a lot of risk 
will be taken by the Government, which, as we have seen through 
Fannie Mae and Freddie Mac, ultimately comes back to the 
taxpayers.
    So to have a realistic kind of system, one that is 
practical and one that is not ultimately causing losses to the 
taxpayers, I think we must go with a private system of some 
kind. Securitization might not be the only system we might 
have, but it should be a private system.
    Senator Johnson. Thank you. I have been handed a note. The 
leadership has called a 12:15 vote. Keep that in mind.
    Senator Bunning.
    Senator Bunning. Thank you, Chairman.
    Mr. Wallison, you have made a very clear point on the GSEs, 
and you have outlined three different alternatives. How do we 
get the GSEs out of business? How? I mean, we are in to them, 
according to the prior panel, about $97 billion. At least that 
is the preferred stock that we own. Now, how do we get them out 
and get into a private sector situation?
    Mr. Wallison. Well, there are really two questions, I 
think, in what you have asked. One is what we do with the GSEs 
in terms of the losses they already have embedded in their 
portfolios or in their----
    Senator Bunning. Do we have to eat them?
    Mr. Wallison. Oh, yes, the taxpayers are going to have to 
eat those losses, and it is just a question of whether we use a 
good bank/bad bank kind of structure--move all those things 
over to a bad bank--and then have the Treasury pay off the 
creditors who would be holding the bag there. But it is clear 
that the U.S. Government has always been willing to and had to 
stand behind the GSEs, and so the taxpayers are going to have 
to take losses.
    This is very regrettable. Many people tried to change this, 
but it never happened.
    On the----
    Senator Bunning. I just want you to realize that we are at 
$12 trillion and counting.
    Mr. Wallison. Yes, understood.
    Senator Bunning. $12 trillion and counting. Now we are 
going to be asked to increase the debt ceiling very shortly. 
There comes a time when my 40 grandkids are going to get tired 
of paying for our excesses. Even though it is a laudable goal 
that everybody own a house, certain people just cannot afford 
to own a house.
    Mr. Wallison. Yes, and, Senator, that is another problem 
with a Government-run system. It is subject to political 
manipulation. That is one of the reasons why we had affordable 
housing requirements and other requirements which have caused 
the tremendous losses that Fannie and Freddie will be 
suffering.
    Senator Bunning. There is no question that the Congress 
pushed Freddie and Fannie to make these loans.
    Mr. Wallison. No question in my mind.
    Senator Bunning. I mean, it was clear.
    Mr. Wallison. It was actually through the Department of 
Housing and Urban Development, which had affordable housing 
guidelines. Those began in the mid-1990s and were gradually 
ratcheted up over time so that by 2005--and we are talking 
about two Administrations here, the Clinton administration and 
the Bush administration--the affordable housing requirements 
required that 55 percent of loans the GSEs bought had to be 
affordable housing loans. Within the 55 percent, had to be to 
low-income people, not just people who were at or below median 
income.
    So it became very difficult for Fannie and Freddie to find 
those loans unless they gave up on downpayments and they gave 
up on blemished credit and they reduced their underwriting 
standards, which they did. Now----
    Ms. Wachter. Senator, when you are complete--I do not want 
to interrupt, but when you complete, this is not the problem. 
This was not the cause of our crisis.
    Mr. Wallison. If I can----
    Ms. Wachter. I apologize.
    Mr. Wallison. But let me just finish my point, because 
there was a second part of your question, and that is, what do 
we do now with Fannie and Freddie? How do we turn them into 
privatized entities?
    Senator Bunning. How do we get out?
    Mr. Wallison. I do think there is a relatively simple way 
to do that, and that is to gradually lower the conforming loan 
limit over time. Once the securitized market returns and 
investors are confident again about what a AAA security might 
mean, then it is possible to reduce the conforming loan limit. 
And as you do that, the private sector will move into that 
market and begin to take up more and more of it. And, finally, 
the GSEs will be reduced to zero, and the private market will 
take it over.
    So I think that is a simple way to accomplish 
privatization.
    Senator Bunning. Dr. Susan, you brought up the Danish 
system. Can that ever work in the United States? I mean, I did 
not know that a lot of people knew about that, but my staff 
did.
    Ms. Wachter. Yes, I do believe a version of the Denmark 
system could work in the United States. I think we have some 
misunderstandings of the Denmark system. Actually, the Danish 
system is very much supported by regulation, with standards 
that are maintained over time.
    Senator Bunning. Absolutely.
    Ms. Wachter. And with securitization that does not allow 
nonstandard private label mortgage-backed securities to----
    Senator Bunning. But it also allows you to go and preclude 
and buy--if the bond goes down, you can go into the market and 
buy at a discount and reduce your rate.
    Ms. Wachter. Senator, you are absolutely right. What is 
required in the Danish system is prepayment options and 
prepayment optionality on both sides of the deal. So unlike our 
private label securitization, which were not subject to 
requiring prepayment options, the Danish systems require 
prepayment options and optionality on both sides.
    Senator Bunning. But let me just bring up the fact that in 
1994 we gave the Federal Reserve the responsibility to regulate 
all mortgages, both by banks and by mortgage brokers. And it 
was 14 years before they wrote a regulation. Now, I mean, it 
was the second year of Ben Bernanke's tenure as Chairman of the 
Federal Reserve.
    Now, you stated from 2000 to 2006 all these different types 
of sophisticated mortgages came in, and there were no 
regulations against them. My question is: Should there have 
been? Should there have been regulations to prevent these 
sophisticated interest-only type things and putting people into 
houses that they should not be put in?
    Ms. Wachter. Absolutely, Senator. Absolutely, the answer is 
yes. Ned Gramlich pushed for this. It did not happen. But it is 
a difficulty. There is actually a significant difficult that I 
think we all must face, which is the following: Do we preclude 
anybody from ever using one of these niche products? Or do we 
allow them to be niche products? And I do think that is the 
difficulty we must face, that the standard mortgage should be a 
safe mortgage. For sophisticated borrowers with special needs, 
we can do something differently.
    So how do we get there? We can get there by having a 
playing field that is supportive of the standard mortgage, a 
playing field where the standard mortgage is funded liquidly so 
that the standard mortgage is the cost-efficient mortgage. And 
that comes through standardization.
    My concern about the private sector is that private sector 
entities do not automatically standardize the products they 
offer. Quite to the contrary. Private sector entities will want 
to differentiate their product not only from their competitors, 
but even within their own entities. So we will get----
    Senator Bunning. Well, but if they are going to bust the 
bank, if they are going to blow the housing and the market 
right out of sight, then we as regulators or as policymakers 
have got to prevent that.
    Ms. Wachter. Absolutely, but the way to prevent it cannot 
simply be to preclude these mortgages altogether, I believe, in 
the United States because, in fact, they are--some will want 
them, and appropriately so. Therefore, there needs to be as a 
cost advantage standardization for what we regard as the safe 
mortgage, which fortunately for the U.S. historically has been 
the 30-year fixed-rate mortgage.
    Senator Bunning. Thank you very much. My time has expired.
    Senator Johnson. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank each 
of you for your testimony. I wish there were more people here 
to hear it. I think it was all very good.
    To GAO, Mr. Shear, I want to say especially the analysis 
you gave was very good, and I guess at the end of the day, 
regardless of where the costs are, there is a cost associated 
with loaning money out to people. And so, you know, one of the 
things that is fascinating about all this is that aside from 
the fact that an entity, maybe a Government entity, can have a 
tax advantage, there are still going to be costs. And so if you 
take risk, somebody at some point is going to bear the cost of 
that risk. And so the question I guess one would have to start 
with--or the assumption is that that is a fact. And, second, is 
there a reason for us in this country to assume risk at the 
Government level as it relates to residential mortgages?
    Mr. Shear. First, thank you for the compliment for the work 
that we do. We have some great people at GAO.
    In terms of the question you ask, it is a great question 
because it is a question of what the priorities are of this 
Committee, of the Congress, and as a Nation of what we think is 
the appropriate Federal role to achieve certain mission 
requirements. We, meaning those of us from GAO, are not here to 
make those value judgments. But I think referring to our work 
and when we discuss these different options and the continuum 
of them, what we are trying to point out is: What are some of 
the safety and soundness concerns? What are some of the 
concerns in terms of reaching out?
    And when you look at this as a whole, some of the issues 
that have come up at this hearing, such as regulatory arbitrage 
or when you have capital requirements that are lower for some 
pipelines compared with others, there will be a tendency for 
risk to move to where it is in a sense taxed or where the 
regulatory requirements are the least. And this is, I think, 
part of the challenge of what we are dealing with here.
    So one of the things that I would hope would come out our 
work is that we have to be careful of what we ask for, because 
none of this comes free.
    Senator Corker. And I think that is a point that, as we 
move through this reg reform process, we need to understand 
that somebody at the end of the day is going to pay for the 
cost. And if the risk is high, the cost is probably going to be 
absorbed down the road by someone else.
    Dr. Wachter, I would assume, based on your comments--and I 
thought they were very good--that you would also agree that if 
we are going to deal with regulatory reform, certainly we need 
to deal with the issues we have talked about in this panel 
meeting and to leave out--as you mentioned, I mean, the GSEs in 
many ways moved toward things--under two Administrations, I 
might add, and I think a lot of folks on the other side of the 
aisle are defensive sometimes about the GSEs. But, in fact, the 
Bush administration pushed the GSEs to purchase subprime 
mortgages to meet quota requirements. They did. And as you 
mentioned, that was not necessarily the problem because it was 
originating of those loans that I think you are alluding to as 
being the problem in the first place, creating loans that 
really did not meet appropriately the needs of the people they 
were being loaned to.
    But I guess you would agree that if we are going to do 
regulatory reform, this area that we are talking about today 
needs to be a big part of that.
    Ms. Wachter. My understanding is that that is just what 
these discussions are about, and I am very pleased to have been 
invited to be part of them. I do think we have to build the 
understanding of the deeply interrelated parts of the systems 
as we move forward. There is no way that we are going to be 
able to move to a new system in the short run. We are reliant 
now on Federal support for the system, and I believe we will be 
for some time to come, which is unfortunate. But, on the other 
hand, there is time to do this right, and we must do it right.
    Senator Corker. There is time to do it right, but it is all 
very related to each other, isn't it? I mean, it would be 
difficult to do regulation to try to deal with the systemic 
risk we just had and not deal with this area simultaneously. 
Would you not agree? Because it is so synchronized.
    Ms. Wachter. Well, I personally do believe that there are 
components that are commonsensical and obvious that we can 
begin to put into place as we deal with the entire system, yes.
    Senator Corker. Since Mr. Wallison and I tend to agree so 
much, I am not going to ask him many questions. I am just going 
to get him to come back to our office as we work this through. 
But is there a reason that we should have loans to home buyers 
that are nonrecourse? Dr. Wachter? I came up here just a fairly 
sophisticated--fairly sophisticated--business person and 
borrowed lots of money on a recourse basis and nonrecourse. 
Every home mortgage I have ever had, I guess because, you know, 
was recourse, and I actually was stunned to realize that there 
are so many mortgages in this country that are nonrecourse--
almost all now. And I do not know what the Danish system is 
like, but should we have loans in the first place that are 
nonrecourse to residential buyers?
    Ms. Wachter. An important question, Senator, and, by the 
way, thank you so much for your kind comments about my 
testimony.
    The recourse, it is true that in Denmark those loans are 
recourse loans. In the United States, this is a State-by-State 
determination. Many States have recourse. Many States do not.
    The difficulty is that even with recourse loans, it is 
difficult in actuality to get recourse. You would then have to 
go through bankruptcy, so it is a complicated situation. Legal 
recourse and actually effective recourse are two separate 
issues.
    Senator Corker. But along with recourse, it does make some 
degree of difference when the borrower asks for the loan, does 
it not? I mean, there is just a different sense of obligation 
when it is a recourse loan.
    Mr. Jakabovics. If I may actually touch upon that, in 
California, for example, there is recourse, but you only have 
access to the recourse if you go through judicial foreclosure. 
Most servicers in California do not avail themselves of 
judicial foreclosure because they find they would rather simply 
get the property in whatever condition they can faster, and 
then get themselves out of the loan. And so while they have the 
opportunity for recourse, in almost all instances they do not 
choose to pursue it.
    So I think that sort of focusing specifically on whether a 
particular loan might be recourse or nonrecourse, again, 
setting aside the fact that there is, in fact, great variation 
in State laws, lenders and servicers seem not to have availed 
themselves of recourse because, in fact, at the end of the day 
when most borrowers find themselves in default and there is 
insufficient amount of value in the property itself, the 
borrower is usually not in the position to make up the 
difference as well. And so the availability of recourse at the 
end of the day has little material impact.
    Senator Corker. Let me get back to the cost issue, and by 
the way, if anybody needs to leave, I promise you I will not do 
anything mischievous if you need to go.
    Senator Johnson. One more question.
    Senator Corker. OK. Since there is a cost with everything--
I mean, you cannot create a fixed-rate loan and there not be a 
cost associated with that. There is a cost.
    So back to Dr. Wachter. Should there not be--why isn't 
there a prepayment penalty? If somebody is going to give you a 
fixed-rate loan for 30 years and you pay it off in advance of 
30 years, there is a loss that that organization has in making 
that loan and tying those funds up. Why isn't there a 
prepayment penalty? I think that is a perfectly ridiculous 
notion that there is not prepayment penalties associated with 
paying a loan off early. Why would that be a good public policy 
because it artificially lowers rates?
    Ms. Wachter. You are absolutely right that one could do 
this. One can have all sorts of options, and they could be 
priced. The problem is what is a standard option that is pro-
home-ownership and pro-building of wealth for families. The 
prepayment penalty, while for some people is, in fact, a good 
option, for many households who wish to--or need to move, let 
us say, because they need to get a job in another part of the 
country, they have lost a job, if they had to pay a prepayment 
option, might find that their loan-to-value ratio in their home 
was such that there would not be enough funds to do so. Their 
only alternative would be to default.
    So, in fact, this is a complicated decision whether from a 
borrower's perspective it is optimal to have a prepayment 
option or not. And for those who are sophisticated, this is a 
good choice, and I do not think that we should preclude them 
from the marketplace. However, we should have a standard 
mortgage with standard features that borrowers understand.
    Senator Corker. Mr. Chairman, thank you for the additional 
time and certainly all of you for your testimony. My sense is 
that there is a way to create some of the standardization that 
has been discussed but do so on the private sector side. And I 
guess I asked the question, and I will ask it continually 
through. I do not know why we artificially do things to 
stimulate the housing industry. I know the Chairman mentioned 
early on wealth creation. You mentioned it again. I think the 
things we have done artificially to stimulate the housing 
market have lowered household wealth in our country over the 
last year hugely. And my sense is that if we had not 
artificially done that, our country as a whole would be in a 
much--the world would be in a much more stable situation.
    So thank you, Mr. Chairman.
    Senator Johnson. I thank the witnesses for your testimony, 
and this hearing is adjourned.
    [Whereupon, at 12:16 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
           PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
    Good morning. Today, we meet to discuss the Government-Sponsored 
Enterprises--Fannie Mae and Freddie Mac--and the role they will play as 
we seek to restore normalcy to the mortgage market.
    But let's not forget what we're really talking about.
    We're talking about whether responsible homeowners will have the 
access to the home loans they need to realize their American dreams.
    Last year, when the mortgage market collapsed, the Director of the 
Federal Housing Finance Authority put Fannie Mae and Freddie Mac into 
conservatorship.
    At the same time, Secretary Paulson exercised the authority he was 
given by last year's bipartisan Housing and Economic Recovery Act to 
provide back-up funding for the two companies, ensuring that they could 
continue financing mortgages during the housing crisis.
    Today, we consider where we need to go from here.
    Now is the time to look forward. But with so much damage done by 
this financial crisis, the role of the GSEs in that crisis is still 
hotly debated.
    Let me just say: Fannie and Freddie were neither the villains that 
caused the crisis, as some claim, nor the victims of that crisis, as 
others would make them out to be.
    They didn't create the subprime and exotic loan market--but they 
did chase it to generate profits.
    And, like many of the supposedly private financial institutions 
that ended up becoming equivalent to GSEs, Fannie and Freddie enriched 
their shareholders and management, while the public took the losses.
    We can't let that happen again.
    As we look forward, we must start by setting benchmarks to 
determine whether the mortgage market is healthy, so that American 
families can once again begin to build wealth--not the kind of wealth 
that buys mansion and yachts, but the kind of wealth that sends kids to 
college and ensures a comfortable retirement.
    First: the mortgage market must remain liquid and stable, 
especially in times of stress. Otherwise, rates are driven up, prices 
are driven down, and American families lose.
    Second: we must encourage product standardization, such as the 
widespread availability of the 30-year, fixed-rate mortgage without 
prepayment penalties. This helps both borrowers and lenders.
    Third: mortgage credit must remain consistently available and 
affordable. Home ownership remains part of the American dream. That 
dream should be accessible to everyone--and sustainable for everyone.
    Today, the market is meeting these tests--but only through massive 
Government intervention.
    The Federal Reserve, for example, has committed to pumping more 
than $1 trillion into the mortgage market. That can't go on 
indefinitely.
    Therefore, it is time to begin the conversation about how we can 
re-create a functional market that stands on its own two feet, and to 
decide what role, if any, the GSEs should play. I want to start that 
conversation by posing a number of questions:
    Can the market function with no Government involvement?
    Should, on the other hand, the Government completely and explicitly 
take over the job previously done by Freddie and Fannie?
    Do we want a model where there is some private capital at risk, but 
only under strict Government control, like a utility?
    These are important questions. The answers are critical to ensuring 
the American dream. And I look forward to considering these questions 
with our distinguished panel today.
    Before turning to Senator Shelby, I want to quickly add that I am 
hopeful that the higher GSE and FHA loan limits, which we first 
established in HERA, will be extended again in the HUD appropriations 
bill currently being negotiated. These higher loan limits are helping 
many borrowers purchase homes or refinance their mortgages. I think we 
need to keep this support in place.
    I'd now like to recognize Senator Shelby.
                                 ______
                                 
            PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
    Thank you Mr. Chairman.
    As we consider the future of the GSEs, we would be wise to remember 
the disastrous consequences that poorly regulated GSEs can have on our 
financial markets.
    Just 1 year ago, Fannie Mae and Freddie Mac were placed into 
conservatorship when they could not cover billions of dollars in 
losses. Despite repeated warnings by me and others about the risks the 
GSEs presented, they were allowed to accumulate more than $5 trillion 
in financial obligations with only minimal amounts of capital.
    The Congressional Budget Office now estimates that resolving the 
GSEs will cost American taxpayers $389 billion. We must ensure that 
this never happens again.
    This hearing, therefore, comes at an opportune time as this 
Committee is considering financial regulatory reform. There is no doubt 
that the failure of Fannie and Freddie was a significant factor in the 
financial crisis because their activities touched nearly every aspect 
of our financial system.
    In addition, their debt is among the most widely held in the world. 
They are also major counterparties to our most prominent financial 
institutions. Accordingly, regulatory reform must involve the GSEs. 
Unfortunately, the Administration made no effort to include the GSEs in 
its financial regulatory reform proposal. Instead, the Administration 
has said that it will not propose how to deal with GSEs until next 
year.
    I believe that this is a grave mistake that will make it more 
difficult to reform our financial system and that will potentially 
expose taxpayers to even greater losses. What we need is a clear plan 
that addresses both the GSEs' ongoing financial difficulties and the 
role the GSEs should play in our economy going forward.
    I fear that the longer we wait, the more it is going to cost the 
American taxpayer.
    Certainly, the question of what to do with the GSEs is difficult 
and complex. Yet, it is a question that we ignore at our peril.
    Thank you, Mr. Chairman.
                                 ______
                                 
                PREPARED STATEMENT OF EDWARD J. DeMARCO
            Acting Director, Federal Housing Finance Agency
                            October 8, 2009
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
thank you for the opportunity to testify on the current condition of, 
and challenges facing, the Nation's housing Government-sponsored 
enterprises (GSEs)--the Federal National Mortgage Association (Fannie 
Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the 
12 Federal Home Loan Banks (FHLBanks).
    The Federal Housing Finance Agency (FHFA) just completed its 14th 
month of existence, Fannie Mae and Freddie Mac (the Enterprises) have 
been in conservatorship for 13 months, and I have just completed my 
first month as FHFA's Acting Director. During its short existence, FHFA 
has been involved in many of the Federal Government's efforts to 
respond to the crisis in the Nation's housing and housing finance 
markets. I will begin this morning by briefly reviewing FHFA's key 
activities and accomplishments. I will then describe the financial, 
managerial, and operational challenges facing the housing GSEs and 
their efforts to respond to those challenges while bringing liquidity, 
stability, and affordability to the housing market. In closing, as 
requested, I will offer some thoughts on the future of the housing 
finance system.
FHFA--A Brief Review
    FHFA came into existence on July 30, 2008, upon enactment of the 
Housing and Economic Recovery Act of 2008 (HERA). To create FHFA, 
Congress combined the Office of Federal Housing Enterprise Oversight 
(OFHEO) and the Federal Housing Finance Board (FHFB), and added certain 
staff from the Department of Housing and Urban Development. FHFA was 
given safety and soundness and mission oversight responsibilities for 
the housing GSEs, including safety and soundness authorities that had 
been lacking at OFHEO.
    In the midst of all the market turmoil of the past year, FHFA has 
devoted long hours to working through the housing crisis and its 
implications for all the housing GSEs we oversee. Among our 
accomplishments:

    We conducted examinations and targeted supervisory reviews 
        at both Enterprises and all 12 FHLBanks to assess their safety 
        and soundness and their support for housing finance and 
        affordable housing.

    We are serving as conservator of the Enterprises--Fannie 
        Mae and Freddie Mac--even as we continue to oversee them as 
        their regulator.

    We have been working with the housing GSEs regarding the 
        valuation of their private-label mortgage backed securities 
        (PLS) and appropriate recognition of other than temporary 
        impairment (OTTI) of those PLS. In particular, we worked with 
        the FHLBanks on their adoption of a common platform for 
        accounting for the impairment of their PLS.

    FHFA staff worked with the Obama administration and others 
        to address foreclosure prevention and borrowers with 
        ``underwater'' mortgages with the aim of keeping people in 
        their homes whenever possible.

    We set new, more feasible affordable housing goals for 2009 
        for Fannie Mae and Freddie Mac and are working on a new housing 
        goal framework for the Enterprises and the FHLBanks for 2010.

    We combined the personnel and financial systems of two 
        separate organizations and established an infrastructure for 
        FHFA, including systems, procedures, and policies that serve as 
        the foundation for accomplishing the mission of the agency.

    We published our first strategic plan, our first human 
        capital plan, our first Performance and Accountability Report, 
        and our first annual Report to Congress.

    We issued numerous regulations, guidances, and reports to 
        Congress as required by HERA.

    We remain committed to the effective supervision of the housing 
GSEs with the objective of promoting financially safe and sound 
operations and ensuring operations consistent with their housing 
finance mission, which includes supporting a stable and liquid mortgage 
market. In that context, I see three priorities for the housing GSEs, 
and hence three supervisory priorities for FHFA.
    First, as the country continues to work through the housing market 
collapse, I am looking to all the housing GSEs to provide ongoing 
support to the mortgage market, consistent with their mission and 
charters. For the Enterprises, this means continuing to provide a 
secondary market outlet for mortgages, including mortgages that meet 
the Enterprises' affordable housing goals. For the FHLBanks, this means 
making advances to member institutions collateralized principally by 
mortgage loans and carrying out their responsibilities to support 
affordable housing and community investment programs.
    Second, the housing GSEs must remediate identified weaknesses and 
further strengthen their operations and risk management practices that 
have been stressed in this housing crisis. As financial institutions 
focused on housing finance, they must address their direct and indirect 
exposure to serious mortgage delinquencies. Our oversight of their 
response to these conditions is core to our mission and our assessment 
of their safety and soundness.
    Third, as part of their overall housing finance mission, the 
housing GSEs each have important roles to play in preventing avoidable 
foreclosures and providing programs that assist the housing market 
recovery. The Enterprises are implementing the loan modification and 
refinance programs under the Administration's Making Home Affordable 
program. The FHLBanks are implementing troubled homeowner refinance 
assistance available through our recent Affordable Housing Program 
(AHP) regulation.
Current Financial Conditions of the GSEs
    Let me now address the current financial conditions at the housing 
GSEs.
    Fannie Mae and Freddie Mac. In the first 2 full years of this 
housing crisis--from July 2007 through the first half of 2009--combined 
losses at Fannie Mae and Freddie Mac totaled $165 billion. In the first 
half of 2009, Fannie Mae and Freddie Mac together reported net losses 
of $47 billion. The Enterprises' financial performance continues to be 
dominated by credit-related expenses and losses stemming principally 
from purchases and guarantees of mortgages originated in 2006 and 2007.
    Since the establishment of the conservatorships, the combined 
losses at the two Enterprises depleted all their capital and required 
them to draw $96 billion from the U.S. Treasury under the Senior 
Preferred Stock Purchase Agreements. With continuing uncertainty 
regarding economic conditions, employment, house prices, and mortgage 
delinquency rates, the short-term outlook for the Enterprises remains 
troubled and likely will require additional draws under the Senior 
Preferred Stock Purchase Agreements.
    Beyond the preferred stock purchases, the Treasury Department and 
the Federal Reserve have made other, sizeable purchases of housing GSE 
securities to instill confidence in their securities, provide stability 
to mortgage markets, and lower mortgage rates. Treasury has purchased 
approximately $192 billion of the Enterprises' mortgage-backed 
securities (MBS). The Federal Reserve has purchased $831 billion worth 
of Enterprise MBS and $134 billion in debt issued by Fannie Mae, 
Freddie Mac, and the FHLBanks. This combined support from the Federal 
Government exceeds $1 trillion and has allowed Fannie Mae and Freddie 
Mac to continue providing necessary liquidity to the mortgage markets.
    Federal Home Loan Banks. The FHLBanks have not been immune from 
mortgage-related credit losses. The most important financial 
development among the FHLBanks in 2009 is the deterioration of the PLS 
portfolios held by the FHLBanks. As of June 30, 2009, the FHLBanks held 
$56.6 billion worth of PLS with an estimated fair value of $46.3 
billion, down from a December 31, 2008, carrying value of $73.0 billion 
and a fair value of $53.7 billion. The decline in the carrying value 
reflects impairment charges of almost $8.2 billion and principal 
payments and prepayments of $8.9 billion. However, a change in 
accounting rules resulted in only $953 million charged against income.
    Net income was $1.4 billion in the first half of 2009, compared to 
$1.2 billion for all of 2008. The apparent improvement reflects new 
accounting rules from the Financial Accounting Standards Board for 
other-than-temporary impairment on PLS.
    The FHLBanks ended the first half of 2009 with assets of $1.1 
trillion, down $201 billion, or 15 percent, since the end of 2008. 
Advances, which had peaked at $1.0 trillion at the end of September 
2008, fell to $739 billion by the end of June 2009 and $659 billion as 
of September 30. The 35 percent decline in advances in just 12 months 
is largely due to a rise in deposits at member banks, decreased loan 
demand, the emergence of new or expanded Federal liquidity programs, 
increased use of the Fed's discount window, and some return of 
liquidity in financial markets. The expansion and contraction of 
FHLBank advances demonstrates that the FHLBanks' capital structure has 
the ability to meet demands for liquidity on the part of member 
financial institutions while leaving the FHLBanks with the portfolio 
flexibility to shrink without untoward consequences.
    At the end of June, total regulatory capital for the FHLBanks was 
$60.6 billion, or 5.3 percent of assets. Total retained earnings were 
$6 billion, but negative accumulated other comprehensive income (AOCI) 
exceeded retained earnings at the six FHLBanks with the greatest PLS 
exposure.
Conservatorship of the Enterprises
    FHFA placed Fannie Mae and Freddie Mac into conservatorships on 
September 6, 2008. This action was a result of substantial 
deterioration in the housing markets, rapidly rising credit expenses, 
and the inability of the Enterprises to raise new capital and access 
debt markets in their customary way.
    At that time, FHFA along with Treasury and the Federal Reserve 
recognized that Fannie Mae and Freddie Mac would be unable to fulfill 
their mission of providing liquidity and stability to the housing 
market without substantial Government support. Uncertainties remain 
about the future structure of the Enterprises, but one thing is clear: 
the conservatorships have accomplished their objective of ensuring that 
the Enterprises continue to provide a secondary market outlet for new 
mortgages.
    Despite unprecedented market events, both Enterprises have been 
able to maintain a significant presence in the secondary market. The 
Enterprises' combined market share of mortgages originated in the 
second quarter of 2009 was 74 percent, up from 54 percent in 2007 and 
37 percent in 2006. Most other loans this year have been guaranteed by 
the Federal Housing Administration (FHA).
    FHFA has also sought to align the Enterprises' housing goals with 
safe and sound practices and market realities. This summer we finalized 
the affordable housing goals for 2009 and are working on a new housing 
goal rule for 2010 as directed by HERA. FHFA meets monthly with each 
Enterprise to review its progress against the goals.
    We recognize that FHFA's duties as conservator means just that, 
conserving the Enterprises' assets. These two companies have $5.3 
trillion in mortgage exposure. Given the Enterprises' importance in the 
mortgage market, Enterprise activities to stabilize the housing and 
mortgage markets are closely linked to conserving assets. Over the long 
term, effective mortgage modifications, refinancings, short sales, and 
other loss mitigation activities assist homeowners and neighborhoods 
and will save the Enterprises billions of dollars.
Challenges the Enterprises Face
    I would like to turn my focus now to some of the challenges the 
Enterprises face and the steps they have taken during conservatorship 
to strengthen and improve safety and soundness.
    1. Executive Leadership/Management and Staff Retention. Both 
Enterprises have filled significant vacancies at the executive 
management level. Since conservatorship, each company's CEO position 
has turned over twice and most executive vice-presidents at each 
company have changed. These changes have included individuals most 
responsible for the problems that led to conservatorship and have 
improved each company's ability to appropriately focus on key business 
strategies given conservatorship and the problems in the housing 
market. We have also replaced the majority of both boards of directors. 
The new boards are now actively overseeing the affairs of the 
Enterprises. However, personnel risk at both Enterprises remains a 
major challenge and risk going forward. Several key officer vacancies 
remain below the executive levels. Moreover, uncertainties about the 
future of the Enterprises keep staff retention a key concern. As we see 
improvements in the economy, opportunities for employees and officers 
to seek other employment will increase, adding to the current retention 
challenge. Both Enterprises, along with FHFA, are working on available 
options to manage personnel risk.
    2. Credit Risk and Loss Mitigation. The size and credit 
characteristics of Fannie Mae and Freddie Mac's mortgage books of 
business remain supervisory concerns. While a few positive signs of 
recovery in housing have begun to emerge, we remain concerned and 
recognize the risk associated with increasing numbers of seriously 
delinquent loans, higher forecasted foreclosures, and the uncertain 
path of the market's recovery. In particular, we are concerned with the 
continued increase in serious delinquency rates, even among prime 
mortgages.
    More than one in four subprime mortgages today is seriously 
delinquent. Among subprime adjustable-rate mortgages, nearly 40 percent 
are seriously delinquent. While mortgages in the prime market are 
performing better, the numbers are still very high. The serious 
delinquency rate is 3.1 percent at Freddie Mac and 4.2 percent at 
Fannie Mae. These rates are disturbing both in their magnitude and in 
the fact that they continue to increase. Currently the Enterprises are 
managing a real estate owned (REO) inventory of almost 100,000 
properties, a number expected to grow. Certainly rising unemployment 
has contributed to defaults as people have lost incomes and the 
employment situation adds to the uncertainty regarding future 
delinquencies.
    On a positive note, both Enterprises are devoting significant 
resources to programs aimed at reducing default rates and preventing 
avoidable foreclosures. Credit underwriting practices during 
conservatorship have been strengthened, resulting in higher quality 
mortgage purchases.
    In addition to the stress in the single-family mortgage market, the 
multifamily market is experiencing declining property values and record 
vacancy rates. As of midyear 2009, rental vacancy rates hit their 
highest level since the U.S. Census Bureau began tracking vacancy rates 
in the 1950s. Still, the Enterprises are working to support the 
multifamily market while adhering to clear and consistent credit risk 
management principles. As of June of this year, the Enterprises' 
combined multifamily portfolios had grown to $357 billion, and their 
market share has increased substantially, growing from 34 percent in 
2006 to 84 percent last year.
    Going forward, we are looking to Freddie Mac and Fannie Mae to 
continue to provide liquidity to the multifamily sector while ensuring 
safety and soundness. For instance, in setting the housing goals for 
2009, FHFA lowered all of the single-family goals but actually raised 
the special affordable multifamily goal. We recognize that this will be 
a challenge for each company given the depressed environment for 
multifamily lending, but we expect each Enterprise to remain focused on 
this sector and bring prudent approaches to enhancing their support for 
this market.
    3. Market Risk. The Enterprises' investments in mortgage assets 
expose them to market risk. Given the uncertainties in the marketplace, 
managing market risk continues to be a challenge.
    4. Operational Risk. Both Enterprises are addressing operational 
risk weaknesses. The systems and models upon which the companies have 
relied in the past have been greatly stressed in this market 
environment and the new management teams are working on appropriate 
remediation. The implementation of the new consolidation accounting 
standard, which will require the Enterprises to bring off-balance-sheet 
mortgage backed securities onto their balance sheets beginning next 
January, is a substantial operational challenge, one that has required 
significant resources at each company.
Foreclosure Prevention/Making Home Affordable
    I have already reviewed the substantial credit risk to the 
Enterprises from mortgage delinquencies in their own books of business. 
Because the Enterprises own or have guaranteed securities backed by 
about 58 percent of the residential mortgages in this country, it is 
fair to say that activities that bring stability to housing markets 
generally are of direct financial benefit to the Enterprises. It is in 
that context that I would like to discuss the Enterprises' current 
efforts to support foreclosure prevention and, more generally, their 
activities under the Obama administration's Making Home Affordable 
program.
    The Enterprises are applying the Home Affordable Modification 
Program (HAMP) to their own mortgage books, and as agents of the 
Treasury Department they are extending the program to mortgages in PLS 
and in bank portfolios. Fannie Mae is the administrator of the program 
and Freddie Mac has responsibility for overseeing program compliance.
    The loan modification initiative is a critical effort to combat the 
slide into foreclosure facing the many households that are seriously 
delinquent on their mortgages. It represents a serious response to help 
those homeowners dedicated to preserving their home if given the 
opportunity through a more sustainable mortgage payment.
    Under the umbrella of the Administration's Making Home Affordable 
program, the Home Affordable Refinance Program (HARP) is an effort by 
FHFA with the Enterprises to enhance the opportunity for homeowners to 
refinance. For homeowners today who have mortgages owned or guaranteed 
by Fannie Mae or Freddie Mac, and who are current on those mortgages, 
HARP provides the opportunity for those homeowners to reduce their 
monthly mortgage payment by taking advantage of the low mortgage rates 
in the market today.
    While a 5 percent mortgage rate creates an inviting opportunity to 
refinance, in today's environment many homeowners have been unable to 
do so. The decline in house prices has raised the current loan-to-value 
ratio for many, and for some, put them underwater on their mortgage. 
Combined with the limited availability of private mortgage insurance in 
the marketplace today, many homeowners have been unable to qualify for 
a refinance.
    HARP has been designed to address these barriers. Fannie Mae and 
Freddie Mac today will refinance mortgages they currently hold, even up 
to a current loan-to-value of 125 percent. For homeowners with a 
current loan-to-value ratio between 80 and 125 percent, the Enterprises 
will refinance those mortgages without requiring additional private 
mortgage insurance. If there already is mortgage insurance on the 
existing mortgage, that coverage will carry forward to the new 
mortgage. If the existing mortgage did not have mortgage insurance, it 
will not be required in the new mortgage. This program recognizes that 
the Enterprises already have the credit risk on their books for these 
mortgages. Enhancing the ability of these homeowners to refinance their 
mortgage improves the credit quality of the loan.
    FHFA has been reporting monthly to Congress and the public on the 
Enterprises' loss mitigation activities, including those under HAMP and 
HARP, in our Federal Property Managers Report. 
Challenges the FHLBanks Face
    While much attention remains focused on the Enterprises, the 
FHLBanks have challenges of their own that warrant the Committee's 
attention. The FHLBanks have served their core statutory function of 
bringing liquidity to member institutions holding mortgage assets. From 
June 2007 to September 2008, advances to members increased from $640 
billion to more than $1 trillion. When liquidity sources for many large 
and small banks were drying up, the FHLBanks provided much needed 
liquidity. I have already described the subsequent decline in advances 
since last Fall.
    The FHLBanks face several important challenges, two of which I 
would like to note:
    1. Private Label Securities. Working through the impairments and 
fair value losses associated with their investments in private label 
mortgage backed securities is an immediate and ongoing challenge for 
the FHLBank System and the potential for losses on those securities 
poses a serious problem for several FHLBanks.
    2. Concentration Risks. The failure or consolidation of System 
members has shifted business volumes among the FHLBanks and increased 
concentration of ownership by, and advances to, a select number of 
large institutions. This raises long-term structural questions 
regarding the FHLBank System.
Future of the Housing GSEs and Mortgage Finance System
    With that Mr. Chairman, let me move to the final topic that you 
asked me to address: my views about the future of the mortgage market 
and the role of the GSEs. To properly consider the future of the 
housing GSEs, one should first consider the goals policymakers have for 
the U.S. housing finance system and specifically the secondary mortgage 
market.
    In its broadest terms, the housing finance system is comprised of a 
set of institutions and financial arrangements that connect capital 
markets to local mortgage lending transactions. The mortgage market is 
a $12 trillion market ($11 trillion in single-family mortgages and $1 
trillion in multifamily mortgages). This market is one of the largest 
individual credit markets in the world, nearly the size of all domestic 
nonfinancial corporate borrowing and 65 percent greater than the 
Federal debt held by the public. Yet this massive size is attained 
through millions of individual transactions that have an average size 
of $200,000. Today, the Enterprises, the FHLBanks, FHA, private 
mortgage insurers, and portfolio lenders are among the primary 
participants in our housing finance system.
    For many years, Fannie Mae and Freddie Mac have been the two 
leading conduits that connected capital markets to individual mortgage 
transactions. Given the extraordinary losses to these companies and the 
need for financial support from the Federal Government resulting from 
the present mortgage crisis, to say nothing of the toll on individual 
households and communities, we as a Nation need to ask and answer some 
hard questions about what we want out of our housing finance system 
going forward. In particular, we need to clearly define the proper 
public policy objectives and the degree and characteristics of 
Government involvement in this housing finance system to best serve 
those objectives.
    We might begin with the following simple purpose statement: To 
promote the efficient provision of credit to finance mortgages for 
single-family and multifamily housing. An efficient system of credit 
allocation would typically have a number of characteristics:

    Allows Innovation. Financial technology, products, and risk 
        management tools and understanding all evolve over time. An 
        efficient housing finance system should be constantly striving 
        to innovate. Competition is the natural generator of market 
        innovation yet the GSE structure limits competition by the 
        grant of exclusive charters to a few firms. At the same time, 
        regulation is necessary in many cases to protect the financial 
        system and other Government interests. The key is a regulatory 
        approach that accomplishes the latter without hindering the 
        former.

    Provides Consumer Choice. A Nation of 50 million plus 
        homeowners is not likely to be well-served by a one-size-fits-
        all approach to mortgage availability. Given the wide array of 
        household structures, income patterns, wealth, age, financial 
        sophistication, other assets, and so on, a robust housing 
        finance system should be able to cater to varying demands and 
        to suitably customize its product offerings.

    Provides Consumer Protection. The costs to individual 
        households of the current record delinquencies and foreclosures 
        reminds us of the need to have a housing finance system that 
        appropriately protects households. Even for households with a 
        substantial degree of financial sophistication, mortgage 
        transactions are not an everyday occurrence and pitfalls and 
        blind spots may exist. Transparency and basic fairness in the 
        lending process need to be assured. Consumer responsibility 
        should also be a goal tied to strong disclosure and financial 
        education.

    Facilitates Transparency. Investors in and guarantors of 
        mortgages and mortgage-related securities need clear, timely 
        information on the mortgages in which they invest in order to 
        make optimal investment decisions and to properly manage the 
        risks of those investments. Market mechanisms that are 
        transparent are more attractive to investors. They also 
        facilitate Government oversight of institutional and systemic 
        risk.

    While the characteristics described above provide a broad framework 
for thinking about the future of the housing finance system, there are 
a number of specific areas related to the current activities of the 
housing GSEs that deserve special attention. In particular, some key 
decisions that policymakers will have to address include what role the 
Federal Government should have in the following key areas of the 
housing finance system: ensuring that the mortgage market has adequate 
sources of liquidity; absorbing credit risk; and promoting the 
availability of mortgage credit.
    Briefly, ensuring liquidity in this context addresses the concern 
that periodic disruptions in credit markets cause investors to 
temporarily exit from holding, or purchasing new, mortgage-related 
instruments. For example, during periods of interest rate volatility, 
the heightened uncertainty makes it difficult to judge mortgage 
prepayment and default risks, so investors may depart that sector. 
Likewise, the extreme credit stress of the current mortgage crisis 
would have caused severe disruptions in the flow of mortgage credit 
were it not for the establishment of Government support programs. 
During such episodes, do we need to ensure there is a balance sheet of 
last resort?
    Second, up to the present crisis, arguably the markets relied upon 
an implicit Government guarantee of Enterprise securities. Going 
forward, a threshold question is what level of Government credit 
support is needed to have a mortgage market that operates efficiently. 
As opposed to more broadly expanding Government guarantees, one 
approach to consider is having the Government take a more limited 
catastrophic credit insurance position backing mortgage assets. Another 
approach could be a combination of enhanced private sector market 
discipline and regulatory oversight to get a more economically accurate 
market price of mortgage credit risk.
    Third, for many decades the Federal Government has sought to affect 
housing finance in ways that promoted the availability of credit for 
low-and moderate-income homeowners and renters. Under the current 
structure, the many subsidies granted the Enterprises were exchanged 
for various requirements, including housing goals, to ensure the 
Enterprises did not ignore these segments of the marketplace. Going 
forward, policymakers may consider alternative approaches to defining 
and targeting subsidies to achieve public policy objectives. For 
instance, subsidies intended to support the financing of affordable 
rental units or to assist first-time homebuyers could be more 
efficiently targeted through down payment assistance or other measures 
than by a general subsidy provided to all types of mortgage credit.
    As policymakers deliberate the future of the housing finance 
system, it is important to keep in mind the benefits that the secondary 
mortgage market provides. Notable among those benefits are 
standardization in the terms of conventional mortgages and a highly 
liquid forward market for mortgage backed securities that allows 
applicants to lock in interest rates when they are planning to buy a 
home or refinance an existing loan. We should strive to maintain those 
benefits while addressing the significant challenges we face.
    Mr. Chairman, I believe we are in the early stages of an important 
national discussion about them, one that I know the Administration has 
committed to addressing in the coming months. There are options 
available to us. The GAO, which will testify at the next panel, has a 
broad framework setting forth some of these options. I have hoped to 
add a few elements to the discussion here. I believe that private 
capital, properly regulated, has a critical role to play in the housing 
finance system of the future. But to do so, we must clearly articulate 
the rules of the road before private risk capital will fully return to 
this market sector. As for the Enterprises and the FHLBanks, they each 
may have important roles to play in this future system. But the place 
to begin the discussion is outside the existing framework of 
institutional arrangements.
    Thank you for the opportunity to appear here today. I would be glad 
to answer any questions.
                 PREPARED STATEMENT OF WILLIAM B. SHEAR
   Director, Financial Markets and Community Investment, Government 
                         Accountability Office
                            October 8, 2009

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                                 ______
                                 
                PREPARED STATEMENT OF PETER J. WALLISON
Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise 
                               Institute
                            October 8, 2009
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee: 
I very much appreciate this opportunity to testify before this 
Committee. The role and structure of Government sponsored enterprises 
(GSEs), and particularly Fannie Mae and Freddie Mac, has been an 
interest of mine since I was General Counsel of the Treasury in the 
early 1980s.
    While most of the attention to the GAO report in today's hearing 
will focus on the agency's analysis of the options for their future, 
the report contains a lot of useful background about Government housing 
policies in general that the Committee should take into account. Table 
1, for example, records the large number of housing programs that the 
U.S. Government now pursues, beginning with the establishment of the 
Federal Home Loan Bank System in 1932, the Federal Housing 
Administration in 1934, and Fannie Mae in 1938, and extending through 
the many programs for direct outlays currently run by HUD and the tax 
subsidies that are enjoyed by most homeowners today. The sheer number 
of these programs is a reminder that there will still be plenty of 
Government support for housing and home ownership in the United States, 
even if Fannie Mae and Freddie Mac are ultimately privatized or 
liquidated.
    Unfortunately, the table does not include or describe the system of 
savings and loan associations (S&Ls), originally operated and regulated 
by the Federal Home Loan Bank Board (FHLBB). The Board was the 
predecessor of the Office of Thrift Supervision, which now regulates 
the S&Ls that are a vestige of the much larger system that collapsed in 
the late 1980s. One of the reasons for abolishing the FHLBB was that 
its mandate included the promotion of housing, and that was deemed to 
be inconsistent with the responsibility of a regulatory agency. As I 
will discuss in this testimony, the same issue of conflict in missions 
occurs in the case of Fannie and Freddie and severely impairs their 
effectiveness. Indeed, for more than just this reason, the example of 
the S&L system has great relevance to what the Committee is considering 
today--both the future of Fannie Mae and Freddie Mac and the wider 
issue of new regulations that are intended to prevent the recurrence of 
the financial crisis we are now experiencing.
The Lesson of the S&Ls
    The S&L system was established in 1932 to provide housing finance. 
At the time, this was only the latest in many Government efforts during 
the 20th century to increase home ownership in the United States. For 
good reason, Americans believe in home ownership. It has many indirect 
benefits--better housing, better neighborhoods, better family 
conditions, less delinquency, and others--that are worthy of Government 
support if they do not occur through operation of the market alone. But 
recalling the history of the S&Ls and their collapse as an industry is 
important for understanding what we should do with Fannie Mae and 
Freddie Mac today.
    This is true for two major reasons. First, the S&Ls were an attempt 
by Congress to use a financial mechanism--a depository institution--to 
achieve a social purpose, an increase in home ownership. S&Ls were 
limited to making housing loans, which meant that they were locked into 
a structure in which they were compelled to carry long-term assets with 
short-term liabilities--a prescription for depository institution 
failure if there ever was one. Commercial banks also carry long-term 
assets with short-term deposits, but they have many more short-term 
assets they can acquire. Fannie and Freddie were initially developed 
simply to make the secondary mortgage market function more effectively 
by purchasing mortgages from banks and S&Ls, thus making these long-
term assets more liquid. However, after the S&L industry failed, 
Congress adopted another way to increase home ownership. In this case, 
Congress gave Fannie and Freddie an additional responsibility--an 
affordable housing ``mission''--intended to direct housing finance 
resources to certain groups that were thought to be underserved in the 
normal credit markets. This effort worked too well. The loans made to 
the borrowers Congress designated, borrowers who did not have the 
financial resources or the credit standing necessary to meet their 
obligations, were largely responsible for Fannie and Freddie's 
insolvency. Accordingly, the failure of both the S&Ls and the GSEs 
should tell us that attempts to manipulate financial institutions in 
order to achieve a particular social purpose are likely to end badly.
    Second, the S&Ls failed because the system was not flexible enough 
to survive in a market where interest rates were set by supply and 
demand. This is important, and bears on many of the issues raised by 
the financial crisis. The S&Ls remained a stable source of housing 
finance only during a unique time--when the deposit interest rates at 
banks and S&Ls were controlled by regulation and depositors had nowhere 
else to go. Under what was known as the Fed's Regulation Q, banks could 
not pay more than 5 percent interest on deposits and S&Ls could not pay 
more than 5\1/4\ percent.
    This created a very stable banking system for many years, and many 
of the advocates of greater regulation today point to this period--
roughly from the end of World War II through the end of the 1970s--as a 
period of ``great moderation'' when we didn't have many banking crises. 
The implication is that we should have more regulation now. What the 
proponents of regulation don't mention is that during this period we 
had many very serious recessions and housing finance crises when there 
was insufficient liquidity in the economy because the banks and S&Ls 
could not raise sufficient funds for lending when money market rates 
exceeded what Regulation Q permitted them to pay for deposits. After 
the deregulation of deposit rates in the early 1980s, we really did 
have a great moderation, with only two mild recessions until the early 
2000s, when the Dot-Com bubble deflated. Even that recession did not 
implicate the banking system, which remained reasonably strong from the 
time of the S&L collapse (when almost 1600 commercial banks also 
failed) until the current crisis.
    The lesson of the S&L collapse is that it was a serious policy 
error to impose a rigid regulatory structure on an institution that is 
supposed to be operating in a market where the cost of its principal 
raw material--i.e., money--is subject to the law of supply and demand. 
The policy worked for a while, as long as the general public had no 
other choices, but with the advent of ordinary money market mutual 
funds, people could get access to higher rates and safe short-term 
investments in the money markets and withdrew their funds from banks 
and S&Ls. These institutions were forced to replace these fleeing 
depositors with funding sources that required them to pay higher rates, 
and the losses that resulted (paying more for funds than the assets 
that they were holding were yielding) caused the collapse of the whole 
industry. It is important to recognize that Regulation Q penalized the 
public and trapped them in low-paying deposit accounts. In effect, they 
were freed by technological changes--primarily the advent of 
computers--that made it possible for mutual funds to calculate their 
net asset value at the end of every day.
    The S&L analogue at Fannie and Freddie is that no financial 
institution can serve two masters. Government-sponsored enterprises--to 
the extent that they are owned by shareholders but also have a 
Government ``mission''--are living contradictions. They were set up to 
achieve two Government purposes--creating a more liquid and efficient 
secondary mortgage market and reducing the interest rates on mortgage 
loans. But they are also private, shareholder-owned companies, and 
their managements have a fiduciary duty to maximize value for the 
shareholders. Just as the S&Ls' rigid structure could not survive in a 
market where their depositors had alternative investments, Fannie and 
Freddie could not serve both their Government purpose and their 
shareholders at the same time. In the end, the shareholders come 
first--if only because in serving the shareholders the managements 
could assure themselves of rich rewards by exploiting the Government 
franchise they had been given. This is part of the story of Fannie and 
Freddie, and why they did not actually reduce mortgage interest rates 
for the great middle class of the United States. As the GAO points out, 
Fed studies showed that the interest rate reductions attributable to 
their operations actually amounted to only 7 basis points.
    One of the reasons that they achieved only this paltry sum for home 
buyers is their affordable housing mission, which was adopted by 
Congress in 1992. This created another inherent conflict of interest in 
their charter. In this case, Fannie and Freddie were required to devote 
a substantial portion of their resources to purchasing loans made to 
home buyers at or below the median income. When HUD first began to 
implement this mandate, the requirement was 30 percent, but it was 
ratcheted up over time, and by 2005 HUD's affordable housing 
regulations required that 55 percent of the loans Fannie and Freddie 
purchased had to be loans to home buyers at or below the median income, 
including 25 percent to low-income home buyers. Of course, the HUD 
regulations said that these loans were to be prudent, but Fannie and 
Freddie were also importuned to be ``flexible'' in their standards, and 
that resulted in their looking for and buying loans that had been made 
to people with blemished credit or limited ability to make 
downpayments. By the early 2000s, Fannie and Freddie were buying loans 
which involved no downpayment at all. The result is clear today. At the 
time Fannie and Freddie had to be taken over by the Government, they 
held or had guaranteed 10 million subprime and Alt-A loans, with a 
total value of $1.6 trillion. These loans are defaulting at 
unprecedented rates, and when it is all said and done, cleaning up the 
mess at Fannie and Freddie will probably cost the American taxpayers 
$200 to $400 billion.
    The losses that finally overwhelmed Fannie and Freddie were hidden 
for a long time in the huge profits that the two companies were able to 
earn from exploiting their Government franchise. It looks today as 
though the allocation of those profits was pretty much as one would 
expect--first to the management, then to the losses incurred in their 
affordable housing mission, then to the shareholders in the form of 
dividends, and finally 7 basis points of benefit to home buyers. Of 
course, the embedded losses were reserved for the taxpayers, who never 
had an opportunity to reject the honor.
    There are certainly good policy reasons for the U.S. Government to 
encourage home ownership, but imposing the burden on companies that are 
supposed to be shareholder-owned and profit-making is not the way to do 
it. A Government program that provides downpayments for people who 
can't afford them would make a lot more sense. Then the losses, if any, 
would be visible and could be balanced against the gains from 
increasing home ownership. But requiring Fannie and Freddie to perform 
this mission--to find an increasing number of ``prudent'' loans that 
met HUD's requirements--was a mission impossible, and the result is the 
insolvency of the two companies and huge eventual losses for the 
taxpayers.
The Future of Fannie Mae and Freddie Mac
    What do these two lessons say about the future of Fannie and 
Freddie? First, I think the GAO's conclusions about the options 
available to Congress are correct. The realistic options are only 
nationalization, privatization, or a return to GSE status, but there 
are some ideas that are refinements of these general categories. For 
example, the Mortgage Bankers Association has proposed a well thought-
out proposal that falls somewhere between privatization and GSE status. 
In addition, the Treasury under Hank Paulson published a plan for a 
covered bonds structure that might get the Government completely out of 
the mortgage market. An evaluation of these ideas as substitutes for 
Fannie and Freddie is beyond the scope of this testimony. Instead, I'd 
like to review each of the possibilities raised by the GAO, beginning 
with a return to GSE status.
Fannie and Freddie as GSEs
    From what I have said above, a return to GSE status would the worst 
choice, especially if Fannie and Freddie were to continue to have an 
affordable housing mission. That mission seems unnecessary when FHA's 
activities could be expanded to achieve the same result, and if the 
objective is to increase home ownership, a program that provides 
downpayments for prospective homebuyers with otherwise good credit 
records is likely to be more effective. At least such a downpayment 
subsidy program would be transparent, which Fannie and Freddie's 
affordable housing losses certainly were not.
    But even if Fannie and Freddie are no longer required to support 
affordable housing, and even if their activities are limited to 
securitizing mortgages (so that they are prohibited from holding 
portfolios of mortgages and mortgage-backed securities), it would be a 
mistake for them to be set up again as GSEs. The GSE form is a 
prescription for moral hazard. If there had ever been any doubt that 
GSEs are backed by the Federal Government, the Federal takeover of 
Fannie and Freddie in 2008 removed it. If they are again set up as 
GSEs, creditors will assume that the Government will rescue them again 
if they get into trouble. There will be no market discipline, no 
market-based restraint on their risk-taking. They and their supporters 
will argue that strong regulation will prevent substantial risk-taking, 
but this is an error. Since FDICIA was adopted in 1991, in the wake of 
the S&L crisis, we have relied on the strongest regulation we could 
think of to make sure that insured banks were safe and sound. Yet, 
today, we have the worst banking crisis since the Great Depression. 
Accordingly, it seems clear that strong regulation cannot overcome the 
incentives of management--indeed their fiduciary obligations as 
managers of shareholder-owned companies--to exploit the GSE franchise 
to the maximum possible degree. No regulator will be able to tease out 
the myriad ways in which the management of a future GSE will be able to 
take risks in order to enhance the returns with which they and the 
shareholders will be rewarded. Risk-taking is appropriate for private 
companies--they should take risks for profit--but not when companies 
are operating with the taxpayers' credit card. Yet that is exactly what 
we will be doing if Congress accepts the facile argument that strong 
regulation will prevent serious risk-taking and losses.
    I should add here that if Fannie and Freddie return as GSEs, and 
creditors assume that their liabilities are backed by the Federal 
Government, the potential losses on their activities will be greater 
than the potential losses to the Government arising out of the FDIC's 
insurance on bank deposits. Bank deposits are only insured up to 
$250,000, but all of Fannie and Freddie's debts will be covered in the 
event of another failure in the future. So the stakes will be high for 
the taxpayers if Fannie and Freddie are returned to GSE status.
Nationalization of Fannie and Freddie
    The next question, then, would be whether nationalization would 
solve this problem. In other words, if Fannie and Freddie were combined 
into a single Government institution, could they more effectively 
perform their secondary market role without a danger of excessive risks 
to the taxpayers? In effect, the new entity would be doing what Ginnie 
Mae is doing, but for a broader range of mortgages. Because a 
Government agency would have no profit motive and no capital 
requirement, it could, in theory, offer less expensive mortgages.
    Again, the question arises whether the new entity would have an 
affordable housing mission, and whether that obligation would require 
them to take on the excessive risks that Fannie and Freddie seem to 
have taken on in pursuit of that mandate. In addition, while there is 
little incentive for a Government entity to take risks, there is also 
little incentive to be careful about the credit risks they might be 
taking on inadvertently. Unless the agency can pay the salaries 
necessary to attract high-quality employees, its staff may not be able 
to understand the complexity of the mortgages that might be created in 
the future. As we saw with Fannie and Freddie, these risks can build up 
over a long period and not come to light. When they do, the losses can 
be substantial, in this case for the account of the Government. In this 
connection, the Government entity could be securitizing trillions of 
dollars in mortgages, and only small errors in risk management could be 
very costly over time.
    The GAO report does not consider the budgetary impact of 
nationalizing Fannie and Freddie. Fannie was originally turned into a 
private company in order to take it out of the budget process. As the 
housing market grew, Fannie's purchases of mortgages were larger than 
the revenues it received on the sale or refinancing of the loans, and 
this added to the budget deficit. The same problem would appear to 
arise if Fannie and Freddie were now to be nationalized. Even if they 
are no longer permitted to accumulate portfolios of mortgages, their 
purchases of mortgages will precede the sale of these loans to trusts 
or other special purpose entities in the securitization process, and 
this will add to the deficit. This phenomenon will be more pronounced 
in a growing housing market, when the size of the GSEs purchases will 
precede the proceeds of sale in a securitization.
The Nexus Between Fannie and Freddie and the Administration's Reform 
        Proposals
    At this point, it is worthwhile to consider the nexus between the 
issues that concern the future of the GSEs and the issues that arise in 
connection with the Committee's consideration of various proposals to 
prevent a repeat of the financial crisis. The GAO did not address these 
issues, but they should be of concern. As part of its effort to prevent 
another financial crisis, the Administration has proposed that in the 
future banks hold more capital and the securitization process be 
revised so that both loan originators and securitization sponsors 
retain some portion of the credit risk associated with the securitized 
mortgages. These proposals have important implications for the 
restructuring of Fannie and Freddie--whether they are reestablished as 
GSEs or merged into a single Government entity. The new capital 
requirements and securitization rules, if they go into effect, will 
increase the costs of securitization-based credit. This seems to be 
acceptable to the Administration, apparently because it believes it 
will reduce or eliminate the risk of another financial crisis.
    But these new capital requirements and securitization rules will 
have major implications for Fannie and Freddie as GSEs or as a 
consolidated nationalized entity performing a secondary market 
function. In both cases, explicit Government backing--or its equivalent 
in the case of the GSEs--would have the potential to substantially 
reduce the cost of the mortgages that go through a securitization 
process run by a GSE or a Government entity. At the same time, the new 
capital and securitization requirements for private sector operators 
would substantially increase their costs. The gap between the cost of 
mortgages in the two systems--Government and private--could be very 
wide. Mortgages that fall within the conforming range for Government or 
GSE securitization would have major advantages over those that do not, 
and this could distort investment in the housing market. This will 
substantially increase pressure for the Government or the GSEs to take 
over all secondary market securitization. The usual groups--
homebuilders, realtors, and others in the business of constructing or 
selling homes--will press Congress to cover all mortgages, not just 
those that are at or below some maximum permitted size. If Congress 
accedes to this pressure, it will significantly increase the amount of 
mortgage debt that becomes a Government risk. For this reason, when the 
Committee gets to a consideration of the Administration's proposals for 
reform of bank capital and the securitization process, it should weigh 
these in light of their effects on the future role of Fannie and 
Freddie in the housing finance system.
    In addition, if Fannie and Freddie survive as GSEs, there is a 
question whether they will be subject to the both the new 
capitalization and securitization requirements. If we assume that they 
will be, then we are starting down the track of allowing Fannie and 
Freddie again to accumulate a portfolio of interests in mortgages. To 
carry these interests, they will be required to borrow, and if they 
borrow they will be required to hold more capital in order to protect 
the Government against losses. However, the Government's potential 
exposure would grow over time, and could get quite large if the GSEs 
take on growing numbers of mortgages for securitization.
Privatization
    The previous discussion suggests that there are serious flaws and 
taxpayer risks associated with both the GSE and the Government agency 
structures. Ideally, Congress and the Administration should be 
considering new and better ways to finance residential housing in the 
United States, but there is no indication that any effort is being made 
to address this issue. Under these circumstances, the Committee should 
consider the privatization of Fannie and Freddie as a better policy 
than the two flawed approaches we have previously discussed.
    There is no reason in principle why mortgages cannot be securitized 
through solely private sector activity, like any other asset that 
creates a cash flow. Car loans, boat loans, insurance premiums, credit 
cards, and many other assets have been securitized without problems. 
The difficulties in the mortgage market come primarily from Government 
interventions to promote home ownership in ways described above. 
Indeed, the current freeze-up in the asset-backed securities market was 
caused by investors' loss of confidence in mortgages and rating 
agencies after unexpected losses appeared in pools of subprime 
mortgages that had been rated AAA. The resulting losses to investors 
caused the entire asset-backed market to shut down in 2007, and it has 
remained largely closed since then. The right kind of reforms--simple 
requirements, such as downpayments for mortgages and transparency for 
the underlying rationale of the rating it received--will encourage a 
return of investor confidence, although it will take time.
    There are many advantages to a fully private housing finance 
market--some of which were clear in the lessons of both the S&L 
collapse and the failures of Fannie and Freddie. Principal among these 
advantages is the fact that the taxpayers are unlikely to suffer any 
losses on a fully privatized mortgage finance system. Failures in 
today's mortgage financing system are increased, not reduced, by 
Government backing. Government support creates moral hazard; creditors 
don't pay attention to risk-taking because they believe the Government 
will ultimately bail them out, and regulators regularly fail to prevent 
excessive risk-taking. All these factors increase the risk of failures. 
In a fully private system, however, creditors will not lend to a Fannie 
or Freddie if they believe the company is undercapitalized or taking 
excessive risks. If the mortgages are securitized through structured 
arrangements, investors will insist on full disclosure concerning the 
nature and risks of the securities they purchase, and, given the recent 
track record of rating agencies, will want to know how a rating on a 
particular tranche in the structure was established. This will mean 
that the taxpayers will not again be burdened with hundreds of billions 
of dollars in losses by Government-backed vehicles that were able to 
take unreasonable risks because of their Government support.
    In addition, a private system will encourage more innovation, 
efficiency, and competition; with many other players joining the 
secondary mortgage market, competition should bring down mortgage 
rates. Privatized entities would have the flexibility to react to 
changes in the economy and the financial markets, and the incentives to 
do so. Finally, privatized companies are not likely have an obligation 
to provide affordable housing financing to targeted groups--a mission 
that was responsible for Fannie and Freddie's overwhelming losses. This 
mission would be assigned to Government agencies such as FHA, so the 
losses--if they occur--will be transparent.
    Privatization can be achieved relatively easily after investor 
confidence in securitization returns. The simplest way would be to 
gradually reduce the size of the loans that Fannie or Freddie are 
permitted to buy. This will gradually move them out of the market and 
make room for new private sector entrants. It will also probably 
stimulate the development of new ways of financing mortgages, such as 
covered bonds, or the MBA's recent proposal, which--although designed 
to use a Government guarantee--could work as a fully private sector 
structure. If at any time the reduction in the GSEs' role is 
interfering with the orderly financing of mortgages, the process can be 
stopped. In current market conditions, it would not be good policy to 
reduce conforming loan levels--investors are still too nervous about 
the private securitization process--but as investor confidence returns, 
and in the absence of any new thinking on how to finance housing in 
this country, this approach would be the best way to prevent future 
taxpayer losses while creating a viable housing finance system.
    To conclude, the choices available to the Committee are rather 
limited. Both the GSE and nationalization option have serious flaws 
that probably make them unworkable. That leaves some form of 
privatization. There are many good reasons to adopt a privatization 
strategy as the future of Fannie and Freddie, but the best is that as 
private entities without an affordable housing mission, they will not 
create losses for the taxpayers. Ultimately, however, we must develop a 
better system of financing housing in the United States, and it is an 
unpleasant fact that no serious thinking along these lines appears to 
be going forward in Congress or the Administration.
                                 ______
                                 
                 PREPARED STATEMENT OF SUSAN M. WACHTER
Richard B. Worley Professor of Financial Management, Wharton School of 
                  Business, University of Pennsylvania
                            October 8, 2009
    Chairman Dodd, Ranking Member Shelby, and other distinguished 
Members of the Committee: Thank you for the invitation to testify at 
today's hearing on the ``Future of the Mortgage Market and the Housing 
Enterprises.'' It is my honor to be here to discuss the future of the 
mortgage market in the United States. Historically home ownership for 
Americans has served as bedrock of social prosperity. Given recent 
history, we must ask ourselves how to envision a safe, sound mortgage 
market for sustainable home ownership going forward.
    As we consider the future of the mortgage market, we need to step 
back and understand the sources of the global financial debacle. 
Treasury Secretary Geithner correctly points out: we need to get this 
phase right in order to minimize future crises. Understanding the 
crisis and its sources is essential as we evaluate the broad options 
before us of nationalization, privatization, and a public/private 
system. While Federal support of the mortgage system is now necessary, 
nationalization is not a long-run solution as it ultimately expands 
taxpayer exposure, while privatization without a stabilizing public 
role also leads to the inevitable socialization of risk, as this crisis 
has demonstrated.
    This crisis resulted from the explosion of risky mortgages, made in 
the USA, the result of a lethal race to the bottom for short term 
profits, enabled by regulatory failure. This explosion can be traced to 
the issuance of private-label securities (PLS). These privately issued 
securities were neither standardized nor transparent; they were not 
traded, and, therefore, they were not subject or accountable to private 
sector forces of market discipline. The common sense defying loans they 
funded including, interest only, negative amortization, zero equity, 
and teaser-rate ARMs, were not designed to be affordable when full 
rates came into effect; and these loans drove the market to an episode 
of irrational exuberance of historic proportions, causing the housing 
bubble and inevitable bust. As these loans were pushed into the market, 
overall household debt to GDP rose, due to mortgage debt, with the 
increase coming from these risky loans.
    As nonstandard mortgages proliferated, the market share of 
traditional mortgages declined. From 2000 to their peak in 2006, 
nontraditional mortgages grew in origination market share from 10 
percent to almost 50 percent at their height (Wachter 2009b). In 
particular, the housing enterprises' share of the market dropped, as 
did the market share of the long-term fully amortized fixed rate 
mortgage that they fund, protecting borrowers from the interest rate 
risk which can undermine sustainable home ownership. The result of the 
tsunami of debt was not an immediate disaster; rather, the initial 
impact was an artificial house price bubble. As financial institutions 
loaded up balance sheets on the upswing (Pavlov and Wachter, 2009a and 
2009b), they were brought to their knees on the downswing, triggering 
the liquidity crunch and subsequent foreclosures and the now far-
reaching and ongoing economic crisis.
    Incentives of mortgage issuers were negatively aligned with the 
production of safe, sound loans or even loans with a likelihood of 
payback. Riskier mortgages were more profitable in the short term, even 
though in the long term they brought down the system. Their greater 
margin was due to highly inflated fees, which uninformed borrowers paid 
without realizing their divergence from the norm. Fees drove the demand 
for securitization at every stage of production: Banks received fees to 
originate and distribute, the secondary market received fees to bundle 
mortgages, and rating agencies received fees to rate pools. At each 
stage, entities were able to book fees without exposure to long run 
risks. Ultimately investors purchased MBS. But investors could hedge 
their risk also. With the purchase of newly available credit default 
swaps (CDS), their positions could be insured against possible loss. 
There was counterparty risk to be considered, but if this was 
evaluated, investors might have concluded that these instruments had to 
be backed up or the entire system would fail. The providers of the 
credit default swaps perhaps would have been viewed as--and certainly 
in the event were--``too big to fail.''
    The fundamental problem, then, was the lack of accountability in 
the system to the long-run risks being generated. Due to the 
illiquidity of their markets, mortgage backed securities and related 
derivatives traded infrequently, and short-selling these assets was not 
feasible--this unbalanced market dynamic led to further overpricing for 
MBS. Without short-selling pressure or frequent trading, prices were 
driven to high levels that could not be sustained. The result was that 
artificially inflated asset prices increased further as credit 
underwriting eroded, which meant that financial institutions' balance 
sheets were also artificially inflated (Pavlov and Wachter, 2009a and 
2009b). In summary, as these balance sheets grew, the assets reflected 
ever-eroding standards for mortgage issuance. In the short term, cash 
flowed in through fees, but each fee that was accounted for represented 
one more mortgage that did not account for the lack of qualifications 
of the borrower.
    For 25 years, securitization worked well and supported sustainable 
home ownership in the U.S. The GSEs were strictly regulated. Contrary 
to popular misconception, they were not allowed to securitize subprime 
or Alt-A mortgages. After they started losing market share to PLS, 
however, shareholder and other pressures led them to purchase PLS 
backed by nonstandard mortgages for their portfolio. To be clear, they 
did not create the risky mortgage-backed securities that caused the 
crisis, but they did become a burden to the taxpayer because they were 
allowed to purchase them after private institutions had manufactured 
them. My fellow panel member Peter Wallison has documented how several 
GSE observers suggested Congress put limits on the portfolios, but to 
no avail.
    More generally, financial regulators did not do their part in 
tracking or preventing systemic risk. With the profusion of mortgage 
instruments it was exceedingly difficult to determine in real time the 
amount and type of debt that was being issued. The extent of the asset 
bubble being generated by this debt explosion was also difficult but 
not impossible to detect. In a forthcoming paper (Pavlov and Wachter 
2009b), we trace the identifiable impact of the debt on asset prices 
across America, especially in the bubble States, where such loans 
aggressively expanded.
    The most striking aspect of this story is that it never should have 
happened. While trading partner countries experienced house price 
increases as interest rates fell from the mid-1990s on, housing price 
inflation accelerated in the U.S. but not elsewhere, even with the 
increase in interest rates, in 2003, as nonstandard mortgages and PLS 
securities issuance took market share in the U.S. The increases in 2003 
and 2004 occurred with the dramatic rise in the issuance of private 
label securities and the aggressive lending they supported. Colleagues 
and I have separately detailed the regulatory competition and 
regulatory failure that enabled the profusion of unsafe loans by 
institutions that were supposed to be regulated for safety and 
soundness by the Federal Government. While the opportunity for 
extraordinary compensation, in the short run, drove these markets, 
regulators were complicit. They failed to hold the suppliers to the 
long-term consequences of their actions. Federal Reserve Governor Ned 
Gramlich, and others, warned us as this was occurring.
    To ensure the safety and long term sustainability of a reenvisioned 
mortgage finance system, we should pursue policies that embody three 
principles. First, policies and procedures are needed to identify and 
prevent out-of-control asset bubbles and systemic risk, under the 
supervision of a risk regulator. Proactive measures to warn and protect 
against asset bubbles must be in place in order to assure sustainable 
home ownership. Loan-to-value ratios, in particular, must be maintained 
over time. This will require specific analytics for the identification 
and monitoring of risks and controls to prevent the procyclical 
production of risk.
    Second, borrowers must have effective, informed choice: safe 
mortgages should be the presumed mortgage vehicle for borrowing. The 
standard mortgage must be a safe mortgage and mortgage regulation 
should favor safe products. To this end, it is important to create a 
dedicated agency, such as the proposed Consumer Financial Protection 
Agency. Consumer choice is inconsistent with nonstandard options that 
cannot be compared or priced.
    Third, we need a structure that promotes and provides safe and 
standard mortgages through liquidity and standardization. Effective 
borrower choice is impacted by the structure of the system. Standard 
mortgages must be cost efficient. Liquidity in funding sources can 
assure this.
    I would also like to draw your attention to a feature of today's 
mortgage market that we all take very much for granted, namely that a 
borrower can lock-in a rate in advance of closing, which means that the 
borrower can come into the closing knowing what the mortgage rate will 
be. This is possible only because of the forward or ``To Be Announced'' 
(TBA) market. In the TBA market, the originator enters into a forward 
contract with the GSE issuer, in which the originator promises to 
deliver in the future a package of loans meeting the GSE's requirements 
in exchange for GSE MBS to be identified in the future. This is 
possible because GSE MBS of the same type, coupon, and maturity are 
interchangeable, unlike private-label MBS, each of which is unique in 
terms of credit risk and interest rate risk. The interchangeability of 
GSE MBS is a function of a large degree of standardization. This 
standardization produces sufficient liquidity to support a TBA market, 
which benefits consumers with guaranteed rate quotes and prevents bait-
and-switch mortgage offers. Because the originator is able to resell 
the loan to the GSE for a guaranteed rate before closing, the 
originator is not exposed to interest rate fluctuations between the 
time it quotes a rate and closing. Without the TBA market, originators 
would have to bear the risk that the market value of the loan would 
change before closing due to fluctuations in market rates. Because of 
the liquidity in GSE MBS, a TBA market is possible that allows 
originators to offer borrowers locked-in rates in advance of closing. 
This is of course key to the ability of a borrower to choose a mortgage 
that in fact the borrower will receive at closing.
    More generally, securitization should be the way to bring liquidity 
and cost efficiency to bear on the provision of safe and standard 30-
year fixed-rate mortgage. This can assure effective choice and support 
for a mortgage system that becomes the bulwark of sustainable home 
ownership in the U.S.
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McCoy, Patricia, Andrey Pavlov, and Susan M. Wachter, ``Systemic Risk 
    Through Securitization: The Result of Deregulation and Regulatory 
    Failure'', Connecticut Law Review, Vol. 41, p. 493, 2009, http://
    ssrn.com/abstract=1367973.
Pavlov, Andrey, and Susan M. Wachter, ``Mortgage Put Options and Real 
    Estate Markets'', Journal of Real Estate Finance and Economics, 
    Vol. 38, No. 1, 2009a, http://ssrn.com/abstract=1285517.
Pavlov, Andrey, and Susan M. Wachter, ``Subprime Lending and House 
    Price Volatility'', Institute for Law and Economics Research Paper, 
    Working Paper 2009b, http://ssrn.com/abstract=1316891.
Pavlov, Andrey D., and Susan M. Wachter, ``Systemic Risk and Market 
    Institutions'', Yale Journal on Regulation, Vol. 26, No. 2, 2009c, 
    http://ssrn.com/abstract=1462360. 
Pavlov, Andrey, and Susan M. Wachter, ``The Inevitability of Market-
    Wide Underpriced Risk'', Real Estate Economics, Vol. 34, No. 4, p9. 
    479-496, 2006.
Wachter, Susan M., ``Bad and Good Securitization'', Wharton Real Estate 
    Review XIII, pp. 23-34, Fall 2009a.
Wachter, Susan M., ``Understanding the Sources and Way Out of the 
    Ongoing Financial Upheaval'', International Real Estate Review, 
    Working Paper 2009b, http://ssrn.com/abstract=1464791.
                                 ______
                                 
                PREPARED STATEMENT OF ANDREW JAKABOVICS
   Associate Director for Housing and Economics, Center for American 
                          Progress Action Fund
                            October 8, 2009
    Any discussion of the housing finance system's future should start 
from a clear sense of what we want the system as a whole to accomplish. 
The recent GAO report considers the range of roles historically played 
by the housing enterprises, specifically Fannie Mae and Freddie Mac. 
But if the Committee restricts its analysis of the past and 
prescriptions for the future to simply the GSEs, it will miss the most 
significant origins of the current crisis and produce a system that is 
inadequate to support the essential role of housing finance in our 
economy. The real question for the Committee's consideration is what 
are the goals of the system and what combination of public, private, 
and hybrid arrangements, if any, will deliver those objectives.
    My goal for today's testimony is to therefore lay out a series of 
principles that describes the essential functions that the housing 
finance system must serve. In short, the specific principles are: 
access to credit and liquidity, countercyclicality, risk management and 
oversight, standardization, transparency and accountability, systemic 
stability, and consumer protection. I hope that these principles are 
useful as a starting point for reform of the housing finance system, 
particularly with respect to the secondary market and its 
participants--both public and private. I will also touch upon important 
lessons to be learned from the past so that we do not learn the wrong 
lessons from the subprime crisis, as some may be inclined to do. In 
short, the systemic failures stemmed from the proliferation of poorly 
underwritten mortgages channeled through the so-called ``shadow banking 
system'' of unregulated private label securities.
    The principles that I present today are the result of the 
collaborative efforts and discussions of a group of experts and 
stakeholders in mortgage finance convened by the Center for American 
Progress that have been meeting for more than a year. The group is 
known as the Mortgage Finance Working Group, or MFWG. These principles, 
which are available on the Center for American Progress's Web site, \1\ 
were publicly released at an event in March. While we at CAP have 
tremendously benefited from MFWG members' insights and expertise over 
the past year, my remarks this morning should not be construed as their 
personal or institutional endorsement of my testimony. Needless to say, 
any errors herein are my own.
---------------------------------------------------------------------------
     \1\ See, http://www.americanprogress.org/issues/2009/03/pdf/
mortgage_finance_principles.pdf.
---------------------------------------------------------------------------
    Looking at any proposal that is made going forward, based on these 
principles, the Committee should ask the following questions:

    Will institutions of any size in any market have access to 
        capital and liquidity in all markets at all times?

    How well will it do in ensuring a steady supply of 30-year 
        fixed-rate mortgages?

    How well will it do in ensuring a steady supply of finance 
        for affordable multifamily house?

    Will it support and speed innovation?

    Will it support and encourage transparency?

    Will all our communities, especially those devastated by 
        this crisis, have access to credit on fair and 
        nondiscriminatory terms?

    How can we transition to a new system without disruption?

    With these questions in mind, policymakers can design a regime that 
not only sets the policy framework for the primary and secondary market 
actions of purely private entities and public credit enhancement 
agencies and provides carefully designed Government backing only for 
those select activities of private actors that are determined to be 
necessary to ensure that there is credit available to support all the 
Nation's housing needs.
Liquidity Across Products and Time
    The first concern of policymakers in contemplating any redesign the 
U.S. mortgage finance system must be ensuring sufficient credit 
liquidity at all times to meet the needs of U.S. homeowners. American 
borrowers have shown a strong preference for long-term, fixed-rate, 
self-amortizing loans that have allowed them to build assets and plan 
loan repayment. Most investors, on the other hand, seek short-term, 
liquid investments. Mortgage markets in the United States in recent 
decades have done a remarkable job of intermediation between those 
different needs. (As Susan Wachter has mentioned, no other housing 
finance system provides long-term, fixed-rate mortgage lending as well 
as the American system.)
    What do we mean by liquidity? An investor needs to know that there 
will be a market for their assets--in the context of mortgage-backed 
securities, their particular share of loans made to individual 
homeowners--at all times. If an investment is not liquid, investors 
will charge more, if they make the capital available at all. If they 
don't, a new homebuyer cannot get a loan and an existing owner may be 
unable to sell.
    In thinking about liquidity, two important aspects must be 
considered: first, the need to have consistent credit liquidity through 
booms and busts; and second, the need to have broad availability of 
credit across places and housing types, Each is of paramount importance 
in thinking about the future of U.S. housing finance.
    Broad demands for liquidity must be consistently met over time. In 
the most recent housing cycle, we saw too much credit flow into the 
U.S. housing markets during the boom, creating a housing price bubble 
that misallocated trillions of dollars of capital. Private mortgage 
securitization played an unquestionably procyclical role during these 
bubble years. Conversely, during the aftermath of the housing bust, 
there has been a notable drying up of credit liquidity, one which has 
only been filled by the housing enterprises, Fannie Mae and Freddie 
Mac, both before and particularly after being placed in 
conservatorship, and FHA/Ginnie Mae. If not for these governmental and 
Government-backed sources of housing finance, the downturn would have 
been much more severe, and no one would be talking about the 
possibility that we've seen a bottom, either for the housing market or 
the broader economy.
    Any housing finance reform efforts must consider the importance of 
ensuring sufficient credit liquidity during down times, and who might 
provide that liquidity. Institutions with the capacity and 
responsibility for countercyclical activity are a requirement for a 
well-functioning system. This countercyclical role is one that will 
require some measure of Government backing, as the private sector has 
proven itself unable or unwilling to independently provide sufficient 
and necessary capital during periods of retrenchment.
    Credit liquidity must also be deep in addition to being broad. 
Policymakers must consider how a revised system will succeed in 
maintaining the confidence of domestic and international investors to 
continue directing their capital into U.S. housing markets. This 
confidence has been shaken, most particularly with respect to the 
primary lenders and secondary market institutions that are at the heart 
of mortgage finance today. Perhaps the biggest question policymakers 
face is whether U.S. housing finance can attract sufficient capital to 
meet its needs without a significant Government role, particularly in 
the wake of massive failures in the private securitization market which 
have caused the global investment community massive losses on U.S. 
mortgage securities. I believe the answer to the question is that there 
remain critical roles for Government to play in the provision of 
mortgage finance liquidity.
    Beyond the issue of constant and deep liquidity, U.S. housing 
finance must provide liquidity across geographies to support the 
acquisition and refinancing of a wide range of housing types, from the 
single-family suburban home to the high-rise apartment building, from 
double-wide manufactured housing to triple-decker row homes. An 
emphasis on ensuring the availability of mortgage finance to support 
home ownership remains appropriate, even in the aftermath of the 
housing crisis, as home ownership is still the key route to economic 
mobility and wealth accumulation for large segments of the American 
populace.
    But home ownership is not appropriate for everyone at every point 
in their lives. If the reformed housing system fails to provide 
sufficient financing for the production and maintenance of affordable 
rental housing, the system will fail to serve the needs not only of a 
large and sometimes vulnerable segment of the population, but also of 
the rest of us. Not only have almost all of us rented at some time in 
our lives, but the lack of quality affordable rental housing affects 
the fabric of our entire economy and society.
    The idea of ensuring sufficient credit liquidity translates for 
most Americans into ensuring a supply of capital flowing to originators 
of single-family mortgages. But policymakers should also be careful to 
consider the needs of multifamily housing as well. In the context of 
the secondary mortgage market, providing liquidity for multifamily 
housing in particular will be a challenge to policymakers going 
forward. Because multifamily housing is not as easily securitized or 
underwritten as single-family mortgages are, ensuring constant 
liquidity is more difficult. In periods of significant to stress to the 
banking system during the past two decades, permanent financing for 
multifamily housing was predominantly financed by the GSEs, both 
through their direct efforts as well as through their role as an active 
purchaser of the tax credits that helped finance the equity portions of 
multifamily housing deals. Research by the National Multi Housing 
Council highlights the critical role the housing enterprises played 
during the S&L crisis, providing $9 billion for multifamily housing at 
a time when savings and loans were responsible for $43 billion of 
disinvestment in the sector. Similarly, between October 2007 and 
September 2008, the GSEs provided a combined 82 percent of the $83 
billion in net new multifamily financing. \2\
---------------------------------------------------------------------------
     \2\ Mark Obrinsky, ``NMHC Research Notes: The GSEs' Role in 
Multifamily Finance'', National Multi-Housing Council. February 3, 
2009; Available at http://www.nmhc.org/Content/
ServeContent.cfm?ContentItemID=5039. See also Paul Weech, ``More than 
Home Ownership: The Role of the Housing GSEs in Multifamily Housing 
Finance'' (Forthcoming from the Center for American Progress).
---------------------------------------------------------------------------
    Demographic changes coupled with the fallout from the housing 
crisis make it a certainty that demand for rental units will soar in 
the near future, and much of that demand will be for affordable rental 
housing in places with access to decent job opportunities. During the 
height of the boom, much of the multifamily construction took the form 
of condominiums and higher-end developments. \3\ Any reformed housing 
finance system will need to meet the demand for financing multifamily 
housing across the range of price points; this will likely require a 
range of delivery channels for deeply subsidized, narrowly subsidized, 
and unsubsidized units.
---------------------------------------------------------------------------
     \3\ Joint Center for Housing Sudies, ``America's Rental Housing: 
The Key to a Balanced National Policy.'' Harvard University, 2008. 
http://www.jchs.harvard.edu/publications/rental/
rh08_americas_rental_housing/rh08_americas_rental_housing.pdf.
---------------------------------------------------------------------------
Fair and Affordable Access to Credit
    We should expect private capital to provide consumers with access 
to credit on profitable but fair terms. In particular, underserved 
communities should receive access to credit on terms that reflect their 
actual, not perceived, credit risk and not on predatory terms. These 
are the communities that have been hardest hit by the housing and 
economic crisis and will need the most capital to rebuild. While an 
emphasis on better risk management is likely to lead to tighter 
underwriting standards, policymakers should be careful in ensuring that 
those changes are based on criteria empirically tied to credit risk--
while remaining sensitive to the true costs of providing that credit--
rather than on ideological or discriminatory assumptions about the 
credit profiles of certain communities. Stronger underwriting should 
ultimately lead to a more careful allocation of credit within all 
communities, not a deprivation of credit to underserved communities.
    It is worth noting that the modern long-term fixed rate mortgage, 
where the homeowner does not bear interest rate risk, such as the 30-
year fixed-rate mortgage that we all take for granted, is actually an 
affordable housing financial product created by Government policy. In 
the 1920s and early 1930s, private-sector mortgages were short-term, 
nonamortizing bullet loans--many of same features found in the most 
toxic of the toxic mortgages originated at the height of the bubble. 
The Home Owners' Loan Corporation was created in 1933 at the height of 
the depression to refinance distressed borrowers into stable, long-
term--then 15-year--mortgages at up to 80 percent loan-to-value. FHA 
followed the HOLC offering these innovative long-term products. The 
adoption of the self-amortizing, fixed-rate mortgage by the private 
sector was a reflection of a need to compete on the best terms with 
public entities--in contrast to the race to the bottom among lenders we 
have witnessed over the past several years.
    Long-term, fixed rate loans are a unique feature of the American 
system. As a policy matter we should want to ensure their continued 
availability, because they remain essential to creating wealth/asset 
building opportunities for consumers. Moreover, unlike adjustable-rate 
mortgages, these loans shift interest rate risk away from homeowners, 
the party with the least ability to manage that risk, onto institutions 
and individuals with greater risk-management capacity.
    Absent a policy intervention to ensure the availability of these 
long-term mortgages, they probably will not exist, a point implicitly 
acknowledged by Wells Fargo CEO John Stumpf in a recent call for the 
GSEs to be given permission to purchase jumbo mortgages as a way to 
``help revive the moribund market for big mortgages.'' \4\
---------------------------------------------------------------------------
     \4\ http://www.ft.com/cms/s/0/85c9c1c8-a258-11de-9caa-
00144feabdc0.html?nclick_check=1.
---------------------------------------------------------------------------
    Another important goal is the provision of affordable housing 
finance products to all communities, not just the middle and upper 
class, but also to those underserved traditionally by decent and fair 
financial products and sources. Unfortunately, many have taken the 
wrong lessons from this crisis about the ability of low and moderate 
income people to be homeowners.
    And while society has sometimes overemphasized home ownership over 
the last two decades at the expense of rental housing, we should not 
learn the wrong lesson. The current high rate of default on subprime 
mortgages does not mean that home ownership is inappropriate for low- 
and moderate-income households. Indeed, from 1998 to 2006, only 9 
percent of subprime mortgages went to first-time homebuyers, with 62 
percent being used to refinance existing homes. \5\ As I will discuss 
shortly, the lesson policymakers should be taking away from the crisis 
is that level playing fields are necessary, particularly when it comes 
to affordable access to credit. When safe, affordable, and well 
underwritten loans must compete against unregulated exotic mortgage 
products priced without regard to underlying asset value or risk and 
marketed by brokers with misaligned incentives, the results are 
disastrous, both for homeowners and for the larger economy. We must 
ensure that parallel systems cannot again emerge that put the soundly 
underwritten loans in competition with unregulated and nontransparent 
products.
---------------------------------------------------------------------------
     \5\ http://www.responsiblelending.org/mortgage-lending/research-
analysis/Net-Drain-in-Home-Ownership.pdf.
---------------------------------------------------------------------------
    Many nonprofit, CDFI, and other innovators such as the Self-Help 
Credit Union were finding compelling and sound ways to lend to lower 
income families that proved to be far more successful than the track 
record of subprime product. \6\ The originations and servicing of these 
successful Self-Help mortgages were by banks motivated by CRA, with the 
liquidity provided by Fannie Mae. The Ford Foundation provided a 
guarantee and Self-Help provided management. In other words, this model 
presents a partnership that relied on Government incentives and 
provided safe loan products to consumers at no risk to the originating 
lender. The real lesson of these loans is that standard, well 
underwritten, low downpayment mortgages to low-wealth, low-income 
borrowers just like those offered through myriad CRA lending programs 
offered a safe and durable alternative to subprime products.
---------------------------------------------------------------------------
     \6\ http://www.self-help.org/secondary-market.
---------------------------------------------------------------------------
    It is important to understand that affordable housing finance for 
lower income and minority families was at a marked disadvantage in 
competing with predatory subprime product that was irrationally priced, 
poorly underwritten, and/or marketed with predatory practices. In 2005, 
55 percent of borrowers given subprime loans that were sold into 
private label securities qualified for prime loans at the time of 
origination. \7\ Good affordable lending was driven out--a perfect 
example of Gresham's law, ``Bad money drives out good.''
---------------------------------------------------------------------------
     \7\ Rick Brooks and Ruth Simon, ``Subprime Debacle Traps Even Very 
Credit-Worthy'', Wall Street Journal, December 3, 2007. http://
online.wsj.com/article/SB119662974358911035.html.
---------------------------------------------------------------------------
    We need to ensure that all the money in the game is available under 
the same rules. This doesn't mean that lenders should not differentiate 
between legitimate credit risks and price their offerings 
appropriately, but recent CAP research found that even among borrowers 
earning at least twice area median incomes, African-American and 
Hispanic borrowers were about three times as likely as whites to be 
given higher-priced mortgages. This is hardly a characteristic found in 
a system that ensures equal access to fairly priced credit.
    We must reestablish such efforts to allocate capital on fair but 
economically viable terms, particularly through innovation, not shy 
from doing affordable home ownership right.
Consumer Protection
    There has been a lot of discussion about the merits of consumer 
protection in the context of the Administration's proposal for a 
Consumer Financial Protection Agency, so I won't go into great detail 
here to explain CAP's support for that proposal. Rather, I will make a 
few brief points about the importance of consumer protection to an 
effective system of housing finance and vice versa--points that have 
been absent from the broader conversation to date.
    First, it is worth noting that to a large extent, consumer 
protection--i.e., efforts to prevent predatory lending and encourage 
the origination of safe and sustainable loans--is really also a means 
to protect investors as well. If loans are originated with aligned 
incentives, consumers should tend to receive sustainable, well-
underwritten loans, which benefits investors by making their 
investments safer. What we saw in the last market cycle was mortgage 
brokers and originators with misaligned incentives to sell 
unsustainable, high-fee mortgages because compensation was immediate 
and risks were divested.
    At the origination level, brokers and originating lenders had no 
incentives to make sustainable loans, and typically had perverse 
compensation incentives to sell high-risk, high-fee mortgages over 
safer products. Subprime and Alt-A mortgages, mainstays of private 
label securitization, were a particular problem, as we all know. 
Originating lenders like Countrywide paid originators more if they sold 
higher risk mortgages such as option ARMs and interest only loans. 
(They also got paid more for higher interest rate loans, which has led 
to our suggesting the need for greater scrutiny of whether there had 
been fair lending violations at the height of the housing bubble.) \8\
---------------------------------------------------------------------------
     \8\ See, http://www.americanprogress.org/issues/2009/08/
tarp_lending.html.
---------------------------------------------------------------------------
    With such misaligned incentives, it is not surprising that there 
have been rampant reports of origination fraud, and more importantly, 
that the mortgages composing private-label MBS were across the board 
poorly underwritten with historically astronomical default risks. For 
example, 44 percent of subprime mortgages, and 9 out of 10 Alt-A option 
ARMs, originated in 2005 were made without full income documentation. 
\9\
---------------------------------------------------------------------------
     \9\ Wei Li and Keith Ernst, ``Do State Predatory Lending Laws 
Work?'', Housing Policy Debate, Vol. 18, Issue 2 at p. 361 (2007), 
available at http://www.mi.vt.edu/data/files/hpd%2018.2/6.hpd_wei-
ernst_web.pdf.
---------------------------------------------------------------------------
    At all levels of the shadow banking system, the incentives for 
market actors, including credit rating agencies, were to generate as 
much volume as possible, with no regard for credit risk and often 
perverse incentives to generate higher cost, higher risk loans. Because 
the costs generated by their poorly underwritten mortgages were not 
ultimately borne by the key market actors in the private securitization 
process, but were instead borne by others (including the taxpayer)--an 
externality--their incentives were all aligned towards generating high 
short-term fees and payments, and away from the long-term viability of 
the underlying mortgages.
    In thinking about these problems, one potential solution stems from 
greater transparency and standardization. It's a lot easier to shop for 
a product where you can do comparison shopping, so to the extent that 
the current system encourages the mass availability of certain standard 
mortgage products (15/30yr FRM in particular), it empowers the 
consumer. This is not to say that certain innovative mortgage products 
should be excluded entirely from the marketplace; borrowers with unique 
circumstances should not be forced to accept a standard product that is 
unsuitable for them. Nevertheless, even in these instances, terms 
should be easily understood and presented in a fashion that allows for 
consistent comparisons across offerings.
    The benefits of standardization accrue to the consumers of 
securitized mortgages--investors--as well. As we have seen, securities 
with the same AAA rating have performed very differently over time. 
Transparency in MBS down to the loan level is often available only to 
market participants with very deep pockets, leaving other investors to 
guess how much future impairment is already priced into the security. 
MBS and collateralized debt obligations trade without TRACE 
requirements, which also impede market participants' ability to 
accurately price securities that may have been sliced and diced 
multiple times over.
    The secondary market ultimately drives the standardization that 
benefits consumers. Investors who innovate with exotic products should 
have a higher, not lower, obligation for transparency and consumer 
protection. Products with transparency that allows for ease of 
comparison across offerings in both the primary and secondary mortgage 
markets provide much greater efficiency and stability for individual 
participants and for the system as a whole.
    These consumer protection considerations are essential not only for 
primary market regulation. The secondary market plays a key role as 
well.
Risk Management and Oversight Creates Transparency
    Finally, there is the principle of risk management. In 
contemplating the reform of the housing finance system, most 
policymakers have understandably focused on the need to restore 
stability and sufficient risk oversight to the housing finance system. 
But those who would focus primarily on GSE reform are missing the 
bigger picture. After all, it is clear that the unregulated private 
securitization markets caused this crisis through poor underwriting and 
misaligned incentives that ultimately became the toxic MBS whose losses 
infected seemingly invincible institutions. And so we believe that any 
efforts to reform the housing finance system that ignore the private 
securitization markets are destined for failure. We must ensure a level 
playing field.
    In discussing the crisis that hit the housing finance system, it is 
critical that the difference between GSE-conforming MBS and private-
label MBS is understood. This is something that is clearly not well 
understood by many.
    GSE-conforming MBS have been around since at least the 1970s and 
involve a guarantee from one of the Government sponsored entities 
Fannie Mae or Freddie Mac on the timely payment of principal. This 
guarantee was thought to carry the implied backing of the Federal 
Government, something which was confirmed in the recent crisis, when 
the Federal Government took over the GSEs in a conservatorship and 
near-explicitly guaranteed their obligations. GSE-guaranteed MBS are 
securities based upon ``conforming mortgages,'' which typically are 
safe and standard mortgages--such as the 30 year FRM--with strong 
underwriting requirements. The GSEs also purchased ARMs, Alt-A, and 
even subprime mortgages, but even in those cases, the quality of those 
loans were mostly better than what was securitized through PLS, in part 
because the terms of the loans contained fewer predatory features. \10\
---------------------------------------------------------------------------
     \10\ See, https://www.efanniemae.com/sf/mortgageproducts/pdf/
armmatrix.pdf for the types of adjustable rate mortgages that Fannie 
Mae would purchase. Note that the factors that determine the interest 
rates (index plus margin) are generally favorable to the borrower and 
prohibit negative amortization and no lifetime floors.
---------------------------------------------------------------------------
    GSE-conforming mortgages, in large part due to the standards set by 
the GSEs themselves and the requirement of private mortgage insurance 
on loans in excess of 80 percent of the property's value, have 
historically performed very well. Even in this historically 
unprecedented housing downturn, GSE-conforming mortgages have seen 
default rates that are small relative to PLS. In fact, serious 
delinquency rates for PLS are considerably higher than Fannie Mae or 
Freddie Mac's portfolios (including their held Alt-A and subprime 
mortgages) as of the end of the second quarter of 2009. PLS make up 13 
percent of the outstanding single-family first mortgages but account 
for 35 percent of the serious delinquencies. The housing enterprises, 
in contrast, collectively hold 57 percent of those mortgages but only 
26 percent of the serious delinquent mortgages. \11\ In other words, 
there are more than one-third more delinquent mortgages in PLS than 
owned by the GSEs, despite the GSEs' market share being more than three 
times the size.
---------------------------------------------------------------------------
     \11\ http://www.freddiemac.com/corporate/company_profile/pdf/
fm_housing_crisis.pdf.
---------------------------------------------------------------------------
The Housing and Financial Crisis Originated in ``Toxic'' Private-Label 
        MBS
    Having laid out the principles that describe the essential 
functions of the housing finance system, I would like to also touch 
upon the key points of failure of the existing system.
    Specifically, the rapid expansion of a ``shadow banking system'' 
consisting of private label securities and their complex derivatives 
distorted the secondary mortgage market and chased safer loan products 
out. The proliferation of PLS comprised of loosely underwritten 
mortgages was made possible by a lack of prudential oversight and 
misaligned incentives throughout the origination and securitization 
processes.
    The unregulated private MBS market, free from any direct safety and 
soundness supervisory oversight, was hailed as a paradigm for efficient 
markets, with sophisticated private actors and cutting-edge 
quantitative analysis efficiently managing and allocating risk, whose 
complexities were boiled down into a series of letter grades issued by 
credit rating agencies who were paid handsomely by those packaging 
mortgages into securities. Despite the inherent conflicts of interest 
in ratings agencies' business model, belief that the ``shadow banking 
system'' could manage its own risk while providing strong returns was 
nearly universal. Thus, the regulatory playing field was tilted to the 
advantage of private securitization, as regulators and legislators 
alike were reluctant to regulate a market that seemed to be functioning 
efficiently without regulation. The lack of regulation allowed the 
shadow banking system to enjoy cost advantages over other sources of 
housing finance, which allowed it to dominate the marketplace.
    Because private securitization had relatively little regulation but 
the near-universal belief that its products were safe--AAA ratings 
coupled with expectations of perpetual house price appreciation--global 
capital flooded into the shadow banking system, and thus the U.S. 
housing markets, during the Bush administration. Private-label MBS have 
been created and sold for more than two decades, but their expansion 
was dramatic in the earlier part of this decade, expanding almost nine-
fold from $135 billion 2000 to almost $1.2 trillion in 2005. \12\
---------------------------------------------------------------------------
     \12\ http://www.fdic.gov/bank/analytical/regional/ro20063q/na/
2006_fall01_chart02.html.
---------------------------------------------------------------------------
    The U.S. PLS share of MBS went from 12 percent in 2002 to nearly 50 
percent in 2006, which had the effect of distorting the overall 
economics of the U.S. housing market. Coupled with low interest rates, 
this flood of capital caused massive appreciation in housing prices 
that was unsupported by the underlying economic trends. By the end of 
2007, U.S. housing prices had seen an inflation-adjusted 86 percent 
increase since 1996, even as household income stagnated. \13\ The PLS-
induced housing bubble burst and has today left approximately one in 
three mortgages underwater, \14\ and that number could rise to nearly 
50 percent by 2011, according to a recent study from Deutsche Bank. 
\15\
---------------------------------------------------------------------------
     \13\ http://www.responsiblelending.org/mortgage-lending/policy-
legislation/congress/senate-testimony-10-16-08-hearing-stein-final.pdf.
     \14\ First American CoreLogic.
     \15\ http://www.bloomberg.com/apps/
news?pid=20603037&sid=ac9y1xr7yNhQ.
---------------------------------------------------------------------------
    The growth in mortgages originated for private securitization 
displaced the so-called ``plain vanilla'' mortgage products offered by 
the GSEs, FHA, and portfolio lenders. GSE conforming mortgages shrank 
to less than 30 percent in 2006, down from 50+ percent in the 1990s. 
2005 was the first year in which PLS originations outstripped mortgages 
originated for agency MBS--including GNMA. Unsurprisingly, 2005 also 
marked the year in which mortgage lending standards deteriorated 
markedly, based on the proportion of loans where the intersection of 
credit score and LTV ratios had historical lending precedents. \16\ 
``By June 2006,'' notes Whitney Tilson based on loan performance data 
presented by Amherst Securities Group, ``mortgage lending standards had 
collapsed, even for the best loans.'' \17\
---------------------------------------------------------------------------
     \16\ http://www.moremortgagemeltdown.com/download/pdf/
T2_Partners_presentation_on_the_mortgage_crisis.pdf.
     \17\ Ibid.
---------------------------------------------------------------------------
    This unprecedented market share of the ``shadow banking system,'' 
which performed the basic functions of bank lending but without the 
risk oversight imposed on banks, was tied to the belief that these 
market players could self-regulate their own risk, and therefore this 
process of private securitization didn't need regulation for safety and 
soundness. As Alan Greenspan noted:

        Deregulation and the newer information technologies have joined 
        . . . to advance flexibility in the financial sector. Financial 
        stability may turn out to have been the most important 
        contributor to the evident significant gains in economic 
        stability over the past two decades . . . . Recent regulatory 
        reform, coupled with innovative technologies, has stimulated 
        the development of financial products, such as asset-backed 
        securities, collateral loan obligations, and credit default 
        swaps, that facilitate the dispersion of risk. \18\
---------------------------------------------------------------------------
     \18\ http://www.federalreserve.gov/boarddocs/speeches/2005/
20051012/default.htm.

    In hindsight, this was clearly a tremendously flawed assumption, 
but one which enjoyed huge support at the time.
Private-Label MBS Imploded Because of a Lack of Prudential Oversight 
        and Misaligned Incentives
    All modern banking systems have a prudential oversight regime, but 
when regulators fail to use their authorities, or loopholes are created 
that allow certain products and market participants to avoid oversight, 
the stability of the entire system is threatened.
    At the origination level, the Federal Reserve, which had 
specifically been tasked by Congress to develop guidance on subprime 
mortgages, ignored this obligation for more than a decade. And when 
State-level regulators sought to provide much-needed guidelines for 
products and institutions operating within their borders, the Bush 
administration's Office of the Comptroller of the Currency sued them 
arguing that national banks were already subject to Federal regulation, 
despite the OCC's determined unwillingness to protect consumers from 
dangerous loan products. The former attorney general of North Carolina, 
Roy Cooper, was led to remark, the OCC ``took 50 sheriffs off the job 
during the time the mortgage lending industry was becoming the Wild 
West.'' \19\
---------------------------------------------------------------------------
     \19\ Robert Berner and Brian Grow, ``States Warned About Impending 
Mortgage Crisis'', BusinessWeek, October 12, 2008. http://
www.msnbc.msn.com/id/27121535.
---------------------------------------------------------------------------
    The problem of regulators being philosophically opposed to 
regulation was an even more critical failing in light of the problem of 
misaligned incentives throughout the system. Put simply, virtually none 
of the participants in the mortgage securitization process had the 
incentive to originate and sell loans that were viable over the long 
term.
    At the securitization level, loan underwriters had no incentives to 
verify the underwriting of the loans they were pooling, or to take 
measures to ensure that defaults were limited. Instead, they merely 
needed to attain a AAA rating for as high a volume of securities as 
possible.
    Credit rating agencies were tasked with assessing the risk 
associated with these private label MBS. As Chairman Dodd, Vice 
Chairman Shelby, and Senator Schumer, among others, have described, 
these rating agencies faced inherent conflicts of interest, as they 
were paid by the MBS issuers, and paid more for higher volumes of new 
issues.
    Indeed, we have begun to see renewed activity among re-REMICs, 
wherein previously downgraded MBS are reorganized into new securities 
with better ratings, even as the underlying impaired mortgages are left 
untouched. This alone should put pause to anyone claiming that the 
market has learned its lesson (once burned, twice shy) and the worst 
excesses of originators and the PLS market are unlikely to return. 
Similarly, some who have put forth proposals that ignored the 
possibility of a reinvigorated PLS market and therefore saw no need to 
develop a regulatory structure for it are inviting a return of these 
distortions on the conventional market.
    One possibility we at CAP are considering to ensure that whatever 
PLS market emerges competes on fair and transparent terms with future 
conventional mortgage lending would be to require all those who 
securitize residential mortgages to obtain a license that brings with 
it certain duties to transparency, risk management, and a 
countercyclical market presence. There are advantages and disadvantages 
to this model, but it is worth exploring further.
The Costs of Excessive Risk Taking by Private MBS Market Participants 
        Were Borne by Others
    In 2007, Fed Chairman Ben Bernanke famously stated that the damage 
from the subprime mortgage crisis had been contained. In fact, as we 
now know, this was terribly incorrect, as the excessive defaults from 
subprime and Alt-A securities, as well as those caused by the 
depreciation of housing markets artificially inflated by the surge of 
global capital into U.S. housing, became so great that they paralyzed 
our entire global financial system, necessitating massive injections of 
public funds into private Wall Street financial institutions and the 
housing enterprises.
    By 2007, all of the world's largest financial institutions had 
assumed enormous exposure to the U.S. private-label MBS market. As a 
result, when these securities began to see higher defaults as a result 
of their poor mortgage origination practices and the overall inflation 
of U.S. housing prices, the resulting losses impacted areas of the 
financial markets far beyond private mortgage origination. Financial 
institutions as disparate as Citigroup (primarily a bank holding 
company regulated by Federal banking regulators), AIG (primarily an 
insurance company regulated by State insurance regulators), and Bear 
Stearns (primarily an investment bank and broker-dealer regulated by 
the SEC) experienced losses related to their private label MBS exposure 
that were so severe that it impacted their other financial activities.
    Ironically, the housing enterprises also experienced enormous 
losses as a result of the private-label MBS market. This occurred 
through losses on their guarantee book of business as well as through 
more profound losses on the private-label securities they themselves 
had bought in an effort to boost profits in response to lost market 
share from the vary same PLS.
Conclusion
    In summation, the housing finance system as a whole must offer 
access to credit and liquidity, countercyclicality, risk management and 
oversight, standardization, transparency and accountability, systemic 
stability, and consumer protection. A robust system will likely require 
a combination of public, private, and hybrid entities to deliver all of 
these objectives. It is instructive to look back at the rapid expansion 
of the PLS market at the expense of conventional lending to identify 
the failures of the past as we begin to consider how to reform the 
housing finance system to achieve the principles we have laid out.
Appendix

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
                     FROM EDWARD J. DeMARCO

Q.1. Availability of Mortgage Capital-- Mr. DeMarco, a witness 
on our second panel will testify that ``Perhaps the biggest 
question policymakers face is whether U.S. housing finance can 
attract sufficient capital to meet its needs without a 
significant Government role, particularly in the wake of the 
massive failures in the private securitization market . . . '' 
What is your answer to this question--Will the United States be 
able to attract the capital necessary to meet our housing needs 
if the U.S. Government does not play such a role?

A.1. In responding, I assume that the Federal Government 
continues to provide direct credit support to the mortgage 
market through its existing programs such as FHA and VA 
mortgage insurance. Thus, I take the question to be in 
reference to attracting private capital to support the 
conforming, conventional market. In the long run, I believe the 
answer to that question is yes and I hope that policymakers 
will seek institutional and regulatory structures aimed at such 
an outcome. In the near-term, however, with the Enterprises in 
conservatorship and much uncertainty in the marketplace today 
regarding housing in the United States, I believe that some 
continued Government support is important to maintaining market 
stability. It may also be a necessary component of a 
transitional period as we move to a post-conservatorship set of 
structures for the secondary mortgage market.

Q.2. Enterprises and Foreclosure Prevention-- Mr. DeMarco, to 
date, the loan modification effort has focused largely on 
payment modifications rather than principal reductions. At the 
very least, I believe principal reductions may be necessary to 
prevent foreclosures for borrowers who are deeply underwater. 
Is there more that Fannie Mae and Freddie Mac can do to 
encourage principal forgiveness? Is this the kind of thing you 
are prepared to explore?

A.2. As an alternative to a principal write-down, the Home 
Affordable Modification Program (HAMP) program incorporates 
principal forbearance as the final step in the waterfall--in 
the event it's needed to create an affordable payment. However, 
with the other features of the program--interest rate reduction 
to 2 percent and term extension--there are few cases when 
principal forbearance is needed.
    The impact of principal forbearance is comparable to a 
principal write-down in that the amount of principal subject to 
forbearance is not amortized and is not subject to interest. 
However, it is due and payable at the time the loan is paid off 
and is included in the payoff quote. If at payoff the value of 
the property is less than the payoff quote, the servicer can 
forgive some or the entire principal forbearance amount. This 
accomplishes several things. First, it minimizes the potential 
for moral hazard. Second, it allows the investor to recover 
some or the entire amount of principal forbearance, if the 
housing market recovers. Third, it's more acceptable to the 
investor community as an option. There are investors and other 
industry stakeholders who take a very strong position against 
principal write-downs.
    Where principal forgiveness may be a viable strategy is 
with addressing the needs of borrowers with option ARMs who may 
not have understood the product and how it worked, and have 
seen the principal balance of their loans increase due to 
negative amortization. Many would say this is the most logical 
and justifiable scenario for a principal write-down. It is one 
that's being considered.
    Finally, I would note that any borrower has an obligation 
to repay their debt even if that debt is backed by an asset 
that has declined in value. Borrowers with an ability to pay 
should be expected to make their payments without regard to 
declining house prices.

Q.3. The Affordable Housing Mission of the Enterprises-- In his 
testimony, Mr. Wallison argues that enterprise purchases of 
both subprime and Alt-A loans were driven by their affordable 
housing mandate imposed in the law. However, my understanding 
from talking to FHFA staff is that the Alt-A book of business, 
which is responsible for 40 to 45 percent of the enterprises' 
losses, was not really used to meet the housing goals. You 
seemed to indicate during the hearing that this is your 
understanding as well. Is that correct?

A.3. FHFA assumed responsibility for setting affordable housing 
goals--previously set by HUD--upon enactment of the Housing and 
Economic Recovery Act of 2008 (HERA) on July 30, 2008. The 
decisions by Fannie Mae and Freddie Mac to purchase certain 
loans with layers of risks, e.g., subprime and Alt-A loans, 
were influenced by several factors, including a desire to 
preserve market share and to achieve the anticipated higher 
yield on such, as well as the affordable housing goals. The 
purchase of Alt-A loans, which has contributed significantly to 
losses at both enterprises, had the effect of making it more 
difficult for the enterprises to meet their income-based 
affordable housing goals, because, by definition, such loans 
often lacked information on borrower income. Purchase of such 
loans did have a modest positive impact on enterprise 
performance on the underserved area goals.

Q.4. You suggest in your testimony that, rather than creating 
housing goals, it might be more efficient to provide more 
targeted subsidies. Senator Reed, with my strong support, 
included in HERA a provision that requires the enterprises to 
contribute to a National Housing Trust Fund, assuming they 
return to profitability. Is that the kind of targeted subsidy 
you think makes sense?

A.4. HERA established a Housing Trust Fund to increase and 
preserve the supply of rental housing for extremely low and 
very low income families, including homeless families, and to 
increase home ownership for extremely low and very low income 
families. This approach might well be more effective than the 
housing goals. Currently, because of the financial condition of 
the companies, Enterprise contributions have been suspended. As 
a general matter, my view about subsidies is that taxpayers 
should clearly see the cost and the delivery mechanism should 
ensure that the subsidy gets to the intended beneficiaries.

Q.5. Liquidity and Standardization-- Mr. DeMarco, you note, as 
I did, that we need a market to ensure standardization and 
liquidity, particularly in times of stress. In your view, is 
some sort of a Federal role necessary to achieve these goals? 
If not, how would we be assured that product standardization 
would result from a purely private marketplace?

A.5. Taking each goal separately, I do not believe that a 
direct Government role is necessary to ensure the 
standardization necessary to create a deep and liquid secondary 
mortgage market in normal times, but a Government role probably 
is necessary if we want depth and liquidity during a period 
like we have experienced recently. Standardization can be 
achieved in several ways. It can be imposed by the Government; 
it can be achieved through a self-regulated organization or 
trade association such as the stock exchanges or the Securities 
Industry and Financial Markets Association (SIFMA); or it can 
be imposed by dominant firms (think of video formats or 
computer operating systems). With respect to market liquidity, 
it seems unlikely that private market-makers will be large 
enough to ensure liquidity in the secondary mortgage market 
during crises. Therefore, some sort of Government buyer of last 
resort authority maybe necessary to avoid severe periods of 
illiquidity in this market.

Q.6. Portfolios Under Conservatorship-- Under the 
conservatorship, FIIFA has directed the GSEs to begin shrinking 
their portfolios beginning in 2010. With the Federal Reserve 
announcing it does not intend to extend its MBS purchase 
commitment beyond the current $1.25 trillion limit, does FHFA 
intend to maintain its requirement that the enterprises shrink 
their portfolios? If so, please assess the market outlook for 
agency MBS in the absence of either enterprise or Fed portfolio 
purchases. What impact do you project this outlook will have on 
mortgage rates?

A.6. The portfolio limits referenced are a part of the 
Treasury's Preferred Stock Purchase Agreement with the 
Enterprises. In the absence of any change in the current Senior 
Preferred Stock Purchase Agreements and the Federal Reserve's 
MBS purchase program, it seems reasonable to expect there could 
be a gradual, modest increase in mortgage rates over time. 
Still, the market is well aware of these pending changes yet 
mortgage rates remain very low and, in fact, have declined 
since the Federal Reserve announced its intention to terminate 
new purchases by March 31, 2010.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM EDWARD 
                           J. DeMARCO

Q.1. What were Fannie and Freddie's respective shares of the 
total mortgage market from 2003 to the present? Did Fannie and 
Freddie lose market share to subprime and nontraditional 
markets during those years? What share of Fannie and Freddie's 
business were subprime mortgages as defined at the time? 
Nontraditional mortgages as defined at the time? Which of these 
types of mortgages caused the most significant losses for 
Fannie and Freddie?

A.1. Table 1 below shows total originations of single-family 
mortgages in 2003 through 2008 and combined Enterprise 
acquisitions of such mortgages during that period. The decline 
in the share of total originations represented by combined 
Enterprise acquisitions in 2004 through 2006 resulted both from 
the boom in subprime and nontraditional lending during those 
years and a reduction in the volume of Enterprise acquisitions, 
as some mortgages that the Enterprise would likely have 
acquired in previous years were financed through private-label 
securitization.

     Table 1. Originations of Single-Family Mortgages and Fannie Mae and Freddie Mac Single-Family Mortgage
                                              Purchases, 2003-2008
                                 (dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
                    Single-Family Mortgage         Fannie Mae and Freddie Mac       Fannie Mae and Freddie Mac
     Year                Originations                  Combined Purchases             Share of Originations
----------------------------------------------------------------------------------------------------------------
        2003                         $3,945.0                         $2,023.7                            51.3%
        2004                          2,920.0                            942.9                            32.3%
        2005                          3,120.0                            918.7                            29.4%
        2006                          2,980.0                            875.6                            29.4%
        2007                          2,430.0                          1,125.4                            46.3%
        2008                          1,500.0                            940.5                            62.7%
----------------------------------------------------------------------------------------------------------------
Sources: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications.

    There is no common industry definition of a subprime 
mortgage, so it is not possible to indicate the volume of 
subprime loans acquired by the Enterprises. However, most 
industry participants would consider a mortgage made to a 
borrower whose credit score is below 620 to be a subprime loan. 
Both Freddie Mac and Fannie Mae have reported that, as of 
September 30, 2009, loans to borrowers with credit scores below 
620 comprised 4 percent of the unpaid balance of their 
respective portfolios of conventional single-family mortgages. 
From 2002 through 2008, each Enterprise's acquisitions of such 
loans accounted for 3-6 percent per year of their total single-
family acquisitions.
    During the mortgage lending boom of the middle years of 
this decade, private-label mortgage-related securities often 
were backed by pools of mortgages that issuers designated as 
subprime loans. Table 2 provides information on issuance and 
Enterprise purchases of such securities in 2002 through 2008. 
The data on securities issuance were obtained from Inside 
Mortgage Finance Publications. The data on each Enterprise's 
purchases in each year and combined Enterprise purchases in 
2006 through 2008 were obtained from the Enterprises and 
published in FHFA's 2008 Annual Report to Congress. The data on 
combined Enterprise purchases for 2003 through 2005 were 
obtained from Inside Mortgage Finance Publications and 
previously reported in annual research reports published by the 
Office of Federal Housing Enterprise Oversight, one of FHFA's 
predecessor agencies.

   Table 2. Issuance and Enterprise Purchases of Private-Label Mortgage-Related Securities Backed by Subprime
                                              Mortgages, 2002-2008
                                 (dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
               Issuance of            Fannie Mae                  Freddie Mac                  Combined
                 Subprime    -----------------------------------------------------------------------------------
    Year      Private-Label
                   MBS          Purchases      Share*       Purchases      Share*       Purchases      Share*
----------------------------------------------------------------------------------------------------------------
    2002        $122,680.9       $5,143.9          4.2%          n.a.          n.a.          n.a.          n.a.
    2003         194,958.5       25,768.6         13.2%          n.a.          n.a.     $81,000.0         41.5%
    2004         362,549.3       67,003.6         18.5%          n.a.          n.a.     176,000.0         48.5%
    2005         465,036.3       24,468.8          5.3%          n.a.          n.a.     169,000.0         36.3%
    2006         448,599.6       35,606.1          7.9%     $74,761.0         16.7%     110,367.1         24.6%
    2007         201,546.7       15,970.5          7.9%      43,667.0         21.7%      59,637.5         29.6%
    2008           2,261.4          637.4         28.2%         106.0          4.7%         743.4         32.9%
----------------------------------------------------------------------------------------------------------------
n.a. = not available.
Sources: for issuance data 2002-2008 and combined data 2003-2005, Inside Mortgage Finance; Fannie Mae and
  Freddie Mac for all other data.
* Reported ``share'' is Enterprise purchases of subprime private-label MBS in each year expressed as a
  percentage of total subprime MBS issued during the year. However, it cannot be assumed that the subprime
  private-label MBS purchased by an Enterprise in a given year were issued in that year.

    Defining a nontraditional mortgage is even more problematic 
than defining a subprime loan, since the use of the former term 
varied widely across lenders and over time. For that reason, it 
is not possible to indicate the volume of nontraditional 
mortgages originated or acquired by the Enterprises. 
Information is available on issuance and Enterprise purchases 
of private-label mortgage-related securities backed by 
Alternative-A (Alt-A) mortgages. Table 3 provides such 
information for 2002 through 2008. The data on securities 
issuance were obtained from Inside Mortgage Finance 
Publications. The data on each Enterprise purchases were 
obtained from the Enterprises and published in FHFA's 2008 
Annual Report to Congress.
    Alt-A mortgages acquired by Fannie Mae and Freddie Mac have 
contributed disproportionately to each Enterprise's credit 
losses. In Fannie Mae's earnings statement for the second 
quarter of 2009, the Enterprise reported $18.8 billion in 
credit-related expenses. Alt-A mortgages accounted for 9.8 
percent of Fannie Mae's total single-family mortgage portfolio 
at that time, but 41.2 percent of the Enterprise's credit-
related expenses in that quarter. Freddie Mac reported $5.2 
billion in credit-related expenses in the second quarter of 
2009. The Enterprise stared that Alt-A mortgages accounted for 
9 percent of its single-family mortgage portfolio at that time, 
but caused 45 percent of its credit losses in the first half of 
the year.
    Data on single-family mortgages that are seriously 
delinquent--past due 90 days or more--sheds additional light on 
how nontraditional mortgages are contributing to Enterprise 
credit losses. As of September 30, 2009, the serious 
delinquency rate on Fannie Mae's conventional single-family 
mortgage portfolio was 4.72 percent; the comparable rate on 
Alt-A loans acquired by Fannie Mae was 73.97 percent. On that 
date, the serious delinquency rate on Freddie Mac's single-
family mortgage portfolio was 3.43 percent; the comparable 
rates on Alt-A, Interest-Only, and Option adjustable-rate 
mortgages acquired by Freddie Mac were 10.94 percent, 15.52 
percent, and 15.55 percent, respectively.

     Table 3. Issuance and Enterprise Purchases of Private-Label Mortgage-Related Securities Backed by Alt-A
                                              Mortgages, 2002-2008
                                 (dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
             Issuance of Alt-         Fannie Mae                  Freddie Mac                  Combined
    Year     A Private-Label -----------------------------------------------------------------------------------
                   MBS          Purchases      Share*       Purchases      Share*       Purchases      Share*
----------------------------------------------------------------------------------------------------------------
    2002         $53,462.7       $1,756.0          3.3%          n.a.          n.a.          n.a.          n.a.
    2003          74,151.0        8,104.0         10.9%          n.a.          n.a.          n.a.          n.a.
    2004         158,585.8       21,999.0         13.9%          n.a.          n.a.          n.a.          n.a.
    2005         332,323.2       16,109.0          4.8%          n.a.          n.a.          n.a.          n.a.
    2006         365,675.8       11,973.0          3.3%     $30,546.0          8.4%     $42,519.0         11.6%
    2007         249,610.0        5,288.0          2.1%      10,008.0          4.0%      15,296.0          6.1%
    2008           1,854.7          175.0          9.4%         618.0         33.3%         793.0         42.8%
----------------------------------------------------------------------------------------------------------------
n.a. = not available.
Sources: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications.
* Reported ``share'' is Enterprise purchases of Alt-A private-label MBS in each year expressed as a percentage
  of total Alt-A MBS issued during the year. However, it cannot be assumed that the Alt-A private-label MBS
  purchased by an Enterprise in a given year were issued in that year.


Q.2. We know that a large percentage of delinquent borrowers 
eligible for the HAMP program are either not responding to 
servicer requests or returning incomplete documentation. 
Freddie has initiated a program to reimburse servicers who hire 
qualified third-parties to help reach out to borrowers. Why are 
GSEs not doing this to help more struggling borrowers, and 
could you launch a pilot program to see whether in person 
outreach would improve the effectiveness of the loan 
modification programs?

A.2. Both Freddie Mac and Fannie Mae are testing the concept of 
reaching out to borrowers with third parties who go door-to-
door to initially solicit borrowers for modifications and/or to 
follow-up on outstanding documentation required by HAMP. Early 
results indicate in-person contact is effective. It mirrors the 
face-to-face contact that occurred when many of these borrowers 
took out their loans and needed individual guidance and to be 
educated. Fannie Mae and Freddie Mac continue to evaluate the 
successes and shortcomings of the current programs to look for 
additional means of addressing shortfalls and reaching more 
borrowers. The Enterprises will continue to work with FHFA and 
the Administration on cost-effective ways of reaching out to 
borrowers and improving the overall effectiveness.
                                ------                                


         RESPONSES TO WRITTEN QUESTIONS OF SENATOR KOHL
                     FROM EDWARD J. DeMARCO

Q.1. Currently, the GSEs own more than half of the mortgages 
across the country. For a period of time, Fannie and Freddie 
started to purchase more exotic and riskier mortgages while no 
additional safeguards put in place. The GSEs, have before, 
required that homeowners who meet a certain criteria receive 
prepurchase counseling. Additionally, Fannie Mae recently 
reinstated a homebuyer education piece for the 
MyCommunityMortgage. Finally, it has been proven that 
homeowners who have received prepurchase counseling have a 
lower default rate and should they get in trouble, they have 
the information on where to get help.
    Do you support expanding a homebuyer education requirement 
to first-time homebuyers who will have their loan guaranteed by 
the GSEs? Do you think this will be an effective tool to help 
better protect the GSE's investments?

A.1. Recent studies have found that households that receive 
prepurchase counseling have slightly lower default rates and, 
if they do default, are likely to seek help from the entity 
that counseled them. Such studies cannot control for 
differences in the quality of counseling services provided by 
different firms or in different jurisdictions, however, so that 
it is not clear that requiring prepurchase counseling for all 
first-time homebuyers whose mortgages were acquired by Fannie 
Mae and Freddie Mac would lower default rates on those loans.
    In addition, default losses would not necessarily go down, 
since there is no evidence that lenders incur smaller average 
losses on defaulted loans whose borrowers were precounseled and 
seek help when they become delinquent. Further, the current 
market counselors who are certified to provide prepurchase 
counseling are very busy working with servicers to assist 
distressed homeowners modify their delinquent mortgages. There 
are also shortages of counselors in nonurban areas.
    For all those reasons, at this time I do not favor 
requiring prepurchase counseling for all first-time homebuyers 
whose loans are acquired by the Enterprises. Still, in view of 
how many homebuyers in the past few years got into mortgages 
they did not understand or could not manage, it seems logical 
that prepurchase counseling should be encouraged for certain 
classes of homeowners and required in certain specified 
circumstances.

Q.2. Fraudulent and inaccurate appraisals have been identified 
as one of the problems that caused the housing bubble. Steps 
have been taken to create a firewall between appraisers, real 
estate agents and mortgage lenders. While it is a good first 
step in trying to ensure that there is not a conflict of 
interest and the homebuyer is getting a fair and accurate 
appraisal of the property, there might be other safeguards that 
can be put in place?
    How often does the Agency review and update appraisal 
standards for the mortgages that the GSEs guarantee? Do the 
GSEs ever ask for a second opinion on appraisals that they 
might find questionable? Does the Agency feel that the new 
reforms for appraisers and lenders will be strong enough to get 
more accurate appraisals?

A.2. Fraudulent and inaccurate appraisals were a contributor to 
the rapid run-up in home prices and have resulted in 
significant problems for lenders and homeowners. Safeguards now 
appear to be adequate and numerous; the critical issue turns on 
enforcement. State regulators--entrusted with authority to 
administer appraisal rules--admit to being underfunded and 
understaffed. Registration of appraisers may help. However, 
strong education and ethical standards work most effectively 
when supported by real enforcement.
    FHFA does not update appraisal standards; that is the work 
of the GSEs. FHFA examines the GSEs to assure that their 
guidelines are being carried forward in dealing with their 
seller servicers. The recently adopted Home Valuation Code of 
Conduct will expire next year in November and new rules will 
add to or amend that code. Further, at any time, the GSEs may 
add to their appraisal guidelines in response to market 
conditions.
    There has been some indication that appraisals have 
improved. This may be a combination of appraisal standards by 
the Enterprises and stronger underwriting and appraisal 
requirements by lenders. For example, Freddie Mac recently 
stated that appraisals received had improved some 15 percent, 
when tested against the automated valuation models they employ 
for quality control.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER
                     FROM EDWARD J. DeMARCO

Q.1. How is FHFA overseeing the way in which Fannie Mae, 
Freddie Mac, and the Home Loan Banks are managing credit risk?

A.1. Fannie Mae and Freddie Mac--FHFA is keenly focused on 
credit risk at Fannie Mae and Freddie Mac. Examiners and 
analysts in the Division of Enterprise Regulation, with the 
support of other offices within FHFA, continuously assess the 
drivers of credit risk for single- and multifamily mortgages 
owned and guaranteed by the Enterprises. We also assess the 
creditworthiness of a wide range of counterparties to which the 
Enterprises are exposed, including loan originators and 
servicers, mortgage insurers, bond guarantors and derivatives 
counterparties. The Enterprises are also exposed to credit risk 
from private-label mortgage-backed securities that they have 
purchased or guaranteed in structured products, and FHFA 
continuously evaluates the performance of these securities.
    Our staff assesses mortgage credit performance, as well as 
the processes used by the Enterprises in assessing their own 
performance, by reviewing a wide range of performance metrics, 
including delinquency statistics, loss severity upon 
disposition of real-estate owned (i.e., properties acquired 
through foreclosure), losses incurred through foreclose 
alternatives such as short-sales and deeds-in-lieu of 
foreclosure, and redefault rates on modified mortgages. FHFA 
personnel also assess credit metrics gauging the performance of 
mortgages by various categories, including credit score, year 
of origination, original and current loan-to-value ratios, 
geographic locale, product type and originating lender, among 
others.
    In addition to continuously monitoring credit performance, 
we assess the quality of the models used by the Enterprises to 
underwrite and price mortgages, as well as models used to 
forecast credit expenses. We also assess a wide range of 
operational processes that directly affect the amount of credit 
risk that ultimately is realized, including processes for 
quality control, fraud prevention and remediation, mortgage 
repurchases and the disposition of real estate acquired through 
foreclosure. Further, we work closely with both Enterprises and 
the Department of Treasury to evaluate controls surrounding the 
Making Home Affordable program, which has a direct effect on 
ultimate credit losses.
    Federal Home Loan Banks--Structurally, the Federal Home 
Loan Banks (FHLBanks) face limited credit risk in their 
advances portfolios. The principal source of their credit risk 
is in their holdings of private-label mortgage-backed 
securities (MBS), which constitute approximately 5 percent of 
their aggregate asset portfolio, or $56.6 billion, as of June 
30, 2009.
    Sixty-four percent of FHLBank assets are advances to 
members. By law, all advances must be collateralized by 
residential mortgage loans, deposits in an FHLBank, Treasury 
and agency securities, or ``other real estate-related 
collateral.'' No FHLBank has ever incurred a credit loss on an 
advance to a member.
    Seven percent of their assets are whole mortgage loans. 
These nonjumbo, fixed-rate loans, principally from 2004 and 
before, have high FICO scores and low loan-to-value ratios. 
They were written to traditional underwriting standards, and 
the originating member retains some credit risk on these loans. 
At June 30, 2009, only 0.35 percent of these loan balances were 
90 or more days delinquent and not accruing interest.
    Fifteen percent of assets are non-MBS investments, mostly 
prime money market investments and Federal agency securities. 
Approximately half of these money market investments have an 
overnight maturity. The FHLBanks face regulatory limitations on 
the amount of investments with any counterparty based on the 
capital levels of both the FHLBank and the counterparty as well 
as the credit rating of the counterparty.
    Mortgage-backed securities are the remaining 14 percent of 
the portfolio. Of these, $56.6 billion were private-label MBS 
and 594.4 billion were agency MBS. By regulatory policy, an 
FHLBank may currently invest in MBS up to six times its 
capital, but any investments in excess of three times its 
capital must be agency MBS.
    FHFA examiners review credit risk at each examination, and 
each FHLBank receives a credit risk component rating at each 
examination. The rating reflects the amount of credit risk at 
the FHLBank and the quality of its credit risk management. The 
FHFA is also completing a targeted review of credit risk across 
all 12 FHLBanks, and will release a report on that review 
within several months.
    The targeted review focused on collateral operations and 
private-label MBS. The principal credit risk stems from the 
private-label MBS. While all these investments were rated 
triple-A at the time of purchase, the credit quality of these 
investments has deteriorated. Approximately 40 percent are now 
rated below investment grade and an additional 29 percent are 
rated investment grade but either have been downgraded or are 
on negative watch. The private-label MBS portfolios are in run-
off mode, In the first half of 2009, the FHLBanks incurred 
credit-related impairment charges on these investments of $953 
million. Additional losses on these investments are possible 
and depend on house prices, unemployment, and other housing 
market conditions. For the past 18 months, the Division of 
FHLBank Regulation and its predecessor entity have devoted 
intense supervisory efforts to private-label MBS.

Q.2. Assuming that the GSEs may be taking on additional risk as 
part of the Administration's effort to help keep people in 
their homes, what is being done to make sure that the increased 
risk to the taxpayer is manageable?

A.2. FHFA does not believe the GSEs have taken on additional 
credit risk as a result of their participation in the Making 
Home Affordable (MHA) program. The MHA program is designed to 
reduce preventable foreclosures. Consistent with this 
objective, underwriting standards are in place. Income and 
employment are verified. Modified mortgages are better aligned 
with the borrowers' capacity to service the debt. This in turn 
lessens the likelihood of foreclosures and reduces the risks to 
Fannie Mae, Freddie Mac, and ultimately the U.S. Treasury and 
taxpayers. If the MHA programs are applied consistently and 
uniformly, they will contribute to stabilizing the mortgage 
market and home prices, so that the value of the collateral 
underlying the GSEs' portfolios can stabilize and increase. 
This can have only a positive impact on their risk profile and 
capital position.
    That said, FHFA recognizes that implementing and managing 
the program results in increased operational complexities for 
the GSEs. FHFA is closely monitoring the GSEs' roles under the 
``Treasury Agency'' agreements to ensure that the program is 
implemented and managed in a safe and sound manner.

Q.3. FHFA was given greater authority to oversee new programs--
including the imposition of new fees--initiated by the housing 
GSEs. What are you doing to implement that new authority, and 
how is that process working?

A.3. One of the important new powers that FHFA received in the 
Housing and Economic Recovery Act of 2008 was the authority to 
review and approve ``new products.'' FHFA has established an 
interim rule implementing that authority, which empowers the 
agency to review both new activities and, as an important 
subset, new ``products,'' which in most cases must be subject 
to public notice and comment before they can be approved and 
commenced.
    FHFA has received public comments on the interim rule, and 
is working to incorporate those comments in a final rule. FHFA 
is working to implement an operational process for reviewing 
new activities and new products that will meet the statutory 
directive and the needs of the public, while meshing with the 
Enterprises' own internal processes for developing and 
reviewing new business initiatives and efficiently deploying 
the agency's supervisory resources. FHFA has reviewed a number 
of Enterprise initiatives to date, none of which have been 
determined to be new products, an outcome consistent with the 
fact that both Enterprises are currently in conservatorships 
and are managed to conserve and preserve their assets while 
carrying out their mission. Several more initiatives are under 
review today, both for safety and soundness considerations and 
to be sure that the agency and the Enterprises address the 
Congressional desire that new products be exposed to public 
review through the notice and comment process.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
                     FROM WILLIAM B. SHEAR

Q.1. Affordable Housing Mission--Mr. Shear, in its review of 
the GSEs' housing goals performance in 2004-2005, HUD concluded 
that both Fannie Mae and Freddie Mac produced a higher share of 
their financings in low mod borrowers than the primary mortgage 
market. Yet your report concludes that there is no evidence 
that the housing goals expanded credit for such loans. Can you 
please explain how to reconcile these two assertions?

A.1. While HUD first established the housing goals in 1993, 
their effectiveness in supporting home ownership opportunities 
for targeted groups and areas is not clear. For example, for 
many years, the goals were set conservatively and do not appear 
to have materially enhanced the enterprises' performance in 
funding such mortgages compared to the primary mortgage market. 
In 1998, we found that the goals HUD has set for the period 
1996 through 1999 were conservative goals, which placed a high 
priority on maintaining the enterprises' financial soundness. 
\1\ According to HUD's 2004 final rule, which set the 
enterprises' housing goals for the period 2005 through 2008, 
while Freddie Mac's performance in funding affordable mortgages 
had improved in prior years, it consistently lagged the 
performance of the primary market. \2\ Specifically, HUD found 
that Freddie Mac lagged the primary market in funding 
affordable home purchase loans for special affordable and low-
moderate income borrowers and underserved neighborhoods 
targeted by the housing goals. From 2001 through 2003, HUD 
found that Fannie Mae led the primary market in funding special 
affordable and low- and moderate-income loans, but lagged the 
market in funding underserved area loans. HUD also found that 
Fannie Mae and Freddie Mac lagged by a rather wide margin the 
primary market in funding mortgages for first-time homebuyers, 
and that their share of the market for minority first-time 
homebuyers was very small. HUD increased the goals starting in 
2005 to encourage the enterprises to facilitate greater 
financing and home ownership opportunities for the groups 
targeted by the goals.
---------------------------------------------------------------------------
     \1\ GAO, ``Federal Housing Enterprises: HUD's Mission Oversight 
Needs To Be Strengthened'', GAO/GGD-98-173 (Washington, DC: July 28, 
1998).
     \2\ 69 Fed. Reg. 63580, 63692 (Nov. 2, 2004).
---------------------------------------------------------------------------
    Recent research also indicates that, although the 
enterprises have enhanced their product offerings to meet the 
housing goals, the effects of the housing goals on 
affordability and opportunities for target groups have been 
limited. For example, a 2006 study found that as the 
enterprises' activities increased in certain areas pursuant to 
the mortgage purchase program, they may have been offset by a 
decline in FHA's existing activities in those areas. \3\ 
Earlier research sponsored by HUD in 2001 found that the 
enterprises generally did not play a leading role in affordable 
multifamily mortgage finance because their underwriting 
standards were considered conservative and fairly inflexible, 
compared with those of other multifamily mortgage providers. 
\4\ In contrast, as discussed in our September 2009 report, 
representatives from mortgage finance, housing construction, 
and consumer groups we contacted said that the benefits from 
enterprise purchases of multifamily mortgages were significant. 
The representatives said that the enterprises' involvement in 
or guarantees of the financing of affordable multifamily 
projects were crucial to their successful completion. In 
addition, they said that during the current financial crisis 
the enterprises were the only source of funding for multifamily 
projects because many other traditional providers, such as 
banks and insurance companies, largely have withdrawn from the 
market.
---------------------------------------------------------------------------
     \3\ Xudong An and Raphael Bostic, ``GSE Activity, FHA Feedback, 
and Implications for the Efficiency of the Affordable Housing Goals'', 
Journal of Real Estate Finance and Economics 36 (2008).
     \4\ ABT Associates ``Studies of Multifamily Underwriting and the 
GSEs' Role in the Multifamily Market: Final Report'', prepared for HUD 
(August 2001).

Q.2. Implied Guarantee--Mr. Shear, your report argues that the 
GSEs' implied guarantee encouraged them to take greater risks 
than a fully private entity would. In reviewing the last few 
years' experience, did you compare the GSEs' portfolio 
performance to that of other institutions, such as Lehman 
Brothers, Bear Stearns, Merrill Lynch, and others holding large 
amounts of mortgages and mortgage backed securities, 
particularly private label securities? If so, how does the 
performance of these fully private portfolios compare with 
---------------------------------------------------------------------------
those of the GSEs?

A.2. The enterprises' structures (for profit corporations that 
derived benefits from their Government sponsorship, 
particularly the implied Federal guarantee on their financial 
obligations) undermined market discipline and provide them with 
incentives to engage in potentially profitable business 
practices that were risky and not necessarily supportive of 
their public missions. In particular, the large retained 
mortgage portfolios that the enterprises acquired over the 
years, while potentially more profitable than their mortgage 
securitization and guarantee business, exposed them to 
considerable interest rate risk without a clear link as to how 
such large portfolios benefited housing finance and other 
mission objectives. In conjunction with the ineffective 
regulatory structure that existed for the housing GSEs for many 
years, the enterprises' activities involved significant risks 
to taxpayers and financial stability. While the enterprises' 
recent financial deterioration involved credit losses rather 
than losses resulting from interest rate fluctuations, their 
mortgage portfolios have proven to be a significant source of 
operational and financial risk. As stated in our September 2009 
report, the substantial financial restatements that both Fannie 
Mae and Freddie Mac were required to make earlier in this 
decade are generally attributable to the misapplication of 
accounting rules for reporting on derivatives, which the 
enterprises used to manage the interest rate risks associated 
with their large mortgage portfolios. The report also noted 
that, more recently, the enterprises purchased large volumes of 
questionable subprime mortgage assets, which were held in their 
portfolios. According to former FHFA Director Lockhart, by June 
2009, 60 percent of the AAA-rated private label MBS that the 
enterprises had purchased had been downgraded to below 
investment grade and the losses on such asset had contributed 
to the need to place the enterprises in conservatorships.
    While our September 2009 report did not compare the GSEs' 
recent business activities, particularly their investments in 
private label MBS and guarantees on Alt-A mortgages, with those 
of other private financial institutions, we acknowledge that 
their appears to have been a breakdown in basic risk management 
practices used to manage credit risk in a range of corporate 
structures in addition to those of the GSEs, including 
commercial banks and investment banks. It may take a 
considerable period to determine why basic risk management 
principles were ignored at so many companies and other market 
participants, such as creditors and ratings agencies, as well 
as why financial regulators failed to exercise sufficient 
oversight and better ensure sound business practices. It does 
appear, though, that the previously identified weaknesses in 
the enterprises' corporate structures and regulatory oversight 
structure facilitated their participation, along with many 
other financial participants, in mortgage asset investments 
that were unsafe and unsound and ultimately threatened 
financial stability.

Q.3. Serving the Underserved--A number of witnesses, including 
Director DeMarco, have said that they would prefer to see some 
more transparent subsidy, like downpayment assistance, instead 
of affordable housing goals in the future. However, one purpose 
of the goals is to try to draw people into the mainstream 
financial system. For example, FDIC Chairman Bair is trying to 
bring the unbanked into the banking system because of the 
overall benefits of doing so. Aren't there many additional 
benefits to pulling people into the mainstream system, over and 
above simply helping them get an affordable home?

A.3. Yes, there are clearly a range of additional benefits 
associated with bringing individuals into the mainstream 
financial system. In previous work, for example, we noted that 
Federal officials and consumer advocates maintain that 
predatory lenders often target certain populations, including 
the elderly and some low-income and minority communities. \5\ 
Some advocates say that in many cases, predatory lenders target 
communities that are underserved by mainstream institutions, 
such as banks and thrifts, leaving borrowers with limited 
credit options. A number of tools, including numeric mortgage 
purchase goals, have the potential to bring individuals, 
especially those that may be underserved by the market, into 
the mainstream financial system.
---------------------------------------------------------------------------
     \5\ GAO, ``Consumer Protection: Federal and State Agencies Face 
Challenges in Combating Predatory Lending'', GAO-04-280 (Washington, 
DC: Jan. 30, 2004).

Q.4. Availability of Fixed-Rate, 30-Year Mortgage--One of the 
crown jewels of our mortgage finance system is the availability 
of a 30-year, fixed rate mortgage that a borrower can prepay 
without penalty when interest rates decline. How do we ensure 
---------------------------------------------------------------------------
that this product remains available for American families?

A.4. While the fixed-rate, 30-year mortgage is likely to endure 
under any of the options to revise the enterprises' long-term 
corporate structures, we did state in our September 2009 report 
that privatizing or terminating the enterprises could have a 
limiting affect on their availability compared to prior 
experience. If the enterprises were privatized or terminated, 
the report noted, any ensuing private-secondary market 
alternatives (such as a consortium of private-sector lenders) 
might be less willing to purchase such mortgages then the 
enterprises had been. As a result, lenders may be less willing 
to originate fixed-rate 30-year mortgages due to the interest 
rate risks associated with holding them in their portfolios. 
However, the potential exists that the establishment of a 
Government mortgage bond insurer for catastrophic risk, as has 
been proposed in conjunction with proposals to privatize or 
terminate the enterprises, could provide a mechanism for 
primary mortgage originators to sell mortgages into secondary 
markets and thereby help maintain the availability of fixed-
rate, 30-year mortgages.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
                     FROM SUSAN M. WACHTER

Q.1. Serving the Underserved--A number of witnesses, including 
Director DeMarco, have said that they would prefer to see some 
more transparent subsidy, like down payment assistance, instead 
of affordable housing goals in the future. However, one purpose 
of the goals is to try to draw people into the mainstream 
financial system. For example, FDIC Chairman Bair is trying to 
bring the unbanked into the banking system because of the 
overall benefits of doing so. Aren't there many additional 
benefits to pulling people into the mainstream system, over and 
above simply helping they get an affordable home?

A.1. While down payment assistance is indeed a potential policy 
tool, the cost of mainstreaming such a program is likely to 
limit its availability. The housing finance system can 
successfully encourage home ownership through cross-
subsidization. That is, marginal borrowers whose risk is 
acceptable nonetheless pay a risk-adjusted rate that reflects 
the average risk for the entire mortgage book of business, 
without putting the financial system at risk. As to the 
benefits of bringing the ``unbanked'' into the system, they are 
real and important.

Q.2. Availability of Fixed-Rate, 30-Year Mortgage--One of the 
crown jewels of our mortgage finance system is the availability 
of a 30-year fixed-rate mortgage that a borrower can prepay 
without penalty when interest rates decline. How do we ensure 
that this product remains available for American families?

A.2. Fixed-rate mortgages are too risky for depositary 
institutions to hold on their books because of interest-rate 
risk. Thus, the availability of a 30-year fixed-rate mortgage, 
which a borrower can prepay without penalty when interest rates 
decline, cannot be ensured without a secondary market in which 
mortgages are securitized. Throughout the world, there is only 
one other country (Denmark) where fixed-rate prepayable 
mortgages are offered, and the Danish mortgage system is based 
on regulated securitization.
    The Savings and Loan (S&L) crisis and similar crises in 
other countries have made this point clear: fixed-rate 
mortgages cannot be offered and held on portfolio by banks 
without causing systemic risk. The result globally was that 
banks shifted away from fixed-rate to adjustable-rate 
mortgages. Because long-term, fixed-rate products are essential 
to protect against the systemic risk of defaults caused by 
volatile interest rates, a secondary market is an indispensable 
part of a stable future housing finance system.
    Nonetheless, we have seen the results, in the present 
crisis, of the creation of secondary markets for mortgage-
backed securities without strict Government regulatory 
oversight. In markets without such oversight, firms will 
compete to offer aggressive lending instruments funded by 
mortgage-backed securitization. As banks and securitization 
firms compete for market share, the inevitable result is the 
lowering of lending standards to increase securitization 
profits over time. The result is increased demand for housing 
and higher prices, making it appear as though real estate 
markets are healthy and that lending is safe. The spread 
throughout the market of aggressive lending boosts artificial 
demand for real estate assets, fueling an unsustainable boom. 
When the boom eventually busts, the resulting property value 
declines lead to sharp declines in credit availability, which 
negatively reverberates throughout the entire economy.
    Regulatory control and oversight are needed to prevent 
reckless lending from overcoming markets. Such regulatory 
control is not possible without information on the loans that 
are being securitized, their underwriting standards, and the 
terms on which they are offered. In order to process such data 
and to monitor markets and identify reckless lending, some 
standardization is necessary. Without standardization, the 
heterogeneity and complexity of MBS make real-time analysis of 
what is in fact being offered in markets in the aggregate, and 
how these terms are changing over time, nearly impossible.
    Standardization both of mortgages and mortgage-backed 
securities can assist in enabling risk and underwriting to be 
monitored over the cycle, preventing the procyclical erosion of 
lending standards. Standardization promotes liquidity, ensures 
suitability, and enhances system stability, but standardization 
will not come about without strict regulatory oversight. Thus 
there must be a mechanism for limiting residential mortgage-
backed securitization to entities that are strictly monitored. 
Without such risk monitoring, securitization, while necessary 
for the steady provision of a 30-year fixed-rate mortgage, will 
not be sufficient. It will subject homeowners and the overall 
economy to credit-induced crises, which will cause housing 
prices to plummet, putting the availability of all credit for 
mortgages, including the 30-year fixed-rate mortgage, 
cyclically at risk.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
                     FROM ANDREW JAKABOVICS

Q.1. Serving the Underserved--A number of witnesses, including 
Director DeMarco, have said that they would prefer to see some 
more transparent subsidy, like downpayment assistance, instead 
of affordable housing goals in the future. However, one purpose 
of the goals is to try to draw people into the mainstream 
financial system. For example, FDIC Chairman Bair is trying to 
bring the unbanked into the banking system because of the 
overall benefits of doing so. Aren't there many additional 
benefits to pulling people into the mainstream system, over and 
above simply helping them get an affordable home?

A.1. Connecting the underserved with the mainstream banking 
system has benefits that flow to underserved families and 
communities as well as to the institutions that extend credit. 
Access to credit on fair and affordable terms allows low-income 
and other ``unbanked'' individuals and families to keep more of 
their hard-earned money. While credit card issuers have rightly 
been chastised for recent moves to hike interest rates on their 
cards prior to more stringent regulations coming into effect, 
even the relatively high rates charged on those cards are far 
less usurious than fees charged by payday lenders. From an 
institutional perspective, bringing the unbanked into the 
mainstream banking system allows the institutions to grow their 
depository base. Moreover, lending to low- and moderate-income 
households is often a profitable, not charitable, endeavor, in 
part because these borrowers have typically been less likely to 
refinance their mortgages as interest rates fall.

Q.2. Availability of Fixed-Rate, 30-Year Mortgage--One of the 
crown jewels of our mortgage finance system is the availability 
of a 30-year, fixed-rate mortgage that a borrower can prepay 
without penalty when interest rates decline. How do we ensure 
that this product remains available for American families?

A.2. Absent a policy intervention to ensure the availability of 
these long-term mortgages, they probably will not exist, a 
point implicitly acknowledged by Wells Fargo CEO John Stumpf in 
a recent call for the GSEs to be given permission to purchase 
jumbo mortgages as a way to ``help revive the moribund market 
for big mortgages.'' Indeed, the existence of such mortgages 
can be directly traced to public policy. The Home Owners' Loan 
Corporation was created in 1933 at the height of the depression 
to refinance distressed borrowers into stable, long-term--then 
15-year--mortgages at up to 80 percent loan-to-value. FHA 
followed the HOLC offering these innovative long-term products. 
The adoption of the self-amortizing, fixed-rate mortgage by the 
private sector was a reflection of a need to compete on the 
best terms with public entities--in contrast to the race to the 
bottom among lenders we have witnessed over the past several 
years.
    As we contemplate both the regulatory environment and the 
institutions likely to emerge to provide capital and liquidity 
to the mortgage markets, it will be necessary to ensure the 
presence of an entity that has the ability to bridge the gap 
between homeowners' desire for long-term affordable mortgages 
and secondary market participants' need for easily marketable 
securities that allow them to appropriately hedge against 
interest rate risk. This role is currently being played by FHA/
Ginnie Mae and the GSEs, but we should not discount the private 
sector's willingness to come back into the market in the 
future. (There are a number of proposals that have been put 
forth describing a restructured secondary mortgage market that 
ignore the potential reemergence of a private label securities 
market, thus leaving potential securitizers entirely 
unregulated.)
    Earlier this year, the Mortgage Finance Working Group 
(MFWG) convened by the Center for American Progress released a 
set of principles to guide redevelopment and regulation of a 
renewed mortgage finance system. (The principles are available 
here: http://www.americanprogress.org/issues/2009/03/pdf/
mortgage_finance_principles.pdf.) I believe that a system based 
upon these principles offers the best way to ensure the ongoing 
availability of 30-year, fixed-rate mortgages while still 
leaving space for innovative (but safe) mortgage products to be 
introduced into the marketplace. Members of the MFWG have been 
developing a more complete blueprint of a restructured mortgage 
finance system that we hope to introduce before the new year 
that will more fully address the mechanisms through which we 
can ensure a continuous presence of the loans that have proven 
so critical in building the middle class.
