EMBARGOED UNTIL 10:00 A.M. EST
Text as prepared for Delivery
March 22, 2000
TREASURY UNDER SECRETARY GARY GENSLER
HOUSE BANKING SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES
AND GOVERNMENT SPONSORED ENTERPRISES
Mr. Chairman, Representative Kanjorski, Members of the Subcommittee, I appreciate the opportunity to testify on the supervision and regulation of government sponsored enterprises. Your bill, H.R. 3703, the Housing Finance Regulatory Improvement Act, focuses on the supervision and regulation of three government sponsored enterprises (GSEs) whose original purpose was devoted to housing. I will divide my remarks into four parts: first, a general discussion on the background of GSEs; second, a description of the GSEs role in the capital markets; third, a discussion of Treasury's general approach to mitigating systemic risk in capital markets; and fourth, the Administration's view on how aspects of the Baker bill meet this general approach.
The nation's interest in a vital housing market is strong. Congress originally created the housing GSEs -- the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Bank System -- to improve consumers' access to mortgage credit. These three GSEs have done much for home ownership in this country. Fannie Mae and Freddie Mac, along with government-owned Ginnie Mae, helped create a market for mortgage securitization. Credit from Federal Home Loan Banks, along with the creation of the Federal Housing Administration, helped banks and thrifts to establish the long-term, fixed-rate mortgage in the 1930s and 1940s.
Currently, we are enjoying the longest period of economic growth in our history. Our financial markets have unquestionably been major contributors to America's economic success, and our financial sector continues to be the world leader. Our capital markets are the most competitive and efficient in the world. They generally operate without the government providing differential treatment among financial institutions.
Government sponsored enterprises are an exception to this general approach because the government provides them benefits in order to affect market outcomes. The potential benefits that GSEs bring to a particular market must be balanced, therefore, against potential risks to the financial system and potential effects on market competition.
Reconsideration of this balance is appropriate from time to time and as financial conditions change. The GSEs have significantly increased both their size and their market share. They have now become the dominant institutions in the secondary mortgage market, and constitute an increasing percentage of the overall credit markets. At the same time, our government's fiscal discipline is leading to less Treasury debt. Together, these factors have caused the GSEs to occupy a more central role in capital markets than ever before.
At the same time, technology and innovation have revolutionized capital markets. Markets are broader and more efficient than they have ever been. Our capital markets have developed increasingly sophisticated techniques for securitizing mortgages and other assets, broadening the holders of mortgages and lessening the need for government intervention.
The housing markets and the overall economy are currently strong. With no particular problems on the horizon, this is an ideal time to review the supervision and regulation of the GSEs.
What are GSEs?
GSEs are privately owned but federally chartered companies, created by Congress to help overcome barriers to the flow of credit into certain segments of the economy.1 Fannie Mae and Freddie Mac are publicly traded companies. The Federal Home Loan Banks are cooperatives owned by their member banks and thrifts.
The federal government created the Federal Home Loan Bank System in 1932 to provide credit to illiquid thrifts and to encourage the development of long-term, fixed-rate mortgages. Freddie Mac was created, and Fannie Mae was transformed from a government corporation to a GSE, during the turbulent financial period of the late 1960s and early 1970s. One of the primary goals of creating Fannie Mae and Freddie Mac was "... to provide supplementary assistance to the secondary market for home mortgages by providing a degree of liquidity for mortgage investments, thereby improving the distribution of investment capital available for home mortgage financing."2
During the 1970s, Fannie Mae provided this assistance primarily by buying mortgages while Freddie Mac concentrated on securitizing mortgages. As there was not a significant secondary market for conventional mortgages at the time, the two GSEs provided assistance to the traditional originators and holders of mortgages, such as thrifts and mortgage banks. By the 1980s, however, securitization had broadened the potential holders of mortgages. Pooling mortgages into securities brought many more potential purchasers into the secondary markets for home mortgages. Freddie Mac and Fannie Mae helped lead the development of this important market.
With rising interest rates in the early 1980s, Fannie Mae's cost of funds rose above the interest rate it was earning on its long-term, fixed-rate mortgages. This interest rate mismatch was similar to that faced by the savings and loan industry. Fannie Mae became insolvent on a mark-to-market basis. A combination of legislative tax relief, regulatory forbearance, and a decline in interest rates allowed Fannie Mae to grow out of its problem. Also, the Farm Credit System was in serious financial trouble in the late 1980s, and the federal government ultimately provided financial assistance to the System.
In 1989, Congress restated Fannie Mae's and Freddie Mac's charters, directing the GSEs to "provide stability" and "ongoing assistance to the secondary mortgage market."3
Since the early 1990s, each of the three housing GSEs has significantly expanded the size and scope of its activities. The FHL Banks now provide both banks and thrifts with advances. In addition, the FHL Banks now directly hold approximately $170 billion in investments. Similarly, Fannie Mae and Freddie Mac now derive significant earnings from purchasing their own mortgage-backed securities in the market. Fannie Mae and Freddie Mac now hold about $850 billion of mortgages and mortgage-backed securities in portfolio, plus another $80 billion in non-mortgage securities.
Today, the GSEs are large, sophisticated financial institutions that retain and manage credit, interest rate, and liquidity risks. They are owned by the private sector. In these ways, the GSEs are very similar to other large financial institutions. As financial institutions, the GSEs earn money in four basic ways:
Credit Guarantees. Fannie Mae and Freddie Mac purchase mortgages and issue mortgage-backed securities on which they guarantee the timely payment of principal and interest. This credit enhancement is similar to what Ginnie Mae and FHA do for securities backed by FHA mortgages. As of year-end 1999, guarantees by Fannie Mae and Freddie Mac totaled $1.2 trillion.4 On average, they charged roughly 19 basis points (nineteen one-hundredths of a percentage point) per dollar of security guaranteed. The GSEs bear the credit risk of individual borrowers defaulting on their mortgages after losses covered by private mortgage insurance. While in the mid-1990s losses averaged 5 to 6 basis points, last year they subtracted only about 1 basis point from the 19 basis points charged.
Mortgage Investments. All three housing GSEs purchase whole mortgages, mortgage-backed securities, and other mortgage-related securities in the capital market. By the end of 1999, the three GSEs held about $920 billion of such assets. The GSEs take on three forms of risk with these investments -- credit risk, interest rate risk and liquidity risk. An important component of interest rate risk relates to forecasting the behavior of borrowers in prepaying their mortgages. In addition, the history of financial markets shows that the significance of liquidity risk increases with size and leverage.
Similar to other financial institutions, the GSEs choose to hold and manage risk rather than attempting to completely hedge it. They thereby seek to increase returns to their shareholders. Thus, the GSEs earn a spread between the interest rate on their mortgage investments and their own below-market cost of funds. This spread has recently been approximately 80 basis points per dollar of assets for Fannie Mae and Freddie Mac, and about 50 basis points for the Federal Home Loan Banks.
Advances. The Federal Home Loan Banks make secured loans, called advances, to the approximately 7,000 banks and thrifts that are System members. These subsidized funds are frequently used by the member to make further mortgage loans, but are also used for non-housing purposes. The Federal Home Loan Bank System Modernization Act liberalized the uses to which small institutions can put those advances. As of year-end 1999, outstanding advances totaled $396 billion, on which the FHL Banks earned about 20 basis points per dollar of advance.
Non-Housing Investments. All three housing GSEs invest in non-housing assets such as asset-backed securities, commercial paper, and other money market instruments. As of year-end 1999, the GSEs held about $180 billion in non-housing assets. Generally, the spreads earned on these investments are smaller than the GSEs' other business lines, ranging between roughly 10 and 30 basis points per dollar of asset.
Benefits of GSE Status
The GSEs' growing role in the capital markets is aided by the numerous benefits derived from their federal charters. The GSEs receive no funds from the federal government, and the government does not guarantee their securities. GSE status, however, does provide a set of benefits that are not available to other financial institutions. These statutory benefits are listed in an appendix to my testimony.
Taken together, these statutory benefits provide the GSEs with three advantages in financial markets: lower funding costs; the ability to operate with less capital; and lower direct costs. These advantages have been identified by past government studies of the GSEs, notably studies by the Congressional Budget Office, the General Accounting Office, and the Treasury Department in 1996, and studies by these same agencies in 1990 and 1991.
Funding. First, the GSEs are able to borrow money at lower interest rates than other financial institutions. Over the last six months, the GSEs borrowed at approximately 40 basis points less than AA-rated banking and financial firms on one- and five-year debt. The spread to AA-rated financial firms is particularly relevant since Standard and Poor's gave Fannie Mae and Freddie Mac a "risk-to-the-government" rating of AA- in 1996, the last time such a rating has been done. Even if one compares to AAA-rated banking and financial firms, the advantage still averaged almost 30 basis points. They also borrow at approximately 18 basis points below three-month LIBOR, which represents the rates at which banks generally obtain inter-bank funding. These spreads may widen or shrink over time. What remains true, however, is that the GSEs operate with a significant funding advantage over other private companies in equal or better financial condition.
Leverage. Second, GSEs operate with less equity capital per dollar of debt than other financial institutions. Fannie Mae and Freddie Mac have roughly $32 of debt for each dollar of capital. The FHLBanks have roughly $19 in debt per dollar of capital. In contrast, per dollar of capital, large banks have about $11.50 of debt, thrifts have $12.50 in debt, and the five largest securities firms have approximately $25 in debt.
Lower direct costs. Third, GSEs receive direct cost savings from their charters. In 1999, the GSEs saved approximately $280 million by being exempt from SEC registration. In addition, Fannie Mae's and Freddie Mac's exemption from state and local taxes was worth approximately $690 million for 1999, based on the GAO's 1996 estimate that this exemption saved those GSEs about 8 percent of net income.
These funding, leverage and cost advantages are particularly significant to the GSEs because of the markets in which they operate. The U.S. capital markets are the most competitive and efficient in the world. Relatively small advantages, even those measured in single basis points, over time can allow firms to dominate their markets.
While a portion of these benefits is passed on in lower mortgage rates, the rest of the cost reductions provide higher returns to GSEs shareholders. Studies conducted by Treasury, CBO, and GAO over the past ten years concluded that the GSEs retain a significant amount of their federal subsidy. Although those estimates have not been updated recently, the high return on equity of the publicly traded GSEs in part suggests that this pattern continues. Between 1995 and 1999, Fannie Mae and Freddie Macs average return on equity was about 24 percent. In comparison, over that same time period, large banks' average return on equity was 15 percent, large thrifts' average return was 12 percent, securities firms averaged 17 percent, and the largest insurance firms averaged 12 percent.
GSEs in the Capital Markets
The advantages of GSE status have also enabled the GSEs to grow rapidly and gain an increasing share of the capital markets. The GSEs now control a central position in the mortgage market and an increasing share of the U.S. debt markets.
The $1.4 trillion of GSE debt is large on any relative scale. It is now roughly the size of the entire municipal bond market the outstanding debt of the fifty states and localities that issue publicly traded debt. The GSEs' debt of $1.4 trillion is now more than one-half of the $2.7 trillion of outstanding privately held marketable Treasury debt.5 Adding the $1.2 trillion in GSE-guaranteed mortgage-backed securities to the mix, GSE involvement in the credit market is approaching the size of the Treasury market.
Based upon recent trends and growth forecasts, GSE debt may double to $3 trillion by 2005. With the government's continued fiscal discipline, GSE debt is forecast to surpass privately held marketable Treasury debt in the next three years.
As the Treasury market declines in size, financial markets will be able to make a smooth adjustment. Investors and hedgers will be able to switch to other securities and derivatives, including those of GSEs. In this environment, the GSEs have been promoting their debt securities as an alternative market benchmark. Like other large firms, the GSEs see benefits in having fewer, more liquid issues of their debt. Such efforts could lower the GSEs funding costs and increase their returns to shareholders. In addition, futures contracts on Freddie Mac and Fannie Mae debt securities began trading last week. These are the first contracts on individual private sector debt securities to trade on the futures exchanges.
The Federal Reserve has principally used Treasury securities and repurchase transactions on Treasury securities to carry out monetary policy. Although the Federal Reserve does not currently purchase GSE debt securities, it has done so in the past and in recent years increasingly has used their debt as collateral for repurchase agreements. Furthermore, in response to liquidity needs spurred by Y2K concerns, the Federal Reserve began to take GSE-guaranteed mortgage-backed securities as collateral in repurchase agreements.
Share of Mortgage Market
The GSEs have become the dominant institutions in the secondary mortgage market. Over the last decade they have grown over four-fold, from just over $300 billion in size to $1.4 trillion. As of year-end 1999, Fannie Mae and Freddie Mac either owned or guaranteed roughly 63 percent of all outstanding conforming, conventional mortgages. Their retained portfolio of mortgages currently represents 26 percent of outstanding conforming, conventional mortgages.
To the extent that the GSEs now finance a significant portion of their sector of the mortgage market, the willingness of a GSE to purchase a mortgage has become a far more significant factor in deciding whether to originate that mortgage. The GSEs' automated underwriting systems are increasingly becoming the means by which originators decide to lend. This technology will make the process more efficient. In the long run, however, this trend may result in less diversity in credit decisions and less price competition.
Ownership of GSE Debt by Depository Institutions
GSE debt also has become a significant portion of the assets of the banking system. Banks held over $210 billion in GSE debt at mid-year in 1999. This constituted just under 4 percent of total bank assets and over one-third of total bank capital. Banks held 75 percent more GSE debt than their holdings of Treasury securities. In addition, banks held over $355 billion in mortgage-backed securities guaranteed by the GSEs.
To protect the exposure of banking institutions, current law places limits on an individual bank's credit exposure to any one entity. National banks may hold no more than 10 percent of their capital in the corporate bonds of any one issuer or lend unsecured more than 15 percent of their capital to any one borrower. Most state banks are subject to similar limits. Among all debt securities issued by private companies, however, only GSE debt securities are exempt from this investment limit.
Principles for Mitigating Systemic Risk
As the GSEs continue to grow and to play an increasingly central role in the capital markets, issues of potential systemic risk and market competition become more relevant. In 1997, Treasury established an Office of GSE Policy in order to monitor these issues.
Treasury's general approach to mitigating systemic risk in capital markets emphasizes the role of the private sector. The public sector has three roles: creating an environment in which market discipline can work effectively; promoting the maximum degree of transparency; and maintaining the competitiveness of the system as a whole. For institutions where the public has a special interest - for example, depository institutions carrying federal deposit insurance - further government involvement such as on-site examinations and capital standards is appropriate.
Promoting market discipline means crafting government policy so that creditors do not rely on governmental intervention to safeguard them against loss.
Transparency is the necessary corollary to market discipline. The government cannot impose market discipline, but it can enhance its effectiveness by promoting transparency. Transparency lessens uncertainty and thereby promotes market stability.
Promoting competition in financial markets lessens systemic risk. The task of public policy must be to ensure the stability and integrity of the market system. In any sector of the financial market, the dominance of one or two firms can lessen competition and the efficiency of the market pricing mechanism. In addition, the entry of a subsidized financial institution into a market may motivate other firms to take on greater risks and weaken their operating results.
We also recognize the important role this Committee has played in addressing risk in the capital markets. Most recently, the Committee reported out a hedge fund bill supported by the Presidents Working Group on Financial Markets.
Mr. Chairman, I appreciate your efforts to highlight these issues and would now like to turn to your legislative proposal, which takes various steps to accomplish these goals.
Promoting Private Market Discipline
H.R. 3703 contains several provisions designed to promote private market discipline.
H.R. 3703 repeals the housing GSEs' conditional line of credit with the Treasury. Congress first authorized the Secretary of the Treasury to lend to the housing GSEs decades ago. The dollar amounts of these lines of credit are now a mere fraction of the GSEs' actual borrowings. For example, since its line of credit was established at its current level in 1957, Fannie Maes mortgage holdings have increased 320 times in size. Each of the GSEs has gone from being a small, relatively unknown borrower in the capital markets to being among the largest debt issuers in the world. Any function the lines perform at this point is purely symbolic. Repeal of the line of credit would be consistent with the congressional requirement that all GSE securities carry a disclaimer that they are not obligations of the U.S. government. Thus, as part of a package of reforms, we would support repeal of the line of credit.
The bill also repeals the Federal Home Loan Banks' so-called "superlien". A law adopted in the midst of the thrift crisis treats a Federal Home Loan Bank's secured, but not perfected, interest in any collateral as having a priority over any other secured, but not perfected, interest in that same collateral. Because the Banks need not take the legal steps necessary to perfect, they typically place a general, or "blanket," lien on most or all of a member's mortgage assets. If the member fails, the combination of the superlien and blanket lien places a Federal Home Loan Bank in a position superior to other secured creditors who have not perfected their interests. Repealing the superlien would restore market discipline by increasing the Banks' incentives to distinguish among their members with regard to credit risk. This in turn would reduce risk to the deposit insurance fund and taxpayers.
For the same reasons, we believe that the Committee should consider repealing a provision of current law that requires the federal banking agencies to provide confidential bank examination ratings to the Federal Home Loan Banks. No other lender possesses this information. We believe that GSEs, just like any other private sector financial institution, should not have access to confidential governmental examination data.
H.R. 3703 provides new authority to appoint a receiver to resolve a troubled GSE. This provision grants the GSE regulator powers comparable to other regulators of government chartered companies. For example, the Comptroller of the Currency can appoint a receiver for national banks. The availability of this authority would contribute to market discipline and enhance stability in the event there were ever a market strain.
H.R. 3703 contains several provisions that increase transparency.
The bill allows the regulator to make public information that it determines would increase the efficiency of the secondary mortgage market or the housing finance system. This provision could enhance transparency. In crafting such language, however, it would be appropriate to recognize that some data is proprietary and may not be appropriate for public disclosure.
The bill also requires the GSEs to obtain an annual credit rating from nationally recognized statistical rating organizations. Such ratings could improve transparency and market discipline by giving investors an independent view of the GSEs' financial condition. It would also be a useful outside tool for the regulator. In determining such ratings, the bill specifically requires the ratings agencies to consider that the United States government does not guarantee the GSEs' obligations. Current law authorizes OFHEO to obtain ratings. We believe this proposal is an improvement over current law, as it requires annual ratings and specifically sets a standard for such ratings.
Promoting Market Competition
H.R. 3703 also contains provisions that are designed to preserve market competition, reducing the potential for subsidized competitors to distort financial markets. Limiting the new activities of the GSEs also has the potential to limit their scale.
The bill sets up a mechanism whereby the regulator would have authority to approve new activities. We have some concern that the notice and comment procedures for such approvals could interfere with the ability of the enterprises to innovate, while leaving the regulator to interpret a rather vague standard. We believe that it is appropriate for Congress, the chartering authority, to provide clear guidance about what activities the enterprises' charters allow and how broadly they should be interpreted. For example, to what extent does Congress wish the GSEs to expand from their current housing finance business into general consumer finance or mortgage origination?
Limiting the non-mission investments of the housing GSEs could also increase their focus on mission-related activities. Such an action could enhance accountability for the GSEs' benefits, and improve market competition.
The bill highlights an important issue the potential for problems at one financial institution to cause instability in the financial markets or at other institutions. As I noted earlier, GSE debt obligations are exempt from banks' investment securities limits. We believe that Congress should seriously consider the best way to repeal such exceptions, including a sufficient transition period to prevent any market disruption.
Further Regulatory Authority
H.R. 3703 also addresses the regulatory structure for the GSEs. We believe that there is an appropriate regulatory oversight role with respect to the GSEs. First, oversight is appropriate to determine whether government sponsored enterprises carry out their public mission, as Assistant Secretary Apgar will later explain. Second, there is also a role for oversight of their financial condition. Such regulatory role should reflect, however, the fact that GSEs are private sector firms with uninsured liabilities.
We believe that any regulator charged with oversight of the financial condition of the GSEs must have a clearly defined and limited mandate. The bill grants the GSE regulator greater flexibility in setting capital standards than current law permits. We support such flexibility, though Congress may wish to provide the regulator greater guidance on the goals of capital regulation in the GSE context.
We believe that the standard for regulation and the tools available to the regulator are issues of primary importance. But the identity of the regulator is important as well. We agree with you, Mr. Chairman, that it may be appropriate to have common regulators for the three housing GSEs. We also believe that supervision of GSEs should be a duty of the Executive Branch of government, which is charged with economic policy, including banking and housing policy. Responsibility for regulating financial condition could be placed with an agency responsive to those in the Executive Branch who oversee the soundness of the financial system. Experts in housing could supervise mission.
That said, we would not wish for regulatory reform to interfere with current efforts by existing regulators. For example, we support the efforts of the Office of Federal Housing Enterprise Oversight to finalize its risk-based capital rule and the Department of Housing and Urban Development to finalize its affordable housing goals. Any regulatory consolidation should allow this effort to be completed without interruption.
In any regulatory scheme, there may be important interactions between regulating mission and regulating financial condition. Congress can best balance these interests by giving the regulators clear guidance as to the mission of the GSEs and the standard for regulatory oversight.
Furthermore, although the three housing GSEs share a common overall goal increasing the availability of credit for housing the charter of the Federal Home Loan Banks mandates a different business from the charter of Fannie Mae and Freddie Mac. Each GSE should be focused on those market failures they were intended to solve. By clearly specifying the mission of each GSE and the regulatory standards for their financial health, Congress can best promote housing finance while providing for financial regulation for these GSEs.
Mr. Chairman, the economy and the financial markets are strong. With no particular problems on the horizon, this is an ideal time to review the supervision and regulation of the GSEs. The GSEs play a central role in the nations housing finance and debt markets. Thus, your Committee is providing a valuable service by thinking through the best framework for supervision and regulation of these enterprises. These are important matters of public policy that require balanced, thoughtful review by all interested parties.
1. Today there are five GSEs: Fannie Mae; Freddie Mac; the Federal Home Loan Bank System; the Farm Credit System; and Farmer Mac. A sixth GSE, Sallie Mae, is in the process of being fully privatized.
2. See Federal National Mortgage Association Charter Act, sec. 301(a) (amended 1989); See also S. Rep. 91-761, 91st Cong., 2d Sess. 7 (April 7, 1970) (explaining Freddie Mac's mission: "The Corporation (Freddie Mac) would be a supplement to, and would have parallel authority to, the Federal National Mortgage Association under its expanded authority proposed by title II of the bill.").
3. Financial Institutions Reform, Recovery, and Enforcement Act, Pub. L. No. 101-73, sec. 731(m)(1), 103 Stat. 183, 435 (August 9, 1989) (codified at 12 U.S.C. sec. 1716).
4. This figure excludes securities held in portfolio by Fannie Mae and Freddie Mac, as the GSEs are the beneficiary of their own guarantee.
5. This is the most relevant measure of Treasury debt for comparisons of market size, as it excludes amounts held by the Federal Reserve and non-marketable securities such as Savings Bonds and those held by municipalities.
The following benefits of GSE status are contained in the GSEs' charter acts and other laws: