[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
OFHEO RISK-BASED CAPITAL RULE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
AUGUST 1, 2001
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-41
_______
U.S. GOVERNMENT PRINTING OFFICE
74-625 WASHINGTON : 2001
____________________________________________________________________________
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Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD, Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missiouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises
RICHARD H. BAKER, Louisiana, Chairman
ROBERT W. NEY, Ohio, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
CHRISTOPHER COX, California NYDIA M. VELAZQUEZ, New York
PAUL E. GILLMOR, Ohio KEN BENTSEN, Texas
RON PAUL, Texas MAX SANDLIN, Texas
SPENCER BACHUS, Alabama JAMES H. MALONEY, Connecticut
MICHAEL N. CASTLE, Delaware DARLENE HOOLEY, Oregon
EDWARD R. ROYCE, California FRANK MASCARA, Pennsylvania
FRANK D. LUCAS, Oklahoma STEPHANIE TUBBS JONES, Ohio
BOB BARR, Georgia MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, North Carolina BRAD SHERMAN, California
STEVEN C. LaTOURETTE, Ohio GREGORY W. MEEKS, New York
JOHN B. SHADEGG, Arizona JAY INSLEE, Washington
DAVE WELDON, Florida DENNIS MOORE, Kansas
JIM RYUN, Kansas CHARLES A. GONZALEZ, Texas
BOB RILEY, Alabama HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
GARY G. MILLER, California RONNIE SHOWS, Mississippi
DOUG OSE, California JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania STEVE ISRAEL, New York
MIKE FERGUSON, New Jersey MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
MIKE ROGERS, Michigan
C O N T E N T S
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Page
Hearing held on:
August 1, 2001............................................... 1
Appendix:
August 1, 2001............................................... 27
WITNESSES
Wednesday, August 1, 2001
Falcon, Hon. Armando, Jr., Director, Office of Federal Housing
Enterprise Oversight (OFHEO)................................... 9
APPENDIX
Prepared statements:
Baker, Hon. Richard H........................................ 28
Oxley, Hon. Michael G........................................ 30
Bentsen, Hon. Ken............................................ 33
Jones, Hon. Stephanie........................................ 31
Kanjorski, Hon. Paul E....................................... 34
Falcon, Hon. Armando, Jr..................................... 36
OFHEO RISK-BASED CAPITAL RULE
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WEDNESDAY, AUGUST 1, 2001,
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises
Committee on Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 2:05 p.m., in
room 2128, Rayburn House Office Building, Hon. Richard H.
Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Ney, Bachus,
Lucas, Hart, Kanjorski, Bentsen, J. Maloney of Connecticut, S.
Jones of Ohio, Capuano, Meeks, Inslee, Ford, Hinojosa, Lucas,
Israel and Ross.
Chairman Baker. I would like to call this hearing of the
Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises of the Committee on Financial Services to
order.
Our hearing today is our continuing oversight of Government
Sponsored Enterprises, (GSEs), and specifically the Risk-Based
Capital Rule that the Office of Federal Housing Enterprise
Oversight, (OFHEO), has recently finalized. And I am looking
forward to its initial implementation within the next few
weeks.
I am particularly glad to have Armando Falcon, the Director
of OFHEO here today to explain the impact, direction and intent
of the new standard, and I want to particularly express my
appreciation to Mr. Falcon. I have, over the years, made
comments concerning OFHEO's performance and my frustration
about their inability to produce the document and to give us
the tools I feel appropriate to make an appropriate assessment
about GSE performance. It has been no easy task, Mr. Falcon,
and I want your professional staff to know that I, for one,
truly appreciate the commitment made and the intense effort to
produce this document.
I will confess to you, I have tried to read it, and admit I
cannot understand it, but I am told by those who can that it is
a pretty good piece of work. And so I intend to keep mine close
by, and as my abilities permit, understand it little pieces at
a time, but congratulations to you all.
I do want to read a few lines from the report I think
important to have in the record.
Government sponsored enterprises are not immune to failure.
For most firms, debt markets provide strong capital discipline,
penalizing a firm that is excessively leveraged with higher
borrowing costs. That discipline is largely lacking for the
enterprises because of their status as Government sponsored
enterprises.
``The economic distress of Fannie Mae from 1979 to 1985 was
significant. But for fortuitous changes in interest rates,
Fannie Mae might have collapsed, costing investors, or the
Government, billions of dollars. Because of the growth of the
enterprises, a failure today could result in much greater loss.
Depending on the response of the Government to such a failure,
significant disruption to financial and housing markets,
significant burdens on the taxpayers, or both would result. The
enterprises have considerably more dollar exposure than the
entire savings and loan industry had in 1986.''
I find these particular provisions of the rule extremely
important, and I think it is the basis on which the
subcommittee should begin its understanding of the importance
of this work. I believe the regulator of Fannie and Freddie
should be a more bank-like regulator in its structure.
Specifically, I have looked at moving the regulation of Fannie
and Freddie to other sites or to the Treasury. Based on a GAO
study, I want to give this new regulator whatever we ultimately
decide with regard to regulatory structure, the full set of
tools necessary to do this work. OFHEO today, in my opinion,
still lacks some of the similar supervisory resources other
regulators enjoy. OFHEO has chosen a risk-based capital system
that is dependent on its ability to field a large team of
financial market experts. I encourage OFHEO to work
constructively with GSE management in continuing to improve
this oversight ability.
I am particularly interested in exploring how the OFHEO
rule differs from bank risk-based capital standards. For
example, it is my understanding that bank regulators take a
very cautious view of hedging and derivative devices
specifically, and requiring banks to hold risk-based capital
regardless of how many hedging devices or derivatives may be in
place. That is a view which I hope will receive additional
consideration from the agency.
I also want to say at the outset today that Fannie Mae and
Freddie Mac today are very well managed, very profitable and
very important contributors to the housing market of our
country, and our actions here today in no way reflect on the
current financial conditions of the enterprises, but are, in
fact, forward-looking in our effort to ensure that, in the
event of a long-term market downturn, we would have in place
the necessary tools and abilities to minimize adverse
consequences should we face undesirable economic conditions.
That is why I am so pleased that OFHEO has come forward with
the capital standard today, and very much look forward to Mr.
Falcon's remarks in a few moments.
Mr. Kanjorski.
[The prepared statement of Hon. Richard H. Baker can be
found on page 28 in the appendix.]
Mr. Kanjorski. Thank you, Mr. Chairman.
Thank you for the opportunity to comment before we begin
our hearing to review the final risk-based capital standard
recently released by OFHEO. Because our subcommittee will hear
from just one witness, we should probably frame today's hearing
instead as a briefing. The briefing will help us to better
understand the contents of the Risk-Based Capital Rule, the
process of its development and the procedures for implementing
it.
OFHEO is the safety and soundness regulator for Fannie Mae
and Freddie Mac, the Nation's two largest GSEs and two of the
country's largest financial institutions. Since its creation
nearly a decade ago, OFHEO has developed and implemented a
robust and continuous examination program that works to protect
taxpayers from risk. Each quarter, for example, the regulator
examination teams review more than 150 separate components of
safety and soundness to develop a comprehensive account for
each of the GSEs' financial conditions.
With the release of this stress test, which the agency
spent nearly 7 years drafting, OFHEO supplements its existing
capital standards and complements its already-tough examination
program. Implemented properly, this rule will ensure that the
two GSEs remain at the forefront of financial regulation.
Furthermore, the implementation of this regulation, in my
opinion, enhances the ability of Fannie Mae and Freddie Mac to
achieve their mission of helping low- and middle-income
families to own homes.
More specifically, this new standard calculates how much
capital Fannie Mae and Freddie Mac need to hold to withstand a
10-year period of economic stress. Relying on the parameters
contained in the 1992 GSE law, OFHEO's stress test simulates
dramatic changes in interest rates and the highest historical
declines in property values to determine these capital
requirements. Notably, the regulator believes its regulation
will, more accurately tie capital to risk than any other
current or proposed standard, for any financial institution.
As you know, Mr. Chairman, our subcommittee has closely
followed the development and issuance of this innovative rule,
holding numerous hearings on the subject, and GSE regulation in
general, since 1997. Some have expressed impatience with the
amount of time OFHEO has taken to develop this standard, but
the relatively quick approval by the Office of Management and
Budget of this complicated regulation demonstrates its
confidence in OFHEO, its competency, reliability and
credibility.
OFHEO's dedicated experts additionally deserve
congratulations for their hard work in finalizing this
intricate rule. In particular, the Director, Armando Falcon,
has demonstrated leadership in successfully guiding this
complex standard through the regulatory process. I look forward
to learning of his thoughts later today during our briefing. It
is also, in my opinion, especially important that the regulator
maintain continuity in its leadership in the months and years
ahead as it works to implement this rule.
Anticipating the complexity of the GSE stress test,
Congress further authorized a 1-year transition period
following the final rule's publication in the Federal Register.
This interlude will allow OFHEO and the affected parties to
work through any concerns and address the procedural issues
likely to arise as the rule becomes operational. Consistent
with the requirements of the 1992 GSE law and the
Administrative Procedures Act, our subcommittee should support
these consultations and reasonable technical modifications.
As they have done in recent weeks, I also hope that all of
the involved parties will work constructively with one another
to implement this rule efficiently. I am also confident that
the management teams of both Freddie Mac and Fannie Mae will
swiftly address any changes required by this regulation.
Finally, I hope that my colleagues will work with me to
ensure that OFHEO receives the resources it needs to get the
job done and consider removing the agency from the annual
appropriations process as we have done with other financial
regulators.
In closing, Mr. Chairman, I continue to share with you your
desire to conduct effective oversight over the housing GSEs and
to ensure that we maintain an appropriate and sufficiently
strong supervisory system for them. The implementation of this
risk-based capital regulation will provide more immediate
protection for taxpayers, investors and homeowners than any
legislation that we could pursue in the 107th Congress. I
consequently look forward to not only our briefing today, but
also to working with you to put this long-awaited rule into
practice.
[The prepared statement of Hon. Paul Kanjorski can be found
on page 34 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.
Mr. Ney, do you have an opening statement?
Mr. Ney. Thank you, Mr. Chairman, and thank you for calling
another oversight hearing on the safety and soundness of Fannie
Mae and Freddie Mac. You are to be commended for your thorough
work on these two companies. This afternoon marks the eleventh
hearing in 16 months.
Today's hearing is on a long-awaited risk-based capital
standard for Fannie Mae and Freddie Mac. In coming weeks, this
567-page regulation will be published in the Federal Register.
One year after the publish date, the regulation will be
enforceable.
Mr. Chairman, I know you have worked long and hard pushing
for the standards and pushing for the conclusion of the work on
this rule, and today I think the credit is due to both you and
also the regulatory agency. I would like to take a moment to
commend Director Falcon for his leadership in bringing this
risk-based capital stress test to completion. Both he and his
staff have worked hard to craft this capital stress test, and
they have worked under tremendous pressure. Mr. Falcon took
office only 18 months ago, I believe. In that time, he has
managed to complete this rule in a fair and balanced manner. We
now have in place a vital component for an effective and
efficient regulatory program. The new risk-based capital
standard puts in place a new sophisticated model that more
specifically aligns capital to risk.
Because of the length and complexity of this final rule,
and because it will be another year before the rule is
enforceable, I would really like to encourage the cooperation
and work of Mr. Falcon and the agency to work with Fannie Mae
and Freddie Mac to make any necessary technical changes and to
ensure the complex regulation conforms to the 1992 Act. This is
a very complicated, complex and sophisticated rule which will
help ensure that Fannie Mae and Freddie Mac remain safe, well-
capitalized and able to continue their housing mission.
However, as with any highly complex Government regulation,
it is inevitable, I think we all know that, that the rule
mandates will have unintended consequences, potentially, or
other problems. So I would encourage Fannie Mae, Freddie Mac
and Mr. Falcon and the agency and the subcommittee to work
together to solve these problems to ensure that this rule is
implemented on time.
Mr. Falcon, your agency has set out to accomplish a very
formidable task, creating a sophisticated internal model that
closely aligns and ties capital to risk. If you consider the
already-existing minimum capital standard, the new risk-based
standard and the six voluntary initiatives put forth by Fannie
Mae and Freddie Mac last October, these two companies really do
stand at the forefront, I think, of financial services, safety
and soundness regulation.
And again, Mr. Chairman, thank you for your diligence on
the issue.
Chairman Baker. Thank you very much, Mr. Ney.
Mr. Israel, you are next by time of arrival.
Mr. Israel. Thank you, Mr. Chairman, and thank you for
convening this hearing.
I am pleased to welcome the Director and join my colleagues
in welcoming the Director this afternoon.
Mr. Chairman, if ever there was any evidence of the
critical need for safe and sound GSEs like Fannie and Freddie,
it is contained in this morning's edition of Newsday, which is
my hometown newspaper. The headline is: ``Long Island Named
Most Expensive Area,'' and it reports on a study done by the
Economic Policy Institute that indicates that Nassau and
Suffolk Counties on Long Island are the number one most
expensive areas to live, more expensive than Boston, than
Washington, DC., than San Francisco, than San Jose, California
and others. According to the study, a family of two parents and
two children would need to make an after-tax salary of $52,000
a year to afford living in my congressional district. And
housing costs are cited as the major reason why Long Island is
ranked as the most expensive area in the country.
Because of that situation, as I have said in the past, it
is critically important that we support Fannie Mae and Freddie
Mac in their mission to provide affordable housing. An article
in the National Mortgage News states that recent HMDA data
suggests that Fannie and Freddie are helping to increase
homeownership numbers for all individuals. By improving their
underwriting guidelines and adding new loan products, Fannie
and Freddie are helping to improve the chances that all
borrowers, particularly low- and moderate-income individuals,
are approved for a loan and receive affordable housing
opportunities.
The new Risk-Based Capital Rule is meant to help the
companies remain efficient and operational even in times of
severe economic stress. It may be too early to determine how
this highly complex rule will affect Fannie and Freddie's
ability to continue to fulfill their mission, however I hope
that we will be mindful that anytime greater restrictions are
placed on the business activities of Fannie and Freddie, it is
more difficult for them to continue to work to achieve their
mission and close the home ownership gap.
I hope that OFHEO will continue to work with this
subcommittee, the Chairman and the Ranking Member, and Fannie
and Freddie to ensure that this new risk-based capital standard
will achieve its intended purpose of helping the two companies
to operate more efficiently. The more efficient those two GSEs
are, the more they will be able to continue to fulfill their
mission and I hope that we will continue to support them as
they work to successfully implement this rule in the year
ahead. And I thank the Chairman for my time.
Chairman Baker. Thank you sir.
Mr. Lucas.
Mr. Lucas. Thank you, Mr. Chairman. And I want to
congratulate both you and Director Falcon for finishing this
important capital rule. I know it has been certainly your
priority, both of you, for that matter, priority for several
years.
And Director Falcon, I appreciate your appearance before
this subcommittee and certainly commend you on this monumental
task. I understand, as the Chairman and a number of my
colleagues have pointed out, that this is a very complex rule,
567 pages long in total length, and of course it has not been
fully evaluated by the two companies that you regulate, or for
that matter, by this subcommittee. Of course, this rule is
intended, as has been mentioned, to implement the intent of
Congress in the 1992 oversight legislation. And it should be
consistent with that Act and should be appropriate in how it
aligned capital with risk.
Because the operation of this capital rule may well have an
enormous impact on the mortgage markets, on lenders in my
district, and ultimately on home buyers, I urge you to work
with Fannie and Freddie to identify any needed clarifications.
And I also hope that these modifications will be made without
delay so that certainly any unintended consequences will be
minimized.
With that, Mr. Chairman, I look forward to the Director's
comments.
Chairman Baker. Thank you very much, Mr. Lucas.
Mrs. Jones, you would be next.
Mrs. Jones. Thank you, Mr. Chairman.
Good afternoon, Ranking Member Kanjorski and other Members
of the subcommittee.
To Mr. Falcon, welcome back to our subcommittee.
I am pleased and would like to congratulate you and your
organization for the completion of this rule. I guess this is
about our tenth hearing on safety and soundness. We have a rule
now. Hopefully, you as a regulatory agency, and Fannie and
Freddie can walk through this and get things going so that we
can continue to move on and perhaps have Capital Markets
Subcommittee hearings on something else as we go along through
the year.
I think it is laudable, however, that as we look at safety
and soundness and to assure the strength of the housing market
in our communities that we engage in some conversation on the
issue. I am confident that Freddie and Fannie, having already
agreed to about six commitments or regulations, are prepared to
sit with you and make sure that the housing industry is safe
and sound.
I have a full statement, Mr. Chairman, that I would seek
unanimous consent to have submitted for the record so that we
can allow sufficient time to proceed through the hearing.
Thank you very much.
[The prepared statement of Hon. Stephanie Jones can be
found on page 31 in the appendix.]
Chairman Baker. Without objection, your statement and all
Members' statements will be included in the record.
Thank you, Mrs. Jones.
Ms. Hart.
Ms. Hart. Thank you, Mr. Chairman.
I am pleased that you chose to have this hearing as well.
Since I am a freshman and have not been long-awaiting this
rule, I will be just very interested in hearing the testimony
from Mr. Falcon, and I will reserve the rest of my time for
questions.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Ms. Hart.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Let me start by welcoming our former staff member, Mr.
Falcon, who was the General Counsel to the Democratic staff for
many years on the subcommittee and is also my fellow Texan. And
we appreciate you being here and we look forward to your
testimony.
Mr. Chairman, I want to commend you for holding this
hearing which will examine the Office of Federal Housing
Enterprise Oversight's final regulation related to risk-based
capital that was released on July 19, 2001. As a Member of this
subcommittee, I am pleased that OFHEO has released this long-
awaited risk-based capital regulation. As you know, in 1992,
Congress approved a new law which established OFHEO and
required OFHEO to draft a risk-based capital regulation within
2 years. As we know, it has taken some time to develop this
very complex model, but we believe and we hope that this
regulation will provide the necessary safeguards to ensure that
the Federal housing enterprises of Fannie Mae and Freddie Mac
have sufficient capital to sustain themselves during extremely
difficult economic conditions, which are described as part of
the law.
As you know, this risk-based capital regulation is an
extremely complex model which requires extensive data input
from the housing enterprises. Because of the complexity of this
model, Congress provided additional time before the GSEs must
comply with the rule. The effective date will be 1 year after
the publication of the final rule in the Federal Register. I
believe that Congress and this subcommittee should use this
time to examine the rule in its entirety to ensure that it is
both fair and reasonable. By holding additional oversight
hearings on the rule, Congress will have such time to review
and make any necessary recommendations for the rule.
In addition, I believe such hearings should bring forward
expert witnesses who can discuss this complex model. For
instance, I believe it would be appropriate, Mr. Chairman, to
invite some of the major rating agencies, such as Moody's and
Standard and Poor's, who have familiarity with such complex
model and will be reviewing this risk-based rule when they make
their own rating determinations for GSE-sponsored debt
instruments.
In addition, major market participants should be heard
from, and I think we should also hear from witnesses who can
provide us more information on other risk-based capital rules,
particularly the Basel risk-based capital proposals which are
currently under discussion as they related to derivatives
instruments.
This is an important hearing that we are having today. I
commend the Chairman for calling this hearing. I commend OFHEO
and the staff for the work that they have done. But of course,
as we all know, this will not be the last word, either on this
rule or the question of the GSEs, and I look forward to
additional hearings that I am sure our esteemed Chairman will
call.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Ken Bentsen can be found on
page 33 in the appendix.]
Chairman Baker. Thank you very much, Mr. Bentsen for that
hearing recommendation. I was not sure whether we would go
further, but based on your request, we certainly will.
[Laughter.]
Mr. Lucas.
Mr. Inslee.
Mr. Inslee. I have nothing to add to the brilliance of my
colleagues. Thank you, Mr. Chairman.
[Laughter.]
Chairman Baker. Mr. Ross.
Mr. Hinojosa.
Mr. Hinojosa. Yes, thank you, Mr. Chairman.
I am pleased to congratulate my fellow Texan, Armando
Falcon, today on finalizing the long-awaited Risk-Based Capital
Rule and the complex computer code that implements the rule.
Combined, the rule brings into force any important
requirement of the Federal Housing Enterprises Financial Safety
and Soundness Act of 1992, the risk-based capital stress test,
a simulation that determines the amount of capital Fannie Mae
and Freddie Mac would need to survive a 10-year period of wild
fluctuations in interest rates and large credit losses.
In addition, the 1992 Act requires that the GSEs each
maintain an additional 30 percent of capital to protect against
management and operations risk in order to meet their risk-
based capital standard. My message to you today, Mr. Falcon, is
very concise. It is sincere and based on the physicians' credo:
``First, do no harm.'' I congratulate you and OFHEO on this
accomplishment.
The new rule, all 567 pages of it, is extremely technical
and reflects countless hours of dedicated work by you and your
staff. But the rule by its nature is long and complex, and the
enterprises it is created to test are dynamic and they are
sophisticated. This, combined with the importance of
homeownership to our economy and the well-being of our people,
require that you take the time, the energy and the resources
you need over the next year to get this rule right.
In closing, I want to say that I fully support OFHEO's
mission and encourage you to make the corrections necessary to
improve the rule and its code so that they conform fully to the
1992 Act and the intent of Congress. The 1992 Act specifically
gives you significant sole discretion to decide on many aspects
of the risk-based capital test. Use it. Align risk to capital
for GSEs in a meaningful, realistic and necessary way.
Chairman Baker. Thank you, Mr. Hinojosa.
At this time, I would like to introduce to the subcommittee
the Director of the Office of Federal Housing Enterprise
Oversight, OFHEO, Mr. Armando Falcon.
Welcome sir. I know you have been waiting a long time for
this day yourself.
STATEMENT OF HON. ARMANDO FALCON, JR., DIRECTOR, OFFICE OF
FEDERAL HOUSING ENTERPRISE OVERSIGHT
Mr. Falcon. I have. Thank you very much, Mr. Chairman. It
is a pleasure to be back here in the subcommittee's hearing
room.
Mr. Chairman, Ranking Member Kanjorski, and Members of the
subcommittee, thank you for the opportunity to testify this
morning on OFHEO's Risk-Based Capital Rule.
Last year, I appeared before this subcommittee and assured
you that completing this much-anticipated rule was my highest
priority as Director of OFHEO. Today, I am pleased to report to
you that the job is done. On July 19, we formally submitted a
Final Risk-Based Capital Rule to the Federal Register for
publication. I am proud of the efforts of the many talented and
dedicated OFHEO employees who worked tirelessly to complete
this unprecedented task. I am also grateful for the support of
this subcommittee, particularly yourself, Mr. Chairman and
Ranking Minority Member Kanjorski. Your input and encouragement
certainly kept us, shall we say, focused and motivated.
As you know, this rule is the final major component of
OFHEO's comprehensive regime to ensure the safety and soundness
and capital adequacy of Fannie Mae and Freddie Mac. Once the
rule is published in the Federal Register, which is estimated
to occur sometime in early September, Fannie Mae and Freddie
Mac will be subject to one of the most sophisticated regulatory
capital standards in the world.
Yet while the rule represents a state-of-the-art approach
to tying capital to risk, it in no way makes the other parts of
OFHEO's regulatory program less vital. Rather, it complements
our current activities by providing yet another assessment of
the enterprise risk. When the results of the stress test are
considered along with other information available to me as the
Director, I will have the best possible view of the companies
current and prospective financial health.
This afternoon, I will provide the subcommittee with
background on the development of the rule, its contents and
rationale and the process for its implementation. In addition,
I will also describe how the test fits into OFHEO's overall
regulatory program.
While the Risk-Based Capital Rule has received the bulk of
attention in recent years, the 1992 Act establishing OFHEO
directed the agency to establish and enforce two major capital
tests for the enterprises, a minimum capital test and the risk-
based capital stress test. The minimum capital requirement is a
leverage standard that is similar to existing capital
requirements for banks and thrifts. The enterprises have
satisfied this minimum capital requirement every quarter since
its implementation.
To supplement minimum capital, we have a more sophisticated
measure of risk. The risk-based capital requirement uses a
stress test to simulate the performance of the enterprises'
balance sheets during a 10-year period of severe economic
stress in the Nation's housing and credit markets.
Mr. Chairman, allow me to provide a brief history of the
development of the Risk-Based Capital Rule as background for
the subcommittee.
After staffing and equipping the agency and completing
initial study of the issues involved, OFHEO sought public input
through an Advance Notice of Proposed Rulemaking and two
Notices of Proposed Rulemaking, or NPR as we call them. The
first NPR, published in June, 1996, proposed the methodology
for developing a house price index and identifying a benchmark
loss experience for use in the stress test. The second NPR was
published in April, 1999, and described how these stress tests
would work. At the conclusion of the comment period, OFHEO
proceeded to analyze and address the comments and finalize the
rule. On March 29 of this year, OFHEO formally submitted the
rule to the Office of Management and Budget for clearance. On
July 16, OMB completed its review and OFHEO sent the rule to
the Federal Register on July 19.
With that short history providing context on how we got
where we are today, I would now like to turn to the rule
itself.
First, the stress test factors in large moves in interest
rates, mortgage rates, Treasury rates and enterprise borrowing
costs. Congress went so far as to specify that the 10-year
Treasury rate changes by as much as 6 percentage points. Other
interest rate changes are done in tandem as determined by OFHEO
using historical experience as a reference point.
Second, the test provides for loan defaults and loss
severity on a nationwide basis comparable to the largest
default and severity rates in any region in recent history.
Third, the test incorporates no new enterprise business and
no asset sales to raise cash. It simply runs off their existing
assets, liabilities and off-balance-sheet activities under
these stressful conditions. This no-new-business requirement,
or a wind-down scenario, is explicitly mandated in the 1992
Act.
If all of these stress conditions were to occur, the
enterprises would be expected to suffer severe losses as
homeowners default or pay off the loans early, and the
enterprises' assets and liabilities go out of balance. OFHEO's
task is essentially to estimate the losses that would occur in
the current books of business and determine how much capital
each enterprise would need to maintain positive capital
throughout this period. To this amount, an additional 30
percent is added to compensate for operations and management
risk.
As compared to other contemporary ``risk-based'' standards,
which simply apply haircuts to buckets of assets, OFHEO's
standard determines an enterprise's actual risk exposure as
measured by the stress test.
I do not mean to suggest that leverage requirements are
inappropriate, but like the proposed new Basel Accord, OFHEO's
risk-based capital standard recognizes the need to more closely
tie capital to risk. And because both approaches give
institutions credit for risk mitigation activities, good risk
management will be rewarded with a lower capital requirement.
But this is not just a capital standard. It will also serve
as a valuable analytical tool. It will help us to identify and
understand the strengths, weaknesses and exposures of the
enterprises under different scenarios. We will use it to its
full capacity for this purpose.
As noted earlier, the risk-based capital standard will be
published in the Federal Register in September. While the rule
is ``effective'' immediately, Congress granted the enterprises
a year to come into compliance before OFHEO can take an
enforcement action based on noncompliance with the standard.
However, because the rule is effective upon publication, OFHEO
will announce in early 2002 how the enterprises fare under the
standard using 4th quarter 2001 data.
To achieve compliance, the enterprises will have many
options. For example, they can raise additional capital, adjust
hedging practices, offset more of their risk, retain more of
their earnings or any combination of these. A capital shortfall
generally can be eliminated at a fraction of the cost of new
equity capital. Thus, another valuable aspect of this rule is
that it will allow the enterprises to choose for themselves the
most efficient means to comply with the rule.
So while the finalization of the rule is a landmark, it
certainly does not close the door on work on the rule. The
standard will not be static. The enterprises will be free to
innovate. OFHEO will work with the enterprises to assess the
risk of new activities and appropriately address them within
the stress test. In addition, the 1992 Act requires us to soon
consider whether or not to incorporate new business into the
rule.
As I mentioned earlier, OFHEO's capital regulation is a
component of an overall regulatory program. We will use the
stress test in conjunction with other tools, which include
examination reports and OFHEO's research. OFHEO's examiners
maintain a physical presence at the enterprises and have
unlimited access to all levels of management and to highly
sensitive corporate records. By staying apprised of the
enterprises' risk and business activities on a timely basis,
the examiners are able to evaluate an extensive array of risk-
related factors and to assess the enterprises' financial safety
and soundness.
As with all financial regulators, research is an area of
great importance to OFHEO's ability to fulfill its mission. Our
research provides the independent analysis necessary to
consider our examination and capital findings in the broader
context of the economy and the markets in which the enterprises
operate.
In conclusion, OFHEO is meeting the mission Congress gave
us. The enterprises are subject to ongoing oversight through
our examination program, must meet quarterly minimum capital
requirements, will be the only entities subject to a risk-based
capital stress test which closely ties capital to risk, and can
be held accountable if found lacking in any of these areas.
Mr. Chairman, Ranking Member Kanjorski, you have in OFHEO a
very talented group of men and women who are dedicated to
fulfilling the agency's mission ensuring the safety and
soundness of Fannie Mae and Freddie Mac. I hope you will
consider that the best investment in safety and soundness
regulation is an investment in the team and talent we have
assembled at OFHEO. Toward that end, I would renew my request
that the Congress consider enacting some enhancements to
OFHEO's statutory authorities. While those enhancements are not
essential, they would help ensure that OFHEO has all the tools
necessary to respond quickly and effectively to any situation.
Let me again thank you, Mr. Chairman, Ranking Member
Kanjorski and other Members of the subcommittee for your
comments and the support you have given this agency.
I would be pleased to answer any questions you may have,
Mr. Chairman.
[The prepared statement of Hon. Armando Falcon Jr. can be
found on page 36 in the appendix.]
Chairman Baker. Thank you very much, Mr. Falcon. Again,
congratulations.
There is one sort of process question that I would like to
start with that I think is very important. You have labored
long. We now have a rule approved by OMB, basically back in
your area of jurisdiction awaiting final publication. It is
also my understanding concurrent that our 60-day congressional
review period would commence beginning the date of July 29, I
think is correct. And since it has 60 legislative days, that
would be to expire sometime in October. I do not have the
correct date.
Between now and the time that the rule is promulgated
formally, would it be your intent that the modifications to the
rule that would be considered would be technical in nature, or
to ensure conformity of the rule to the agency's intent, as
opposed to a substantive policy alteration that would depart
from the original proposal?
Mr. Falcon. Mr. Chairman, I view the process going forward
between the time we submitted the rule to the Federal Register
and the time that it is published as similar to what happens
with the House when the enrolling clerk takes a bill that has
been enacted by the House and the clerk makes technical
corrections to fix punctuation and other things to make sure,
as you stated, it is consistent with the intent of the
Congress. Any changes that we would make to the rule between
now and the date of publication would be consistent with that
spirit. And if we recognize a need to make any changes in the
rule, we will do so through probably a notice and comment
period, perhaps an expedited one, so that we can move quickly
to make sure that the rule works properly.
Chairman Baker. Terrific. Because it would be my interest,
and would intend to do so, to make comment to the agency early
in the August recess about some areas of concern that, and I
have regard for your judgment. Whether I am right or not would
be for you to determine. But for example, in the area of
hedging, it is my understanding that a financial regulator in
looking at interest rate risk and let's say credit risk is two
categories, and where we find an excess of hedge with regard to
interest rate, but a deficiency on credit risk, that they
cannot be averaged. So that if you are over a little bit in one
and under a little bit in the other, the aggregate hedge is
deemed to be adequate under the risk-based standard, but
insufficient under financial standards. I want to make sure I
am understanding it properly, but I will forward that at a
later date to give you a more detailed explanation.
And then, generally the whole question of the first step
being left to the enterprises, let's assume they are modestly
deficient, and that a relatively small acquisition of hedging
devices would get them into proper balance. I would be a lot
more comfortable if rather than having the enterprises manage
to maintain minimum capital, that we--and there are operative
reasons for this--minimize the use of hedging devices and
instead establish a preference for capital, principally because
of the enormity of their hedging portfolio and, frankly, the
limited number of counter-parties internationally available for
these enterprises to be able to acquire those hedging
instruments. So it is against the international capital markets
concern that I am worried about the level of their derivatives
portfolio. Again, I will forward that in a comment.
And I do not want to get Mr. Bentsen in more trouble with
his colleagues, but I shared some of his concerns in his
opening statement about having broader formal comment on the
applicability of the rule beyond the agencies. So I do not know
exactly the process by which I will pursue that, but I do want
to have other financial opinions about the applicability and
consequences of the rule.
I also want to compliment you, because I think your
decision to run the test based on the last quarter of 2001 data
is very, very important. Many Members of this subcommittee are
concerned about the volatility in the marketplace, and that
unanticipated consequence of the rule, either requiring
significant capital or reducing risk exposure, could
potentially have some impact on interest rate costs to
homeowners. I think by taking this step as an early market
indicator a year out, should give great confidence to everyone
that if in fact there is a deficiency, that the 12 month
intervening period can easily be utilized to come into
conformity with your requirements without any of the adverse
market consequences some are concerned about.
Given that general statement, I am sure I am going to come
back. I do not want to run too far over my own time. I will
yield my time at this time to Mr. Kanjorski.
Mr. Kanjorski. Thank you very much, Mr. Chairman, and
congratulations to you for taking a very strong leadership role
on this entire issue.
Congratulations to you and the employees and staff of the
agency, Mr. Falcon. You have only been there 18 months, but it
has been a long process, 9 years now, and I am sure the Members
of the subcommittee, those even that are not here or do not
know about this event can breathe a little easier today to know
that we finally do have the regulation ready to go.
One of the things I have been concerned about all along,
and intend to support the agency and the GSEs, is that they
have given a vitality to our economy at this particular point
in time, the real estate transactions in the country. I hope
they can maintain that vitality and remain healthy, because I
see it as one of the two remaining legs to see the economy
afloat, that and consumer confidence, and consumer confidence
may start to wane in the latter part now of this year. So it is
very important that we stabilize and keep a very vibrant real
estate market in the country. And I think your risk-based
regulation will help to accomplish that, but also the fact that
we attended this briefing, and this entire issue, was the fact
that we are providing tremendous stability for 10 years of
downturn. There is little worry in the marketplace. We have a
very secure financing structure in the United States, and not
only in the domestic market, but the international markets
should be perfectly willing to buy the securities of these
entities as we proceed through the rest of this year and the
following year.
I want to be a little optimistic. I think by next spring we
will see a turnaround. We will be turning out of this thing.
But if we do not, as I understand, the regulation will have a
capacity to support a 10-year downturn, which no one
anticipates now, nor should we, since it probably has never
occurred other than maybe the Great Depression.
I think it is important that you maintain a relationship
with the Chairman of this subcommittee and the Chairman of the
full committee, maybe the Ranking Members, and also on the
Senate side. If there are technical adjustments or substantive
adjustments that may have to be made that we are not presently
aware of, I think to speed that process along, communications
should be set up between your office and the Congress so that
they can be attended to and understood, so that we move through
this process without the need for hearings, without the need
for even communication by letters of question, but that we are
only responding to issues that you or the GSEs raise as they
look at the implementation of this role.
I join the Chairman in congratulating you on picking that
quarter at the end of the year to be the base which we will
gear off of. I hope we do not have a real bad downturn in that
quarter, and that could always happen, but maybe that is what
the rule is really promulgated to protect against.
Again, this has been a long series of hearings and a lot of
skin has been left on the roadway, so to speak, but I
congratulate you and the agency for coming to the extent that
you have, and wish you well. And I certainly offer my
assistance if there is anything we can do, and I am sure the
Chairman joins me in that.
Thank you.
Chairman Baker. Ms. Hart, did you have questions?
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
So to clarify the Chairman's question, the ink is dry on
the rule now, and any changes you will make will be purely
technical and the rule will be published prior to or within
that 60-day legislative period?
Chairman Baker. It is my expectation that the rule will be,
I think, printed before the 60-day legislative day comment
period expires. Is that correct, Mr. Falcon?
Mr. Falcon. That is out of our control, Mr. Chairman. It is
subject to the ability of the Federal Register to get the rule
typeset and proofed within that timeframe. But our expectation
is that they could do it within 45 days of the day that it was
submitted to them. So it would be within that 60-day time
period.
Chairman Baker. Mr. Bentsen, it is my intent to, believe it
or not, be the least amount of disruptive element in this
process. That is the reason for the hearing today, for Members
to be aware of the rule. And as quickly as we return, if there
are any issues which we would need to address, do that early in
September so the agency would have appropriate time, if
warranted, to respond before the final promulgation.
Mr. Bentsen. Although I think what Mr. Falcon is saying is
the final promulgation has occurred, other than really dotting
``i's'' and crossing ``t's.'' And if that is the case, then
once the final rule is published, and I do not want to get into
a long drawn-out discussion of the Administrative Procedures
Act, as interesting as that would be; but once the rule is
published, then we go to, what, an APA-type mechanism, which is
Congress or others have issues that they petition OFHEO and
OFHEO then takes under advisement can propose a rule or if
OFHEO itself determines that something needs to be modified,
and then you go under the standard APA?
Mr. Falcon. Right. Once the rule was published, it is a
final rule, and if we saw a need to make any changes to the
rule, we would utilize the amendatory process of the
Administrative Procedures Act. And that allows us flexibility
to move at any point in time to make changes that we thought
were necessary. We have a wide range of tools from an extended
notice and comment period to something as quick as an interim
final rule where changes are effective immediately, subject to
notice and comment and subject to potential change after that
notice and comment period.
So we have the ability to move expeditiously to correct any
changes that might need to be made. And Congressman, if we
thought that we needed to make any changes, technical or
substantive, to get this right as soon as possible, we would do
so, I think, in an expeditious manner. If we see a need to make
any changes in this to make it fully operational and to correct
any problems in it, we could possibly do so very quickly after
the rule was published. But we have that ability, and I think
we would want to utilize it to make sure we got this right as
soon as possible.
Mr. Bentsen. There has been some concern raised by the
GSEs, and I am sure there will be lots of concern raised from
time to time, as is the case with any regulated party, but with
respect to haircut requirements on hedging instruments, I was
just looking at an article from the Wall Street Journal from a
while back regarding the mortgage insurance companies, that
there is concern that the reserve requirements on that may
exceed industry standards. Is that an issue that you would see,
if you were to agree with them, that you would see taking up in
a subsequent rulemaking process?
Mr. Falcon. Yes, I am aware of the issue you are talking
about, Congressman, with respect to the counter-party haircuts
that are embedded in this rule. Part of the issue there has to
do with the distinction we have made between AAA, AA, A and so
forth, and how much of a haircut we give to the securities or
the counter-parties. Our judgment on the distinctions between
those various rating levels and the reflection of those
distinctions in the percentages of the haircuts is grounded in
a lot of historical analysis and various studies that we looked
at to come up with the ultimate resolution in the rule.
However, we are very willing to look at those issues with
an open mind and take a fresh look at them. If we did not come
up with the optimal resolution of the issue, we will not
hesitate to make a correction.
Mr. Bentsen. If I might, Mr. Chairman, very quickly, given
that the rule is not fully effective until a year following the
publication date, or whichever date, do you think that you
would be able to address issues, and again, you may come down
and decide that there is no merit in the arguments, in such a
way that would allow the companies the ability to deal with
this without having to comply with a rule that might otherwise
be modified to meet the implementation day?
Mr. Falcon. I think we would definitely want to, if we
thought that there were improvements that could be made to the
rule, I think we would want to act expeditiously to make those
modifications, certainly well before the end of the 1-year
transition period, so that it is clear to the enterprises, in
fairness to them, what rule they will be expected to meet at
the end of that 1-year transition period, and even more so
before the end of the quarter when we begin to make public
pronouncements about how they fare under this rule.
Mr. Bentsen. Thank you.
Thank you, Mr. Chairman.
Chairman Baker. Mr. Ford.
Mr. Ford. Thank you, Mr. Chairman.
I think my colleague Mr. Bentsen got at much of what I
wanted to ask. It is a big thick rule, and I guess it will take
a lot of us a long time to get through it all. But just so I
can understand, we will have some flexibility to make changes
if need be between now and then, Mr. Director?
Mr. Falcon. Yes, Congressman, you will. And if I can just
say, I know the Chairman held up a copy of the rule. It is a
big thick rule. But I think it is important, if I may, to just
state that the 1992 Act which required the promulgation of this
rule also required that the agency promulgate a rule which was
fully transparent and was specific enough so that any
interested party could replicate the regulation and the code,
the stress test that implements the rule. So in order to meet
that requirement of the 1992 Act, we had to put out a rule
which was very specific and lay out all the details about how
this model would work. Otherwise, we would not have been in
compliance with the rule. I would have loved to have a rule
which is maybe 50 pages long, but then I do not think we would
have been in compliance with the spirit or the requirements of
the 1992 Act.
Mr. Ford. I am not being critical at all.
Mr. Falcon. I know you are not.
Mr. Ford. As a matter of fact, it will make for some good
vacation reading during the August recess. But I appreciate you
responding to the specificity that, I was not here in the
Congress in 1992, you were asked to do.
Mr. Chairman, if it would be appropriate, sir, I know that
perhaps this is not an appropriate venue to do this, related to
this, there was an issue or two raised in the July 11 hearing
on your part, sir, a series of assertions regarding the average
loan limit and loan-to-value ratios of loans purchased by
Fannie Mae. And I had some numbers that I would love to submit
to the record. I certainly do not want to go into those details
with the Director here and cloud this hearing, but I did want
to, I was curious about that, and asked Chairman Raines at
Fannie Mae to respond to some of those issues and have some of
that. And if it would be OK without objections.
Chairman Baker. Sure, without objection. Just for the
record, my comments really in the July hearing were with regard
to Freddie, but we always welcome Fannie to any fight.
Thank you.
Mr. Ford. Thank you.
Chairman Baker. I am sorry, Mr. Meeks.
Mr. Meeks. Timing is everything. I just walked in.
Chairman Baker. Yes, sir. You took me by surprise.
Mr. Meeks. I apologize in regard to missing your testimony.
I am on roller skates today. We have various hearings and
markups going all over the place. And so I only have two quick
questions. If you have answered of them already, please I
apologize in advance.
But this is something that has come up, and I was just
wondering if there were any conflict between the Final Risk-
Based Capital Rule and the HUD affordable housing goals of
Freddie Mac and Fannie Mae?
Mr. Falcon. There will not be, Congressman. We think this
rule, once it is implemented, will allow them to continue their
affordable housing activities and remain in compliance and
exceed the goals of the affordable housing goals as established
by HUD.
Mr. Meeks. And let me ask another question that I do not
know, maybe it is unfair, but I know that there has been a lot
of discussion regarding OFHEO's ability to properly regulate
the safety and soundness of the GSEs. And so I guess my
question is in regards to your capacity, whether there is a
lack of capacity in your organization to properly regulate GSEs
in general structure, or are you lacking anywhere in
legislative authority or resources?
Mr. Falcon. Thank you. I think the agency fully fulfills
its mission in supervising the enterprises. I think we could
use some additional tools to make sure that we can always
respond adequately to any situation that might arise. I would
like to have some adjustments to our statutory
responsibilities. I do not think they are essential to our
ability to fulfill our mission, but items like exemption from
the appropriations process that would allow us to adjust our
budget to our needs on a real-time basis should any situation
arise. That is an authority that every safety and soundness
regulator has, and I think OFHEO should be put on par with
other agencies. And there are other issues related to
enforcement powers, some independence issues, clarifications
about our authority. I think those would be nice tools to have,
but currently I am comfortable that we do a good job with the
staff we have and that we are able to leverage the technology
and a very experienced staff to make sure we fulfill our
mission on a daily basis.
Mr. Meeks. Thank you.
That is all from me, Mr. Chairman.
Chairman Baker. Thank you, Mr. Meeks.
Let me return to process again, because it is apparently a
source of concern, and in the brief interim I counseled with
staff as to the two processes. One is the current 60-day
comment period in which the subcommittee, if it so chose, could
only adopt a resolution of disapproval, thereby blocking the
implementation of the entire rule. That is not likely to
happen. However, after the rule is formally promulgated and
published, all changes subsequent to that date would then be
subject to the provisions of the Administrative Procedures Act,
which can have an expedited notice and comment period, but
would in all substantive cases require notice and public
comment period of some sort, so that the subcommittee would
then have an opportunity to understand and then again comment
on any subsequent change that might be considered at the
agency's request.
Is that your understanding of the process?
Mr. Falcon. Yes, that we are subject to all the provisions
of the Administrative Procedures Act once this is----
Chairman Baker. Well, I only mention that because there was
some apparent view that we could get together and work this out
without going through conformity with the APA. And I think for
record purposes, we all ought to acknowledge that that is the
law and we will abide by whatever it provides.
Mr. Falcon. Right. We could not do anything inconsistent
within the express provision of the regulation absent an
amendment to those provisions.
Chairman Baker. All right.
And the other minor point is that it is actually effective
when printed, and it is only enforceable a year later. So that
is the reason why the APA becomes effective after it is
printed, and that is just again for the record purposes.
And I want to return to the issue raised about
modifications. As you know, I have been available for any
suggestion by anybody about how to enhance your ability to
perform this task. Clearly, getting you out of the
appropriations process based on a fee schedule for the
regulated enterprises would be something I would strongly
support, as all other financial regulators are so funded. And
second, giving you more financial regulatory authority is
something I have always thought made a great deal of sense
wherever the agency may land in some future iterations of
congressional legislation. So for the record, I want to
acknowledge that you requested funding levels last year in the
appropriations process higher than you actually received,
although you did receive an increase in budget. And to a great
extent, using the OCC model and applying their standards to
assessments for regulatory purposes, the two enterprises would
have an assessment of approximately $67 million for regulatory
compliance, and you are now operating on a $23 million
platform.
Now, whether or not the people within the agency are
working very hard or not, on its face there is a regulatory
mismatch that should be addressed, and for your purposes, I am
strongly supportive of adjusting that mismatch.
With regard to the rule, there has been some comment
expressed that the effect of the rule is to be procyclical in
that in good times that capital assessment may turn out to be
excessive, but in bad times the capital assessment may turn out
to be too little, which would then result in capital swings
that might be excessive within a short-term duration. Further,
and this is, I believe, the explanation that OFHEO feels that
the capital adjustments that will be required will come from
early warning devices that are now within the agency's ability
to observe. Don't regular examinations kind of give you leading
indications without having to wait on the application of the
stress test? You know, make us feel more comfortable about how
this capital requirement can and will be adjusted?
Mr. Falcon. Absolutely. As I said, the stress test is only
part of our comprehensive oversight program with the
enterprises. Our examiners are looking at 150 or so different
examination areas with respect to the enterprises. They are in
there on a daily basis. They are constantly evaluating the risk
of the enterprises, how they manage those risks, and certainly
they work in concert with other areas in the agency. With
respect to whether or not this rule is procyclical, I think
what makes this unique from any other capital standard is that
it incorporates a downward cycle. In a sense, it anticipates a
downward cycle. That is what happens when you apply stressful
economic conditions, a 600 basis point swing, whether up or
down, in interest rates. The worst historical credit losses in
any region apply to their entire portfolio. So this anticipates
the worst possible cycle and makes sure that the enterprises
can survive such a down cycle over a 10-year period.
And if problems were to occur, the fact is that this rule
gives the enterprises the flexibility to decide for themselves
the most efficient means for coming into compliance with the
capital standard. It would not have, in a true downward cycle,
the effect of forcing them to find the most inefficient means
of coming to compliance like raising pure equity capital. They
would have the flexibility to adjust the risk profile so that
they would be in compliance with the rule.
Chairman Baker. Thank you.
Mr. Bachus has arrived. Mr. Bachus, did you have a comment
or question?
Mr. Bachus. I appreciate it, Mr. Chairman. I commend you
for holding this hearing.
I have been on the floor of the House debating the energy
bill, and I apologize for missing your testimony, Mr. Falcon. I
want to congratulate you. You have only been on the job 18
months, and yet you and your agency have completed the rule,
and it is long-awaited, but I appreciate your work.
This is a very long and complex rule. It is over 600 pages.
And I would first urge, and I am sort of doing an opening
statement here too, but I would also urge you to give the GSEs
an opportunity to work with you and for them to work with OFHEO
in crafting the final rule. I hope this is not considered a
final rule.
Additionally, it is my hope that the final rule will not
damage the GSEs' mission to increase homeownership in America,
and at the same time protect the taxpayers' interests from any
unnecessary exposure from GSEs' debt and mortgage holdings.
Let me ask you, I have two questions in mind. One is, and
it goes along with working with the GSEs and their mission of
creating home ownership, particularly for the less advantaged.
What impact, if any, will the final rule have on GSEs' efforts
to finance loans with small down payments? Will these loans
become more expensive and harder to get?
Mr. Falcon. Congressman, in order to have a risk-based
capital stress test, we do look at historical defaults and
prepayment rates and loss severities for mortgages of different
types, including various loan-to-value ratios for mortgages.
But just because a mortgage may have less equity does not
necessarily mean that it might require greater capital. The
enterprises can take steps to mitigate their potential risk
through the use of credit enhancements, offsetting risk, and we
would certainly give them full credit for those types of
activities in the Risk-Based Capital Rule. So if the data
dictates that a certain type of loan has greater risk
associated with it, that risk can be mitigated through
activities by the enterprises.
Mr. Bachus. But to a certain extent, HUD, for instance, has
asked them to go and make loans in certain areas, and some of
these loans as a necessity are going to be higher risk loans
than the premium market.
Mr. Falcon. Actually, interestingly, the loans that the
enterprises can count toward compliance with HUD's affordable
housing goals fall across the spectrum of mortgages. We
compared those types of mortgages and their spread across
various LTVs and found that the spread across the LTVs for
affordable housing mortgages was about the same as it is for
non-affordable-housing-goal mortgages. And the affordable-
housing-goal mortgage is not quite going to be just a high LTV
mortgage. In fact, I think the bulk of them have an LTV which
is 80 percent or less.
Mr. Bachus. Will it make it harder for the GSEs to buy
loans from borrowers with poor credit histories? The rule?
Mr. Falcon. The rule? Perhaps. We have not incorporated
FICO scores yet through this rule. That is an area of research
that we are undertaking, and if it is appropriate we will
incorporate things like FICO scores. I think if it is
appropriate, we will do it, but as far as what we are now
taking into account, I guess you could think of things like
borrowers credit history as embedded in the average default
rate on that type of mortgage. If it has got a higher default
rate, it is probably because it was made to someone with a
higher risk profile. And so in that sense, we do incorporate
someone with a bad credit history if they receive a mortgage
that Fannie and Freddie buy, into the stress test.
Mr. Bachus. I would simply, again, just stress to you that
their mission being to bring home ownership to the less
advantaged, and sometimes this requires smaller down payments,
things of this nature, which does involve greater risk, but
that is part of what Congress has charged them with a mission
of doing. And I know that there is probably some tension
between some of what HUD asks them to do, and then safety and
soundness considerations, but hopefully you can be aware of
that. Are you working with HUD in formulating the rule?
Mr. Falcon. Yes, they have been following the progress of
this rule. At various points in time, we have discussed it with
them, that is over many past years. But I am confident that
this rule will not detract from the ability of the enterprises
to fulfill their mission, especially with respect to affordable
housing.
Mr. Bachus. OK, including small down payments and things?
Mr. Falcon. Yes. Absolutely.
Mr. Bachus. All right.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Bachus.
Mr. Bentsen.
Oh, I am sorry. Mrs. Jones.
Mrs. Jones. Thank you, Mr. Chairman.
I want to thank my colleagues for asking questions. My
questions should not be too lengthy, though, Mr. Chairman.
Mr. Falcon, as a regulator for Fannie and Freddie, part of
regulation also is to ensure that these can continue to
operate, or you do not really have a job to do if they are not
in operation. Fair statement?
Mr. Falcon. Yes, ma'am.
Mrs. Jones. So it is not always an adversarial role. I
guess that is what I am trying to ask of you. Is that correct?
Mr. Falcon. Absolutely.
Mrs. Jones. And someone may have asked this question, but
in light of the fact that I was not here to hear the answer, I
am going to ask it again. On page 68 of the regulation, it says
that OFHEO has the authority to make any changes it deems
necessary to the code at any time without notice and comment,
as long as those changes are not inconsistent with the
technical specification of the RBC rule. This authority allows
OFHEO to address any technical or other problems that might
arise in the operation of the code on a timely basis. Any
change to the code will be made available to the public.
As the Director of this regulatory agency, do you believe
that this gives you the ability you need to operate or to have
oversight over agencies that operate with safety and soundness?
Mr. Falcon. Yes, Congresswoman. The way the rule will work
is the rule itself contains various mathematical equations and
formulas which make up this stress test. And separate and apart
from that, we have this computer code, this model that we
constructed using the blueprint of the rule. That code
implements the rule. It is that code that we will plug various
quarters' worth of data into and that will produce a capital
requirement for the enterprises. Now, the code is something
that is separate and apart from the rule, but code will always
be consistent with any express provisions, all the policy
decisions, that are embedded in the rule. If we find ways to
make the code operate more efficiently, to make it more
operational from the enterprises' standpoint, we made sure that
we maintained the discretion to this question to do so.
Mrs. Jones. So you have what you need?
Mr. Falcon. Yes.
Mrs. Jones. But this new program or code will, as you said
previously, operate in conjunction with the other means that
you have had to have regulation over Freddie and Fannie.
Correct?
Mr. Falcon. Yes.
Mrs. Jones. And so it will be, versus two things to judge
or assess their safety and soundness, you now have how ever
many there are other than this, as well as this new code that
came from the law or came from this recent ruling.
Mr. Falcon. Absolutely.
Mrs. Jones. Is that correct?
Mr. Falcon. Absolutely. We have our examination program,
various other regulations designed to maintain the safety and
soundness. We have our minimum capital regulation. We have this
risk-based capital regulation. We have a full array of
activities that we do.
Mrs. Jones. Generally, we do not want to allow anyone to
toot their own horn, but based on what you had available to you
previously and this new rule, do you believe that you are now
in a position to help assure the safety and soundness of these
two Government Sponsored Enterprises?
Mr. Falcon. Absolutely. And we do a very good job at it,
Congresswoman, if I may toot our horn.
Mrs. Jones. Toot, toot, toot, you got the rest of the time.
[Laughter.]
Anything else you want to say?
Mr. Falcon. Yes. I think the 1992 Act which established
OFHEO gave us a very solid set of tools to work with, very
similar to the tools that any other financial safety and
soundness regulator has. We have sought some enhancement to
that, but basically I think we have a very talented staff, the
tools. We could always use additional resources, but I think we
fulfill our mission very thoroughly.
Mrs. Jones. I yield the balance of my time, Mr. Chairman.
Thank you very much.
Chairman Baker. Thank you, Mrs. Jones.
Just to clarify, with reference to page 69 citation that is
technical in nature with regard to data and computational
matters, so that if you are provided new data or you see an
error in the coding, you can modify those in accordance with
fairness to reflect an accurate portrayal of the enterprises'
condition. But we cannot take the 2.5 percent capital standard
and make it 2.0 percent, as distinguished between substantive
and technical application. If it is demonstrated by GSEs or
other interested parties that an outcome of the computations
are not consistent with the agency's intent, then certainly
that is viewed, I think, as a technical matter which could be
changed not subject to the Administrative Procedures Act.
Mr. Falcon. Right. For instance, if we wanted to change the
haircuts, we would move through the Administrative Procedures
Act to make those changes in the rule.
Chairman Baker. I think I am very comfortable with your
explanation.
Mrs. Jones. Just so the record is clear, Mr. Chairman, it
is page 68 that I was reading from.
Chairman Baker. Page 68.
Mrs. Jones. Yes.
Chairman Baker. OK.
Fannie and Freddie will continue to evolve and provide, we
hope, creative new products to serve homeowners. Your rule as
constructed today, what affect will it have on new product
development? Any? None? Any delay for them to proceed? Or how
will you assess the risk associated with a new product?
Mr. Falcon. We designed this rule so that it will allow
full innovation by the enterprises. There is a section of the
rule that deals with new activities. As the enterprises
innovate, develop new products that might not be covered by
this rule, because they just do not exist today, we will work
quickly to incorporate those new products into the stress test
as soon as possible. And we will decide whether or not to apply
some interim conservative treatment to the new activity until
we are able to fully understand the risk and how they manage
the risk; decide whether or not we want to incorporate a simple
application to the stress test; or perhaps do a separate
modeling of the performance over time of that particular
product.
So we allow them full innovation, but at the same time make
sure that the risks of that innovation are incorporated as soon
as possible into the stress test.
Chairman Baker. Thank you.
I am going to yield back my time to enable other Members to
ask questions before the break.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Let me say at the outset, I feel a little deficient. I
studied the Administrative Procedures Act in graduate school,
but I do not think I can quote from various pages what the regs
are. But obviously, there is some interest in that.
There has been some discussion and even I guess some
criticism in the construct of the rule, both as it relates to
whether or not it properly addresses the credit quality of the
assets, and then the question of the use of derivatives as
hedges. On the first part, and I realize a lot of this came
straight out of the 1992 Act, is the treatment with the stress
test of the mortgage portfolios, that is similar to what is
required in, it is either FIRREA or FDICIA, for the holdings of
mortgage instruments by federally insured depository
institutions? Is it the same type of model?
Mr. Falcon. It is a different type of risk-based capital
requirement. What we currently have in place for banks and
thrifts is a risk-based capital requirement that basically
places assets into different ``buckets,'' and then assigns
haircuts to those ``buckets'' based on the assessment.
Mr. Bentsen. No, I understand that. I guess what I am
asking is, I thought it was either FIRREA or FDICIA that
requires if a thrift or bank is making a purchase of a
mortgage-backed security or REMIC or some sort of mortgage
portfolio. Aren't they required under one of those acts to
engage in certain stress tests? And if so, is that similar to
what you do in this rule?
Mr. Falcon. I am not certain.
Mr. Bentsen. If you could find out for the record, I would
just be interested in that.
Mr. Falcon. Sure. I would be glad to.
Mr. Bentsen. Second of all, how did you all come up with
your models for determining risk for the use of derivatives or
other types of hedge instruments? The reason I ask is, I am
looking at one, on the one hand, I know there is concern that
the haircuts are too strict, and on the other, I see where
someone says you are using the same model as Long-Term Capital
Management. And I find that hard to believe. So I am curious,
obviously, this is a new phenomenon in the market used by
banks, thrifts and other entities. How did you all come up with
your model?
Mr. Falcon. Well, first off, on the issue of derivatives,
and Mr. Chairman, we will certainly work to provide what
information you would like on the subject that you mentioned
previously, but the enterprises use derivatives as hedging
instruments to help manage basically their interest rate risk.
They do not engage at all in derivative transactions for
speculative purposes. We would not allow that. So the situation
with Long-Term Capital Management and the enterprises is vastly
different. Long-Term Capital Management used its pricing models
to try to anticipate various swings in foreign currency and
other types of investments they had. And they lost that bet. So
you saw what happened with Long-Term Capital Management. The
enterprises do not engage in derivative transactions for
speculative purposes. They use them only to hedge their risk.
They do not take the naked position in the derivative or
trading position. So we are comfortable that they do use
derivatives in a prudent manner.
Now, what we did with respect to haircutting for
derivatives in the rule, we looked at various studies that had
been produced as to whether or not to differentiate between
different rating levels, rating agency levels, and what that
haircut should be. There were various studies that we looked at
which everyone cites, Hickman, Moody's, Standard and Poor's,
Duffs and Phelps, everyone has looked at this. We came out with
what we thought was a sound judgment, but we are willing to
take a fresh look to make sure that we properly balanced a rule
which was appropriately stressful, but at the same time was not
excessive.
Mr. Bentsen. Thank you.
Thank you, Mr. Chairman.
Mr. Baker. Thank you very much.
Mr. Falcon, again, I think every Member has expressed it.
We want to again say thank you.
Mrs. Jones. Mr. Chairman, can I just do a quick follow up
from the question. I would like one second.
Chairman Baker. Fine.
Mrs. Jones. Mr. Chairman was talking about the change, or
new products. But any financial institution or bank or whatever
may come up with new products. And when you come up with a rule
or regulation that regulates such a thing, you conceptually
would include in that the possibility that there would be new
products that would allow you to still withstand the test of
time based on your stress test, if I said that right. Did I
make any sense? Or can you answer that question?
Mr. Falcon. Yes. If we did not allow for new products in
this rule, it would be obsolete from the day that it was
published. And so it does appropriately make sure that the
enterprises can innovate and put out new products, and we can
incorporate them on a timely basis into the stress test.
Chairman Baker. Again, thank you, Mr. Falcon, for your
agency's work. There is a fair certainty that the application
of the rule eventually will cause some modification of the
enterprise business activity, which will yield, I think,
benefit in the long term for the market and for the taxpayer as
well. It is my hope that the time available for review, comment
and implementation will provide us with sufficient flexibility
to ensure that there are not untoward market consequences of
the application of the test. That, of course, is everybody's
desire. But I just want to assure you of my longstanding,
intense interest in seeing the rule implemented on the best of
your professional capabilities. And I think the subcommittee
stands ready to be of assistance.
We will probably return in the fall for sort of a wrap up
after the formal implementation of the rule, and perhaps to
receive comment from others as to the advisability of the rule,
even the GSEs if they would choose to have some statement on
the record as to any concerns about the implementation. This
should be an ongoing dialogue that results in the best public
policy for all parties concerned.
With that, I thank you and our hearing stands adjourned.
Mr. Falcon. Thank you, Mr. Chairman.
[Whereupon, the hearing was adjourned.]
A P P E N D I X
August 1, 2001
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