WILLIAM MICHAEL CUNNINGHAM
Registered Investment Advisor
June 15, 2000 10am.
TESTIMONY BY WILLIAM MICHAEL CUNNINGHAM
HOUSE BANKING SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES
AND GOVERNMENT SPONSORED ENTERPRISES
Thank you, Mr. Chairman, Representative Kanjorski, Members of the Subcommittee, for giving me the opportunity to testify on the supervision and regulation of government sponsored enterprises, or GSE's. Your bill, H.R. 3703, the Housing Finance Regulatory Improvement Act, comes at a critical time. The bill proposes a new regulatory structure for three government-sponsored enterprises (GSE's). Given the importance of this legislation, I am honored to have an opportunity to comment. It is appropriate to note, however, that my comments represent my own views and are not meant to represent the views of my employer, the Board of Pensions of the Evangelical Lutheran Church in America. Nor do my views represent opinions from the GSE's themselves or Wall Street. I come before this Committee as an independent investment analyst.(1)
I will divide my remarks into five parts: first, a general discussion on social investing; second, a description of the GSEs' role in social investing; third, background information on my activities in both social investing and the secondary mortgage markets. Fourth, I will outline my concerns with GSE performance in fulfilling their public purpose mission. I'll end with my view on certain aspects of the Baker bill
"Social investing" describes a style of investing combining a desire to maximize financial return with an attempt to maximize social "good." Many believe social investing began with the Religious Society of Friends, better known as the Quakers. In 1758, the Quaker Philadelphia Yearly Meeting prohibited members from participating in the business of buying or selling humans. Religious institutions have been at the forefront of social investing ever since. (In the interest of full disclosure, I feel it appropriate to note that I am a Quaker.)
In general, social investors favor:
· Environmentally responsible corporate practices(2).
· Corporate practices that support workforce diversity.(3).
· Corporate practices that result in increased product safety and quality(4).
Social investing preferences are broad, however. Certain social investors prefer not to invest in companies involved in the production of medical equipment used in performing abortions, for example.
According to a study released by the Social Investment Forum (SIF), a nonprofit professional association dedicated to promoting socially responsible investing, more than $2 trillion is now invested in a socially responsible manner in the U.S. Social investments now account for about 13 percent of the estimated $16.3 trillion under professional management in the U.S.
Social Investing Strategies
Social investors use three basic strategies, outlined below.
SCREENING excludes certain securities from portfolios based on social criteria. For example, many socially responsible investors screen out tobacco company investments. Recently, "CalSTRS (California State Teachers' Retirement System) announced the removal of more than $237 million in tobacco holdings from its investment, portfolio after 6 months of financial analysis and deliberations." This is an example of a social screen at work.
SHAREHOLDER ACTIVISM. Shareholder activism efforts attempt to positively influence corporate behavior. These efforts include initiating conversations with corporate management, or dialoging, on issues of concern, and submitting and voting proxy resolutions. These activities are undertaken with the belief that social investors, working cooperatively, can steer management on a course that will improve financial performance over time and enhance the well being of the stockholders, customers, employees, vendors, and communities.
POSITIVE INVESTING involves making investments in activities and companies believed to have high and positive social impact. Positive investing activities tend to target underserved communities. These efforts support activities designed to provide mortgage and small business credit to minority and low-income communities. It is in this area that Fannie and Freddie are most active. According to their web sites:
"Freddie Mac is a stockholder-owned corporation chartered by Congress to increase the supply of money that mortgage lenders, such as commercial banks, mortgage bankers, savings institutions and credit unions, can make available to homebuyers and multifamily investors."
"Fannie Mae is a private, shareholder-owned company that works to make sure mortgage money is available for people in communities all across America. We do not lend money directly to home buyers. Instead, we work with lenders to make sure they don't run out of mortgage funds, so more people can achieve the dream of homeownership. "Fannie Mae is "the country's third largest corporation, in terms of assets, and the nation's largest provider of funds for home mortgages."
Clearly, these are positive investing activities. Carried out consistently, these activities have high and positive social impact. (5)
Background: Socially responsible investing and the secondary mortgage markets
Let me now speak about my efforts in both socially responsible investing and the secondary mortgage markets.
In a 1996 article in the Washington Post, I commented that:
"It seems their (Freddie and Fannie's) primary mission has been completed and completed successfully. Now its time to look for a different mission, which could include finding mortgage money for low income parts of the District and housing the homeless."
Others have echoed this sentiment. Federal Reserve Board Chairman Alan Greenspan noted, in a letter to the Chairman of this Committee dated 5/19/2000,
"(The GSE's) were each chartered with the purpose of smoothing out regional imbalances in mortgage supply and integrating regional mortgage markets into the national capital markets. Much to their credit, they succeeded in accomplishing this goal many years ago."
Mr. Chairman, I believe it is time to renew, refocus and broaden the mission of the GSE's. I believe the first step in doing so requires the adoption of a new regulatory framework, as outlined in your bill.
With respect to their mission, I would like to see the GSE's become much more active in the low end of the housing market ($127,000 versus the current Fannie/Freddie maximum loan limit of $227,150). Needs in this area are great. According to HUD,
· The housing affordability crisis facing very-low-income renters continues to worsen as 5.4 million renter households, a record high, are experiencing worst case needs for housing assistance.
· The number of working families with worst case housing needs has increased sharply since 1991.
· The stock of rental units that are affordable to extremely low-income renters has continued to shrink, with even sharper decreases in units that are both affordable and available to these renters.
· Worst case needs have become more concentrated among families with extremely low incomes.
· Worst case needs have increased most quickly in minority households, particularly among working families with children.
· Very-low-income families remain most likely to face worst case problems when they live in the suburbs.
In looking for a new, broader public mission, I suggest the GSE's also focus on housing markets populated by minorities and women. Devoting even a small percentage of GSE mortgage financing activity to markets populated by persons of low to moderate income, minorities and women will help even the distribution of income and wealth, contribute to domestic political and economic stability, and earn a competitive return. It is my belief that investors, women, and minorities are all well served by these efforts. Further, I believe it is possible to create targeted mortgage investments and portfolios that perform well financially and that address social concerns. I have uncovered many investment opportunities of this type. Let me describe one such investment opportunity.
Prior to joining the Board of Pensions of the ELCA in 1999, I served as CEO of Creative Investment Research, an independent investment research and management firm I founded in 1989. The firm specialized in socially responsible investing. My background in finance and investing led me to develop several socially responsible community investment products. One of these was a set of mortgage-backed securities originated by financial institutions owned by minorities and women and serving areas of high social need. As noted in the American Banker Newspaper(6), I was the first investment advisor to create a mortgage-backed security (MBS) composed entirely of loans from minority and women owned financial institutions. Working with G.E. Capital(7), I identified minority owned lenders willing to participate in the program, arranged G.E. Capital's participation as aggregator of the loans originated by these minority owned financial institutions, and worked to place these MBS pools with a socially responsible institutional pension fund.
Social Investing Concerns: GSE's
Given their public purpose and mission, social investors have long believed
Fannie and Freddie to be both positive investors and good corporate citizens.(8) In the main and for the most part, they are. But, I have
been troubled by certain aspects of GSE corporate behavior over the years. I am deeply
concerned with a recently issued report on GSE home mortgage lending to minorities. The
report, issued by the U.S. Department of Housing and Urban Development, showed that, in
1998, "the share of GSE mortgages going to minorities trailed the national average of
15.3 percent. Fannie Mae lent only 14 percent and Freddie Mac lent only 12.2 percent to
The disparity is even more pronounced in mortgages to black Americans. While the total market for mortgages to blacks is 5 percent, Fannie Mae only lent 3.2 percent and Freddie Mac lent only 3.0."
I believe I can explain this data. A history of discrimination has created a lack of data on black borrowers, making it hard to predict which factors affect their repayment performance. Cultural and community differences may also affect loan performance. It is unlikely that the GSE's have an ethnically neutral set of evaluation criteria. Lacking a set of ethnically neutral loan evaluation tools, both Fannie and Freddie lent relatively fewer dollars to African Americans than others did. In essense, the GSE's may have incorrectly assessed home mortgage loan risk in minority markets. By reducing the flow of mortgages to minorities, GSE's may have ignored profitable lending opportunities. This behavior reduces GSE income and stifles the flow of mortgage credit. This, I think we all agree, is contrary to their Congressionally mandated mission.
We have seen other financial institutions repeat this behavior. On October 22, 1998, Freddie Mac Board member and economist Henry Kaufman, speaking of the Russian financial crisis, noted in the Washington Post that:
"All the problems pervading Wall Street just can't be blamed on outside forces..Institutions have incorrectly assessed risk. If they had done their due diligence, a lot of this (the Russian financial crisis) mess would not have happened."
Likewise, all of the uncertainty Freddie and Fannie now face cannot be blamed on outside forces, like Congress, HUD, or incorrectly interpreted statistics. I agree with Chairman Greenspan when he said:
"The history of financial involvement in increasing home ownership is one of taking risks - of designing new financial instruments and financial products to make financial resources available so that more people can realize the goal of home ownership. Taking prudent risks in lending so that others may attain an objective is the essential role of a financial intermediary..."(9) I suggest the GSE's renew their involvement in the home ownership process by designing new financial products tailored to the needs of homebuyers in the lower end on the market, enabling and facilitating others as they take the prudent lending risks outlined above.
Both Freddie and Fannie dispute the HUD numbers. I expect the debate concerning GSE performance in this area to be a lively one. However one views the statistics, I think we can all agree that much remains to be done in this sector of the home mortgage market.
It is certainly appropriate for Congress to review both GSE financial performance and their public mission performance. It is, therefore, important that GSE management understand Congress has a legitimate role in reviewing their activities, both from the standpoint of financial safety and soundness and with respect to the performance of the GSE's in carrying out the public mission for which they were chartered. I note that the Chairman has been examining GSE activities since at least 1996.
Mr. Chairman, I would now like to turn to your legislative proposal.
Promoting Private Market Discipline
I support repealing the GSEs' conditional line of credit with the Treasury. I agree with Treasury Under Secretary Gary Gensler when he stated, in testimony on March 22, 2000 before this Committee, that: "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."
I support provisions in the bill that increase transparency. I support provisions in the bill that require the GSE's to receive an annual credit rating from nationally recognized statistical rating organizations. Such an examination would significantly improve transparency by providing an independent and objective opinion concerning the GSE's financial condition.
I also suggest that the GSE's be subject to a "Social Audit." A Social Audit is an examination of the performance of an enterprise relative to certain social objectives. The GSE's are currently subject to a limited social audit: central city and minority lending goals have been established and progress GSE's make in meeting those goals is reviewed annually. I am suggesting, however, that the GSE's be subject to a more detailed and rigorous social audit covering all aspects of their operations. Congress may want to specify, in detail, which social objectives should be measured.
For the GSE's the major benefits of a social audit are:
· Improved accountability with respect to social and community investment activities
· Increased social efficiency and effectiveness
· Increased ability to effectively monitor and steer social performance
· Social achievements reported in an unbiased manner
Promoting Market Competition
I support provisions in the Bill to further encourage market competition.
I support the creation of a fully independent GSE regulator. I further suggest this regulator not part of the executive branch. As an alternative, the Chairman may wish to consider designating the Federal Reserve Board the primary GSE financial institution regulator.
I believe the Fed will, one day soon, need to oversee the activities of banks, thrifts, pension funds, insurance companies, mutual fund companies, brokerage firms and investment banks. Recent advancements in financial and computer technology require the creation of such a strong central bank.
Role of the Executive Branch in regulating GSE's.
I strongly suggest that the Executive Branch's role in regulating GSE's be limited. Recent incidents suggest that political interference may limit Executive branch regulatory effectiveness and objectivity. I refer the Committee to one such incident:
"A top federal bank regulator, responding to concerns over possible political interference in bank examinations, has ordered his staff to quit fielding a list of friendly bankers to support a controversial fair lending law.
John D. Hawke Jr., acting Comptroller of the Currency, told his staff in a memo issued Friday that bank examinations must be 'kept completely free from even the appearance of being influenced by political considerations.' The comptroller, an arm of the Treasury Department, regulates 2,600 national banks."(10)
We have observed this type of inappropriate behavior before, preceding the S&L Crisis of the 1980's, and more recently, with the Community Development Financial Institution program, a financial institution program administered by the U.S. Treasury. According to the House Banking Committee:
"$37 Million Clinton Inner-City Loan Fund in Disarray and subject to Political Cronyism. 1 in 3 Grants To First Lady's Favorite.
A $37 million Clinton Administration campaign centerpiece designed to overcome perceived inequities in bank lending to poor and inner-city clients appears to be in disarray, is without adequate standards for making grants, and has at least the appearance of conflicts of interest that 'raises questions concerning the fairness of the system,' a senior House Banking Committee member said today."(11)
In this case, critical federal assistance and funding was determined to have been distributed, in part, based on political ties and not on efficiency, market requirements, performance or need. Given this, I believe making an executive branch agency the chief GSE institution regulator may have harmful consequences. The Federal Reserve System, an independent body, is not subject to and has not been shown to engage in this type of politically biased regulatory interference
In an interdependent financial world, with capital and information flows often determining the short-term fate of nations, it is entirely appropriate for this committee to review the proper role and function of the GSE's. Given the speed with which capital market destabilization can occur, as shown during the Long Term Capital Management (LTCM) incident, the creation of a strong, unbiased, and politically independent GSE regulator is essential.
As many who have come before this committee have noted, domestic housing finance markets are currently broad and well functioning. These markets have been the beneficiaries of an unprecedented increase in financial market activity and asset values. GSE shareholders have profited greatly as a result. Now is the time to review GSE financial and social performance. By so doing, we are likely to insure that GSE shareholders continue to prosper and the nation continues to enjoy the world's best housing finance markets.
This Committee has done this country a great service by focusing public attention on the GSEs. In this way, the Committee continues to meet its obligation to enhance the long term stability of the U.S. financial system. I applaud the Committee for doing so in a balanced, thoughtful manner.
1. I hold MA and MBA degrees from the Department of Economics and the Graduate School of Business at the University of Chicago, and earned my BA degree from Howard University in Washington, D.C. I am registered with the U.S. Securities and Exchange Commission as an investment advisor. From 1987 to 1988 I was a Security Sales Representative with Freddie Mac.
2. These practices give rise to "increased potential for cost savings in energy, water, land, and raw materials; reduced clean-up costs; decreased chance for legal liabilities; improved public image and community relations."
3. These practices give rise to "enhanced global competitive edge resulting from a greater range of skills and perspectives; greater ability to attract and retain talented employees from a broad-based labor pool; reduced likelihood of EEO lawsuits and negative publicity."
4. These practices give rise to "decreased chance for product liability lawsuits (e.g., tobacco); greater satisfaction and loyalty."
5. "CBO Faults Subsidies for 2 Finance Firms," The Washington Post, Thursday, May 30, 1996. Page D-9.
6. "Security Backed Exclusively By Minority Loans," American Banker Newspaper, Friday December 2, 1994, Page 10.
7. G.E. Capital is no longer in the residential mortgage business.
8. Both Fannie Mae and Freddie Mac have received numerous corporate citizenship awards, such as: "Fannie Mae - Best Company to Work for in Washington, D.C., Metro Area, Washingtonian Magazine - November 1999, "Fannie Mae - One of the 100 Best Companies for Working Mothers," Working Mothers - September 1999.
9. These quotes are taken from comments made by Chairman Alan Greenspan at The Social Compact Awards Luncheon, San Francisco, August 1995.
10. Complaints Prompt U.S. Bank Regulator to Warn Staff on Contacts. By Robert Wells. Washington, Feb. 8, 1999. (Bloomberg)
11. Press release from the U.S. House Banking Committee, issued by U.S. Representative Spencer Bachus, (AL - 6th.) Dated May 15, 1997. http://www.house.gov/banking/51597bpr.htm.