Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S.
Housing Finance System (Testimony, 07/25/2000, GAO/T-GGD-00-182).

The efforts of Fannie Mae and Freddie Mac have successfully lowered
mortgage cost and increased home ownership in the United States.
However, these two government-sponsored enterprises had combined debt
and mortgage-backed securities liabilities of more than $2 trillion at
the end of 1999. The enterprises' close relationship with the federal
government and their federal charters provide them with advantages.
First is the perception in the financial markets that the government
would not allow the enterprises to fail, thus allowing them to borrow at
relatively lower cost than private firms. Their charters also exempt
them from paying state and local income taxes and some of the fees
charged by the Securities and Exchange Commission for securities. Each
enterprise has a $2.25 billion conditional line of credit with the
Department of the Treasury. Federal sponsorship creates significant
risks and costs because taxpayers might end up paying part of that more
than $2 trillion debt. The 1992 Federal Housing Enterprises Financial
Safety and Soundness Act established the Office of Federal Housing
Enterprise Oversight to ensure adequate capitalization and safe
operations. The act also provided the Department of Housing and Urban
Development with additional regulatory authority to ensure that the
enterprises fulfill their housing finance mission.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  T-GGD-00-182
     TITLE:  Housing Enterprises: The Roles of Fannie Mae and Freddie
	     Mac in the U.S. Housing Finance System
      DATE:  07/25/2000
   SUBJECT:  Mortgage programs
	     Financial management
	     Government sponsored enterprises
	     Mortgage-backed securities
	     Mortgage loans

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.                 **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************
GAO/T-GGD-00-182

United States General Accounting Office
GAO

Testimony

Before the House Budget Committee's Task Force
on Housing and Infrastructure

For Release on Delivery
Expected at
10:00 a.m. EDT
Tuesday
July 25, 2000
GAO/T-GGD-00-182

HOUSING ENTERPRISES
The Roles of Fannie Mae and Freddie Mac in the

U.S. Housing Finance System

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

Viewing GAO Reports on the Internet
For information on how to access GAO reports on
the INTERNET, send e-mail message with "info" in
the body to:
[email protected]
or visit GAO's World Wide Web Home Page at:
http://www.gao.gov

Reporting Fraud, Waste, and Abuse in Federal
Programs
To contact GAO's Fraud Hotline use:
Web site:
http://www.gao.gov/fraudnet/fraudnet.htm
E-Mail: [email protected]
Telephone: 1-800-424-5454 (automated answering
system)

 (233664)

Statement
Housing Enterprises: The Roles of Fannie Mae and
Freddie Mac in the U.S. Housing Finance System
Page 3                           GAO/T-GGD-00-182
Mr. Chairman and Members of the Task Force:

We are pleased to be here today to discuss the
roles of Fannie Mae and Freddie Mac in our
nation's housing finance system.  Congress created
Fannie Mae and Freddie Mac (the enterprises), the
two largest government sponsored enterprises
(GSEs), to promote home ownership in the United
States.  The enterprises fulfill their housing
mission by borrowing funds or issuing mortgage-
backed securities (MBS) and using the proceeds to
purchase home mortgages from banks, thrifts, and
other financial institutions.  Financial
institutions, in turn, may use the proceeds from
their mortgage sales to the enterprises to fund
additional mortgage loans, thereby helping to
ensure a stable supply of mortgage credit across
the nation.  Financial institution mortgage
lending is commonly referred to as the "primary
residential mortgage market," while the
enterprises' mortgage purchase activities are
commonly referred to as the "secondary residential
mortgage market."

Most analysts agree that the enterprises'
activities have successfully lowered mortgage
costs and increased home ownership in the United
States.  However, these benefits must be weighed
against the potential costs associated with the
federal government's implied sponsorship of the
enterprises, which had combined debt and MBS
liabilities of over $2 trillion at the end of
1999.  In particular, the federal government could
potentially decide to provide financial assistance
to the enterprises in an emergency situation.

In recent years, we have issued several reports
that assess the enterprises' roles in the housing
finance system and federal oversight of their
activities.  My testimony today will briefly
discuss the following important topics covered in
these reports:

ï¿½    the benefits and costs of the enterprises'
housing finance activities,
ï¿½    federal efforts to ensure the enterprises'
safety and soundness, and
ï¿½    federal efforts to ensure that the
enterprises promote home ownership opportunities
for all Americans.

The Benefits and Costs of the Enterprises' Housing
Finance Activities
The enterprises are hybrid organizations that
contain elements of both private- and public-
sector organizations.  Like many private
companies, the enterprises issue equity and debt
instruments to the investing public.  The
enterprises have also developed compensation
packages that reward top executives for increasing
shareholder value.  On the other hand, the
enterprises' close relationship with the federal
government and their federal charters provide them
with several important advantages over private-
sector companies. The most important of these
benefits is an indirect one--the perception in the
financial markets that the government would not
allow the enterprises to fail, which allows them
to borrow and issue MBS to finance mortgage
purchases at relatively lower cost than private
firms.  The enterprises' federal charters also
exempt them from paying state and local income
taxes and some of the fees charged by the
Securities and Exchange Commission for securities
and debt issuances.  The charters also provide
each enterprise with a $2.25 billion conditional
line of credit with the Treasury Department.

In a May 1996 report, we estimated that the total
annual value of these benefits to the enterprises
ranged from $2.2 billion to $8.3 billion on a
before-tax basis and $1.6 billion to $5.9 billion
on an after-tax basis.1  To some extent, the
enterprises pass these savings on to home buyers
in the form of lower mortgage interest rates.
Although it is not possible to calculate these
savings precisely, we estimate that in 1995 the
enterprises' mortgage purchase activities resulted
in savings of about a quarter of a percentage
point annually on a typical $100,000 mortgage.
This translated into savings of about $10 to $25
per month on such a $100,000 mortgage, or about $3
billion to $7 billion annually for the
approximately $2 trillion in mortgages that the
GSEs were eligible to purchase and that were
outstanding at the time.2  Most analysts also
agree that the enterprises' activities, such as
their imposition of greater standardization on
mortgage products and processes, have also
facilitated the development of an efficient,
nationwide mortgage finance system.

However, federal sponsorship of the enterprises'
activities as GSEs also creates significant risks
and costs.  First, the potential exists that U.S.
taxpayers would end up paying for a portion of the
enterprises' debt and MBS obligations, which stood
at over $2 trillion at the end of 1999.  In fact,
Fannie Mae experienced significant financial
difficulties because of a sharp rise in interest
rates between 1981 and 1984, resulting in losses
of $277 million.  To help Fannie Mae overcome
these problems, the federal government provided
limited tax relief and relaxed the enterprise's
capital requirements.  Congress also showed its
willingness to assist GSEs that experience
financial difficulty in 1987 when it authorized up
to $4 billion to help the Farm Credit System,
another GSE, overcome a farm crisis and the
resulting increase in loan defaults.  Second,
opportunity costs can also be generated when the
perceived backing of a GSE by the federal
government diverts funds from other financial
institutions that may otherwise be able to provide
more efficient services to the public.  Third,
opportunity costs can also be generated if a GSE
enters into activities that are outside its
statutory mission.

To help ensure that the enterprises conduct their
business in a safe and sound manner and use their
government-provided benefits to achieve a public
purpose, in 1992 Congress passed the Federal
Housing Enterprises Financial Safety and Soundness
Act (1992 Act).  The 1992 Act established the
Office of Federal Housing Enterprise Oversight
(OFHEO) to ensure that the enterprises are
adequately capitalized and operating safely.  The
1992 Act also provided the Department of Housing
and Urban Development (HUD) with additional
regulatory authority to ensure that the
enterprises fulfill their housing finance mission.
As part of the 1992 Act, Congress concluded that
the financial benefits that the enterprises derive
from their government sponsorship involve a
corresponding obligation to meet the mortgage
credit needs of all potential home buyers,
including those with low- and moderate-incomes.
This regulatory scheme allows the enterprises to
continue to have the same powers as private
companies to conduct their day-to-day business.

In the remaining two sections of my testimony, I
will discuss the status of OFHEO and HUD's efforts
to fulfill their regulatory responsibilities under
the 1992 Act.

OFHEO Monitors the Financial Safety of the
Enterprises
The 1992 Act established OFHEO as an independent
agency within HUD to monitor the enterprises'
financial safety and soundness.  Under the act,
OFHEO is subject to the congressional
appropriations process but the enterprises pay
assessments to finance its activities.  OFHEO's
budget was about $16 million in fiscal year 1999.
The act provided OFHEO with two essential
responsibilities to carry out its safety and
soundness mission: (1) establish capital standards
for the enterprises and (2) establish an
examination program.

As required by the 1992 Act, OFHEO has established
minimum capital standards for the enterprises,
which are capital ratios applied to certain on-
balance-sheet and off-balance-sheet obligations.
OFHEO has consistently classified the enterprises
as in compliance with the minimum capital
standards since they were established in 1993.
The act also mandated that OFHEO develop a stress
test to serve as the basis for more sophisticated
risk-based capital standards.  The purpose of the
stress test is to help manage taxpayer risks by
simulating, in a computer model, situations where
the enterprises are exposed to adverse credit and
interest rate scenarios.  The enterprises are
required to hold sufficient capital to withstand
these adverse conditions for 10 years, plus an
additional 30 percent of the required capital to
cover operations and management risk.

Although the 1992 Act directed OFHEO to complete
the stress test and risk-based capital standards
by December 1, 1994, OFHEO has not yet completed
these tasks.  In an October 1997 report, we
identified several reasons for OFHEO's inability
to comply with the deadline, including (1) the
complexity of the task, (2) OFHEO's decision to
develop a new stress test rather than adopt or
modify existing stress tests, (3) OFHEO's initial
difficulties in obtaining required financial data
from the enterprises, and (4) greater than
expected managerial and technical difficulties.3
OFHEO has proposed a rule to implement the stress
test and risk-based capital standards and expects
to issue a final rule by the end of 2000.

OFHEO also has the authority to establish an
examination program to monitor the enterprises'
management and financial condition.  Our 1997
report found that OFHEO had not been able to
implement its plan to examine all relevant
operations of the enterprises on a 2-year
schedule.  We attributed OFHEO's inability to meet
the schedule to limited staff resources and the
start-up challenges associated with examining the
enterprises, which are extremely large and complex
financial institutions.  Since that time, OFHEO
has revised its examination program and
implemented an annual examination schedule.
OFHEO's examination staff has generally found that
the enterprises have been operated in a safe and
sound manner.

HUD Has Responsibility for Overseeing the
Enterprises' Fulfillment of Their Housing Mission
HUD has statutory authority to ensure that the
enterprises fulfill their mission of promoting
housing and home ownership opportunities for all
Americans.  In passing the 1992 Act, Congress
concluded that HUD's regulatory framework had not
been effective in ensuring that the enterprises'
activities benefit low- and moderate-income
Americans and those who live in underserved areas,
such as central cities and rural communities
(targeted groups).  The 1992 Act required HUD to
develop, implement, and enforce a comprehensive
housing mission regulatory framework.  Among other
provisions, the 1992 Act directed HUD to set
housing goals, which require the enterprises to
meet specified criteria each year for the purchase
of mortgages serving targeted groups.

In 1995, HUD established a final rule for
enterprises' housing goal mortgage purchases for
the years 1996 through 1999.  In a July 1998
report, we found that HUD generally adopted a
conservative approach to setting the housing goals
that placed a high priority on maintaining the
enterprises' financial soundness.4  For example,
HUD and OFHEO conducted research during the
rulemaking process that concluded that the
proposed housing goals were modest and would not
materially affect the enterprises' financial
condition.  According to HUD data, the enterprises
met or exceeded the housing goals between 1996 and
1998.

In March of this year, HUD proposed a new rule
setting housing goal requirements for the period
2000 through 2003.  HUD's proposed housing goals
are set higher than the goals set for the period
1996 through 1999.  According to HUD, the
enterprises' share of the affordable housing
market remains below desired levels.  For example,
banks and other lenders continue to make
relatively more mortgage loans in the primary
market to targeted groups than the enterprises
purchase in the secondary residential mortgage
market.  HUD believes that the proposed housing
goals will provide strong incentives for the
enterprises to more fully meet the housing needs
of targeted groups.  The comment period on the
proposed rule ended in May 2000.  HUD is currently
reviewing comments and expects to issue a final
rule by the end of 2000.

The 1992 Act also defined HUD's general regulatory
authority over the enterprises and its new
mortgage program approval authority.5  HUD has the
general regulatory authority to ensure that the
enterprises' activities are consistent with their
housing mission.  HUD also has the authority to
review new mortgage programs proposed by the
enterprises to ensure that the programs are
consistent with the enterprises' charters and not
contrary to the public interest.  In our view,
Congress correctly recognized, in passing the 1992
Act, that the enterprises-given their hybrid
structure-face a natural tension between
maximizing profitability for their shareholders
and fulfilling their housing mission.

In a March 1998 report, we provided an example of
this natural tension and HUD's critical
responsibility to exercise its general regulatory
authority in a way that ensures that the
enterprises fulfill their housing mission.6  We
pointed out that the enterprises have incentives
to use the funding advantage associated with their
government sponsorship to make nonmortgage
investments-such as corporate bond purchases-that
may result in arbitrage profits.7  Our report
recognized that some nonmortgage investments,
particularly short-term investments, can
contribute to mission achievement by facilitating
liquidity in the secondary market for residential
mortgages.  However, our report concluded that the
relationship between long-term nonmortgage
investments and the enterprises' housing mission
is not entirely clear.

Our March 1998 report found that HUD did not act
promptly to ensure that the enterprises'
nonmortgage investments were consistent with their
housing mission.  In fact, HUD did not exercise
its general regulatory authority provided in the
1992 Act until 1997, when a public controversy
erupted over Freddie Mac's investment in long-term
Philip Morris corporate bonds.  In 1997, HUD
initiated a rulemaking process designed to develop
criteria that would help ensure that the
enterprises' nonmortgage investments are
consistent with their housing mission and federal
charters.  We recommended that HUD promptly
implement this rulemaking process, and HUD agreed
to do so.  However, HUD has not yet developed
criteria for overseeing the enterprises'
nonmortgage investments.

The enterprises have also engaged in other complex
financial activities whose relation to their
housing mission is not entirely clear.  For
example, in our March 1998 report, we pointed out
that HUD approved a new mortgage program by Fannie
Mae that would involve Fannie Mae in purchasing
cash value life insurance, which is essentially a
nonmortgage investment.8  HUD officials told us
that they lacked expertise in cash value life
insurance when they approved the Fannie Mae
program.

More recently, the enterprises' involvement in
other activities-such as automated
underwriting-have raised questions as to whether
they are attempting to move beyond the secondary
mortgage market into areas traditionally served by
private lenders in the primary mortgage market.
Some lenders believe that the enterprises'
automated systems standardize the mortgage loan
process to such an extent that the lenders' role
in mortgage lending is minimized.

Conclusions
In summary, Congress provided Fannie Mae and
Freddie Mac with substantial financial benefits so
that they can fulfill their housing finance
mission.  There is widespread agreement that the
enterprises' secondary mortgage market activities
have lowered the cost of home ownership for
millions of Americans.  However, perceived federal
sponsorship of the enterprises' activities as GSEs
also involves significant risks and costs.  In
passing the 1992 Act, Congress created a
regulatory structure with the potential to help
ensure that the enterprises, in their attempts as
private corporations to create shareholder value,
would do so by focusing on and fulfilling their
public missions without exposing U.S. taxpayers to
undue risk.

In their oversight roles, OFHEO and HUD face a
difficult challenge in ensuring that the
enterprises meet their housing responsibilities in
a safe and sound manner, while simultaneously
being afforded sufficient latitude to manage their
day-to-day business needs and meet their
shareholder obligations.  The enterprises are
large, sophisticated financial institutions.
Beyond various nonmortgage investments, the
enterprises have become engaged in complex
financial activities that may serve multiple
purposes.  Therefore, it is difficult to assess
the financial risks of many of their activities as
well as the relationship between their activities
and mission achievement. Nonetheless, the making
of such assessments by the enterprises' regulators
and Congress is imperative to ensure that the
interests of U.S. taxpayers are protected.

Mr. Chairman, this concludes my statement.  My
colleagues and I would be pleased to respond to
any questions that you or other members of the
Task Force may have.

Contact and Acknowledgements

For further information regarding this testimony,
please contact Thomas J. McCool, Director,
Financial Institutions and Markets Issues, (202)
512-8678. Individuals making key contributions to
this testimony included William B. Shear and
Wesley M. Phillips.

_______________________________
1 Housing Enterprises: Potential Impacts of
Severing Government Sponsorship (GAO/GGD-96-120,
May 13, 1996).
2 The enterprises' charters restrict them  from
purchasing mortgages above a set dollar amount,
known as the conforming loan limit.  The
conforming loan limit  depends upon how many
housing units are financed by a single residential
mortgage loan.  The conforming loan limit is
currently set at  $252,700.  The charters also
require the enterprises to meet certain
underwriting standards for mortgage loan
purchases.
3 Federal Housing Enterprises: OFHEO Faces
Challenges in Implementing a Comprehensive
Oversight Program (GAO/GGD-98-6, Oct. 22, 1997).
4 Federal Housing Enterprises: HUD's Mission
Oversight Needs to Be Strengthened (GAO/GGD-98-
173, July 28, 1998).
5 12 U.S.C.  4541-2.  The 1992 Act defines a "new
program" as being significantly different from
mortgage programs that have been approved  or that
represent an expansion, in terms of the dollar
volume or number of mortgages or securities
involved, of programs previously approved.
6 Government-Sponsored Enterprises: Federal
Oversight Needed for Nonmortgage Investments
(GAO/GGD-98-48, Mar. 11, 1998).
7 We defined the term "arbitrage" to mean that the
enterprises use their funding advantage from
government sponsorship to raise funds for making
certain nonmortgage investments. Our definition of
arbitrage is similar to the definition of an
arbitrage bond defined in reference to federal
income tax exemption for interest on state and
local bonds in the U.S. tax code.
8 The program was called the Mortgage Protection
Plan (MPP).  Under MPP, Fannie Mae would purchase
a cash value life insurance on a first-time home
buyer after the selected borrower's residential
mortgage was purchased by Fannie Mae and the
borrower agreed to such coverage.  MPP was
designed to protect Fannie Mae and the borrower
against default caused by the borrower's death.
Fannie Mae did not go ahead with MPP because of
tax law changes.
*** End of document ***