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Committee on Financial Services

United States House of Representatives

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Statement of
Peter J. Sepp, Vice President for Communications
National Taxpayers Union

Before the
Subcommittee on Capital Markets, Securities, and Government Sponsored Enterprises
Banking and Financial Services Committee
United States House of Representatives

HR 3703, The Housing Finance Regulatory Improvement Act

June 15, 2000


Mr. Chairman, on behalf of the 300,000 members of National Taxpayers Union (NTU), I am deeply grateful for the opportunity you have given my organization to testify before the Subcommittee today on HR 3703 and policies toward Government Sponsored Enterprises (GSEs) involved in housing finance.* By holding these hearings, you have once again demonstrated your concern that Congress fulfill its obligation to effectively oversee not only direct federally-funded programs, but also entities that receive indirect or implicit federal subsidies. Taxpayers across the country are most appreciative that you, Mr. Chairman, and the Members of this Subcommittee have taken the time to give this issue additional exploration.


Mr. Chairman, I appear before the Subcommittee today not as a financial services wizard or as a political insider, but rather as an institutional historian. As you know, NTU has long expressed concern about the potential risks to taxpayers posed by GSEs.

Since the early 1970s, my organization has compiled a "Taxpayer’s Liability Index" that tracks federal financial obligations above and beyond the national debt. That analysis has continually pointed to an expanding level of potential taxpayer costs associated with GSE debts.

Our Founder and Chairman Emeritus James Davidson testified before the House Ways and Means Committee on this topic in September 1989, at what was then billed as the "first oversight hearing on GSEs in recent memory."

Throughout the early 1990s, NTU actively sought GSE oversight legislation in Congress, and pointed to the unfairness of rising compensation packages among senior GSE officials while the entities they managed were enjoying taxpayer subsidies.

Also during that period, our research affiliate, NTU Foundation, sponsored a well-attended Washington, DC policy conference, "A Crisis in Values." The event brought together the top experts in the financial industry to discuss the role of the real estate economy in the S&L Crisis and in the potential liabilities of GSEs.

Earlier this year, NTU organized a Capitol Hill conference entitled "Fannie Mae & Freddie Mac – Issues for Taxpayers," which featured diverse authorities on Government-Sponsored Enterprises that included: Peter Wallison, former General Counsel for the Treasury Department and current Resident Fellow at the American Enterprise Institute; Bert Ely, a longtime financial institutions consultant who was one of the first to predict the massive S&L bailout; Steve Moore of the Cato Institute and Tom Miller of Competitive Enterprise Institute, whose organizations have tracked GSE liabilities; and, Betsy Hart, a syndicated columnist who has investigated the political activities of Fannie Mae and Freddie Mac.

Given this lengthy history, NTU’s positions on GSEs and possible reforms have transcended, and will continue to transcend, any existing political or fiscal environment.

At this point, Mr. Chairman, I wish to mention that NTU and NTU Foundation have extensive information on GSE-related issues available online at Naturally, it would also be our great pleasure to furnish you and your colleagues with any additional archived materials from earlier events upon your request.

To briefly summarize our concerns:

  • According to Congressional Budget Office methodology, Freddie and Fannie’s 1999 federal subsidy was $10 billion, $3.5 billion of which benefited their stockholders and managers.
  • But in order to keep earnings growing by 15% per year, the two quasi-private firms must resort to increasingly risky practices, such as fishing into the consumer credit and jumbo mortgage pool, holding derivatives, and conducting interest-rate swaps.
  • GSE debts and liabilities, which most capital markets assume to be backed by the federal government, is estimated to be at least $1.4 trillion and as much as $2.6 trillion. This level would be 12-20 times the amount of on-balance-sheet debt carried by the ill-fated private firm Long Term Capital Management when it crashed.

No less than Federal Reserve Chairman Alan Greenspan forcefully drove home the implications of these issues when he recently wrote to the Subcommittee that:

Federal government guarantees -- implicit or explicit -- are one way, along with government outlays and mandates on the private sector, that the federal government makes claims on the real resources of the private sector. Subsidies accorded to GSEs are, of necessity, at the expense of other federal or private sector initiatives and hence are ultimately financed by households, either through taxes or through the reduced accumulation of wealth.

In the past, NTU’s forums and committee appearances have generated discussion over a range of possible reforms to Fannie Mae and Freddie Mac, such as:

  • The government could levy a GSE "user fee" that would reflect the subsidy margin that Freddie and Fannie enjoy over private lenders;
  • Freddie and Fannie could be re-federalized and re-structured to perform a more limited role as strictly a low-income mortgage underwriter;
  • Competing GSE housing finance franchises could be auctioned off in a manner similar to the successful FCC spectrum auctions;
  • A targeted housing finance tax credit could replace the lender-of-last-resort practices of the GSEs, thereby preventing much of their housing market price distortions;
  • Privatize the GSEs entirely, along the lines of the Student Loan Marketing Association.

These types of changes are well beyond the scope of HR 3703, and I have provided them partially as background for Members of the Subcommittee. However, it is also our hope that mentioning these proposals, and noting their absence in HR 3703, will underscore what should be the non-controversial nature of the legislation presently under consideration by the Subcommittee. Far from initiating some sweeping overhaul, HR 3703 merely seeks to consolidate and improve Congress’s existing mission to oversee the operations of the housing GSEs.

Familiar Echoes from the Past: S&Ls

Members of this Subcommittee are now in the midst of a third round of hearings on housing GSEs, and many of the arguments taxpayer advocates are raising today may seem shopworn. Officials with the GSEs themselves dismiss any analogy to a possible "2nd S&L Crisis" as ill-informed, or unfitting, or even alarmist. It is this historical nexus to present-day GSEs, and its considerable merit, that will constitute the remainder of my testimony.

No history of political institutions can ever be completely objective, especially when recounted from the viewpoint of an interested organization. However, one can make great strides toward objectivity in drawing parallels between the S&L Crisis and GSEs by employing tracts from other official sources.

A helpful document in this regard is Origins and Causes of the S&L Debacle: A Blueprint for Reform. Prepared by the National Commission on Financial Institution Reform, Recovery, and Enforcement [hereafter known as "the Commission"] pursuant to Public Law 101-647, the report identified "conditions necessary for the [S&L] collapse to occur, causes precipitating the collapse, and factors intensifying and prolonging losses once the process was under way." Some of the Commission’s findings, which I quote in pages to follow, provide useful points for comparison.

1) "Fundamental condition necessary for collapseFederal deposit insurance on accounts at institutions was at the heart of it. With federal deposit insurance, S&Ls attracted large quantities of deposits at a subsidized rate and invested these funds in risky activities."

Market discipline cannot prevail if Congress allows the institutions it creates to privatize profits but socialize risks. In an unsubsidized environment, S&L consumers would have helped to act as "self-regulators" against institutions that invested deposits in risky portfolios. They would either demand a better interest rate or would simply move their deposits to a "safer" institution. But by raising the per-account insurance limit to $100,000, and by failing to introduce adequate risk-based deposit insurance premiums, the Commission concluded that the government created an environment in which "depositors could benefit with no meaningful risk of financial loss."

Although not mandated to do so by law, the federal government does effectively extend a sort of "deposit insurance" to housing GSE shareholders, in the form of an implicit bailout guarantee. GSE officials have tended to downplay this connection, and cite legal requirements to inform investors that their securities are not backed by the full faith and credit of the United States. The Congressional Budget Office, not known to express unsupported opinions, disagrees with the officials’ claims:

Short of placing an explicit guarantee on the securities of the housing GSEs, the law could hardly be more clear: the government’s financial interests in the safety of Fannie Mae and Freddie Mac ensure that their obligations are safe from the risk of default. Although the federal guarantee is only implicit, the financial markets grant "agency status" to the securities issued by GSEs on the basis of those statutory provisions, as though the enterprises were part of the federal government ("Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac," May 1996).

Ironically, some of the few seeds of doubt that do exist over the GSEs’ taxpayer-backed status were sowed by the GSEs themselves. In a summer 1998 article he wrote for Brookings Review, Harold Seidman recounted just a few of these bizarre turnabouts:

[W]hen HUD Secretary Patricia Harris directed FNMA to increase its percentage of mortgage purchases in central-city areas, the agency insisted it was private … [and] that its primary obligation was to its stockholders … FNMA argued no less vigorously that it was a federal instrumentality when New York State attempted to compel it to pay interest on its escrow funds. [And when the Reagan Administration proposed] to cut off its special privileges … FNMA protested that ‘Congress established Fannie Mae to run efficiently as an agency, not as a fully private company.’

Indeed, even the boundaries of explicit federal guarantees are fluid. In one of the first landmark bank bailouts of modern times, Continental Illinois, the government not only reimbursed insured depositors for their losses, but it also covered the losses of uninsured depositors and creditors of the parent holding company. If Washington cannot exercise fiscal discipline within clearly established limits on its own largesse, there is little chance it will do so in a situation where the taxpayers’ checkbook is left wide open.

With implied federal guarantees, a very important incentive for prudent risk-taking is removed. In a truly private-sector corporation, owners and managers face the harsh reality of severe financial losses or bankruptcy if excessive risks are undertaken. Earning the kind of record profits that the GSEs proudly celebrate is far less difficult when someone else can pay the bills for any potential losses.

This was precisely the reason why S&Ls accumulated investments in such capricious markets as real estate development and interest rate speculation. Socializing the risk behind those investments freed the S&Ls from many prudent business constraints, and allowed the industry to grow by a spectacular 56 percent from 1982 to 1985. These explosive growth rates are being matched today by Fannie Mae through other riskier business ventures, such as consumer credit, jumbo mortgages, and derivatives.

2) "Factors precipitating the collapseThe macro-economic shock of unprecedented high interest rates adopted to combat soaring inflation during 1979-82 was a prime factor in precipitating the collapse of the S&L industry."

Due to their initial regulatory charters and later their habits of business, Savings and Loan institutions tended to operate in a "niche market" of long-term mortgages with fixed interest rates. This situation rapidly changed in the late 1970s and early 1980s, when interest rates began to soar. The income earned on most assets held by S&Ls was often outstripped by the outgo they were forced to offer depositors in order to remain economically attractive. This in turn led S&Ls to disastrous attempts to "grow their way out" of their profitability problems by seeking more profitable, but more volatile, investment options for their assets. Although the resulting taxpayer bailout for these ill advised – and sometimes fraud riddled – decisions could have been ameliorated by earlier and aggressive oversight, the root of the problem for S&Ls remained their vulnerability to downturns in a single economic sector.

GSEs have not been immune to this perilous phenomenon. By its very nature, the Farm Credit System (FCS) concentrated its lending in agricultural activities and was particularly exposed to risks in that sector. Yet, the normal market forces that would compel a private firm to make tough business decisions did not apply to FCS.

In comments about an article he co-wrote for the July/August 1989 edition of Public Administration Review, Tom Stanton noted that "even after the farm credit system recorded $4.6 billion of losses in 1985 and 1986, Farm Credit securities remained eligible investments for AAA-rated debt." What private corporation could post losses like these and still retain a debt rating like this? Certainly not one backed by investors instead of taxpayers. No matter – the "investors" who guessed the FCS wouldn’t be allowed to fail were duly rewarded, when Congress provided special assistance through the Agricultural Credit Act of 1987.

If a new interest rate crisis were to affect Fannie Mae adversely, history would be repeating itself, not just inflicting itself on a new victim. According to the 1996 Congressional Budget Office Report cited earlier:

The rapid and sustained rise in interest rates that occurred in the late 1970s and 1980s vividly demonstrates the destructive potential of interest rate risk on debt-financed mortgage portfolios. … [A]s interest rates rose, borrowers were less likely to prepay their mortgages. …By the early 1980s, the market value of Fannie Mae’s mortgages was $10 billion less than its outstanding debt. By that measure, Fannie Mae was insolvent. Eventually, interest rates declined, and Fannie Mae recovered.

Earlier this summer Treasury Under Secretary Gensler reiterated this observation in his own testimony, when he noted that Fannie was put in a bind "similar to that faced by the Savings and Loan industry. Fannie Mae became insolvent on a mark-to-market basis."

Fannie Mae’s first reprieve from the fate suffered by many S&Ls has resulted in a different management style. Interest-rate risk has been balanced so far through issues of long-term callable debt, short sales of Treasury securities, and derivatives. Such practices are not inherently wrong, but some of them do make, as CBO noted, "the assessment of total risk exposure more complex for both management and the federal government."

Housing GSEs can also resort, within limits, to diversifying their holdings or services. However, there are few worlds left to conquer within a literal reading of their charters. Today, Fannie and Freddie dominate the retail market mortgage market by owning or guaranteeing 40 percent of all mortgages. Together they have approximately 65 percent of market value for mortgage intermediary services and almost 100 percent of the market for securitizing conventional mortgages.

If Freddie and Fannie do not expand their pool of borrowers, they are likely to experience "mission creep" as they compete for other services, such as home equity loans. As Jeffrey Zeltzer, Executive Director of the National Home Equity Association, has stated, "The home equity area is a refinancing of consumer debt, or a home improvement, or sending someone to college, or a family medical emergency. So they’re not even within the mission."

In attempting to avoid a repeat of the S&L Crisis or its own insolvency during the 1980s, Fannie Mae (along with other housing GSEs) has created a long-term dilemma that taxpayers and policymakers must eventually confront. Diversifying portfolios within their mission risks concentration of entire lending sectors, not to mention the use of complex financial instruments for which private investors and companies can pay steep "opportunity costs." Diversifying portfolios outside of their mission risks a sort of "industrial policy" that could unintentionally put large sectors of our economy under the control of entities that enjoy a substantial public subsidy over their private rivals.

Do Americans really want to import the kind of system now evolving in China, where branches of its national government are investing as if they were multinational corporations? We think not.

3) "Factors intensifying and prolonging the collapseA systematic breakdown in the political system involving Congress, the independent regulators and the Administration prevented corrective actions."

To be clear, the S&L Crisis involved a share of abuse and fraud among operators of those institutions that would not be found at all among the managers of housing GSEs. Nonetheless, the regulatory process does not merely concern itself with uncovering or punishing illegal acts. It establishes guidelines, provides reporting standards, and creates a rudimentary "alarm system" designed to alert lawmakers and the public to the need for their involvement in drafting reforms. It is in the latter areas that a comparison between S&Ls and GSEs remains appropriate.

According to the Commission, regulators were often blinded to the poor business practices of certain S&Ls due to "the absence of an information structure that obscured the extent of the mounting losses and the degree to which the federal deposit insurance program and the Treasury were exposed to loss."

Despite recent efforts to establish reporting and capital standards for the housing GSEs, transparency is still an elusive goal. GSEs can trade on the New York Stock Exchange, but are exempt from Securities and Exchange Commission fees and reporting requirements that burden other companies that offer stock. Nor are the GSEs required to disclose trading positions held by their top-level managers.

Another element of transparency, capital hedges against risks, illustrates the critical policy juncture we have now reached. In 1992, the Federal Housing Enterprises Safety and Soundness Act of 1992 instructed a newly-created Office of Federal Housing Enterprise Oversight (OFHEO) to develop risk-based capital standards to apply to GSEs. Progress on this front has been painfully slow. Fannie Mae could not meet a "test run" of a proposed OFHEO risk-based capital rule in 1997.

The limited standards for GSEs that exist today, which are not necessarily risk-based, point to a major advantage vis-a-vis their competitors. Private banks and thrifts must maintain at least 4 percent capital against on-balance sheet assets as well against any "prudent" mortgage-related assets, on- or off-sheet. The total risk-based capital minimum for on-balance and off-balance sheet assets is 8 percent.

In contrast, Fannie Mae and Freddie Mac fall under just two established core requirements – 2.5 percent for on-sheet assets and .45% against off-sheet assets. A risk-based standard has not yet been implemented by outside regulators.

Senior GSE officials contend that their agencies are in a far better position than most private financial institutions, and that the existing standards are fair given the structure of the GSEs’ holdings. However, outside analysts seem unable to verify these claims with any certainty. Fannie Mae insists it has developed its own "internal" risk-based capital model that purportedly complies with the intent of the 1992 law, but without a detailed analysis of this model, taxpayers remain unassured.

Conclusion: A Sustainable Future Must Build on Lessons of the Past

The "Summary and Recommendations" section of the Commission’s report begins with the historical observation that "Congress transformed S&Ls into agents of national housing policy" and that "government regulation sheltered S&Ls from competition, allowing the industry to be profitable and failures to be rare." But beginning with the interest rate problems of the 1980s, the Commission found policymakers to be "ill-prepared to deal with the crisis." The result was "a large and unnecessary expense to taxpayers" that "has shaken the public confidence in financial institutions, government, and the political process." This need not be the case with other Congressionally-chartered "instruments of national housing policy," the GSEs.

More than a decade ago, NTU Founder James Davidson began his presentation to the Committee on Ways and Means by prophetically observing that:

[D]espite dramatic increases in borrowing by GSEs, too little is known about the magnitude of the very real risks underwritten by American taxpayers. One of the unfortunate lessons of the Savings and Loan [S&L] debacle is that off-budget activities, loan guarantees, and quasi-government functions can have a tremendous impact on the federal budget… Should a similar fiscal catastrophe hit GSEs, bailout costs could multiply to levels that would not currently seem credible…Given these risks, it is absolutely essential that the Congress be provided with accurate information concerning the potential costs of GSEs to the federal government.

Unfortunately, the strong, permanent framework of oversight our Founder envisioned has yet to evolve. Granted, government studies of the impact of housing GSEs on the federal balance sheet have significantly informed the debate over the past decade. In addition, preliminary efforts to establish a free-standing structure of standards and reviews are underway. Yet these developments have only served as a foundation upon which Congress must now build. HR 3703 would continue the construction process, and for this reason alone it deserves the support of the Subcommittee and your colleagues throughout the House and Senate.

In closing, Mr. Chairman, I thank you and all the Members of the Subcommittee on Capital Markets, Securities, and Government Sponsored Enterprises for your initiative and leadership in holding these vital hearings. I look forward to answering any questions you may have.


* National Taxpayers Union does not solicit or accept any form of government funding. In 1999 National Taxpayers Union received no federal grants. NTU has prepared and delivered this testimony solely on behalf of its 300,000 members.


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