Thank you, Chairman Baker. I appreciate the opportunity to speak to the Subcommittee today about Fannie Mae, our regulatory structure, our role in the marketplace, and the concerns you have raised.

I also want to take this opportunity to recognize the importance of this Subcommittee’s oversight of the housing finance system. The housing finance system is crucial to the American people who overwhelmingly aspire to be homeowners. I appreciate the work that you and your colleagues on the Subcommittee have done to strengthen homeownership in America, and I look forward to an ongoing dialogue.

From the perspective of both consumers and investors, the U.S. housing finance system is the best in the world. While most of the G-7 countries have a well-developed mortgage finance industry, the mortgages they offer are less consumer-friendly. In the U.S., for example, we take the 30-year, fixed-rate mortgage for granted, with downpayments as low as five and three percent. That is not the case in Germany, France, the United Kingdom, or Japan. In Germany, the down payment is typically 35 to 40 percent, and in Japan, homebuyers have to put 50 to 60 percent down.

And unlike in the United States, the long-term fixed-rate mortgage is a rarity in these countries. Last year, 66 percent of all conforming mortgages originated in the United States were 30-year fixed-rate mortgages. In Canada, rollover mortgages have a fixed rate during the first one to five years, with a prepayment penalty equal to 3 months of interest; at rollover, borrowers select another mortgage period. The fixed-rate term in Spain and France is about 15 years, and 5-10 years in Germany. And homeowners cannot refinance during this period unless they pay a huge penalty.

Why are low down payment, fixed-rate mortgages with an option to refinance at little or no cost so common here and a rarity elsewhere? The difference is Congress’s long-standing commitment to homeownership and Congress’s decision to create what has become a well-developed, sophisticated secondary mortgage market that meets the needs of both homebuyers and investors.

It is worth spending a few minutes on how the secondary market works. [CHART 1] Lenders originate mortgage loans in the primary market. (Fannie Mae does not originate loans. Our charter does not allow it and we are not equipped to handle direct contact with consumers.) Lenders can either sell the mortgages they originate to investors in the secondary market or retain them in their own portfolios. When lenders sell their mortgages, they replenish their funds so they can lend more money to homebuyers.

Fannie Mae’s role is to transform mortgage risk into the various forms that investors want to buy. [CHART 2] For example, some investors want the higher returns they can get from investing in mortgage-backed securities (MBS). MBS are created when a lender comes to us with a pool of mortgages and pays us a fee to guarantee the creditworthiness of those loans. The lender then sells the mortgage-backed security to Wall Street and other investors. Some investors choose to buy MBS because they want the yield that comes from taking the prepayment risk — the risk that borrowers will repay their mortgages (if interest rates fall) and thus reduce the cash flow from the MBS investment — but want the liquidity and lack of credit risk in MBS. (Indeed, if investors want to take both interest rate and credit risk and sacrifice liquidity, they can buy whole mortgage loans from lenders without the Fannie Mae credit guarantee.)

Fannie Mae performs a similar role with regard to credit risk, working with our risk-sharing partners such as lenders, mortgage insurers and others to transform the risk of default on each loan into exposures each partner is best suited to hold.

There are a few important points I want to emphasize about the MBS market. First, Fannie Mae does not ordinarily sell MBS to Wall Street; lenders do. Once Fannie Mae has securitized a pool of mortgages into an MBS, the lender owns that MBS and can either hold it or sell it to investors, one of whom may be Fannie Mae.

Second, the price of MBS is set by a highly liquid and efficient market. The most recent data available indicate that dealers traded $70.6 billion worth of MBS during the week of May 3, 2000, and April 2000 MBS settlements were approximately $330 billion. Fannie Mae does not set prices in that market. The fee that we receive from securitizing mortgages is related only to the credit risk (and the remittance schedule) on those loans. Indeed, when the demand for MBS rises and prices go up, Fannie Mae’s credit fees remain the same.

The benefit that Fannie Mae MBS receive from our charter flow directly from Wall Street to lenders and then to consumers. Fannie Mae is also an investor in the MBS market, however, and as such, we compete with other investors on equal footing. Like any other large investor, we can influence the market to the extent that the addition of our demand in the market raises prices and, in turn, lowers mortgage rates. That is precisely the role we played in the 1998 credit crunch. When other investors withdrew from the market, we stepped up our purchases, which kept mortgage rates low.

Third, the market price is set by the actions of many buyers and sellers. Because we help supply the market with securities in demand by investors, we increase the flow of funds into the mortgage market and thereby drive down mortgage rates for consumers.

But some investors do not want to take the prepayment risk that comes with MBS. Instead, they may want to purchase an investment that has a more predictable cash flow — at the cost, of course, of a lower yield. Fannie Mae’s role is to make it possible for these investors to participate in the mortgage market. We do this by purchasing mortgages and MBS and selling debt securities to pay for those purchases. Our various debt securities give investors two basic choices. Investors can buy some — but not full — prepayment risk by purchasing our callable debt securities. Callable debt is debt that Fannie Mae can redeem earlier than its stated maturity if interest rates fall and homeowners refinance their mortgages faster than expected. Or investors who want the liquidity and predictability of a traditional debt instrument can buy our bullet — or non-callable — debt securities. These debt securities provide the greatest predictability; Fannie Mae must repay at, and only at, the stated maturity date.

MBS, callable debt, and bullet debt are the three primary ways that Fannie Mae transforms the risk of fixed-rate, long-term mortgages — which have illiquid, unrated, unpredictable cash flows — into securities that are liquid, high-quality, and have cash flows covering a range of predictabilities. The reason that the U.S. mortgage market is so efficient is that investors can find almost any combination and level of prepayment risk and yield in one of these three securities. And within these three categories, we create highly specialized security structures for large investors who have very specific risk demands. By creating securities that are attractive to the broadest universe of investors, Fannie Mae and Freddie Mac increase the demand for mortgages, which raises the prices of MBS and, in turn, lowers mortgage rates for homebuyers.

The best starting place for a discussion of Fannie Mae’s role in the market is the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the "1992 Act").¹ This law made significant changes to Fannie Mae’s charter and our regulatory structure, providing the foundation for the successful secondary market that exists today.

In the early 1990s, Congress took up legislation to change Fannie Mae’s and Freddie Mac’s overall structure for mission and financial soundness. Congress considered the issues against the backdrop of the failures in the thrift and banking industries during the 1980s and early 1990s — the resolution of which cost the American taxpayer about $125 billion and took close to a decade to resolve. The Banking Committee was deeply involved in the policy decisions needed to correct the poor regulation, reckless investments, and inadequate capital that caused many thrifts to fail and left taxpayers with an exorbitant bill.

The stability of the banking system was also in question. Between 1980 and 1994, more than 1,600 banks failed or received financial assistance from the FDIC. Many of these losses were associated with rapid growth and unsound speculative real estate lending. Exacerbating the situation, exams of many banks became infrequent in the early and middle 1980s. In addition, bank regulators did not adopt uniform capital standards covering all federally regulated banks until 1985, and did not adopt any form of risk-based capital until 1990.

Some of those weakened banks were so large that regulators decided to avoid liquidation for fear of damaging public confidence in the banking system as a whole. In 1984, such concerns led the FDIC to prop up Continental Illinois after it began to experience enormous withdrawals of foreign deposits in a high-speed electronic run. Again in the early 1990s, regulators quietly intervened to help avert another major bank failure, exercising veto power over every significant decision made by bank management until business restructuring and the Federal Reserve's lowering of interest rates restored financial health.

Simply stated, the troubled banks and thrifts of the 1980s and early 1990s reached a crisis point because of the weakness of their regulatory regime and the riskiness of their lending activities. This is precisely why Fannie Mae will never be the source of such a crisis. Congress ensured in 1992 that we would always be subject to rigorous safety and soundness regulation and oversight, and our investments are geographically diverse and limited to one type of low-risk and liquid asset — residential mortgages. The thrift bailout cost taxpayers $125 billion and the FDIC spent over $36 billion from the deposit insurance fund to prop up the banks. In contrast, since our privatization in 1968 — and even though we, like all other financial institutions, experienced financial difficulties in the early 1980s — Fannie Mae has never cost the American taxpayer a single penny. (Even as it suffered losses in the early 1980s, Fannie Mae never became insolvent on a generally accepted accounting principles basis.) Indeed, Fannie Mae helped mitigate the effects of the thrift crisis by consistently maintaining liquidity in the mortgage market.

Congress responded to the problems of the banking and thrift systems in the 1980s and early 1990s by enacting sweeping reforms in 1989 (the Financial Institutions Reform, Recovery and Enforcement Act of 1989, or FIRREA) and 1991 (the Federal Deposit Insurance Corporation Improvement Act, or FDICIA). These reforms addressed the need to identify possible problems early on through increased supervision and examination and to deter risky behavior through risk-based capital and risk-based deposit insurance premiums.

With the lessons of the thrift and bank crises still fresh and with the reforms enacted in FIRREA and FDICIA as a context, Congress turned in 1991 to the housing government-sponsored enterprises (GSEs). Congress recognized the public policy successes of Fannie Mae and Freddie Mac as well as the consumer and market benefits that our companies produced. Most important, Congress wanted to ensure that as many homebuyers as possible were served by Fannie Mae’s and Freddie Mac’s role in the market, that the companies were regulated effectively, and that the companies maintained the financial soundness to fulfill their housing missions through varying economic conditions.

Two years of hearings, the preparation of many government studies, and committee consideration covering numerous mission, capital and enforcement proposals, ultimately produced the 1992 Act. In crafting and enacting the 1992 Act, Congress reassessed the benefits, restrictions, and obligations of Fannie Mae and Freddie Mac and the safety and soundness regulation needed to ensure fulfillment of the companies’ responsibilities to consumers and the housing market. The result is a complex and interdependent set of benefits and responsibilities that maintains the critical role of private equity capital and private management, allows Fannie Mae to link more efficiently than ever the international capital markets with the U.S. housing finance market, and, at the same time, requires the company to serve affordable housing and homeownership needs throughout the country. The critical role of private equity capital and private management were maintained in the legislation.

In this way, Fannie Mae’s Congressional charter is a "compact" — an agreement between private investors and the Congress. By investing in Fannie Mae, our shareholders provide capital to a company upon which Congress has conferred a structure and business purpose aimed at furthering the public policy priority of homeownership. As part of this compact, Congress gave Fannie Mae and Freddie Mac certain benefits and tools paired with certain restrictions, including limiting these companies to a single line of business — the residential mortgage market within our loan limits. Congress also reinforced the nature of our relationship with the federal government, requiring the explicit "non-guarantee" that appears on the front of every debt and mortgage-backed security. The work that Congress did in 1992 was a reaffirmation of this compact, the success of which is evident across America today.

The mandate of the 1992-revised charter is summarized in the purposes set forth for Fannie Mae:

• To provide stability in the secondary market for residential mortgages;

• To respond appropriately to the private capital market;

• To provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and

• To promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.

In every area of concern that Congress addressed in 1992, the record of the last eight years has been one of remarkable achievement. Since the 1992 Act, Fannie Mae’s performance — in terms of our housing mission, our safety and soundness, providing liquidity and stability in the market, and delivering and fostering innovation — is a clear success story.

Ensuring Fannie Mae’s continued focus on affordable housing and affordable homeownership was one of the main objectives of the drafters of the 1992 Act. Congress determined that Fannie Mae should vigorously reach underserved markets. Fannie Mae’s response to this challenge was particularly dramatic, even though the company’s efforts to reach more low- and moderate-income borrowers had already begun. For Fannie Mae, expanding access to affordable homeownership for more borrowers throughout the country is much more than a regulatory requirement. It is what we as a company and as a business are all about. As I have said on many previous occasions, expanding homeownership and affordable rental housing is good public policy and good business.

My predecessor, Jim Johnson, embraced this philosophy when he announced, in 1994, Fannie Mae’s Trillion Dollar Commitment. This commitment was a pledge to invest $1 trillion to serve 10 million underserved families — including low- and moderate-income families, minorities, new Americans, residents of central cities and rural areas, and people with special housing needs — by the end of 2000. This promise transformed our company. In 1993, just over 31 percent of our single family business served borrowers with incomes at or below the area median. In 1999, this percentage was over 40 percent. [CHARTS 3 & 4] In 1999, 68.6 percent of our total business served families targeted in this initiative, and over 500 of Fannie Mae’s 3,900 employees work full-time on affordable housing. [CHART 5] The result has been a strong focus on overcoming the barriers to homeownership. Through product innovation, underwriting experimentation and flexibility, and technology, Fannie Mae achieved greater efficiencies, lowered mortgage costs, created easier access to financing, and revitalized communities. I will mention a few brief examples:

• In partnership with Holy Name Housing, NuStyle Development, and the Equity Fund of Nebraska, and the City of Omaha, Fannie Mae has an $800,000 equity investment in 40 single-family homes, which are homeownership incubators. Known as Omaha Crown, this $4.5 million project is helping to maintain the historic Kountze Park neighborhood and to educate qualified families about homeownership skills. A portion of their monthly rent goes to a homeownership savings account so that after several years of affordable renting, the families are able to buy a home of their own.

• In 1991, Fannie Mae launched a new experiment in cooperation with the National Training and Information Center in Chicago to create a low downpayment mortgage with extended underwriting flexibilities. The Community Home Buyer's initiative provided a standard, secondary market product that enabled many of our lender partners to begin offering significant volumes of low downpayment mortgages, targeted to low- and moderate-income families and those living in underserved neighborhoods. Since the introduction of the Community Home Buyer suite of products, Fannie Mae has built a portfolio of about $50 billion in these mortgages, and created a standard that is used by lenders throughout the country.

• In 1998, Fannie Mae launched a unique partnership with the Self Help Venture Fund of North Carolina, one of the nation's foremost community development financial institutions, and the Ford Foundation to finance up to $2 billion over five years in home loans to 35,000 minority and low-income home buyers nationwide. Fannie Mae is providing a low cost secondary market outlet that provides liquidity for a market segment that in the past has relied more heavily on portfolio lending by depositories. This unique risk sharing arrangement gives us the opportunity to work with others to transform risks in the market to provide new and tangible benefits to consumers. To date, through this initiative, we have financed nearly $500 million in loans to reach traditionally disadvantaged groups as reflected in the demographics of the borrowers: 24.9 percent African American, 7.4 percent Hispanic, 38 percent female-headed household, 4.6 percent rural with an average income, as a percent of median, of 70 percent.

As many of you know, I announced earlier this year that we met the goals of the Trillion Dollar Commitment in April, eight months early. Not wanting to rest on our laurels and recognizing that much remains to be done, I also announced Fannie Mae’s new American Dream Commitment — a 10-year, $2 trillion commitment to serve 18 million targeted families. This initiative will place a special emphasis on increasing homeownership among minorities, young families, women-headed families, new immigrants, and others whose homeownership rates lag the general population. This effort will also target Americans who have not fully benefited from the economic expansion of the past nine years, including many who live in economically depressed urban and rural areas.

One manifestation of Congress’s emphasis on our housing mission is the affordable housing goals established by the 1992 Act. Under the statute, we are required to meet annual, percent-of-business targets in terms of our service to low- and moderate-income borrowers, to residents of central cities and other underserved areas, and to very low-income borrowers. No other company in America has percent-of-business goals as tough as the ones Fannie Mae and Freddie Mac must meet.

Fannie Mae has met or exceeded each and every one of our affordable housing goals every year since 1994. [CHARTS 6 & 7] Here are a few snapshots that provide a perspective on our commitment to meeting both the letter and the spirit of these goals:

• In 1993, Fannie Mae provided $62.3 billion in mortgage financing for over 994,000 low- and moderate-income borrowers. In 1999, we provided $101.6 billion to serve over 1.34 million low- and moderate-income families.

• In 1996, Fannie Mae provided $36.3 billion in financing for over 534,700 families living in underserved areas, including central cities and rural areas. In 1999, the level of this business reached $65.9 billion and 790,450 families.²

Meeting our annual affordable housing goals has been a challenge, and this challenge will only grow. When the Federal Housing Enterprise Safety and Soundness Act of 1992 passed, Congress had set an interim low- and moderate-income goal at 30 percent of our annual purchases for 1993 and 1994. This goal remained in place for 1995. Then, in 1996, HUD published the first formal rule governing the affordable housing goals, increasing the low- and moderate-income goal to 40 percent in 1996 and to 42 percent for 1997, 1998, and 1999. Then, on March 9^th of this year, HUD announced another round of proposed increases in our goals. The proposed HUD rule would increase the low- and moderate-income goal to 48 percent in 2000 and to 50 percent for the 2001-2003 period.

HUD proposes to increase our other goals. Our special affordable housing goal for business serving very low-income families or low-income borrowers in low-income areas is now 14 percent. The proposed HUD rule would increase this goal to 20 percent. And, our goal for borrowers living in underserved geographic areas, which is now set at 24 percent, would rise to 31 percent under the proposed HUD rule. We are committed to trying to reach these stretch goals. [CHART 8]

Although none of our housing goals specifically focuses on minority homeownership, I would like to take a moment to address this issue. Minority lending is a key part of our mission and our business, and it represents an ongoing challenge for all of us in the housing finance industry. Minority homeownership rates have grown tremendously during the 1990s, but they continue to lag the national homeownership rate. In 1993, the Hispanic homeownership rate was 39.4 percent; today it is 45.7 percent. The African-American homeownership rate was 42 percent in 1993, and today it has reached 47.8 percent. Yet, today, the national homeownership rate stands at over 67 percent, and the white homeownership rate is 73.4 percent. [CHART 9] Clearly, much more needs to, and can, be done — and we are committed to playing a leadership role to increase minority homeownership.

At Fannie Mae, we have long recognized that minority families seeking to buy a home and obtain mortgage credit face barriers of wealth, income, credit, information, and discrimination. Through the expansion of low down payment mortgages, innovations in credit assessments and underwriting flexibilities, as well as our support for a variety of educational initiatives, Fannie Mae has sought to break down these barriers. These efforts have borne tangible results:

• In 1993, we provided $36.8 billion in mortgage financing for over 355,000 minority families — this included $5.7 billion in mortgages for over 65,000 African-American families.

• In 1999, Fannie Mae provided $45.6 billion in housing finance for nearly 412,000 minority families, including $8.4 billion for nearly 86,000 African-American families.

These numbers reflect an increase from 1993 to 1999 of nearly 31 percent in financing for African-American homeownership, and a 16 percent increase in financing for minorities overall. [CHART 10] I fully expect that I will be able to report to you continued progress in Fannie Mae’s service to the minority community over the coming years.

Those who worked on the 1992 Act recognized that the housing finance system needed further assurances that our company would be able to carry out its mission in both good and bad economic conditions. They saw that the public policy benefits that Fannie Mae and Freddie Mac delivered would be only as good as our financial strength. Congress determined that, while the companies then posed a low risk of financial insolvency, more effective Federal regulation was needed to further reduce the companies’ low risk of failure.

Office of Federal Housing Enterprise Oversight (OFHEO) Examination Process

The 1992 Act created the Office of Federal Housing Enterprise Oversight to monitor Fannie Mae’s and Freddie’s Mac’s safety and soundness. Since 1994, OFHEO has been conducting regular, on-site safety and soundness examinations. The scope and rigor of OFHEO’s examinations equal or exceed those to which any regulated financial institution is subject.

OFHEO’s exam program closely resembles the risk-focused large bank exam programs of the OCC and Federal Reserve System. In fact, OFHEO’s Chief Examiner was formerly OCC’s Deputy Comptroller for Risk Evaluation and Capital Markets and also led the OCC exam teams at Chase and Citibank. Like other financial regulators, OFHEO examiners must compile and maintain an individual risk profile for Fannie Mae and Freddie Mac. The profile, which is updated continuously based on exam results, reflects each company's specific risk level as well as the quality of its risk management. The examiners also benchmark Fannie Mae's and Freddie Mac's risk-management practices against those of other regulated financial institutions.

The size of OFHEO’s examination staff relative to the number of regulated entities highlights the resources that OFHEO is able to devote to its examination duties. OFHEO has 26 examiners for 2 regulated institutions — a 13 to 1 ratio. In comparison, the Office of the Comptroller of the Currency (OCC) has 1,902 examiners for 2,485 regulated entities, or about 0.75 examiners for every institution; the Federal Deposit Insurance Corporation has 1,796 examiners for 5,807 regulated entities, or 0.30 examiners for every regulated institution.

Moreover, the size of OFHEO’s examination staff is comparable to the number of examiners that other financial regulators assign to large institutions. For the 28 institutions in the OCC large bank program, the OCC has an average of 12 examiners per institution. The OCC has 28 examiners assigned to Citicorp, a company that is far more complex than we are, operating as it does around the world and in a broad range of activities. The Federal Reserve has approximately eight examiners assigned full-time to Chase.

Also important is the transparency of OFHEO’s examinations and oversight. Congress requires public disclosure of summary findings in OFHEO’s Annual Report to Congress. While OCC, OTS, and the Federal Reserve also issue annual reports, only OFHEO reports individual companies’ exam results to the public. In reporting its 1998 exam results, OFHEO wrote that "the 1998 examinations found both Enterprises to be financially sound and well managed" and that "the results of the 1998 examination show that in all categories, Fannie Mae exceeds safety and soundness standards."³

In 1997, at Chairman Baker’s request, OFHEO contracted with S&P to rate Fannie Mae and Freddie Mac on their risk to the government. Both companies were given a AA- rating. Fannie Mae’s AA- rating was an improvement from the A- rating that S&P gave us in 1991. S&P cited our consistently strong profitability and our improvements in hedging, especially our ability to weather changing market conditions and interest rate environments. There are only six bank holding companies with a AA- rating. Some of the best known companies such as Bank of America and Wells Fargo have lower ratings.

Minimum Capital Standard

The 1992 Act requires that Fannie Mae meet a ratio-based minimum capital standard as well as its stress-test requirement. Under this leverage requirement, we must have capital equal to 2.50 percent of on-balance sheet assets. We must also hold capital equal to 0.45 percent for off-balance sheet assets. Fannie Mae must meet this minimum capital requirement using "core capital" — common stock, perpetual noncumulative preferred stock, paid-in capital and retained earnings.

Risk-Based Capital Standard

Congress also set in place a forward-looking capital standard for Fannie Mae. This Subcommittee — and Chairman Baker in particular — has devoted significant time and energy to oversight of OFHEO’s implementation of the risk-based capital standard in the 1992 Act. We believe that a great deal of progress has been made over the seven months since Director Falcon has taken the helm at OFHEO. We hope and expect that this will continue as the regulatory process moves forward. We would like to see the final risk-based capital standard in place as soon as possible.

The risk-based capital standard requires Fannie Mae to be able to withstand extremely severe economic conditions that are far more severe and persist far longer than those of the thrift crisis in the 1980s. As stated in the statute, the standard requires each company to hold enough capital to withstand a 10-year stress period characterized by unprecedented interest rate movements and credit losses occurring simultaneously. The standard is truly extraordinary, and Fannie Mae and Freddie Mac are unique in having to meet such a test.

• The credit stress component takes the worst regional economic environment in the U.S. in the last 20 years and extends it across the entire country for a full 10 years. That downturn was the recession in the oil patch in the 1980s. To get comparable conditions across the entire country would constitute an economic disaster comparable to a major nationwide depression in effect for a period of time longer than this country has ever witnessed.

• Not only does the stress test envision a ten-year period of nationwide depression but it couples it with dramatic and sustained changes in interest rates. The interest rate stress scenarios call for interest rates to rise or fall up to 600 basis points and remain at that level for 10 years. The market currently estimates that these interest rate changes are extremely unlikely. The possibility of these two credit and interest-rate scenarios happening simultaneously is vanishingly small. Nonetheless, to demonstrate the robustness of our risk-management techniques, we are measured against a confluence of highly unlikely events.

• Our risk-based capital standard requires us not only to have sufficient capital to maintain solvency throughout both events while doing no new business, but also to maintain a 30 percent capital cushion over and above these stresses. Therefore, we must maintain 130 percent of the capital necessary to survive the stress period.

OFHEO is in the final stages of promulgating regulations to implement the standard in the 1992 Act, but Fannie Mae designed its own stress test from the specifications in the statute in 1993 and has complied with that risk-based capital test ever since.

In developing our risk-based capital requirement, Congress sought to tie closely our capital to the specific risks of our business. Furthermore, the standard set out in the 1992 Act is an explicit rejection of the leverage and traditional "risk-based" ratios to which other financial institutions are subject. Unlike our risk-based capital standard, traditional leverage requirements do not adequately contemplate or measure all types of risk and impose a "one-size-fits-all" standard on sophisticated institutions operating in technologically advanced markets. Furthermore, bank capital requirements are not based upon the quantification of risk under protracted stressful interest-rate and credit conditions. Rather, their regulatory risk-based minimums derive from arbitrary formulas using only four credit risk categories.⁴

Improved Interest Rate Risk Management

Fannie Mae’s approach to debt issuance gives us the ability to match, in a very wide range of interest rate environments, the cash flow we receive from the mortgages we buy with the payments we have to make on the debt funding those mortgages. The basis of our strategy is to invest in mortgages and issue debt securities that are matched in duration and perform similarly in different interest-rate environments. We are continually assessing the sensitivity of our portfolio to changes in interest rates and rebalancing the portfolio in the context of a well-defined risk-management process and strict limits imposed by our Board of Directors. As part of this strategy, we use option-embedded instruments such as callable debt and option-based derivatives. Long-term callable debt locks in lower-cost funding if interest rates rise, and Fannie Mae can call the debt prior to maturity if interest rates fall and the mortgages funded by the debt prepay. Off-balance sheet derivative financial instruments, such as interest-rate swaps, also protect Fannie Mae against losses caused by swings in interest rates.

In 1981 and 1982, Fannie Mae suffered substantial losses because of dramatic changes in interest rates that raised its borrowing costs. The interest rate environment caused similar problems for thrifts and banks. At that time, Fannie Mae had a significantly shorter liability structure and made far less use of callable debt, interest rate swaps, and other hedges to protect it against swings in interest rates.

Today, Fannie Mae is far safer than it was twenty years ago, in part because of our greater use of option-imbedded funding instruments. Indeed, if the interest rate scenario of the early 1980’s were repeated today, Fannie Mae would not only avoid substantial losses — we would continue to show strong earnings. In 1990, option-based instruments were 10 percent of our mortgage assets. Other financial institutions either choose not to or are unable to use option-based funding instruments to the same extent as Fannie Mae. In 1999, Fannie Mae issued $93 billion in long-term callable debt, compared with less than $1 billion in such debt issued by the largest bank holding companies.

In 1999, the gross revenue available to us from mortgage financing was $8.1 billion. But because we chose to spend $4.6 billion to hedge the interest rate risk on those mortgages by extending our liability durations, issuing callable debt, and purchasing option-based derivatives, the amount we actually booked as revenue was $3.5 billion. That is a concrete commitment to risk management that few, if any, other mortgage investors can match. Fannie Mae incurs two types of costs to hedge its interest rate risk. The first is the cost of funding with longer-dated liabilities to create a duration match to the mortgages we buy. The second is the cost of adding optionality to our liabilities, either in the form of callable debt or option-based derivatives.

Through callable debt and other hedges, Fannie Mae protects itself from changes in interest rates. We routinely test the performance of our portfolio under adverse market conditions. Even if the 10-year Treasury rate were to move up or down by two standard deviations over the next six months — movements that cover 95 percent of probable interest rate changes — and then fluctuate randomly after that, our net interest income would vary only slightly over 2000-2003. And, indeed, despite interest rate swings of almost 5 percentage points during the 1990s, Fannie Mae experienced consistent double-digit growth in operating earnings — powerful evidence that our interest rate risk management strategy is sound and effective. [CHART 11]

Fannie Mae manages credit risk by using sound underwriting guidelines to determine which mortgages we will buy or securitize, by paying close attention to loans with a higher risk of default, by monitoring the performance of those who service loans held by Fannie Mae, and by sharing risk across a broad range of structures and partners. Over the past three years, Fannie Mae has made strategic investments in new credit risk management tools, creating the finest mortgage credit risk management capabilities of any financial institution. These investments – coupled with a strong economy and robust housing market – have yielded dramatic results. Fannie Mae’s credit losses have plunged to a very low 1.1 basis points of our outstanding book, from $367 million in 1995 to $125 million in 1999. [CHART 12] Specifically:

• 1999’s credit losses of $125 million were the lowest dollar losses since 1984, when Fannie Mae’s book of business was one-tenth its current the size.

• 1999 marked the third consecutive year of declining credit-related expenses.

• The $1.2 trillion in mortgages we owned or guaranteed last year generated a total of $400 million in gross credit losses, but Fannie Mae took only $125 million of those losses (the rest were borne by risk sharing partners such as mortgage insurers). Approximately $1.8 billion of gross revenue in 1999 went to Fannie Mae’s credit risk sharing partners, providing Fannie Mae with significant protection against credit losses.

• In 1999, Fannie Mae’s single family credit losses were 1.1 basis points of average assets compared with bank credit losses of 61 basis points of average assets. [CHART 13]

Additionally, over the past four years, Fannie Mae has instituted a variety of loss mitigation efforts aimed at identifying and assisting borrowers who, for one reason or another, are in danger of having their homes foreclosed upon. Our Risk Profiler technology enables servicers to predict with great precision which delinquent borrowers are likely to catch up on their payments and which ones need immediate intervention. In 1999, for the first year ever, more than half our delinquent loans were resolved without a costly foreclosure because we had servicing consultants on-site working every loan with our major loan servicers. The combination of advanced technology and human judgment allowed 44 percent of our delinquent loans in 1999 to be resolved with consumers not losing their homes. For those loans where foreclosure is unavoidable, we have lowered costs and helped home values by selling properties quickly.

Liquidity and Market Stability

The rigorous safety and soundness structure created by the 1992 Act and our credit risk and interest rate risk management efforts are aimed at ensuring our constant presence in the market in every community through good and bad economic times. Our charter mandates that we fulfill this role as a market stabilizer, and we have consistently demonstrated our ability to fulfill this obligation.

At times of financial crisis, or when there is a high level of mortgage originations, demand for mortgages frequently does not keep pace with supply. At those times, we can sell debt securities and use the proceeds to buy mortgages. In this way, we can expand the financing available to mortgages and help reduce mortgage rates by increasing demand. Our purchases provide two additional important benefits to consumers in addition to lowering mortgage rates: (1) they reduce the volatility of mortgage rates; and (2) they provide stability to the flow of mortgage funds.

We serve this role especially well during financial crises. The most recent significant crisis was in the fall of 1998 when the commercial mortgage market dried up and even some sovereign nations found themselves unable to borrow. Homebuyers, on the other hand, enjoyed uninterrupted access to affordable housing finance. The reason for this "privileged" position of homebuyers is clear. As Grant’s Interest Rate Observer noted: "It was the extraordinary purchases by Fannie Mae and Freddie Mac...that righted the...market."⁵ Similarly, the Wall Street Journal, referring to Fannie Mae and Freddie Mac, explained: "Their presence helps to keep the market liquid and mortgage rates reasonable."⁶

Similarly, in 1994, there was a rise in interest rates that caught many leveraged debt holders by surprise. Yet through this upheaval, Fannie Mae provided stability and maintained liquidity in the residential mortgage market — even as other markets were in turmoil — by increasing our mortgage purchases and debt issuance.

Reducing volatility is valuable in and of itself, as borrowers are not subject to such large swings in mortgage rates. But volatility also affects mortgage pricing – the greater the volatility, the higher the rate investors will charge borrowers. As a result, reducing volatility also reduces mortgage rates. First Manhattan Consulting Group, applying sophisticated econometric techniques to a unique and comprehensive data set, is completing the first quantitative study examining this issue. Their results show that during the global financial crisis of the fall of 1998, the reduction in mortgage rate volatility alone saved mortgage borrowers 33 basis points – that is a third of a percentage point.

Innovation

Expanding homeownership opportunities for underserved families and meeting the needs of our primary market partners require that we develop new products and new business processes and bring these initiatives to market in real time. In the 1992 Act, Congress designed a regulatory system to address these very requirements. The new program approval provisions of the Act strike the right balance between mission oversight and the realities of our business and our industry, while avoiding micromanagement of our day-to-day operations. As Senators Donald Reigle and Jake Garn wrote recently, "Congress thought it vital that these companies be able to bring to market new products and initiatives in a timely manner and free of unnecessary micromanagement."⁷

Since enactment of the 1992 Act, Fannie Mae has had tremendous success in developing mortgage products that are extensions of its successful mortgage programs and that well serve our lender partners and their customers, the consumer. Of particular note are the product enhancements made possible as a result of our development of Desktop Underwriter (DU), our automated underwriting technology. DU evaluates specific pieces of information to help the lender make objective, informed decisions about the relative credit risk of mortgage loans, and whether those loans are eligible for purchase by Fannie Mae. DU improves lenders’ efficiency, delivering time and cost savings.

Most importantly, DU has allowed our lender partners to serve more borrowers and reduce costs — savings that are passed to borrowers. More than 75 percent of eligible mortgage applicants can be approved through DU in two to three minutes, based on a reduced set of data as compared with traditional underwriting. We have been able to expand the scope of mortgage products we offer to lenders, reduce mortgage insurance requirements, stretch loan-to-value ratios, and reduce the time and costs associated with property valuation.

A recent example of products DU has made possible is our new Timely Payment Rewards mortgage for borrowers with tarnished credit histories. With this mortgage, borrowers who qualify will be able to finance their home at a mortgage rate as much as two percentage points lower than what credit-impaired borrowers typically pay, and automatically will be guaranteed a mortgage rate reduction of an additional one percentage point after 24 monthly payments without a delinquency. This option gives credit-impaired borrowers a lower rate than they would get currently in the A-minus market, and gives them the chance to bring their interest rate down still more by making mortgage payments on time. This product is now in the pilot stage, and is being offered by 20 lenders throughout the country. Fannie Mae was able to launch this pilot as a result of the more sophisticated risk analysis available from DU.

We have also been an industry leader in conventional, low downpayment lending. Our Flexible 97 mortgage is a 3 percent down payment loan for home buyers who have trouble amassing funds for a down payment and closing costs and who have good credit histories. In addition, in our portfolio of community lending products, we have a 3 percent down payment Community Home Buyer’s mortgage designed for low- and moderate-income homebuyers who earn no more than 100 percent of the area median household income and who have the income to handle their monthly payments but have difficulty accumulating cash for a down payment.

Fannie Mae’s innovation is not limited to mortgage products. On the funding side of the business, we are constantly looking for new debt products to meet the demands of investors in the U.S. and abroad. One good example is our Benchmark Notes program, which we launched in early 1999. We recognized that, with the federal government moving toward a balanced budget, the size of Treasury debt issuances would decline. We saw the opportunity to step in to meet the needs of fixed-income investors with larger, more liquid securities issuances, conducted on a regular monthly basis. The introduction of the Benchmark Note products has drawn over 500 new investors to the market for Fannie Mae's debt.

Clearly, Fannie Mae’s record demonstrates that we manage mortgage risk with a high degree of expertise and efficiency. This is what Congress chartered us to do, and since 1992 we have enhanced how we fulfill this obligation. Recently, some critics have argued that we somehow increase risk. These comments reflect a misunderstanding of the mortgage market and the role that we and others play. Often these comments also reflect misapprehension about certain key facts.

1. The U.S. housing finance system is safe and stable.

Compared with other forms of credit (commercial credit, credit cards, and other forms of consumer credit), mortgages are far less risky because they are secured by a very safe asset — borrowers’ homes. In addition to the security of the underlying assets, the housing finance system is transparent and liquid. Mortgage risk is relatively easy for investors to value; and in the primary market, market efficiencies and the ease of entry have created tremendous competition and transparency, providing borrowers with a wide range of financing options. The secondary market’s activities are similarly transparent: Fannie Mae transforms mortgage debt into liquid, easy-to-value instruments that meet a wide range of investor demands. Moreover, the mortgage market is heavily collateralized: the average Fannie Mae borrower has 40 percent equity in their home.

Additionally, while mortgage debt in our country is growing, it is growing at a slower pace than consumer debt and at about the same rate as business debt. [CHART 14] In fact, the growth of mortgage debt has a very positive element: it is a sign of expanding homeownership, a product of low interest rates and a strong economy.

2. Fannie Mae is growing steadily based on the needs of other investors to share risk.

Fannie Mae’s growth is a reflection of the demands of the market in which we operate. Over the last decade, Fannie Mae grew as mortgage debt outstanding continued to grow. In 1990, Fannie Mae held 5 percent of mortgage debt outstanding. During the 1990s, the thrifts’ share of mortgage debt declined by 13 percentage points, while the share held by Fannie Mae and Freddie Mac increased. Even so, by 1999, commercial banks, thrifts and credit unions together still held 46 percent of mortgage debt outstanding, while Fannie Mae and Freddie Mac held 17 percent. [CHART 15]

Between 1990 and 1997, Fannie Mae grew at an average rate of 17 percent annually, a growth rate slower than that of the largest bank holding companies during 1994 to 1997. [CHART 16] Our growth expanded at the end of the 1990s as rates fell to historic lows and the demand for mortgage financing increased at record rates. We do not expect history to repeat itself over the next several years, particularly as mortgage rates are on the rise. We anticipate that Fannie Mae’s growth will come from a general expansion in the market and some modest shifts in market share. An examination of GSE growth that lumps all of the housing GSEs together fails to appreciate certain differences and distinctions: Fannie Mae's 1999 growth rate of 19 percent was far eclipsed by the 34 percent growth in Federal Home Loan Bank System assets, the benefits of which accrued to FHLB member depositories. [CHART 17]

Fannie Mae holds or securitizes 23.6 percent of mortgage debt outstanding. But in terms of revenues available for managing interest rate and credit risk, our market share is not 23.6 percent — it is far less, just under 9.4 percent. In other words, we purchase or guarantee 23.6 percent of the mortgage debt in the market, but we receive 9.4 percent of the revenues available for managing the credit and interest-rate risk on it. The difference between the 23.6 percent and the 9.4 percent is the mortgage risk we share with other partners. About one-half of the revenue available to us goes to our risk-sharing partners. This takes our revenue share down from 9.4 percent to around 4.7 percent. This is also why, of our $12.8 billion in gross revenues last year, we reported $6.4 billion net. The other $6.4 billion went to our risk-sharing partners – mortgage insurance companies, mortgage lenders through recourse arrangements, and investors in our debt securities. We shared or hedged our risks with all of these partners to bring our credit losses to a very low level.

This should answer two questions that often arise about our growth projections. Is Fannie Mae too big to grow? The answer is no, we have only 9.4 percent of the gross revenues – and only 4.7 percent of the net revenues – available in our market. And as we grow, are we taking too much risk? Again, the answer is no. Not only do we specialize in risk management on mortgages, we don’t take all the risk – we share most it with others in the market.

3. Fannie Mae's expansion of the market is consistent with its charter.

Some critics have claimed that we cannot grow without exceeding the limits of our Congressional charter. To the contrary, we can grow precisely because our charter directs us to expand homeownership opportunities for all Americans. Our investors choose to invest in us because of our charter and the public policy mission that Congress has charged us with fulfilling. The composition of our assets reflects our commitment to our charter. Just over 91 percent of our assets are mortgages or mortgage-related, e.g., Low-Income Housing Tax Credit investments. The remainder is mostly made up of cash and other short-term assets that we need for liquidity. [CHART 18]

Part of our charter mandate requires that we work to increase the liquidity of mortgage assets and to promote access to mortgage credit throughout the Nation. Through initiatives such as our $2 trillion pledge to reach 18 million underserved families during this decade we are fulfilling our mission by expanding the universe of consumers able to achieve the dream of homeownership. Homeownership rates among minorities, women-headed households and residents of central cities and underserved areas are well below the national average. The wave of immigration during the eighties and nineties will play out in this decade with more families seeking homeownership. These are the fastest growing mortgage markets, and Fannie Mae is committed to help these families achieve the dream of homeownership.

We will also grow as a company, increase the number of borrowers served by the conforming market, and fulfill our liquidity function by helping lenders to offer our low-cost conventional financing to consumers that are now being sent to higher-cost segments of the market. We estimate that about half of the borrowers today getting subprime loans are A-minus borrowers, just a notch below qualifying for our conventional financing. And many consumers are being offered FHA and VA loans when they could qualify for a Fannie Mae loan and save money. Our job is to lower mortgage costs, and by helping lenders offer consumers our low-cost loans we can achieve both our mission goals and our business goals.

4. The secondary mortgage market transforms debt — it does not add to outstanding debt.

Fannie Mae is a financial intermediary; it does not create mortgage debt. To illustrate, when the company buys mortgages originated by a lender and issues debt, Fannie Mae transforms the mortgages — which have illiquid, unrated, unpredictable cash flows — into debt securities that are liquid, high-quality, and have predictable cash flows.

Here is an illustration of how this works. When a lender originates $1 billion in mortgages, the lender creates $1 billion of mortgage debt financed with short-term borrowing. Having made the loans, the lender then swaps the $1 billion into mortgage-backed securities, which are sold to Wall Street. The transformation of the loans into MBS and the sale to Wall Street eliminates the debt the lender took on to fund the initial loans — thus, the amount of outstanding debt is still $1 billion.

Of the $1 billion in mortgage-backed securities, Wall Street sells $160 million to Fannie Mae and the rest to other investors. The amount of debt outstanding is still $1 billion. Fannie Mae has now purchased 16 percent (or $160 million) of the original $1 billion in outstanding mortgage debt, and we fund our purchases by issuing effective long-term debt. The loans and MBS that we have purchased are now, for us, assets delivering income streams. (Wall Street firms use the proceeds from investor purchases to pay down their debt.) Thus, we have transformed these obligations into liquid and marketable assets, and the amount of debt outstanding remains $1 billion, funded by $1 billion of borrowing by Fannie Mae and others. [CHART 19]

Risk transformation is Fannie Mae’s essential role in the system. We create mortgage products that consumers want, such as our 3 percent down payment loans. And we raise capital to finance them by creating debt securities that investors want, such as our Benchmark series. Once we purchase or securitize the mortgages, we then manage and/or disperse the credit and interest rate risk on the mortgages.

5. Fannie Mae’s debt is not guaranteed by the U.S. government.

An increase in Fannie Mae’s debt does not increase the indebtedness of the U.S. government. Our obligations are in no way backed by the full faith and credit of the United States government.

The 1992 Act requires that the front page of all our debt and mortgage-backed securities state that they "are not guaranteed by the United States and do not constitute a debt or obligation of the United States."⁸ The market recognizes that fact by pricing our debt at yields that are far higher than U.S. Treasury yields. Our 10-year debt, for example, yields more than a percentage point over U.S. Treasury debt. If investors believed that a Fannie Mae obligation was a full-faith-and-credit obligation, the yield would be the same or virtually the same as Treasury obligations.

Nonetheless, our critics have asserted that our debt will soon be larger than the federal debt, so it is worthwhile to take a few moments here to clarify the numbers. [CHART 20]

• At the end of 1999, federal debt held by the public was $3.7 trillion and the total federal debt (including debt held by government trust funds) was $5.8 trillion. Our critics like to claim that the relevant number for federal debt is $2.7 trillion. They do this by using a figure they say is derived from Treasury and CBO, which they call "publicly held, interest-bearing Treasury debt." In determining the indebtedness of the United States, such a figure is meaningless. Congressional and Administration presentations of the federal budget always focus on two debt figures: gross debt and debt held by the public.
• At the end of 1999, Fannie Mae and Freddie Mac had $909 billion in outstanding debt and the Federal Home Loan Bank system had $543 billion in debt outstanding — for a total of $1.5 trillion. Our critics use a figure of $1.9 trillion — 28 percent off.

Our critics also like to assert that in some number of years, Fannie Mae debt will exceed that of the federal government. Since the government is paying down the publicly-held debt, of course that is true. Once the publicly-held debt is paid off, every company in America that issues debt to finance its operations will have more debt outstanding than the federal government. At the same time, consumers will still seek mortgage credit to buy their homes — and the secondary mortgage market will help lenders provide consumers with the financing they need.

6. Fannie Mae’s ability to manage and transform risk makes us an extraordinarily safe institution.

Much of the misinformation that has been generated about Fannie Mae centers on the theme of our riskiness. Thoughtful examination of the way that we do our business and the way that our company is run and regulated demonstrates that Fannie Mae is one of the safest holders of mortgage risk.

First, Fannie Mae is in only one line of business, dealing with one type of asset. Our charter limits the company to the residential mortgage market serving middle-, moderate-, and low-income borrowers. In 2000, Fannie Mae’s single-family loan limit is $252,700. While our business revolves around one kind of asset, our asset base comes from all regions of the country and consists of various mortgage product types, diversifying our risk and protecting us from the disproportionate impact of a regional downturn. For this reason, Fannie Mae has not suffered unsustainable losses when certain regions have experienced severe economic downturns. [CHART 21]

Second, our business centers on managing the risks of our assets and transforming these risks into instruments that appeal to a wide range of investors. Fannie Mae’s interest rate risk management focuses on tightly matching our assets and liabilities using a mix of callable and non-callable debt and other duration matching instruments. This strategy provides us with the ability to match, in a very wide range of interest rate environments, the cash flows we receive from the mortgages we buy with the payments we have made on the bonds funding those mortgages. It also enables us to disperse the risks inherent in mortgages among a broad range of domestic and international investors including commercial bank portfolios and trust departments, investment fund managers, insurance companies, pension funds, state and local governments, and foreign central banks.

Indeed, Fannie Mae is a safer holder of mortgage interest rate risk than banks and thrifts. Our national diversification insulates us from credit losses resulting from regional economic downturns that devastate banks and thrifts that are more geographically concentrated. And our specialized funding structures are designed expressly for mortgages and are a better match for mortgage risk than federally insured deposits and short-term debt, neither of which are consistent with mortgage maturities or perform similarly to mortgages in different interest rate environments.

• When interest rates rise, homeowners hold onto their fixed-rate mortgages that are now a bargain relative to what is available in the marketplace. At the same time, people with short-term deposits will tend to withdraw their funds because they can get better rates by investing in a new (higher-rate) instrument. The result is that the lender will have to replace the lost funds with new deposits at a higher cost.
• When interest rates fall, borrowers tend to refinance their higher-rate fixed-rate mortgages with new lower-cost mortgages. People who had made longer-term deposits keep those deposits in place since they have higher-yielding investments than are now available in the market. The result is that the lender will have lower-rate mortgages being funded by the same high-cost deposits.

Properly managing the risks of our business also means sharing and managing credit risk effectively. The efficiency and stability that we bring to the market is due in part to our ability to properly disperse credit risk among a variety of entities. We share credit risk with: the homeowner (through down payments and the subsequent equity buildup); mortgage insurance companies (our charter requires credit enhancement on all loans where the loan is greater than 80 percent of the value of the underlying property); our lender partners (through recourse arrangements); and others. Fannie Mae has $838 billion in credit loss protection, including $740 billion of borrower equity, $68 billion in mortgage insurance, and $30 billion in other recourse. To put this in context, Fannie Mae has had $285 million in average annual credit losses during the 1990s. [CHART 22] This credit-risk sharing, along with marked improvements and innovations in our risk management, has meant that Fannie Mae’s credit losses have been declining even as our book of business has increased.

In addition, banks and thrifts engage in a range of lending activities from mortgages, auto loans, credit cards, and commercial lending, to far riskier and obscure activities. In fact, in the post Gramm-Leach-Bliley Act world, these institutions have a whole range of new business lines available to them, including merchant banking, real estate development, and insurance underwriting. These varied activities present a spectrum of risk levels to be constantly managed.

7. Fannie Mae is subject to rigorous safety and soundness oversight.

Some of the recent public discussions about Fannie Mae and about the secondary mortgage market suggest that we operate without sufficient regulation. This claim ignores the regulatory regime created by the 1992 Act.

Overseeing our interest rate and credit risk management efforts is a regulatory regime that is both exceptionally rigorous and closely calibrated to the risks of our business. When Congress examined Fannie Mae’s and Freddie Mac’s capital and regulatory structures in 1992, it chose to put together a progressive capital standard that measures both credit and interest rate risk and that requires us to hold capital in relation to the amount of risk we take. The risk in our business stems from the cash flow variability of assets relative to liabilities. Accordingly, the correct risk management and risk oversight involves stressing absolute levels of interest rates and cash flows. That is the test that we have been managing our business to since 1993, and this is the test that OFHEO is now implementing.

No other financial institution is subject to as detailed or rigorous a capital standard as the one imposed on Fannie Mae and Freddie Mac by the 1992 Act. A Fannie Mae-commissioned study by IPS Sendero found that this standard would require a typical thrift to hold 50 percent more capital than required by the current Basle standards. Furthermore, when subject to the rigors of our risk-based capital stress test (which the company must be able to withstand for 10 years), the Sendero study found that the thrift industry would deplete its total capital base as early as year 5 or as late as year 7 of the 10-year stress period, depending upon the severity of the credit loss assumption applied. Similarly, banks would deplete their capital base in 5 to 7 years.

Congress imposed on Fannie Mae and Freddie Mac a stress test with extreme credit and interest rate conditions while other financial regulators still focused on leverage ratios. In recent years, bank supervisors have agreed on the need for substantial changes to the current leverage and risk-based formulas for banks and thrifts. There is a growing view that these prescriptive standards look backward and focus on past performance of portfolios; do not adequately measure all types of risk; allow banks to engage in regulatory capital arbitrage; and impose a "one-size-fits-all" standard on sophisticated institutions operating in technologically advanced markets.⁹

Indeed, the consensus of banking regulators on the direction of capital standards demonstrates that the 1992 Act stress test was far ahead of its time, and remains the state of the art. As Federal Reserve Chairman Greenspan commented recently:

"In estimating necessary levels of risk capital, the primary concern should be to address those disturbances that occasionally do stress institutional solvency — the negative tail of the loss distribution that is so central to modern risk management. As such, the incorporation of stress scenarios into formal risk modeling would seem to be of first-order importance. However, the incipient art of stress testing has yet to find formalization and uniformity across banks and securities dealers. At present most banks pick a small number of ad hoc scenarios as their stress tests. And although the results of the stress tests may be given to management, they are, to my knowledge, never entered into the formal risk modeling process.

Additional concern derives from the fact that some forms of risk that we understand to be important, such as liquidity and operational risk, cannot at present be precisely quantified, and some participants do not quantify them at all, effectively assuming them to be zero. Similarly, the present practice of modeling market risk separately from credit risk, a simplification made for expediency, is certainly questionable in times of extraordinary market stress. Under extreme conditions, discontinuous jumps in market valuations raise the specter of insolvency, and market risk becomes indistinct from credit risk."¹⁰

8. The secondary market reduces systemic risk.

In addition to our ability to closely match our assets and liabilities, our structure and our presence in the market reduces systemic risk in the housing finance market. Fannie Mae offers depositories an opportunity to lower their risk by purchasing Fannie Mae debt instead of MBS. Depositories, which lack many of the risk management advantages of long-term, option-based bonds, are able to avoid the significant prepayment risk of MBS. Our ability to use such instruments mitigates that risk substantially.

Fannie Mae’s purchase and funding activities are transparent, which applies market discipline to its operations. We buy liquid, easy-to-value assets, and we sell liquid, easy-to-value debt. This dynamic makes us different from other leveraged investors, who are often involved in a wider and less transparent range of financial purchasing and funding activities.

Fannie Mae’s performance during the latter part of 1998, contrasted with that of the hedge fund Long Term Capital Management (LTCM), illustrates the weakness of comparing Fannie Mae with a hedge fund such as LTCM. Fannie Mae differs from LTCM in three core aspects: the nature of our business, the scope of regulatory oversight, and the transparency of our operations. LTCM is an unregulated, highly secretive, opaque hedge fund. In contrast, Fannie Mae is a highly regulated, transparent company. LTCM sought to profit from the relative price movements of a variety of exotic investments, much of them financed with short-term debt. Fannie Mae has a narrow charter and a simple and safe product line. We hold assets to maturity, not for trading gains, and we fund them with long-term borrowing.

In 1998, Fannie Mae was ready and willing to step into the market, when other mortgage investors could not or would not. We had the structure and the tools to substantially increase our mortgage purchases and to fund these purchases efficiently in the international capital markets. Our earnings growth was uninterrupted, and homeownership surged during this crisis, leading to what was then an all-time record homeownership rate of 66.3 percent.

In contrast, LTCM had to be rescued by a consortium of 13 banks and investment firms, at the urging of the Federal Reserve. With losses mounting in August and September of 1998, LTCM had trouble in meeting margin calls and its positions were threatened with foreclosure. A rescue was the only alternative to the collapse of the firm. While LTCM was experiencing problems, several other hedge funds also experienced difficulties. Some of those problems led to the forced sale of mortgage assets held by hedge funds. Those sales could easily have disrupted the mortgage market significantly, were it not for our portfolio. By broadening the pool of available financing to include investors in our debt, we stabilized the mortgage market and kept it in alignment with other fixed income markets.

9. Restricting bank holdings of Fannie Mae debt would increase risk in the financial system.

At the hearing held by this Subcommittee in late March, there was some discussion of whether commercial banks should hold fewer GSE debt securities as assets on their balance sheets. I would like to offer some perspective on this issue.

First, the "loan to one borrower" restriction currently in place refers to bank holdings of the debt of individual issuers, not groups of issuers. So to analyze bank holdings of GSE debt, it is necessary to disaggregate the debt issuances of Fannie Mae, Freddie Mac, the Federal Home Loan Banks and other GSE issuers.

Second, commercial banks in the aggregate are not over-invested in Fannie Mae. We estimate that the banking industry holds Fannie Mae debt equal to 15 percent of bank capital — the same limit imposed on bank lending to individual borrowers — and just 1.28 percent of total bank assets.

Finally, the largest relative holders of Fannie Mae debt are small banks. The 725 banks that hold more than 100 percent of their capital in Fannie Mae comprise only 8 percent of all banks and only 2.1 percent of bank assets. In contrast, the 20 percent of all banks that hold less than 10 percent of their capital in the form of Fannie Mae debt are the banks that control nearly two-thirds of the assets in the banking industry.

The implication of these statistics is that if policymakers decided to impose a limit on banks' holdings of GSE debt, the banks most affected would be the smallest banks — the same banks that pose the smallest threat of any systemic risk in the financial system. These banks choose to hold Fannie Mae debt — as opposed to MBS or even unsecuritized mortgages — because they want the liquidity of mortgages but are not well-equipped to manage mortgage risk. GSE debt securities give them a high quality, highly liquid investment with predictable cash flows and a higher interest rate than Treasury securities. Forcing small banks to divest most of their holdings of such securities would likely increase the risk in the system, as these banks would need to replace GSE debt with investments less suited to their needs. For example, if these small banks replaced Fannie Mae debt with MBS, they would be taking on the prepayment risk they now avoid. As a risk transformer, what Fannie Mae does is put our access to the capital markets and our risk-management expertise at the disposal of smaller depositories.

As Thomas J. Sheehan, President of the Independent Community Bankers of America wrote recently, "GSE debt is one of a very limited number of investments that are eligible as collateral for public deposits. Many community banks would have to replace GSE investments with Treasury securities at rates that currently range from 25 to 50 basis points below comparable GSE securities. The loss in income would be passed on to public depositors and/or the banks’ private customers and owners."¹¹

Ironically, the largest banks do not hold a significant portion of their capital in GSE debt. Thus, a proposal to limit bank holdings of GSE debt aimed at reducing systemic risk would have virtually no impact on the largest banks — the very institutions whose failures could actually pose a risk to the health of the financial system.

The second implication is that by imposing a limit on bank holdings of GSE debt, policymakers would reduce the capital available to fund mortgages. This loss of funding would drive up mortgage rates.

10. The agency debt market is a distinct credit market.

As a result of the status it receives from its charter, Fannie Mae can issue debt in what is known as the agency debt market. This does not mean Fannie Mae is equivalent to a federal agency, or that its debt trades at yields similar to U.S. government securities. Indeed, Fannie Mae borrows at rates far higher than the U.S. Treasury and much closer to top-rated corporations.

Instead, the agency debt market refers to that part of the private capital markets that fund private entities (such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks) that carry out a specific public purpose. When the government chartered these institutions to raise private capital for a public purpose (in Fannie Mae’s case, the expansion of homeownership), it helped create and give these institutions access to the agency debt market.

One way that our access to the agency market helps American homebuyers is that it allows us to reach a broader range of investors. Foreign central banks, which generally will not invest in U.S. corporate debt, will buy agency debt. In fact, foreign central banks purchase 15 percent of our debt securities — effectively increasing the capital available for U.S. mortgages and reducing mortgage rates.

One implication of having access to the agency debt market is that investors assume that the government, in chartering Fannie Mae, also has made a commitment to regulate Fannie Mae in a manner that ensures our continued ability to pursue our public mission. The 1992 Act reaffirmed the government’s commitment to Fannie Mae’s mission and to its safety and soundness, through the creation of OFHEO and the establishment of a risk-based capital standard.

11. Fannie Mae passes on the benefits its charter confers — and the benefits are not automatic.

The role Fannie Mae plays in the secondary market creates a clear benefit for homeowners every day. Every academic and government study ever done on this issue confirms what every consumer knows by checking the Saturday "rate sheets" in their local newspapers: rates on conforming loans are significantly lower than rates on jumbo mortgages.

How much do we lower rates? A comparison between conforming and jumbo rates over time generally shows a range of 20-50 basis points, or about one-quarter to one-half of a percentage point. Put in dollar terms, a 50 basis point rate reduction can reduce the cost of a 30-year mortgage by as much as $31,000 over the full life of the loan. Based on mortgage rates last week, a Fannie Mae mortgage saved consumers $18,700. Put another way, a loan one dollar above Fannie Mae’s loan limit costs $18,700 more than a loan at or below our loan limit. These savings accrue to borrowers with conforming mortgages whether or not lenders sell those mortgages to Fannie Mae.

Furthermore, a 25 basis point rate reduction allows an additional 400,000 renter families to qualify for a mortgage on the median starter home. But even this understates the benefit we provide. Recent research has demonstrated that rates on jumbo mortgages "piggy back" off the rate reduction we bring to the conforming market. Without Fannie Mae and Freddie Mac, jumbo rates would be about 10 basis points higher.¹² Thus, the true rate reduction we bring to consumers is not the difference between conforming rates today and jumbo rates today, but rather between conforming rates today and what jumbo rates would be without us. I doubt that other holders of mortgage debt could demonstrate such quantifiable consumer benefits.

However, it would be a mistake to assume that Fannie Mae’s access to the agency market automatically provides this benefit to the consumer. In fact, the impact Fannie Mae creates stems from an interplay between the benefits of the agency market, the efficiency Fannie Mae itself creates, and the role the market plays every day in providing capital to support homeownership.

As I noted, Fannie Mae benefits from access to the agency market, but that benefit does not automatically translate into lower mortgage rates. The yield of longer-term agency debt is substantially above comparable Treasuries, but it is somewhat below comparable corporate debt. Fannie Mae enhances that benefit through the efficiency of its structure.

One way to demonstrate that efficiency is by examining our relatively narrow margins and low overhead. Our net interest margin is just over 100 basis points, compared with 420 basis points for major banks. Because we operate efficiently, our non-interest expense is 18 basis points, compared with banks’ 300 basis points. This leaves us with an 82 basis point return on assets compared to 120 basis points for banks. These narrow margins mean that we can add to the benefit we receive from the agency market through the efficiency of our structure.

The market recognizes our efficiency and rewards it. When we issue Benchmark bonds that provide greater liquidity to the market, we are rewarded with lower yields. When the market trades our MBS, which carries no explicit government guarantee, it often sets a higher price and lower yield than Ginnie Mae securities, which do enjoy an explicit government guarantee.

Despite the daily evidence of lower mortgage rates and efficiencies that the market rewards, some continue to argue that we do not pass on the benefits of our charter, citing a 1996 Congressional Budget Office (CBO) study. That study concluded that Fannie Mae and Freddie Mac in 1995 received $6.4 billion in federal "subsidies," of which they supposedly retained $2.1 billion. In addition to its questionable methodology, the CBO study is plagued by a number of critical errors.

• CBO assumed that Fannie Mae issues debt at yields 70 basis points lower than AA-rated financial companies (and that Freddie Mac issues debt at 68 basis points lower). In fact, the debt advantage for Fannie Mae and Freddie Mac in the 1990s has averaged about 35 basis points. Correcting CBO’s analysis for this error reduces the $2.1 billion retained benefit to $0.8 billion.
• CBO also produced flawed figures for MBS, reflecting a misunderstanding of how the MBS market operates. In its analysis, CBO claimed that the higher price investors are willing to pay for Fannie Mae MBS gives Fannie Mae a 40 basis point "subsidy" in its securitization of mortgage-backed securities. In fact, the higher price is paid not to Fannie Mae, but rather to the lenders with whom Fannie Mae has swapped MBS for mortgages. Fannie Mae’s only income is the guaranty fee, which depends on the credit risk of the loans underlying the MBS pool, not on the market price of Fannie Mae MBS compared with private MBS. CBO valued this subsidy, which Fannie Mae and Freddie Mac never receive, at $3.8 billion. Correcting CBO’s analysis for this error reduces the $0.8 billion retained benefit to a net positive $3.0 billion. [CHART 23]

The CBO study also includes other methodological flaws. For instance, it only credits Fannie Mae and Freddie Mac for the loans they buy or securitize, while the benefit of lower rates is felt across the entire conforming market. In addition, the impact of their activity helps pull down jumbo rates as well, which is also not reflected in the CBO analysis. Simply correcting the errors CBO made in quantifying any advantage accorded our debt or MBS erases any "retained subsidy." Correcting the larger methodological flaws demonstrates that Fannie Mae and Freddie Mac deliver a greater value to the consumer than they receive through access to the agency market.

12. Fannie Mae’s service to homebuyers depends on the company’s profitability.

Our pre-tax income is used for three purposes: to pay Federal taxes, to distribute as shareholder dividends, and to retain as capital to back the purchase and securitization of mortgages (subject to our strict risk-based capital standards). In 1999, 28 percent of our income went to pay Federal taxes, and another 22 percent went to pay a 1.7 percent dividend yield to our shareholders. (Our shareholders accept this low return because they know that we have an opportunity to grow, unlike a public utility that cannot grow and therefore has to pay much higher dividends to shareholders. If our shareholders decided that we did not have any growth potential, we would have to pay higher dividends, reducing the capital available for homeownership.) In 1999, we used the remaining 50 percent of our pre-tax income — $2.7 billion — to provide the capital required for the $195 billion we invested in homeownership and rental housing. [CHART 24]

Since 1968, when Fannie Mae became a private company, we have increased our capital from $185 million to $19 billion. That $19 billion in private capital is what keeps liquidity flowing in the conventional mortgage market, and what keeps interest rates for homebuyers as low as possible. That $19 billion in capital is what has allowed Fannie Mae to own or guarantee $1.2 trillion in mortgages for close to 16 million families.

H.R. 3703 Does not Improve on the Successes of the 1992 Act

I have spent a great deal of time today discussing the improvements and reforms set in motion by the 1992 Act. That is because I believe the 1992 Act — developed when the lessons of the S&L crisis were fresh in the minds of policy makers — got it right. It established rigorous safety and soundness requirements; it focused us more than ever on our affordable housing mission; and it created an environment conducive to innovation. This is a structure that has demonstrated value — for the market and for home buyers.

With this in mind, I would like to offer a few comments about H.R. 3703. I apply a straightforward test for examining policy proposals affecting our housing finance system:

• Does it reduce costs for consumers?
• Does it improve the safety and soundness of the housing finance system?
• Does it expand opportunities for homeownership?
• Does it allow innovation in the market without cumbersome regulatory requirements?

If the provisions of the Baker bill are enacted, homeownership will be more costly. This bill seeks to change a system that effectively links the international capital markets with the U.S. mortgage market by undoing several years of serious work by Congress and the Executive Branch. Our housing finance system is characterized by the efficiency and the predictability that comes from market discipline. H.R. 3703 calls into question the system’s current predictability and its future efficiency, and consumers would pay the price of its passage.

The bill creates an inefficient and unwieldy structure and imposes a new web of regulatory requirements and burdens on our company — and hence on consumers — without enhancing safety and soundness. The benefits that consumers receive from the housing finance system are best protected and promoted by the system's continued safety and vitality. Unfortunately, despite H.R. 3703's stated objective to enhance safety and soundness, the bill could very well undermine our safety and soundness, add confusion to our regulatory structure, and impede the efficiency of the housing finance market.

The bill creates a new regulatory structure that offers nothing in the way of improved regulatory oversight, while undermining key regulatory priorities. First, the bill creates a five-member, politically divided board with ill-defined powers — a structure prone to division and delay. Although the bill purports to consolidate the regulation of Fannie Mae, Freddie Mac, and the FHLBs, the new regulator would have the cumbersome responsibility of carrying out two entirely different schemes of regulation. No attempt is made to harmonize the different capital, tax, and mission requirements under which the FHLBs operate, compared to Fannie Mae and Freddie Mac.

Second, the inevitable uncertainty of any transition would further delay implementation of the risk-based capital requirements of the 1992 Act. This would be caused not only by the problems surrounding any change so significant, but also by the broad, undirected authority in the bill for the regulator to change the risk-based standard.

Third, the bill would propose to limit our liquid investment portfolio, threatening our ability to manage our liquidity in response to market demands. One only has to look back to the market downturn in the fall of 1998 for an illustration of the centrality of our liquidity to the stability of the markets and the interests of the consumer.

The failure to improve safety and soundness is accompanied by new and unwarranted regulatory burdens. The regulatory structure set out in the 1992 Act set the stage for a tremendous amount of innovation in the housing finance system — innovation that has delivered more variety and more affordability to an ever-growing universe of borrowers, helping to increase the homeownership rate. This innovation came about because, as discussed previously, the 1992 Act created a regulatory approval process that helped keep us focused on our mission, without micromanaging the day-to-day operations of our business.

H.R. 3703 would create a very different regulatory process — one requiring that any new product, or new business process, be subjected to a formal notice-and-comment process, with publication in the Federal Register. It would give to this multi-headed regulator the responsibility of deciding whether the public should have access to this new product based on a vague "public interest" standard. Such a process would be excessively slow, reveal to our competitors — and to our lenders' competitors — our proprietary product development efforts, and be unpredictable in result. It would choke off important innovation, stifling our ability to adapt with the lenders we serve in the changing mortgage market. Finally, it would directly contradict the goal of the 1992 Act to allow Fannie Mae and Freddie Mac to innovate in pursuit of our mission.

As I mentioned at the outset of my testimony, we view our charter as a compact between Congress and our shareholders. If the charter is the agreement, Fannie Mae operates under that agreement to provide private capital in support of Congress's interest in furthering homeownership. H.R. 3703 seeks to surgically adjust certain elements of this agreement, which would upset the overall balance of rights and responsibilities. The 1992 Act examined this balance and strengthened it. H.R. 3703 fails to improve any of the areas addressed or reforms put in place by the 1992 Act; indeed, it weakens the structure created by the 1992 Act.

A section-by-section analysis of H.R. 3703 is attached as Appendix A.

Conclusion

I said at the outset of my statement that Congressional and regulatory oversight of Fannie Mae and Freddie Mac are important to the vitality of the system. Such oversight takes place in the context of an international capital market that is being asked to invest billions of dollars everyday to support the U.S. housing finance system. Because these investors are making long-term investments, they deserve long-term stability in the regulatory framework of the issuer. The 1992 Act provided the type of long-term stability investors need. The Congress should be careful to not create instability by creating changes to the 1992 Act without compelling justification. Any uncertainty injected into the housing finance market will ultimately be paid for by consumers in the form of higher mortgage rates.

Thank you for inviting me to testify before you today. I look forward to working with the Subcommittee on these important issues.

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1. Title XIII of the Housing and Community Development Act of 1992, Pub. L. No. 102-550, 106 Stat. 3672.

2.  The goal for underserved areas first took effect in 1996.

3. 1999 Report to Congress, Office of Federal Housing Enterprise Oversight, June 15, 1999, pp. 11, 18.

4.  See A New Capital Adequacy Framework, Consultative Paper, Basel Committee on Banking Supervision, Basel Committee (1999)(hereafter "Basel II"); available on the Internet at www.bis.org/publ/bcbs50.pdf.

5. Grant’s Interest Rate Observer, May 7, 1999.

6. Wall Street Journal, October 29, 1998, p. C1.

7.  Letter to Housing and Urban Development Secretary Andrew Cuomo, April 25, 2000.

8.  See Section 1381(f) of the 1992 Act; see also Sections 314(b), (d) and (e) of the Fannie Mae Charter, codified at 12 U.S.C. sec. 1719 (b), (d), and (e).

9. See, e.g., Remarks by Federal Reserve Board Governor Janet L. Yellen, "Recent Developments in the Financial System," Jerome Levy Economics Institute of Bard College, September 16, 1996, at 12.

10.  Remarks to the 36^th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago, May 4, 2000.

11.  Letter to U.S. Treasury Secretary Lawrence H. Summers, March 24, 2000.

12.  "The Effects of Purchases of Mortgages and Securitization by Government Sponsored Enterprises on Mortgage Yield Spreads and Volatility," draft report by The First Manhattan Consulting Group.