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Committee on Financial Services

United States House of Representatives

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Testimony of
Thomas A. Schatz
President
Citizens Against Government Waste
Before the House Subcommittee on Capital Markets, Securities, and Government Sponsored Enterprises
June 15, 2000

 

Mr. Chairman, members of the committee, thank you for the opportunity to testify today. In particular, I would like to thank Mr. Baker for convening this important series of public hearings to address the issue of government-sponsored enterprises (GSEs). My name is Tom Schatz. I am the president of Citizens Against Government Waste (CAGW), a nonpartisan, nonprofit organization with more than one million members and supporters nationwide dedicated to eliminating waste, fraud and abuse in government.

CAGW is part of the Homeowners Education Coalition (HomeEC) a coalition comprised of taxpayer groups, several of which have representatives at this table today. This newly formed group intends to raise questions with our members, the media and the public about the nation’s largest GSEs and how their activities impact taxpayers.

CAGW was created 16 years ago after Peter Grace presented to President Ronald Reagan 2,478 findings and recommendations of the Grace Commission (formally known as the President's Private Sector Survey on Cost Control). These recommendations provided a blueprint for a more efficient, effective and smaller government.

Since 1984, the implementation of Grace Commission recommendations has helped save taxpayers more than $625.4 billion. CAGW has been working tirelessly to carry out the Grace Commission's mission to eliminate government waste.

In fact, CAGW’s interest in the activities of the nation’s housing government-sponsored enterprises originates with the Grace Commission’s Report on Board/Commissions – Banking.

The Grace Commission recognized the special advantages that Fannie Mae and Freddie Mac had and described the leverage these benefits conferred. The commission understood then, as do many of you of you today, that the GSEs’ "agency" status assures them access to credit at a preferential rate. The commission concluded that the implication of federal support ensured that "even without full faith and credit, the government would rescue an agency in trouble. This appears to be important in increasing the credit limits of an agency, even though less creditworthy agencies pay interest rates above more creditworthy agencies."

The Grace Commission also stated that the special advantages enjoyed by Fannie Mae and Freddie Mac distort the market. They acted as "a powerful disincentive for well-capitalized private sector entities to compete in the mortgage market." The commission also stated that there was no reason for Fannie Mae and Freddie Mac not to pay state and local taxes, and outlined a potential transition to fully private status for all government sponsored enterprises, "without threatening their ability to perform their historic mission."

The Grace Commission further noted that the concern over federal debt had not been carried over to comparable increases in agency debt. That lack of concern was related to the fact that farming and home building, two "powerful constituencies," were primary beneficiaries of the GSEs, "making them a difficult target for any activity that gives the appearance of a reduction in Government support."

The Grace Commission summed up why it is important for Congress to convene hearings such as these and to continue oversight of the GSEs. "The Government does not control agency growth because it is private; but the agencies depend upon Federal sponsorship (i.e., being treated as part of the Government) for their growth. This contradiction has extremely important consequences, now and for the future." Remember that this was in 1984.

I have included these recommendations for the record with my testimony.

Originally created to create liquidity in the secondary market for mortgages, Fannie Mae and Freddie Mac were chartered by the federal government and charged with a specific mission; to promote homeownership. In order to accomplish this mission, Fannie Mae and Freddie Mac were endowed with a raft of special privileges. For example,

  • Fannie Mae and Freddie Mac do not have to register their securities with the Securities and Exchange Commission (SEC). This frees them from expensive regulatory burdens that their private-sector competitors carry. According to Treasury Undersecretary Gary Gensler, this exemption was worth $280 million to Fannie Mae and Freddie Mac last year.
  • Fannie Mae and Freddie Mac are also exempt from paying state and local income taxes, an advantage that any business, small or large, would love to have. In 1999, that exemption saved Fannie Mae and Freddie Mac $690 million.
  • In 1996, the Congressional Budget Office (CBO) estimated their total subsidies to be $6.5 billion in 1995. That study determined that one-third of the subsidy was absorbed by Fannie and Freddie, rather than benefiting homeowners and also appropriately questioned whether the GSEs continue to be necessary to the financial markets at all.
  • Fannie and Freddie do not have to meet the same capital requirements that are imposed on banks and thrifts. In other words, they do not have to keep as much money on hand to cover losses if people default on the mortgages Fannie Mae and Freddie Mac have bought.
  • Because of their special advantages, the GSEs are able to borrow at rates almost as low as the Treasury itself. Cheaper money for Fannie Mae and Freddie Mac means that they can loan money more cheaply or make more money on the same loans than their private-sector counterparts. That message has been received loud and clear on Wall Street. A May 12, 2000 Moody’s press release ascribed the GSEs’ high bond rating to their "good financial fundamentals, the strong implied government support of the enterprises, and the competitive advantages they enjoy as a result of their special status" [italics added].
  • The prize that tops them all, though, is the financial markets' belief that Fannie Mae and Freddie Mac are too big to fail. This implied federal guarantee is the most significant benefit the GSEs enjoy. The CBO found in 1996 that about 40 percent of the earnings of Fannie Mae and Freddie Mac could be traced to their government-sponsored status. This implied guarantee is reinforced by the fact that Fannie Mae and Freddie Mac each have a $2.25 billion line of credit at the U.S. Treasury Department. Though they have never tapped that credit line, it is the GSEs’ most visible tie to the federal government.

Since the creation of the GSEs, times have changed. Today, the nation’s home ownership rates hover near 67 percent. Fannie and Freddie have played a key role in helping millions of Americans achieve the quintessential American dream of owning their own home. This kind of success is laudable. The overall economy is strong. Indeed, Fannie Mae, which was in dire financial straits just seventeen years ago, is now on sound financial footing and both Fannie Mae and Freddie Mac today enjoy double digit growth rates.

In addition, because of the outstanding success of the securitizations undertaken by Fannie Mae and Freddie Mac, the notion of securitization is a firmly established financial practice. Today, thousands of private entities are standing by with sophisticated techniques to securitize everything from credit cards to taxi cab licenses in New York City, thanks in large part to the successful example established in the marketplace by the GSEs.

If that were the end of the story, we wouldn’t be here today. The activities of Fannie Mae and Freddie Mac do not exist in a vacuum. Their duty to shareholders requires that they maximize profits. Yet, since there is also a duty to the taxpayers that runs with their special status, one mission necessarily comes into conflict with the other. There are strong indications that the GSEs' activities in recent years have begun to stray from their chartered mission, that their primary motivation has become the pursuit of high profit, and that this is driving them into increasingly risky financial practices.

If Fannie Mae and Freddie Mac were purely private, and if they were not supported by tens of billions of dollars worth of taxpayer-backed special benefits over the years, the nature of their activities might attract only a passing glance. But Fannie Mae and Freddie Mac are not purely private. In fact, their lucrative links to the federal government obligate Congress and the industry's regulators to pay special attention to what they do and how they do it. Failing to exercise an appropriate level of oversight would be an abrogation of Congress’ constitutional duties.

Questions raised about Fannie Mae and Freddie Mac must not be characterized as dry academic musings or dismissed as the rantings of disgruntled competitors, as several Fannie Mae and Freddie Mac representatives have repeatedly tried to do. Fannie Mae and Freddie Mac have characterized those who have made an issue of their activities as being "anti-homeownership." As an individual taxpayer group with a 16-year track record of exposing waste and mismanagement and as a member of the HomeEC coalition, we are one of those falsely accused of wanting to drive up costs for homeowners. Nothing could be further from the truth. Unfortunately, it is not unusual for CAGW and others who wish to maximize the efficient use of tax dollars to be attacked by federal agencies and others who are loath to submit to the scrutiny of congressional oversight or suggested improvements in their operations.

CAGW is proud of our desire to increase oversight of Fannie Mae and Freddie Mac. In fact, the U.S. Treasury Department shares our concerns. The U.S. General Accounting Office shares our concerns. The Congressional Budget Office shares our concerns. As of May 19th, we can count Alan Greenspan, Chairman of the Board of the Federal Reserve System, among our allies. The truth is that the housing GSEs have become so ascendant in the financial markets that their activities have far-reaching effects throughout the entire national financial system and therefore into the pocketbooks of ordinary citizens.

How large are they? By 2003, Fannie Mae and Freddie Mac combined will have more debt outstanding than Treasury debt held by the public. It is ironic that Fannie Mae Chairman Franklin Raines, as former director of the Office of Management and Budget, saw the national debt begin to ebb during his tenure there, only to preside over an explosion of implicitly taxpayer-backed debt at his next job.

In January of this year, Fannie Mae announced that it was positioned to issue its debt securities in unlimited quantities, a statement that ought to send chills down the spine of taxpayers. At current growth rates, by the year 2005, the GSEs are expected to carry $3 trillion in debt.

This is a point that has been addressed by Treasury Undersecretary Gary Gensler in his March 25th, 2000 testimony before this subcommittee. Mr. Gensler characterized the $1.4 trillion in current GSE debt as "large on any relative scale. It is now roughly the size of the entire municipal bond market,"which is the combined debt of all fifty states and localities that issue publicly traded debt. That figure does not include the $1.2 trillion in GSE-guaranteed mortgage backed securities.

From the time of their congressional charters in the late 60’s and early 70’s Fannie Mae and Freddie Mac have grown exponentially, well beyond the imagination of anyone active in those decisions. According to the Treasury Department, last year Fannie and Freddie together either owned or guaranteed 63 percent of the outstanding conventional mortgages in the country. GSEs are no longer passive pass-through agencies in the secondary mortgage market. As Mr. Gensler pointed out, the GSEs’ willingness to purchase a mortgage on the secondary market now more or less dictates whether the mortgage will be written at all.

It isn’t just the amount of their debt which ought to trouble taxpayers. After all, the congressionally chartered purpose of the GSEs is to provide liquidity in the mortgage market, to purchase mortgages, bundle them into securities and resell them to private sector investors, who then bear the risk. Today, what Congress, regulators, and taxpayers ought to be focused on, in addition to the amount of the debt they have outstanding, is the nature of the debt they hold in their own portfolios, the maturity of the mortgage market, and the direction Fannie Mae and Freddie Mac are taking in the future. In particular, the proposed replacement of Treasury debt with Fannie and Freddie debt as a marketplace benchmark deserves the utmost scrutiny. That is a major concern expressed by Chairman Greenspan in his recent letter.

Since 1993, Fannie and Freddie have begun to repurchase their own mortgage-backed securities and hold them in portfolio. Why? The answer is profit. Fannie Mae and Freddie Mac have experienced double digit growth rates over the last few years. Their institutional investors and stockholders have become very accustomed to those high profits and Fannie Mae and Freddie Mac have committed publicly to continue to deliver those kinds of profits on an annual basis. Repurchasing mortgage-backed securities is one way to scoop up higher profits. This is why, in our view, the percentage of mortgage-backed securities held on Fannie Mae’s books has increased from 5 percent in 1993 to 29 percent in 1999. Instead of dispersing risk into the private market, where it belongs, Fannie and Freddie are reconcentrating it in their own portfolios, which are implicitly backed up by the taxpayers. The question that Congress should be asking is "how does repurchasing mortgage-backed securities further the congressionally-chartered missions of Freddie Mac and Fannie Mae?" This question has not been adequately answered.

The Grace Commission recognized that GSE debt would expand and suggested that such expansion be restrained by proposing, in recommendation BANK 40-2, that "Congress should be requested to mandate that organizations having agency status be allowed to invest only in Government securities unless held pursuant to their mission. This will remove the opportunity for an agency to arbitrage investments against its lower cost of borrowing." This is precisely what Fannie Mae is now doing.

Groups such as CAGW and the other organizations in HomeEC represented at this hearing today are pressing for oversight on behalf of taxpayers because our members vividly remember the S & L crisis of the 1980s and the $500 billion bailout of the 90s, which they paid for. We applaud Chairman Baker for stimulating a much-needed debate about the government-sponsored enterprises, their activities, their motivations, and their impact on average taxpayers. It is timely and we urge you to continue pushing for disclosure, transparency and clarity with regard to the GSEs.

With regard to the specifics of H.R. 3703, CAGW commends Chairman Baker, Chairman Jim Leach and their colleagues for co-sponsoring the bill. The legislation has obviously ruffled a few feathers and brought down a firestorm of criticism from some quarters. All we can say is, our one million members and supporters thank you for simply doing what more subcommittees should do – make sure that programs and policies continue to be effective, and modify or terminate them if they don’t.

CAGW views several aspects of this legislation as extremely well-advised. In particular, we strongly favor the elimination of the GSEs’ lines of credit with the U.S. Treasury. These credit lines are miniscule in comparison to the GSEs’ potential liabilities and their existence sends a false message to Wall Street that taxpayers would bail the GSEs out in a financial crisis.

We also believe that Congress must examine the GSEs’ forays outside their charters into highly competitive financial areas where they unfairly undercut competition.

And we concur with Treasury Undersecretary Gary Gensler’s concerns as to whether commercial banks ought to be permitted to hold in portfolio unlimited percentages of GSE debt. This practice also reinforces the notion that the debt of the GSEs is equivalent to the debt issued and explicitly guaranteed by the Treasury, and reinforces the belief that the GSEs are too big to fail and that taxpayers will be forced to shore them up in an emergency. This is an issue that should be explored further by the subcommittee.

During his recent testimony before this subcommittee, Fannie Mae’s Chairman repeated several times that Fannie Mae’s activities pose "zero risk" to the government and to taxpayers. This statement is very misleading. In the world of high finance, growth and a high rate of return are inextricably linked to risk. There is much to talk with regard to risk management, but I’d like to take a moment to address one issue that has recently made the papers.

I refer to the ads that Fannie Mae has been running in which they talk about the financial "stress test" they are required to undergo. This stress test was established as part of 1992 legislation, which also created the GSEs’ regulator, the Office of Federal Housing Enterprise Oversight. Mr. Raines also referred to the stress test in his testimony before this subcommittee.

Now would be a good time to set the record straight on the stress test. This regulation, which is designed to certify the financial safety and soundness of the GSEs, has not in fact gone into effect, though it is in its final stages. Even so, almost nine years after the law requiring this test was enacted by the Congress, it will be at least another year before it is activated. What is more, Fannie Mae in particular has consistently resisted submitting to the stress test. It is strange indeed to now see Fannie Mae extolling the virtues of a regulation that they have consistently argued against and which has never actually been applied.

Mr. Chairman, CAGW would like to submit the ad, along with a series of letters from Fannie Mae criticizing the stress test, into the record.

With Fannie Mae and Freddie Mac, we have two mammoth quasi-governmental entities that claim agency status when it suits them and simultaneously claim to be private financial institutions when it suits them.

Franklin Raines has stated that the great success of Freddie Mac and Fannie Mae shows that one can pursue a public mission and still deliver high returns to shareholders. But the usual experience is quite the opposite. This kind of public/private schizophrenia breeds mismanagement and inefficiency and often ends up costing taxpayers billions. As one longtime observer of the financial markets has noted, with the creation of Fannie Mae and Freddie Mac, we have only succeeded in privatizing the profits, while socializing the risks.

Taxpayers must not be victimized again by a financial crisis that would dwarf the S & L crisis. Now, while the economy is strong, is the best time to begin examining crucial questions regarding the nature of the nation’s government-sponsored enterprises.

On behalf of our one million members and supporters, we thank the committee for the opportunity to speak to you today and are available to answer any questions you might have.



 

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