[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
WASTE, FRAUD, ABUSE, AND MISMANAGEMENT
=======================================================================
HEARINGS
before the
TASK FORCE ON
HOUSING AND INFRASTRUCTURE
of the
COMMITTEE ON THE BUDGET
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
__________
HEARINGS HELD IN WASHINGTON, DC: APRIL 13, MAY 25, JUNE 9, AND JULY 25,
2000
__________
Serial No. 10-1
Printed for the use of the Committee on the Budget
U.S. GOVERNMENT PRINTING OFFICE
63-822cc WASHINGTON : 2000
COMMITTEE ON THE BUDGET
JOHN R. KASICH, Ohio, Chairman
SAXBY CHAMBLISS, Georgia, JOHN M. SPRATT, Jr., South
Speaker's Designee Carolina,
CHRISTOPHER SHAYS, Connecticut Ranking Minority Member
WALLY HERGER, California JIM McDERMOTT, Washington,
BOB FRANKS, New Jersey Leadership Designee
NICK SMITH, Michigan LYNN N. RIVERS, Michigan
JIM NUSSLE, Iowa BENNIE G. THOMPSON, Mississippi
PETER HOEKSTRA, Michigan DAVID MINGE, Minnesota
GEORGE P. RADANOVICH, California KEN BENTSEN, Texas
CHARLES F. BASS, New Hampshire JIM DAVIS, Florida
GIL GUTKNECHT, Minnesota ROBERT A. WEYGAND, Rhode Island
VAN HILLEARY, Tennessee EVA M. CLAYTON, North Carolina
JOHN E. SUNUNU, New Hampshire DAVID E. PRICE, North Carolina
JOSEPH PITTS, Pennsylvania EDWARD J. MARKEY, Massachusetts
JOE KNOLLENBERG, Michigan GERALD D. KLECZKA, Wisconsin
MAC THORNBERRY, Texas BOB CLEMENT, Tennessee
JIM RYUN, Kansas JAMES P. MORAN, Virginia
MAC COLLINS, Georgia DARLENE HOOLEY, Oregon
ZACH WAMP, Tennessee KEN LUCAS, Kentucky
MARK GREEN, Wisconsin RUSH D. HOLT, New Jersey
ERNIE FLETCHER, Kentucky JOSEPH M. HOEFFEL III,
GARY MILLER, California Pennsylvania
PAUL RYAN, Wisconsin TAMMY BALDWIN, Wisconsin
PAT TOOMEY, Pennsylvania
------
Task Force on Housing and Infrastructure
JOHN E. SUNUNU, New Hampshire, Chairman
GARY MILLER, California, Vice KEN BENTSEN, Texas,
Chairman Ranking Minority Member
NICK SMITH, Michigan BENNIE G. THOMPSON, Mississippi
JOE KNOLLENBERG, Michigan DAVID MINGE, Minnesota
PAUL RYAN, Wisconsin EVA M. CLAYTON, North Carolina
PAT TOOMEY, Pennsylvania BOB CLEMENT, Tennessee
------
Professional Staff
Wayne T. Struble, Staff Director
Thomas S. Kahn, Minority Staff Director and Chief Counsel
C O N T E N T S
----------
Page
Hearing held in Washington, DC, April 13, 2000: Abuse of the
National Transportation Safety Board's Rapidraft Payment System 1
Statement of:
Kenneth M. Mead, Inspector General, U.S. Department of
Transportation......................................... 3
James E. Hall, Chairman, National Transportation Safety
Board.................................................. 11
Prepared statement of:
Mr. Mead................................................. 6
Mr. Hall................................................. 14
Hon. Paul Ryan, a Representative in Congress from the
State of Wisconsin..................................... 42
----------
Hearing held in Washington, DC, May 25, 2000: Lack of Income
Verification in HUD-Assisted Housing--The Need to Eliminate
Overpayments................................................... 49
Statement of:
Emil J. Schuster, Special Agent in Charge, Southeast/
Caribbean Field Office of the HUD Inspector General.... 52
Raymond A. Carolan, Special Agent in Charge, New England
Office of the HUD Inspector General.................... 56
Saul N. Ramirez, Jr., Deputy Secretary, U.S. Department
of Housing and Urban Development....................... 61
Sheila Crowley, President, National Low-Income Housing
Coalition.............................................. 65
Prepared statement of:
Hon. John E. Sununu, a Representative in Congress from
the State of New Hampshire............................. 50
Mr. Schuster............................................. 55
Mr. Carolan.............................................. 59
Mr. Ramirez.............................................. 63
Ms. Crowley.............................................. 68
----------
Hearing held in Washington, DC, June 9, 2000: Government Failure
in Disposing of Obsolete Ships................................. 85
Statement of:
Thomas J. Howard, Deputy Assistant Inspector General for
Maritime and Departmental Programs, U.S. Department of
Transportation......................................... 89
John E. Graykowski, Acting Maritime Administrator, U.S.
Department of Transportation........................... 99
Vice Adm. James F. Amerault, Deputy Chief of Naval
Operations Logistics................................... 103
Prepared statement of:
Mr. Sununu............................................... 87
Hon. Peter A. DeFazio, a Representative in Congress From
the State of Oregon.................................... 88
Mr. Howard............................................... 91
Mr. Graykowski........................................... 102
Vice Adm. Amerault....................................... 105
----------
Hearing held in Washington, DC, July 25, 2000: Implications of
Debt Held by Housing-Related Government-Sponsored Enterprises.. 127
Statement of:
Barbara Miles, Specialist in Financial Institutions,
Government and Finance Division, Congressional Research
Service................................................ 129
Thomas J. McCool, Director, Financial Institution &
Market Issues, General Government Division, General
Accounting Office...................................... 137
Bert Ely, President, Ely & Co., Inc...................... 144
Armando Falcon, Jr., Director, Office of Federal Housing
Enterprise Oversight................................... 214
William C. Apgar, Housing and Urban Development Designee
to the Federal Housing Finance Board................... 225
Prepared statement of:
Ms. Miles................................................ 132
Mr. McCool............................................... 140
Mr. Ely.................................................. 147
Hon. Eva M. Clayton, a Representative in Congress from
the State of North Carolina............................ 200
Mr. Falcon............................................... 217
Mr. Apgar................................................ 229
Abuse of the National Transportation Safety Board's Rapidraft Payment
System
----------
THURSDAY, APRIL 13, 2000
House of Representatives,
Committee on the Budget,
Task Force on Housing and Infrastructure,
Washington, DC.
The Task Force met, pursuant to call, at 10:15 a.m. in room
210, Cannon House Office Building, Hon. John Sununu (chairman
of the Task Force) presiding.
Members present: Representatives Sununu, Knollenberg,
Miller, Ryan, Toomey, Bentsen, Clement and Lucas.
Mr. Sununu. Good morning. Today's hearing is the first of
the Housing and Infrastructure Task Force, one of six such
panels recently established by the House Budget Committee. The
overriding objective of these panels is to identify and review
cases of mismanagement or misuse of Federal funds in an effort
to better allocate resources, improve government operations and
ultimately look out for the taxpayers' interests.
I do not view these issues that we are going to be
addressing in these hearings as partisan, and it is not our
objective to point fingers or place blame. Frankly, both the
administration and the Congress share a responsibility to
oversee these agencies. If problems occur, we need to work
together to look for solutions.
I believe that success in the continuing efforts here will
not be marked by a dramatic hearing or simplistic legislation
that guarantees accountability but instead by painstaking
review and evaluation of what works and, of course, what
doesn't work in government.
Today's hearing is a modest step in this direction. In
reviewing the problems associated with the Rapidraft check
writing system within NTSB, I hope that this Task Force can
address three specific areas:
First, we need to understand what basic flaws of the
Rapidraft system led to very significant abuses, a significant
number of drafts being processed for inappropriate uses.
Second, we should consider the corrective action that has been
taken by NTSB leadership and assess whether or not similar
changes should be implemented in other Federal agencies that
might still be relying on Rapidrafts or other similar third
party systems. And, third, I believe we should consider whether
extending legislation such as the Inspector General Act or the
Chief Financial Officers Act to additional Federal agencies
would help prevent similar problems from occurring in the
future.
I believe that today's two witnesses and NTSB Chairman Jill
Hall and Inspector General Ken Mead will help provide answers
to these important questions.
Before we begin, however, I want to make a few personal
observations about the NTSB itself. In my view and I believe
the view of Congress and the American people, the NTSB is
without peer in the performance of its core mission. The
technical expertise and objectivity of its investigators helped
to ensure the safety of travelers not just in the United States
but throughout the world. And this is indeed a unique role. The
NTSB provides an invaluable service to the country and has
earned its reputation for integrity.
It should be emphasized that the problems we are going to
discuss today relating to the Rapidraft system are unrelated to
the core investigatory work of the NTSB. Moreover, it was the
leadership within the NTSB itself that first identified the
problems and requested that the Department of Transportation
Inspector General work to begin an audit and make
recommendations to the Board.
This could not have been an easy request for Mr. Hall and
the Board to make. Moreover, implementing the changes to
financial systems, which the NTSB has already begun, is a
difficult task in any organization. Yet, throughout this
process, the Board has continued to meet its critical
responsibilities in an exemplary fashion. It is a fact that I
believe is a great credit to Mr. Hall's personal leadership.
The objective of this hearing is not to assign blame or
responsibility for a system that we know is flawed and that the
current Board inherited and which had been in place for about
10 years. The Task Force's goal is not to second-guess the
overall effort of Mr. Hall or Mr. Mead. To the contrary, Mr.
Hall's initial problem identification and request should really
serve as a model for others in similar positions.
Instead, I hope we will work to make the best possible use
of the hard work already done by Mr. Hall and Mr. Mead and
their respective staffs and apply the important lessons before
us across all areas of the Federal Government.
It is my pleasure to yield at this time to Mr. Bentsen for
an opening statement.
Mr. Bentsen. I thank my chairman of the Task Force, Mr.
Sununu, for yielding to me.
I want to thank or welcome both Chairman Hall and Inspector
General Mead here today. We appreciate you testifying.
I can't help but say that--it's not Mr. Sununu's fault--but
we probably should have had the FAA here today. Because, as we
speak, the conference report on the budget resolution is coming
up on the floor, and you have got members of the committee who
are stuck here. But we do have important business before us
today, and I know Mr. Sununu and I are eager to get over to the
floor and do rhetorical battle with respect to the budget, as
well as the other members are.
The Task Force is charged with holding oversight hearings
on waste, fraud and abuse and reporting our findings and
recommendations to the full House Budget Committee. I know of
no one, Democrat or Republican, in the Congress who believes
the American people should tolerate any waste, fraud and abuse
involving their hard-earned tax dollars.
In this our first oversight hearing we turn to the
Rapidraft check writing program of the National Transportation
Safety Board. With all due respect to Chairman Hall, the NTSB
is not really on the Nation's radar screen except for those
tragic times when there is a major accident. When there are
tragedies in our skies like the Egyptair crash off the coast of
Nantucket or the TWA flight 800 in New York, we look to the
NTSB to investigate. I think I can safely say that there is a
broad agreement by Members on both sides of the aisle that the
NTSB is the world's premiere independent accident investigation
agency.
I would like to start also by commending you, Chairman
Hall, on your proactive stance with respect to financial
inconsistencies that your agency unearthed at the NTSB.
From my reading of the materials supplied, in 1999, when
your Office of Finance became aware of potential abuses of the
Rapidraft system, you contacted the Inspector General, who did
not have jurisdiction over your agency, and requested that he
come in and conduct an audit. You then terminated the Rapidraft
system and replaced it with a program universally used
throughout the government. Shortly after, the Chief Financial
Officer, who failed to properly audit payments under the
system, was voluntarily separated from his position. All the
while, you apprised the authorizing congressional committees of
your activities. Moreover, I understand that you recently
contracted with an outside firm to have them conduct a complete
audit of the abandoned Rapidraft system that goes beyond the
Inspector General's investigation.
Chairman Hall, I want to commend you and your agency for
showing us how an agency can take the reins of responsibility
and initiate reform that deters waste, fraud and abuse. I think
this is something that you ought to be proud of and something
that, at the conclusion of these hearings, Mr. Chairman and
members, that we ought to hopefully hold out as a model for the
Federal Government in standing up and addressing problems
within an agency rather than not doing anything.
And, with that, I yield back the balance of my time.
Mr. Sununu. Thank you, Mr. Bentsen.
Mr. Sununu. At this time, it is my pleasure to welcome both
of our witnesses. We will take testimony from each, Mr. Mead
and Mr. Hall, and then allow members 5 minutes on alternating
sides for comments and questions.
STATEMENTS OF KENNETH M. MEAD, INSPECTOR GENERAL, DEPARTMENT OF
TRANSPORTATION; AND JAMES E. HALL, CHAIRMAN, NATIONAL
TRANSPORTATION SAFETY BOARD
Mr. Sununu. Welcome, Mr. Mead. We're pleased to have you
begin.
STATEMENT OF KENNETH M. MEAD
Mr. Mead. Thank you, Mr. Chairman and members of the Task
Force.
I want to at the very outset here reaffirm what you said in
your opening remarks. The Department of Transportation
Inspector General does not have statutory audit or
investigative jurisdiction over the National Transportation
Safety Board. We did our work at the request of Chairman Hall,
who called us promptly upon learning of some issues concerning
this Rapidraft program; and he just as rapidly took action upon
our recommendations. Indeed, even in advance of us issuing our
formal recommendations, the chairman acted.
And that is not always the case. As you look about
government, when you find recommendations from the Inspector
General or GAO, you don't always see such expeditious
implementation. So I just want to say I hold Chairman Hall in
the highest personal and professional regard.
Now, beginning in 1984, NTSB contracted with a vendor to
provide a line of credit for writing third-party checks, which
in our testimony we will refer to as Rapidrafts. They are much
like your own checks except they have NTSB's name on them. A
primary purpose of these Rapidrafts was to eliminate extra
paperwork and processing time required to issue Treasury
checks. The vendor administered the Rapidraft program,
including issuing blank checks and providing NTSB with monthly
transaction statements and canceled checks.
Now our testimony is going to cover three areas: First, the
established internal controls for this program were not working
as intended, and clearly so; second, what our recommendations
were and NTSB's response; and, finally, I think our findings
illustrate the need for some type of institutional oversight of
NTSB in the financial management area.
The Rapidraft system was in operation from 1984 through
September 1999. It authorized some NTSB employees, 177 of the
total complement of about 450 staff, to write Rapidrafts for
accident and nonaccident investigation purposes.
During the past 3 fiscal years, NTSB issued 26,000
Rapidrafts totaling nearly $13 million. During the first 11
months of 1999 about $3.6 million in Rapidraft payments were
made. This system was under the general management of NTSB's
Chief Financial Officer, called a CFO for short. Its operation
was governed by an NTSB order.
In late August 1999, after learning about incidents of
possible abuse, Chairman Hall asked for our assistance in
investigating and auditing the suspected abuse. We agreed to do
so.
We performed the work under what is called a memorandum of
understanding, which actually had been under discussion between
NTSB and our office even before this abuse was uncovered.
Chairman Hall told me that he wanted audit coverage just as a
good financial management practice.
Well, our audit revealed that the Rapidraft system was
seriously mismanaged. Of the 1,000 Rapidrafts paid during
fiscal 1999 which we sampled, 902 of those, or over 90 percent,
failed to comply with NTSB internal controls. Now what do I
mean by that? There are seven specific deficiencies that I
would like to note here.
First, 678 of the 1,000 Rapidrafts didn't contain a
required explanation for the check. Now, without an explanation
or supporting documentation, it is difficult to determine
whether the disbursement is for a legitimate purpose. An
example: in November, a $2,150 Rapidraft was issued and
negotiated with no payee and there was no explanation on the
Rapidraft as to what the purpose of the check was.
Second deficiency: 222 of the 900 checks were paid without
the required signature or authorization number. We found, for
example, a $1,416 check that was paid--issued--but it bore no
authorizing signature. It is like you cashing a check but not
signing it.
A third deficiency: 22 Rapidrafts were issued in 1999 in
excess of the $2,500 ceiling. For example, six ranging from
$7,800 to $24,000 were issued for building renovations.
Fourth deficiency: as a matter of practice, paid Rapidrafts
were not reconciled with supporting documentation by NTSB. In
fact, when my staff retrieved the canceled Rapidrafts from
NTSB, they were still in the same unopened envelopes that the
vendor used to send them to NTSB. That compares to getting your
bank statement, throwing it in a drawer and never looking to
see whether the checks were yours or the charges appropriate.
Fifth: employees separating from NTSB weren't required to
turn in their unused checks, and many did not. Moreover, the
contractor was not notified, in turn, that 37 employees, 37 of
the 177 users, had left the agency. The headquarter's employee
who embezzled over $70,000 and who in fact worked for the Chief
Financial Officer used Rapidrafts that were left behind by a
former employee.
Sixth: employees could order blank Rapidrafts from the
contractor without management approval or knowledge. Management
didn't track how many Rapidrafts were issued to the employees,
and they were not kept in secure locations.
And, finally, these checks were used to split purchases and
circumvent Federal regulations. Splitting is the practice of
using multiple checks to divide a single purchase to avoid
competition. For example, one employee wrote three checks
totalling $4,600 to the same vendor on one day for the same
thing. And this lack of adherence to internal controls overall
rendered the system susceptible to fraud, waste and abuse.
Our investigations disclosed that two employees had
embezzled government funds using the Rapidraft system. The
employees have resigned. Criminal prosecution has been
initiated against both of them.
On April 4, one former employee was indicted by a Federal
grand jury on seven felony counts.
On April 11, the other former employee, the one who worked
under the Chief Financial Officer, was charged with a felony
for embezzling nearly $74,000.
In November 1999, we apprised NTSB of our findings. We
recommended that they discontinue the Rapidraft system,
implement an approved payment program using credit cards and
ensure that the Chief Financial Officer's Office developed and
implemented comprehensive internal controls.
Chairman Hall told us that he had discontinued the
Rapidraft Payment System. He adopted the governmentwide
purchase credit card and travel credit card programs. He also
appointed a new CFO. He has retained the services of a private
sector audit firm to audit the financial management systems.
Now the NTSB, as your opening remarks indicated, is held in
very high regard for its investigations. And, in this case,
NTSB took prompt action to get help, and it took prompt
corrective action, and they have committed to a meaningful
course of corrective action on a broad front.
Now, it is necessary for Chairman Hall to seek outside
assistance, because NTSB doesn't have an Inspector General or
an equivalent institutional oversight mechanism. We feel that
if they had been subject to some type of institutional
oversight and follow-up of corrective action, it is likely that
the problems uncovered in 1999 may have been avoided.
And just by way of illustration, I should say that, because
of the experience at NTSB and our own prior audit work at FAA,
the Department is terminating a similar program at FAA where
similar weaknesses were found. And that wouldn't be possible if
we weren't there to constantly monitor the situation. It just
shows I think the value of continuing oversight. And that
concludes my remarks.
Mr. Sununu. Thank you very much, Mr. Mead.
[The prepared statement of Mr. Mead follows:]
Prepared Statement of Hon. Kenneth M. Mead, Inspector General, U.S.
Department of Transportation
Mr. Chairman and members of the Task Force, we appreciate the
opportunity to discuss the National Transportation Safety Board's
(NTSB) Rapidraft Payment System.
In 1984, NTSB contracted with a vendor to provide a line of credit
for third-party check writing privileges. A primary purpose of these
checks, referred to as Rapidrafts, was to eliminate the extra paperwork
and processing time required to issue checks through the Treasury
Department. The vendor served to administer the Rapidraft program,
including issuing blank checks (drawn against the vendor's bank
account), maintaining a list of authorized NTSB users, and providing
NTSB with monthly transaction statements and canceled checks. NTSB
renewed the firm's contract, most recently in 1996.
The Rapidraft Payment System--in operation from 1984 through
September 1999--authorized some NTSB employees, including on-site
accident investigators, to write Rapidrafts ``for accident and
nonaccident investigation costs.'' These Rapidrafts were limited to
$2,500 per transaction. During the past three fiscal years (FY), 1997
through 1999, NTSB issued 26,097 Rapidrafts totaling $12.9 million.
During the first 11 months of FY 1999, only $227,776 (6 percent) of the
$3.6 million Rapidraft payments were associated with on-site accident
investigations.
The Rapidraft Payment System was under the general management of
NTSB's Chief Financial Officer (CFO). Its operation was governed by an
NTSB Order prescribing the procedures and internal controls on use of
Rapidrafts.
In late August 1999, after learning about incidents of possible
abuse of the Rapidraft Payment System by one or more NTSB employees,
NTSB Chairman Jim Hall requested our assistance in investigating the
suspected abuse. In addition to rendering investigative services, we
agreed to perform a broader audit of the Rapidraft Payment System. As
NTSB is not within the scope of our investigative and audit authority,
we performed the work under a mutually agreed to Memorandum of
Understanding and Agreement.
In brief, our audit revealed that the Rapidraft Payment System was
seriously mismanaged. Our review of 1,000 Rapidrafts paid during FY
1999 showed that 902, over 90 percent, were noncompliant with NTSB
internal controls. Specific deficiencies we identified include the
following:
678 Rapidrafts did not contain the required explanation
for the check.
222 Rapidrafts were processed and paid without the
required signature or authorization number.
22 Rapidrafts were issued in excess of the $2,500 limit.
In the two prior fiscal years, more than 150 Rapidrafts exceeded
$2,500, including eight Rapidrafts issued for $20,000 or more.
As a matter of practice, paid Rapidrafts (forwarded by the
contractor to NTSB, similar to a bank's return of canceled checks to a
customer) were neither reviewed nor reconciled with supporting
documentation by NTSB.
The contractor was not notified that 37 of the 177
authorized users had left NTSB.
Employees separating from NTSB employment were not
required to turn in unused Rapidrafts and many did not.
Employees ordered and received blank Rapidrafts from the
contractor without management approval or knowledge.
NTSB management did not track how many Rapidrafts were
issued to employees.
Rapidrafts were not kept in secure locations at NTSB.
Rapidrafts were used to ``split'' purchases and circumvent
Federal Acquisition Regulations and NTSB Orders. (``Splitting'' is the
practice of using multiple Rapidrafts to divide a single purchase--
which exceeds the Government's $2,500 micropurchase ceiling--into a
series of separate, smaller purchases in order to circumvent the
ceiling.)
NTSB's lack of adherence to internal controls rendered the
Rapidraft Payment System susceptible to fraud, waste and abuse, as
evidenced by two known embezzlements which we investigated. Our
investigations disclosed that two NTSB employees, one in a field office
and one at Headquarters had separately embezzled Government funds using
the Rapidraft System. The employees resigned before our investigation
commenced in August 1999. Since then, our findings concerning each of
those former employees have resulted in criminal prosecution by the
Department of Justice.
Our investigation disclosed that a former employee was responsible
for misappropriating in excess of $20,000. On April 4, 2000, she was
indicted by a Federal grand jury in the Northern District of Georgia on
seven felony counts of embezzlement. On April 11, 2000, the other
former employee--who worked under NTSB's former CFO--was charged in a
one-count felony Information by the U.S. Attorney's Office for the
District of Columbia for embezzling approximately $74,000.
In early November 1999, we apprised NTSB of our audit and
preliminary investigative findings, transmitting our formal audit
report. Our audit report recommended that NTSB:
Discontinue the Rapidraft Payment System.
Implement approved payment programs, such as the
Governmentwide commercial purchase card and a Federal payment processor
for travel-related reimbursements.
Ensure that the CFO's office develops and implements
comprehensive internal controls for these programs.
In response to our recommendations, Chairman Hall notified us that
he had discontinued the Rapidraft Payment System and NTSB adopted the
Governmentwide purchase credit card program. Moreover, NTSB appointed a
new CFO in January 2000 and has retained the services of a private
sector audit firm to assist in identifying weaknesses and recommending
procedures and resources for improved audit control. This outside audit
firm will audit and examine internal control weaknesses in other
financial systems, such as NTSB's travel program, accountability of
property and internal controls, and electronic certifications. These
programs and systems were beyond the scope of our review of the
Rapidraft Payment System.
The NTSB is held in high regard for its expertise and role in
assuring the safety of all modes of transportation. It is widely
regarded as the preeminent investigative agency of its kind in the
world. We note NTSB's prompt action in requesting assistance to
identify the cause and extent of the problems with the Rapidraft
program and appreciate its cooperation with our auditors and
investigators. NTSB has committed to a meaningful course of corrective
action on a broad front, promptly ending its use of Rapidrafts even
before the completion of our audit, and must now follow through in its
implementation of these actions.
To help the Task Force in its efforts, our testimony today
addresses three areas related to the problems identified with the
NTSB's Rapidraft program.
First, the established internal controls were not
operating as intended,
Second, our recommendations to correct the problems
identified and NTSB actions relative to those recommendations, and
Finally, our findings in this matter illustrate the need
for some type of institutional oversight within NTSB in order to
provide the Chairman and the Board with independent reviews of NTSB's
financial management programs and business operations. This capability
presently does not exist.
In December 1997, we issued an audit report to the Federal Aviation
Administration (FAA) regarding the closeout of its imprest fund, which
included recommendations concerning third-party drafts. At that time,
we recommended FAA limit its use of third-party drafts to exceptional
circumstances. As a result of our work with the NTSB in this matter, we
made follow-up inquiries about the continued use of third-party drafts
in the Department of Transportation (DOT).
On March 30, 2000, DOT's Assistant Secretary for Budget and
Programs issued a memorandum informing all DOT operating
administrations that the use of third-party drafts will be discontinued
by the end of Fiscal Year 2000. As originally designed, third-party
draft programs once served a useful purpose by providing a payment
mechanism for time-sensitive missions such as NTSB's. However, the
Government's adoption of purchase and travel credit card programs has
supplanted the need for third-party drafts.
internal controls were not operating as intended
The Rapidraft Payment System was seriously mismanaged and subjected
to embezzlement. During fiscal years (FY) 1997 through 1999, NTSB
issued 26,097 Rapidrafts totaling $12.9 million. While intended ``for
accident and nonaccident investigation costs'', Rapidrafts were
predominately used to reimburse employees for nonaccident related
travel, pay tuition for training, make equipment purchases, and pay
employees' salaries. Also, Rapidrafts were processed and paid when they
exceeded the $2,500 limit, and employees ``split'' purchases to
circumvent that limit and the Federal Acquisition Regulations.
The internal controls designed for the Rapidraft Payment System
were not followed, resulting in numerous weaknesses that left the
System inherently vulnerable to fraud, waste, and abuse. For example,
Rapidraft stocks were not protected from unauthorized use, Rapidrafts
were paid without the required signature or authorization number, and
37 of the 177 authorized users no longer worked for NTSB. Rapidrafts
were also paid when the signatures of current and former employees were
forged. The CFO's office did not review paid Rapidrafts or reconcile
them with required supporting documentation to ensure payments were
authorized and appropriate.
Our review of 1,000 Rapidrafts paid during FY 1999 showed that they
frequently lacked supporting documentation. The lack of documentation
precluded us from determining whether many of the payments were for
legitimate NTSB purposes.
Rapidrafts Were Used in Violation of NTSB Policy
Contrary to NTSB policy, Rapidrafts were paid when they exceeded
the $2,500 limit, and payments were split to circumvent acquisition
regulations and the $2,500 limit. NTSB Order 1542 Section 5b(2) states
``Rapidrafts are limited to a maximum of $2,500 per item/service.''
During FY 1999, the Rapidraft Payment System contractor processed 22
NTSB Rapidrafts that exceeded the $2,500 limit, including ones for
$11,076 and $4,070. During a limited review of FY 1998 and FY 1997
Rapidrafts, we identified 107 and 49, respectively, that were processed
for more than $2,500 including individual Rapidrafts as follows:
$28,532 for hotel services;
$24,461, $20,000, and $13,357 for building renovations (FY
1997);
$16,404, $10,000, and $7,890 for building renovations (FY
1998); and
$5,795 for telephone service.
Also, NTSB Order 1542 Section 5b(3) notes ``A paid Rapidraft does
not eliminate or mitigate . . . the prohibition against subdividing
foreseeable purchases, merely to use simplified procedures.'' However,
NTSB employees--including the former CFO--were ``splitting'' payments
using multiple Rapidrafts to divide a purchase that exceeds the
government's $2500 micropurchase ceiling into a series of separate,
smaller purchases in order to circumvent the ceiling, a violation of
Federal Acquisition Regulations and NTSB Order. For example, one
employee wrote three Rapidrafts totaling $4,649 to the same payee on 1
day for computer equipment.
Internal controls were not sufficient to protect the System from
fraud, waste, and abuse. Although some controls existed on paper, the
controls were not followed. Also, NTSB staff were not trained in the
proper use of Rapidrafts (NTSB Order 1542, Section 5a) or the penalties
for misuse (NTSB Order 1542, Section 7a).
NTSB Order 1542 prescribes internal control procedures for
Rapidrafts, including segregation of duties, limitations on use,
requirements for supporting documentation, and guidance on safeguarding
the Rapidrafts. For example, Section 6d states ``If the Rapidrafts do
not meet certain pre-established criteria, [the contractor] will reject
them for payment. The amount may not exceed $2,500. The signature
appearing on the Rapidraft must be an authorized employee, and the
authorization number must match the one assigned to that employee.''
However, the internal control procedures were not followed by NTSB
and the contractor. Specific weaknesses OIG identified include:
Rapidrafts were paid without the required signature or
authorization number.
Rapidrafts were paid without the required supporting
documentation.
The contractor was not notified that 37 of the 177
authorized users had left NTSB.
Employees leaving NTSB were not required to turn in unused
Rapidrafts and many did not.
Employees ordered and received blank Rapidrafts from the
contractor without management approval or knowledge.
NTSB management did not track how many Rapidrafts were
issued to employees.
Rapidrafts were not kept in secure locations at NTSB.
As a matter of practice, paid Rapidrafts (forwarded by the
contractor to NTSB, similar to a bank's return of canceled checks to a
customer) were neither reviewed nor reconciled by NTSB.
Our sample of 1,000 Rapidrafts from the 7,749 paid during the first
11 months of FY 1999 showed that 902 Rapidrafts (90 percent) were
noncompliant with NTSB internal controls. For example, 678 Rapidrafts
(68 percent) did not contain the required explanation of the purpose
for the check. Also, 222 Rapidrafts (22 percent) were processed and
paid even though they did not include the required authorization
number. Additionally, 52 Rapidrafts contained more than one deficiency
such as no signature on the check and no explanation of the purpose for
the check. While the contractor should not have paid Rapidrafts without
signatures or authorization numbers, NTSB officials did nothing to
check the contractor's actions or processes.
Specific examples of Rapidrafts issued and transacted in violation
of the usage procedures are as follows:
In August 1998, a $1,416 Rapidraft bearing no authorizing
signature was issued and subsequently negotiated.
In November 1998, a $2,150 Rapidraft for which no payee
was listed was issued and later negotiated.
Further, canceled Rapidrafts were not reviewed or reconciled with
supporting documentation to verify that the payments were for
legitimate products or services, and that the transacting employee was
authorized to make the payment. Bundles of paid Rapidrafts from the
contractor were stored unopened, and the CFO's office did not compare
them against supporting documentation.
The CFO's office only compared a listing of check numbers and
dollar amounts on the contractor's bill with check numbers and amounts
entered into the accounting system by employees who issued the
Rapidrafts. If there was a match, NTSB paid the bill without question.
Reconciling Rapidrafts to the supporting documentation is an important
control mechanism because it provides independent assurance that
payments and purchases are authorized and appropriate.
Control Weaknesses Were Previously Identified
Weaknesses in internal controls for the Rapidraft Payment System
were identified on at least two previous occasions. A 1992 audit report
by the General Services Administration's (GSA) Inspector General on
NTSB's travel procedures and practices identified internal control
weaknesses in the use of Rapidrafts. Also, staff began raising concerns
to the NTSB CFO in early 1999 that internal controls were not being
implemented.
The GSA Inspector General concluded that Rapidrafts were not
properly safeguarded and were improperly used. Specifically, the GSA
Inspector General's report noted that investigators or their
supervisors were routinely issuing Rapidrafts for travel advance
purposes even though they were not authorized to do so. The report also
noted that subordinates issued Rapidrafts to their supervisors for
travel purposes. The GSA Inspector General noted that these practices
were of particular concern because they circumvented a fundamental
control--separation of duties.
The then-Comptroller (former CFO) responded to the report outlining
planned corrective actions to be taken, including issuing a memorandum
to all employees on authorized uses and safeguarding of Rapidrafts.
Based on our work, corrective actions were either never implemented or
sustained because we identified the same weaknesses as the GSA
Inspector General.
Also, in January 1999, CFO staff began raising concerns to the CFO
that Rapidraft users were not complying with internal control
requirements. Specifically, CFO staff noted that Rapidraft users were
not submitting required supporting documentation for purchases and not
entering required data into the accounting system. When these concerns
were ultimately raised to and reviewed by senior managers outside of
the CFO's office, instances of embezzlement were uncovered. Further, we
found that in January 1999, NTSB personnel in the office of the CFO
alerted the former CFO to irregularities involving the use of
Rapidrafts by the former Headquarters employee who has since been
charged with theft. Yet the CFO did not take timely or adequate action
and, in the next 8 months, until the Headquarters employee resigned in
August 1999, this employee embezzled approximately 34 Rapidrafts
totaling $30,000. The CFO resigned effective November 29, 1999, after
our investigation was commenced.
Rapidrafts Were Exploited in Two Known Embezzlements
In the end, the lack of adherence to internal controls subjected
NTSB to separate known embezzlements by two employees. We investigated
a former GS-7 employee in the Atlanta field office of the NTSB
suspected of embezzling approximately $20,000. The employee resigned in
July 1999. Investigation disclosed that between October 1998 and June
1999, the employee embezzled money from NTSB by writing Rapidrafts to
employees of NTSB and then fraudulently endorsing the Rapidrafts to
herself. The employee then deposited the Rapidrafts into a personal
bank account. On April 4, 2000, the employee was indicted by a Federal
grand jury in Atlanta, charged with seven counts of theft.
We also investigated a former GS-8 employee of the NTSB
Headquarters staff who resigned in August 1999. On April 11, 2000, the
former employee was charged in a one-count felony Information by the
U.S. Attorney's Office for the District of Columbia for embezzling
approximately $74,000 between September 1997 and August 1999, by
fraudulently writing 97 Rapidrafts to herself using the signature
authority of a former NTSB employee and then cashing the majority of
these Rapidrafts at a local liquor store. The Headquarters employee
knew that once cashed, the canceled Rapidrafts were not reviewed by
NTSB for purposes of reconciliation.
ig recommendations and ntsb corrective action
On October 26, 1999, we met with Chairman Hall and senior NTSB
staff to discuss our audit results and preliminary investigative
findings. On November 8, 1999, we issued an audit report to the NTSB
that recommended NTSB discontinue the use of the Rapidraft System and
instead use the Governmentwide commercial purchase card program for its
on-site investigative expenses and other purchases. We recommended that
NTSB discontinue processing employee travel claims and instead use a
Federal processor for reimbursement of travel claims to ensure that
proper voucher examination is performed.
By letter dated November 5, 1999, we notified the NTSB of our
preliminary investigative results. Subsequently, on March 21, 2000, we
issued a final investigative report to the NTSB. Our investigative
report supported the earlier recommendations of the audit and
recommended that NTSB consider disciplinary action for employees as
appropriate.
The NTSB generally concurred with our recommendations. By letter
dated November 23, 1999, Chairman Hall responded that NTSB had
discontinued the Rapidraft System and adopted the Governmentwide
Citibank Purchase card Program in its place. The Chairman also reported
that NTSB had commenced discussions with a private sector audit firm
for assistance in identifying audit weaknesses and recommending
procedures and resources for improved audit control. We were recently
informed that such a contract has been executed and that an audit will
begin in the near future.
On January 3, 2000, the NTSB appointed a new CFO. The new CFO was
hired from the U.S. Treasury Department and has 35 years of Federal
service in the field of financial management. We have met with the new
CFO several times to review our audit and investigative results. He has
identified and initiated specific actions necessary to implement our
recommendations, but his efforts require the full support of the NTSB
Board and senior staff if he is to succeed in reforming and improving
the financial management of the NTSB.
need for institutional oversight within the ntsb
To his credit, NTSB Chairman Hall promptly sought our assistance in
this matter. It was necessary for the Chairman to seek outside
assistance because the NTSB is without an Inspector General or an
equivalent institutional oversight organization. The NTSB has
historically relied on agreements with other Inspectors General or
private sector firms for audit assistance. Outside oversight has
included General Accounting Office audits and congressional oversight
exercised through the authorizing and appropriations process.
There is no full-time oversight of NTSB. Our work with respect to
the Rapidraft System was carried out in accordance with an August 31,
1999, Memorandum of Understanding (MOU) between our office and the
NTSB. The MOU allows for our office to conduct investigations and
audits at the request of the NTSB on a reimbursable basis. It does not
provide authority for us to self-initiate audits or investigations as
we do for the Department of Transportation, nor does it authorize, or
create a responsibility for us to ascertain whether or not NTSB
implemented the corrective actions discussed with us. As you are aware,
such follow-up is critical to oversight. For example, as noted above,
the GSA IG was not in a position to follow up on its 1992 audit
results. If NTSB had been subject to some type of institutional
oversight, it is possible that the 1992 audit would have resulted in
real corrective action and the problems uncovered in 1999 may have been
avoided.
Similarly, if the NTSB had an institutional oversight organization,
the employees who reported irregularities to the CFO in January 1999
would have had an in-house channel to pursue when they did not see
action on the part of the CFO in response to their reports of
irregularities. At the Department of Transportation, we receive
approximately 600 telephone calls, letters, and E-mail messages a year
reporting suspected fraud, waste and abuse within the Department. Our
fraud, waste and abuse Hotline offers employees confidentiality or the
opportunity to provide information anonymously. Reports to our Hotline
receive independent attention from our staff and are also shared with
the Department management. For management, they serve as a useful
source of information about programs and operations in the Department
that, at a minimum, require management attention. The NTSB does not
have a vehicle similar to our Hotline to ensure an independent review
of suspected fraud, waste and abuse.
``The National Transportation Safety Board Amendments Act of
1999,'' (H.R.2910) was passed by the House on October 1, 1999. The
legislation reauthorizes the NTSB and also contains provisions that
address Inspector General oversight at the NTSB. The bill provides that
the Inspector General at the Department of Transportation will carry
out Inspector General responsibilities only with respect to the
financial management and business operations of the NTSB. While we did
not seek this additional responsibility, we concur that our audit and
investigation concerning the NTSB's Rapidraft System strongly suggests
that some type of institutional oversight is appropriate. The Senate is
considering similar provisions as part of its reauthorization
legislation for the NTSB.
Mr. Chairman, this concludes our testimony. I would be happy to
answer any questions you may have.
Mr. Sununu. Welcome, Mr. Hall. We're pleased to hear your
testimony.
STATEMENT OF JAMES E. HALL
Mr. Hall. Thank you very much, Mr. Chairman, Congressman
Bentsen, members of the committee.
I was invited to appear before you today regarding the
National Transportation Safety Board's request for an audit and
investigation by the Department of Transportation's Inspector
General regarding financial discrepancies found during an
August 1999 document reconciliation in preparation for our end-
of-year financial closeout. I have brought with me today our
Managing Director, Dan Campbell; our General Counsel, Ron
Battocchi; and our Chief Financial Officer, Mitch Levine, who
will be available to be responsive to any questions the
committee may have as well.
Before I begin, permit me, Mr. Chairman, to spend just a
few moments on the NTSB and its mission. Since Congress created
it as an independent agency in 1967, the Safety Board has
served as the eyes and ears of the American people at more than
100,000 aviation accidents and thousands of surface
transportation accidents. Over time, it has become one of the
Board's premiere accident investigation agencies. In fact, it
is only one of nine independent investigative organizations in
the world.
Perhaps more importantly, as part of our investigations we
make safety recommendations that we hope will prevent similar
accidents from recurring. In its 33-year history, the Board has
issued almost 11,000 recommendations in all transportation
modes to more than 1,250 recipients. In 1990, we began
compiling the ``most wanted list'' that highlights some of what
we considered to be our most important but not yet implemented
recommendations and covers concerns such as data recorders in
all transport vehicles, aircraft icing, fuel tank flammability
and human fatigue.
It is important to note that, because the Board does not
have regulatory or enforcement powers, we rely on our
reputation for impartiality and thoroughness to get our
recommendations implemented. To date, more than 80 percent have
been adopted. Many safety features currently incorporated into
airplanes, automobiles, trains, pipelines and marine vessels
have had their genesis in Safety Board recommendations; and
over the years Board recommendations on ground proximity
warning systems, windshear, crew resource management, railroad
passenger safety, drunk driving, seat belts, child safety
seats, graduated licensing and emergency response to hazardous
material substances have been implemented. At an annual cost of
less than 20 cents a citizen, the 400-member Safety Board I
believe is one of the best investments this Congress makes.
My testimony submitted for the record details the series of
events that led up to the August 1999 discovery. Today, I would
like to focus on what actions have occurred since I requested
Mr. Mead's assistance.
I would, however, like to emphasize several facts. NTSB
staff discovered the discrepancies and notified me of the
findings. Because I was concerned about this compromise to our
agency's financial integrity and our reputation, I immediately
requested the Department of Transportation Inspector General to
perform an audit and criminal investigation to determine if our
concerns were valid and whether there were any additional
problems even though, as previously mentioned, the IG had no
jurisdiction over the agency. The NTSB staff and leadership
cooperated fully throughout the IG's audit and investigation.
We were already taking corrective actions before the IG
completed their work, and we kept our appropriating and
authorizing committees fully informed throughout the
investigation.
I asked the IG to look at three areas during their audit
and investigation. Was there criminal conduct by any NTSB
employee? Were there systemic problems with the Rapidraft
program? And were there sufficient financial controls for small
purchases?
Mr. Mead and his staff responded to my request quickly and
very effectively. He sent a full team of auditors and
investigators who devoted 3 months to the audit and 7 months to
the investigation. The IG's audit did conclude that there were
weaknesses in our internal controls and that existing controls
were not followed.
The report made three recommendations: to discontinue the
Rapidraft Payment System immediately; to implement an approved
payment program to meet NTSB's needs; and, third, to ensure
that the Chief Financial Officer's Office develops and
implements comprehensive internal controls.
I terminated the Rapidraft system even before I received
the IG's preliminary report in October 1999, based on an oral
briefing from the Inspector General and his staff. Following
that report, we took a series of additional actions. I placed
the Chief Financial Officer on administrative leave. In January
2000, I hired a new Chief Financial Officer, Mr. Mitch Levine
who is with us today, who has 35 years of Federal financial
management service.
We are currently recruiting to fill vacancies in accounting
operations and system accounting. We implemented governmentwide
commercial credit card programs for travel expenses and small
purchases. Travel vouchers and purchase card bills are now paid
through the Treasury Department Disbursing Centers.
And we selected an independent audit firm,
PriceWaterhouseCoopers, which began work yesterday to develop a
program for comprehensive financial integrity. As part of their
audit, they will conduct a closeout review of the Rapidraft
Payment System; document NTSB's financial management processes
and systems; perform a baseline analysis of existing financial
policies, procedures and systems; test internal controls;
develop internal control recommendations; and assess our audit
readiness.
We received the Inspector General's investigative report on
March 21st. It did not find any additional criminal activity
beyond that already found by the NTSB. It concluded that the
two previously identified employees had embezzled about
$95,000. Both employees have left the NTSB. I have been advised
that one has been indicted by a grand jury and the other is
pleading guilty for criminal acts involving embezzlement and
that restitution to the American people will be sought.
Let me close, Mr. Chairman and members of this committee,
by saying to you that I take this situation very seriously, and
it is the most deeply troubling experience I have had in all my
years of public service. It has unduly impugned the reputation
of this agency and its dedicated employees.
This has been an especially difficult time for the Board's
employees, and it has been a distraction from our mission. As
you may know, while we have been managing this event, we have
had to deal with both the Egyptair and Alaska Air
investigations.
We are taking, Mr. Chairman, every action necessary to
ensure that these deficiencies are rectified and procedures are
put in place to ensure that they do not recur. I give my this
committee my pledge that will be done.
Now, I fully support independent oversight of the Board's
operations on a regular basis. In fact, that concerned me most
when I became chairman of this agency, and I was trying to move
in the that direction at the time these events occurred.
I want to publicly express my appreciation to Mr. Mead and
his staff, and to thank them for assisting us in this task.
Mr. Chairman, I appreciate your attention and the attention
and time the committee staff and you and the members have given
me. That completes my statement.
Mr. Sununu. Thank you very much, Chairman Hall. I
appreciate your statement and its candor and certainly want to
invite Mr. Levine and Mr. Campbell to assist you as we go
through the questioning process with any details that might be
helpful.
[The prepared statement of Mr. Hall follows:]
Prepared Statement of Jim Hall, Chairman, National Transportation
Safety Board
Good morning, Chairman Sununu and Members of the Task Force. I was
invited to appear before you today regarding an audit and an
investigation that the National Transportation Safety Board (NTSB)
requested from the Department of Transportation's Inspector General
(IG). In August 1999, as the NTSB's staff was engaged in reconciling
documents to close our books for the fiscal year, financial
discrepancies were found and brought to my attention. I promptly called
Inspector General Mead and asked for a full and independent
investigation.
Before turning to the circumstances of that request, I would like
to put the problems we discovered in our program for Rapidraft payments
program in context. I became Chairman of NTSB in October 1994, and
inherited a financial accounting system and organization that had been
in place for many years and had not been modernized with automated
information capabilities. Weaknesses in its utility for budgeting
purposes were apparent, and after preparation of budgets for 1996, I
asked senior managers at NTSB to rethink our finance and budget process
to make recommendations to improve our performance. Staff reviewed the
provisions of the Chief Financial Officer Act, which, although it does
not apply by its own terms to a small agency such as NTSB, appeared to
reflect a ``best practice'' approach to financial operations. As a
consequence of this review, in February 1997, I requested the
Department of Treasury's Financial Management Service (FMS) to do a
top-to-bottom evaluation of the finance accounting system that had been
in place at NTSB for more than a decade. The cost for this service was
$55,000, not insignificant for NTSB, but we believed that modernization
was critical.
NTSB received FMS's initial report in June 1997. The report found
that the existing accounting system was insufficient to support
modernized accounting practices. It recommended that we acquire a new
accounting system. We contracted again with FMS for assistance in
selection of such a system. This resulted in the purchase of an off-
the-shelf, Joint-Financial-Management-Improvement-Program (JFMIP)
compliant accounting program. The FMS report also recommended that we
target October 1, 1998, as the date for changeover to a new system. We
met that date, and began use of an entirely new, modern system for
fiscal year 1999. Achieving this target placed a substantial workload
on the accounting staff, but we believed it was a critical first step
in permitting us to achieve a clean audit opinion on NTSB's financial
statements. The goal of a clean audit was a key recommendation of FMS
and is a central concept embodied in the Chief Financial Officer Act. I
wholeheartedly agreed with this approach.
I concurrently elevated the organizational structure of the
comptroller's function to independent office status, headed for the
first time by a Senior Executive level official, also as recommended by
the FMS report and the Chief Financial Officer Act. And we undertook
intensive training of administrative staff in the program offices, in
order to use the new accounting system to its full potential. We knew
that the total process of modernization and information integration
would take several years. However, by the middle of 1999, we were in
the midst of a substantial revision in our financial processes, with
the goal of meeting financial accounting practices at a level not yet,
even today, required of us.
Discovery of Embezzlement
From April 1989 until August 1999, Safety Board offices used what
was for a time a governmentwide, GSA-approved Rapidraft payment system.
Rapidraft is a service offered by a commercial vendor that enables a
government employee to write checks to pay for goods and services. NTSB
Board Order 46A, issued in October 1990, established the Rapidraft
program for payment of small purchases, travel advances, travel
expenses, training registration, and other services. Proper
reconciliation of accounts within the program was a shared function
between program offices and the financial specialists within what is
now organized as the Office of Chief Financial Officer (CFO). In August
1999, during reviews to prepare for the fiscal year-end closeout, a
highway safety program officer asked for assistance from the CFO office
in reconciling records discrepancies concerning a particular Rapidraft
payment. That meeting triggered further analysis, and the subsequent
review identified suspect behavior on the part of two NTSB employees
concerning possible embezzlement. Approximately $95,000 appeared to be
at issue.
NTSB's Request to IG for Audit and Investigation
NTSB has traditionally used the services of outside, independent
auditors to assess financial management issues. In this instance, I
asked DOT IG if it would conduct an audit and a criminal inquiry. The
IG does not have jurisdiction over the NTSB. However, NTSB has the
authority to use the services of other Federal agencies and has used
the services of other IGs in the past. We were in the process of
finalizing a new voluntary audit agreement with the DOT IG when the
discrepancies were uncovered. We believed that an IG, with the ability
to simultaneously pursue a financial audit and a criminal
investigation, was especially well suited to assist us. Consequently,
we broadened the scope of our pending agreement to include criminal
investigations and requested the DOT IG commence an immediate two-
pronged review of the problem we had uncovered. Staff and management
were instructed to cooperate fully with the work of the IG. NTSB (with
DOT IG participation) briefed its Congressional authorizing and
appropriating committees on the problems identified and the initiation
of work by the DOT IG. The concerns shared with the Inspector General
were:
Was there criminal conduct by any NTSB employee? (criminal
investigation)
Were there systemic problems with the Rapidraft program?
(audit)
Are there sufficient financial controls for small
purchases? (audit)
The IG completed its audit work and briefed top NTSB management on
its results on October 26, 1999, and their final report was delivered
on November 8, 1999. In addition, the IG periodically shared
information on the progress of their criminal investigation, and
delivered the results of that investigation on March 21, 2000.
IG Audit and Investigation Report Recommendations
The IG's audit report concluded that there were weaknesses in
internal controls, and that existing controls were not followed. The
report made the following three recommendations:
1. Discontinue use of the Rapidraft Payment System immediately.
2. Implement an approved payment program to meet NTSB needs,
specifically for:
On-site investigative expenses, office supplies, computer
equipment, tuition and training payments, and other similar expenses,
NTSB should use the Governmentwide Commercial Purchase Card Program.
And, travel-related reimbursements, NTSB should use the
same organization that currently provides their payroll services (FAA)
or another Federal processor.
3. Ensure that the CFO's office develops and implements
comprehensive internal controls over these programs.
The IG investigative report concluded that there was criminal
activity on the part of the two employees that were originally referred
by the NTSB.\1\ No other embezzlements were uncovered by the IG.
Criminal enforcement is ongoing and restitution will be pursued. In
addition, the report recommended administrative action be considered
for certain irregularities concerning use of agency e-mail, and that
NTSB ensure proper procedures for the acquisition of small purchases,
the payment of performance bonuses only within the payroll process, and
adherence to government regulations regarding the use of frequent flyer
mileage upgrades.
---------------------------------------------------------------------------
\1\ Both employees identified by NTSB resigned from the agency
prior to investigation by DOT IG and the Federal Bureau of
Investigation.
---------------------------------------------------------------------------
NTSB Actions Taken and Planned
In September 1999, NTSB terminated the Rapidraft Payment System.
After receiving the October 26 briefing on this subject, the then
incumbent CFO was placed on administrative leave. In January 2000, a
new CFO with 35 years of Federal financial management service was
hired. Recruitments are underway to fill additional vacancies in
accounting operations and system accounting. After the new CFO
familiarized himself with the circumstances of DOT IG's work, a series
of briefings were undertaken with NTSB's authorizing and appropriating
committees of Congress concerning the results of the IG's work and our
responses. The NTSB has initiated implementation of all the IG Audit
Report's recommendations.
1. Rapidraft Payment System has been canceled.
2. Governmentwide commercial credit card programs have been
implemented for travel expenses and small purchases. Travel vouchers
and purchase card bills are being paid through Treasury Department
Disbursing Centers.
3. An independent audit firm (PriceWaterhouseCoopers) has been
selected to develop a program for comprehensive financial integrity.\2\
PriceWaterhouseCoopers will perform the following tasks:
---------------------------------------------------------------------------
\2\ A copy of the PriceWaterhouseCoopers proposal, and the Board's
acceptance letter, were provided to the Committee.
PriceWaterhouseCoopers began their audit activity on April 12, 2000,
and we expect the review to take about 4 months.
---------------------------------------------------------------------------
Conduct a closeout review of the Rapidraft Payment System;
Document NTSB's financial management processes and
systems;
Perform a baseline analysis of existing financial polices,
procedures and systems;
Test internal controls;
Develop internal control recommendations; and
Assess audit readiness.
As I noted, the IG's report on the investigation was received at
the Board on March 21, 2000, and we are currently preparing an action
plan that will address all stated recommendations. As a result of the
IG's work, we understand that one of the two clerical employees
originally referred to the IG by NTSB has been indicted, and the other
is pleading guilty for criminal acts involving embezzlement.
I would like to close by indicating NTSB's appreciation for the
work of Ken Mead and members of his staff. This has obviously been a
difficult time for NTSB, but as an institution we strongly favor having
the ability to resort to independent, expert assistance as a means of
quality assurance and improved performance. We would like to thank the
DOT IG for providing that service to us in this case. Mr. Chairman,
that completes my statement and I will be happy to respond to
questions.
Mr. Sununu. I would like to begin the questioning by
discussing the 1997 Treasury FMS recommendations and the
changes that were recommended as part of that process. And also
I know there were some controls, control changes recommended as
part of the Inspector General's audit. Could I ask you to talk
about those changes? Specifically, has the new system for
financial control been implemented, what elements are in place
and working, and what elements are yet to be implemented?
Mr. Hall. I think the person with the most knowledge to
respond to that is our CFO, Mr. Levine.
Mr. Levine. This is history, Mr. Chairman, so I am looking
back at a time when I wasn't at the Board. The Board selected
the new accounting system based on work done by the Center for
Applied Financial Management, which is a Treasury entity that
they brought in to look at their old financial system. They
concluded that in order to comply with most of the government
regulations dealing with financial management and the plethora
of laws that have been enacted by the Congress, we needed to
move to an integrated financial management system that was
approved by the Joint Financial Management Improvement Program
and certified by the General Services Administration.
NTSB selected a system with an assistance from the same
consulting group from Treasury. A system was selected. The
vendor is ICF Kaiser, it is called FINASST. That system
recently was again recertified through independent testing by
the Joint Financial Management Improvement Program as a system
that complies with the core financial requirements that are set
by JFMIP and GSA.
Mr. Sununu. If I may, you are not required, though, by law
to comply with the Chief Financial Officer's Act, is that
correct?
Mr. Levine. I have to defer to the Chief Counsel or the
Managing Director on that.
Mr. Hall. No, we are not.
Mr. Sununu. I don't believe that is the case.
So, to be clear, you are setting--as a set of compliance
standards you are using the Joint Financial Management
Improvement Program. Are you required to meet that standard by
law or that is the one that you chose as a best practice model?
Mr. Campbell. There are elements within it that we would be
required to meet. We intend to meet all the elements, because
we do see it as a best practice approach.
Mr. Sununu. And have all of the elements been implemented
to date that enable you to meet those standards? And, if not,
what system needs to be implemented to meet the standards you
have established for yourselves?
Mr. Levine. The system is the accounting system of record,
and was the accounting system of record for all of fiscal 1999.
It is the system we are using to account for the fiscal year
2000 appropriation. It meets all the accounting standards.
Where we find it lacking is we need to better improve the
financial management information reporting capabilities of the
system. I look at it as a powerful data warehouse, but somehow
we don't have a key to opening all the doors.
Basically, we can do the obligation accounting, the
expenditure accounting, all the things required to make
Treasury reporting, but we do not have all the capabilities we
need to provide information to the executives and the managers
of the NTSB to manage their resources as effectively as they
could.
Mr. Sununu. Have you set a time line for achieving those
goals of providing the Board with executive financial
management information?
Mr. Levine. This year we are working with our vendor to
develop scripted management reports that we can put on the
desktops of our managers so they can click on an icon and get
the kind of management information they need.
We are working with the different managers and the
administrative officers to determine what is needed. In other
words, we are not just pushing it, we are trying to work with
them as if they are customers, which they are.
Through the remainder of FY 2000 and into FY 2001, we plan
to invest about $100,000 to $150,000 more for necessary system
enhancements. We are also hiring an additional systems
accountant to help us roll this out.
Mr. Sununu. Let me ask you specifically about the
disbursement system that is, I hope, fully in place fully now
to replace the Rapidraft system. You have gone to a commercial
credit card system, is that correct, the governmentwide credit
card system?
Mr. Levine. Yes, the Board, long before I got here,
implemented both the Citibank travel card and the Citibank
purchase card programs. We have issued more than 350 travel
cards to our investigators and employees who travel. We have
also issued over 100 purchase cards to our investigators and
others with procurement responsibilities.
Mr. Sununu. Do you have documentation requirements that are
more formal than what was used in the past? And are you
performing--I should ask, how frequently are you performing
reconciliation on those credit card accounts?
Mr. Levine. The personal travel cards are like your own
personal card. When Chairman Hall or Dan Campbell travel, or
whatever, the price of the airline ticket is put on the card
through our approved travel agency. All travel expenses are
placed on the card. When we return, we file a travel voucher.
That travel voucher comes to the CFO organization and is
reviewed and processed.
I am concerned because I don't believe the review is
sufficient. One of the things that Ken Mead reported in his
audit report was that we needed to look to a third-party
processor. We are in negotiations with the Department of
Veterans' Affairs to implement a travel voucher processing
system where they will review and pay our vouchers and conduct
post audits.
My intent is to also have DVA perform a post audit on a
sample of FY 2000 vouchers.
Mr. Sununu. Mr. Mead, I want to ask you a couple of
questions about the Rapidraft system in general before opening
it up to Mr. Bentsen for questions. Could you talk a little bit
about the degree to which the Rapidraft system was used in
other departments within agencies within the Department of
Transportation, the volume of Rapidrafts that were previously
used by the FAA, for example, prior to canceling their program?
Mr. Mead. Yes. The FAA this past year spent about $14
million using a like system.
Mr. Sununu. Conceptually, at least, the subcontractor--
third-party subcontractor--was the same Gelco, and the
contractual limitations, $2,500 maximum and authorization
number requirements were similar, is that correct?
Mr. Mead. Yes. But the fact is, we went in and audited the
FAA system in 1997. Although we found no embezzlements, we did
find weaknesses that were remarkably comparable to the ones
that we found at NTSB, unauthorized signatures and so forth.
And we recommended that--at the time, that FAA tighten up that
program.
We could understand how there might be exigent
circumstances or emergencies where you needed it. I don't think
that they fully responded to the recommendations. As a result
of the experience at NTSB and that prior audit work that
program must be terminated.
The Volpe Center is in Massachusetts, the research center.
They, too, were using the like system, as was the Federal
Highway Administration.
Mr. Sununu. Now, there are 10 other Federal departments or
agencies that are using a similar third-party payment system
through the same subcontractor; and another six we have
identified that are using a different third-party draft system.
I understand that you don't know all of the limitations
associated with each of the contracts, but I do want to ask you
a general question which is, do you believe that the weaknesses
you have identified in the nature of a third-party check
writing system, in particular the system that was used through
this subcontractor, do you think those weaknesses are likely to
exist at other agencies--Department of Education, Department of
Energy, Immigration? Do you think it is in the interest of the
committee at least to raise your concerns about the weaknesses
of the system with these other agencies?
Mr. Mead. Yes, I would. I would be surprised if you didn't
find weaknesses, at least to some degree. And here is why: When
you just talk NTSB, which is a small agency cashing
approximately 8,000 checks a year worth about $4 million, it is
a very paper-intensive system. And when you have holes that
turn up where there is no reconciliation, where checks are
being paid and nobody is even signing the check, where there is
no payee, where there is no purpose on the check, you have to
have a very rigorous oversight system to make sure that a check
writing program, is going to be airtight. And that is tough. In
fact, that is why the Federal Government moved to credit cards.
It is much tighter accounting system.
Mr. Sununu. Thank you.
One final question for Chairman Hall, and that is--and Mr.
Levine as well--as you move through this credit card system,
have you found that there is anything unique regarding the
NTSB's critical mission that in certain cases might make the
commercial or government credit card system impractical and do
you think there may be situations in some of these other
agencies that would somehow prevent them from ever implementing
a government credit card system if they chose?
Mr. Hall. I am not aware of any. My answer would be no.
Mr. Sununu. Thank you.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Let me say, first of all, Mr. Mead, with respect to the
chairman's most--his line of questioning there that, on its
face, I think the credit card system clearly works better than
a Rapidraft. And it is an antiquated type structure to use and
does raise the potential, if not for abuse, the potential for
sloppy recordkeeping, if nothing else.
I have yet in my experience in the private sector or the
public sector found an expense reimbursement system that has
been smooth and clean. I know in my old banking days we always
wondered whether the company was carrying us or we were
carrying the company. I am sure that is sometimes the case here
as well.
That being said, obviously the system has some problems;
and I do have a number of questions. Let me go to the
chairman's last question, though.
Mr. Hall, I can see certainly in most cases where you are
buying an airline ticket, charging a hotel room, that the
credit card system works pretty well. In fact, in some cases
you couldn't do it without a credit card. But are there
instances that you could explain to us in the--where in the
case of NTSB, which is a somewhat unique agency, where a credit
card system might not work? I don't think we want to have
Federal employees walking around with a pocketful of cash, but
there are cases where you are on the ground that you have to
have something a little more liquid than a credit card.
Mr. Hall. Well, I might ask Mr. Campbell to comment on this
as well. He has more years of experience than I do in this
area, Congressman.
In the aviation area, our investigators operate sort of the
highway patrol of the skies. Every time there is a fatal
aviation accident, we have an investigator there. They have to
take charge of that wreckage. They have to be responsible for
assisting with the wreckage removal, with the engine tear
downs, other things that are routinely done as part of the
investigation. Obviously, to be able to pay for those things is
very important.
On major accident investigations, it is hard to anticipate
in advance things that you may be called upon to do.
The credit card system, to my knowledge, so far has served
us fairly well.
Mr. Levine wanted to comment. Somebody over was there was
rustling.
Mr. Levine. Congressman Bentsen, the credit card contract
permits the use of convenience checks to handle situations
where credit cards are not accepted by a vendor.
Convenience checks are set up for unique situations. Let me
give you some examples. Convenience checks are limited to
investigators in charge at an investigation, and a handful of
others.
NTSB often has to take custody of wreckage or equipment and
often needs to buy services from the local economy. For
example, the local police department may moonlight and be
willing to provide protection of that material overnight. Last
I heard, off-duty policemen don't take credit cards. The
convenience check program is one way we can handle that.
It is also possible for our people to get cash advances
from their travel card from an ATM machine. They can take these
funds and then seek reimbursement through proper channels when
they come back to their duty station.
So there are a few cases where the credit card just doesn't
work, and the contract with Citibank which GSA negotiated for
all of government does provide for that. We have limited the
utilization of the convenience checks, and very few of them
have been used. We have very bright people doing this work.
They know how to get it done.
Mr. Bentsen. Let me ask just a few other questions. With
respect to the Financial Management Service Review in 1997,
there were a number of recommendations in that report. Some
included adding budget officers and staff, implementing new
systems technology for management--for financial management.
The agency didn't follow through on all those. Were there
budgetary reasons related to that? In the scheme of your agency
that you all go from one emergency to the next emergency?
Mr. Hall. The last 10 years almost any mode of
transportation in the United States doubled. As a result, there
has been a tremendous impact on the work of our agency and the
number of employees we need to accomplish our mission at a time
when everyone else in Washington is basically downsizing.
I have requested every year I have been chairman more
people in my budget. And our committees of Congress normally,
usually over the objection of the Office of Management and
Budget, have assisted us in getting more people. In retrospect,
we took most of those additional people and placed them in
investigative positions in order to accomplish the mission. And
I did not, at the same time, put enough people in our
accounting and budget office to perform the mission of the
additional amount of money that we were using.
We will have additional employees in the new fiscal year.
Many times, I find those employees are tied by OMB or Congress
to specific slots. I have difficulty getting money to fund
accountants. I am going to take the first people we get and be
sure that we have enough people to be responsible stewards of
the money we are given.
So that is a long answer of saying I think, yes, we have
had some difficulties in being able to accomplish everything
that we wanted to do because of manpower limitations.
Mr. Mead. My I offer a perspective on that?
I think in this case, as in the case in many situations in
government and private industry, the leadership and stewardship
of the people you have in place is critical. And here, as is
illustrated by the experience with the Rapidraft system, there
were plenty of early warning signs given directly to the Chief
Financial Officer. And they were not acted on. And I think with
the new leadership in place, that you should see a strong
improvement.
Mr. Bentsen. This reminds me a little bit of graduate
school. This is going to be a great case study some time.
Mr. Mead, two things. One is, as I understand it, H.R.
2910, the NTSB reauthorization that passed last year now does
give you authority to look at NTSB?
Mr. Mead. Yes, sir, on rather nonjudgmental financial
management areas only. And I think it would be inappropriate to
have the Inspector General for the Department of Transportation
in a position to second guess programmatic judgments or
investigative judgments of the NTSB. So, yes, that is in the
bill. It has passed. It hasn't moved through the Senate yet,
and we are prepared to do it if the Congress wants us to, but
we don't want authority into the programmatic areas.
Mr. Bentsen. So you want to limit it to the financial
scope.
Mr. Mead. Keep it clean, rules and regulations, internal
controls that reasonable people can agree upon and you can
empirically audit.
Mr. Bentsen. That would solve that part of the problem in
your testimony.
Mr. Mead. Yes, it would.
Mr. Bentsen. In your investigation and in the investigation
that was carried out that Justice is now involved in with the
two individuals that have been indicted, is the loss to the
government, the taxpayers, the fraud or theft limited to the
two payments, the $90,000? Did you find any overpayment of a
contractor? Or was it a case of inefficient bookkeeping,
recordkeeping, questionable use of using the Rapidraft Payment
System for paying accounts that probably should have been paid
out of another vouchering system? Or have you found a situation
where there might be other, higher dollar misuse of funds?
And I know there is a difference of agreement with respect
to Board orders in 1992 and 1995 as to what areas are covered,
and we could get into that debate. But I guess my question is,
bottom line, other than lax controls and using the Rapidraft
system for vouchers that other systems should have been used
for, did you find other cases where Acme Trucking Corp. was
paid more money than it should have been paid or anything like
that?
Mr. Mead. We do not know of any embezzlements other than
the one that we have reported to you. I would be surprised if
there were not other instances of abuse of this system, but
they would be very difficult to track down. Why? Well, when
nobody signs the check and it is paid or there is no purpose
and no documentation underlying it, it is difficult to tell
what the purpose was for or whether it was for a legitimate
expense.
I think the fair answer to your question is that the vast
majority of these checks were probably written by upstanding
people for legitimate purposes. Where there were weaknesses was
in internal controls and so forth, and sloppiness. But I can't
vouch that we have uncovered all the abuse in this program.
Mr. Bentsen. I assume the PriceWaterhouseCoopers audit
should show some of that.
You raised one issue that I hadn't thought about, and my
time is up, but the way this system works is there is a
contractor who is the bank account holder on behalf of the
agency, and the check is written and passed through them. But
they cleared checks without a signature?
Mr. Mead. Yes, sir. Do you see this package here? When we
went to NTSB when Chairman Hall said come on in here and
investigate and audit, we said, let's see the checks. And my
auditors picked up unopened packages of checks that had been
sent to NTSB's Chief Financial Officer unopened, bundles of
them. Well, under the contract----
Mr. Bentsen. Canceled checks.
Mr. Mead. Oh, yes. These are all paid, and it was never
opened by anybody, so there was never any reconciliation done.
And under the terms of the contract with the vendor, at least
our reading of it, NTSB had 45 days to tell them don't pay this
check. But since there was no reconciliation or review, that
just wasn't done. And now the 45-day period that NTSB did have
to assert a claim has expired.
Mr. Sununu. If Mr. Bentsen would--thank you, Mr. Bentsen.
So that point--we have a check here that is displayed on
our far right that gets to the point that you raise, which is a
check that was cleared by the third-party contractor and it has
no authorizing signature on it whatsoever. And there is a 45-
day period where there might be a response but clearly there
were significant problems with both internal controls not
performing reconciliation but with the controls and the process
used by the third-party contractors.
I would like to ask unanimous consent that all members be
allowed to revise and extend their remarks and also ask
unanimous consent that we include in the record a list of other
departments or agencies that are using this third-party
contractor. Without objection.
[The information referred to follows:]
List of Federal Departments or Agencies That Gelco Provides Third-Party
Draft Services To
African Development Foundation
U.S. Department of Treasury--Bureau of Engraving & Printing
Federal Aviation Administration
Immigration & Naturalization Service
Internal Revenue Service
U.S. Department of Treasury
U.S. Mint
Office of Thrift Supervision
Federal Highway Administration
Internal Revenue Service--Southeast
U.S. Department of Energy
U.S. Department of Energy--Oak Ridge
U.S. Department of Education
U.S. Department of Transportation--Volpe
Mr. Sununu. I recognize Mr. Miller for 5 minutes.
Mr. Miller. Rapidrafts, often in the private sector known
as voucher systems, meet accountability standards when they are
used properly and they are reviewed properly, so I don't want
to get the focus off the Rapidraft, saying that is the problem.
That is not the problem. But when you have checks written to
Myriad Investments and the intent of those checks, as you said,
Mr. Mead, are supposed to be used for accident and nonaccident
purposes. A flag should have come up to somebody that you don't
pay it.
When a check comes to Gelco with no signature, the fact is
it should not have been paid. When a check comes to Gelco--and
please put one of the ones up that exceed $2,500--exceeding
$2,500, the fact is the check should not be paid. Period.
Now, there is not any question that there was some
corruption internally. But I don't think there is any doubt
that there is incompetence on the part of Gelco if you look
what has happened and transpired. If you go to the Gelco
contract, it is very specific. Gelco Payment System and the
National Transportation Board agree to notify each other
immediately of any misuse of the Rapidraft authorization--
Rapidraft orders.
Now a certain amount of those were done. Many were not,
based on the investigation.
Also, Gelco's payment system assumes responsibility for the
face value of Rapidraft orders which fail to properly screen or
be rejected. And if you look at their daily draft processing
and standard violation systems, these checks did not comply
with the criteria necessary to process those checks.
Travel cards are going to be no better than Rapidrafts if
oversight does not occur. I have done dozens of loans when I
was in the building industry with lending institutions that we
used voucher systems or Rapidrafts, and they work if done
properly, without a doubt.
And I don't want to get off the focus of Rapidrafts, saying
that is our problem here and we are going to stop using
Rapidrafts and when we stop using Rapidrafts the problems go
away. That is not true. And there are certain Rapidrafts or
vouchers or payments that are going to continue into the future
that are going to be made to vendors, am I not correct? Nobody
in their right mind is going to use their travel card to pay
those. So they are still going to be paid.
And that is where the problem lies. And the shift to using
a travel card does not deal with the problem.
Gelco did not do their job. They were incompetent. And
there was corruption on the part of staff, without a doubt. And
we don't know how widespread that corruption was, and we don't
know how widespread this is here. So you have a checks and
balances system.
In fact, Al Gore praised this system in one of his
statements, saying this is how we reinvent government. We have
taken care of it because we installed the checks and balance
system that, if used properly, works.
And in your testimony--Mr. Mead, you stated, contrary to
NTSB policy, drafts were paid when they exceeded the $2,500
limits. It was printed on the check that these Rapidrafts
should not exceed that amount. Why did Gelco honor these
checks?
Mr. Mead. I can't respond to that.
Mr. Miller. That is what I thought.
Mr. Mead. The $2,500 is an NTSB order, and it was in the
agreement with the contractor. But employees internal to NTSB
wrote letters to Gelco saying for these employees, honor the
checks over $2,500 all the way up to, in one case, $20,000. In
another case, under the contract with the contractor, NTSB
committed to notify the contractor whenever somebody left and
was no longer an authorized user. They did not do so. Then
employees internal to NTSB would sign somebody else's name who
had been an authorized user. Gelco pays the check. So----
Mr. Miller. The largest checks that were cashed were to
J.D. Rainbolt Contractors--one for $7,500 one for $16,000, one
for $20,000, one for $5,000, one for $26,000, one for $13,000--
were by a former employee, not even employed at the time when
he wrote them. I mean, it is more than Rapidrafts. It is
internal incompetence on the part of the government and on the
part of the agency that is supposed to be supervising the
payment of these.
It says clearly $2,500. And if you put one of the checks
up, that shows $2,500 crossed off by the person signing the
check, and it was paid.
I guess I have a question. Is Gelco being held accountable
for paying these? Are they being prosecuted right now? Can
anybody answer that?
Mr. Mead. No, not to my knowledge.
Mr. Miller. Why not? I have a contract right here signed by
William Park, signed by--I can't read the other name--but one
by Gelco, and one by part the government, that specifies what
they are to do. It specifies accountability. It specifies the
process to go through. This is not new. This has been known.
In fact, one thing that really bothers me is, when I go to
the history of events--and this is for Mr. Hall. You became
aware of this in August of last year. Yet on September 23 we
did a markup of your authorization bill, and you came before us
as a committee. You never mentioned it. And on September 30,
the bill was passed on the House floor, and you never mentioned
it. And yet you knew about this problem in August.
Now, trust me, we have always voted for this stuff. Based
on statements made before us on May, 1999, that you never
refuted when you found out they were incorrect, one is, I know
nothing that has caused me any concern.
In addition, Mr. Keller notified--he was a financial
officer. He was a problem. ``Eighty percent of our budget is
dedicated to the people, so there is not a whole lot of
flexibility as far as abuse or fraud or whatever that can take
place,'' was stated. And also the statement was made, ``The
most important job you have given me is responsibility for
handling taxpayer's money.''
And, Mr. Hall, you gave me the courtesy of coming by my
office yesterday, and you told me that you had notified
everybody when you found out about this, and I took that at
face value. I am not trying to criticize you. But when I look
back, because I was responsible for voting for your
authorization last year, you knew about it a month before we
voice voted it out of committee. You never brought it up. And
it went out unanimously on the floor. You never brought it up.
Why not?
Mr. Hall. At the time that I learned of this, I notified
Mr. Mead and attempted to follow every piece of advice Mr. Mead
gave me, including when to advise our committees, because we
were dealing with an ongoing criminal investigation. At the
time that Mr. Mead said we should go and meet with committee
staff and advise them of this matter, we did so. So that is the
reason.
On the matter of those checks, I would like to have a
chance to check those and respond for the record in terms of
who signed those checks and their status at the time they were
signed.
Mr. Miller. I don't have time. We do have those checks. But
I do have the sequence of events as they unfolded. We have to
break.
Mr. Sununu. I appreciate it, Mr. Miller. We will allow
Chairman Hall to make that response for the record.
[The information referred to follows:]
Chairman Hall's Response for the Record Regarding ``Who Signed Those
Checks and Their Status at the Time They Were Signed''
The checks referred to that exceeded $2,500 were signed by Mr. Don
Libera, currently the NTSB's Deputy Chief Financial Officer. At the
time he signed the checks, he was the agency's Budget Officer. Mr.
Libera had specific written authority from the Chief Financial Officer,
which also was provided to Gelco, to write checks in excess of the
$2,500 limit. Because all of the checks were preprinted with the ``NTE
$2,500 limit,'' Mr. Libera crossed through this note and initialed the
checks he wrote that exceeded this limit. All of the checks written
over the $2,500 limit were to expedite payment for legitimate purposes
and were paid to NTSB employees, primarily for travel-related expenses,
or to vendors for supplies or services provided. It should be noted
that when Gelco received a check over the $2,500 limit, they would
usually call appropriate Safety Board CFO personnel to verify
authorization to override the established system limit.
Mr. Sununu. At this time, I would like to yield to Mr.
Clement and make members aware that at the conclusion of Mr.
Clement's questioning we will recess for this vote on the rule
and return back promptly, at which time Mr. Miller will take
the Chair to complete questioning from the remaining members.
Mr. Clement.
Mr. Clement. I don't think I am going to have enough time,
but I will at least start anyway.
Mr. Chairman, as you know, I serve on the House
Transportation and Infrastructure Committee, the jurisdictional
and oversight congressional committee for NTSB. I am acutely
aware of the tremendous significance of the National
Transportation Safety Board.
Under Chairman Hall's leadership, the NTSB has had to
address some of the most challenging national transportation
catastrophes on record. As a fellow Tennesseean, I will say I
am especially proud of Chairman Hall's commitment to excellence
and public service.
Like other members here, I strongly believe that every
level of the Federal Government should be held accountable for
its actions. On behalf of American taxpayers, Chairman Hall has
worked to make improvements in the deficient financial
accounting system that he inherited from the previous
administration in 1994. He has indeed worked on behalf of
taxpayers by reversing NTSB practices that were mismanaged.
Mr. Hall--Chairman Hall, it is my understanding that NTSB
does not have an IG of its own. You contacted the Department of
Transportation's IG to come in and do an audit of the Rapidraft
check system, payment system. You have also contracted with
PriceWaterhouseCoopers to do an outside audit as well. Do you
feel that it would be beneficial to the NTSB to have an
internal IG instead of having to rely on DOT's IG?
Mr. Hall. I certainly would have no objection to an
internal Inspector General in our agency.
I was told when I first inquired about an IG that our
agency was too small to have a full-time Inspector General. I
consulted with a number of people on getting that advice. But I
think it is imperative that our agency in the future have an
annual audit of all of our financial activities, and we are
moving to do that.
Mr. Clement. Mr. Mead, do you have any comment about the
question I asked?
Mr. Mead. Just a point of perspective. When a problem comes
up like this, you need a critical mass to be able to deploy. I
think you can make a case for an internal IG. I think you can
make a case for having a Cabinet-level IG with the critical
mass that can come in.
Mr. Hall and I have a very good professional and personal
relationship, and I think that helps a great deal. You would
have a problem if--you have a case like this come up--there is
no way that NTSB could responsibly have a permanent IG staff of
10 or 15 people. And that is the only perspective I would have.
If you want us to do it, we will do it. But please don't give
us any responsibilities that go into the programmatic area or
the investigative area. Keep it down to the financial
management.
Mr. Clement. I may have another question or two when we
come back.
Mr. Sununu. We have approximately 4 minutes left in the
vote. If you would like to ask one of your questions and you
can resume questioning when we return.
Mr. Clement. I will wait.
Mr. Sununu. We will recess at this time. We will reconvene
as soon as we return from the vote. Thank you, gentlemen.
[Recess. ]
Mr. Miller [presiding]. I would like to correct one
misstatement that I made on the checks that were in the
individual larger amounts, the individual was still employed.
But the comment was more directly to the Rapidrafts were not to
be used for this type of purpose at this amount. And that was
the issue.
Mr. Toomey, do you have questions?
Mr. Toomey. Is Mr. Clement finished?
Mr. Clement. I am through. And I appreciate what you just
said, Mr. Chairman; and Mr. Hall may want to comment.
Mr. Hall. No, that is fine.
Mr. Clement. Thank you.
Mr. Toomey. I will be brief, but I did want to just get
actually maybe both Mr. Mead and Mr. Hall to react to some
thoughts.
First of all, if we look at the case of the Rapidraft
payments that the IG reviewed, there were 1,000. And I take it
there is no reason to believe that that is not a representative
sampling. And when we consider that 90 percent of these had
some kind of noncompliance, one kind or another, it suggests,
obviously, a routine lack of regard for the rules of
compliance. And I wonder if it doesn't reveal to some degree
almost a culture of disrespect for certainly the rules of the
reimbursement, the whole Rapidraft system, and I wonder how
much more pervasive that culture would be of disregarding rules
which are really rather important.
Now, I take it that your investigation focused more on
discovering individual and systemic misuse rather than focusing
on whether there was criminal intent or fraud that went with
that. But I was wondering, Mr. Mead, if you could clarify that
for me a little bit.
Mr. Mead. I will try, yes, sir.
Inspector General offices are divided into two parts. One
side is a criminal investigative, looking at quasi-criminal
administrative violations that get an individual in serious
trouble. The other side of an IG operation is audit, program
evaluation, financial audit where you look at the effectiveness
of the programs.
And in a case like this, what we had was criminal
misconduct, and we suspected that from the beginning. But once
we got in there and saw the type of criminal misconduct and how
it was allowed to occur, the latter--the unauthorized people
signing checks, the no-known purpose on them, the no payees,
going over the limits, things of that nature--we began to see
that there was an underlying vulnerability to this whole
program. That triggered the audit side of our office which led
to the broader audit, sir.
Mr. Toomey. But as for those broader audits, we had a
system that we know was extremely vulnerable to abuse.
Obviously, if you don't need to sign checks, you don't even
need to write a payee and yet the check will be cashed. And yet
there are only two cases of fraud and embezzlement that have
been pursued on a criminal level. With such a high degree of
noncompliance it strikes me there must be a whole lot more
flaws that occurred that we don't know about certainly beyond
those two cases. And that is--you know, I have no direct
evidence of that, just by the sort of--intuitively seems quite
likely. So one of my questions is, what do we do about that?
What can be done?
Mr. Campbell. If I may respond to that, Congressman, that
is the first order of business with our contract with
PriceWaterhouseCoopers. We understood from the nature of the
investigation that DOT IG did for us that they would not
necessarily get to the universe of all the difficulties that
they might see. And so the first order of business we have with
the independent audit firm is to assess that problem for us and
give us some advice on how to proceed. The agency has chosen to
continue to pursue that issue.
Mr. Toomey. And specifically with respect to the checks
that were cashed a year ago or 2 years ago with the old
payments, are they still being investigated or is that the kind
of thing where that is being given up and we are trying to
prevent repeat offenses?
Mr. Campbell. No, sir we are looking at the past.
Mr. Toomey. In the inspection that you did do, the auditing
and investigation work that you did, was most of the
noncompliance that was cited about the handling of the
Rapidraft system itself and fault in that process? Could you
also tell me about to what extent do you believe that these
items that were being paid for were purchasing things that
either were not intended to be--you addressed those which were
not intended to be used by the Rapidraft system--but what about
items that shouldn't be bought at all that were being
purchased? Any more thoughts on that?
Mr. Mead. Yes, there is clearly some instances of those
where you don't really know what the payment was for. You see
the check behind you to American Express. That is one where
nobody signed. But even if it was signed, the question occurs,
well, what about American Express? Why were you writing checks
to American Express? What was it for? And there are a lot in
that category. A large number.
Mr. Campbell. If I could expand on that. The actual Gelco
book that you write checks from has a check at the top and a
series of additional documents that--additional parts of the
document that need to be filled out. What we will attempt to do
is take some of the difficult, the problematic checks and marry
them back up with their underlying documents which themselves
need to be accompanied by the obligating form.
The check is not actually permission to obligate money. The
check is just a way of making the payment. Each check needs to
be accompanied either by a training form, a travel voucher, a
4400 for purchases and so forth.
So there is an opportunity to go back and look at these
checks and ask yourself, one, do we have the documents--of
course, the ones we don't have the documents for would then by
themselves be particularly suspicious. But if we have the
documents you can review the document to give you some sense of
what the underlying purchase was about and make a determination
about whether it was for an authorized purpose or not. And that
is our intention.
Mr. Toomey. So that is ongoing, that investigation.
Well, finally, just my last question for the Chairman, are
you concerned that there may be within the Board a sort of
culture of disrespect for internal rules and procedures, a sort
of lax attitude that has been revealed by this whole discovery
that might pervade both the institution and into other areas
other than just the finances?
Mr. Hall. Congressman, I have a great deal of respect for
all of my employees. Setting the culture of the agency is the
responsibility of the management of the agency. I can assign
that responsibility, but I must accept that accountability. In
this case, the individual that was responsible was not
enforcing the type of culture that should be in place.
We are going to, as Mr. Campbell said, look at each and all
of these transactions. That is one of the things we have asked
PriceWaterhouseCoopers to do. But, you know, my employee base
there does an outstanding job, in my opinion, performing their
mission. And a part of their mission and part of their time was
supposed to be given and needed to be more directed toward a
proper accounting of these funds, and so we are going to put an
emphasis on that. If we had a cultural problem, we are going to
change that cultural problem.
I don't know how else to comment on it. I don't choose to
be in this position. The employees in the agency work very hard
in their job. It is the responsibility of management to lay
down that culture and direction for them. In this area we have
not been as successful as I would like. We have had this
embarrassing situation, and I intend to do everything we can if
there is a problem to be sure it is effectively addressed.
Mr. Mead. I think, just from the observations of my own
auditors and investigators, there was a culture of looseness at
the top in the Chief Financial Officer's office. You didn't
have an IG that every so often did visitations at the agency on
a routine basis to make sure everything was honest. We found
that, transcending the Rapidraft program, there were problems
with the travel vouchers not being reviewed. The computer
equipment frequently wasn't inventoried properly. The CFO
should have made sure that employees got periodic ethics
training. And these things just were not happening.
And I, too, know a number of NTSB employees and have the
highest respect for them. But I do think you have to look at
that CFO for a great deal of leadership. And I don't believe
the Board, Mr. Hall or NTSB was being well served, sir.
Mr. Toomey. Thank you, Mr. Chairman. I yield the balance of
my time.
Mr. Miller. Chairman Hall, a couple of questions I need to
ask you, just to clear up some confusion. Under Federal reg 31
CFR 208, which is under the management of the Federal Agency
Disbursement Act--can you hear me?
Mr. Hall. I was having a little difficulty.
Mr. Miller [continuing]. Which implements the Debt
Collection Improvement Act of 1996, requires the authority of
the Secretary of Treasury to grant waivers of all Federal
payments made after January 1, 1999, when it must be made by
electronic fund transfer. And 31 CFR 208 permits nonelectronic
payment for national security interest, military operations,
national disasters, law enforcement, amounts less than $25,
certain payments in foreign countries or in emergencies or,
``mission-critical circumstances that are of such an unusual
and compelling urgency that the government would otherwise be
seriously injured.''
Based on that, under what circumstance did NTSB qualify for
a waiver of 31 CFR 208 to continue using the Rapidrafts after
January 1, 1999?
Mr. Campbell. Congressman, I don't believe that NTSB
qualified for a waiver under those provisions. And I don't
believe that we had a waiver under those provisions. I think
that the program for the Chief Financial Officer, who is,
unfortunately, not here to answer this question, was to make a
transition to the purchase card program and the travel card
program which we have implemented now as of about September of
1999. And during the period between January 1 and September, I
have personally asked this question and----
Mr. Miller. So you are confirming they should not even have
been using Rapidrafts after January 1.
Mr. Campbell. It is my understanding that we should have
gone to electronic transfer.
Mr. Miller. We need to ask this, because that issue has
come up and we didn't have clarification. The confusion I had--
there was an ongoing problem with a system that shouldn't even
have been in existence.
Mr. Campbell. There would have been a class of transactions
which would have met the exemption standards, particularly
those in the field where the actions are--making an electronic
funds transfer at an accident scene may have been difficult,
but there was another whole class of transactions which
probably would not have met the waiver requirement.
Mr. Miller. Probably the last question I can think of is--
we ran out of colleagues here--is part of the Rapidraft Payment
System NTSB maintained $350,000 in a non-interest-bearing
account with Gelco Information Network Inc. Have you made any
effort to get that money back at this time?
Mr. Levine. We are, right now, trying to get that money
back. There are a couple of issues on float and miscellaneous
charges that my people are trying to reconstruct, but they have
been in contact with Gelco. That is money that was put in
deposit, I believe, as far back as 1989. It is basically to
cover the float. We have been in contact with them, and I have
been assured that that is being expedited.
Mr. Miller. Well, Mr. Hall, you have been very courteous
and kind and forthright, and Mr. Mead, also. I appreciate the
input.
We were told that other members are coming, but we are
going to go check. We will not delay you any longer than you
have to. Is there any final comment you would like to make?
Mr. Hall. No, sir.
Mr. Miller. If somebody doesn't show up in the next 5
seconds, we will thank you graciously for being here today. Our
comments were not an attack. I hope they were not taken as
such. They were not meant to be.
Mr. Knollenberg, I have been informed, will be here within
60 seconds, so I will have to wax eloquently for the next 60
seconds.
This is probably not the best of times--with Egyptair, what
is ongoing right now? We just had a hearing in Transportation
on that issue. It is not the best of times to be here.
I know your focus is on issues very important to us, very
important to commuters. I think you are doing an excellent job
in that area. It is a shame that a situation like this has to
occur. I know you are a man who probably takes this very
personal because you are the top. It is not meant to be
personal.
From our perspective, it is just an issue that was believed
should have been discussed publicly, and it sounds like just
the process we have taken has changed some other agencies from
the direction they have gone in using these, trying to come up
with more of an accountable system. It sounds like and it
appears like the individual now you have put in charge of CFO
is going to be a thumbs-on individual and he is going to make
sure something like this never occurs in the future, and I am
glad to see that.
But your agency does an excellent job, and this hearing is
not in any way intended to impugn the quality of work you do.
Because you do top-quality work. We are not--that is not the
goal. It is more accountability. And I know that you have taken
many steps to create accountability, and we thank you for that.
And, again, I want to say there was nothing personal in the
questions that had to be asked. I think we are all glad they
probably were, and we can move forward when Mr. Knollenberg
shows up to ask his final questions.
Mr. Clement. Mr. Chairman how do you stay physically in
shape and be mentally alert? That is what I would like----
Mr. Miller. You keep me in line. I try very hard, sir.
Why don't we talk a break for just a minute or so for Mr.
Knollenberg? We will adjourn the meeting after that.
[Recess.]
Mr. Miller. We are going to reconvene the meeting.
Mr. Knollenberg has walked in. He has 20 seconds worth of
questions left, because he has used up 40 minutes and 40
seconds already.
Mr. Knollenberg. Well, I apologize for being late. Three
places at the same time doesn't work.
Let me again welcome everybody, and I appreciate your being
here. I am sure I might touch on a question that has been
handled before, and if it has just mention that. Mr. Chairman,
you obviously may want to reflect on that, too.
Simple question, and I will get right to the heart, it was
how many Rapidrafts exceeded 5,000?
Mr. Levine. $5,000 or $2,500, sir?
Mr. Knollenberg. I am sorry. Your question was what again?
Mr. Miller. How many exceeded 2,500?
Mr. Levine. I sorted it----
Mr. Knollenberg. I am asking how many exceeded 5,000.
Mr. Levine [continuing]. I have a list. And the only reason
I asked for clarification, sir, is my list tells me we issued
about 169 that were over $2,500. I will have to go back to that
list and to get you an answer. If I could provide that for the
record, I will.
Mr. Mead. I have the answer here, so you won't have to do
that. There were 70 Rapidrafts totalling $708,000 written for
amounts between 5,000 and 28,000.
Mr. Knollenberg. That is fine. What was the maximum
Rapidraft limit authorized for any user?
Mr. Mead. Under the Board order, the limit was $2,500.
Mr. Knollenberg. Who were the persons primarily involved in
writing the over-limit checks?
Mr. Mead. Mr. Libera, who was a Deputy Chief Financial
Officer, and Mr. Mills, who was an Accounting Officer. And I
should note that administratively they wrote or their
supervisors wrote to the vendor Gelco and said please authorize
these people to write checks over $2,500. The NTSB Board never
approved that.
Mr. Knollenberg. Another quick question, for what
purposes--and this is probably general, but what purposes were
the checks written for and what was the total dollar value?
Mr. Hall. We have Mr. Libera here.
Mr. Knollenberg. That question has been raised before. I am
not trying to duplicate. If you can't do it quickly, would you
do it for the record?
Mr. Hall. Be glad to do it for the record. Yes, sir.
[The information referred to follows:]
RAPIDRAFTS OVER $2500
[Fiscal Years 1997-1999]
----------------------------------------------------------------------------------------------------------------
Cleared
No. FY Last Name First Name Date Check Number Amount Pay to Purpose
----------------------------------------------------------------------------------------------------------------
1 1997 Libera Jr Donald P. 80697 020001231-9 $2,644.67 North American Invoice
Van Lines
2 1997 Libera Jr Donald P. 81597 020001237-3 $4,703.21 Shane Lack Travel Voucher
3 1997 Libera Jr Donald P. 81897 020001236-4 $3,717.55 Robert Benzon Travel Voucher
4 1997 Libera Jr Donald P. 82697 020001245-4 $5,137.89 Robert Hilldrup Travel Voucher
5 1997 Libera Jr Donald P. 82997 020019002-4 $4,896.93 Ronald Schlede Travel Voucher
6 1997 Libera Jr Donald P. 90297 020019003-3 $3,807.48 Alfred Travel Voucher
Dickinson
7 1997 Libera Jr Donald P. 90497 020001234-6 $3,560.19 Dennis Jones Travel Voucher
8 1997 Libera Jr Donald P. 90897 020019011-4 $8,709.96 Ronald Schlede Travel Voucher
9 1997 Libera Jr Donald P. 90897 020019008-7 $3,819.24 Ronald Travel Voucher
Wentworth
10 1997 Libera Jr Donald P. 90897 020019006-9 $3,176.26 Cynthia Keegan Travel Voucher
11 1997 Libera Jr Donald P. 90997 020019005-1 $3,153.58 Deepak Joshi Travel Voucher
12 1997 Libera Jr Donald P. 91097 020001249-9 $10,729.59 Robert Francis Travel Voucher
13 1997 Libera Jr Donald P. 91097 020019007-8 $3,395.38 George Black Travel Voucher
14 1997 Libera Jr Donald P. 91097 020019009-6 $2,508.58 Gordon Hookey Travel Voucher
15 1997 Libera Jr Donald P. 91297 020019001-5 $3,930.20 Keith D. Travel Voucher
Holloway
16 1997 Libera Jr Donald P. 91297 020019010-5 $2,689.92 Gregory J. Travel Voucher
Phillips
17 1997 Libera Jr Donald P. 91597 020019014-1 $3,815.76 Paul Schlamm Travel Voucher
18 1997 Libera Jr Donald P. 91897 020019015-9 $2,950.35 Matthew M. Travel Voucher
Furman
19 1997 Libera Jr Donald P. 92297 020019025-8 $2,852.08 James Skeen Travel Voucher
20 1997 Libera Jr Donald P. 92997 020019052-8 $10,162.68 Robert Benzon Reimbursement
21 1997 Libera Jr Donald P. 92997 020019018-6 $4,744.42 James R. Jeglum Travel Voucher
22 1997 Libera Jr Donald P. 92997 020019017-7 $2,890.73 Malcolm Brenner Travel Voucher
23 1998 Libera Jr Donald P. 10898 020019283-2 $3,166.52 Richard J. Travel Voucher
Wentworth
24 1998 Libera Jr Donald P. 11498 020019282-3 $2,871.61 Matthew M. Travel Voucher
Furman
25 1998 Libera Jr Donald P. 12198 020019286-8 $4,596.76 Linda A. Jones Travel Voucher
26 1998 Libera Jr Donald P. 12698 020019289-5 $6,106.39 Richard J. Travel Voucher-
Wentworth Prehearing
Prep
27 1998 Libera Jr Donald P. 12698 020019288-6 $6,045.76 Ronald Schlede Travel Voucher-
Prehearing
Prep
28 1998 Libera Jr Donald P. 12898 020019287-7 $5,194.33 John Goglia Travel Voucher
29 1998 Libera Jr Donald P. 20498 020019290-4 $3,509.67 Robert McGuire Travel Voucher
30 1998 Libera Jr Donald P. 20598 020019292-2 $6,183.51 Robert Hilldrup Travel Voucher
31 1998 Libera Jr Donald P. 20698 020019293-1 $5,442.72 Cynthia Keegan Travel Voucher
32 1998 Libera Jr Donald P. 20698 020019291-3 $4,897.93 Robert Francis Travel Voucher
33 1998 Libera Jr Donald P. 20998 020019295-8 $4,696.18 Jamie Finch Travel Voucher
34 1998 Libera Jr Donald P. 21798 020019296-7 $3,000.20 Robert Travel Voucher
Macintosh Jr.
35 1998 Libera Jr Donald P. 22098 020019303-9 $6,513.41 Robert Travel Voucher-
Macintosh Jr. Silk Air
36 1998 Libera Jr Donald P. 22398 020019302-1 $7,714.14 Greg Phillips Travel Voucher
37 1998 Libera Jr Donald P. 22398 020019299-4 $4,473.88 Malcolm Brenner Travel Voucher
38 1998 Libera Jr Donald P. 22498 020019301-2 $6,297.40 Scott Warren Travel Voucher
39 1998 Libera Jr Donald P. 22598 020019297-6 $2,938.00 Richard Parker Travel Voucher
40 1998 Libera Jr Donald P. 31098 020019309-3 $6,692.20 Barry Sweedler Travel Voucher
41 1998 Libera Jr Donald P. 31198 020019307-5 $3,411.66 Robert Francis Travel Voucher
42 1998 Libera Jr Donald P. 31198 020019306-6 $3,288.47 Deborah Smith Travel Voucher
43 1998 Libera Jr Donald P. 31298 020019308-4 $2,602.25 Denise Daniels Travel Voucher
44 1998 Libera Jr Donald P. 32598 020019312-9 $5,233.23 James Hall Travel Voucher
45 1998 Libera Jr Donald P. 32798 020019310-2 $4,403.19 Jerome Travel Voucher
Trachette
46 1998 Libera Jr Donald P. 40198 020019311-1 $3,548.83 Paul Weston Travel Voucher
47 1998 Libera Jr Donald P. 40998 020019317-4 $5,326.21 Thomas Haueter Travel Voucher
48 1998 Libera Jr Donald P. 40998 020019314-7 $5,237.61 Deborah Smith Travel Voucher
49 1998 Libera Jr Donald P. 41398 020019319-2 $6,260.06 Robert Hilldrup Travel Voucher
50 1998 Libera Jr Donald P. 41398 020019316-5 $4,918.46 John Goglia Travel Voucher
51 1998 Libera Jr Donald P. 41498 020019320-1 $3,175.35 Thomas Conroy Travel Voucher
52 1998 Libera Jr Donald P. 41798 020019322-8 $4,655.14 Gregory A. Travel Voucher
Feith
53 1998 Libera Jr Donald P. 42098 020019326-4 $9,157.86 Robert Francis Travel Voucher
54 1998 Libera Jr Donald P. 42798 020019321-9 $5,272.43 Evan Byrne Travel Voucher
55 1998 Libera Jr Donald P. 42898 020019329-1 $6,785.50 Scott Warren Travel Voucher
56 1998 Libera Jr Donald P. 42998 020019327-3 $4,387.70 James Pericola Travel Voucher
57 1998 Libera Jr Donald P. 43098 020019332-7 $6,881.87 James Hall Travel Voucher
58 1998 Libera Jr Donald P. 50898 020019331-8 $5,317.69 Gregory Travel Voucher
Salottolo
59 1998 Libera Jr Donald P. 51398 020019335-4 $5,644.60 Robert Francis Travel Voucher
60 1998 Libera Jr Donald P. 51398 020019333-6 $3,395.27 Ronald Robinson Travel Voucher
61 1998 Libera Jr Donald P. 60998 020019337-2 $6,473.44 Gregory Feith Travel Voucher
62 1998 Libera Jr Donald P. 61598 020019340-8 $2,839.83 Robert Francis Travel Voucher
63 1998 Libera Jr Donald P. 62298 020019341-7 $5,000.00 Gregory Feith Advance for
Travel
64 1998 Libera Jr Donald P. 62998 020019342-6 $3,597.08 Gordon Hookey Travel Voucher
65 1998 Libera Jr Donald P. 81398 020019345-3 $6,309.77 James Hall Travel Voucher
66 1998 Libera Jr Donald P. 100197 020019057-3 $8,816.11 Gary K. Abe Travel Voucher
67 1998 Libera Jr Donald P. 100297 020019059-1 $14,466.36 Gregory Feith Travel Voucher
68 1998 Libera Jr Donald P. 100397 020019058-2 $2,995.47 Gary K. Abe Travel Voucher
69 1998 Libera Jr Donald P. 100797 020019062-7 $3,156.32 American Airfare RE
Express
70 1998 Libera Jr Donald P. 100797 020019064-5 $2,694.00 Rivy Cole Travel Voucher
71 1998 Libera Jr Donald P. 100897 020019063-6 $4,830.44 Peter Goelz Reimbursement
72 1998 Libera Jr Donald P. 100997 020019066-3 $6,476.75 Woodfield employee
Suites accomodations
73 1998 Libera Jr Donald P. 101097 020019056-4 $4,089.87 Richard parker Travel Voucher
74 1998 Libera Jr Donald P. 101497 020019068-1 $2,822.63 Gregory Feith Travel Voucher
75 1998 Libera Jr Donald P. 102297 020019074-4 $4,089.87 Richard B. Travel Voucher
Parker
76 1998 Libera Jr Donald P. 102497 020019252-6 $8,904.04 Lawrence D. Travel Voucher
Roman
77 1998 Libera Jr Donald P. 102797 020019255-3 $2,709.00 Barry Sweedler Travel Voucher
78 1998 Libera Jr Donald P. 110697 020019258-9 $5,516.21 Robert m. Travel Voucher
Macintosh
79 1998 Libera Jr Donald P. 110797 020019259-8 $3,269.50 Linda Jones Travel Voucher
80 1998 Libera Jr Donald P. 111297 020019260-7 $2,516.60 Richard J. Travel Voucher
Wentworth
81 1998 Libera Jr Donald P. 111897 020019263-4 $5,386.47 Jim Hall Travel Voucher
82 1998 Libera Jr Donald P. 111897 020019261-6 $2,723.47 Gregory Travel Voucher
Phillips
83 1998 Libera Jr Donald P. 112497 020019264-3 $5,176.33 Jamie Finch Travel Voucher
84 1998 Libera Jr Donald P. 120997 020019267-9 $3,577.05 Dennis Grossi Travel Voucher
85 1998 Libera Jr Donald P. 121997 020019273-3 $3,339.19 Jerome Travel Voucher
Frechette
86 1998 Libera Jr Donald P. 122297 020019270-6 $2,821.60 Robert Francis Travel Voucher
87 1998 Libera Jr Donald P. 122397 020019272-4 $3,212.69 Paul Misenick Travel Voucher
88 1998 Libera Jr Donald P. 122697 020019280-5 $3,789.36 Ronald Schlede Travel Voucher
89 1998 Libera Jr Donald P. 122997 020019271-5 $2,699.65 Kenneth Egge Travel Voucher
90 1998 Libera Jr Donald P. 123197 020019278-7 $2,738.41 Deborah Smith Travel Voucher
91 1999 Libera Jr Donald P. 040899 030400001 $8,202.13 James E. Hall Travel Voucher
92 1999 Libera Jr Donald P. 112398 010030512 $2,799.47 Tom Conroy Travel
Reimbursement
93 1998 Mills William J. 81798 020033326-8 $4,070.00 James V. Travel Voucher
Roberts
94 1998 Mills William J. 81798 020033327-7 $3,232.54 Michael T. Travel Voucher
Brown
95 1998 Mills William J. 82898 020033328-6 $2,979.07 George Black Travel Voucher
96 1998 Mills William J. 90298 020033330-4 $3,003.80 Paul Alexander Travel Voucher
97 1998 Mills William J. 90998 020033331-3 $4,435.76 Paul Misenick Travel Voucher
98 1998 Mills William J. 91198 020033332-2 $2,780.02 Dennis L. Jones Travel Voucher
99 1998 Mills William J. 92298 020033337-6 $4,693.43 Alfred Travel Voucher
Dickinson
100 1999 Mills William J. 020599 020033362 $6,474.24 Robert Francis Travel Voucher
101 1999 Mills William J. 031799 020033365 $2,980.77 Deepak Joshi Travel Voucher
102 1999 Mills William J. 100898 020033343 $3,902.65 Paul Misenick Travel Voucher
103 1999 Mills William J. 101398 020033350 $2,737.00 James Hall Travel Voucher
104 1999 Mills William J. 101498 020033345 $2,576.77 Ronald Schlede Travel Voucher
105 1999 Mills William J. 101998 020033347 $4,720.01 Robert Francis Travel Voucher
106 1999 Mills William J. 102298 020033351 $4,571.66 John Goglia Travel Voucher
107 1999 Mills William J. 102798 020033352 $3,025.17 Deepak Joshi Travel Voucher
108 1999 Mills William J. 111998 020033353 $2,783.64 James Hall Travel Voucher
109 1999 Mills William J. 112598 020033357 $2,934.07 Dave Tew Travel Voucher
110 1999 Mills William J. 112598 020033356 $3,381.28 Dave Tew Travel Voucher
111 1999 Mills William J. 120998 020033360 $3,962.12 Robert Francis Travel Voucher
112 1999 Mills William J. 121198 020033358 $2,530.54 Paul D. Weston Travel Voucher
113 1999 Mills William J. 122198 020033361 $2,583.54 James Hall Travel Voucher
114 1999 Mills William J. 073099 020033372 $3,154.17 James Hall Travel Voucher
115 1997 Thomas Laura J. 63097 020018153-7 $2,604.10 American Airfare RE
Express
..... ........... ........... ....... .............. $515,396.10 TOTAL TRAVEL 115 DRAFTS
REIMBURSEMENT
================================================================================================================
116 1996 Caldwell Alice 100296 020005696-8 $2,772.00 Training 2000 Registration
MITAGS
117 1997 Libera Jr Donald P. 71897 020001230-1 $14,907.13 Capital Hill Invoice
Reporting
118 1997 Libera Jr Donald P. 80697 020001232-8 $23,412.29 Jacksonville Invoice
Hilton and
Towers
119 1997 Libera Jr Donald P. 81897 020001240-9 $17,000.00 John Davis Attorney
120 1997 Libera Jr Donald P. 81997 020001233-7 $19,723.77 Metrocall pager bill
121 1997 Libera Jr Donald P. 81997 020001239-1 $5,785.19 Tharpe Company purchases
122 1997 Libera Jr Donald P. 82097 020001238-2 $12,705.00 Dupage Airport Invoice
Authority
123 1997 Libera Jr Donald P. 82097 020001241-8 $8,304.31 Proctor Invoice
Electric
124 1997 Libera Jr Donald P. 82597 020001244-5 $11,267.20 Paul Schlamm service
125 1997 Libera Jr Donald P. 82797 020001242-7 $22,407.00 Tratech equipment
International
126 1997 Libera Jr Donald P. 82797 020001243-6 $3,982.17 Nelson Invoice
Marketing
127 1997 Libera Jr Donald P. 90297 020001247-2 $7,000.00 Office of HWY41
Coroner,
Washington Cty
128 1997 Libera Jr Donald P. 90897 020019004-2 $4,530.46 MicroWarehouse purchase
129 1997 Libera Jr Donald P. 90897 020001246-3 $4,500.00 Brave Audio Hearing
visual, Inc.
130 1997 Libera Jr Donald P. 90997 020001248-1 $8,721.15 Embassy Suites Hearing rooms/
Hotel Audiovisual
equip
131 1997 Libera Jr Donald P. 91097 020001250-8 $20,500.00 G.W. Hoch, Inc Comm Ctr A/C
132 1997 Libera Jr Donald P. 91097 020019012-3 $20,000.00 J.D. Rainbolt PO-5th Fl
renovation
133 1997 Libera Jr Donald P. 91097 020019013-2 $4,272.00 Spirit Rewire 5th Fl
Telecommunicat
ions
134 1997 Libera Jr Donald P. 91597 020019023-1 $13,359.20 KEV Corporation 6th floor
renovations
135 1997 Libera Jr Donald P. 91597 020019022-2 $7,000.00 System Safety Accident
Development Investigation
Workshop
136 1997 Libera Jr Donald P. 91797 020019021-3 $13,000.00 Boeing Modifications
Commercial to B-727
Airplane group
137 1997 Libera Jr Donald P. 91997 020019024-9 $20,000.00 J.D. Rainbolt 5th floor
renovations
138 1997 Libera Jr Donald P. 92297 020019051-9 $13,357.00 KEV Corporation 6th floor
renovations
139 1997 Libera Jr Donald P. 92997 020019053-7 $2,800.00 Spirit RE Installation
Telecommunicat 5th&6th
ions
140 1997 Libera Jr Donald P. 93097 020019054-6 $2,918.16 GES Exposition Oshkosh Exhibit
Services
141 1998 Libera Jr Donald P. 10798 020019281-4 $3,996.64 Phillip Photograph TWA
Humnicky 800 Hearing in
Baltimore
142 1998 Libera Jr Donald P. 10898 020019284-1 $3,875.00 Federal Partition RM
Construction 6100 and paint
contractors
143 1998 Libera Jr Donald P. 11498 020019285-9 $9,459.00 Mitech Data NEC Laptops
Systems
144 1998 Libera Jr Donald P. 21198 020019294-9 $5,055.60 Southwestern Bill for TX
Bell Sept-Nov
145 1998 Libera Jr Donald P. 22098 020019298-5 $9,375.00 Federal PO
Construction
Contract
146 1998 Libera Jr Donald P. 30998 020019304-8 $5,000.00 Donald H. TWA 800
Mershon,PHD
147 1998 Libera Jr Donald P. 30998 020019305-7 $3,690.00 Ocngressional PO
Quarterly, Inc
148 1998 Libera Jr Donald P. 42798 020019324-6 $2,900.00 DOD Joint Invoice
Spectrum
Center
149 1998 Libera Jr Donald P. 61198 020019338-1 $5,794.70 Southwestern Bill for TX
Bell office
150 1998 Libera Jr Donald P. 61198 020019339-9 $2,678.70 Southwestern Bill for TX
Bell office April
98-May 98
151 1998 Libera Jr Donald P. 90898 020019346-2 $11,510.00 J&H Marsh & Travel
McLennan, Inc Insurance
152 1998 Libera Jr Donald P. 93097 020019054-6 $2,918.16 GES Exposition Oshkosh Exhibit
Services
153 1998 Libera Jr Donald P. 100397 020019055-5 $2,800.00 General Testing AZ accident,
Laboratories Testing of
school bus
windows
154 1998 Libera Jr Donald P. 100697 020019061-8 $17,400.00 Graduate Procurement
School, USDA Training
155 1998 Libera Jr Donald P. 100697 020019065-4 $10,000.00 KEV Corporation 6th Floor
renovation
156 1998 Libera Jr Donald P. 101797 020019067-2 $24,461.00 J. D. Rainbolt 5th floor
renovations
157 1998 Libera Jr Donald P. 101797 020019071-7 $6,739.75 Campbell Carpet Install carpet/
Service GAPAFA
158 1998 Libera Jr Donald P. 101797 020019073-5 $3,730.75 Spirit install video
Telecommunicat cable/GAPAFA
ions
159 1998 Libera Jr Donald P. 102097 020019072-6 $28,532.25 Loew's L'Enfant Board Meeting
Plaza
160 1998 Libera Jr Donald P. 102297 020019075-3 $5,980.00 S.P.Bryant Refinish
furniture
161 1998 Libera Jr Donald P. 102397 020019253-5 $5,657.18 Capital Hill Invoice
Reporting, Inc
162 1998 Libera Jr Donald P. 102397 020019070-8 $3,278.50 Graebel contract movers/
Companies supplies
163 1998 Libera Jr Donald P. 102997 020019254-4 $3,912.86 Oceaneering TWA 800
International
164 1998 Libera Jr Donald P. 110697 020019256-2 $12,000.00 KEV Corporation 6th Floor
renovation
165 1998 Libera Jr Donald P. 111097 020019262-5 $16,403.80 KEV Corporation 6th floor
renovations
166 1998 Libera Jr Donald P. 111097 020019257-1 $7,890.00 J.D. Rainbolt 5th renovations
167 1998 Libera Jr Donald P. 112597 020019265-2 $3,495.00 George J. Finch CED
Washington program
University
168 1998 Libera Jr Donald P. 121897 020019276-9 $3,714.50 American TWA 800 Hearing
Relocation Invoice
169 1998 Libera Jr Donald P. 122497 020019275-1 $3,910.00 American Invoice
Relocation
170 1998 Libera Jr Donald P. 123197 020019279-6 $20,917.41 Miami Airport Invoice
Hilton &
Towers
171 1999 Libera Jr Donald P. 012799 020019350 $2,957.50 Susan T. Conduct Psych/
Strahan, MD Employment
Examination
172 1999 Libera Jr Donald P. 100598 020019348 $11,076.00 Hyatt Regency Speaker's
Hotel Accomodations
26 Rooms
173 1999 Mills William J. 101998 020033344 $3,013.26 Elizabeth Kinko Cop.
Cotham Symp98
174 1997 Fenwick Angela C. 21897 020006368-2 $2,833.92 Digital VAX Maintenance
Equipment
Corp.
175 1999 Patel Seema 022699 020032545 $2,826.00 RSPA Mike Training
Moroney Center Tuition
..... ........... ........... ....... .............. $554,006.51 TOTAL PURCHASES 60 DRAFTS
================================================================================================================
176 1999 Libera Jr Donald P. 011999 020019349 $3,719.56 Donna M. Advance payment
Seipler for amounts
due
177 1998 Libera Jr Donald P. 93098 020019347-1 $4,000.00 William P. Advance for
Fannon salary
..... ........... ........... ....... .............. $7,719.56 TOTAL OTHER 1 DRAFT
================================================================================================================
..... ........... ........... ....... .............. $1,077,122.17 TOTAL OVER 177 DRAFTS
$2500
----------------------------------------------------------------------------------------------------------------
Mr. Knollenberg. How many instances of split invoices are
you aware of?
Mr. Mead. We are aware of two.
Mr. Knollenberg. Two.
Mr. Mead. Two instances where purchases over $2,500 were
simply submitted to avoid the Federal regulations. There may be
more, but these are the ones that turned up in our sample.
Mr. Knollenberg. There were copies of all the checks that
were made available. Five checks on one day to--there is five,
I believe. They were made on the same day, as I remember. That
is a little bit strange. Was that done obviously to conceal
exceeding the 2,500 limit?
Mr. Mead. Yes, well, what was happening here was you buy
the same thing but to stay under the ceiling you simply write
multiple checks that, added together, equal the purchase price.
Mr. Knollenberg. One of these is Tratech. Another one, was
it Skill--Skillcraft, I believe it was. I think there were five
made in one day. That is kind of strange.
Mr. Mead. One was for computers. I think the other was for
training.
Mr. Knollenberg. Mr. Chairman, how is my time here?
Mr. Hall. We will be glad for the record to get you
whatever information the Board has on those five checks.
Mr. Knollenberg. I appreciate that.
[The information referred to follows:]
Response From Director Hall to Query By Mr. Knollenberg About Specific
Split Invoices
There were a total of four Rapidrafts that were involved in two
split purchases with Tratech that were reported by the Inspector
General in their investigative report.
There were two rapidrafts issued on February 5, 1998, for $1,400
each to pay an invoice for $2,800 that was dated February 4, 1998.
There were two rapidrafts issued on July 7, 1999, for $2,047 and
$2,338 respectively to pay for one facsimile machine purchased on June
9, 1999, and 3 computers purchased on June 29, 1999.
With regard to the question concerning Skillcraft, our research did
not yield any information.
Mr. Knollenberg. What I found too disturbing, and I am sure
this has been talked about previously, but what were these
expenditures for? In the indications of the copied checks, the
photocopies, there is nothing there to say it was for carpet
purchase or furniture refinishing or payroll advances. There
wasn't a lot of disclosure. And I think that it becomes clear
that there must have been suspicion that it was beyond the
scope of the authority and for purposes other than what would
normally be covered in the cost of business. Would you agree
with that?
Mr. Mead. Yes, in general, I would.
Mr. Knollenberg. And I presume that these people that have
been involved with some of the accounting are no longer on the
job or are being oversighted in a fashion that would tell you
that there won't be anymore of this?
Mr. Mead. The former Chief Financial Officer who was
incumbent during all times pertinent to this inquiry has
resigned. Mr. Levine down at the end of the table is his
successor. He has 35 years of experience. I have confidence
that he is going to serve the Chairman, the Board and NTSB
well.
Mr. Knollenberg. Thank you.
Just very quickly I will close with this: How did these
authorized users obtain the Rapidrafts? Were they just about?
Mr. Mead. Actually, the interesting thing, you think they
would have to go in to the Chief Financial Officer and get
them, but under the procedures they had set up you could call
up the contractor and say, send me some checks, and he would
send some checks.
Mr. Knollenberg. We didn't use that in my business. I guess
I was missing something. But that sounds like a pretty good
deal do me.
Well, I think that I will just close with the assurance
that I am looking for is that those who had access in such an
open fashion to these checks no longer have that access. Can we
say that there is 100 percent security on that?
Mr. Hall. Yes, sir. And we are bringing in an independent
auditor. I would in a moment's notice bring the IG back in if I
thought there was any difficulty. Mr. Levine has his orders,
and his orders are if there is anything improper in any way
that has been going on in the past is to change it and change
it immediately.
Mr. Knollenberg. Any talk about having an IG inside?
Mr. Hall. We did have that conversation, sir, while you
were out of the room, but we would be glad to respond depending
on----
Mr. Knollenberg. I think that concludes my questions.
Thank you, gentlemen; and thank you, Mr. Chairman.
Mr. Miller. Mr. Ryan and Mr. Sununu are headed back. I know
Mr. Ryan has a few questions, so why don't we take a break for
a few minutes until they arrive.
[Recess.]
Mr. Sununu [presiding]. In the interest of time, I am going
to reconvene the hearing at this time.
We have one additional member that would like to ask
questions. I hope he arrives in a timely way. I am confident he
will.
I do have a few additional follow-up questions, and then we
will try to adjourn the hearing in a timely way, because I know
all of you gentlemen have important work to do.
Mr. Mead, we talked a little bit about other agencies that
are currently using third-party systems, some with Gelco, that
was a subcontractor to NTSB, some with other third-party draft
systems. And some discussion was made that perhaps it would be
appropriate to audit some of those systems.
My question for you is, given the experience of your
investigators and auditors with the Rapidraft system at NTSB,
what kind of an audit--what kind of a scope of an audit might
you suggest that the committee seek in other agencies or
departments where we might have questions about the nature of
the program?
For example, I am asking your recommendations with regard
to time period. Is it best to look at a broad period, 2 or 3
years, at a top-level audit? Should we look in depth at a month
in the documentation, in the internal controls? What kind of
guidance might you give this Task Force in making sound
recommendations for looking at this system in other agencies?
Mr. Mead. Well certainly we have a methodology that we know
what questions to ask. And we know what answers you might get.
I would suggest that if you were to ask other agencies to
do such an audit, you would go back at least one year and ask
for a description of the internal controls and whether they
were in place, and we could actually itemize those for you. For
example, do people sign the checks, what are they for, so forth
and so on.
I would also go back and ask for trend lines, say, going
back about 4 or 5 years, about program usage so you could see
the aberrations, if there were sharp aberrations, in program
usage.
I would also want to know about the management that was in
place at all pertinent times for the program going back, say, 5
years. And I say 5 years because Congress passed a law in 1995
or 1996 that phased these programs out and said you should go
to electronic fund transfers only in emergencies and so forth
should you be using these third party drafts. So 1995 really
marked a demarcation point. I would not go back before then.
Mr. Sununu. Thank you.
Mr. Hall, what kind of internal communication have you
utilized in trying to make employees aware as appropriate of
the results of this audit and the concerns regarding financial
controls and are employees making a best effort to understand
those controls but also to abide by them?
Mr. Hall. Mr. Levine has presently underway a training
program for all Board employees.
Mr. Levine. Mr. Chairman, on March 2, almost 2 months after
my arrival, we began training managers and employees. We have a
power point presentation that I personally give, and I also
include our labor-management relations specialist.
We go over the events, we discuss the audit, we review the
findings, and we go over the two credit card programs. We
explain the dos and don'ts, and we explain management
responsibilities.
The first one I gave was to the office directors. All of
them are getting management reports. There is no such thing as
privacy when you use a government credit card.
We have explained to them how to use it, what to look for.
We also involved the labor-management relations people because
there are cases of delinquent debt. But it is not debt owed to
the government. It is debt owed by our employees who on their
travel card have incurred charges and are not paying bills
timely. That has labor-management relations implications as
well. I have also briefed the employees of several offices.
Mr. Sununu. If I may, you mentioned delinquent credit
cards. Is that a problem right now within NTSB? Do you have an
approximate number or percentage of the cards issued that may
be delinquent at this time?
Mr. Levine. Less than 10 percent at the last look. It has
gotten better, actually.
Mr. Sununu. I should ask for your definition of
delinquency.
Mr. Levine. Per Citibank's terms, it means they are over 60
days delinquent in paying their bill.
Mr. Hall. One of the other things I am trying to do is get
a new travel agency, Congressman. What happens is that we end
up with people getting things put on their card by hotels or
because they changed plans because of sudden travel, and then
it takes forever to get these items reimbursed. I have asked
Mr. Levine to be very aggressive in that area, and we will be
glad to provide you information on the record on the total
amount.
Mr. Sununu. Thank you.
[The information referred to follows:]
Review of Citibank Report On NTSB's Credit Card Delinquencies
Citibank has issued 367 travel credit cards to our
employees. A review of the latest Citibank report on
delinquencies indicates that we have a 7 percent delinquency
rate. Approximately 75 percent of the delinquencies are just 1
month overdue. NTSB management officials are working with
employees to get their accounts current.
Mr. Sununu. Mr. Levine, how many employees have received a
power point presentation and how many do you intend to present
it to? I know that not--every single employee might not be an
appropriate.
Mr. Levine. I have made a presentation to the top
management and the officer directors of every major mode. I
have also made a presentation to three of the smaller offices,
and I have presentations scheduled right now for three more.
The regional directors for aviation are coming in this May, and
I am scheduled to present to them as well. That is our biggest
mode and that is where a lot of the travel occurs. To date, I
can't put a percentage on it, sir, but by office I have had
three of the seven major offices.
Mr. Sununu. Will you have all seven completed by June?
Mr. Levine. Yes sir. That is what the chairman wants, and
that is what I am going to do.
Mr. Sununu. I highly encourage to you do your best.
Mr. Levine. Appreciate your encouragement.
Mr. Hall. We are trying to move expeditiously, Congressman.
As you may know, we have nine regional offices, stretching from
Anchorage to Miami and covering the United States. I won't
ensure that our new CFO gets to each one of those by June, but
we have a priority right now in trying to brief our
headquarters offices.
Mr. Sununu. I understand. Perhaps you can follow up just
for the record the detail of that schedule and just so that the
Task Force has a sense of coverage. Because I think there is a
great value, even if it is a presentation at a fairly high
level, so that employees really understand what kind of an
effort is being made and also they understand the value of the
oversight that has been provided in this case by the Inspector
General.
Mr. Levine. Can I add one point of clarification, Mr.
Chairman, that you may not be aware of?
Citibank basically requires us to give very specific
training on the purchase card and the use of it before that
card is issued. And I have to say that NTSB--and this occurred
before I arrived--made sure that all employees who received
that card had to receive that training as well. So there was
training in addition to what I have given.
Mr. Mead. I would like to, in the interest of full
disclosure in light of the conversation with Mr. Miller earlier
and NTSB on this credit card delinquency point, this is not
just an issue with NTSB. We are dealing with it at the
Department of Transportation, too. We had roughly $3.6 million
of delinquencies in the serious category a couple months ago;
and the Assistant Secretary for Budget, the CFO, myself, the
Deputy Secretary have all thought this is an area we need to
pay attention to as well. Since February, we have had a marked
reduction. We are down to $2.9 million, but we still have a
ways to go. So NTSB is not in this swimming pool all alone.
Mr. Sununu. I appreciate that clarification, Mr. Mead.
Mr. Levine, I certainly believe this is a question best
addressed to you. Can you tell me, before the system that you
have in place now, and perhaps the system that was or was not
in place previously, how did you track property and equipment,
not just furniture but, most importantly, electronic equipment,
computers and information systems themselves?
Mr. Levine. I am not sure I have a good answer here, so I
need to look over to my managing director and check.
Mr. Campbell. The reason Mr. Levine is hesitating is that
the inventory system is not within his control, and marrying up
the inventory system and the financial system is one of the
projects that we have under way.
Mr. Sununu. Once the FMS recommendations are implemented,
will the inventory control system be part of the Mr. Levine's
jurisdiction?
Mr. Campbell. It will be part of the same data base. The
way that the property system works now, when property is
brought into the building, it is identified as NTSB property
and tagged as such as it is in an inventory system. What we do
not presently have is a marrying between the acquisition
document and the inventory document.
Mr. Sununu. I believe Mr. Levine gave a rough time line for
completing the implementation of the goals set out by the FMS
review and some of the additional goals of the Inspector
General's recommendations of perhaps completing by the end of
this year. My question for Chairman Hall is, given that time
line, when do you expect to and when have you set a goal for
having a clean audit completed?
Mr. Hall. I would hope we could have a clean audit at the
end of fiscal year 2001. That is my goal. I want to do
everything I can so that my successor at this agency doesn't
experience the same situation I have. I think the best way to
do that is to be sure that this agency annually can produce a
clean audit. And now I have given Mr. Levine all these
responsibilities, and I have got to get him some more people to
help him perform his responsibilities.
Mr. Campbell. If I might, Mr. Chairman, one of the issues
that we have asked PriceWaterhouseCoopers to look at is the
degree of readiness that we have for such an audit and to tell
us what it is that we would necessarily have to do. Depending
upon what they come back with in terms of readiness or the lack
thereof, we will probably pick the earliest possible target
date. If it could be this year, it is this year; if it is next
year, it is next year.
But we have to have an independent auditor come to us and
say these are the deficiencies and these are the needs within
your existing system that will produce such a possibility. As I
mentioned once before, the first order of business was to
relook at the Gelco Rapidraft issue in terms of whether there
is any continuing liability there; and the second order of
business is to put us on the path for a clean audit.
Mr. Sununu. Thank you.
Mr. Hall. I know you read my testimony. That was where I
was trying to head with the Treasury in 1997, 1998, because at
that time I was told we couldn't get a clean audit without
redoing our financial house. I am committed to that, and I hope
it will happen very soon.
Mr. Sununu. Mr. Mead, the various responsive or the various
remedial actions that NTSB has undertaken and outlined, are
they responsive to the recommendations in your report? And I
mean that in two ways.
One, of course, specifically, are you comfortable with what
they have outlined and set for goals to respond to the results
of your audit? More generally, are there any areas that are of
concern for you that it would be difficult for them to achieve
the goals of your report even if those remedial actions are
implemented? In other words, are there objectives or problems
that you see that--areas where we will need continued oversight
in any agency? In other words, it is not just necessarily a
problem with their inventory management system or
reconciliation process, but they are just, in your opinion,
going to continue to be problem areas?
Mr. Mead. I would have to say that the termination of the
Rapidraft program, the hiring of PriceWaterhouse, the
installation of a new CFO and the broad front of actions that
have been articulated as planned are responsive and should take
care of the problem.
Now, there is a lot planned, and so the key is going to be
in their implementation. You know, earlier--I think you were in
the hearing room--Congressman Miller said, well, it is not just
the Rapidraft that is the problem, it is a deeper issue. And he
is right. Because if we don't deal with some of these other
internal control issues such as reconciling payments you could
have a recurrence of this sort of thing with credit cards. So I
think their ship is headed in entirely the right direction. The
key is going to lie in the implementation. And you are
absolutely right. This is the type of situation you can find at
almost any agency.
Mr. Sununu. Thank you.
Finally, I believe, as a result of this, it would be in our
best interest to have you audit the system as it exists or was
used in FAA and at the Volpe Center within the Department of
Transportation. And I anticipate that we will be making a
formal--as a full committee--formal recommendation to you to do
just that.
Again, I appreciate all of your time.
I want to yield to Mr. Ryan for his question period, and
then we will adjourn forthwith. Mr. Ryan.
Mr. Ryan. Thank you, Mr. Chairman. I would like to ask
unanimous consent that my opening statement be included in the
record.
Mr. Sununu. Without objection.
Mr. Ryan. Thank you.
[The prepared statement of Mr. Ryan follows:]
Prepared Statement of Hon. Paul Ryan, a Representative in Congress From
the State of Wisconsin
Mr. Chairman, I am perplexed by the apparent financial
mismanagement that has occurred over the last 18 years at the National
Transportation Safety Board (NTSB). As I had the chance to read the
Inspector General's report last night, I was shocked to find some of
the ways that our tax dollars are being spent.
In 1982, the NTSB set up the Rapidraft Payment System to provide
investigators with a mechanism to pay authorized expenses associated
with on-site investigations. This system allowed NTSB investigators to
write checks, up to a $2,500 limit, for items such as tow trucks and
crane rentals. The NTSB's Chief Financial Officer was put in charge of
the system.
In 1999, the NTSB's Rapidraft Payment System came under
investigation by the Inspector General of the Department of
Transportation. The results of the Inspector General's report were
startling. By the Inspector General's account, the Rapidraft Payment
System was turned into the CFO's personal playground at the taxpayers
expense. In a random sample of one thousand FY99 Rapidrafts, the
Inspector General found 902 noncompliant drafts. That's over 90 percent
of the drafts, with many of these checks exceeding the $2,500 limit.
Worse yet, the audit found that only 5 percent of the $3.6 million in
allocated funds were used in on-site accident investigations. The
results of the audit found that Rapidrafts were being used for such
noncompliant expenses as:
$731,000 for nonaccident related travel.
$410,000 for tuition for training.
$286,000 for nonaccident related equipment office
supplies.
More than 100 checks cashed at one DC liquor store.
And the list goes on from there.
In 1992, a similar audit of the RPS was conducted by the General
Services Administration. The GSA audit found that 92 percent of the
Rapidrafts issued in the first 9 months of Fiscal Year 1991 were
improperly used. The NTSB took no appropriate actions at or since that
time.
All though the 1992 audit found significant weaknesses in the
system's internal controls, they were not corrected. The Rapidraft
Payment System may just as well have been called the Rapiddraft
Profligate System. The Inspector General found that 37 of the 177
authorized investigators that were approved to write these checks no
longer work for the NTSB. Checks were paid without signatures,
authorization numbers or explanations. The CFO did not reconcile these
checks to ensure payments were authorized.
Mr. Chairman, I think that any American citizen would find this
kind of abuse offensive. Americans work hard for their money. As it is
tax season, we are all reminded of the large portion that we pay in
taxes every year. The average financial tax burden that the government
imposes on an individual today is 33.5 percent of their income. In
1999, Americans worked from January 1st until May 3rd to pay off their
taxes. That's over 4 months that Americans work just to pay their
taxes.
Through the Inspector General's report of the NTSB, we are finding
today that Americans worked hard to give entertainment money to NTSB
workers. Americans worked hard to assign blank checks to former NTSB
workers with no accountability. Americans have worked hard to provide
computer upgrades to top NTSB officials to download questionable
material. This is simply unacceptable.
How does such a system become so poorly managed? Why weren't these
obvious problems fixed after the 1992 audit? What other government
agencies are using this Rapidraft Payment System? How many tax dollars
are being wasted in these agencies because of improper oversight of the
RPS? These are all questions that I hope are answered today.
I do appreciate Inspector Meade and Chairman Hall for being here
and testifying today. I also commend Chairman Hall for his willingness
to request that Inspector General Meade audit the NTSB when he saw
deficiencies in the system. I understand that an audit by the Inspector
General was a voluntary move by Chairman Hall in response to widespread
abuse of the financial accounting system.
Mr. Chairman, it has come to my attention that the Department of
Transportation has recently called for the end of the RPS system--not
only for the NTSB, but for all related DOT agencies. I am disappointed
that it took a Congressional hearing to end the eighteen years of fraud
and abuse. Government agencies like the NTSB should be implementing new
payment programs that meet its needs with appropriate controls built
in. It's time for an end to these kind of slush funds.
Weeding through government waste and abuse is serious business. For
a government employee to waste taxpayers time is reprehensible, but for
that employee to waste taxpayer's money is criminal. My staff and I
take the responsibility of working for the American taxpayer very
seriously. We work hard not to abuse the awesome power to which we have
been entrusted. I expect nothing less from the NTSB, or any other
government agency, than to hold them to that same standard.
Mr. Ryan. Mr. Hall, I would like to go back to the 1992 GSA
audit. In 1992, the General Services Administration found
serious deficiencies in the management of the Rapidraft Payment
System, including a lack of supporting documentation, that
Rapidrafts were issued without proper authorization and that
travel advances made with Rapidrafts were sometimes used for
nontravel purposes and used to circumvent proper payroll
procedures. In fact, the GSA found that as many as 92 percent
of the Rapidrafts issued for travel purposes were not in
compliance with NTSB internal controls.
In response, the NTSB Comptroller identified specific
solutions for correcting those deficiencies that the NTSB
intended to implement.
This was 1992. I know you weren't there then, and I know
the people are new. But GSA did an audit in 1992. Why did it
take so long for you to take action? What happened in 1992 that
NTSB didn't do anything to follow up on that audit and why was
that the case?
Mr. Hall. Congressman, I want to be responsive to you and
to this committee on all questions, but I must tell you, in all
honesty, that I was not aware of that audit. My predecessor did
not inform me of that. I was not aware of that audit until this
whole matter came up in this year.
Mr. Ryan. Who on your staff would have been aware of the
audit?
Mr. Hall. Mr. Keller, who is the individual that is no
longer with us. I am sure there are other individuals. We could
get that information for the record, but I don't know.
The office at that time was structured differently, sir. We
had an Office of Administration, and the Accounting Office was
under the Office of Administration. The Accounting Office
reported to the head of that office, who then reported to the
managing director, who reported to the chairman.
My concern, when I read the statute in Congress, was I was
accountable. But there were three people in between me and the
individual that was responsible for the proper accounting of
the money. That was when I couldn't get good numbers. The
second and third year I was there, I tried to move toward a
reform of the system.
[The information referred to follows:]
Response From Director Hall to Queries By Mr. Ryan About 1992
Deficiencies
In 1992, GSA performed an audit for NTSB to evaluate the adequacy
of administrative procedures and practices for travel at the agency.
The audit found that: (1) travel advance documents were signed by
officials with appropriate authority; (2) expense claims were within
Federal limits; (3) required receipts were attached; (4) amounts
claimed were accurate; and (5) travel vouchers were appropriately
authorized and timely.
However, the audit found problems with travel advance accounts
(NTSB no longer uses a travel advance system and has not for some
time), including a failure by NTSB to undertake periodic reviews of
travel accounts balances. The audit also found that investigators had
written rapiddrafts to cover travel expenses, though investigator
authority was limited to on-scene purchases. Rapiddrafts for travel
reimbursements were to be written only by NTSB designated imprest fund
cashiers. Additionally, it was found that rapiddraft booklets were not
always adequately secured or locked up. No fraud, waste, or theft was
in any way intimated. Distribution of the GSA audit report indicates
that three copies were delivered to the then Chairman of the agency,
since departed.
At the time of the report, financial management was undertaken by a
division of the Office of Administration, which in turn reported to the
Managing Director, a non-career appointee, who reported to the
Chairman. As a practical matter, the Deputy Managing Director would
have had day-to-day supervisory responsibility for the Office of
Administration. None of these individuals are currently with NTSB.
According to a memorandum dated November 16, 1992, the Chief of the
Financial Management Division proposed to his immediate supervisor
several remedial actions, apparently acceptable to the Director of the
Office of Administration. Whether any of these actions were reported
further up the management structure, I am unable to say.
Factually speaking, NTSB did move away from the travel advance
system that was the principal issue of criticism, and I am unaware of
any present issue with investigators having subsequently written
rapiddrafts to cover travel expenses. It would appear that the chief
deficiencies stated in the 1992 audit resolved themselves, whether as a
result of precautionary actions or simple changes in circumstances,
again I cannot say with any certainty.
I would add that NTSB has undergone an extensive administration
reorganization that should help to prevent any repetition. All purely
administrative functions now report directly to Managing Director. (The
titles of Deputy Managing Director and Managing Director are now
Managing Director and Executive Director, respectively.) Financial
management has been removed from administration altogether, and, in
accord with the principles of the Chief Financial Officer Act, a
freestanding office reporting directly to the Chairman has been
established. We did not hesitate to implement the recommendations of
the DOT IG coming from the recent audit, and I am confident that NTSB
follow-through will be exemplary.
Mr. Mead. Here is something that I think--illuminating on
that. After the General Services Administration filed its
report back then, it was the IG from GSA, the incumbent, the
fellow that was the chief financial officer who was then called
the comptroller, same person, he wrote a memo and in it he said
that he was going to write another memo reminding everybody not
to do these things.
Mr. Ryan. Was the content of that memo notifying employees
about NTSB Order 46A and 1542?
Mr. Mead. Yes, sir. And so--but we have been unable to
establish whether in fact that was actually done. And,
moreover, it has been our experience, and I am sure yours, that
just issuing memoranda really doesn't do the trick.
Mr. Ryan. So the GSA audit was conducted in 1992. They said
92 percent of the Rapidrafts were for out-of-compliance check
writing. And then the comptroller at that time, which is also
the CFO, you are saying, may or may not have issued a memo to
the staff reminding them of how to comply with the Rapidraft
system. Is that the gist of what you are saying?
Mr. Mead. He did write to his boss saying he was going to
do these things. But we do not know whether in fact he actually
did.
Mr. Ryan. Are you looking at--your audit was a 3-year
audit, from fiscal year 1997 through 1999. Have you looked at
pre-fiscal year 1997 checks?
Mr. Mead. No, sir.
Mr. Ryan. Do you have them?
Mr. Mead. No.
Mr. Ryan. Do you know how much money has been appropriated
within the agency to the Rapidraft system? Just the macro
numbers of what had been appropriated to the Rapidraft system
from 1992 to 1997? Because I know you know what money was
deposited into Rapidraft system for fiscal year 1997, 1998,
1999. What about 1992 to 1997?
Mr. Mead. No, I don't know. All I can say is that the 1997,
1998, 1999 patterns are similar. I do not know if the trend
existed before that time.
Mr. Ryan. Mr. Hall, do you have access to the data that
would show us how much money was ultimately passed through the
Rapidraft system from 1992 to 1997?
Mr. Hall. We would be glad to try and obtain that for the
record, Congressman.
Mr. Ryan. If you could, that would be helpful.
[The information referred to follows:]
TOTAL DOLLARS PAID THROUGH THE RAPIDRAFT SYSTEM AND THE NUMBER OF CHECKS WRITTEN
[Fiscal year]
----------------------------------------------------------------------------------------------------------------
Number of Rapidrafts
Fiscal year Dollar value written
----------------------------------------------------------------------------------------------------------------
1992...................................................... $1,202,580.57 5,937
1993...................................................... $2,677,364.18 7,929
1994...................................................... $1,398,778.13 6,718
1995...................................................... $2,407,865.42 7,685
1996...................................................... $2,824,574.71 7,696
1997...................................................... $4,277,124.64 8,836
-----------------------------------------------------
Total............................................... $14,788,287.65 44,801
----------------------------------------------------------------------------------------------------------------
Mr. Ryan. Mr. Mead, at your entire Department of
Transportation Inspector General--I came late, so I know these
questions may have been exhausted already--but it is my
understanding that yesterday the Department of Transportation
ceased all Rapidraft procedures as of yesterday, is that
correct?
Mr. Mead. Yes, sir. This subject did come up before. And
based on the NTSB experience, our own audit of FAA previously,
that Departmentwide instruction was issued yesterday that, as
of May 10, they will no longer be used in the Department. The
reason for the 30 days, I hasten to add, is because we have air
traffic control facilities in the field we want to make sure
that they have credit cards and they don't say, well, thanks
for leaving us hanging.
Mr. Ryan. How many Rapidraft systems were in place within
the entire Department as of yesterday?
Mr. Mead. I believe that there were two, FAA and the Volpe
Center in Boston. The Federal Highway Administration I believe
had discontinued it. I will correct that for the record if I am
wrong. FAA had been spending, I think, about $15 million this
past year; the Federal Highway Administration, $80,000; the
Volpe Center, about 80 or 90,000. I think 40,000 checks at FAA.
Mr. Ryan. Forty thousand at the FAA.
Mr. Mead. In 1999.
Mr. Ryan. What is the total dollar amount?
Mr. Mead. About $15 million.
Mr. Ryan. That is, again, the total budget? You are
auditing that right now?
Mr. Mead. No, but we soon will be.
Mr. Ryan. I hope we look at other areas within the entire
Federal structure where Rapidraft systems are employed. I think
that is something that is a challenge for the committee here.
I want to go back to in 1992. What is the procedure that
occurs when another government agency like the GSA audits a
program--what is the procedure that is in place today to make
sure that those audits are actually recognized, that those
audits are responded to, that the audits are acknowledged? What
happens? I am just curious as to what happens when those audits
come to you.
Mr. Mead. Within the Department of Transportation over
which we have jurisdiction, there is a requirement that they
respond. In this case, where we didn't have the jurisdiction
over NTSB, there is no requirement for follow through; and in
the GSA case the GSA never follows up. In this case, there is
follow up I think largely because of the relationship between
the NTSB and us. But it is not a legal requirement, if you
will.
Mr. Ryan. So in your opinion--and I don't want to
paraphrase for you, but this was discovered in 1992, these
inherent flaws: room for embezzlement, over-the-limit
expenditures, and noncompliant expenditures were known in 1992.
Mr. Hall, when you found out, you put an end to it just
this last year. Why do you think it took so long to find this
out? And what went wrong in 1992? Is it simply that they went
to one individual, which was at that time the CFO, who just let
it die by the wayside? Then it cropped back up in 1999? Or what
do you think, Mr. Mead, was the cause for that?
Mr. Hall, please feel free to answer as well.
Mr. Hall. Congressman, in fairness to the people, I don't
know. Because I wasn't there, I don't know what they did. I
don't want to respond to a question when I truly do not know
the answer.
Mr. Mead. What happens when we travel, we put it on a
credit card. In order to get paid back, we have to fill out a
form that says where we traveled, how much we spent. It has to
be approved, goes into the system. The Department of the
Treasury eventually cuts an electronic transfer to our personal
bank account. And there is also a general audit made.
That is, obviously, a more difficult procedure to get money
from the U.S. Government than a procedure where you simply
write a check to yourself and cash it. And if you have a system
in place where you don't even have to sign the check or you
don't have to put down the purpose, it is more expeditious. But
I think we all know that we can't have a system like that in
place in government and public service. So it is easier.
Mr. Ryan. This question may have been asked as well, but I
would like to hear from you Mr. Hall, as part of the Rapidraft
Payment System NTSB maintained a $350,000 in a noninterest-
bearing account with Gelco. What efforts have NTSB undertaken
to retrieve the $350,000 deposit since the Rapidraft system was
stopped?
Mr. Hall. That matter was covered, and that question
responded to. I will be glad to have Mr. Levine respond again.
Mr. Ryan. If you could respond.
Mr. Levine. I became aware of the deposit about a month and
a half into my tenure. I directed my people to go after Gelco.
There are some issues dealing with float charges and
outstanding charges. We intend to get that money very shortly.
Mr. Ryan. Thank you.
That is all, Mr. Chairman.
Mr. Sununu. Thank you very much, Mr. Ryan.
I want to thank all of our witnesses today for their time
and for their candor. Should the Task Force have any additional
requests for information, I want you to know that we will be
mindful of the burden that is on you now with the work that you
do every day. And, again, I appreciate the information that you
provided that I believe has already made a difference in
putting important focus on the way we disburse money in
departments and agencies across the Federal Government; and for
that you are to be congratulated.
Thank you, all.
The Task Force is adjourned.
[Whereupon, at 12:40 p.m., the Task Force was adjourned.]
Lack of Income Verification in HUD-Assisted Housing: The Need to
Eliminate Overpayments
----------
THURSDAY, MAY 25, 2000
House of Representatives,
Committee on the Budget,
Task Force on Housing and Infrastructure,
Washington, DC.
The Task Force met, pursuant to call, at 10:05 a.m. in room
210, Cannon House Office Building, Hon. John Sununu (chairman
of the Task Force) presiding.
Mr. Sununu. Good morning. I would like to start by thanking
Congressman Bentsen and all the members of the Task Force for
participating in this hearing and supporting the oversight
hearings for which we are responsible in both housing and
infrastructure. But also I would like to recognize and thank
the Special Agents that are here today, Raymond Carolan and
Emil Schuster of the U.S. Department of Housing's IG Office;
Deputy Secretary Saul Ramirez, who has testified here before on
behalf of the Department of Housing and Urban Development; and
Ms. Sheila Crowley of the National Low Income Housing
Coalition.
I know you all have busy schedules. I appreciate your
taking the time out to testify.
Since its inception, the Section 8 housing assistance
program has helped millions of American families find
affordable housing. Through the Section 8 voucher and
certificate programs, HUD provides rental subsidies which help
over 1.4 million households in the United States.
The subsidies are reserved only for very low-income tenants
and are based on the amount of income the tenant earns.
Typically, the tenant pays the rent capped at 30 percent of
income, and HUD pays the remaining rental cost of the
apartment.
Obviously, determining a tenant's true income level is
essential for the programs to operate not just efficiently, but
fairly as well, because as we all know, the waiting list for
these positions can be quite long.
Unfortunately, there has been a long-standing problem at
the Department of Housing and Urban Development in assuring
that subsidy payments are made in the right amount to those
eligible low-income tenants.
Both the GAO and the HUD Inspector General's Office have
determined that the systems in place ``do not provide
reasonable assurance that subsidies paid under the programs are
valid and correctly calculated, considering tenant incomes and
contract rents.''
Since 1996, the HUD Inspector General has reported that
HUD's housing subsidy programs do experience improper payments
when beneficiaries' income status changes and they do not
notify housing authorities to adjust their benefits.
HUD itself has estimated that approximately $935 million in
excessive payments have been made in its Section 8 housing
program for 1998. Had this $935 million been used to assist
low-income tenants, it is estimated that approximately 150,000
families could have been assisted with their housing needs. So
this is not simply a budgetary problem, but it is also a
fairness problem.
We want to make sure within HUD that resources are made
available to assist those that need help. Again, the waiting
lists for many of these programs are quite long.
In 1999, HUD developed an approach to use a large-scale
computer-matching income verification process that would
compare IRS and Social Security information and identify
tenants who had underreported their income. In the first
quarter of the year 2000, HUD used its new matching methodology
to identify approximately 280,000 tenant households with income
discrepancies. HUD then prepared letters to inform tenants of
their responsibility to disclose their proper income and tax
data to the Public Housing Authority, as well as notifications
to the housing authorities themselves.
Although the Department had originally planned to mail
notification letters to all of these tenants with income
discrepancies, it was decided to engage in a pilot program in
Washington, DC. In February, about 900 letters were sent to
tenants, which were not received well. As a result, the program
was temporarily suspended.
Our goal today is to attempt to shed light on the nature of
the problems that were encountered early on with the 1995
problem, understand what efforts the Department of Housing and
Urban Development has made to solve the problems, and try to
better understand the scope of the problem that the Inspector
General's Office has been evaluating.
We will hear testimony from the Office of Inspector
General, explaining their understanding of the problem and
talking about several real-world examples of how and why
overpayments are made.
In addition, we will hear testimony from the controller at
HUD, who has responsibility for monitoring these finances, and
hear about what steps HUD has taken to bring in the concerns of
tenants and try to shed additional light on the tenants'
perspective in these attempts to reduce the significant level
of overpayments.
I would like to recognize Congressman Bentsen for any
remarks he might have.
[The prepared statement of Mr. Sununu follows:]
Prepared Statement of Hon. John E. Sununu, a Representative in Congress
From the State of New Hampshire
Good morning. I'd like to start by thanking Congressman Bentsen and
all the members of the Task Force for being here this morning. I'd also
like to recognize and thank Special Agents Raymond Carolan and Emil
Schuster of the U.S. Department of Housing and Urban Development's
Office of Inspector General, Deputy Secretary Saul Ramirez, U.S.
Department of Housing and Urban Development, and Ms. Sheila Crowley of
the National Low Income Housing Coalition. I appreciate your taking the
time out of your schedules to be here this morning.
Since its inception the Section 8 housing assistance program has
helped millions of American families to find affordable housing.
Through the Section 8 voucher and certificate programs HUD provides
rental subsidies which help over 1.4 million households in the United
States. These subsidies are reserved only for very low-income tenants
and are based on the amount of income the tenant makes. Typically, the
tenant pays a rent capped at 30 percent of income, and HUD pays the
remaining rental cost of the apartment.
Clearly, determining a tenant's true income level is essential for
the programs to operate properly and fairly. Unfortunately, there has
been a longstanding problem at the Department of Housing in assuring
that subsidy payments are made in the right amount to eligible low
income tenants. Both the General Accounting Office and the HUD
Inspector General's Office have determined that the systems in place
now do not ``provide reasonable assurance'' that ''subsidies paid under
these programs are valid and correctly calculated considering tenant
incomes and contract rents.'' Since 1996, the HUD IG has reported that
HUD's housing subsidy programs experience improper payments when
beneficiaries income status changes and they do not notify housing
authorities to adjust their benefits. In fact, HUD itself has estimated
that $935 million in excessive payments have been made in its Section 8
Housing program for 1998. Had this $935 million been used to assist
eligible low income tenants, it is estimated that an additional 150,000
families could have been helped.
In 1999 HUD developed an approach to use a large-scale Computer
Matching Income Verification Process to compare IRS and Social Security
information and identify tenants who had under-reported their income.
In the first quarter of 2000, HUD used its new matching methodology to
identify 280,000 tenant households with income discrepancies. HUD then
prepared letters to inform tenants of their responsibility to disclose
their proper income and tax data to their Public Housing Authorities,
as well as notifications to the PHA's themselves. Although the
Department had originally planned to issue notification letters to all
tenants with income discrepancies, it was decided instead to use the
Washington, DC, Housing Authority as a preliminary test area. In
February 2000, letters were sent to approximately 900 tenants. It is my
understanding that these letters were received rather negatively, and
as a result the Department has halted its income verification program.
The purpose of this hearing will be to attempt to shed light on the
nature of the problems in the income verification program, and the
effort of the Department to solve these problems. The Task Force will
hear testimony from two investigators from the HUD Inspector General
Office explaining their understanding of the problem and relating real
world examples of how and why the overpayments are made. In addition,
we will hear testimony from the Controller at HUD who has
responsibility for monitoring the finances at HUD. Finally, we will
hear what steps HUD has taken and plans to take in the future, along
with testimony from an advocate for tenants to bring light to their
perspective on recent attempts to bring down these overpayments.
I would now like to recognize Congressman Bentsen for any opening
remarks he may have.
Mr. Bentsen. Thank you, Chairman Sununu. I want to thank
our panelists for being here, both the individuals from the
IG's Office, as well as my fellow Texan, the Deputy Secretary,
who, prior to becoming Deputy Secretary of HUD, had real power
as the county judge of Webb County, Texas, and gave that up to
come here to Washington; and also Ms. Sheila Crowley from the
National Low Income Housing Coalition.
Let me say, this Task Force of the Committee on the Budget
is charged with investigating areas where there is either
fraud, waste, or abuse in government programs. I think that
there is strong bipartisan support among all members of the
committee, as well as all Members of the House, that fraud and
abuse in government programs with taxpayers' money should not
be tolerated.
That being said, I think we also--and as a member of the
Committee on Banking and Financial Services, which has
jurisdiction over HUD, we also must not lose sight of the fact
that we do have a low-income housing crisis in America; that as
strong as our economy has been, we still have tens of
thousands, or more, Americans who are on waiting lists trying
to get into assisted homes, assisted living, including in my
district in the greater Houston area. It is something that we
should be focused on.
Additionally, as we have found through hearings on the
Committee on Banking and Financial Services, while there is
great concern, and I have great concern with respect to
overpayments, we also have concerns about underpayments.
This is a broad problem and a complicated program that has
probably been somewhat more complicated with the passage of
H.R. 2 a couple of years ago, which I was involved in drafting
with Mr. Lazio and Mr. Frank and others, that changed some of
the income rules and targeting rules and others in the Section
8 program. So HUD is going through a transition with respect to
that.
Finally, I am eager to hear not only about the findings of
the IGs and the methodology and how we might address this, but
also about the income verification program that HUD has
instituted, both in terms of HUD, as to how that is going; but
also from the IG, your perspective on that as well, and how
that might be made even better, given that it appears to be the
first time this is even done.
Finally, I think we must not lose sight of the fact that
the clientele that we are talking about here are among the
poorest of Americans, that there are many who are struggling
their way up the rungs of the ladder; and we must be cautious
in our diligence to root out fraud and abuse not to lose sight
of the fact that many of these individuals may not share the
technical expertise that those of us in the Washington realm
do--and we should be cautious in that regard.
Mr. Chairman, thank you for holding this hearing. I look
forward to participating in it. I yield back the balance of my
time.
Mr. Sununu. Thank you, Mr. Bentsen.
I would like to begin with the testimony from the Office of
Inspector General, and once we have completed that testimony, I
would ask that you gentlemen literally just slide down to one
side of the table so we can have all of the testimony presented
from Ms. Crowley and Mr. Ramirez before we get to questions.
Then if the four of you can participate in the question-
and-answer session, we will have questions from both me and Mr.
Bentsen, but hopefully in a somewhat informal way; and you
should feel free during that question period to make any points
that you think are relevant, even if the questions are not
necessarily directed to you, because our interest is in
presenting as much information here as we can in what is,
unfortunately, a short amount of time.
Mr. Schuster, I would appreciate your testimony. I yield to
you for whatever time you might need.
STATEMENT OF EMIL J. SCHUSTER, SPECIAL AGENT IN CHARGE,
SOUTHEAST/CARIBBEAN FIELD OFFICE OF THE HUD INSPECTOR GENERAL
Mr. Schuster. Thank you. Good morning.
Chairman Sununu and Congressman Bentsen, I appreciate the
opportunity to be here before you this morning to provide a
little bit of insight on what the Office of Investigations for
the Office of Inspector General of HUD does as far as tenant
fraud.
I ask that my full written statement be included in the
record.
Mr. Sununu. Without objection.
Mr. Schuster. My knowledge of this issue is based on the
9\1/2\ years I have been in charge of the HUD Office of
Inspector General, Office of Investigations Southeast/Caribbean
District in Atlanta, Georgia.
We, like many in the IG community, have limited resources.
Because of that, it is essential to set strict priorities in
their use. These priorities are affected in large measure by
the prosecutorial guidelines set by the various U.S. Attorneys.
There is generally a minimum dollar threshold on fraud
charges in each judicial district. For example, it might be
$10,000, or it could be as high in some districts as $100,000.
In addition, each district might have their own set of
priorities, so the priorities in, for example, Miami may be far
different than in Memphis, Tennessee.
Nonetheless, there are deviations from these minimums when
circumstances are so heinous that criminal prosecution is
called for. Because of these limitations, our investigations
leading to the prosecution of tenant fraud in the Southeast
District have averaged approximately only five per year.
To further clarify our addressing of tenant fraud, I would
like to use an interview question I pose to recent college
graduates who are applying for Special Agent positions.
I explain to the person that a complaint is received and
that a Section 8 tenant, identified as Mary Doe, is defrauding
HUD by not disclosing income she is receiving from a part-time
job. You conduct an investigation and find the following: Mary
Doe has been working part-time at McDonald's for the past year.
She has three elementary schoolchildren.
From the interviews, it appears that she is simply trying
to earn some extra money to buy new school clothes, shoes, et
cetera, for her children. She has not disclosed this additional
income, and thereby has defrauded HUD out of $1,000 this past
year.
How do we handle this?
The answer I look for is that this is not a prosecutable
criminal case. Rather, this is the type of situation that we
would refer back to the Housing Authority and/or the HUD
program staff, recommending that they take some type of
appropriate administrative action.
The purpose of this question is to show that not every
fraudulent act warrants criminal prosecution. Judgment is
needed, especially with limited resources.
Now, having identified the type of case that would
generally not be pursued, I would like to describe several
specific cases where we have undertaken investigations, alone
or with other law enforcement agencies, that have led to
successful prosecutions. We will often work with the Department
of Health and Human Services IG, or Secret Service, or any of
the various other IGs in looking at fraud.
Example number one is Nashville, TN, an IRS employee we
prosecuted for falsifying her income in order to obtain Section
8 benefits. She failed to report her income she earned as an
IRS employee. Her fraud resulted in a loss to HUD of over
$15,000.
Example number two, Memphis, TN. A Memphis Housing
Authority employee conspired with the Shelby County Corrections
Officer to create a fictitious Section 8 landlord and place the
property into the Section 8 program. The corrections officer
became the tenant, receiving the Section 8 assistance. The
officer would then receive the Section 8 checks and forge the
fictitious owner's signature, and they would split the money.
They took in about $11,000 of HUD funds.
In Campbellsville, KY, during a Safe Home operation--and
this is our operation for violent crime in public and assisted
housing; primarily we deal a lot with drug cases--we were
investigating a situation with two people selling drugs in the
Housing Authority developments.
During the investigation, we discovered that one of the
individuals was a Section 8 landlord who was renting to another
individual, who was another person who was selling drugs.
During the search warrant, we found that the landlord was
living actually in the residence with the tenant.
Now, this only amounted to fraud of just $1,070, but the
Assistant United States Attorney [AUSA] decided to include this
in the prosecution with the drug counts because of the
heinousness of this situation.
In Atlanta, GA, the defendant created false birth
certificates in order to obtain four different Section 8
subsidized apartments under fictitious names in Tennessee and
Georgia. In addition, she received food stamps and welfare in
each of the units. The loss to the government was over $15,000.
This was one of the situations where we worked with the
Department of Agriculture IG and the HHS IG.
Then in Broward County, FL, 35 individuals were prosecuted
for fraudulently obtaining over $300,000 in Section 8
subsidies. The tenants were Nigerians, or spouses of Nigerians,
who were in this country illegally or whose status had expired.
The defendants were able to create false employers and have
their verification of income forms sent to the post office
boxes that they owned or were owned by Nigerian-owned
businesses.
Twelve of the defendants were employees of the Florida
Department of Human Rehabilitation Services, HRS, which is a
basic State entity which handles welfare payments in the State
of Florida.
Another side to this is, these people were making in the
area of $35,000 to $40,000 per year as salary from the State of
Florida. In addition, they were also receiving food stamps,
AFDC, and educational grants that they were not entitled to
receive.
There are certain common threads that run through these
prosecutable-type cases. A subject who is a city, State, or
Federal employee will spark the interest of an Assistant United
States Attorney. A subject who is defrauding other government
programs, like food stamps or AFDC, likewise is seen as a good
target. Another good subject would be a drug dealer, obviously.
Of course, there are some whose actions are so flagrant
that a jury would not hesitate to convict: for example, a
subject who owns several rental houses, yet still claims
Section 8 assistance.
Another important aspect of this case is the deterrent
value prosecution will bring. For example, if there is some
notoriety attached to the case, the media will run a story
which has a positive impact on making an applicant think twice
about lying. These are all things that we consider before
opening an investigation.
We continue to receive allegations from a number of
sources, and as I said, undertake approximately five
investigations per year. Over the 9-plus years I have been in
Atlanta, I have seen the same type of allegations occur and
recur, understating income or failing to report jobs for the
purpose of receiving a subsidized unit or a larger subsidy from
HUD.
As both resources and prosecutorial appeal exist, we
investigate the most egregious cases. Any remaining allegations
are referred to the Housing Authority and/or HUD program staff
for administrative action, as appropriate.
Mr. Chairman, that concludes my remarks. I would be happy
to answer any questions following the testimony.
Mr. Sununu. Thank you very much, Mr. Schuster.
[The prepared statement of Mr. Schuster follows:]
Prepared Statement of Emil J. Schuster, Special Agent in Charge,
Department of Housing and Urban Development, Office of the Inspector
General, Southeast/Caribbean District
Chairman Sununu and members of the Housing and Infrastructure Task
Force, I appreciate the opportunity to appear before you today to
provide insight on the investigation of tenant fraud as it relates to
the Department of Housing and Urban Development, Office of Inspector
General. I ask that my full written statement be included in the
record.
My knowledge of this issue is based on the 9\1/2\ years I have been
the Special Agent in Charge of the HUD Office of Inspector General,
Office of Investigations Southeast/Caribbean District in Atlanta, GA.
We, like many in the IG community, have limited resources. Because of
that it is essential to set strict priorities on their use.
These priorities are affected in large measure by the Prosecutorial
guidelines set by the various U.S. Attorneys. There is generally a
minimum dollar threshold on fraud schemes for each judicial district.
It may range from $10,000 to as much as $100,000. In addition,
jurisdictions have different priorities--Miami's are not the same as
Memphis. Nonetheless, there are deviations from these minimums when
circumstances are so heinous that criminal prosecution is called for.
Because of these limitations our investigations leading to the
prosecution of tenant fraud in the Southeast District has averaged
approximately five cases per year.
To further clarify our addressing of tenant fraud, I would like to
use an interview question I pose to recent college graduates who are
applying for Special Agent positions in our office. I explain to the
person that a complaint is received and that a Section 8 tenant
identified as Mary Doe is defrauding HUD by not disclosing income that
she is receiving from a part time job. You conduct an investigation and
find the following: Mary Doe has been working part time at McDonalds
for the past year. She has three elementary school children. From
interviews it appears she is simply trying to earn some extra money to
buy new school clothes, shoes, etc., for her children. She has not
disclosed this additional income and thereby has defrauded HUD out of
$1,000.00 this past year. How do you handle this? The answer that I
look for is that this is not a prosecutable criminal case. Rather this
is the type of situation that we refer back to the Housing Authority
and/or HUD program office recommending that they take appropriate
action.
The purpose of this question is to show that not every fraudulent
act warrants criminal prosecution. Judgment is needed, especially with
limited resources.
Now having identified the type case that would generally not be
pursued, I would like to describe several specific cases where we have
undertaken investigations, alone or with other law enforcement
agencies, that have led to successful prosecutions. The reasons, I
believe, are quite evident.
Nashville, TN--Evelyn Haggen Hodgins an IRS employee, was
prosecuted for falsifying her income in order to obtain Section 8
rental assistance. Ms. Hodgins had failed to report the income she
earned from the IRS. Her fraud resulted in a loss to HUD of over
$15,000.
Memphis, TN--A Memphis Housing Authority employee Donna Dillihunt,
conspired with a Shelby County Corrections Officer Pamela Allen to
create a fictitious Section 8 landlord and place a property in the
Section 8 program. The Corrections Officer became the tenant receiving
the Section 8 assistance. The officer would receive the Section 8
checks and forge the fictitious owner's signature. The two defendants
received over $11,000 in HUD funds.
Campbellsville, KY--During a Safe Home Operation evidence was
obtained that Kelly Lee Shipp and Patricia May Wooley were selling
drugs in the Campbellsville Public Housing Developments. During the
investigation it was discovered that Mr. Shipp was a Section 8 landlord
who was renting to Ms. Wooley. Mr. Shipp had moved in with Ms. Wooley
after he had certified that he did not reside there. The loss to HUD
was only $1,070. But due to the other criminal activities of the pair,
the fraud charge was included in their prosecution.
Atlanta, GA--The defendant Marylin Arinzee, created false birth
certificates in order to obtain four different Section 8 subsidized
apartments under fictitious names in Tennessee and Georgia. In
addition, she received food stamps and welfare at each of the units.
The loss to the Government was over $15,000.
Broward County, FL--Thirty Five individuals were prosecuted for
fraudulently obtaining over $300,000 in Section 8 subsidies. The
tenants were Nigerians or the spouses of Nigerians, who were in this
country illegally or whose status had expired. The Defendants were able
to create false employers and have their Verification of Income forms
sent to post office boxes that they owned or were owned by Nigerian
owned businesses. Twelve of the Defendants were employees of the
Florida Department of Human Rehabilitation Services (HRS). HRS is the
State Agency that administers welfare payments in Florida. In addition,
the defendants also received food stamps, AFDC, and educational grants
that they were not entitled to receive.
There are certain common threads that run through these
prosecutable type cases. A subject who is a City, State, or Federal
employee will spark the interest of an Assistant United States
Attorney. A subject who is defrauding other Government programs like
food stamps or AFDC likewise is seen as a good target. Another good
subject would be a drug dealer. And, of course, there are some whose
actions are so flagrant that a jury would not hesitate to convict. For
example, a subject who owns several rental houses yet still claims
Section 8 assistance. Another important aspect of these cases is the
deterrent value prosecution will bring. For example if there is some
notoriety attached to the case the media will run a story which has a
positive impact on making an applicant think twice about lying. These
are all things that we consider before opening an investigation.
We continue to receive allegations from a number of sources and as
I said undertake approximately five investigations per year. Over the 9
plus years I have been in Atlanta I have seen the same type of
allegations occur and recur--understating income or failing to report
jobs for the purpose of receiving a subsidized unit or a larger subsidy
from HUD. As both resources and prosecutorial appeal exist, we
investigate the most egregious cases. Any remaining allegations are
referred to the Housing Authority and/or HUD program staff for
administrative action, as appropriate.
Mr. Chairman, that concludes my remarks, and I would be happy to
answer any questions you may have.
Mr. Sununu. Mr. Carolan.
STATEMENT OF RAYMOND A. CAROLAN, SPECIAL AGENT IN CHARGE, NEW
ENGLAND OFFICE OF THE HUD INSPECTOR GENERAL
Mr. Carolan. Good morning, Mr. Chairman, Mr. Bentsen, and
members of the committee. I am pleased to appear before you
today and highlight a few examples of our work in the subsidy
fraud area.
I would ask that my comments be entered into the record.
Mr. Sununu. Without objection.
Mr. Carolan. Mr. Chairman, I am a career Office of
Inspector General employee. I have been with the Office of
Inspector General for 28 years. I have been the Special Agent
in charge of the New England District for the last 18 years. I
believe that my district, New England, was the first to present
subsidy fraud cases for prosecution to the United States
attorney in the mid-1970's.
The investigation of these cases today is basically the
same as it was then. The cases usually fall into four major
categories: a tenant's failure to report income or assets; a
tenant's failure to accurately report total family composition,
which usually results in an underreporting of income;
conspiracy between tenants and management; and conspiracy
involving subsidized tenants and property owners.
Today, I would like to present especially egregious
examples of subsidy fraud stemming primarily from the last two
categories, the conspiracy ones.
My first example involves a 262-unit fully subsidized
cooperative housing complex in the Charlestown section of the
City of Boston. In cooperative housing, a tenant board of
directors oversees all aspects of the property management. In
this case, tenants were also employed by the management company
at the site office to administer the annual income
recertifications and to oversee all of the daily operations.
Our investigation revealed widespread fraud and conspiracy
between some of the tenants and the management office
employees. It also included the board members. The widespread
fraud at this complex required the cooperation of the office
staff, members of the board, in order to perpetuate the scheme.
The investigation indicated that employment verifications
that were supposed to be independent were false and forged.
Tenants and management staff conspired to report half of actual
income and conspired to hide the occupancy of employed family
members. There was a pattern of this. They also conspired to
falsify family composition in order to qualify for larger unit
sizes.
An example: Section 8 tenants Barbara and Michael failed to
report total family income, resulting in overpayments of
approximately $14,000. Michael was related to a project
manager. The Section 8 forms failed to accurately reflect
Michael's total income generated from his employment at a
hospital, and failed to reflect any income generated by
Barbara, the spouse, through her employment at the same
hospital.
The Section 8 forms for 1988 reflected the total family
income as $9,000, when, in actuality, in 1988 income for the
gross wages for the entire family was over $57,000.
In addition, the Section 8 forms incorrectly listed their
family composition as consisting of Michael, Barbara, and their
son, Cory. When asked by our agents who Cory was, Barbara
indicated that Cory was her dog, that she has no children. She
could not explain how her dog appeared on the Section 8 forms
as her child.
Listing a child on the Section 8 forms would entitle the
Section 8 tenants to a deduction which is formulated into the
total rent calculation. In addition, the bedroom size allocated
to a Section 8 tenant family is based upon total family
composition. In this case, the family qualified for a two-
bedroom apartment. There were a lot of these cases at this
particular site, where families were overhoused as a result of
falsification of family composition.
Once these schemes were crafted, the employment
verification forms were falsified and formed in order to fit
each scheme. There was a pattern of this particular type of
fraudulent activity at varying levels for many of the tenants
at this complex.
When we attempted to verify the accuracy of their
employment forms, the employees reported that the income
information was inaccurate and that the signatures were all
forged. The investigation involved the use of Federal grand
juries and Federal search warrants.
Twenty-two tenants at the site, including four board
members, were federally indicted for false statements,
conspiracies, and other related charges. All defendants either
pled or were found guilty in 1993. Monetary losses representing
subsidy overpayments related to these indictments were
approximately $245,000.
Following our investigation, the management company was
required to repay HUD over $366,000, and was removed. A new
management company was required to recertify all residents at
this complex. This company's recertification process resulted
in a $400,000 annual reduction in Section 8 subsidies the next
year.
My second example involves a conspiracy between a property
owner and a subsidized tenant. This case was not prosecuted due
to evidence and statute of limitations issues. It is, however,
I believe a good example of this type of scheme.
Our investigation indicated that a property owner
transferred ownership of a single-family property to a straw
buyer just prior to the application to the Public Housing
Authority for participation in the Section 8 program. What he
did was reversed his role from a property owner to a tenant.
From 1981 to 1995, subsidy was paid to the straw buyer in
the amount of over $74,000. The scheme was disclosed when IRS
began to investigate the straw buyer for failure to report
rental income from the property to the IRS. What happened was
the IRS received a 1099 from the Housing Authority disclosing
rental income to that straw buyer.
In response to the IRS, the straw buyer stated that her
ownership of the subsidized property was ``in name only,'' that
the rental income reflected on the form 1099 ``was arranged''
without her knowledge and was sent in--these payments were sent
by the Housing Authority, the Public Housing Authority, to a
post office box rented in her name without her knowledge.
Furthermore, she stated that the subsidy checks were also
cashed without her knowledge or her endorsement on the checks.
An administrative process to recoup this overpaid subsidy is
ongoing.
So even though this case was not prosecuted for various
reasons, the administrative process is ongoing, and I heard
recently that what this straw buyer is doing is turning the
deed back to the Housing Authority for that property, so the
Housing Authority will be the owner, in an attempt to recoup
the $74,000.
Some other examples that parallel income issues. An
investigation was initiated to determine whether Jose and Rose,
public housing tenants in Manchester, NH, failed to report
their income. This was a joint investigation with the Social
Security Administration Office of Inspector General.
The only income claimed on their public housing
applications was Social Security and SSI, disability benefits.
Both Rosa and Jose worked at a variety of jobs during the
period of overpayment, which was July, 1995, to November, 1996.
None of this income was reported on the applications.
Jose was indicted on December 9, 1998, on four counts of
making false statements, three to HUD and one to the Social
Security Administration, and two counts of misusing Social
Security numbers. Jose pled guilty. A Federal judge sentenced
him on June 30, 1999, to time served, which was 6 months. He
got 3 years probation and an assessment of $200, and was
ordered to make repayments in the form of restitution in the
amount of $25,000.
In another case, this particular Section 8 tenant received
Section 8 assistance in Lynn and Lexington, MA, from January
1987 until August 1998. During the period, they only claimed
benefits received from Aid to Families with Dependent Children.
They also held occasional part-time jobs.
Penny, using another name and another Social Security
number of a deceased uncle, worked at a computer company from
December, 1989, to July 1989, and did not report this income.
On September 13, 1999, a criminal complaint was filed in U.S.
District Court in Massachusetts, charging Penny with violating
18 U.S.C. 641, conversion of government funds.
On January 5, 2000, Penny waived her right to indictment
and pled guilty to one count, information. The Federal district
judge sentenced Penny to 6 months' confinement in a halfway
house, 2 years' probation, a $100 special assessment, and
$37,000 in restitution to the Federal Government.
Mr. Chairman, that concludes my remarks. I would be pleased
to answer any questions you may have following the other
witnesses's testimony.
Mr. Sununu. Thank you very much, Mr. Carolan.
[The prepared statement of Mr. Carolan follows:]
Prepared Statement of Raymond A. Carolan, Special Agent in Charge,
Department of Housing and Urban Development, Office of the Inspector
General, New England District
Mr. Chairman and members of the committee. I am pleased to appear
before you today to highlight a few examples of our work in the subsidy
fraud area. I am a career Office of the Inspector General employee with
over 28 years of service. I have been the Special Agent in Charge of
the New England District for the last 18 years.
I believe that my District was the first to present subsidy fraud
cases for prosecution to the United States Attorney in the mid 1970's.
The investigation of these cases today is basically the same as it was
then. The cases usually fall into four major categories:
Tenants failure to report income and/or assets.
Tenants failure to accurately report total family
composition resulting in understated total family income.
Conspiracy between tenants and management.
Conspiracy involving a subsidized tenant and a property
owner.
Today I would like to present especially egregious examples of
subsidy fraud stemming primarily from the last two categories.
conspiracy between tenants and management
My first example involves a 262 unit, fully subsidized. cooperative
housing complex in the Charlestown section of the City of Boston. In
cooperative housing, a tenant Board of Directors oversees all aspects
of the property management. In this case, tenants were also employed by
the management company at the site office to administer the annual
income recertifications and to supervise daily operations.
Our investigation revealed widespread fraud and conspiracy between
the tenants and the management office employees.
The widespread fraud at this complex required the cooperation of
the office staff and members of the tenant Board of Directors in order
to perpetuate the scheme. The investigation indicated that employment
verifications that were supposed to be independent were falsified and
forged.
Tenants and management staff conspired to report half of actual
income and conspired to ``hide'' the occupancy of employed family
members. They also conspired to falsify family composition in order to
qualify for larger unit sizes:
Section 8 tenants, Barbara and Michael failed to report total
family income resulting in an overpayment of $14,506. Michael was
related to a project manager. The Section 8 forms failed to accurately
reflect Michael's total income generated from employment at a hospital
and failed to reflect any income generated by Barbara through her
employment at the same hospital. The Section 8 forms for 1988 reflected
the total family income as $9,073, when in actuality, the 1988 income
for gross wages was $57,785.92. In addition, the Section 8 forms
incorrectly listed their family composition as consisting of Michael,
Barbara and their son, Cory. When asked by the agents who Cory was,
Barbara indicated that Cory was her dog, that she has no children. She
could not explain how her dog appeared on the Section 8 forms as her
child. Listing a child on the Section 8 forms entitles the Section 8
tenants to a deduction which is formulated into their total tenant rent
payment calculation. In addition, the bedroom size allotted to a
Section 8 family is based upon total family composition. In this case,
the family qualified for a two bedroom apartment.
Once the schemes were crafted, the employment verification forms
were falsified and forged in the management office in order to fit each
scheme. There was a pattern of this particular type of fraudulent
activity at varying levels for many of the tenants at the complex.
When we attempted to verify the accuracy of the forms, the
employers reported that the income information was inaccurate and that
the signatures were forged. The investigation involved the use of the
Federal Grand Jury and Federal Search Warrants. Twenty two tenants,
including four board members, were federally indicted for false
statements, conspiracy and other related charges. All defendants either
plead or were found guilty in 1993. Monetary losses representing
subsidy overpayments, related to the indictments, were approximately
$245,000.
Following the OIG investigation, the management company was
required to repay HUD over $366,000 and was removed by HUD. A new
management company was required to recertify all residents. This
company's recertification process resulted in a $400,000 annual
reduction in Section 8 subsidies.
conspiracy between tenant and property owner
My second example involves a conspiracy between a property owner
and a subsidized tenant. This case was not prosecuted due to evidence
and statute of limitations issues. It is however a good example of this
type of scheme.
Our investigation indicated that a property owner transferred
ownership of his single family property to a straw buyer just prior to
the application to the public housing authority (PHA) for participation
in the Section 8 program.
From 1981--1995 subsidy was paid to the straw buyer in the amount
of $74,508. The scheme was disclosed when the IRS began to investigate
the straw buyer for failure to report rental income from the property
to the IRS. The IRS had received a Form 1099 from the PHA disclosing
payment of this rental income to the straw buyer.
In a response to the IRS, the straw buyer stated that her ownership
of the subsidized property was ``in name only"; that the rental income
reflected on the Form 1099 was ``arranged'' without her knowledge and
was sent by the PHA to a post office box rented in her name without her
knowledge. Furthermore she stated that the subsidy checks were cashed
without her knowledge or endorsement. An administrative process to
recoup the overpaid subsidy is ongoing.
other examples
An investigation was initiated to determine whether Jose and Rosa,
Public Housing Tenants, Manchester, NH, failed to report their income.
This was a joint investigation with the Social Security Administration,
Office of Inspector General. The only income claimed on their public
housing applications was SS/SSI. Both Rosa and Jose worked at a variety
of jobs during the period of overpayment, July 1, 1995 to November 26,
1996, and none of this income was reported on their public housing
applications.
Jose was indicted on December 9, 1998 on four counts of making
false statements (18 USC 1001; 3 related to SSA and 1 to HUD) and two
counts of misusing Social Security numbers (42 USC 408, SSA violation).
Jose plead guilty to counts 1 (18USC1001 re: SSA) and 4 (18USC1001 re:
HUD) and the other four counts were dismissed. A Federal judge
sentenced him on June 30, 1999 to time served (6 months), 3 years
probation, an assessment of $200, and restitution of $25,906.33
($18,650.33 to SSA and $7,256 to HUD)
Penelope, a/k/a Penny, received Section 8 assistance in Lynn and
Lexington, MA, from January 1987 until August 1998 and during that
period of time Penny only claimed benefits received from Aid to
Families with Dependent Children and/or an occasional part time job.
Penny, using another name and a SSN of her deceased uncle, worked at a
computer company from December 1989 until July 1998 and did not report
this income on her Section 8 applications.
On September 13, 1999 a Criminal Complaint was filed in U.S.
District Court, District of Massachusetts charging Penny with violating
18USC641, Conversion of Government Funds. On January 5, 2000 Penny
waived her right to indictment and plead guilty to a one count
Information charging her with violating 18USC641. On April 10, 2000 a
U.S.
District Judge sentenced Penny to 6 months confinement in a halfway
house, 2 years probation, $100 special assessment, and $37,709 in
restitution.
Mr. Chairman, that concludes my remarks, and I would be pleased to
answer any questions you may have.
Mr. Sununu. At this time, I would like to ask Ms. Crowley
and Mr. Ramirez to please have a seat at the witness table.
Mr. Bentsen.
Mr. Bentsen. Mr. Chairman, I misspoke. Secretary Ramirez
was the mayor of Laredo, not the county judge of Webb County. I
apologize for that. I have found, as you have probably found,
that the mayor of a city is the most powerful individual you
can meet. So I want to make sure I got that right.
Mr. Ramirez. That is OK.
Mr. Sununu. I appreciate Mr. Ramirez' sacrifice, giving up
that power for a little bit of public service, and obviously
serving the needs of those looking for decent, affordable
housing.
At this time, I would be happy to yield to Mr. Ramirez for
his testimony for any time that he may require.
STATEMENT OF SAUL N. RAMIREZ, JR., DEPUTY SECRETARY, U.S.
DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
Mr. Ramirez. Thank you very much, Mr. Chairman, and Ranking
Member Bentsen, as well as other members of the committee. I
would like to submit my written testimony and its exhibits for
the record, and provide you with just a summary of the key
points of my testimony to move on to the question-and-answer
period, if I may, Mr. Chairman.
First, let me say that it is historic for us at the
Department to be able to deal with an issue such as tenant
income verification. Let me just clear up a point. It is not
just Section 8 that we are talking about when we are talking
about tenant income verification; that we are actually talking
about 4.5 million families that include residents of public
housing, as well, and not just Section 8 subsidized housing.
What we have done is, we have a tool for assisting the
Department in furthering our goal of targeting rental
assistance only to eligible families and ensuring that each
family pays the correct amount of rent. But we cannot act
alone; both tenants and our partners who provide the housing
have a direct responsibility for correcting and actually
correctly determining the rental assistance, and HUD's new
income verification program does not alter those roles.
The complexities associated with providing eligible
individuals with the correct level of rental assistance are
numerous. Legislation over the last couple of years has given
different POAs, or private owners and agents, such as Housing
Authorities, different types of wide discretion, or discretion
in the delivery of rental assistance and recovery of excess
rental assistance.
The differences include varied recertification policies,
exclusion of specific income from rent determination
calculations, the establishment of ceiling rents, and the
adoption of diverse recovery policies.
Until now, the Department's past efforts to enhance the
effectiveness of POAs, efforts to ensure that low-income
eligible families receive the correct level of rental
assistance, have been limited. However, the Department is now
implementing a large-scale computer-matching income
verification program to dramatically enhance the information
our partners need to fulfill their income verification
responsibilities.
HUD has matched tenant-reported income with Federal tax
information, and has identified approximately 230,000 tenants
who have underreported income. At this very moment, letters are
being sent to these tenants and notifications are being sent to
the POAs. HUD has worked with the tenant groups, as well as
industry groups, to obtain the highest level of support for
this initiative.
Also, in the interests of fairness to all parties, the
Department is also addressing the overreporting of income, and
will be mailing letters as part of this initiative in the near
future to tenants who might not have received all the
assistance to which they were entitled.
HUD's new large-scale computer-matching program achieves
the delicate balance between the needs of tenants, including
tenants' rights to privacy and due process, the
responsibilities and work loads of our private owners and
agents that are partners out there, and the ultimate goal of
allocating scarce resources to eligible tenants at correct
levels of rental assistance.
For several years, staff from OIG have conducted a sample
of 1,000 households to estimate excess rental assistance. These
estimates have ranged from--anywhere between $417 million and
$935 million.
There are many reasons why this excess rental assistance
cannot be fully recovered by HUD. Perhaps many tenants who have
underreported their income will leave once they are identified,
before any back rents can be collected. Recovery costs can be
excessive and often fall way short of any rental assistance
that could be received. Administrative costs paid by the POAs
associated with tracking recoveries reduce the amount of any
potential to us in the long run.
Moreover, when a tenant vacates after underreporting of
income is identified, the tenant typically is replaced by
another eligible family requiring assistance. And, of course,
we endorse the goal of targeting rental assistance only to
eligible families. However, we must point out that in cases
like this, when an eligible family replaces an ineligible
family, the net amount of rental assistance may not decline and
may even increase. This is one reason why our program focuses
on setting current rents correctly to prevent future abuses
before they happen, when it is much more difficult for us to
actually go out and collect after the abuses have occurred.
Through the use of our large-scale computer-matching income
verification process, HUD is providing our partners, the
private owners and agents, with an additional tool to help
identify tenants responsible for program abuses.
In this first year of large-scale computer-matching income
verification, HUD is seeking to establish a baseline by which
to measure the private owners' and agents' income verification
efficiency and effectiveness at the level at which the tenant
program abuses can be better detected and better deterred.
With that, I would like to conclude by saying that our
efforts to further enhance our abilities to create a more on-
time system of verifying could probably be strengthened by
seeking a stronger partnership with the Department of Health
and Human Services quarterly new-hire reports, so that both the
POAs and HUD can better track incomes, but that would certainly
take some help on your part with additional legislation.
That concludes my summary of my written testimony, Mr.
Chairman. I am prepared to answer any questions when we are
done.
Mr. Sununu. Thank you very much, Mr. Ramirez.
[The prepared statement of Mr. Ramirez follows:]
Prepared Statement of Saul N. Ramirez, Deputy Secretary, U.S.
Department of Housing and Urban Development
Thank you for allowing us this opportunity to testify on the
Department's computer matching income verification efforts. For the
first time in the history of public housing, we have a tool for
assisting the department in furthering its goal of targeting rental
assistance only to eligible families and ensuring that each family pays
the correct amount of rent.
The Department acknowledges that more could be done to assure only
eligible low income tenants receive HUD rental assistance and to assure
that all tenants pay their fair share of rent as required by statute.
We are aware--indeed we have estimated--the size of possible under-
reporting of income. And, we are moving to do more by implementing an
income verification program under the authorities given us by the
Congress.
We are confident that our computer matching income verification
efforts will improve the targeting of our scarce rental subsidy
dollars, make the administration of these programs more fair, and bring
in additional resources to offset the cost of reaching more of the 5.4
million low-income families who have severe housing needs.
The complexities associated with providing eligible individuals
with the correct level of rental assistance are numerous. First, we
cannot act alone in this area. As you know, HUD has no direct
relationship with the tenants who benefit from our programs. Rather,
both tenants and our partners who provide the housing each have a
direct responsibility for correctly determining the rental assistance.
Tenants must accurately and completely report their income to their
housing managers--the Public Housing Authorities and private owners,
and agents who administer our rental assistance programs. In turn, the
housing providers have ultimate responsibility for verifying tenant
incomes and setting the rents correctly. Our new computer matching tool
is designed to dramatically improve the information our partners need
to fulfill their income verification responsibilities.
In addition, comparing IRS or Social Security data with the income
reported by tenants is not a straightforward calculation. Great care
must be taken in drawing conclusions from the matching process because
there are many reasons that IRS data, for example, might indicate that
an improper underpayment is occurring when, in fact, it is not.
Legislation over the years has given different housing providers wide
discretion or varying directions in how they set rents, calculate
tenant contributions and go about recovering excess rental assistance.
These differences include exclusion of specific types of income from
rent determination calculations and the establishment of rent ceilings
that do not go up with increases in household income. Recent
legislation has added additional variables in the form of longer
intervals between recertifications for tenants under some of the
Department's programs which means that increases in a tenant's income
may not be captured in a timely manner by the recertification process.
Frankly, until now the Department's past efforts to enhance the
effectiveness of POAs' (Private Owner or Agent) efforts to ensure that
low income-eligible families receive the correct level of rental
assistance have been limited. Beginning in the mid-1980's and
continuing until 1992, the Department performed several narrow matches
of tenant-reported income with tenant income supplied by State wage
agencies and the Office of Personnel Management to identify under-
reported income and excess rental assistance. The Omnibus Budget
Reconciliation Act of 1993 allowed the Department to expand its
computer matching efforts to include Federal tax information provided
by the Internal Revenue Service and the Social Security Administration.
There are a number of laws and other requirements to adequately safe
guard the privacy of this sensitive data, for example Section 6103 of
the Internal Revenue Code (IRC) and the Computer Matching and Privacy
Protection Act of 1988. HUD and its partners have worked diligently on
these issues and continue to work on ensuring that this sensitive data
remains protected. The Department used that new authority to complete
computer matching initiatives focused on individual POAs and on
sampling the universe of subsidized tenants to estimate overpaid rental
assistance. This sampling was conducted by HUD's Office of the
Inspector General with the goal of quantifying under-reported income
for financial statement purposes.
The Department is now implementing a large-scale computer matching
income verification program. HUD has matched tenant-report income with
Federal tax information and has identified approximately 230,000
tenants who under-reported income at some fairly large thresholds
levels set by the Department for this initial effort. At this very
moment, letters are being sent to those tenants and notifications are
being sent to all our housing authorities and landlords requesting that
tenants resolve the potential discrepancies we have identified through
our income-matching program. The letters to the housing providers do
not disclose any income data regarding tenants, but only advise the
housing provider to recertify the income of these particular tenants.
HUD has worked diligently with tenant and industry groups to obtain
the highest level of support for this initiative. For example, we
conducted two training sessions for our partners and stakeholders, soon
to be followed by a third. We developed an online guide to help our
housing providers in processing and resolving income discrepancies, and
we established two call centers to handle both housing provider and
tenant inquiries. We are also including a fact sheet on the income
verification program with all mis-match letters that are being sent to
tenants.
In the interest of fairness to all parties, the Department is also
addressing over-reporting of income and will soon be mailing letters as
part of this initiative in the near future to tenants who might not
have received all of the assistance to which they were entitled.
This large-scale computer matching program achieves the delicate
balance between the needs of tenants, including tenants' rights to
privacy and due process, the responsibilities and workload of housing
providers, the responsibility to assure fairness among all tenants by
assuring that each pays his/her proper amount as require by statute,
and the ultimate goal of allocating scarce resources to eligible
tenants at correct levels of rental assistance. HUD is undertaking
these efforts because of statutory requirements and because it is the
right thing to do. It is important to recognize, however, that this
income verification efforts is primarily designed to improve voluntary
compliance by providing reasonable assurance that tenants pay the
proper amount in the future. We do not expect a large windfall from
collections of past underpayments, Indeed, we ask POAs to be work with
tenants on an prudent payment plan as appropriate that does not
overwhelm their finances.
For many years now, the Department's financial statement has
reflected an estimate that tenant underpayments total some $900
million. I think it is important to advise the Committee that this
number is a gross estimate of underpayments and not a net amount that
could be collected through tenant income verification efforts. For
several years, staff conducted a sample of 1,000 households to estimate
excess rental assistance. These estimates were developed under specific
parameters and assumptions with numerous qualifying statements and have
a wide statistical range $417 million and $935 million. It is extremely
important to note that these are estimates of total excess rental
assistance if all tenants reported income on a retrospective basis. It
is not a total of recoverable excess rental assistance. Nor are they
estimates of achievable departmental savings.
There are many reasons excess rental assistance cannot be fully
recovered by HUD. First of all, our experience with a pilot income
verification program indicates that approximately 30 percent of tenants
who have under-reported their income will leave once they are
identified before any back rents or future higher rents can be
collected. In accordance with recent statutory changes, these tenants
will be replaced by eligble households who are predominately very low-
income households with the end result probably being little or no
significant increased returns to the housing provider. Indeed, in such
instances, the rents being paid to the provider for that unit may
decrease. Our experience also suggests that even where a tenant agrees
to pay off back rent owed, the average length of the agreed-upon
payment plan is between 5 and 7 years. Given these circumstances, we do
not expect big dollar returns to result from back rent collections
under the income verification effort.
Second, while HUD has advised housing providers to pursue cases of
blatant fraud, the recovery costs for the run-of-the-mill tenant
underpayment can be excessive, and often far exceed any rental
assistance that could be recovered. These include direct costs
associated with verifying excess rental assistance and recovering funds
through the legal system and administrative costs associated tracking
recoveries. Businesses associated with debt collection have often cited
20 percent as a reasonable estimate of debt recovery, and recent
experience with tenant income verification efforts around the country
have been consistent with this benchmark. For example, in a recent
computer matching initiative, the Dallas Housing Authority identified
95 tenants who received excess rental assistance totaling $350,000. The
housing authority was able to establish repayment agreements with only
17 of these tenants. The repayment agreements totaled $80,000, or about
20 percent. The $900 million figure makes no attempt to calculate these
costs of collection.
For all of these reasons--tenant move-outs, high administrative
costs, the administrative payments to our partners--the amount of
``excess'' assistance paid to tenants cannot be easily recaptured by
HUD. We believe that more is gained by looking forward than back. In
the case of the Dallas Housing Authority, the agency terminated rental
assistance to 42 of the 95 tenants who under-reported their incomes--
freeing up units for eligible families. Through the use of large-scale
computer matching income verification, HUD is providing housing
providers with an additional tool to help identify tenants responsible
for program abuses. In this first year of large-scale computer matching
income verification, HUD is seeking to establish a baseline by which to
measure housing provider's income verification effectiveness and the
level of tenant program abuses. This information will allow HUD to
effectively target its future enforcement and monitoring efforts to
those areas where the problem is most acute.
HUD continues to work to improve its income verification program.
The Department needs your support to better serve the needs of those
eligible to receive rental assistance.
Mr. Sununu. Ms. Crowley, welcome. Thank you for being here.
I am pleased to yield to you, for testimony, whatever time you
might need.
Ms. Crowley. Thank you.
STATEMENT OF SHEILA CROWLEY, PRESIDENT, NATIONAL LOW-INCOME
HOUSING COALITION
Mr. Sununu, Mr. Bentsen, I am very pleased to be here. I
would like to submit my written testimony and attachments for
the Record.
Mr. Sununu. Without objection.
Ms. Crowley. I am Sheila Crowley, the President of the
National Low Income Housing Coalition. We are a membership
organization. We represent individuals and organizations around
the country that are committed to ending the affordable housing
crisis and assuring decent housing and healthy neighborhoods
for everyone.
Our members include nonprofit housing providers, homeless
service providers, fair housing groups, State and local housing
coalitions, public housing agencies, private developers and
private owners, housing researchers, local and State government
agencies, faith-based organizations, and residents and their
organizations.
So on behalf of all our members, thank you for the
opportunity to offer our perspective on the income verification
issue and how it fits into the broader picture of housing
affordability and the Federal response to the affordable
housing crisis.
We have worked closely over the last 2 months with our
partner resident organizations and HUD officials to shape the
implementation of the income verification program in a manner
that will achieve the objective of assuring that scarce housing
assistance is used to help as many eligible families and
individuals as possible, while preventing unwarranted panic and
housing destabilization for thousands of public and assisted
housing residents who have done nothing wrong.
Everyone, all of us, agree that people who fraudulently
misreport their income in order to accrue more Federal benefits
than that to which they are entitled should not be allowed to
get away with it. As someone who is acutely aware of the severe
limits of housing choices for poor Americans, I make no excuses
for people who deliberately deprive others of badly needed
housing assistance.
However, we believe that a substantial percent of the
discrepancy between the rent certifications and the tax returns
that have been identified in the IG's report have occurred for
one of a number of legal and legitimate reasons or as the
result of honest mistakes, or are rooted in errors made by
Housing Authorities or private owners.
It is wrong to jump to the conclusion that lots of poor
people are ripping off the system. The list of possible
explanations for so-called ``false positives,'' that is,
leaseholders with legitimate discrepancies, is extensive. Mr.
Ramirez has reviewed some of those.
Indeed, Congress has authorized many explanations for this
discrepancy in order to reduce the disincentives for work that
have been a problem in Federal housing programs. Further, if
there are inaccuracies in how a tenant's share of rent is
calculated that results in overpayment by the Federal
Government, there are also many cases where residents are
making overpayments.
As I understand it, the amount of resident overpayment has
not yet been determined, so a true picture of what the
overpayment problem is will emerge once both the false
positives and the tenant overpayment are factored into the
equation.
The concern of residents and their advocacy partners was
that HUD's initial plan for implementation of the income
verification program had the effect of accusing many innocent
people of wrongdoing and then requiring them to prove
otherwise. While there are some lingering concerns, I am happy
to report that it is very accurate that HUD leadership has been
very responsive to the issues raised by residents, and the
income verification program has undergone significant
improvements as a result.
The negotiations have necessarily slowed down the program,
but we believe that taking the time to do it right is the right
thing to do.
We want to solve the income discrepancy problem and
eliminate the income discrepancy issue as an argument that has
been raised against increased funding for housing assistance.
Solving the problem in a way that causes precipitous harm to
low-income residents for no valid reason is counterproductive
and simply wrong.
It is equally wrong for Congress to use this income
discrepancy analysis as justification for failing to address
serious housing affordability problems. So I want to put this
problem into perspective.
The widely accepted standard in the housing industry is
that housing should cost no more than 30 percent of household
income. Our analysis shows that in 1997 10.8 million very low-
income households, that is, households with incomes at less
than 50 percent of the area median, paid over half of their
income for their housing. This is nearly 11 percent of all
households in the United States. That includes 8.4 million
renters and 2.4 million homeowners.
A more vivid illustration of the depth and breadth of the
housing affordability crisis is our analysis of housing costs
in comparison to wages in every jurisdiction in the country. We
can say with assurance that nowhere in the country can a full-
time minimum-wage worker afford the fair market rent for a two-
bedroom rental unit. Nowhere.
The housing wage which we calculate, that is, the hourly
wage one needs on a full-time basis to afford basic rental
housing, ranges from $8.02 in West Virginia to $17.10 in
Hawaii. In the Manchester, New Hampshire, metropolitan
statistical area, for example, 44 percent of renter households
cannot afford the two-bedroom fair market rent, and the housing
wage is $13.20 an hour. One hundred and 2 hours of minimum wage
work a week is required to afford the fair market rent in the
Manchester SMA.
In the Houston SMA, 40 percent of the renters cannot afford
the fair market rent. The housing wage is $11.56 an hour, and
one must work 90 hours at the minimum wage in order to afford
the fair market rent.
I have attached to my written testimony analysis of the
housing costs and income gaps in the States that are
represented by all the members of the Task Force for your
review. The numbers are stark, but what does it mean to be a
low-income family and have a severe housing cost burden?
One or more of the following happens: The family pays a
precariously high percentage of its income for its housing, and
then must scrimp on other necessities, like food or medicine;
or adults in the family work two or three or more low-wage jobs
and have precious little time left over to devote to family and
parenting duties; or they are forced into substandard or
overcrowded housing, paying rent to unscrupulous landlords who
can take advantage of the severe housing shortage that poor
people experience; or they simply cannot pay the rent, are
threatened with eviction, gain poor credit records, and in some
cases, spiral down into homelessness.
We are increasingly aware that the high rate of mobility
among poor families, driven in large part by staying on the
move to stay a step ahead of the eviction server, contributes
to poor school performance by children who drift from one
school to another and just never catch up. In the age of
standardized tests as the primary indicator of academic
achievement, these kids do not have a chance at success.
We all tacitly understand the centrality of stable housing
in our ability to do our jobs and raise our families. If we
ponder even for a moment how we would cope if maintaining our
housing was a daily struggle, we could easily understand the
human dimensions of the affordable housing crisis.
We know that receipt of Federal housing assistance
contributes to housing stability for formerly homeless families
and is associated with success at moving from welfare to work.
It is a good investment in American families.
Federal expenditures on low-income housing are woefully
inadequate in the face of this challenge, and when examined in
comparison--and this is an analysis the National Low Income
Housing Coalition has done for some time--when we examine this
in comparison to Federal expenditures to subsidize the housing
of middle- and upper-income households, the lack of investment
in low-income housing becomes more apparent.
In 1997, assisted housing outlays were $26 billion, while
housing tax expenditures, mostly mortgage interest deductions
and property tax deductions, were $97 billion. In constant 2000
dollars, the tax expenditure level will go to $123 billion by
2005. It is going to take much more than fine tuning the
existing low-income housing programs, which we must continue to
do, to seriously make a dent in this program.
The good news is that we know how to solve the affordable
housing crisis. It is not rocket science. We have a thriving,
mission-driven, community-based, nonprofit housing sector that
is only increasing in its capacity to provide safe, decent, and
affordable housing. We believe strongly that the resources
exist to intervene at the scale needed to make a difference.
What we need now is creative and visionary leadership.
Thank you for your consideration of my remarks. I will be
happy to answer any questions.
Mr. Sununu. Thank you very much, Ms. Crowley.
[The prepared statement of Ms. Crowley follows:]
Prepared Statement of Sheila Crowley, President, National Low-Income
Housing Coalition
Mr. Sununu and Mr. Bentsen, I am Sheila Crowley, President of the
National Low Income Housing Coalition. I would like to submit my
written testimony and attachments for the record.
The National Low Income Housing Coalition is a membership
organization representing individuals and organizations that are
committed to ending the affordable housing crisis in America and to
assuring decent housing in healthy neighborhoods for everyone. Our
members include non-profit housing providers, homeless service
providers, fair housing organizations, state and local housing
coalitions, public housing agencies, private developers and property
owners, housing researchers, local and state government agencies,
faith-based organizations, and residents of public and assisted housing
and their organizations. On behalf of our membership, I thank you for
the opportunity to offer our perspective on the income verification
issue and how it fits into the broader picture of housing affordability
and the Federal response to the affordable housing crisis.
We have worked closely over the last 2 months with our partner
resident organizations and HUD officials to shape the implementation of
the income verification program in a manner that will achieve the
objective of assuring that scarce housing assistance is used to help as
many eligible families and individuals as possible, while preventing
unwarranted panic and housing destabilization for thousands of public
and assisted housing residents who have done nothing wrong.
Everyone agrees that people who fraudulently misreport their income
in order to accrue more Federal subsidy than that to which they are
entitled should not be allowed to get away with it. As someone who is
acutely aware of the severe limits of housing choices of very poor
Americans, I make no excuses for people who deliberate deprive others
of badly needed housing assistance.
However, we believe that a substantial percent of the discrepancy
between rent certifications and tax returns that is identified in the
Inspector General's report has occurred for one of a number of legal
and legitimate reasons or is the result of honest mistakes or is rooted
in errors on the part of housing authorities or property owners. It is
wrong to jump to the conclusion that poor people are ripping off the
system. The list of possible explanations for so-called ``false
positives,'' that is, leaseholders with legitimate discrepancies, is
extensive. Indeed, Congress has authorized many explanations for the
discrepancy to reduce the disincentives for work that have been a
problem in Federal housing policy. Further, if there are inaccuracies
in how tenant share of rent is calculated that results in overpayment
by the Federal Government, there also are cases where residents are
making overpayments. As I understand it, that amount has not yet been
determined. A truer picture of the Federal overpayment problem will
emerge once both the ``false positives'' and tenant overpayments are
factored into the equation.
The concern of residents and their advocacy partners was that HUD's
initial plan for implementation of the Income Verification Program had
the effect of accusing many innocent people of wrongdoing and then
requiring them to prove otherwise. While there are some lingering
concerns, it is accurate to say that HUD leadership has been responsive
to issues raised by residents and the income verification program has
undergone significant improvements as a result. The negotiations have
slowed down the program, but we believe that taking the time to do it
right is the right thing to do and is well worth the effort.
We want to solve the income discrepancy problem and eliminate the
income discrepancy issue as an argument against increased housing
funding. But solving the problem in a way that causes precipitous harm
to low income residents for no valid reason is counterproductive and
simply wrong. It is equally wrong for Congress to use this income
discrepancy analysis as justification for failing to seriously address
the affordable housing crisis of low income Americans. Let's put this
problem into perspective.
The widely accepted standard in the housing industry is that
housing should cost no more than 30 percent of household income. Our
analysis shows that in 1997, 10.8 million very low income households
(that is, households with income less than 50 percent of the area
median) paid over half of their income for their housing. This is over
11 percent of all households in the United States and includes 6.4
million renter households and 4.4 million homeowners.
A more vivid illustration of the depth and breadth of the
affordable housing crisis is our analysis of housing costs in
comparison to wages in every jurisdiction in the country. We can say
with assurance that nowhere in the country can a full time minimum wage
worker afford the Fair Market Rent for a two bedroom rental unit. The
housing wage, that is, the hourly wage one needs on a full time basis
to afford basic rental housing, ranges from $8.02 in West Virginia to
$17.01 in Hawaii. In the Manchester, NH, Metropolitan Statistical Area,
44 percent of the renter households cannot afford the two bedroom Fair
Market Rent and the housing wage is $13.02. One hundred and 1 hours of
minimum wage work a week is required to afford the Fair Market Rent. In
the Houston, TX, MSA, 40 percent of renters cannot afford the Fair
Market Rent, the housing wage is $11.56, and one must work 90 hours a
week at minimum wage to afford a basic rental unit. I have attached to
my written testimony analysis of the housing costs and income gap for
the states of each of the members of the Task Force. I also have
provided a copy of the complete jurisdiction by jurisdiction analysis
for your use.
The numbers are stark. But what does it mean to be a low income
family and have a severe housing cost burden? One or more of the
following happens. The family pays a precariously high percentage of
its income for its housing and must scrimp on other necessities like
food and medicine. Or the adults in the family work two, three, or more
low wage jobs and have precious little time left over to devote to
family and parenting responsibilities. Or they are forced into
substandard or overcrowded housing, paying rent to unscrupulous
landlords who can take advantage of the severe housing shortage
affordable for the poor. Or they simply cannot pay the rent and are
threatened with eviction, gain poor credit records, and in some cases,
spiral down into homelessness.
We are increasingly aware that the high rate of mobility among poor
families, driven in large part by staying on the move to stay a step
ahead of the eviction server, contributes to poor school performance by
children who drift from one school to another and never catch up. In
the age of standardized tests as the primary indicator of academic
achievement, these kids do not have a chance at success. We all tacitly
understand the centrality of stable housing in our ability to do our
jobs and raise our families. If we ponder even for a moment how we
would cope if maintaining our housing was a daily struggle, we can
easily understand the human dimensions of the affordable housing
crisis.
We know that receipt of Federal housing assistance contributes to
housing stability for formerly homeless families and is associated with
success at moving from welfare to work. It is a good investment in
American families.
Federal expenditures on low income housing are woefully inadequate
in the face of this challenge. And when examined in comparison to
Federal expenditures to subsidize the housing of middle and upper
income households, the lack of investment in low income housing becomes
even clearer. In 1997, assisted housing outlays were $26 billion, while
housing tax expenditures (mortgage interest and property tax
deductions) were $97 billion. In constant 2000 dollars, the tax
expenditure level will go to $123 billion by 2005.
It will take much more than fine-tuning existing low income housing
programs, which we must continue to do, to seriously make a dent in
this problem. The good news is that we know how to do solve the
affordable housing crisis. We have a thriving mission-driven,
community-based, non-profit housing sector that is continually
increasing its capacity to provide safe, decent, and affordable
housing. We believe strongly that the resources in our country to
intervene at the scale needed to make a difference. What we need now is
the creative and visionary leadership to make it happen.
Thank for your consideration of my remarks.
Mr. Sununu. I would like to begin the questioning now,
touching on a few of the points that you raised with Mr.
Ramirez.
First, you raised, I think, a very important concern about
false positives, about trying to approach the verification
process carefully.
There is no question when you have the number of letters
that are going out, the number of discrepancies in income
reporting that we have, there are going to be some legitimate
reasons that both of you touched on in your testimony for the
problem.
I think we can minimize those issues by putting in place a
reasonable threshold for income discrepancy. We are not talking
about a difference of $100 or $500 or even $1,000, as I
understand it, in the income that is reported. It is at a
higher threshold than that.
Mr. Ramirez, can you review for instance what those
thresholds are?
Mr. Ramirez. Yes. We have actually two thresholds. One is
for the multifamily Section 8 subsidized housing, which is a
$4,000 threshold. Then we have an $8,000 threshold for public
housing.
Mr. Sununu. For annual income?
Mr. Ramirez. Yes, sir, annual income.
Mr. Sununu. In your testimony on March 8, you suggested
that there were, I think, 260,000 letters that were about to go
out. In your testimony today, you mentioned 230,000 letters. It
is a difference of about 10 percent. I just want to be clear
for the record; how many letters are being mailed out today?
Mr. Ramirez. We have two family incomes, so the number has
shrunk in matching up addresses and individuals in those
incomes. We anticipate that that will be the case in a bigger
mailing that will take place after working with the different
industry groups, as it relates to the overpayments that will be
discovered as we run the analysis, as well as the notification
to all residents that are currently receiving some sort of
subsidy that--in their verification recertification process, we
are advising them, in the same form that we have advised by way
of information and handout attached to these letters, what kind
of income they need to take with them as they get recertified
for the following year, sir.
Mr. Sununu. In your testimony, you said those letters are
being sent as we speak. How many letters are being sent out
this week?
Mr. Ramirez. I couldn't tell you exactly how many this
week. It is a massive mailing of 230,000.
Mr. Sununu. When is the goal for having completed the
entire mailing?
Mr. Ramirez. We should be done mailing all of these letters
within the next 2 weeks or so, sir.
Mr. Sununu. Two weeks? That is the initial----
Mr. Ramirez. This is the initial match of discrepancies for
underreporting income as it relates to the entire population.
Mr. Sununu. That is a total of 230,000 notifications?
Mr. Ramirez. Approximately, yes, sir.
Mr. Sununu. You talked about the concern of those that may
be overreporting income, and therefore--and Ms. Crowley touched
on that, as well. You didn't give an estimate of the number of
cases of overreporting.
Has a similar IRS match been done to try to quantify the
number?
Mr. Ramirez. Yes. We are currently working on that match.
But let me, if I may, Mr. Chairman, just bring some perspective
to where we are and where we were.
We have over the last several years depended on the
Inspector General's review of a random sample of 1,000
residents. We have now gone to matching the entire population
that is receiving some sort of benefit from public housing or
subsidized housing.
We have worked very hard to reduce the false positive
percentage on the underreporting process, and we feel
comfortable in saying that we are running at about 20 percent
in comparison to perhaps up to maybe as much as 50 percent in
the old sampling method; and we are currently calibrating the
false positives based on the thresholds that we have for the
overpayment.
We run a similar risk in estimating an overpayment, if we
are not careful, in first getting these false positives, as
small a number as it can be, because you can imagine someone
receiving a letter saying, you have something due you, and they
go in and they then find out that they don't have anything due
them as a result of us advising them that they have overpaid.
So we are in the process of doing that. We have gone
through two runs of getting it. The number has reduced from
about 55 percent to about 30 right now. We are not comfortable
yet with where we are on the false positives. We are running
the systems to see if we can further reduce that.
We are also working with the different industry groups to
get together with them in the near future on these
notifications and to report out to them.
Mr. Sununu. Ms. Crowley, I don't want to put you on the
spot, but in the March testimony, Mr. Ramirez talked about
trying to touch base with industry groups and tenant groups.
My question is, to what extent have you or your members
participated in discussions with HUD, and what more do you
think that HUD can do to make sure that the process they are
undertaking is fair?
Ms. Crowley. I would say that our interactions with HUD
officials have been extensive. My experience was that it did
take getting it to the attention of the very highest levels to
get us heard, but once that happened, then we were heard loud
and clear. So there have been a series of meetings and
discussions about that.
There are, as I said, lingering concerns. It is not 100
percent resolved. There are--my concern, my more than concern
at this point, is about how it is going to play out at the
local level and how we are going to assure that what it is that
we have agreed to at this level actually happens there.
That is the tricky part, because if everything unfolds the
way we have been told it will, then it should happen in a fair
kind of way. But we are talking about the behavior of a large
number of different people who are going to get communications
through several layers, and there is always the danger of
distorted communication.
So we will be very alert to how it is happening on the
ground with our members and be prepared to advocate at that
level as well.
Mr. Sununu. We don't need to take Mr. Ramirez to task for
not including you?
Ms. Crowley. No.
Mr. Sununu. Good.
A few final questions about the scope of the problem,
because there are two large issues here. One is the financial
issue, which is estimating the size of the underpayments. That
is important because the demand for the services are high.
You gave a very stark picture of that, Ms. Crowley. If we
take the estimate of $935 million that has been presented to
the Task Force by HUD and the Inspector General's Office, that
does translate into 150,000 or so certificates, new
certificates, which is even more than is being requested by the
administration this year. So it is a significant number.
If I can finish, the other side of the problem is that if
there is a case of someone who is ineligible receiving housing,
then that means someone is on the waiting list, obviously, who
is in need that would otherwise qualify for a slot. Of course,
it is worth emphasizing that the vast majority of all of the
tenants here are completely honest, law-abiding, and deserving
of the services.
Even if you take the full figure of $935 million--I think
you used the total figure of 26 million for low-income
housing--but just at the Federal level, if you look at a figure
of 15\1/2\ million for the certificate program, it is well
under 10 percent. It is probably--that is roughly 7 percent. So
at the absolute worst, 93 or 94 percent of the people in this
are not even matched, so there is not an issue there.
So there are two sides to the problem. The specific
question I have Mr. Ramirez, is the gross figure of $935
million--you gave an estimate of $400 million to $935 million--
that is an annual loss; is that correct?
Mr. Ramirez. Well, that is the estimate that comes out of
the methodology that was recommended to us to employ in
partnership with the Inspector General, sampling only 1,000
of--after taking dual incomes, of about 4\1/2\ million
families. So it is a broad estimate or a big estimate----
Mr. Sununu. Based on a sample of 1,000?
Mr. Ramirez. Yes.
The other thing is, because of some of the reasons I cited
as to the difficulty in recapturing these funds, as a result of
folks moving away and other activities, that the more realistic
estimate that OMB has come out with in the budget we believe is
closer to accurate, which is about $80 million. That is taking
into consideration not just the turnaround that may occur, but
also remember that there is that category of overpayments.
It is very preliminary for me to make any real estimate on
that, but based even on a 50 percent false positive, the number
is quite substantial on the overpayment side, as well.
So our goal in the end, Mr. Chairman, is to try to get
folks qualified at the front end to avoid the back-end
discrepancies that could lead to any sort of waste, fraud, and
abuse that we know is occurring, as was highlighted by the
Office of Inspector General.
Mr. Sununu. Ms. Crowley.
Ms. Crowley. I do not pretend to understand all the
intricacies of these numbers, but my understanding--and Mr.
Ramirez, correct me if I'm wrong--is that the 935 million is
the first cut at the analysis, and it is before all the false
positives have been cleaned out.
So once--as I said, to get to the true overpayment, you
have to screen out all the false positives and you have to do
the overpayment, and then you will get to what that real number
is. So it is going to be something substantially less than
that.
So the 230,000 letters that are going out, the total of
that does not get up to $935 million because that analysis was
based on sort of a gross analysis at that point.
Mr. Ramirez. Yes.
Ms. Crowley. So that has to be further refined to get at
some understanding of what the true number is.
Mr. Sununu. Thank you.
Mr. Ramirez. May I just say--real quick, just to say that
what we have done is that this year, for the first time ever,
we will have an accurate baseline of what that number really
is, instead of these estimates that are based on a small
population of a greater population.
Mr. Sununu. That is the importance of keeping to your time
line with regard to the issuance of the first 230,000?
Mr. Ramirez. Yes. On that one, working with the industry,
because that is also an important piece of correspondence that
needs to go out, we would anticipate that we could finish up
our work on that letter and what we need to refine in our
estimates to get that letter out on the overpayment side by
June 30, Mr. Chairman.
Mr. Sununu. Thank you.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. Mr. Chairman, let me
talk a little bit about the methodology, and then I want to
talk a little bit about the broader program.
Again, in the methodology, this is based upon a--the $935
million figure is based upon a random sample of 1,000
households, so it is a sampling-type issue which has questions
of accuracy, and then is extrapolated out against the entire
program; but false positives and overpayments by tenants are
not netted out, so it is still a rather nebulous figure that is
out there.
The 230,000 notices that you are sending out, that is not
net false positives?
Mr. Ramirez. It is--we have 90 days after they get sent
out. We anticipate there may be as high as 20 percent false
positives on the 230,000. That is just based on local policy
for exemptions of certain incomes. Again, because of the way
the law is now structured, there is a great deal of discretion
that is given at the local level.
The difference between the old methodology and what we are
employing now is that there is a complete match of income and
Social Security, and based on that and the tiers we have
established, we have narrowed down that universe to just
230,000 where there are these discrepancies.
Mr. Bentsen. Can the IG's Office tell me, in these cases
that have been going on for some time--this is a 60-year-old
program, in effect, and a lot of your cases go back to the
early 1980's, and have gone on for periods of time,
unacceptable periods of time. In the IG's study, if you could
speak to that, is there a preponderance of underpayment by
tenants in the high-dollar range or the low-dollar range, and
is it $10 and $20 a month, just outright fraud, or several
thousand dollars?
Secondly, is there a preponderance of individual tenant
abuse through PHAs, or is it with respect to third-party
private-sector operators?
Mr. Schuster. Sir, basically, as criminal investigators in
our little world, we are just dealing with what we would call
prosecutable criminal cases, so we would not get into the whole
universe. We could not answer that.
Mr. Bentsen. On that issue, Mr. Chairman, I will submit for
the record from the IG's Office--I would be interested to know
where the mean is and where they come down.
Let me ask this. From an investigator standpoint, the way I
understand this, reading through this, Congress in 1993 adopted
a law allowing, in the famous Omnibus Budget Reconciliation Act
of 1993--one of the many things that did not get talked about
in the 1994 elections was a change in the law that allowed for
the use of IRS data for income verification and match; I
believe that is correct.
From the IG's perspective and investigators' perspective,
do you believe this new income verification will be a
sufficient tool in trying to root out either outright fraud or
just inadvertent underreporting of income?
Mr. Schuster. Once again, I don't know, as a Special Agent,
whether I am equipped to answer that particular question. I
think it would give you maybe an idea. But once again, dealing
with our resources and our priorities and what the U.S.
Attorney's offices are, in a sense dictating to us, we probably
would not get into those specific areas unless we had proper
resources.
Mr. Bentsen. Mr. Carolan.
Mr. Carolan. I would say that it is very helpful, and some
of the things that we talked about around the table, in some of
the testimony, as long as this information is timely, where it
is not old information, as long as it is accurate, apples to
apples, and as long as we are all sensitive to the individual
circumstances, the case-by-case family----
Mr. Sununu. If the gentleman would yield for a moment----
Mr. Bentsen. Yes.
Mr. Sununu. Specifically, would an income matching program,
as we are beginning to implement here, would that have assisted
you in the Charlestown case? Would that have uncovered the
income discrepancies that were prevalent in that case?
Mr. Carolan. I would assume that it may have pointed to a
pattern, multiple cases at a particular site, which would have
led us to look at something other than individual tenant fraud;
that there had to be something there that was a common
denominator. So I think, like I said, it would be helpful.
We have to remember, most of the cases we look at are the
egregious ones. They are multiple years of underreporting of
income, resulting in multiple years of overpayments, usually.
They have to meet the test of the prosecutor.
We also look at ability to make restitution.
Mr. Bentsen. Just a couple more questions. Let me ask, let
me look at this from a broader perspective in the income
verification.
As I understand how the Section 8 assisted housing program
works, and has for the last long period of time, it has
somewhat devolved from the Federal Government to local partners
which--we actually expanded their authority through H.R. 2, or
whatever the public law is now, back in 1998, and third-party
contractors to the government who operate project-based housing
and the Section 8 assistance is made to those entities.
They are required to verify the income and have that
approved by a third party, and that is what the Federal
Government has relied on in the past, for the last 60 years, I
guess.
The income verification program, if I understand it, which
is the first of its kind in HUD, came out of the 1993 act. It
effectively is designed to try and match W-2, W-3 data of every
tenant of record in the program against the data that is
provided by the PHA, that they collect, or the third-party Acme
Project-Based Housing Corps, whatever third party, to see
whether that matches up.
So this will be the first time ever that HUD is basically
looking over the shoulder of your clients in the field; is that
correct?
Mr. Ramirez. It is correct on the income verification side.
But let me say, it is one more component of our overall 20-
20 management reform. We have always taken the other side of
oversight seriously, as well, and have reshaped the way we go
about inspecting the Housing Authorities and the project-based
owners for housing quality standards, for financial stability,
for tenant satisfaction, and for management, as well, through
our real estate assessment system and center.
So, yes, it is the first time we have ever done that, and
it is a baseline that we are establishing so that Congress then
can have a more accurate account of underpayment, overpayment,
and the real number that is out there, and to assist you in
providing the funding that we need to provide affordable
housing.
Mr. Bentsen. To the IG's, and then I will finish up, and I
am going to apologize, because I am going to have to leave
after that; there is another meeting I was supposed to start
chairing 15 minutes ago.
In your history of 28 years--and I don't know how long, Mr.
Schuster, you have been there--is this a problem that you have
seen throughout your career with HUD in the Section 8 public
housing; or is this a problem that has just sort of started to
occur in recent years?
Second of all--and you may not know the answer to this--but
how would you compare the potential loss to the program in this
with the old FHA coinsurance program that was designed to
create affordable housing, multifamily housing, primarily in
the late 1970's, but also in the 1980's? I assume you all dealt
with some of those issues, as well.
Mr. Schuster. I will start off first by saying, you know,
is there a history of it? As long as I have been a criminal
investigator, which is over 30 years, there have been people
who have been out to defraud the system. So I have always--I
have never had to worry about work. I have always had a lot of
work. This has been continually.
I worked with ATF, I worked with Health and Human Services
IG, and for the last 11 years I have worked for HUD IG. There
has been--there has been a problem. There are people who are
out to defraud the program.
As I said, we are dealing with a small number of people who
are really ripping off the system. That is the only way to say
it. There is no doubt that this is not by accident. They have a
plan; they are conspiring to do this.
Mr. Bentsen. This is not just an innocent, ``I didn't
report--I didn't realize that my minimum wage went up and I was
getting more money,'' or something?
Mr. Schuster. Right. This is not an accident. That is why
in my statement I wanted to point out that there are situations
where people are not trying to rip off the system, they are
trying to do for family, or whatever. They might be actually,
in a sense, defrauding the system, but it is not something
that, you know, we would be concerned about in our particular
responsibilities.
So I think, yes, there have always been problems. To what
extent, we have no way of knowing. We don't get into that.
Probably our audit side of the House has made more studies of
that and may be more able to respond.
Mr. Bentsen. Thank you.
Mr. Carolan.
Mr. Carolan. I would agree. We presented the first cases in
my district, in the district of Massachusetts, in the 1970's,
so I believe the problem is there and continues to be there.
But again, we look at the most egregious cases. We have a
lot of criteria where we test them, like ability to make
restitution, multiple years of the problem with one individual
or family. So there are a lot of ways we screen out those that
do not meet the standards, and refer them back to the HUD
program people or to the providers for administrative recovery,
to look at it and see whether they can recover.
As far as the second part of your question, the insurance
programs, back to the 236 program and other programs, the same
type of things were happening. We had falsification. As my
associate said, there are people out there that are going to
beat the system, and will find a way to try to beat the
matching and everything else. I think it did exist back in some
of those programs, also.
Mr. Bentsen. Thank you, Mr. Chairman.
Mr. Sununu. Thank you, Mr. Bentsen.
Mr. Miller.
Mr. Miller. Thank you, Mr. Chairman.
Deputy Secretary Ramirez, we discussed preventing waste,
fraud, and abuse from happening in the future. You briefly said
how the law is now structured.
Mr. Ramirez. Yes.
Mr. Miller. That raised a question.
Is there anything Congress can do to help you?
Mr. Ramirez. Yes, sir. We believe that to bring the
accuracy of the system to an even more on-time basis--again, to
bring a little perspective to the situation--the 1,000 number
sampling that came out of this population of 4.5 million is
based the same as we base our current verification process,
which is prior year returns. So a year has gone by before we
can actually match up and see if there was any discrepancy in
what was certified and what income was actually reported.
If we were to be able to get legislative relief to work in
greater cooperation with HHS, and in particular, for the 941
quarterly reports on new hires, that would help enhance the
ability of the private owners or operators, as well as agents
and our agency, to be more on time in capturing any
discrepancies in recertification and underreporting.
Mr. Miller. Has anybody asked for that legislative relief
to date?
Mr. Ramirez. Consider it asked, sir.
Mr. Miller. OK. I would like to follow up after the hearing
with you on that.
Mr. Ramirez. We will be----
Mr. Miller. If that has not occurred and there is something
we can do to help you, we need to do that.
You basically talked about the DC pilot program and the new
verification program we will be using in the future.
Can you give me just a brief overview of the difference, if
you have not already done that? I know I missed part of the
hearing.
Mr. Ramirez. The difference between the pilot and what we
are doing now?
Mr. Miller. The DC pilot program and the new verification
program you are going to be using now.
Mr. Ramirez. What we have done--the biggest difference is
that the letter, as Ms. Crowley mentioned earlier, what was
sent in our pilot to the District of Columbia residents was a
little more menacing then it needed to be. It was pretty
bureaucratic, and had not really been vetted at the highest
levels to be able to be a little more descriptive and clear in
the objective of sending this letter and, also, in outlining
the facts as to the type of incomes that qualified, did not
qualify, what kind of rights tenants had in pursuing their--any
remedial action they felt they needed to take.
I would like to acknowledge the great work and cooperation
that we got, not just from Ms. Crowley, but, as well, other
industry groups both on the private owners' side, the agents'
side, through the Housing Authorities, and the tenants, which I
thought was somewhat historic, to be able to get all these
groups together around a table for the first time.
This was the issue that brought it. We have worked together
since then. We will continue.
We now have a couple of issues that we need to resolve
together, and now that we have gotten into a rhythm of
exchanging documentation and corrections in language and
whatnot, we need to clear up the correspondence that is going
out to the agents and operators, advising them of what they
need to do as a result of people receiving--the tenants having
received these letters for over- or underpayments.
We have the letter for overpayment that we will be working
on, and then a bigger mailing that will just lay out what
qualifies, what does not qualify, and remedies that a tenant
can pursue that will be going out.
Again, let me reiterate for the record that our notices--
the way the mail works, and everything else, for underpayments,
June 30, we are hoping to work with the industry to have the
overpayment discussion done by that time as well, to get those
letters out and proceed accordingly, and be able to come back
with a more defined--because there is a 90-day period; sometime
by December 1 this process should be concluded for this first
cycle.
Mr. Miller. Knowing that you could never eliminate all the
waste, fraud, and abuse that might exist within any system,
based on what you are proposing--and you are moving forward
now--do you believe the next time you come before Congress, you
will have fairly much resolved this problem?
Mr. Ramirez. We will have the baseline and an accurate
number, gross number, of what we believe would be
underreporting on the part of tenants.
We need to then, at that point, factor, as we believe is
correct, the probability of being able to recapture those
funds, and up to what level, without it becoming overly costly
for this collection.
Finally, let me say that what we will have been able to
accomplish, which is our goal in this process, is to be able to
have eligible residents that are sitting on waiting lists, that
have doubled over the last year and a half, into these units,
and ineligible residents out of those units; and we feel that
in that regard we will be able to meet that particular area of
our mission.
I cannot say that we will be meeting our mission as
completely as we should. There were some very accurate figures
brought out by Ms. Crowley as to the real need that is out
there. There are additional resources we would need to be able
to create affordable housing opportunities.
Mr. Miller. As a type of an aside, are you involved in any
way with down-payment assistance with nonprofits?
Mr. Ramirez. Yes, sir.
Mr. Miller. One problem we have noticed in the last few
years, and I don't know why it is--I have dealt with a couple.
Some I have looked at and I shake my head; some are doing a
good job, but it seems like there is vague and ambiguous
language that HUD keeps putting out. I have written letters to
try to get this resolved. We have been effective in every
instance.
It seems like there is a problem with HUD about putting out
vague language, whether certain nonprofits' loans are going to
be approved in the future, with no data to say that they are
not going to be, no scheduled hearings to say there is going to
be an overview. I am wondering why that continues to happen. It
is becoming a problem.
There are some out there that are providing down-payment
assistance for groups that are not using any government funds
and are very successful. It seems like they are repeatedly
being impacted in some fashion by HUD. It does not make any
sense to me.
Mr. Ramirez. There are two issues there that you have
touched on, Congressman.
The first issue is that when we put out a regulation to
create the facilitation of the delivery of whatever programs we
have, or activities that we have jurisdiction over, we
purposely try to make sure that this regulation is as flexible
and as open as possible to create as much local flexibility as
possible. That may be interpreted as ambiguity, perhaps, in
some instances.
We believe that it is better for us to refine it than to
come out with something that is--that will, in essence, lock
communities and not-for-profits into doing things a certain
way, and we have learned that the cookie-cutter approach does
not work.
The other side of the equation is that we do have some very
successful not-for-profits that do not use any government funds
that provide down-payment assistance to low- and moderate-
income families for home ownership.
Our concern there, and we are working with the different
groups, is that there are--there is a negative equity that is
built as a result of what is brought in at the front end of
these loans that, in essence, creates a bigger burden through
the life of a loan for these low- and moderate-income families.
Mr. Miller. Through inflated appraisals or such?
Mr. Ramirez. Correct.
So what we have been doing is, we have been talking to both
the ones that are effective in doing this and have worked to
monitor their activity to make sure that this does not occur,
as well as those that are quite lax in dealing with it.
We have to step in and make sure that in the end what we
are doing is that we are truly creating the opportunity for a
family to realize the American dream and not end up living the
American nightmare.
Mr. Miller. One thing--and I think it is really important,
because we have gone over this, I have done this too many times
in the last year with nonprofits--that HUD should be a little
more sensitive.
There are some that there is absolutely no--even suggestion
that they are inflating appraisals, they are dealing with
approved lenders who are providing quality appraisals; and yet
some of the language comes out that implies that at a future
date this specific nonprofit might not be an approved HUD agent
to deal with those types of loans.
I would ask that you try to create more sensitivity. I
understand that you try to deal with the problem, but in some
cases, a problem is being created where there is none. I have
not tried to be an advocate of any one specific group, but when
we come back and approach HUD, we find no reason at all that
they should be using language like that, and they change it. It
just causes some problems and hurts some people who have tried
to take advantage of these down-payment assistance programs,
because their loan has not been recorded or has been delayed
for some reason. It should not have been.
If you can just do that, I will appreciate it.
Mr. Ramirez. Yes, sir. We will get back to you with a
response.
Mr. Sununu. Mr. Clement.
Mr. Clement. Thank you, Mr. Chairman, Mr. Secretary, and
the panel. It is a pleasure to have you here today.
Let me ask you this question, first. What percentage of
households eligible for Federal rental subsidies actually get
help?
Ms. Crowley. It is about one-third. That is the number that
is most frequently cited; that if you defined the eligibility
under what the law allows now and then you look at how many are
actually getting assistance, it is about one-third.
There are other ways of looking at the number. Our number
is, as I said, 10.8 million households with a severe housing
cost burden who are low-income people. That includes both
homeowners and renters. HUD's analysis is that the worst-case
housing needs is 5.4 million households. Those are renters who
receive no assistance and have a variety of housing problems.
Mr. Clement. Of course, we all, Democrats and Republicans,
want to stop waste and fraud. We should do everything we can to
stop Federal payments to families who are not eligible.
If you assume that a $935 million overestimate is accurate,
and every penny went to eligible families, how many more
families would be covered?
Mr. Ramirez. About 150,000. But we don't agree with that
assumption, Congressman.
Mr. Clement. I wish you would expand on that.
Mr. Ramirez. As we went into this subject earlier in our
testimony and in earlier questioning, the $935 million figure
that is out there is based on a small sampling of--I hate to
sound repetitive, but just to be able to clear things up, in
the past, what we have done is that we would take a sampling of
1,000 residents in a total population of about 4.5 million.
Then from there, the methodology that was employed would
extrapolate to that number that you see up there.
What we are doing now is that we have actually matched up
these households through tax returns, Social Security benefits
that are paid, and their residency, and set thresholds as to
whether they are underreporting or not. We have gotten down to
the point of refining that, and have identified, in that
universe of about 4.5 million, 230,000 households that have
technically underreported.
I need to add that within that number, because of the broad
discretion that has been provided to local Housing Authorities
and operators, that they do have discretion as to what they
would allow or disallow as eligible income. So we are going to
be going through that process of getting down to the final
number.
The other circumstance that we run into is that there are
situations where people overpay in the program. We are
currently matching up income and payments that get to a number
that would reflect, as closely as possible, those amounts that
are being overpaid, to advise those residents as well that they
need to go in and clear up those overpayments, so they can
actually be getting what they are entitled to.
The $935 million number that is out there is a number that
is--that is, we believe, quite inaccurate in reflecting a true
picture of what actually exists in the overpayment category.
Once we have--because this year is a baseline year,
Congressman, for establishing that number, that baseline then
is also impacted by certain situations, again allowable
exceptions plus collection difficulties that occur, to get to a
real number of actual recovery of any overpayments that are out
there.
Our goal in the end, by establishing this system, is to be
able to better qualify at the inception the residents, number
one; and number two, that when we do find these discrepancies,
and someone is living in a unit that is not qualified to live
in that unit, that that unit then be vacated by that
individual, or that family, and that it now be occupied by
someone that is eligible.
Mr. Bentsen. Mr. Secretary, there is no doubt in your mind
there is a huge unmet need that exists?
Mr. Ramirez. I would further add that even after getting to
this number, we would not be making a dent in the need.
It was earlier stated that we have over 11 million American
families out there that--or close to 11 million that are out
there that are suffering conditions of housing where they are
paying more than 50 percent of their income in rent. So it is
an unacceptable condition that exists.
Even with the current request that the President has
proposed of 120,000 additional vouchers, it is a baby step in
trying to resolve this problem, but a step that we feel is
absolutely necessary, because it is an escalating problem.
Mr. Clement. Mr. Secretary, these numbers up here on this
chart, you don't really accept those numbers as true or
accurate numbers?
Mr. Ramirez. That is correct. We accept those as rough
estimates based on the methodology that has been employed in
partnership with the figure of the Department of Housing and
Urban Development to come up with a number that needs to be
included in our financial statements.
Mr. Clement. All right. Thank you.
Mr. Sununu. Thank you very much, Mr. Clement.
I have just a few final questions.
Mr. Ramirez, has the Department shared the match list of
the 230,000 tenants that have a significant underreporting of
income with the Inspector General's Office in order to try to
identify patterns that might exist there that would be worthy
of their investigation?
Mr. Ramirez. No, sir. It is premature for us to share that
list with anybody, first off, because it has not gone through
the cycle of it being exempted or not.
Secondly, it is--the private operators and agents, such as
the Housing Authorities, it is up to them to assume the
principal responsibility in rectifying any differences in
underreporting.
So the principal obligation of having this reported to the
Inspectors General throughout the country that serve the
Department would be based, more than likely, on referrals from
the Housing Authorities, agents, or private owners, sir.
Mr. Sununu. As this process moves forward, however, is it
your intention to share information that HUD might develop
regarding patterns in income underreporting, or egregious cases
of income underreporting, to the Office of Inspector General?
Mr. Ramirez. We are prepared to share information that
would not violate the Privacy Act and the method in which we
were able to collect this information, and certainly we are not
going to be the ones initially to make the call as to whether
there is fraud or not occurring.
Inspectors General, as has been my experience through the
years that I have been with the Department now--they have the
run of the room. If they so wish to come in and audit these
numbers, they are certainly welcome to.
Mr. Sununu. There is nothing that would prevent them
statutorily from reviewing the income underreporting
information that you might generate?
Mr. Ramirez. That would be a question that I would suggest
be posed to the inspectors.
Mr. Sununu. Mr. Carolan, is there anything that would
prevent you from reviewing information to identify patterns or
egregious cases of underreporting that might be worthy of
investigation?
Mr. Carolan. I don't believe there would be any barrier.
Mr. Sununu. Thank you.
A final question: Mr. Ramirez, we have talked a lot about
this process, which I think is important. Mr. Clement mentioned
the value of determining whether or not $935 million is
recoverable, identifying what is recoverable. Ms. Crowley
talked about looking at income overreporting as well.
These are all issues, though, at the end of the process,
where we are trying to verify after the fact and match actual
income to what was initially reported.
What has been done to deal with the front end of the
process, to improve the internal control systems of HUD so that
the Housing Authorities can better determine tenant income up
front when they first apply, or when they are recertified?
Mr. Ramirez. One of the things, because of the discretion
that is written into the law to create greater flexibility at
the State level and local level, there have been some States
that have been proactive in trying to get more on-time
information as it relates to wages. So there are State wage
reports that now go to Housing Authorities, but it is on a
State-by-State basis. That is the only way it could be done.
Mr. Sununu. How many States do that?
Mr. Ramirez. I think there are three--we are actually using
two right now. Two.
Mr. Sununu. Is that something that you are encouraging
States to do?
Mr. Ramirez. Absolutely, sir. But that is, again, at their
discretion.
Mr. Sununu. Thank you very much.
Thank you to all the witnesses for your testimony today.
This is a significant problem, both in terms of the finances,
but also in terms of the fairness of the program.
It is important that these programs are viewed by both the
public that does not benefit from the program and those that
are in need, that they are fair, in order to ensure the
credibility of HUD that has a number of other programs that it
uses to reach out to communities with, and the credibility of
the Federal Government that is trying to oversee these and
other programs efficiently and effectively.
Your testimony has helped us a great deal here today. Thank
you for your time.
The committee is adjourned.
[Whereupon, at 11:41 a.m., the Task Force was adjourned.]
Government Failure in Disposing of Obsolete Ships
----------
FRIDAY, JUNE 9, 2000
House of Representatives,
Committee on the Budget,
Task Force on Housing and Infrastructure,
Washington, DC.
The Task Force met, pursuant to call, at 10:10 a.m. in room
210, Cannon House Office Building, Hon. John E. Sununu
(chairman of the Task Force) presiding.
Chairman Sununu. Good morning and welcome to the witnesses.
I want to thank Ken Bentsen and all the committee members for
participating in the hearing today.
Today we welcome three witnesses to testify on the problems
and the failure governmentwide in disposing of obsolete ships.
Our witnesses today are Thomas Howard, Deputy Assistant
Inspector General for the Department of Transportation; John
Graykowski of the Maritime Administration; and Vice Admiral
James Amerault, Deputy Chief of Naval Operations for Logistics.
I understand all of you have busy schedules and I appreciate
your taking the time today.
The Merchant Ship Sales Act of 1946 created the National
Defense Reserve Fleet to provide merchant and nonmilitary
vessels to meet shipping requirements during national
emergencies. The Maritime Administration, MARAD, administers
this fleet, and they are responsible for disposing of obsolete
vessels of 1,500 gross tons or more. DOD provides funding to
maintain the fleet, and right now there are 114 vessels that
have been designated for disposal because most of them are no
longer operational and they do pose problems that are both
financial and environmental.
Unfortunately, we have a situation that is beginning to
develop into a crisis. Over the last 5 years, in a number of
ways, the government has restricted the ability of MARAD to
engage in this task. There are current restrictions on MARAD to
use its own funds to pay for the scrapping of these vessels.
There have in the past been restrictions on utilizing foreign
scrap yards, and there is a problem with the domestic supply of
available scrap yards to handle the disposal of these obsolete
vessels.
The vessels are maintained at three locations: James River
Reserve Fleet in Virginia; Beaumont Reserve Fleet in Texas; and
the Suisun Bay Reserve Fleet in California. During 1999 the
cost to maintain this disposable fleet exceeded 4.2 million and
there was an additional $1 million that we will have Mr.
Graykowski talk about in some more detail for emergency repair.
This is really no direct fault of MARAD. These are old
vessels, in some cases decades old. They have hazardous
materials in some cases on them. They can leak oil and I think
this environmental issue has really been undiscussed, at least
unquantified. That is one of the issues I hope we can touch on
today to better understand the potential environmental threat,
the cost of that environmental threat, and the threat it poses
not just on the river itself or the bay where these boats are
being held but on local economy, shipping, and local navigation
safety.
The estimates to deal with this problem in its entirety
range from $500 million to over $2 billion. That is a
significant amount of money. It is an enormous range of costs
and I think that is simply an indication of how little we
really understand both the short-term and long-term costs of
dealing with these problems.
Since 1995 MARAD has only scrapped 7 vessels. Several were
sold to contractors in 1999, but a number of the vessels were
never removed and remain moored with the MARAD fleet. Progress
has clearly dropped off in the past 10 years; but at the same
time the longer we wait, the larger this problem becomes. The
problem grows because over the next year over a dozen
additional vessels are scheduled to come into the MARAD fleet.
Now, between 1987 and 1994, MARAD disposed of 130 vessels,
most of which were exported to China, India, Mexico and Taiwan.
Problems with the world price of scrap metal has also hindered
efforts by MARAD to scrap the vessels because when scrap metal
prices are depressed, there is less likelihood that either a
foreign or a domestic scrap yard is going to be willing to pay
to take the vessel off MARAD's hands. Current legislative
restrictions exist, as I said earlier, that prevent MARAD from
engaging in contracts to pay for the scrapping of these vessels
and as a result the problem grows.
I think it is a problem that is getting worse. The estimate
is that there would be as many as 155 vessels waiting for
disposal by the end of 2001. The administration response to
date, in addition to imposing a moratorium that lasted for some
time and significantly delayed the scrapping process, was to
move the date that we required these ships to be disposed of
back 5 years or at least to request a movement in that date.
While I understand that this reflects a recognition of the slow
pace of progress in this area, I don't think that moving the
date that we require all these vessels to be scrapped in and of
itself is going to really address the problem. Delaying when we
have a known environmental crisis before us really is no
solution.
I am very interested to hear what our real options are for
dealing with this problem. I don't think waiting is acceptable.
I think and I hope Mr. Graykowski from MARAD will be candid and
even creative in perhaps looking beyond some of the existing
financial restraints or political restraints and talking
through with this subcommittee, with this Task Force, what some
of the potential options might be. And I am sure that members
on both sides of the Task Force recognize that this is a
problem that may actually cost money in the short term in order
to save money in the long term, and certainly it warrants our
closest attention.
We don't have a good handle on the costs and the potential
risks associated with this, with these obsolete vessels, but I
hope at the end of this hearing today we will have a much
clearer picture of the options ahead of us.
[The prepared statement of Mr. Sununu follows:]
Prepared Statement of Hon. John E. Sununu, a Representative in Congress
From the State of New Hampshire
I would like to start by thanking Congressman Bentsen and all the
members of the Task Force for being here this morning. I would also
like to thank and recognize Mr. Thomas J. Howard, Deputy Assistant
Inspector General, Department of Transportation, Mr. John E.
Graykowski, Deputy Administrator of the Maritime Administration
(MARAD), and Vice Admiral James F. Amerault, Deputy Chief of Naval
Operations for Logistics. I appreciate your taking time out of your
busy schedules to be here with us.
The Merchant Ship Sales Act of 1946 created the National Defense
Reserve Fleet (NDRF), which would provide merchant and nonmilitary
vessels to meet shipping requirements during national emergencies. The
Maritime Administration (MARAD) administers the fleet and is charged
with the responsibility of disposing of vessels of 1,500 gross tons or
more. The Department of Defense (DOD) provides funding to maintain the
fleet. At this time, 114 vessels have been designated for disposal
because many of them are no longer operational and pose serious
problems both financial and environmental. It is my hope that we can
explore here today the extent of the problems with scrapping these
ships and discuss the possible solutions. Furthermore, I would like to
know what we in Congress can do to help move this potentially costly
situation forward or at least closer toward a comprehensive resolution.
These 114 NDRF vessels are maintained at three locations: the James
River Reserve Fleet in Virginia; the Beaumont Reserve Fleet in Texas;
and the Suisun Bay Reserve Fleet in California. During fiscal year
1999, the cost to maintain 110 vessels awaiting disposal exceeded $4.2
million, and an additional $1 million was spent on an emergency repair.
The estimates to do away with this problem range from $500 million to
$2 billion. The yearly costs to maintain an NDRF ship averages $20,000.
If some of these ships are not disposed of soon, they may sink, causing
serious environmental problems. Repairing and drydocking these vessels
could be very expensive and may cost as much as $900,000 per vessel.
Environmental cleanup and remediation could be even more expensive to
address, and appears to be very hard to estimate, which is a large
concern in my mind.
Since 1995, MARAD has only scrapped 7 vessels. Several vessels were
sold to contractors in 1999, but the vessels were never removed and
remain moored with the MARAD fleet. Progress in scrapping vessels has
clearly dropped off in the past 10 years. The longer we wait the larger
and more costly the problem becomes.
Typically, a ship scrapping company buys the rights to scrap a
government ship and later sells the salvaged metal to recyclers.
Remediation of hazardous materials takes place before and during the
dismantling process. If a vessel is taken apart improperly, a ship
scrapping operation can pollute the land and water surrounding the
scrapping site and risk the health and safety of the scrapping
operation's employees.
Exporting these ships is not an option at present. In 1994, the
Environmental Protection Agency (EPA) prohibited the Navy and MARAD
from exporting vessels after determining that the export of government
ships for scrapping was prohibited by the Toxic Substances Control Act.
In fact, MARAD has not sold a vessel to overseas markets for scrapping
since 1994. MARAD disposed of 130 vessels between 1987 and 1994, of
which 128 were exported to China, India, Mexico, and Taiwan. In
September 1998, the Clinton administration placed a moratorium on
overseas scrapping due to concerns about environmental and worker
health and safety. The moratorium expired October 1, 1999. Currently,
the administration requires MARAD to request approval from the EPA to
sell vessels overseas to markets that are capable of scrapping in an
environmental complaint manner.
It is apparent that this problem cannot continue to go unresolved.
The Department of Transportation Inspector General's office indicated
in its audit report of March 10, 2000, that the number of obsolete
vessels could be as high as 155 by the end of fiscal year 2001. We can
surely all agree that this situation is getting worse and something
must be done soon.
I am interested to hear what plans are currently being made and
developed to deal with these issues. I am hopeful that MARAD and the
Navy can coordinate their efforts to bring about a solution. Solutions
may range from allowing overseas scrapping of these vessels, creating a
domestic scrapping industry in the United States to handle the
workload, or to simply spend the money necessary to dispose of every
obsolete vessel.
The bottom line is that the U.S. Government does not have a good
understanding of the potential long-term cost of scrapping these ships
or the environmental impact resulting from a ship-related accident. I
look forward to hearing the thoughts of our panel members. I would like
to recognize Congressman Bentsen for any opening comments he may have.
Chairman Sununu. Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman, and I thank the
members of the panel for testifying today. As the Chairman
pointed out, this Task Force is charged with holding oversight
hearings on waste, fraud, and abuse and reporting our findings
and recommendations to the full House Budget Committee.
In this, our third oversight committee hearing, we turn to
disposal of obsolete vessels in the National Defense Reserve
Fleet by the Maritime Administration, MARAD program. I have a
dual interest in this, the one which you all are doing; but, I
also might add, representing the district which includes a
great deal of watershed in the port of Houston and the ship
channel.
I have had my own experience in trying to remove abandoned
barges from the San Jacinto River, which the Coast Guard was
kind enough to do with a little nudging from Congress. And, Mr.
Chairman, we did find that in many cases, the cost of removal
and decontamination exceeds the scrap value greatly and ends up
being a net loss situation.
I am particularly interested in hearing about the Navy's
pilot project for scrapping obsolete vessels and whether it can
be used as a model for MARAD. While I am interested in learning
the magnitude of the inventory excess problem, I am primarily
concerned about how MARAD plans to economically scrap these
vessels while complying with safety and environmental
standards. I understand the issue is the relative feasibility
of scrapping these vessels in the United States and overseas.
I might mention that our colleague, Mr. DeFazio of Oregon,
has introduced a bill, H.R. 4189, which would establish a pilot
program for the Department of Transportation to carry out the
vessel scrapping and processing program in the United States.
At his request, Mr. Chairman, I would ask unanimous consent at
the appropriate time that his statement regarding his bill in
this matter be included in the record.
Chairman Sununu. Without objection. And I would ask also
unanimous consent that all members be given 5 days to submit
written statements for the record.
[The information referred to follows:]
Prepared Statement of Hon. Peter A. DeFazio, a Representative in
Congress From the State of Oregon
Thank you very much for the opportunity to testify on the issue of
how to dispose of the U.S. Government's obsolete ships. As the ranking
Democrat on the House Transportation and Infrastructure Committee's
Subcommittee on Coast Guard and Maritime Transportation, I am keenly
interested in resolving this problem. I have introduced legislation,
H.R.4189, to address the issue and the Subcommittee has held two
hearings on this subject.
As you know, the U.S. used to send its surplus vessels for
scrapping at overseas facilities, under terrible conditions. Public
outrage over the U.S. sending its toxic legacies overseas, led the
Administration to halt this practice several years ago. Since that
time, virtually no ships have been scrapped. Why? Because the U.S.
Maritime Administration (MARAD) is statutorily obligated to sell these
ships, and cannot, under current law, provide funds for their disposal
here in the United States. No U.S. shipyard can possibly scrap these
ships in an environmentally responsible and safe manner. So, these
ships remain rotting at anchor in U.S. harbors.
The government's current options are to again send its vessels to
overseas shipyards where third world workers toil in unspeakable
conditions, or leave them in U.S. harbors where they risk sinking and
polluting our waters.
Instead of lamenting over this dilemma, Congress should take the
initiative to change MARAD's statute and allow the agency to provide
funding for shipyards in the United States to scrap ships. These ships
are the responsibility of the U.S. Government and we should take
responsibility the environmental hazards and safety risks posed by
these vessels.
It is time to admit that it will cost money to take care of our
toxic legacy. I have introduced legislation to do just that. My bill,
H.R.4189, authorizes funding for a ship scrapping pilot program at
MARAD, to pay qualifying shipyards to scrap its obsolete vessels.
I hope that as a result of this hearing, more Members of Congress
and the public will be aware of this problem and work to enact
legislation to solve it.
Mr. Bentsen. I thank the Chairman and with that, I will
yield back the balance of my time and look forward to hearing
the testimony today.
Chairman Sununu. Thank you very much Mr. Bentsen.
I would like to begin our testimony with Mr. Howard from
the Inspector General's office and then provide time for Mr.
Graykowski to talk about his perception of the problem and
thoughts on ways to deal with the problem. And then we will
hear from Vice Admiral Amerault about the Navy pilot program
which I know has met with some success, and even more
important, I hope has yielded a good deal of information about
the process, the costs, and the technical and financial
obstructions to dealing with this problem.
Mr. Howard, welcome, and we are pleased to hear your
testimony.
STATEMENTS OF THOMAS J. HOWARD, DEPUTY ASSISTANT INSPECTOR
GENERAL FOR MARITIME AND DEPARTMENTAL PROGRAMS, U.S. DEPARTMENT
OF TRANSPORTATION; JOHN E. GRAYKOWSKI, ACTING MARITIME
ADMINISTRATOR, U.S. DEPARTMENT OF TRANSPORTATION; AND VICE ADM.
JAMES F. AMERAULT, DEPUTY CHIEF OF NAVAL OPERATIONS LOGISTICS
STATEMENT OF THOMAS J. HOWARD
Mr. Howard. Thank you, Mr. Chairman, members of the Task
Force. I ask that my statement be submitted for the record and
I will summarize my remarks.
Chairman Sununu. Without objection.
Mr. Howard. My statement is based on our March 10th report
on MARAD's ship-scrapping program. The Office of Inspector
General has identified MARAD's ship-scrapping program as one of
the 12 most pressing management issues in the Department of
Transportation. The Department, the administration, and the
Congress face a challenge in determining how to dispose of
MARAD's fleet of old, environmentally dangerous ships in a
timely manner.
The current approach of selling ships for domestic
scrapping is not working. MARAD will not be able to meet the
legislative mandate to dispose of its ships by September 30,
2001. It also will not be able to gain meaningful financial
returns from these ships.
As you mentioned, Mr. Chairman, MARAD maintains its ships
in the water in three locations. The picture being displayed
shows a few of the ships in Suisun Bay. The one in the
foreground is the Mission Santa Ynez, which is 56 years old and
has been awaiting disposal for 25 years. Environmental dangers
associated with these old, deteriorating ships are increasing
daily. The so-called worst-condition ships average 50 years old
and have been awaiting disposal for 22 years.
These photos show actual conditions on 3 of the 40 worst-
condition ships. The ships contain hazardous materials such as
PCBs, asbestos, lead-based paint, and fuel oil. Some have
deteriorated to the point where a hammer can penetrate their
hulls. If the oil from these ships was to leak into the water,
immediate and potentially expensive Federal and State action
would be required.
MARAD currently has 114 obsolete ships awaiting disposal.
As shown in the chart being displayed now, this number has
grown from 66 just 3 years ago. It is expected to reach 155 by
the end of fiscal year 2001.
As shown in the next chart, only 7 ships have been scrapped
since 1995. This represents a significant change from 1991
through 1994 when 80 ships were scrapped overseas. In addition,
recent sales to domestic scrappers have only yielded between
$10 and $105 per ship. This is down from an average price of
$433,000 per ship during the early nineties.
MARAD's inability to reduce the backlog of ships awaiting
disposal is attributable to a couple of factors: the loss of
overseas sales, current limited domestic scrapping capacity and
the Navy's pilot program.
Since 1994 MARAD has been relying on the domestic ship-
scrapping market but its capacity is currently limited. Only
four companies have passed MARAD's technical compliance reviews
to scrap ships. Although MARAD sold 22 ships to these domestic
scrappers since 1995, 13 are still moored in MARAD's fleet.
Recent contractor delays in picking up ships and a default by
one contractor raise a question as to whether the ships will be
removed from the fleet.
The Department of the Navy experienced a similar inability
to sell its obsolete combatant ships in the domestic market. In
1998 Congress authorized and appropriated funding for a pilot
project allowing the Navy to pay domestic contractors to scrap
ships. Last year the Navy awarded contracts amounting to $13.3
million for the scrapping of 4 ships. The contractor that
defaulted on MARAD is scrapping a ship under the Navy pilot
program. MARAD is coordinating with the Navy on its initiatives
and is pursuing alternative disposal methods, but due to
capacity limitations, no one of those alternatives has the
potential of significantly reducing the backlog in a timely
manner.
In our March report we recommended that the Maritime
Administrator take several actions:
First, seek legislative approval to obtain an extension on
the disposal mandate and eliminate the requirement to gain
financial returns on vessel sales.
Second, continue to pursue programs to improve scrapping
sales and identify alternative disposal methods.
Third, develop a proposal seeking authority and funding to
pay domestic contractors to scrap ships, targeting the 40
worst-condition ships for priority disposal.
In its authorization request for fiscal year 2001, MARAD
proposed a 5-year extension to develop and begin implementing a
plan to dispose of these ships. We do not believe it is
acceptable to begin disposal within 5 years, considering the
condition of some of the ships, the environmental risk, and the
cost to maintain them. In our opinion, the legislation should
require MARAD to develop a disposal plan and substantially
dispose of these ships within 5 years. Further, MARAD's plan
needs to identify viable disposal methods, set milestones, and
target the worst-condition ships for priority disposal.
This concludes my remarks. I will be happy to answer
questions.
Chairman Sununu. Thank you Mr. Howard.
[The prepared statement of Thomas Howard follows:]
Prepared Statement of Thomas J. Howard, Deputy Assistant Inspector
General for Maritime and Departmental Programs, U.S. Department of
Transportation
Mr. Chairman and members of the Task Force, we appreciate the
opportunity to be here today to discuss the Maritime Administration's
(MARAD) program for scrapping obsolete vessels. We have identified this
program as 1 of the 12 most pressing management issues in the
Department of Transportation. The Department, the Administration, and
the Congress face a challenge in determining how to dispose of MARAD's
Fleet of old, environmentally dangerous vessels in a timely manner.
The current approach of selling obsolete vessels for domestic
scrapping is not working. There is limited capacity in the domestic
scrapping market and the Navy is paying contractors to scrap its
obsolete warships while MARAD is asking contractors to pay to scrap its
vessels. Further, MARAD has been constrained from selling vessels
overseas for scrapping, although this had been a key market in the
past.
MARAD will not meet the legislative mandate to dispose of its
obsolete vessels by the end of fiscal year (FY) 2001 in a manner that
will yield financial benefits. MARAD will need relief from those
requirements. MARAD will also need authorization and funding for a
program to pay for the disposal of obsolete vessels if it is to have
the potential to significantly reduce the Fleet.
MARAD is pursuing a number of alternatives for disposing of its
obsolete vessels, but because of capacity limitations, no one has the
potential to significantly reduce the backlog of vessels in a timely
manner. MARAD needs to develop a plan and take prompt action to dispose
of all of its obsolete vessels.
Our statement is based on our March 10, 2000 report on the
scrapping program. We will discuss three issues today:
The environmental threats posed by MARAD's growing backlog
of obsolete vessels;
Key factors contributing to MARAD's inability to scrap
vessels domestically; and
The need for prompt implementation of a plan that
prioritizes disposal of the ``worst condition'' vessels and identifies
methods and milestones for disposing of all obsolete vessels in the
Fleet.
Growing Backlog of Obsolete Vessels is a Threat to the Environment
MARAD currently has 114 obsolete vessels awaiting disposal. This
number has grown from 66 vessels 3 years ago. Moreover, the inventory
of obsolete vessels awaiting disposal is continuing to increase, and is
expected to reach 155 by the end of FY 2001.
MARAD maintains its vessels in the water at three locations--the
James River in Virginia; Beaumont, Texas; and Suisun Bay, California.
Environmental dangers associated with these old, deteriorating ships
are increasing daily. The so-called ``worst condition'' vessels are
about 50 years old and have been awaiting disposal for 22 years on
average.
Vessels Awaiting Disposal at Suisun Bay Reserve Fleet
These vessels contain hazardous materials such as polychlorinated
biphenyls (PCBs), asbestos, lead-based paint and fuel oil. Some vessels
have deteriorated to the point where a hammer can penetrate their
hulls. If the oil from these vessels were to enter the water, immediate
and potentially very expensive Federal and State action would be
required. For example, MARAD spent $1.3 million on a costly
environmental cleanup because one of the ``worst condition'' vessels
deteriorated to a point where oil leaked into the water.
MARAD's Inability to Scrap Vessels is Attributable to Several Key
Factors
Since 1995, only seven vessels have been scrapped. This represents
a significant change from 1991 through 1994 when 80 ships were sold
overseas at an average price of $433,000 per vessel. Recent sales to
domestic scrappers have only yielded between $10 and $105 per vessel.
MARAD Vessels Scrapped
MARAD stopped selling vessels overseas for scrapping in 1994 due to
Environmental Protection Agency (EPA) restrictions. In September 1998,
the Administration placed a moratorium on all sales of vessels for
scrapping overseas that remained in force through October 1, 1999.
MARAD has continued to refrain from exporting obsolete vessels because
of concerns about the environment and worker safety.
Since 1994, MARAD has been relying on the domestic ship scrapping
market, but its capacity is limited. Only four companies have passed
MARAD's technical compliance review to scrap vessels. Although MARAD
sold 22 vessels to these domestic scrappers since 1995, 13 of the
vessels are still in MARAD's Fleet. Recent contractor delays and a
contractor default raise a question as to whether these vessels will be
removed by contractors from the Fleet.
The Department of the Navy experienced a similar inability to sell
its combatant vessels for domestic scrapping. In 1998, Congress
authorized and appropriated funding for a pilot project allowing the
Navy to pay domestic contractors to scrap vessels. On September 29,
1999, the Navy awarded four contracts amounting to $13.3 million for
the scrapping of four vessels.
MARAD cannot compete with the Navy pilot program in the limited
domestic market because, by law, MARAD is prohibited from paying for
scrapping services. The contractor that defaulted on MARAD, is
scrapping a Navy ship under the pilot program.
MARAD Needs a Plan and Prompt Action
To Dispose Of its Obsolete Vessels
While MARAD has been pursuing alternative ways to dispose of
vessels, it is constrained by the legislative requirement to maximize
financial returns. Also, the alternatives MARAD is pursuing have
capacity limitations and, therefore, no single option has the potential
to significantly reduce the backlog of vessels in a timely manner.
These alternatives include: coordinating with the Navy and a west coast
company on a proposal for a potential scrapping site; participating in
interagency work groups to look for innovative ways to improve the ship
scrapping process; and requesting approval from EPA to sell vessels to
overseas markets.
The National Maritime Heritage Act of 1994 requires MARAD to
dispose of its obsolete vessels by the end of FY 2001, which is an
extension from 1999, the original deadline. MARAD does not have a plan
to dispose of these vessels.
We recently recommended that the Maritime Administrator:
1. Seek legislative approval to obtain an extension on the disposal
mandate and eliminate the requirement to gain financial returns on
vessel sales;
2. Develop a proposal seeking authority and funding to pay domestic
contractors to scrap vessels, and target the ``worst condition''
vessels for priority disposal; and
3. Continue to pursue programs to improve scrapping sales and
identify alternative disposal methods for its obsolete vessels.
In its authorization request for FY 2001, MARAD proposed a 5-year
extension ``to develop and begin implementing a plan to dispose of
these vessels.'' We do not believe it is acceptable to begin disposal
within 5 years considering the condition of some of the vessels, the
environmental risks, and the costs to maintain them. In our opinion,
the legislation should require MARAD to develop a disposal plan and
substantially dispose of these vessels within 5 years. Further, MARAD
needs to identify viable disposal methods, set milestones, and target
the ``worst condition'' vessels for priority disposal.
Background
The Merchant Ship Sales Act of 1946 created the National Defense
Reserve Fleet (NDRF), a Government-owned and administered Fleet of
inactive, but potentially useful, merchant and non-military vessels to
meet shipping requirements during National emergencies. MARAD
administers the Fleet, and the Department of Defense provides the
funding to maintain the Fleet. The Federal Property and Administrative
Services Act gave MARAD responsibility for disposing of all Federal
Government merchant-type vessels of 1,500 gross tons or more. The
National Maritime Heritage Act of 1994 required MARAD to dispose of
obsolete vessels in the Fleet by September 30, 1999, in a manner that
maximizes financial return to the United States, but the Act was
amended to extend the original disposal date by 2 years, from 1999 to
2001.
As of April 30, 2000, 114 obsolete vessels were designated for
disposal because the majority of them are no longer operational. MARAD
maintains the inactive vessels in the water at the following locations:
James River Reserve Fleet (JRRF) at Ft. Eustis, Virginia
(61 vessels);
Beaumont Reserve Fleet (BRF) in Beaumont, Texas (9
vessels); and
Suisun Bay Reserve Fleet (SBRF) in Benecia, California (42
vessels).
The Coast Guard holds two vessels in Mobile, Alabama for fire
fighting training.
As shown in the following chart, the average age of the 114
obsolete vessels is 48 years. These vessels have been in the Fleet for
an average of 15 years.
The Number of Obsolete Vessels Awaiting Disposal is Increasing
The number of obsolete vessels has almost doubled since 1997. MARAD
expects its inventory of obsolete vessels awaiting disposal will
increase to 155 vessels by the end of FY 2001, as shown in the
following chart.
Vessels Awaiting Disposal
This projected increase is due to additional vessel transfers from
the Navy, downgrades of other NDRF vessels to obsolete status, and the
inability to sell ships for scrap. Of the 155 vessels, 132 will be
targeted for scrapping. The remaining 23 vessels will be targeted for
disposal through the fish reef program, use by a State or Federal
agency, or held for useful parts and equipment. However, some of these
vessels may be transferred into the scrapping category in future years
if they cannot be disposed of through other means.
Obsolete Vessels Pose Environmental Risks
The 114 obsolete vessels currently awaiting disposal pose
environmental risks because they are deteriorating, contain hazardous
materials, and contain oil that could leak into the water. These
vessels are literally rotting and disintegrating as they await
disposal. Some vessels have deteriorated to a point where a hammer can
penetrate their hulls. They contain hazardous substances such as
asbestos and solid and liquid polychlorinated biphenyls (PCBs). If the
oil from these vessels were to enter the water, immediate and
potentially very expensive Federal and state action would be required.
In 1999, MARAD identified the 40 ``worst condition'' vessels. These
vessels were classified as ``worst condition'' due to their severe
deterioration and threat to the environment. As of April 30, 2000, 3 of
the 40 had been moved out of the Fleet to domestic scrappers. As shown
in the following chart, the ``worst condition'' vessels are older and
have been in the Fleet longer than the other vessels awaiting disposal.
The ``worst condition'' vessels are in particularly bad condition,
and may require additional or special maintenance. Our inspection of 11
of the original 40 ``worst condition'' vessels revealed corrosion,
thinning, and rusting of the hull; asbestos hanging from pipes below
deck; lead-based paint easily peeled from the ship; solid PCBs (in
cabling); and in some instances, remnants of liquid PCBs in electrical
equipment.
Deteriorating Vessel at James River Reserve Fleet
Costs to maintain these vessels will likely increase due to their
deteriorating condition, leaks, and the need for additional time-
sensitive maintenance. For example, MARAD spent $1.3 million to
maintain 1 of the 40 ``worst condition'' vessels over the past 2 years.
This vessel is over 35 years old, contains hazardous substances
including asbestos, and has deteriorated to the point where oil leaked
into the water requiring costly environmental clean-up. MARAD has
applied over 20 patches to leaks, removed hazardous materials, deployed
containment booms, and pumped oil out of the vessel. The vessel is
disintegrating to a point where it will not be seaworthy much longer.
Monitoring efforts for this vessel are ongoing.
Progress in Scrapping Vessels is Limited
Although MARAD has sold 22 vessels since 1995, only 7 have been
scrapped. Two other vessels have been towed to scrapping sites. The
remaining 13 vessels sold are still moored in MARAD's Fleet, requiring
continued maintenance at U.S. Government expense.
Between 1991 and 1994, MARAD sold 80 vessels overseas for scrapping
at an average price of $433,000 per vessel. During the past year,
vessel sales yielded between $10 and $105 per vessel. On October 25,
1999, MARAD sold three vessels for $10 per vessel. The most recent sale
was for two vessels at $105 per vessel on December 21, 1999.
Loss of Overseas Markets Contributed to the Decline in Scrapping
MARAD suspended the sale of vessels to overseas scrappers in 1994
because the EPA prohibited the export of Government-owned ships
containing PCBs. In September 1998, an Administration moratorium halted
all sales of Government-owned vessels for scrapping overseas. The
moratorium expired on October 1, 1999, but MARAD has refrained from
exporting vessels overseas for scrapping.
Based on a 1997 agreement between MARAD and EPA, MARAD is required
to request EPA's approval to sell vessels to overseas contractors that
can scrap them in an environmentally compliant manner. The agreement
requires MARAD to ensure that all liquid PCBs in transformers,
capacitors, hydraulic and heat transfer fluids and that all ``readily
removable'' solid PCBs are removed prior to exporting these vessels.
This agreement also requires EPA to notify countries of import that
they will be receiving vessels and that these vessels may contain PCBs.
To date, MARAD has not requested EPA approval to sell any of its
vessels awaiting disposal to overseas scrappers. However, on April 14,
2000, the Maritime Administrator sent a letter to the EPA requesting
its assistance on developing an option for exporting vessels for
scrapping and implementation of the 1997 EPA/MARAD agreement.
Limited Domestic Capacity Hampers Progress in Scrapping
Since 1995 MARAD has been relying on the domestic market, but
capacity in the domestic market is limited. In the 1970's, there were
30 U.S. contractors in the ship scrapping industry. Over the past 19
months, however, only four companies have bid on MARAD's scrapping
contracts and passed MARAD's technical compliance review to scrap
vessels. These four companies can only handle approximately one to five
vessels at a time, depending on the size of the scrap yard and the
dimensions of the vessel. For example, one company could only scrap two
or three vessels per year. According to industry sources, it takes
approximately 4 to 6 months to completely scrap a MARAD vessel.
Additional companies are not attracted to this industry because of
the low profits currently available. Scrap steel prices in the United
States are low and contractors must comply with environmental
regulations. Most of the domestic scrapping company officials we
contacted indicated that the profit from scrapping vessels is not worth
the effort. At a minimum, contractors in this business must pay for the
towing costs and provide $150,000 as a performance bond to secure a
vessel after a contract has been awarded. Contractors receive no return
on a vessel until scrap metal and the equipment removed from the vessel
are sold.
Even when it has been able to sell vessels, MARAD has encountered
problems with domestic contractors. In 1999, MARAD sold 17 vessels to 3
ship scrapping companies located in Brownsville, Texas. At the time of
our review, we found that only two companies were actively scrapping
ships, and only one of these companies was currently scrapping a MARAD
ship. MARAD has granted a number of extensions to contractors, and in
one instance, MARAD had to resell vessels because of contractor
default. During our review, we also found that another company had not
taken possession of any vessels because of an ongoing dispute with the
Port of Brownsville regarding contamination of its scrapping site. It
has since taken possession of its vessels.
Navy Pilot Project Poses Competition for MARAD
The Department of the Navy experienced a similar inability to sell
its combatant vessels for domestic scrapping. In 1998, Congress
authorized and appropriated funding for a Navy pilot project for the
disposal of obsolete warships. The Navy and MARAD are coordinating
efforts to improve ship scrapping programs, as recommended by the
Interagency Panel on Ship Scrapping and the General Accounting Office.
The Navy agreed to share its findings from the pilot project with
MARAD.
On September 29, 1999, the Navy awarded four cost-plus contracts
totaling $13.3 million for the scrapping of four vessels under its new
Pilot Ship Disposal Project. This pilot project departs from the sales
contracting process by providing for cost plus incentive fees for
scrapping the first vessels. It guarantees profitability by providing
for the cost of scrapping the vessels and gives the contractor the
opportunity to earn incentive fees, which encourages and rewards
superior contractor performance. If the contractors are successful in
scrapping the first 4 vessels, they will be given the opportunity to
scrap more vessels, potentially leading to the disposal of 66 warships.
One of these contractors was also under contract with MARAD to
scrap its vessels. The company completed scrapping four MARAD vessels
during 1998 and 1999; however, it defaulted on a contract for another
five MARAD vessels in August 1999.
MARAD cannot compete with the Navy's pilot project while it is
required by law to maximize financial return on its vessels. If MARAD
were authorized to implement such a project, it could cost as much as
$515 million to dispose of the obsolete vessels that MARAD expects to
have by the end of FY 2001.
Alternatives Offer Potential But Have Limitations
While MARAD has been pursuing ways to improve scrapping sales, its
ability to explore creative solutions for disposing of vessels is
constrained by the requirement to maximize financial returns. Also, the
alternatives MARAD is pursuing have capacity limitations, so no one
single option has the potential to significantly reduce the backlog of
vessels awaiting disposal in a timely manner. We have identified
additional alternatives that MARAD has not pursued that may have the
potential to contribute to the goal of disposing of obsolete vessels.
Programs to improve scrapping sales and alternatives MARAD is
pursuing include: coordination with the Navy and a west coast company
on a proposal for a potential scrapping site; participation in
interagency work groups to look for innovative ways to improve the ship
scrapping process and establish consistent procedures; donation of
vessels designated for disposal for uses such as museums and the fish
reef program, given legislative or executive approval; and coordination
with the Navy on its program to sink vessels in deep water after
hazardous materials are removed.
MARAD may be able to explore alternatives that have the potential
to assist in disposing of some of its vessels such as: selling vessels
to other countries for non-military uses, given legislative approval
and approval from the EPA to sell vessels to overseas markets that are
capable of scrapping them in an environmentally compliant manner.
According to MARAD, selling vessels overseas for non-military uses
would require a change in the law that only allows MARAD to sell
vessels for disposal or non-transportation use. However, legislation
was passed in 1996 for four vessels to be sold on a competitive basis
for operational use. One vessel was sold in 1999 and bids on two
vessels are currently under review. The fourth vessel requires an EPA
approval, which MARAD requested April 1999.
On April 14, 2000, MARAD sent a memorandum to EPA requesting its
assistance in facilitating an export option for scrapping based on the
1997 EPA/MARAD agreement. MARAD also said it would contact the EPA
staff to discuss recommendations made by the Interagency Panel on Ship
Scrapping.
Disposal Plan and Prompt Action Are Needed
The National Maritime Heritage Act of 1994 requires MARAD to
dispose of its obsolete vessels by the end of FY 2001, which is an
extension from 1999, the original deadline. MARAD does not have a plan
to dispose of these vessels.
In our March 10, 2000 audit report, MA-2000-067 \1\, we recommended
that the Maritime Administrator:
---------------------------------------------------------------------------
\1\ Report on the Program for Scrapping Obsolete Vessels, MARAD,
March 10, 2000.
---------------------------------------------------------------------------
1. Seek legislative approval to extend the 2001 mandate to dispose
of obsolete vessels and to eliminate the requirement that MARAD
maximize financial returns on the sale of its obsolete vessels.
2. Continue to pursue programs to improve scrapping sales and
identify alternative disposal methods that can contribute to the goal
of reducing the number of obsolete vessels awaiting disposal, to
include working with the Navy on the results of its studies on the
environmental impact of sunken vessels.
3. Develop a proposal for submission to Congress seeking approval
and funding for a project to pay contractors for vessel scrapping. The
proposal should include a plan to target the ``worst condition''
vessels first, identify funding and staffing requirements, and provide
milestone dates to dispose of all obsolete vessels.
MARAD concurred with our recommendations. In its FY 2001
authorization request, MARAD proposed a ``five year extension [in the
deadline that] will provide MARAD with additional time to develop and
begin implementing a plan to dispose of these vessels.'' Considering
the condition of some of the vessels, the environmental risks, and the
costs to maintain them, we find the MARAD proposal unacceptable. MARAD
must develop and implement a disposal plan for its obsolete vessels
once legislative approval is obtained for an extension.
As a part of its disposal plan, MARAD must state specific
milestones and steps it will take to scrap its obsolete vessels within
the next 5 years. The plan must state how MARAD proposes to dispose of
these vessels taking into consideration all the available options.
MARAD must identify viable disposal methods, and target the ``worst
condition'' vessels for priority disposal.
Mr. Chairman, this concludes our statement. I would be pleased to
answer any questions.
Chairman Sununu. Mr. Graykowski.
STATEMENT OF JOHN E. GRAYKOWSKI
Mr. Graykowski. Thank you, Mr. Chairman. And thank you,
members of the Task Force, for the opportunity today to appear
before you to talk about what we consider to be a serious and a
growing problem with national significance.
By way of background, I am John Graykowski and I am
currently the Acting Administrator of the Maritime
Administration, which is a modal administration within the
Department of Transportation. MARAD is a small Federal agency
with a large portfolio of responsibilities generally focused on
the promotion, enhancement, and strengthening of the U.S.
maritime industries, consisting of vessel owners, maritime
labor, our shipyards and our ports.
MARAD performs these duties in direct support of U.S.
national and economic security objectives, one of which is to
maintain a commercial sealift capability and shipyard capacity
to be made available to the Department of Defense in times of
war, national emergency, or under Presidential directive. In
effect, MARAD serves as a bridge between the national defense
apparatus of the country and the commercial maritime assets
which are critical to support national needs.
I note the attendance today of one of our major partners in
our effort to support the United States maritime industry, Vice
Admiral Amerault, who will, I am certain, concur that our
current defense posture relies heavily on the commercial
maritime industry to maintain its readiness and response
capabilities.
Mr. Chairman and Members of the Task Force, it is precisely
this partnership with the Department of Defense that has
created the situation we have today, where a civilian agency,
MARAD, has control and title to a large fleet of obsolete ships
around the country.
I have submitted written testimony and I will thus simply
summarize a few points:
One, the problem is ours, the Federal Government's problem.
It is our responsibility to fix it. No matter how hard one
might try to look at it differently, these are government
ships, they are stored and maintained by the government and
required by law to be disposed of properly by the government.
Secondly, the problem will not go away on its own. Indeed
this problem grows larger with each passing day, both in terms
of the increasing number of ships that need to be scrapped and
in the simple and inescapable fact that like all of us, ships
get old, steel wastes, and structural integrity degrades. We
simply cannot ignore it. We can't pretend it doesn't exist and
we can't simply persist in holding our collective breaths each
time there is a storm near one of these fleets or in the calm
of the night that something, quote, ``bad'' might happen.
We are paying considerable amounts of money now, as the
Chairman noted, and that amount of expenditure will continue to
grow. For example, we spent around $3 million last year just to
take care of this fleet. We anticipate spending perhaps five
times that in the next couple of years unless we resume
scrapping operations.
As the Chairman referred to and wanted me to speak to, last
year with that ship right there, the Export Challenger which is
some 40 years old, we and the taxpayers spent $1.3 million to
pump out some oil, to fix it up and return it to site in the
James River where she sits today. And this, Mr. Chairman, and
all of you, as all of us who are responsible for managing the
taxpayers' resources, it is very hard to justify that type of
expenditure but it is not going to stop with the Export
Challenger.
We are going to begin, and it is no secret to Admiral
Amerault or anybody familiar with this program, we are going to
begin dry docking these ships, ships such as the Export
Challenger. Their average age is 48 years old. That is older
than me, I think it is older than the Chairman and older than
others here, at the cost of $900,000 apiece minimum, because we
don't know what it is going to take once they are in the dry
dock to fix them up.
We will have 155 ships under our control at MARAD by the
end of 2001. Anyone here can do the math and see that it will
cost this country hundreds of millions of dollars in the next
decade. And what do we end up with? Exactly what we have
today--155 ships sitting in the James River, Beaumont, Texas,
and Suisun Bay--unless we resume scrapping.
How we got here has been chronicled in my written
testimony. Admiral Amerault will speak to it. Tom Howard just
spoke to it. I am not going to repeat it. I will say, however,
that there have been a series of decisions taken within our
government that have resulted in the current impasse, decisions
that were well founded in intention and desire but which did
not address the fundamental and again inescapable fact that
something has to be done with these vessels.
In a sense, I think that we have substituted in the last 7
years an appearance of action on this problem for real action
while the infinite patience of time continues to take its toll
on our vessels. But I would caution all of us against leveling
recriminations against any of the agencies or people who have
been involved in this matter, since that would, I believe,
undermine our common purpose and desire to eliminate these
ships as fast as possible and in the most responsible fashion
we can.
Mr. Chairman and members of the Task Force, my agency MARAD
is forbidden by law to do anything other than sell these ships.
We did it for quite a number of years and very successfully and
yielded a lot of money that was used to offset our need for
appropriations. But because of this situation, MARAD has not
taken any of the actions that might be necessary to inventory
the fleet for both the hazardous materials that might exist and
to estimate possible recoveries from the sale of metals from
the ships. To do that would require a huge amount of money and
a devotion of staff resources that we simply don't have at this
time.
However, let me stress, if the statutory mandate is
changed, and MARAD is given the authority to pay for scrap
vessels domestically, MARAD is fully prepared, equipped and, I
would submit emphatically, the right agency for the job. We are
already charged by DOD for these, to take care of these vessels
and to keep the ready reserve force ready to fight, and we do
that in an outstanding fashion. We know these vessels, we know
the shipyards that might be willing to participate in a
program, and indeed we have a very strong and vibrant
relationship with those shipyards that is in all senses a
commercial partnership by virtue of the other programs MARAD
implements. Thus I am confident that if directed by Congress,
we, MARAD could establish a program that yields the best value
to the government. We have proved that elsewhere and I am
confident we would do it here.
Finally, Mr. Chairman, members of the Task Force, we all
need to remove the extensive mystery about ship disposal--and I
mentioned this to you yesterday--the mystery which leads to
imposing regulations and treating this situation different from
disposal situations elsewhere.
A ship is nothing more in a sense than a building. It
differs because it floats, but it is a building. Fifty years
ago, just as buildings were made using materials such as
asbestos and PCBs, so are ships. But the problems are the same,
the challenge is identical, and the technical responses to that
need to be much different, whether it is a ship or a building.
We have those resources, we have that capability, and we have
the ability to take care of the problem.
I thank you for your interest, look forward to working with
you, and again this is a long overdue opportunity.
Chairman Sununu. Thank you very much Mr. Graykowski.
[The prepared statement of John Graykowski follows:]
Prepared Statement of John E. Graykowski, Acting Maritime
Administrator, U.S. Department of Transportation
Good morning Mr. Chairman and Members of the Task Force. I welcome
the opportunity to be here today to discuss an issue of great
importance to the Maritime Administration (MARAD)--the disposal of
obsolete government vessels. As you know, the Federal Property and
Administrative Procedures Act of 1949 designates MARAD as the
Government's disposal agent for merchant type vessels of 1,500 gross
tons or more. Thus, in addition to MARAD's own National Defense Reserve
Fleet (NDRF) obligations, the agency has taken title to over 40
merchant type Navy ships for disposal in the last 2 years.
Currently, there are 114 vessels slated for scrapping moored at the
James River Reserve Fleet in Ft. Eustis, Virginia; Beaumont Reserve
Fleet in Beaumont, Texas; and Suisun Bay Reserve Fleet in Benecia,
California. This number is expected to grow to 155 by the end of Fiscal
Year 2001 if additional vessels are not disposed of. MARAD is committed
to finding an appropriate means of scrapping these vessels safely,
economically and in an environmentally sound manner.
Under the National Maritime Heritage Act of 1994, MARAD is required
to dispose of obsolete NDRF vessels by September 30, 2001, in a manner
that maximizes financial return to the United States. Fifty percent of
the amounts received from scrapping are to be used by the Maritime
Administrator for the acquisition, maintenance, repair, reconditioning
or improvement of NDRF vessels. Twenty-five percent is to be used for
expenses incurred by the State or Federal maritime academies for
facility and training ship maintenance, repair, modernization and the
purchase of simulators and fuel; the remaining 25 percent is to be made
available to the Secretary of Interior for maritime heritage grants.
Historically, MARAD's primary means of disposing of obsolete
vessels has been to sell them for scrapping. From 1987 to 1994, MARAD
sold approximately 130 obsolete vessels for scrapping overseas. During
that period the agency received an average of $108 per ton for those
ships.\1\ Since an average ship in the NDRF weighs approximately 6,000
tons, the gross returns for scrapping such a ship overseas have been
about $600,000.
---------------------------------------------------------------------------
\1\ All references to tonnage in this statement are to lightship
displacement tonnage. Lightship displacement tonnage refers to the
actual weight of the ship.
---------------------------------------------------------------------------
Since 1995, MARAD has not scrapped any vessels overseas due to
concerns raised by the Environmental Protection Agency (EPA) about the
export of hazardous substances. Specifically, the EPA advised MARAD of
its position that the export of a Government ship for scrapping was the
equivalent of distributing in commerce regulated quantities of
Polychlorinated Biphenyls (PCBs) under the Toxic Substances Control Act
(TSCA). In November 1995, EPA issued a discretionary enforcement letter
to MARAD allowing the export of two ships for scrapping once all PCBs
had been removed. That procedure was unworkable since the removal of
all PCBs could have compromised the watertight integrity of the ships.
In 1997, MARAD and the EPA signed an agreement allowing foreign
ship disposal after removal of liquid PCBs and readily removable solid
PCBs. Prior to implementation of the export agreement, however, the
Department of Defense formed an Interagency Panel on Ship Scrapping to
review the process for scrapping Government vessels. Thus, in January
1998, MARAD agreed to continue to refrain from selling any vessels for
scrapping abroad until the Panel had completed its review.
Additionally, in the fall of 1998, an executive memorandum requested
that MARAD and the Department of Defense observe a moratorium until
October 1, 1999, on the export of obsolete vessels to be scrapped, to
ensure that the Panel's recommendations were fully considered. MARAD
complied with this request.
The Interagency Panel, composed of representatives from DOD, the
EPA, the Occupational Safety and Health Administration (OSHA), the
Department of State, the Department of Justice, the U.S. Coast Guard
and MARAD reviewed the process and procedures for scrapping ships. The
Panel made recommendations regarding economic soundness and
environmental and worker safety. It also concluded that all options for
ship scrapping, including overseas scrapping, should remain open.
With regard to exports, the Panel made a number of
recommendations--such as expansion of the notification process to
importing countries regarding the presence of hazardous materials, and
the requirement for bidders to submit a technical compliance plan--
which could be incorporated into the process relatively quickly.
Nevertheless, developing meaningful technical assistance, and
determining how to enforce contractual requirements and monitor
contractual performance overseas could take significant time and
resources to implement.
Since 1996, MARAD has been exploring the domestic ship scrapping
market. The agency has revised its solicitation process for domestic
sales, incorporating environmental and safety issues as part of the
award. A bidder is required to submit a technical compliance plan
including environmental, worker health and safety, business, and
operational plans that describe the bidder's knowledge and ability to
address the problems inherent in ship scrapping. Following a review of
the bidder's technical compliance plan, its compliance history and a
site visit, MARAD awards vessels to qualified bidders on the basis of
price. During the scrapping process, MARAD also conducts both announced
and unannounced visits to the scrapping site to monitor the
contractor's compliance with the sales contract.
Unfortunately, the capacity of the domestic market for buying and
scrapping obsolete MARAD ships is limited, and the drop in the price of
scrap steel has eroded the profitability of existing scrappers.
Moreover, only four bidders have satisfied the requirements of MARAD's
technical review since 1997, and only 9 of the 22 ships sold
domestically during that time have been removed from the fleet sites.
Three of these vessels were sold for $10.00 each. One sales contract
for five vessels was terminated last year because the purchaser did not
take possession of the vessels. We are likely to continue facing a
backlog given the number of ships waiting to be scrapped.
You may be aware that about 40 NDRF vessels are in extremely poor
condition. Time is critical in this effort. The cost to the Department
of Defense of maintaining each NDRF vessel is approximately $20,000 per
year. However, as obsolete vessels in the NDRF continue to deteriorate,
the costs of upkeep will rise. For example, the Export Challenger, a
vessel in the James River Virginia Reserve Fleet, experienced a
relatively minor release of oil in 1998. Due to the deteriorated
condition of the hull, the remainder of the oil aboard needed to be
removed. The combined cost of clean up and removal of oil from the
vessel was $1.3 million. The cost of dry-docking a vessel in order to
prevent it from sinking is estimated to be about $900,000 per ship.
MARAD expects to begin dry-docking 16 obsolete vessels in poor
condition per year beginning in fiscal year 2002 in order to avoid
environmental problems. In the meantime, these ships are monitored
closely by MARAD to prevent sinking or a hazardous discharge.
We are fully committed to working with Congress to find a swift and
appropriate solution for scrapping obsolete NDRF vessels. MARAD's
authorization proposal for fiscal year 2001 contains a provision that
would extend the deadline for the disposal of obsolete NDRF vessels
from 2001 to 2006. During this period, MARAD intends to develop and
implement a program to scrap these vessels safely, economically and in
an environmentally sound manner.
In addition, Maritime Administrator Clyde J. Hart, Jr. recently
wrote to Carol Browner, Administrator of the EPA, seeking to explore
the possibility of resuming exports in a manner consistent with the
prior agreement negotiated between EPA and MARAD. Although we have not
yet received a response to our inquiry, we do not believe that this
option has been foreclosed.
Mr. Chairman and Members of the Task Force, we appreciate the
concern that you have shown in this area and want to assure you that we
are working diligently to resolve the matter as soon as possible. This
concludes my statement. I would be happy to answer any questions you
may have.
Chairman Sununu. Admiral.
STATEMENT OF VICE ADM. JAMES F. AMERAULT
Vice Adm. Amerault. Good morning, Mr. Chairman, and
distinguished members of the Task Force. I am very pleased to
appear before you today to discuss the Navy's approach to
reducing our own inventory of excess ships. With your
permission, I would like to submit my prepared statement for
the record but take a few minutes here to give you a shortened
summary version.
Chairman Sununu. Without objection.
Vice Adm. Amerault. Thank you sir. The Navy's Inactive
Fleet has 57 ships designated for scrapping. The decision to
scrap a Navy ship is made only after carefully evaluating all
other options, and these include several such as retention as a
mobilization asset, sale to allied Nations under the foreign
military sales program, use as a war memorial or historical
museum, use for training, or use as a weapons development
asset.
The Navy's primary interest is to dispose of all of our
excess ships in a manner that is environmentally sound,
economically neutral, and worthy of the proud service that
these ships have performed for this Nation.
Historically, the scrapping rights to our ships have been
sold to domestic shipbreakers, very much like what has gone on
in the MARAD fleet. More recently, environmental concerns,
worker safety, and changing economic conditions have impacted
the methods and locations available to scrap our ships. Up
until the mid-1990's, domestic shipbreakers were willing to pay
for the rights to scrap Navy ships because the value of metal
and other equipment in the ships offset their costs and
provided a profit. This, of course, matched our goals and
reinforced our expectation that Navy ships could be scrapped at
no cost to the Navy. However, since 1996 eight scrapping
contracts have defaulted, causing the Navy to expend over $12
million to return 28 ships to a safe storage condition. So
within Navy we faced a dilemma: A backlog of ships to be
scrapped was growing but there was no domestic market in which
scrapping could be accomplished at no cost.
Consequently, we began in 1997 to work with EPA to
determine the conditions under which scrapping might be
accomplished overseas. In 1998 increased interest by the
Congress and the public resulted in both the Vice Presidential
and Secretary of the Navy moratorium on overseas scrapping. At
the same time, the Under Secretary of Defense for Acquisition
and Technology created an interagency panel to explore the
problems and solutions to disposing of excess Navy and MARAD
ships. The panel recommended that the Navy conduct a pilot
program to determine the conditions under which domestic
scrapping could be made feasible.
Consistent with this recommendation the Navy developed a
ship disposal project with a pilot phase that was designed to
qualify and quantify the technical scope and costs associated
with ship scrapping. That pilot phase is currently underway.
The goals of this project are:
1. To document all processes, costs, revenues and hazardous
materials generation while demonstrating an environmentally
sound and cost-effective method for dismantling ships;
2. To minimize the Navy's net cost of ship disposal by
realizing a fiscal return on scrap metal and other equipment
sales; and
3. Develop a viable domestic capability to scrap additional
ships from the Navy's inventory after the pilot phase is
completed.
A significant feature of the ship disposal project is that
the Navy, not the shipbreaker, assumes the risks associated
with the vagaries of the scrap metal market and equipment
resale. The shipbreaker's profit is set in terms of the
contract. Proceeds generated by the sale of scrap metals in
excess equipment are then credited against the cost of the
contract.
It is by decoupling this volatile scrap market from the
contractor's profit or loss that a contractor can establish a
stable economic model within which scrapping processes can be
optimized, and hopefully that is our solution to defaulting
contracts.
In September 1999 we awarded four indefinite delivery/
indefinite quantity contracts for the pilot phase. The initial
task order under each of these contract is to dispose of one
ship--and all ships, by the way, all four are exactly the same
type and model of ship--to dispose of one ship under a cost
plus incentive fee structure. Progress to date has been
satisfactory. The data concerning the processes utilized and
the cost revenue stream is being collected but has not yet been
completely evaluated. The last of the four ships should be
completely dismantled and all materials recycled in the fall of
this year.
It became obvious to us during the initial performance of
these task orders that much of the contract cost was
attributable to process start-up of an infrastructure
facilitation required for the dismantling process to provide
further insight into the true cost of shipbreaking. Two
additional task orders were awarded under the pilot phase on
May 24th of this year under a fixed price incentive structure.
Task order awards after the pilot phase will be made
following careful examination of the data collected and
dependent upon the availability of Navy funding.
The Navy has also worked with MARAD on the ship disposal
problem for several years. Through group participation in
several joint agency working groups, we have shared our
technical and process information. We will continue our open
dialogue and provide the ship disposal project data when it is
completely available to MARAD.
In summary, the Navy is committed to dismantling our excess
ships in a way that is environmentally sound, publicly
acceptable, and advantageous to the Navy and the government.
The ship disposal project assists in accomplishing these goals
while providing empirical data on the processes and costs
associated with domestic ship scrapping in an environmentally
safe way.
Mr. Chairman and member of the Task Force, this concludes
my remarks. Thank you for your interest in the program. I would
be happy to answer questions that you may have.
Chairman Sununu. Thank you, Admiral.
[The prepared statement of Vice Adm. James Amerault
follows:]
Prepared Statement of Vice Adm. James F. Amerault, Deputy Chief of
Naval Operations (Logistics)
Mr. Chairman and distinguished members of the panel, thank you for
the opportunity to appear before you to discuss the Navy's approach to
reducing our inventory of excess ships and how we are working with the
Maritime Administration on this problem. We sincerely appreciate your
interest in our program and processes.
Before going further, I would like to note for the committee that I
have not included in my testimony any discussion of our process for
disposing of nuclear powered warships. This is because that work is
accomplished exclusively in our public shipyards and is subject to
requirements more stringent than those necessary to dispose of non-
nuclear powered ships.
I also wish to point out that Navy warships may present a more
complex dismantling challenge than traditional merchant ships due to
two facts. First, our warships are constructed to maintain mission
capability despite battle damage; and second, they have a high density
in terms of equipment and compartments.
The Navy's interest is to dispose of our excess ships in a manner
that is environmentally sound, economically neutral and worthy of the
proud service they have performed for this nation.
Let me now briefly explain the process we use to determine the
manner in which we dispose of our conventionally powered ships. After a
careful evaluation, the Chief of Naval Operations may declare a ship to
be ``excess'' to the current operational needs of the Navy. The next
step is to determine if the ship is required as a Mobilization Asset.
If the ship is needed, it is placed in a state of preservation such
that it can be reactivated and returned to active service.
If the ship is not needed as a Mobilization Asset, then it is made
available for sale or lease to an allied Navy under the Foreign
Military Sale/Lease program.
If the ship is not a candidate for lease, it is stricken from the
Naval Vessel Register and may then be designated for transfer to a
nonprofit organization for display as a historical memorial or museum.
The requirements and mechanics of these transfers are governed by
statute.
If not designated as a potential historical museum or memorial, the
ship may be made available for Navy fleet weapons training or
developmental testing of weapon systems. If used in this manner, the
ship is usually sunk as a result of the training or testing. Therefore,
prior to conducting the training or testing the ship is prepared in
accordance with requirements set forth by the Environmental Protection
Agency.
The ship may also be held as a logistics support asset to fill
requests by active ships for parts or equipment that are no longer
manufactured or stocked.
If the ship is not disposed of or held for any of the
aforementioned purposes and it is a merchant type ship, then it must be
transferred to the Maritime Administration (MARAD) in accordance with
Federal Property and Administrative Services Act of 1949. Navy ships
transferred to MARAD supplement the National Defense Reserve Fleet.
If it is not practical to use the ship in any of the ways I have
mentioned, then the ship is designated for scrapping.
Ships that are declared to be in excess and are awaiting final
disposition enter the Navy's Inactive Fleet. Today the Navy Inactive
Fleet has 144 ships in its inventory, 28 of which are being prepared
for transfer to MARAD, and 57 of which are designated for scrapping.
The average age of the ships waiting scrapping is approximately 37
years and they have been out of active Navy service for an average of 7
years.
The traditional method the Navy used to scrap conventionally
powered ships was to engage the Defense Reutilization and Marketing
Service (DRMS) as a Government sales agent to sell the scrapping rights
to a domestic shipbreaker. Proceeds from the sale of these rights were
deposited with the United States Treasury, not the Navy. The
shipbreaker's profitability was solely a function of his costs and the
price of scrap metals on the open market.
No matter where the shipbreaking is accomplished, the ``Title'' to
the ship remains with the Navy until the ship is deemed by the Navy to
no longer be a ship. This generally occurs when the hull is no longer
floatable. I think it is important to note that while the Navy holds
the title it is the Navy that is presumed to be responsible for the
disposition of the ship, even if the shipbreaker defaults on the
contract.
Until 1996, DRMS awarded scrapping rights principally to the
highest bidder. As scrap metal prices began fluctuating in the mid-
nineties, these shipbreakers experienced fiscal difficulties leading in
many instances to contract defaults.
In 1996, seeking to address the problem of contract defaults, DRMS
initiated changes to improve the selection process for scrapping
contractors. A two-step process was instituted that included an
evaluation of the contractor's technical plans followed by an
invitation to bid. Oversight at the contractor's facility was
increased.
Under the old sales to the highest bidder process, eight scrapping
sales contracts were defaulted and five sales contracts were completed
between 1996 and 1999. The Navy has expended approximately $12 million
since 1996 to return 28 of the ships from the eight defaulted contracts
to a safe storage condition. Under the new two-step sales process, only
two contracts have been awarded. One contract has been satisfactorily
completed and contract default procedures have been initiated on the
second contract. The contractor being defaulted has informed DRMS that
it does not intend to pick up the eight remaining ships under this two
step sales contract because the company will lose money.
Since the domestic scrapping industry was not meeting the needs of
the Navy, the Navy entered into an agreement with the Environmental
Protection Agency (EPA) in 1997 that identified the conditions under
which EPA would exercise enforcement discretion against the Navy for
exporting vessels that may contain regulated levels of PCBs for
disposal.
At about that same time, Congress and the media increased their
interest in both the environmental and safety concerns associated with
ship scrapping. Overseas scrapping came under scrutiny; and some
foreign scrappers were identified as not adhering to procedures that
protected the environment and their workforce, especially when compared
to the standards required in the United States. In response, on 19
December 1997, the Secretary of the Navy (SECNAV) suspended all
initiatives to explore overseas ship scrapping. In addition,
congressional hearings on ship scrapping were conducted in March 1998
and June 1998.
As a result of public and congressional interest, the Under
Secretary of Defense (Acquisition and Technology) established the
Interagency Ship Scrapping Panel on 24 December 1997. The panel was
charged to review Navy and MARAD scrapping programs and investigate
ways to ensure that Navy ships are scrapped in an environmentally
sound, economically feasible and occupationally safe manner.
The panel issued its report in April 1998. One of its
recommendations was that the Navy carry out a pilot project to quantify
the scope and costs associated with ship scrapping in private industry.
This pilot project would also serve as a vehicle for gathering
information to improve the ship scrapping process.
On 23 September 1998, Vice President Gore requested both Navy and
MARAD to observe a moratorium on efforts to award contracts or transfer
vessels for scrapping overseas. This moratorium expired on 2 October
1999; however, Navy continues to operate under the previously mentioned
SECNAV suspension.
Consistent with the panel's recommendation, the Navy initiated the
Ship Disposal Project (SDP) in 1999 with three goals in mind. These
are:
1. Document all processes, costs, revenues, and hazardous material
generation while demonstrating an environmentally sound and cost
effective method for dismantling ships;
2. Minimize the Navy's net cost of ship disposal by realizing a
fiscal return on scrap metal and equipment sales; and
3. Develop a viable domestic capability to scrap additional ships
from the Navy's inventory after a pilot phase is completed.
The Ship Disposal Project is structured in two parts. The first
part, referred to as the ``pilot,'' is underway and is intended to gain
insight into the process and costs of scrapping warships. Navy will
gather all revenue and expense data, document quantities and locations
of hazardous waste that are generated during the scrapping process, and
develop cost models for future decision making. The domestic
shipbreaker is required to maximize the value (within a specified time
period) of the recyclable equipment and scrap metal and sell these
items as an offset to the Navy costs incurred under the contract. Part
Two of our Ship Disposal Project is to award additional ships to one or
more of these same shipbreakers as funds are available.
A significant feature of our Ship Disposal Project is that the
Navy, not the shipbreaker, assumes the risk associated with vagaries of
the scrap metal market and equipment resale. The shipbreaker's profit
is set in the terms of the contract (i.e., cost contract or fixed price
contract). Any proceeds realized from the sale of scrap metal or
equipment are used to offset Navy contract costs. With this decoupling
mechanism in place the contractor can establish a profitable economic
model to optimize scrapping processes. The contractor is paid for the
services he provides. The SDP also features a performance incentive for
effective environmental and safety programs.
The Navy's Supervisor of Shipbuilding, Conversion, and Repair
(SUPSHIP) performs oversight and contract administration for the SDP.
This allows the contractors to benefit from the Navy's ship repair
experience and further facilitates the exchange of information between
the Navy and the contractor.
Prior to a ship arriving at a contractor's facility for scrapping,
the Navy accomplishes some environmental remediation of the vessel.
Nearly all hazardous waste and some other hazardous materials are
removed from the ship. The Navy also performs limited sampling on each
vessel to identify the existence and location of other hazardous
materials.
On 29 September 1999, Navy awarded four Indefinite Delivery/
Indefinite Quantity (IDIQ) contracts under Phase One of the Ship
Disposal Project (i.e., the pilot phase). The initial task order under
each of these contracts is to dispose of one ship under a Cost Plus
Incentive Fee structure. Progress to date by the four domestic
contractors has been satisfactory. Data concerning the processes
utilized and cost/revenue stream are being collected but have not yet
been evaluated. The last of the four originally awarded ships should be
completely dismantled and all materials recycled in the fall of this
year.
Two additional task orders were awarded under the pilot portion of
the SDP to provide the Navy with further insight into shipbreaker's
start-up costs. These additional task orders were offered under a Fixed
Price Incentive structure to provide additional encouragement to reduce
dismantling costs.
Decisions concerning Phase Two task order awards will be made after
careful evaluation of the data collected during the pilot phase and are
dependent on the availability of funding.
The Navy has worked with MARAD on the ship disposal problem for
several years. Through participation in several joint agency working
groups, we have shared our technical and process information. We will
continue our open dialogue and provide the Ship Disposal Project data
when it is available.
In summary, our Ship Disposal Project is pursuing the goal of
dismantling our excess ships in a manner that is environmentally
friendly, publicly acceptable, and advantageous to the Navy. The
backlog of ships awaiting disposal presents an increasing burden on the
Navy's resources and could present an environmental concern as they
continue to age. We are committed to eliminating our backlog and
avoiding any environmental risks. The Ship Disposal Project assists in
accomplishing these goals while providing empirical data on the
processes and costs associated with domestic ship scrapping. In
addition, we continue to look for and study other disposal methods that
may contribute to further reducing our backlog and our costs.
Mr. Chairman and members of the Committee, I thank you for your
interest in our program and the opportunity to tell you about the
Navy's ship disposal goals and programs. I will be pleased to respond
to any questions.
Chairman Sununu. Let me begin the questioning with Mr.
Graykowski. I think you have touched on this in your remarks
but I want to be clear as to exactly what the problem is. Why
hasn't MARAD at least put together a plan for disposing of
obsolete vessels during the period where you have received an
extension on disposal, a temporary one, from 1999 to 2001? What
has kept you at least from putting together a strategic plan
outlining how this might be accomplished?
Mr. Graykowski. Well, as I mentioned in my opening
statement, Mr. Chairman, first and foremost, we don't have any
authority beyond selling the ships at a cost which generates a
positive cash flow to the government and we have endeavored to
do that. We have had a number of offerings of ships which you
know have been taken at low prices and the ships never get
picked up. We had one instance of contractor default.
So in one sense we have been sort of struggling to take the
program into a domestic context. In 1993 we had run an export
program for years generating tremendous amounts of money. We
didn't have that much familiarity with domestic scrapping and
there were constraints which, frankly, resulted in a lot of
conflicting signals, I think, among various agencies as to how
we were going to solve this problem. So MARAD tried to respond
that way. We have never really explored or had the opportunity
to explore with the Navy with respect to a pilot project but I
don't think it is fair to say----
Chairman Sununu. Do you have any legislative mandate to
develop such a plan?
Mr. Graykowski. No, we do not have a legislative mandate to
develop any plans.
Chairman Sununu. Do you think it is, despite the fact that
you don't have a plan in place now, do you think that we really
can afford to wait 5 years before we begin the disposal
process? I was struck by the request by the administration to
move that date back 5 years and that the disposal process would
have been required to begin then. That would seem to be far too
much time, given the condition of the vessels. Would you agree
with that?
Mr. Graykowski. I think that the perception that was
created by the legislation was that we were going to somehow
take all 5 years, and then at the end of 60 months we are going
to sort of start doing what we came up with to do; and I think
that a fairer assessment is give us a reasonable amount of
time. We could have, I think, done what we did several years
ago, which was asked for 2 years, knowing that that was
unrealistic, from our perspective. The 60 months was an outside
date.
I don't think in our hearts and minds at MARAD it was going
to take that long or be that long and, quite frankly, looking
at the development of the interest level within the Congress,
both House and Senate, I think it is going to be overtaken by
events. I am confident there is going to be some action and
directives from the Congress which will both shorten the time
and increase the pace of activity.
Chairman Sununu. I would tend to agree and very much hope
that it is overtaken by proactive events rather than defensive
events. And to that point, could you talk a little bit more
about the problems associated with the Challenger? Was it a
single leak, a single fracture, or a series of problems? And
again, could you summarize the total cost associated with that
one vessel?
Mr. Graykowski. I will do that, Mr. Chairman, and I will
also--I would like to submit a better answer for the record.
All of these ships, or many of them, have pockets of oil, I
mean, for want of a better term. In some cases there are 1,000
barrels and in other cases 20 barrels. But we have surveyed 40
ships and I think I came up with a ballpark figure of some
40,000 barrels of oil that are scattered around the country,
which would cause a problem in anybody's district, anybody's
river.
On the Challenger there were small leaks and the Coast
Guard notified us, as I recall, and I may be wrong on this,
that this was a problem. And we had to boom it by putting
containment booms around her, and were sort of--``directed'' is
too strong a word--encouraged and supported by the Coast Guard
to sort of remediate the potential for additional oil to leak
and this is oil deep in tanks. The ships are just laid up in
some cases.
Chairman Sununu. Are you unable to pump it?
Mr. Graykowski. Yeah. You have got to see it to believe it.
In some cases, this is bunker oil, if any of you are familiar
with the thick, heavy, sludgy stuff which over the years
hardens into tar-like road tar. So just the process of peeling
open the tanks and heating up the oil, if you will, to the
point where you can pump is extensive and a very arduous
process. So that is what we went through on her, to the cost of
$1.3 million.
Chairman Sununu. All of the effort was done while it was
still on the water?
Mr. Graykowski. Yes, sir. She still remains there, and
indeed we spent some more money down at the James River when
Hurricane Floyd came through and we were very concerned. That
was the reference I made there, additional funds we didn't
anticipate having to spend.
Chairman Sununu. How many of the vessels, approximately, of
the 40 worst-condition vessels are at or near the condition of
the Export Challenger?
Mr. Graykowski. We have triaged it or identified sort of a
priority list and we have got sort of--not a new term--but the
``dirty dozen.'' There are 12 ships that really, Mr. Chairman,
are--Export Challenger, she is our poster child, but she has a
lot of siblings. And so I say there are 12 that really are
approaching the condition of the Export Challenger.
Chairman Sununu. Was it ever in danger of sinking?
Mr. Graykowski. I don't think so. I mean, I don't want to
impart--it is a tough question to answer.
Chairman Sununu. I don't know if that is an encouraging
answer or discouraging answer from my perspective.
Mr. Graykowski. I could say none of them sunk yet. No, we
monitor them carefully, we do the best we can, and I don't
think they are in danger of imminent sinking and hulling,
absent sort of major storm and waves and conditions that don't
exist today. These are calm waters. Congressman Bentsen, I
think if he is familiar with where Beaumont sits, is a very
well protected area. Over time will they sink? I think it is
unavoidable, yes, but not imminent. I would like that message
to be there.
Chairman Sununu. Has any effort been made to quantify what
the potential costs would be of a catastrophic accident, either
a sinking or a serious hull rupture of one of these vessels?
Mr. Graykowski. I am getting no encouragement from the
folks behind me. My bench is weak here. Well, to quantify the
costs, fine; what kind of accident, we would have to remediate
whatever leakage problem or environmental damage that occurs.
And frankly as a lawyer, I have always looked at it as I have
got the ultimate strict liability here. I am a generator under
EPA, under TSCA, under CERCLA, under Fish and Wildlife and
Migratory Birds; there are a whole number of acts out there.
And the Federal Government is the ultimate deep pocket, so
quantification depends on the extent of damage to a certain
extent, but the checkbook is going to be open for a long time.
Chairman Sununu. OK. What kinds of marine wildlife are
there in the James River, and was there any damage to the
ecosystem or the wildlife with the Export Challenger accident?
Mr. Graykowski. The answer is an emphatic no. There was no
damage. We contained very limited minor leaks. We have got a
containment boom pretty much around the fleet now in terms of
where that is. There are State certified oyster beds. I
understand there are a couple of wildlife refuges. Indeed we
have ospreys building nests on our ships, and certain times of
the year we can't go near them. They are wildlife habitat
wetlands which we have got to protect as best we can.
Chairman Sununu. Your predecessor, Mr. Hart, wrote at least
twice to the EPA requesting a meeting with the Administrator to
resolve the issues that are preventing the timely scrapping of
government vessels. Has there been any response from Ms. Brown
or the EPA today?
Mr. Graykowski. Mr. Chairman, there hasn't. I think that
recently Deputy Administrator Bonnie Green, who testified in
front of Congressman Gilchrest, has written the Administrator
of the EPA, and I intend on writing her today to tell her once
again that we have testified and we need to work in an
interagency fashion.
To date, no sir, there has not been a response.
Chairman Sununu. Has the EPA put together guidelines for
you or for the Navy, that you are aware of, for the disposing
of obsolete vessels?
Mr. Graykowski. We have got a memorandum of understanding,
if you will, or agreement with EPA on certain conditions that
have to be conformed with before we can scrap a ship, so that
is in place. However, there are still some of the guidelines--I
was just getting to that. While we have this memorandum, the
particulars in terms of the regulations, for instance PCBs, and
that the guidelines that we would employ to scrap and to
monitor are not in place, sir.
Chairman Sununu. Would you explain that in a little more
detail? What do you mean, the guidelines aren't in place?
Mr. Graykowski. I think that EPA, and I am going to have to
elaborate for the record if I could, EPA, we have got this
memorandum of understanding, but it lacks sort of--that says we
are going to cooperate, and here's the basic structure of that:
Before MARAD scraps a ship, you have to clean out all the PCBs,
for example, but in terms of the exact procedures and the
quantities that would be allowed or not, they are still under
development at EPA.
Chairman Sununu. I am confused. Does the memorandum, does
the agreement that you signed, lay out what you need to do
before you can move forward with a scrapping--is that valid or
invalid? Either those are the guidelines you need to follow or
the EPA has changed their minds and is walking away from this
agreement and saying we are going to come up with different
guidelines.
Mr. Howard. Mr. Chairman, may I speak to the agreement?
Chairman Sununu. Please.
Mr. Howard. The agreement contains three conditions: one,
that all liquid PCBs be removed; that solid PCBs be removed to
the extent possible; and that the country that is accepting the
vessel be notified that the PCBs were on board and attempts
were made to remove them. That is what the agreement covers.
Chairman Sununu. Those sound like reasonable guidelines.
Mr. Howard. MARAD received authority in 1997 or 1998 to
sell two ships under those guidelines. When they attempted to
put together a plan that complied with the guidelines they
found that once they had removed the PCBs, that the ship
wouldn't be seaworthy and it wouldn't be able to be towed to
the foreign country that was willing to purchase it.
Mr. Graykowski. So we are still waiting for final guidance,
if you will, out of EPA to avoid this conundrum.
Chairman Sununu. I understand. So you are looking for a
little additional guidance so that you won't have to destroy
the seaworthiness of the vessel in an effort to scrap it
efficiently and economically.
Mr. Graykowski. Yes, sir; and I don't know what the status
of the guidelines are at this point in time.
Chairman Sununu. Has MARAD or anyone else evaluated EPA's
environmental concerns to determine whether they are
supportable on an environmental or economic basis?
Mr. Graykowski. The short answer would be no. I guess it
would be very difficult for the Maritime Administration to
second guess the Environmental Protection Agency on a
determination of environmental----
Chairman Sununu. I understand that is not your expertise,
but there has been no other outside or independent evaluation.
Mr. Graykowski. No. We are sort of leaning--we as a country
by approaching it this way are way ahead of, if you will, the
rest of the world. Scrapping practices vary worldwide, and what
we are trying to impose as standards and that the Admiral has
worked with, for example, is where I believe sincerely the
world is going to end up. But it is going to be several years
before it gets there, but we will be the first to get there.
Chairman Sununu. Thank you very much. Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. I have a few
questions. First of all, I am familiar with the Beaumont area,
even though I am in Houston. But let me tell you, when a
hurricane comes up the Gulf Coast, and a lot of times they head
toward an island in the Beaumont area, you can be in that
protected part of the Sabine River and still get some pretty
good surf over there. In my district back in 1994, as well as
just last year, when you get either a storm or a hurricane or
heavy rainstorm, you move the current on that river and you can
lose control of operating ships.
Plus we had in 1994 a situation with these abandoned
barges, some that were beached, that got moved off the beach,
off the banks, and smashed into the I-10 bridge, was involved
in part setting off an explosion in a pipeline.
So even though you are in a protected water area, the force
of nature can sometimes change it, and that is something that
we have to be concerned about, particularly in--at least I am
most familiar with the Texas areas. And I do understand the
environmental hazard related to these with, again, my own
experience in going through it with these barges and most of
the working ships in the Texas area.
Again, though, it is--and I know you have been having this
discussion with Mr. Sununu about this--but it is my
understanding that EPA has said that you could--if MARAD would
remove the hazardous waste, be it PCB or whatever, then you
could direct the vessel for scrapping. And I guess what you are
saying is in some cases the vessel becomes unseaworthy and you
can't do it. Why not salvage the vessel on site? I mean, we do
that. I don't, but the organizations along the Houston ship
channel do that from time to time, where they just do an onsite
salvaging instead of trying to tow something in and take it
apart.
Mr. Graykowski. Well, number one--and probably you don't
have to go farther than number one--we don't have the money for
it, Mr. Bentsen.
Number two, the EPA agreement--let me correct myself if I
could, please. And the Admiral was kind enough to tell me this.
It pertained to exports, OK and it is very dicey at this point
in time politically as well as I think practically, if you
will, to be exporting these ships. And so while we have turned
our attentions domestically as I have indicated----
Mr. Bentsen. Can I say that, for a second, on EPA, on the
exports, they were opposing the export of the ships because of
PCB content?
Mr. Graykowski. Primarily; and other what they consider to
be toxic waste, they viewed it as----
Mr. Bentsen. It is an interesting notion, and I only add
that because I have had a small battle with the EPA over the
last several years changing what has been the position for the
last 15 years to allow for the export of PCBs for disposal and
incineration abroad, which we believe violates the TSCA act,
although EPA seems to believe that it doesn't. EPA has taken
the position that they would like to export PCBs to Mexico and
Latin America and other countries where they can be disposed
of. Some would argue that this is because the volume of
American PCBs is declining and there continues to be industry
demand.
So it sounds to me like EPA may have a--the left hand may
not know what the right hand is doing at the EPA. I would
encourage you all to go back and talk to them.
Now they are under court order precluding them from doing
that, from the California circuit, the West Coast circuit and
we have tried to block them from doing that through the defense
bill in the past. Again, EPA has taken this position that in
some cases, at least, you would export PCBs for incineration.
Mr. Graykowski. I am incredulous, frankly. This is news to
me because when I leaf through, this is the agreement that I
signed with EPA in 1997, it specifically links PCBs, the
vessels and TSCA and the prohibition against introducing PCBs
into international commerce and that is what ground the
exporting to a halt.
Mr. Bentsen. Maybe instead of offering up the ship for
scrap metal you should have offered it up for PCB
consideration. I would encourage you to revisit that, and that
is in the courts, I think the 9th Circuit.
Let me ask you this. The chairman mentioned that the range
of cost for addressing this problem would be between half a
billion to $2 million. Why is there that amount of fluctuation
or band in the cost? Is it because you don't know necessarily
what you have out there until you get into the ship?
Mr. Graykowski. We have not inventoried, and I told the
chairman this yesterday, we have not really conducted the
inventory necessary to say we have 5 pounds or 5,000 pounds of
PCBs, I don't know, liquid versus solid. My impression is that
most of the liquids have been removed except those transformers
and capacitors that are buried in the bowels of the ship. We
don't know approximately how much we can get off of the ship. I
think the admiral can speak to the fact that--it is a net
outlay when you pay to have someone scrap it, but there is a
return that we would anticipate having a similar experience
with.
Vice Adm. Amerault. Assuming you will ask about this
anyway, but our program is based on the fact that we are paying
someone to scrap the ships. Heretofore that was very difficult
to do because they would default, there being no longer a
viable market for the scrap material which used to finance the
whole venture. So what we do is we reduce their risk of making
nothing by paying their workforce and facilitization and other
costs, by paying the cost of doing business, if you will, just
the labor and so forth.
Any materials that come off the ships that then can be sold
in the scrap market are, by contract, used to net the total
cost in our favor.
Now, we don't know exactly how well that is going to do and
I think it is going to depend on some things, one being
facilitization that is taking place up front, and we have paid
for that in the four pilots, the four yards that we have used
as pilot program participants. Part of what we pay for is the
facilitization to be able to handle the environmental and the
other things. Once that is done, then you have learning curve,
which can reduce the cost of their operation, and you have of
course the value of that material. As you get a good steady
throughput and the learning curve comes into play, their costs
will go down and you will have a volume of material that you
can sell for scrap. And the net, if things were to work out,
might, and I say might because we don't have the final
information and we don't have this--we don't know how scalable
this is, but it could be that the net cost of this whole thing
equals the cost of living up to the EPA agreements of taking
out the PCBs and making the ships environmentally safe for
export. So that is our hope.
Then you would have at least two processes that you could
look at and compare. I would think that we would want to try to
export a few ships so we could test that hypothesis to see if
doing it domestically with a net value, if you will, approach,
that we have done in this pilot program is indeed better or if
you can still beat it overseas even if you pay the up front
environmental costs.
Mr. Bentsen. It seems to me there would be a couple of
factors between domestically and overseas, the laboratory input
and the capacity, but also there are some transportation costs
associated as well. I am sure that these ships are not cheap to
move around.
Vice Adm. Amerault. There is a cost of getting them there.
That could work in our favor domestically.
Mr. Bentsen. There are two bills, one being Mr. DeFazio's
bill, and I would be interested in your comments on that. I
don't know if MARAD has taken a position on that.
The other, in the Senate, the chairman of the Senate
Commerce Committee, Senator McCain, has introduced a bill which
gives DOT the authority to scrap 39 foreign vessels under terms
determined by the agency. Is this an effective way to deal with
the problem or do you have a position on that bill?
Mr. Graykowski. No, we have not taken a position on any of
the legislation. There are four bills in total. We don't have
an administration position on any of the bills introduced.
Mr. Sununu. If I could interject there, Mr. Howard, those
two alternatives, correct me if I'm wrong, were part of the
recommendations that you made, one, to release the restriction
on these exports, and, two, to authorize MARAD or get rid of
the restriction on MARAD from being able to pay to scrap, and
that is what Mr. DeFazio's bill does. He includes an
authorization amount but of course in order to do that he needs
to eliminate that restriction?
Mr. Howard. Yes, sir, that is consistent with what we
recommended.
Mr. Bentsen. It seems to me that this is a situation that
there isn't going to be much of a market for and we just need
to get a handle on this and how much it is going to cost and
deal with it because again I realize these ships are docked and
they are in somewhat secure waters most of the time, but I
guarantee you there will be another storm that will come up
high island and there will be more water in Suisun and Beaumont
and everywhere else you have these and it is going to become a
problem. It would be worthwhile for us to get a handle on this
now and address this and figure out a way to do it. This is not
unlike a Superfund situation or any other hazardous waste
disposal, we just have to deal with it.
Mr. Graykowski. Mr. Bentsen, I didn't mean to imply in my
statement that the calm waters are always calm. Hurricane Floyd
caused us some sleepless nights. The first report indicated
that some of the nests had not broken but they were drifting
apart, had hurricane Floyd been stronger and hit differently,
our lives would have been differently. These ships cannot
withstand heavy water.
Number two, I might take issue with you. I do see a
potential for this country. There are 10,000 commercial ships
operating around the world. If indeed we set the standard as we
have consistently through the years on environmental matters
and the rest of the world does catch up and I would point to
the Basel Convention, which is part of the U.N. Process, if you
will, moving toward declaring obsolete ships as a hazardous
waste, the country of the Netherlands, which is a major world
shipowner, there was one conference, they are pushing for
another one, Norway has been talking about incorporating
scrapping into the life cycle cost of the vessel, imputing to
owners this notion that you are going to have to pay to scrap.
I would pose to you if we put a program together now with
these government ships, quite possibly we are in a position to
take advantage of it in a commercial sense when the rest of the
world says, oh, my gosh, we are going to have to.
Mr. Bentsen. That is a legitimate point. I had a discussion
last week with some people in the maritime industry in Houston,
where there is a discussion going on both in Texas and I think
somewhat through the international maritime organization
regarding emissions controls. Houston, of course has a serious
ozone problem. One idea--and part of the contribution of that
comes from the ships that go up and down the Houston ship
channel. We can't impose a Houston emissions control policy on
ships calling on our port because they will go somewhere else.
There probably needs to be a national standard, but it is
difficult to impose a national standard with respect to WTO and
other international agreements that we have, and perhaps it
needs to go through the International Maritime Organization. I
do appreciate that.
However, surely you have some ships that are decaying to
the point where we may not be able to wait for an international
convention to--you know, necessarily get an agreement. We may
be talking something more prospective than retroactive.
Mr. Graykowski. The imminence is undeniable. I think long
term there are benefits to be gained by sort of creating this
new industry just as we have seen in other environmental
recovery operations. Right now, Mr. Bentsen, we have to do
something with, as I said, these 12 or the 40. I mean there are
other benefits. We have not really looked at it in a broad
perspective. If we attack it, we ought to attack it in a
comprehensive fashion. We are dying for people to work in basic
shipbuilding industries and trades. The shipyards are essential
to the national defense. This is the type of program that can
help support them different than building brand new ships. We
have a source of labor to keep people coming in because this is
another problem that has not been looked at.
Mr. Bentsen. I agree with that. In order to get there, it
may be something that has to be subsidized initially. The
chairman doesn't always like to hear that word, but I think he
understands as well this may be a situation where the need is
great to deal with this problem, and I understand the need and
the idea of maintaining shipyard operations. You might be able
to match the two. Perhaps in the long run you are right. As in
other environmental services which we have seen grow in waste
disposal, this may be applicable also.
Mr. Graykowski. Yards that I have talked with this about
comment that there is a crossover point. If we guarantee a
certain feedstock at some point, however many ships, the
economies become such that it becomes a positive situation for
the company or in this case the joint venture between
government and industry. You are running so many ships,
ostensibly you get the efficiencies down and the yields up in
terms of the metals. And the projections that I have seen show
a definite crossover point from subsidy to a revenue generating
or certainly a wash situation referred to by the admiral. Until
we start it, we are not going to know and we right now don't
know much other than our ships are getting old and the problem
is getting bigger.
Mr. Bentsen. Thank you.
Mr. Sununu. Thank you.
Ms. Hooley.
Ms. Hooley. I am sorry that I missed your testimony but I
have the written statements.
Having gone through your information, Mr. Graykowski, do
you think we have the capacity to dismantle the ships today in
a domestic market?
Mr. Graykowski. Nope.
Ms. Hooley. You do not?
Mr. Graykowski. No.
Ms. Hooley. Let me ask the vice admiral if we have enough
capacity in domestic market to dismantle the ships?
Vice Adm. Amerault. I don't think now. It could possibly be
generated but again as Mr. Graykowski said, I think one of the
problems in trying to get it generated is what will be the
throughput so that when it is capitalized there will be a
continuous throughput to pay off that capitalization. So if we
were to generate it, it would either have to be subsidized, or
there would have to be some feeling that in an economic or
business model, that there will be throughput to keep it going.
Ms. Hooley. When you say that we don't have the capacity,
that has nothing to do with that we may have to pay to get this
dismantled, it is simply that there are not enough shipbuilders
or facilities?
Vice Adm. Amerault. There are people in the ship
maintenance business and shipbuilding business and public
yards.
Ms. Hooley. Which have the capability?
Vice Adm. Amerault. Yes. This is not rocket science. You
need basically a berm or a dry dock or some sort of containment
and metal workers and the new part of it is the environmental
sense or the ability to deal with the environmental issues.
Ms. Hooley. Don't you think on the domestic side that we
have much greater ability to deal with the environmental
issues?
Mr. Graykowski. Yes, ma'am. I was trying to get at that. I
think export ought to be looked at as almost a last resort
option. We will have 155 ships by the end of fiscal year 2001
and the Navy has----
Vice Adm. Amerault. We have 57 that are in excess category
that will be disposed of in some way or another, and an
additional 28 of which we will turn over to MARAD, so we will
add to their problem.
Mr. Graykowski. Exporting is almost giving up on the notion
that we can do it better. I believe we can do it better here in
America. Our standards are higher, but we have proven that is a
better way to go. We have yards that are interested. When I say
there is not the capacity, today there is not. People are not
bidding on our ships because they have to pay us.
Ms. Hooley. As long as they have to pay you, they can't
afford to do it?
Mr. Graykowski. If we turn it around, I am confident that
we can put a program together and there will be sufficient
people to do it. But we need to do 12 to 15 ships a year, not
onesies and twosies.
Ms. Hooley. Right now does MARAD have to maximize the
economic value of the ships, and is that a problem?
Mr. Graykowski. Absolutely. I mean, we went from selling
ships in 1993 or so at $108 a ton which netted us several
hundred thousand dollars, netted to the government, so we
didn't have to ask for appropriations to the last bid we had
accepted was $10 a ship for the whole ship that people paid us
and even those contracts ran into problems.
Ms. Hooley. Most of those were foreign; is that right? The
bids?
Mr. Graykowski. No, the $10 ship bid was domestic.
Ms. Hooley. OK. OK. How much does it cost for you to store
these ships? Wouldn't we be better off to pay somebody to
dismantle them than storing them?
Mr. Graykowski. Well, I have the statutory problem which
precludes that. Intuitively, logically, and as a taxpayer,
absolutely; but the money that we are spending to care take,
which was $3 million last year, isn't enough to address the
problem in a substantive and dramatic fashion. We would still
have to increase the amount of money. The admiral spent a lot
of money last year just on four ships. But we--you missed the
part of the testimony regarding the dry dock. We are projecting
that it is going to cost us $900,000 per ship times 155, and
that is sort of a benchmark level of expenditure to just take
it into the garage, if you use the analogies of a car. That is
every single ship. That is a nonavoidable cost. We are going to
spend that irrespective of a scrapping problem or not, but if
we have a scrapping problem, we don't have to do it, we can
devote the money to scrapping and we will have to do that with
fewer ships. That is a function of time.
But your point remains. We are spending the money now and
we are going to spend more and more money and end up exactly
where we are today with ships sitting in the James River and
elsewhere.
Ms. Hooley. Didn't the Navy have a pilot project and what
happened with that?
Vice Adm. Amerault. Yes, ma'am. We still have the pilot
program underway.
Ms. Hooley. It has been going what, a couple of years?
Vice Adm. Amerault. We had a 1999 contract for four ships.
We have some money in 2000 that we are applying to two other
ships, four contractors. So that ship breaking is underway. All
four contractors are working on ships. All four ships are
frigates. So if you look at this as a pilot or experiment, the
control variable is the same. We had some money in 2000 which
we asked for bids to continue. The best value bids were taken
up on two of the contractors. So we basically are scrapping two
more. We will learn a little more with those two.
What we are hoping to do is find out some data with regard
to what are the costs of facilitizing a yard to take care of
the environmental aspects of this and other things that they
might need to create an efficient ship breaking process that is
environmentally safe, by paying for their labor, and then
finding out how much the value is in a typical ship in terms of
the scrap material and scrap metals. Copper alloys, aluminum,
steel, these are all in abundance. That would then net against
the cost, and we would like to find out what the net value is
and then subtract the initial facilitization, and then we would
have some data to say if you create a steady stream and apply a
learning curve. Maybe that net cost could go down over time and
approach zero, or at least we would know what it would be and
we can compare it to exactly the costs that are you talking
about. If we do spend money on these ships in both the reserve
fleet and in our own reserve fleet or in active fleet to keep
them from sinking and having these environmental disasters, and
in fact if eventually there is a cost of dry docking at a lot
of money, considerable cost, it could be that your present
value one-time costs are cheaper than your annualized costs of
keeping all of that going.
So I think that is where you are going and that is what the
project is all about to some degree. It is not the same kind of
ships in their reserve fleet but there should be lessons----
Ms. Hooley. But MARAD cannot do a pilot project?
Vice Adm. Amerault. They are still enjoined to produce a
scrap ship at no cost to the government. It is impossible for
them to do that under statute. We are giving them all of the
information that we find, or will, and there will be some--I
don't know how scalable this is. There are lessons to be
learned.
Ms. Hooley. Mr. Graykowski, Peter DeFazio from Oregon has
introduced a piece of legislation that would allow you to do
that. Are you supporting that?
Mr. Graykowski. No, we have not taken a position as the
administration on that legislation. But I am aware of it and
following it with great interest.
Ms. Hooley. Why haven't you taken a position? It would seem
to me that here is an opportunity for you to do a pilot
project, to try this out. You are spending a ton of money
keeping the ships, you know. Tell me why.
Mr. Howard. If I might comment on that, ma'am, Mr.
DeFazio's bill is consistent with the recommendation that we
made in our March 10 report. We recommended that the Maritime
Administration develop a proposal for a pilot program and seek
legislation and funding for that program. In order to do that,
the Maritime Administration has to work that proposal through
the Department of Transportation and through the Office of
Management and Budget. What they told us in response to our
report is that they would work that in next year's
authorization bill.
Mr. Sununu. Ms. Hooley, recognizing that it wouldn't be
good form, to say the least, for Mr. Graykowski to lobby for or
against any single piece of legislation, I think it probably
does bear emphasizing Mr. DeFazio's bill would be consistent
with the goal of helping to build a domestic capability to do
this work.
Ms. Hooley. Thank you. I am sorry that I put you on the
spot.
Mr. Graykowski. No, I am not on the spot. Look at--when I
say----
Ms. Hooley. It just seems to me that it seems stupid. I
don't know any other way to put it. It seems stupid that we
don't develop our own program in this country based on some of
the information that was in your testimony not only to keep our
shipyards going and the workers there and trained workers, but
it is costing us so much money to store these ships right now
and we could be dismantling them in an environmentally sound
way and put people to work, and we need to do that in this
country. I am hoping that that can be something that we can
look at this year, frankly, to begin at least if nothing else a
pilot project on figuring out how do we do this the best way
possible.
Thank you, Mr. Chairman.
Mr. Sununu. Thank you very much.
Let me take some time to ask one final round of questions
and begin with the issue of subsidies, foreign or domestic. Mr.
Graykowski, your predecessor Mr. Hart attended an international
ship scrapping conference in the Netherlands last year, you are
probably aware of that. One of the issues they discussed was
providing international assistance to improve the working
conditions or environmental conditions at ship breaking
facilities in third world countries.
My first question, is the U.S. Government to your
understanding considering providing any type of assistance to
foreign countries or foreign ship breaking facilities?
Mr. Graykowski. I am unaware of any efforts. We are not
aware of anything at MARAD.
Mr. Sununu. Is that something that MARAD would support or
oppose?
Mr. Graykowski. Hmm. I am trying to be diplomatic here
because we are talking about international things.
It strikes me if there is going to be a decision made to
subsidize foreign companies and we are not willing as a country
to spend the same tax dollars on a domestic program, that that
might be hard to sustain politically in the body in which you
serve and others serve. That is a gut reaction.
Mr. Sununu. EPA's moratorium on exporting vessels, was it
based solely on the hazardous materials issue or was it also
based on concerns for environmental and labor standards abroad?
Mr. Graykowski. Yeah. I am just confirming that.
The moratorium, so-called, we are sort of confusing a
number of different events. EPA was concerned about TSCA, as I
discussed with Mr. Bentsen, and in 1993-1994 began to look at
ships covered by TSCA and, therefore, restricting its exports.
The moratorium was imposed by the administration, by Vice
President Gore, to enable this DOD interagency panel to come up
with a solution. So in a sense one may have fed into another,
and the moratorium was extended until October 1999.
Mr. Sununu. Has the government done anything to express
concerns, to discuss guidelines or objectives with any foreign
ship breaking facilities since these discussions and the panel
was convened and the memorandum of understanding was signed?
Mr. Graykowski. I know we have maintained contacts. We had
relationships with foreign scrapping facilities because we had
dealt with them in the past, but let me give you an update in
terms of our conversations with them.
Mr. Sununu. Has MARAD inspected any overseas facilities
since 1994?
Mr. Graykowski. No, we have not.
The notion of us imposing our standards on other countries
around the world is difficult.
Mr. Sununu. Without question. Mr. Bentsen touched on those
points, and the imposition of any number of requirements would
be a violation of the regulations or the guidelines that we
agree to abide by as part of the WTO.
Mr. Graykowski. Furthermore, any requirements that we levy
on the exports of our ships would require--would raise the cost
to the scrap and lower the yield to the government, thereby
making our ships less competitive with others.
Mr. Sununu. Are there any limits on the use of foreign
scrap yards that are imposed on privately owned U.S. vessels?
Mr. Graykowski. No, sir.
Mr. Sununu. None at all?
Mr. Graykowski. They can take a ship any time, any way up
to these foreign scrap yards and sell it without restriction.
Mr. Sununu. At this point under the memorandum of
understanding that has been signed with the EPA, given those
guidelines, you have the ability to utilize those breaking
yards as well?
Mr. Graykowski. Well, you mean under the EPA agreement?
Theoretically if we clean up all of the PCBs, we are in that
loop, but we have to make the ship unstable.
Mr. Sununu. The remaining issue is seaworthiness.
Mr. Graykowski. You have to tell the country formally as
the United States, we are going to send you a ship that might
contain stuff, PCBs and other stuff, which in a political
context is hard for a country to say no problem because every
country has an environmental movement or green party, however
you want to characterize it.
Mr. Sununu. It doesn't seem to me that the notification
that a vessel going to a breaking yard might contain lead paint
or PCBs or residual asbestos would surprise anyone in this
country or abroad.
Mr. Graykowski. Actually, I think our experience--actually,
Mr. Chairman, we did run into a problem in India, which is 50
percent of the world market in scrapping. Because of that we
are notifying you, Mexico is another outlet that--you know, I
suppose in a lot of ways people don't know what they don't want
to know, if you will. So private people take the ships and run
them up on the beach and life goes on. But formal notification
to the government, we are sending stuff that might be bad for
you, do you mind?
Mr. Sununu. I am confident that your technical presentation
could be a little more detailed on that.
Let me ask about the growth of the fleet. Do you have the
option to object to or reject any additions to the reserve
fleet?
Mr. Graykowski. There are no additions. We don't have the
money.
Oh, no. We have to take them under contract.
Mr. Sununu. Why have you never included funds in your
budget request to cover the costs of domestic scrapping?
Mr. Graykowski. Because we do not have the statutory
authority to do anything other than sell them.
Mr. Sununu. That has never been part of the budget request
either? You have never requested a repeal of that statutory
limitation?
Mr. Graykowski. No, because we had this DOD interagency
panel. So we saw the panel in place and so there was no impetus
to develop that legislative position.
Mr. Sununu. Admiral, could you run through the costs of the
pilot program? You talked about the initial vessels, the two
that were done using 2000 money. What have been the gross costs
of the contracts that were let, the number of ships for each,
and then the amount of scrap credits that have come?
Vice Adm. Amerault. I don't have the scrap credit yet, but
I can tell you what we have paid so far. There have been four
contractors and thus four contracts. Metro Machine Corporation
in Philadelphia and Chester, PA, we paid $3.5 million for the
initial phase, that is for one ship. That includes some
facilitization, as I mentioned, the cost of labor, and we have
yet to get a full accounting of the sales, and thus the net
costs.
Mr. Sununu. So that is $3.5 million gross. Then anything
they get through the sale of scrap will be credited against
that. Do you split it 50/50?
Vice Adm. Amerault. No, sir, it always comes to us because
again the insurance for them is that their costs will be borne.
We are taking the risk, and that is what we are paying for.
Mr. Sununu. These are aluminum hull?
Vice Adm. Amerault. These are steel hull with aluminum
superstructure.
Mr. Sununu. So the scrap value is a little higher?
Vice Adm. Amerault. I can't say with authority. Aluminum is
one of the more saleable commodities, however. And I think
warships tend to have more copper. There are other things that
are good about those in a sense; however you determine
goodness, I guess.
Baltimore Marine Industries, the cost is $4 million. The
variance in this is mostly facilitization, what they were
prepared and able to do to start with.
Again when we come out of this, we will have four
facilitized contractors.
International Shipbreaking in Brownsville, Texas, $2.7
million. They are fully facilitized. This is a contractor that
once defaulted on I think MARAD as well as us. And the reason
that they are working out now is again, we have removed the
risk. The reason that they defaulted was they bought the ship
from us expecting to make money and didn't. So that puts them
back in the business in a sense.
Ship Dismantling and Recycling, which is a consortium
working in San Francisco, that is $3.9 million. So the ones
that have to be facilitized are roughly about the same amount.
Mr. Sununu. Which were the two that were let with 2000?
Vice Adm. Amerault. We added a ship to Metro Machine and we
added a ship to Ship Dismantling and Recycling.
Mr. Sununu. What were the incremental costs for adding each
of those?
Vice Adm. Amerault. $2.7 million and $3.2 million. Again,
that doesn't have the cost reduction that will come.
Mr. Sununu. The 2.7 was let to whom?
Vice Adm. Amerault. Metro Machine, and the other was 3.2.
That is to Ship Dismantling and Recycling, which is a joint
venture----
Mr. Sununu. That is six ships that have been placed?
Vice Adm. Amerault. Four contractors. Two of them have two
ships.
Mr. Sununu. In the case of Metro Machine, the difference
between the 2.7 and the 3.5 represents the start-up costs and
the facilitization costs?
Vice Adm. Amerault. It will be that, yes, sir. And what we
will find out is again how much this will all be reduced
because none of these figures have the reduction for the sale
of scrap.
Mr. Sununu. Did Metro Machine complete the scrapping of the
first vessel?
Vice Adm. Amerault. They are almost done.
Mr. Sununu. But you don't have the cost figures?
Vice Adm. Amerault. Not yet, but that is part of the
deliverable on the contract.
Mr. Sununu. To what detail will those cost figures be
provided?
Vice Adm. Amerault. I think to great detail. It will almost
have to be a CPA like accounting because it is contractual. I
don't think that we will get it until some of these sales----
Mr. Sununu. There is a joke in here about whether or not
DOD's books meet FASB standards, but----
Vice Adm. Amerault. Yes, I have been involved in that
previously.
Mr. Sununu. Will all of that cost information be shared
with MARAD?
Vice Adm. Amerault. It is open. Since I have been in this
job, I have tried to engage MARAD in this problem. So I feel
like a partner. I don't particularly want to have the Navy bear
the cost of the problem they have.
Mr. Sununu. There are obviously economies of scale in the
numbers that we are dealing with here. To the extent that there
is cooperation or a long-term solution to the problem with
MARAD, it is going to help both groups.
Are there any issues or concerns that you have, Mr.
Graykowski, with regard to information sharing, either
administrative problems or legislative problems, that somehow
inhibit you from getting information that you think might be
helpful?
Mr. Graykowski. No. You are too modest. I told the admiral
that. When he took over, he was the first person who really
took ahold of this, not only on behalf of the Navy, but reached
out to MARAD.
I don't see any impediments. We all have the same problem
here, and I think we all want a solution.
Mr. Sununu. Admiral, do you have even a rough estimate for
the scrap credit?
Vice Adm. Amerault. Let me just say that it is encouraging.
Mr. Sununu. Give me a range.
Vice Adm. Amerault. Any figures I had seen were rough and I
don't want to pin them down to anything.
Mr. Sununu. Give me a wild range?
Vice Adm. Amerault. Well, it could be that say--say a
million dollars a ship. $800,000 to a million dollars.
Mr. Sununu. If I were you testifying to me, I probably
would have said something like well, between $200,000 to a
million five.
Vice Adm. Amerault. That is my answer.
Mr. Sununu. If we have the opportunity, we will correct the
record.
Vice Adm. Amerault. The reason is that I would be hesitant
to create a program based on that figure would not be in either
ours or your best interests.
Mr. Sununu. I understand. If we look at the gross numbers,
it is 1,300 a ton to scrap the ships and that is an enormous
figure at 10 times the scrap value. There seems to be a
disconnect, so I would expect the credits to be significant in
just trying to gauge where we might be at the end of this
process.
Vice Adm. Amerault. I think the other thing is that this is
a one-time venture, too. I think again their costs will come
down and that probably affects it almost more than the price of
the market.
Mr. Sununu. How much of their costs are driven by EPA
mandated directives and environmental concerns?
Vice Adm. Amerault. I would say that is the second most
significant thing. Labor is the most, and then the
environmental concerns.
Mr. Sununu. Thank you.
The Navy received $284 million in fiscal year 2000 for
environmental restoration. What is that funding directed for
and why would the Navy need a new program for disposal of
vessels if it could utilize that funding for this program?
Vice Adm. Amerault. Sir, the environmental remediation Navy
is the appropriation or the line item, and it is for
remediation. So I would say in our case, our ships that are
scrappable, if you will, are not yet needing remediation. So I
would have to find out whether those funds--we have
appropriation lawyers, would tell us whether we can spend those
funds on this.
Also in terms of the MARAD fleet, it is not just a Navy
fleet. I am not so sure we would be spending our ERN funds on
their fleet.
If we--and I think part of the answer might be in what Mr.
Graykowski mentioned in terms of this has not yet--or these
ships have not yet been declared as environmental hazards. So
environmental restoration Navy is for declared environmental
hazards.
Mr. Sununu. Who makes that declaration?
Vice Adm. Amerault. I am not sure.
Mr. Graykowski. We have to find out what the scope of the
ERN program is. I am guessing that it is SECNAV, but I don't
know.
Mr. Sununu. If you would provide any clarification for the
record, I would appreciate it.
Vice Adm. Amerault. We have not had difficulty in paying
for the scrapping of ships that need to be scrapped. We are not
running into an environmental problem with the ships that are
in our Navy controlled inactive fleet.
Mr. Sununu. Would the Navy consider holding onto those
vessels that are scheduled to be transferred to MARAD in order
to dispose of them through the pilot project?
Vice Adm. Amerault. We are enjoined by statute to transfer
them.
Mr. Sununu. Mr. Graykowski, putting aside political
constraints and financial constraints, what do you think would
be an ideal path forward for your agency?
Mr. Graykowski. Give me a moment to sort of bask in this
new found freedom that you have sort of given me.
Mr. Sununu. Believe me, it is very temporary.
Mr. Graykowski. You don't know how temporary. I have to go
back to my office.
The answer is obvious. You have picked up on it and you
know it. Your colleagues have as well. We need, A, to have the
statutory constraints lifted. We have to recognize reality and
pay people.
B, I think we can set up a real partnership with the
shipbuilding industry and create a ship breaking industry which
focuses on breaking them in an efficient and economically and
environmentally responsible way, and that is going to take
money. I think we should start with, as the Navy has done with
a pilot program, although I would suggest perhaps a bit more
ambitious, and guarantee to a yard we will give you 12 ships. I
have 40 to work with and so we could give them to 2 or 3
different yards. We can say here is the results, it is going to
work or not.
I suggest that we hold off on exporting until we have a
chance to get a program up and running, and I think we could do
that in fairly short order if we have got the money and if the
statute changes.
Mr. Sununu. What other alternatives are there for dealing
with this that we haven't discussed? I will also editorialize
by emphasizing that it seems to me that there is a problem
where we probably want to take multiple approaches, where there
is no single solution that is going to be ideal or best for
every single vessel that we are talking about. There is the--I
think the need to deal with the 40 vessels that are in the most
serious condition and I think with the memorandum of
understanding in place, foreign breaking yards ought to be an
alternative. I think there is the very promising prospects of
the Navy's pilot program and I think we need to continue to
have discussions about the statutory requirement that hinders
you, whether or not that means that we authorize a 12-ship or
40-ship pilot or we simply get rid of the requirement and allow
you to use your annual maintenance budget more creatively.
But outside of those alternatives that we have discussed,
are there any other opportunities that you see as strong
alternatives for disposing of these ships?
Mr. Graykowski. I am really racking my brain here. Because
of the criticality of the problem, we have to focus. We cannot
chase different options. To me we are going to export it or do
it here. If we need to do it here we need to come up with a
decision tree and come up with money. Limited capability and
you have to ship everything out of the ship. Other than that, I
mean knowing the ships as I do, I don't see anything other than
getting them out of the water and cut up and disposed of as
soon as possible. That is scrapping, either domestic or
foreign.
Mr. Sununu. Thank you very much. Thank you, gentlemen. We
are adjourned.
[Whereupon, at 11:46 a.m., the Task Force was adjourned.]
Implications of Debt Held by Housing-Related Government-Sponsored
Enterprises
----------
TUESDAY, JULY 25, 2000
House of Representatives,
Committee on the Budget,
Task Force on Housing and Infrastructure,
Washington, DC.
The Task Force met, pursuant to call, at 10 a.m. in room
210, Cannon House Office Building, Hon. John Sununu (chairman
of the Task Force) presiding.
Members present: Representatives Sununu, Bentsen, Miller,
Smith, Ryan, Toomey, Hoekstra, Minge, and Clayton.
Chairman Sununu. Good morning. The purpose of today's
hearing is to discuss recent trends in the issuance and
accumulation of mortgage-backed securities at government-
sponsored enterprises and other financial institutions.
As the internal portfolio is held by the GSEs continues to
grow, a number of questions have been raised by Federal
regulators, Members of Congress and others regarding the change
in the risk profiles and the ability of GSEs and others to
appropriately manage these risks.
This hearing will focus on the economic implications of
this GSE debt, but, most important, it is meant to provide
information. We intend to shed light on the nature of these
portfolios, their size and their economic implications, rather
than engage in extended policy debate over potential
legislative prescriptions.
These questions are made even more timely by the current
trends in the growth of the Federal budget surpluses and the
projected pace of debt retirement over the next 3 years. Today,
the GSEs play a central role not only in the housing finance
market, but also in the global debt markets.
According to the Treasury Department, the GSEs' debt of
$1.4 trillion is roughly the size of the municipal bond market
and more than half of the outstanding amount of privately held
Treasury debt.
Given that the Treasury Department forecasts that GSEs may
well double over the next four to 5 years, it will likely
surpass the level of privately held, marketable Treasury debt
by 2004.
GSE debt also represents a significant portion of the
assets of the banking system. Federally-insured deposit
institutions hold around one-fifth of all GSE debt. Naturally,
the strength, the safety, the soundness of this GSE debt is
going to have an impact on financial institutions around the
country.
Today, our budget Task Force will hear from witnesses who
will describe the structure of GSE held debt in mortgage-backed
portfolios, the nature of the financial risks involved in GSE
debt and mortgage-backed securities, and the degree to which
interest rate risk, credit risk, prepayment risk and other
risks exist under different economic scenarios.
I think it is essential for policy-makers to better
understand the nature of these risks and their relative sizes
and the strategies for managing these risks before making
assumptions or commitments regarding policy initiatives.
The housing GSEs continue to operate very successfully in
today's marketplace. They are literally the backbone of
America's residential mortgage system that is the most liquid
and competitive in the world.
Moreover, GSE regulators in the most recent reports have
offered clear opinions supporting the safety and soundness of
the GSEs. However, these institutions are enormous and complex
entities and we should understand the impact that an economic
downturn might have on the GSEs themselves and the holders of
their securities.
In the 1980's, Congress learned a difficult lesson when the
American taxpayers were called upon to provide a financial
backstop for the savings and loan industry. Despite the fact
that GSE debt securities clearly disclose that they are not
guaranteed by the United States, some analysts and investors do
believe that GSE debt is implicitly backed by the Federal
Government's moral obligation to support these important
institutions.
Our goal is to better understand this potential liability
as investors look toward GSE debt as a potential benchmark
security.
The markets will ultimately decide whether or not to confer
such a benchmark status, but as policymakers we will determine
whether such a status is based upon safety and soundness alone
or precipitated by Federal regulation, sponsorship or subsidy.
I look forward to the testimony of our witnesses and am
pleased to yield to Representative Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. I thank you for
calling this hearing. As the members of the panel know, this
Task Force is charged with holding oversight hearings on waste,
fraud, and abuse and reporting our findings and recommendations
to the full House Budget Committee.
This is our fourth oversight hearing and in this hearing we
turn to the economic implications of debt held by government-
sponsored enterprises. This is an issue which, as I think
members of the panel know and I would imagine the rather large
audience we have today for this task farce knows, has been a
subject of numerous hearings before the House Banking Committee
Subcommittee on Capital Markets, of which I am a member. I
appreciate those who are testifying today.
I think in talking with the chairman this is an interesting
subject which we are embarking upon. It is one that we should
look at more from, I think, an academic perspective rather than
whether or not GSEs in and of themselves are a good or bad
thing.
I think the focus ought to be on the question of GSE debt,
in particular, the issuance of GSE corporate debt, the issuance
of GSE conduit debt in the form of mortgage-backed securities
and the repurchase of such conduit debt and whether or not that
constitutes either a secondary market function, taking
advantage of an arbitrage function or both.
I look forward, Mr. Chairman, to the testimony of our panel
and the ability to question them on their expertise of this
subject. I would say that this is a subject, the question of
the GSEs themselves is a subject that will go on for quite some
time.
Let me just close in saying this. The GSEs have without
doubt contributed tremendously to a very stable housing market
in the United States, along with the Federal Housing
Administration. We know this has been of great benefit. It is
something that was jump started by the Congress and the Federal
Government.
The question before us on the House Banking Committee at
least at this point is to what extent is a continued Federal
involvement still necessary, have the GSEs grown too large and
rather than aid the market now distort the market and is the
answer to curtail the activities of the GSEs.
I am not sure that is the right question that is being
asked or is the answer to unleash the GSEs and have the Federal
Government get out of the business all together.
I am not sure that is the answer that those who are asking
the question want. So this is an issue that is going to be
around for a couple of years and I think, Mr. Chairman, that
you are on point in having this hearing.
I yield back the balance of my time.
Chairman Sununu. Thank you, Mr. Bentsen.
Our witnesses today on our first panel are Barbara Miles of
the Congressional Research Service, Thomas McCool of the GAO,
and Bert Ely of Ely & Company.
We would like to try to keep our testimony to 5 minutes,
and once we have taken testimony from each of the panelists, we
will have questions from the members.
Ms. Miles, we will begin with you. Welcome, and thank you
for being here.
STATEMENTS OF BARBARA MILES, SPECIALIST IN FINANCIAL
INSTITUTIONS, GOVERNMENT AND FINANCE DIVISION, CONGRESSIONAL
RESEARCH SERVICE; THOMAS J. McCOOL, DIRECTOR, FINANCIAL
INSTITUTION & MARKET ISSUES, GENERAL GOVERNMENT DIVISION,
GENERAL ACCOUNTING OFFICE; AND BERT ELY, PRESIDENT, ELY &
COMPANY, INC.
STATEMENT OF BARBARA MILES
Ms. Miles. Good morning. Mr. Chairman and members of the
committee, I am Barbara Miles, a specialist in financial
institutions in the Congressional Research Service of the
Library of Congress. Thank you for inviting me to appear this
morning to discuss the housing-related government-sponsored
enterprises and the implications that their activities may pose
for the economy and the Federal budget.
At the end of the first of quarter of this year, the three
housing GSEs--Fannie Mae, Freddie Mac and the Federal Home Loan
Banks--had outstanding debt of $1.47 trillion. For comparison,
publicly held marketable Treasury debt was about $2.7 trillion.
The current and projected declines in the publicly held
debt of the U.S. Government imply that at current growth rates,
GSE debt could surpass Treasury debt as early as 2003.
When Fannie Mae and Freddie Mac's outstanding guarantees of
mortgage-backed securities are added in, the GSE presence in
capital markets is very nearly equal to the size of the
Treasury market today.
Both the absolute size of the debt and its rapid growth
have raised questions and concerns about the risks that the
GSEs' activities pose for the economy and for the government.
In this regard, I will discuss briefly two fundamental
questions.
The first is what is the Federal Government's
responsibility to and for the housing GSEs?
And, second, what are the specific risks that these
companies' activities pose?
GSEs are a special class of financial institutions in our
economy. They are government in that they serve as instruments
of public policy for influencing credit allocation in our
economy--in this case, into the housing sector. Their
sponsorship means that they have congressional charters that
assign them narrow lending powers, but that also grant them
exemptions and privileges that lower their costs, in part by
implying a guarantee that is formally denied. That they are
enterprises means that they operate as private sector
institutions for the benefit of their owners.
The public policy purpose of the housing GSEs is reasonably
clear. They all provide liquidity to mortgage markets by
lending to primary lenders or by buying and selling mortgages
in a secondary market that crosses geographic and institutional
boundaries that for many years characterized our banking
system.
The charter benefits of sponsorship are significant. They
are arrayed in the table that I attached to my written
testimony.
Some of the benefits are clear subsidies, exemption from
State and local income taxes, for example. Others accord
preferential treatment, granting GSEs securities agency status.
The main value resides, however, not in the individual benefits
but in the nature of the charter itself. Even though there is
no explicit Federal backing, the benefits and public policy
importance of the mission denoted by the charters leads market
participants to infer that the GSEs would not be allowed to
fail such that creditors would lose their money.
This is the implied guarantee. It effectively lowers
funding costs for the GSEs and lowers the capital requirements
below those of other private companies in otherwise similar
financial conditions.
The risks that the GSE operations pose fall into two
categories.
The normal business risks experienced by any intermediary
in mortgage markets include interest rate risk, credit risk, a
variety of business and market risks. All of these risks can be
managed. They cannot be made to disappear, but they can be
managed by a prudent company and by all accounts they are being
managed well.
Ordinarily, the private market can be expected to exercise
discipline over any excessive risk taking, but the market
discipline is weakened by the implied guarantees in the case of
the GSEs. As a result, all three GSEs have safety and soundness
regulators to examine and to test the companies and control for
those excessive risks.
The Office of Federal Housing Enterprise Oversight is
responsible for safety and soundness regulation of Fannie Mae
and Freddie Mac, while HUD oversees their mission, and the
Federal Housing Finance Board has responsibility for the Home
Loan Banks. Both OFHEO and FHFB have proposed risk based
capital standards, although they are not yet in effect.
OFHEO, HUD and the FHFB are, in an important way, the last
line of defense against the larger risks to the economy. And
those greater risk to the financial system and the economy are
systemic risks and a kind of systematic risk.
Systemic risk is the likelihood that a failure of a GSE
would cause widespread failures of other financial institutions
and result in severe damage to the financial system. In this
case, it is partly a direct result of the charter provision
that allows depository institutions to hold GSE securities
without the normal limits that would be imposed on banks by
their safety and soundness regulators.
According to the Treasury, banks currently hold GSE debt
that is equivalent to one-third of bank capital and many banks
have sufficient holdings that a GSE failure could wipe out
their capital. A failure of a GSE under these circumstances
could create a domino effect and seriously strain the deposit
insurance funds.
Systematic risk is risk that cannot be controlled by
diversification. It is the problem of having all your eggs in
one basket, but there is only one basket. Portfolio theory
holds that diversification makes for better management of risk,
but by law GSEs can only diversify so far. Ultimately, they
build and grow on a single sector of the economy--and actually
only a large part of that sector--and that sector therefore
poses systematic risks for the companies. Beyond some point,
they cannot continue to grow in their current path without
``breaking out'' of their assigned market.
For the government, this same risk is one of having an
entire sector of the economy more or less identified with the
GSEs. So long as the GSEs have their benefits fully operating,
the sector becomes dependent upon the companies and cannot
diversify away from them. If, on the other hand, GSEs are
allowed into other sectors, they are better diversified, but
the economy is not.
The growth in GSE debt has also led to consideration of GSE
debt as the ``risk-free'' benchmark for pricing in securities
markets. But for a benchmark asset to function properly, it
should reflect risks that are inherent to the economy overall.
These clearly do not. Yet because of their inferred safety, the
private sector could turn to them and, as a result, there could
be pressures on the GSEs other than their announced growth
plans and, as a result, also on their regulators to allow them
to expand their missions further to fill that kind of benchmark
role.
This completes my prepared statement and I would be pleased
to answer any questions you may have.
[The prepared statement of Barbara Miles follows:]
Prepared Statement of Barbara Miles, Specialist in Financial
Institutions, Government and Finance Division, Congressional Research
Service
Mr. Chairman and members of the committee, I am Barbara Miles,
Specialist in Financial Institutions in the Congressional Research
Service of the Library of Congress. Thank you for inviting me to appear
before you to discuss the housing-related government-sponsored
enterprises (GSEs) \1\ and the implications their activities may pose
for the economy and the Federal budget.
---------------------------------------------------------------------------
\1\ There are five GSEs in our financial system. Two operate in
farm credit markets--the Farm Credit System and ``Farmer Mac.'' A sixth
GSE, Sallie Mae, provides student loans and is currently in the process
of converting to a fully private company.
---------------------------------------------------------------------------
At the end of the first quarter of this year, the three housing
GSEs--Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System--
had outstanding debt totaling $1.47 trillion. \2\ For comparison,
publicly held, marketable Treasury debt was about $2.7 trillion. \3\
The current and projected declines in the publicly held debt of the
U.S. government imply that, at current growth rates of about 20 to 25
percent per year, GSE debt could surpass Treasury debt outstanding by
2003. When Fannie Mae and Freddie Mac's outstanding guarantees of
mortgage-backed securities (MBS), $1.21 trillion (net of the $508
billion of MBS the GSEs have repurchased), are added in, the GSE
presence in capital markets is very nearly equal to the size of the
Treasury market.
---------------------------------------------------------------------------
\2\ Sources: quarterly statements of Fannie Mae, Freddie Mac and
the Office of Finance of the Federal Home Loan Banks.
\3\ This excludes non-marketable debt which, by definition, does
not trade in capital markets and is, therefore, not an indicator of
market size.
---------------------------------------------------------------------------
Both the absolute size of the GSE debt, and its rapid growth have
raised concerns about the risks the GSE's activities pose for the
economy and the U.S. Government. In this regard, I will discuss two
fundamental questions:
First, what is the Federal Government's responsibility to and for
the housing GSEs?
Second, what are the specific risks that these companies'
activities pose?
what are gses and why do we have them?
The answer to the first question is tied up in what GSEs are, why
we have them, how they are perceived by investors and why. GSEs are a
special class of financial institutions in our economy. They are
government in that they serve as instruments of public policy for
influencing credit allocation in the economy--in this case into the
housing sector or, more accurately, into mortgage finance. Their
sponsorship means that they have congressional charters that assign
them narrow lending powers, but also grant special exemptions and
privileges that lower their costs, in part by implying a guarantee that
is formally denied. That they are enterprises means that they operate
as private sector institutions for the benefit of their owners.
Public Policy Purpose. The initial government purpose of the three
housing GSEs is reasonably clear. The 12 regional Federal Home Loan
Banks were chartered in 1934 as a collective GSE in order to provide
liquidity to savings and loan associations so that they could continue
lending for home mortgages, or at least not be forced by depositor
withdrawals to call in mortgage loans already made. There was only very
limited private sector ability to take the risks associated with
assisting thrifts facing liquidity problems; and nothing, short of the
commercial banks' Federal Reserve or the Federal Government itself,
could fill the financing gaps on a scale sufficient to deal with the
widespread problems of the 1930's. The Banks were chartered to be owned
by the S&Ls themselves, and given a series of benefits that lowered
their costs. In turn, the Banks made low-cost loans (called
``advances'') to the S&Ls on the strength of their mortgage lending,
and turned a profit for their member-owners in doing so.
Fannie Mae and Freddie Mac were both started to assist in providing
liquidity to lenders by developing a secondary mortgage market. A
series of problems--including Federal and state laws restricting
depository institutions--impeded nationwide flows of mortgage funds and
made tapping the resources of general capital markets difficult. As a
result, funds did not flow in a normal market response from areas with
high savings or from investments with low returns into the regions and
mortgages where rates and yield were higher. Fannie Mae, originally a
government agency in 1938, but rechartered as a GSE in 1968, and
Freddie Mac in 1970, were to help solve these problems by doing what
the primary lenders could not do: act as national intermediaries to
first, move funds across the country by borrowing where funds were
cheap to invest in mortgages where rates were high, and second, develop
appropriate securities to tap into non-traditional investment sources.
Both actions made mortgages funds more uniformly available.
The charter benefits. The benefits that have been granted to the
GSEs are significant and valuable. (See Table, attached.) Some of the
benefits directly and explicitly lower the costs of operation of the
GSEs below those of any other private-sector company. Exemption from
State and local income taxes, for example, was worth about $490 million
to Fannie Mae and Freddie Mac last year. \4\ The SEC registration
exemption, according to the U.S. Treasury, was worth another
approximately $280 million. CBO estimates that, were all five GSEs
required to register, the Federal budget would gain $313 million in
2001, and about $1.5 billion for 2001-2005.
---------------------------------------------------------------------------
\4\ This assumes a state tax average of about 8 percent and
cooperation under the state tax compacts. See Zimmerman, Dennis.
Unfunded Mandates and State Taxation of the Income of Fannie Mae,
Freddie Mac, and Sallie Mae: Implications for D.C. Finances. CRS Report
95-952 E.
---------------------------------------------------------------------------
Other benefits accord GSE debt preferential treatment, including
the eligibility for unlimited investment by depository institutions--
circumventing the normal safety and soundness limits on loans to a
single borrower--and the eligibility of their debt and MBS as
collateral for public deposits. Still others simply provide links that
signal that these companies are more ``important'' than ``normal''
corporations as a matter of public policy.
Implied Guarantee. The charter value resides not simply in the sum
of the individual preferences but in the nature of the charter itself.
Even though there is no explicit government backing, because of the
benefits and because of the public policy importance of the GSE mission
as demonstrated by their special charters, market participants infer
that the Federal Government would not allow the GSEs to fail such that
creditors would lose their money. \5\ This is usually referred to as
the ``implied guarantee,'' and it effectively lowers funding costs for
the GSEs below those of other private companies in similar financial
condition. A series of studies since 1990 have generally put the
funding advantage at about 30 basis points (or 0.3 percentage point)
below what is available to triple-A companies and about 40 basis points
below double-A companies. While there appears to have been some
narrowing of this advantage in the past few months, the advantage is
still significant.
---------------------------------------------------------------------------
\5\ All GSEs are required to inform investors that their securities
do not carry full-faith-and-credit guarantees. Yet the statutory
equivalence of GSE and Federal debt for a variety of purposes reassures
investors that the government in some way stands behind the debt.
Investors are probably correct in their assessments: when the Farm
Credit System was in trouble in the late 1980's, it was rescued so that
no investors lost.
---------------------------------------------------------------------------
The implied guarantee also allows for high leverage on the part of
GSEs. That is, less capital is needed to assure investors of safety for
any given level of assets. Relatively low financial capital allows a
higher rate of return for the company so that there is an incentive
toward toward maintaining minimum levels consistent with investor
comfort and low borrowing costs. Capital provides a kind of cushion
against losses for investors. But the implied guarantee replaces, to
some extent, the normal market discipline that would take into account
the actual risks of the business operations of the company.
Market power. By most accounts, the problems that gave rise to
creation of the housing GSEs have been corrected. \6\ Correction is
generally measured in terms of the degree to which housing finance is
integrated with general capital markets. Mortgage rates are effectively
uniform across the country, and mortgage markets tap funds in the rest
of the capital market with relative ease. Further, many sources of
liquidity are now available to primary mortgage lenders, although they
would generally be more expensive than the terms available from the
GSEs. The charters continue, however, and now contribute to
considerable market power.
---------------------------------------------------------------------------
\6\ Jud, G. Donald. Regional Differences in Mortgage Rates: An
Updated Examination. Journal of Housing Economics, June 1991.
Hendershott, Patrick, and Robert Van Order. Integration of Mortgage and
Capital Markets and the Accumulation of Residential Capital. Regional
Science and Urban Economics, May 1989.
---------------------------------------------------------------------------
Because their costs are lower than for non-favored companies, many
private sector observers are particularly concerned that GSEs can reap
greater-than-competitive profits, even while undercutting pricing of
potential competitors. They need only price their products a little
below what fully private companies would have to charge. And GSEs
control the value of their charters, because increasing business volume
increases the extent of the benefits conferred by the charter, while
increasing risk adds to the depth of the gains. In short, the special
charters confer benefits on the GSEs that increase in value as a
company's business volume and risk increase. This arguably provides
incentives not only to dominate the assigned market but also to seek
ways to continue to grow even after the market to which the GSEs are
constrained by charter is saturated. This, in turn, gives rise to new
risks for the government.
the risks of gse operations
The risks that GSE operations pose fall into two separate
categories: the normal business risks of the GSEs' operations, and the
larger risks to the financial system and the economy.
Normal business risks. Normal risks are those that would be
experienced by any intermediary in mortgage markets and include the
following.
Interest rate risk: that changes in interest rates will
result in a loss of economic value.
Credit risk: that borrowers will default on (not repay)
loans or other obligations.
Business risk: that factors beyond a firm's control could
result in unanticipated loss of earnings, or capital.
Management risk: losses arising from decisions made (or
not made) by managers.
Ordinarily, the private market can be expected to maintain
discipline over risk-taking by assessing the riskiness of a company's
operations and acting in accordance with what it sees. If leverage were
high enough (capital were low enough), for example, to raise concerns
about insolvency, creditors would demand prompt payment or attempt to
accelerate principal repayment where possible, and new credit would
become costly. This market-imposed discipline means that a company has
every reason, so long as it is solvent, to control its own risk-taking
in order to avoid the costs that would be imposed by creditors. GSEs,
like other companies, have an incentive to maintain their shareholder
value.
In the case of GSEs, however, the market discipline is weaker
because of the implied government-backing. Creditors, so long as they
continue to infer that GSE debt is near-equivalent to Treasury debt,
will allow greater risk and countenance lower capital. GSEs can borrow
at preferential rates in good times, and in bad times. While this is
supposed to be a strength, it is also a problem if matters get out of
hand because once capital is lost, the GSE may have reason to take
greater risks in the pursuit of rewards large enough to work itself
back out of difficulty.
A case of not-well handled interest rate risk did create severe
problems for Fannie Mae. The secular rise in interest rates that
occurred in the 1970's and the sharp rise in 1979 presented major
problems for all mortgage lenders who had basically lent for long-term
mortgages at fixed rates while financing at shorter term rates. Fannie
Mae was such a lender at that time and its high leverage exacerbated
its problems. The spread between interest rates on mortgages and the
rates required on new debt turned negative. At the same time, fewer
mortgages were being prepaid as home buyers either assumed the
mortgages of the sellers, or homeowners simply did not move, both
reactions to high interest rates that prolonged the expected life of
loans held by Fannie Mae and prolonged their losses. According to a
1986 study by HUD (then the sole regulator for Fannie Mae), the GSE was
insolvent on a mark-to-market basis every year from 1978 through 1984.
The worst year was 1981 when estimated net worth fell to minus $11
billion and the corporation actually booked losses. Ultimately, Fannie
Mae was allowed to grow its way out of difficulty, although it required
regulatory forbearance, some tax adjustments, and declining interest
rates to return to health after 1985.
All three housing GSEs have safety and soundness regulators who are
specifically charged with examination and testing to keep these risks
in check. The Federal Housing Finance Board oversees the Banks. The
Office of Federal Housing Enterprise Oversight (OFHEO) oversees Fannie
Mae and Freddie Mac for safety and soundness, while HUD has
responsibility for mission oversight. Both the FHFB and OFHEO have
proposed risk-based capital standards that are intended to test the
GSEs for excessive interest rate and credit risk and would require
capital holdings accordingly. If the tests work as intended and are
timely, it should be possible for regulators to require sufficient
capital at all times to avoid a repeat of the 1980's experience. Those
tests are not yet in effect.
Repurchase of mortgage backed securities. The repurchase of their
own MBS by the GSEs can be thought of as a case of repatriating
interest rate risk. When mortgages are securitized and sold, the GSE
retains the credit risk on the loans, but sells to investors the
interest rate risk. MBS are less profitable than portfolio holdings as
a result. Repurchase restores profits along with risk. Fannie Mae and
Freddie Mac are the largest holders and purchasers of their own MBS,
holding nearly 30 percent of their own issuances and in some recent
periods repurchasing a volume equal to or greater than what they
issued.
While it is clear that this increases shareholder value, it is
difficult to understand what, if anything, it does for mortgage
markets. In order to repurchase the securities, the GSEs must issue new
debt. Given that U.S. capital markets are highly integrated, mainstream
economic theory holds that there should be no lasting change in yields
required by the market on either the debt or the MBS. As a result there
should be no benefit to pass through to housing markets. \7\
---------------------------------------------------------------------------
\7\ The exception would be if GSE debt and MBS were not good
substitutes for one another, i.e., the products were not well
integrated in capital markets.
---------------------------------------------------------------------------
Larger Risks. The larger risks to the financial system and the
economy are systemic risk and systematic risk.
Systemic risk. Systemic risk is the likelihood that a failure of
one institution would cause widespread failures of other institutions
and result in severe damage to the financial system. In the case of the
GSEs, the potential for systemic risk is a direct result of the charter
provision that allows depository institutions to hold their debt and
MBS without limit. Normally, depositories are restricted to no more
than 15 percent of capital in loans to a single borrower. According to
the Treasury, banks held over $210 billion in GSE debt 1 year ago,
which constituted one-third of bank capital, and over $355 billion in
MBS. These holdings have raised concern among banking regulators. A
failure of a GSE could create a domino effect if it resulted in the
sudden loss of capital at banks and thrift institutions, and could
strain the deposit insurance funds were the situation unanticipated or
severe enough.
Systematic risk. Systematic risk is basically that risk that cannot
be controlled by diversification. This kind of risk brings to mind the
old adage about the dangers of putting all your eggs in one basket: it
is generally a very risky thing to do. In the case of the GSEs, there
are two sides to the risk: first, portfolio theory holds that
diversification makes for better management of risk. But by law, the
GSEs can only diversify so far. Ultimately, they build and grow on a
single sector of the economy, one that because of their dominance and
ability to increase dominance, poses systematic risks for the
companies. They cannot diversify away from residential mortgages
without a change in mission. Beyond some point, they cannot continue to
grow without ``breaking out'' of their assigned market. One recent
study estimates that by 2003, Fannie Mae and Freddie Mac will have to
control (retain or guarantee) better than 90 percent of all outstanding
conventional/conforming mortgage loans, and essentially all of new
loans originated. \8\
---------------------------------------------------------------------------
\8\ Wallison, Peter J. and Bert Ely. Nationalizing Mortgage Risk:
The Growth of Fannie Mae and Freddie Mac. AEI Studies on Financial
Market Deregulation, 2000.
---------------------------------------------------------------------------
On the other side, if the GSEs take over the housing sector, the
government runs systematic risk with respect to the housing sector. So
long as the agencies have their benefits fully operating, the sector
becomes dependent upon these companies and cannot diversify away from
them. If the GSEs are allowed into other sectors, they are better
diversified, but the economy is not.
Recall now the data on Treasury and GSE debt. The growth in GSE
debt, combined with the projected declines in Treasury debt, has led to
consideration of GSE debt as the ``risk-free'' benchmark for pricing
debt in securities markets. Indeed, the GSEs have been positioning
themselves to fill such a function by regular issuances of debt in a
manner that creates an alternative to the Treasury yield curve. The
possibility that the Federal Reserve might use GSE securities for
conducting monetary policy has also arisen. But a major economic
drawback of using GSE securities--or the securities of any other
corporation--is that for the benchmark asset to function properly, it
should reflect only risks inherent to the economy overall. GSE
securities, on the other hand, include risks specific to their
corporations, in this case housing sector risks, which are very
different than risks to the overall economy. Yet, because of their
inferred safety, the private sector could use them as a benchmark
anyway. Thus, the problem arises again that the GSEs may have cause to
expand their missions to fill the benchmark role.
The point behind creating GSEs is to increase efficiency by
improving the allocation of credit in the economy. But the risk to the
economy from introducing what is effectively a subsidized entity into a
new market is that current competition will be displaced and economic
inefficiency increased.
That completes my prepared statement, Mr. Chairman. I will be
pleased to respond to any questions you may have.
TABLE 1.--GOVERNMENT-SPONSORED ENTERPRISE LINKS TO THE FEDERAL GOVERNMENT
--------------------------------------------------------------------------------------------------------------------------------------------------------
Federal
Federal National Federal Home Loan Federal Home Loan Farm Credit Agricultural Student Loan
Feature Mortgage Mortgage Banks System Mortgage Marketing
Association Corporation Corporation Association
--------------------------------------------------------------------------------------------------------------------------------------------------------
Chartered by Act of Congress.......... Yes Yes Yes Yes Yes Yes
Form of Ownership..................... Publicly held Publicly held Cooperative Cooperative CooperPublicly held
publicly held
President or Presidential Appointees Yes (5/18) Yes (5/18) Yes (6/14)\1\ No Yes (5/15) Yes (7/21)
Name Some Board Members..............
Treasury Lending Authorized........... $2.25 billion $2.25 billion $4.0 billion No\2\ $1.5 billion\3\ $1.0 billion
Treasury Approval of Debt Issuance.... Yes Yes Yes No No Yes
Securities Eligible for Federal Yes Yes Yes Yes N/A Yes
Reserve Open Market Purchases........
Use of Federal Reserve as Fiscal Agent Yes Yes Yes Yes Yes Yes
Debt Eligible to Collateralize Public Yes Yes Yes Yes Yes Yes
Deposits (All U.S. Government; Most
State and Local).....................
Exempt from SEC Registration (1933 Yes Yes Yes Yes No Yes
Act).................................
Government Securities for Purposes of Yes Yes Yes Yes No Yes
the SecuritiesExchange Act of 1934...
Securities Eligible for Unlimited Yes Yes Yes Yes Yes Yes
Investment by NationalBanks and State
Bank FR Member.......................
Securities Eligible for Unlimited Yes Yes Yes Yes Yes Yes
Investment by Thrifts Regulated by
FDIC or OTS..........................
Exemption of Corporate Earnings from No No Yes Yes\4\ No No
Federal Income Tax...................
Exemption of Corporate Earnings from Yes Yes Yes Yes No Yes
State and LocalIncome Tax............
Exemption of Interest Paid from State No No Yes Yes No Yes
Income Tax...........................
Subject to GAO Audit.................. Yes\5\ Yes\5\ Yes No Yes No
Federal Regulator..................... HUD/OFHEO\6\ HUD/OFHEO\6\ FHFB\7\ FCA\8\ FCA ED
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Each bank.
\2\ Treasury is authorized to guarantee up to $4 billion of Financial Assistance Corporation bonds.
\3\ Upon required certification from FAMC, borrowing from Treasury authorized to make payments under guarantee.
\4\ Federal Land Banks, Farm Credit Banks and Financial Assistance Corporation.
\5\ Mortgage transactions may be subject to GAO audit under rules that may be prescribed by the Comptroller General.
\6\ HUD regulates mission and program; the Office of Federal Housing Enterprise Oversight regulates safety and soundness.
\7\ Federal Housing Finance Board.
\8\ The Farm Credit System Assistance Board also has certain powers with respect to the Financial Assistance Corporation and the System institutions
needing financial assistance.
Source: Statutes and regulations pertaining to the GSEs as compiled in Report of the Secretary of the Treasury on Government Sponsored Enterprises, May
1990, updated by CRS.
Chairman Sununu. Thank you very much.
Mr. McCool.
STATEMENT OF THOMAS J. McCOOL
Mr. McCool. Thank you, Mr. Chairman.
Mr. Chairman and members of the Task Force, we are pleased
to be here today to discuss the roles of Fannie Mae and Freddie
Mac in our nation's housing finance system.
Congress created Fannie Mae and Freddie Mac to promote home
ownership in the United States. The enterprises fulfill their
mission by borrowing funds or issuing mortgage-backed
securities and using the proceeds to purchase home mortgages
from banks, thrifts and other financial institutions.
Financial institutions in turn may use the proceeds from
their mortgage sales to the enterprises to fund additional
mortgage loans, thereby helping to ensure a stable supply of
mortgage credit across the nation.
Most analysts agree that the enterprise's activities have
successfully lowered mortgage costs and increased home
ownership in the United States. However, these benefits must be
weighed against the potential costs associated with the Federal
Government's implied sponsorship of the enterprises, in
particular, the cost of any financial assistance the Federal
Government might decide to provide in an emergency situation.
In recent years, GAO has issued several reports that assess
the enterprises' role in the housing finance system and Federal
oversight of their activities. My testimony today will briefly
discuss topics covered in these reports, including the benefits
and costs of the enterprises' housing finance activities,
Federal efforts to ensure the enterprises' safety and soundness
and Federal efforts to ensure the enterprises promote home
ownership opportunities for all Americans.
Now, I will shorten my discussion of the benefits, since
Barbara has already gone through some of the benefits that the
GSEs obtain.
The enterprises are hybrid organizations that contain
elements of both private and public sector organizations. Like
many private companies, the enterprises issue equity and debt
instruments to the investing public. The enterprises have also
developed compensation packages that reward top executives for
increasing shareholder value.
On the other hand, the enterprises' close relationship with
the Federal Government and their Federal charters provide them
with several important advantages over private sector
companies. Again, the most important of these benefits is the
perception in the financial markets that the government would
not allow the enterprises to fail, which allows the enterprises
to borrow and issue MBS to finance mortgage purchases at
relatively lower cost than fully private firms.
These and other benefits, again, which have been discussed
already, are to some extent passed on to home buyers in the
form of lower mortgage interest rates.
In our report on privatization, which we issued in 1996, we
gave an example of a reduction in mortgage interest rates for a
$100,000 mortgage would add up to about $10 to $25 a month. So
again, there are substantial benefits passed on to homeowners.
However, Federal sponsorship of the enterprises' activities
as GSEs also creates significant risks and costs. First, the
potential exists that U.S taxpayers would end up paying for a
portion of the enterprises' debt and MBS obligations which
stood at over $2 trillion at the end of 1999.
Second, opportunity costs are generated when the perceived
backing of the GSE by the Federal Government diverts funds from
other financial institutions that may otherwise be able to
provide more efficient services to the public.
Third, opportunity costs can also be generated if a GSE
enters into activities that are outside of its statutory
mission.
To help ensure that the enterprises conduct their business
in a safe and sound manner and use their government-provided
benefits to achieve a public purpose, in 1992 Congress passed
the Federal Housing Enterprises Financial Safety and Soundness
Act.
This act established the Office of Federal Housing
Enterprise Oversight, OFHEO, to ensure that the enterprises are
adequately capitalized and operating safely and provide the
Department of Housing and Urban Development with additional
regulatory authority to ensure that the enterprises fulfill
their housing finance mission.
The 1992 act established OFHEO as an independent agency
within HUD to monitor the enterprises' financial safety and
soundness. The act provided OFHEO with two essential
responsibilities to carry out its mission: first, to establish
capital standards for the enterprises and, second, to establish
an examination program.
As required by the 1992 act, OFHEO established minimum
capital standards for the enterprises, which are capital ratios
applied to certain on balance and off balance sheet
obligations.
The act also mandated that OFHEO develop a stress test to
serve as the basis for more sophisticated risk-based capital
standards. The purpose of the stress test is to help manage
taxpayer risks by simulating situations where the enterprises
are exposed to adverse credit and interest rate scenarios.
OFHEO has proposed a rule to implement the stress test and
risk-based capital standards and expects to issue a final rule
by the end of 2000.
OFHEO also has the authority to establish an examination
program, to monitor the enterprises' management and financial
conditions. At the time of our 1997 report, OFHEO has revised
its examination program and implemented an annual examination
schedule. OFHEO's examination staff has generally found that
the enterprises have been operated in a safe and sound manner.
HUD has statutory authority to ensure that the enterprises
fulfill their mission of promoting housing and home ownership
opportunity for all Americans. The 1992 act required HUD to
development, implement and enforce a comprehensive housing
mission regulatory framework. This included setting housing
goals which required the enterprises to meet specified criteria
each year for the purchase of mortgages serving targeted
groups.
In our work, we found that HUD generally adopted a
conservative approach to setting the housing goals that placed
a high priority on maintaining the enterprises' safety and
soundness.
In March of this year, HUD proposed a new rule setting
housing goal requirements for the period 2000 through 2003
which are higher than the previous goals. HUD believes that the
proposed housing goals will provide strong incentives for the
enterprises to more fully meet the housing needs of targeted
groups. The comment period on the proposed rule ended in May.
HUD is currently reviewing comments and expects to issue a
final rule by the end of 2000.
The 1992 act also defined HUD's general regulatory
authority over the enterprises to ensure that the enterprises'
activities are consistent with their housing mission and its
new mortgage program approval authority to review new mortgage
programs proposed by the enterprises to ensure the programs are
consistent with the enterprises' charters and not contrary to
the public interest.
In giving HUD this mission oversight authority, Congress
correctly recognized that the enterprises face a natural
tension between maximizing profitability for their shareholders
and fulfilling their housing mission. For example, we have
pointed out that the enterprises have incentives to use the
funding advantage associated with their government sponsorship
to make non-mortgage investments, some of which may result in
arbitrage profits.
While our reports found that HUD had not acted promptly to
ensure that the enterprises' non-mortgage investments were
consistent with their housing mission, in 1997, HUD initiated a
rulemaking process designed to develop criteria that would help
ensure that the enterprises' non-mortgage investments are
consistent with their housing mission and Federal charters.
However, HUD has yet to develop criteria for overseeing the
enterprises' non-mortgage investments.
Enterprises have also engaged in other complex financial
activities whose relation to their housing mission is not
always clear. We reported on HUD's approval of a new mortgage
program by Fannie Mae that would have involved Fannie Mae
purchasing cash value life insurance. More recently, the
enterprises' involvement in other activities have raised
questions as to whether they are attempting to move beyond the
secondary mortgage market into areas traditionally served by
private lenders in the primary mortgage market.
In summary, Congress provided Fannie Mae and Freddie Mac
with substantial financial benefits so that they can fulfill
their housing finance mission. There is widespread agreement
that the enterprises' secondary mortgage activities have
lowered the cost of home ownership for millions of Americans.
However, perceived Federal sponsorship of the enterprises'
activities as GSEs also involves significant risks and costs.
In passing the 1992 act, Congress created a regulatory
structure with the potential to help ensure the enterprises
would focus on and fulfill their public mission without
exposing U.S. taxpayers to undue risk.
In their oversight roles, OFHEO and HUD face a difficult
challenge in ensuring that the enterprises meet their housing
responsibilities in a safe and sound manner while
simultaneously being afforded sufficient latitude to manage
their day-to-day business needs and meet their shareholder
obligations.
As large sophisticated institutions, the enterprises have
become engaged in complex financial activities that may serve
multiple purposes. It is difficult to assess the financial
risks of many of their activities as well as the relationship
between their activities and mission achievement.
Nonetheless, the making of such assessments by the
enterprises' regulators and Congress is imperative to ensure
that the interests of U.S. taxpayers are protected.
Mr. Chairman, this concludes my statement. I will be happy
to answer any questions.
[The prepared statement of Thomas J. McCool follows:]
Prepared Statement of Thomas J. McCool, Director, Financial
Institutions and Markets Issues, General Government Division
Mr. Chairman and members of the Task Force, we are pleased to be
here today to discuss the roles of Fannie Mae and Freddie Mac in our
nation's housing finance system. Congress created Fannie Mae and
Freddie Mac (the enterprises), the two largest government sponsored
enterprises (GSEs), to promote home ownership in the United States. The
enterprises fulfill their housing mission by borrowing funds or issuing
mortgage-backed securities (MBS) and using the proceeds to purchase
home mortgages from banks, thrifts, and other financial institutions.
Financial institutions, in turn, may use the proceeds from their
mortgage sales to the enterprises to fund additional mortgage loans,
thereby helping to ensure a stable supply of mortgage credit across the
nation. Financial institution mortgage lending is commonly referred to
as the ``primary residential mortgage market,'' while the enterprises'
mortgage purchase activities are commonly referred to as the
``secondary residential mortgage market.''
Most analysts agree that the enterprises' activities have
successfully lowered mortgage costs and increased home ownership in the
United States. However, these benefits must be weighed against the
potential costs associated with the Federal Government's implied
sponsorship of the enterprises, which had combined debt and MBS
liabilities of over $2 trillion at the end of 1999. In particular, the
Federal Government could potentially decide to provide financial
assistance to the enterprises in an emergency situation.
In recent years, we have issued several reports that assess the
enterprises' roles in the housing finance system and Federal oversight
of their activities. My testimony today will briefly discuss the
following important topics covered in these reports:
the benefits and costs of the enterprises' housing finance
activities,
Federal efforts to ensure the enterprises' safety and
soundness, and
Federal efforts to ensure that the enterprises promote
home ownership opportunities for all Americans.
the benefits and costs of the enterprises' housing finance activities
The enterprises are hybrid organizations that contain elements of
both private- and public-sector organizations. Like many private
companies, the enterprises issue equity and debt instruments to the
investing public. The enterprises have also developed compensation
packages that reward top executives for increasing shareholder value.
On the other hand, the enterprises' close relationship with the Federal
Government and their Federal charters provide them with several
important advantages over private-sector companies. The most important
of these benefits is an indirect one--the perception in the financial
markets that the government would not allow the enterprises to fail,
which allows them to borrow and issue MBS to finance mortgage purchases
at relatively lower cost than private firms. The enterprises' Federal
charters also exempt them from paying state and local income taxes and
some of the fees charged by the Securities and Exchange Commission for
securities and debt issuances. The charters also provide each
enterprise with a $2.25 billion conditional line of credit with the
Treasury Department.
In a May 1996 report, we estimated that the total annual value of
these benefits to the enterprises ranged from $2.2 billion to $8.3
billion on a before-tax basis and $1.6 billion to $5.9 billion on an
after-tax basis.\1\ To some extent, the enterprises pass these savings
on to home buyers in the form of lower mortgage interest rates.
Although it is not possible to calculate these savings precisely, we
estimate that in 1995 the enterprises' mortgage purchase activities
resulted in savings of about a quarter of a percentage point annually
on a typical $100,000 mortgage. This translated into savings of about
$10 to $25 per month on such a $100,000 mortgage, or about $3 billion
to $7 billion annually for the approximately $2 trillion in mortgages
that the GSEs were eligible to purchase and that were outstanding at
the time.\2\ Most analysts also agree that the enterprises' activities,
such as their imposition of greater standardization on mortgage
products and processes, have also facilitated the development of an
efficient, nationwide mortgage finance system.
However, Federal sponsorship of the enterprises' activities as GSEs
also creates significant risks and costs. First, the potential exists
that U.S. taxpayers would end up paying for a portion of the
enterprises' debt and MBS obligations, which stood at over $2 trillion
at the end of 1999. In fact, Fannie Mae experienced significant
financial difficulties because of a sharp rise in interest rates
between 1981 and 1984, resulting in losses of $277 million. To help
Fannie Mae overcome these problems, the Federal Government provided
limited tax relief and relaxed the enterprise's capital requirements.
Congress also showed its willingness to assist GSEs that experience
financial difficulty in 1987 when it authorized up to $4 billion to
help the Farm Credit System, another GSE, overcome a farm crisis and
the resulting increase in loan defaults. Second, opportunity costs can
also be generated when the perceived backing of a GSE by the Federal
Government diverts funds from other financial institutions that may
otherwise be able to provide more efficient services to the public.
Third, opportunity costs can also be generated if a GSE enters into
activities that are outside its statutory mission.
To help ensure that the enterprises conduct their business in a
safe and sound manner and use their government-provided benefits to
achieve a public purpose, in 1992 Congress passed the Federal Housing
Enterprises Financial Safety and Soundness Act (1992 Act). The 1992 Act
established the Office of Federal Housing Enterprise Oversight (OFHEO)
to ensure that the enterprises are adequately capitalized and operating
safely. The 1992 Act also provided the Department of Housing and Urban
Development (HUD) with additional regulatory authority to ensure that
the enterprises fulfill their housing finance mission. As part of the
1992 Act, Congress concluded that the financial benefits that the
enterprises derive from their government sponsorship involve a
corresponding obligation to meet the mortgage credit needs of all
potential home buyers, including those with low- and moderate-incomes.
This regulatory scheme allows the enterprises to continue to have the
same powers as private companies to conduct their day-to-day business.
In the remaining two sections of my testimony, I will discuss the
status of OFHEO and HUD's efforts to fulfill their regulatory
responsibilities under the 1992 Act.
ofheo monitors the financial safety of the enterprises
The 1992 Act established OFHEO as an independent agency within HUD
to monitor the enterprises' financial safety and soundness. Under the
act, OFHEO is subject to the congressional appropriations process but
the enterprises pay assessments to finance its activities. OFHEO's
budget was about $16 million in fiscal year 1999. The act provided
OFHEO with two essential responsibilities to carry out its safety and
soundness mission: (1) establish capital standards for the enterprises
and (2) establish an examination program.
As required by the 1992 Act, OFHEO has established minimum capital
standards for the enterprises, which are capital ratios applied to
certain on-balance-sheet and off-balance-sheet obligations. OFHEO has
consistently classified the enterprises as in compliance with the
minimum capital standards since they were established in 1993. The act
also mandated that OFHEO develop a stress test to serve as the basis
for more sophisticated risk-based capital standards. The purpose of the
stress test is to help manage taxpayer risks by simulating, in a
computer model, situations where the enterprises are exposed to adverse
credit and interest rate scenarios. The enterprises are required to
hold sufficient capital to withstand these adverse conditions for 10
years, plus an additional 30 percent of the required capital to cover
operations and management risk.
Although the 1992 Act directed OFHEO to complete the stress test
and risk-based capital standards by December 1, 1994, OFHEO has not yet
completed these tasks. In an October 1997 report, we identified several
reasons for OFHEO's inability to comply with the deadline, including
(1) the complexity of the task, (2) OFHEO's decision to develop a new
stress test rather than adopt or modify existing stress tests, (3)
OFHEO's initial difficulties in obtaining required financial data from
the enterprises, and (4) greater than expected managerial and technical
difficulties.\3\ OFHEO has proposed a rule to implement the stress test
and risk-based capital standards and expects to issue a final rule by
the end of 2000.
OFHEO also has the authority to establish an examination program to
monitor the enterprises' management and financial condition. Our 1997
report found that OFHEO had not been able to implement its plan to
examine all relevant operations of the enterprises on a 2-year
schedule. We attributed OFHEO's inability to meet the schedule to
limited staff resources and the start-up challenges associated with
examining the enterprises, which are extremely large and complex
financial institutions. Since that time, OFHEO has revised its
examination program and implemented an annual examination schedule.
OFHEO's examination staff has generally found that the enterprises have
been operated in a safe and sound manner.
hud has responsibility for overseeing the enterprises' fulfillment of
their housing mission
HUD has statutory authority to ensure that the enterprises fulfill
their mission of promoting housing and home ownership opportunities for
all Americans. In passing the 1992 Act, Congress concluded that HUD's
regulatory framework had not been effective in ensuring that the
enterprises' activities benefit low- and moderate-income Americans and
those who live in underserved areas, such as central cities and rural
communities (targeted groups). The 1992 Act required HUD to develop,
implement, and enforce a comprehensive housing mission regulatory
framework. Among other provisions, the 1992 Act directed HUD to set
housing goals, which require the enterprises to meet specified criteria
each year for the purchase of mortgages serving targeted groups.
In 1995, HUD established a final rule for enterprises' housing goal
mortgage purchases for the years 1996 through 1999. In a July 1998
report, we found that HUD generally adopted a conservative approach to
setting the housing goals that placed a high priority on maintaining
the enterprises' financial soundness.\4\ For example, HUD and OFHEO
conducted research during the rulemaking process that concluded that
the proposed housing goals were modest and would not materially affect
the enterprises' financial condition. According to HUD data, the
enterprises met or exceeded the housing goals between 1996 and 1998.
In March of this year, HUD proposed a new rule setting housing goal
requirements for the period 2000 through 2003. HUD's proposed housing
goals are set higher than the goals set for the period 1996 through
1999. According to HUD, the enterprises' share of the affordable
housing market remains below desired levels. For example, banks and
other lenders continue to make relatively more mortgage loans in the
primary market to targeted groups than the enterprises purchase in the
secondary residential mortgage market. HUD believes that the proposed
housing goals will provide strong incentives for the enterprises to
more fully meet the housing needs of targeted groups. The comment
period on the proposed rule ended in May 2000. HUD is currently
reviewing comments and expects to issue a final rule by the end of
2000.
The 1992 Act also defined HUD's general regulatory authority over
the enterprises and its new mortgage program approval authority.\5\ HUD
has the general regulatory authority to ensure that the enterprises'
activities are consistent with their housing mission. HUD also has the
authority to review new mortgage programs proposed by the enterprises
to ensure that the programs are consistent with the enterprises'
charters and not contrary to the public interest. In our view, Congress
correctly recognized, in passing the 1992 Act, that the enterprises-
given their hybrid structure-face a natural tension between maximizing
profitability for their shareholders and fulfilling their housing
mission.
In a March 1998 report, we provided an example of this natural
tension and HUD's critical responsibility to exercise its general
regulatory authority in a way that ensures that the enterprises fulfill
their housing mission.\6\ We pointed out that the enterprises have
incentives to use the funding advantage associated with their
government sponsorship to make nonmortgage investments-such as
corporate bond purchases-that may result in arbitrage profits.\7\ Our
report recognized that some nonmortgage investments, particularly
short-term investments, can contribute to mission achievement by
facilitating liquidity in the secondary market for residential
mortgages. However, our report concluded that the relationship between
long-term nonmortgage investments and the enterprises' housing mission
is not entirely clear.
Our March 1998 report found that HUD did not act promptly to ensure
that the enterprises' nonmortgage investments were consistent with
their housing mission. In fact, HUD did not exercise its general
regulatory authority provided in the 1992 Act until 1997, when a public
controversy erupted over Freddie Mac's investment in long-term Philip
Morris corporate bonds. In 1997, HUD initiated a rulemaking process
designed to develop criteria that would help ensure that the
enterprises' nonmortgage investments are consistent with their housing
mission and Federal charters. We recommended that HUD promptly
implement this rulemaking process, and HUD agreed to do so. However,
HUD has not yet developed criteria for overseeing the enterprises'
nonmortgage investments.
The enterprises have also engaged in other complex financial
activities whose relation to their housing mission is not entirely
clear. For example, in our March 1998 report, we pointed out that HUD
approved a new mortgage program by Fannie Mae that would involve Fannie
Mae in purchasing cash value life insurance, which is essentially a
nonmortgage investment.\8\ HUD officials told us that they lacked
expertise in cash value life insurance when they approved the Fannie
Mae program.
More recently, the enterprises' involvement in other activities-
such as automated underwriting-have raised questions as to whether they
are attempting to move beyond the secondary mortgage market into areas
traditionally served by private lenders in the primary mortgage market.
Some lenders believe that the enterprises' automated systems
standardize the mortgage loan process to such an extent that the
lenders' role in mortgage lending is minimized.
conclusions
In summary, Congress provided Fannie Mae and Freddie Mac with
substantial financial benefits so that they can fulfill their housing
finance mission. There is widespread agreement that the enterprises'
secondary mortgage market activities have lowered the cost of home
ownership for millions of Americans. However, perceived Federal
sponsorship of the enterprises' activities as GSEs also involves
significant risks and costs. In passing the 1992 Act, Congress created
a regulatory structure with the potential to help ensure that the
enterprises, in their attempts as private corporations to create
shareholder value, would do so by focusing on and fulfilling their
public missions without exposing U.S. taxpayers to undue risk.
In their oversight roles, OFHEO and HUD face a difficult challenge
in ensuring that the enterprises meet their housing responsibilities in
a safe and sound manner, while simultaneously being afforded sufficient
latitude to manage their day-to-day business needs and meet their
shareholder obligations. The enterprises are large, sophisticated
financial institutions. Beyond various nonmortgage investments, the
enterprises have become engaged in complex financial activities that
may serve multiple purposes. Therefore, it is difficult to assess the
financial risks of many of their activities as well as the relationship
between their activities and mission achievement. Nonetheless, the
making of such assessments by the enterprises' regulators and Congress
is imperative to ensure that the interests of U.S. taxpayers are
protected.
Mr. Chairman, this concludes my statement. My colleagues and I
would be pleased to respond to any questions that you or other members
of the Task Force may have.
endnotes
1. Housing Enterprises: Potential Impacts of Severing Government
Sponsorship (GAO/GGD-96-120, May 13, 1996).
2. The enterprises' charters restrict them from purchasing
mortgages above a set dollar amount, known as the conforming loan
limit. The conforming loan limit depends upon how many housing units
are financed by a single residential mortgage loan. The conforming loan
limit is currently set at $252,700. The charters also require the
enterprises to meet certain underwriting standards for mortgage loan
purchases.
3. Federal Housing Enterprises: OFHEO Faces Challenges in
Implementing a Comprehensive Oversight Program (GAO/GGD-98-6, Oct. 22,
1997).
4. Federal Housing Enterprises: HUD's Mission Oversight Needs to Be
Strengthened (GAO/GGD-98-173, July 28, 1998).
5. 12 U.S.C. Sec. 4541-2. The 1992 Act defines a ``new program''
as being significantly different from mortgage programs that have been
approved or that represent an expansion, in terms of the dollar volume
or number of mortgages or securities involved, of programs previously
approved.
6. Government-Sponsored Enterprises: Federal Oversight Needed for
Nonmortgage Investments (GAO/GGD-98-48, Mar. 11, 1998).
7. We defined the term ``arbitrage'' to mean that the enterprises
use their funding advantage from government sponsorship to raise funds
for making certain nonmortgage investments. Our definition of arbitrage
is similar to the definition of an arbitrage bond defined in reference
to Federal income tax exemption for interest on state and local bonds
in the U.S. tax code.
8. The program was called the Mortgage Protection Plan (MPP). Under
MPP, Fannie Mae would purchase a cash value life insurance on a first-
time home buyer after the selected borrower's residential mortgage was
purchased by Fannie Mae and the borrower agreed to such coverage. MPP
was designed to protect Fannie Mae and the borrower against default
caused by the borrower's death. Fannie Mae did not go ahead with MPP
because of tax law changes.
Chairman Sununu. Thank you, Mr. McCool.
Mr. Ely.
STATEMENT OF BERT ELY
Mr. Ely. Mr. Chairman and members of the Task Force, I am
pleased to testify this morning on the economic implications of
debt issued by government-sponsored enterprises, or GSEs. I
request permission to submit additional material to the
committee for inclusion in the record of this hearing.
Also, I am testifying today on my own behalf. The
statements I will make and the opinions I will offer are mine
alone and do not necessarily reflect those of any client.
I will begin by addressing the issue of the systemic risks
posed by the GSEs and specifically Fannie Mae and Freddie Mac.
Within that context, I will then discuss the amount of GSE
obligations federally-insured banks and thrifts hold relative
to their capital. GSE obligations include mortgage-backed
securities the GSEs have guaranteed as well as the debt they
have issued. I will close by offering a recommendation.
Systemic risk arises when the failure of a large financial
institution threatens the stability of the financial markets.
While the failure of a small institution would not threaten
financial stability, the failure of a large institution could.
Hence, size matters.
Because stable financial markets are essential to the
smooth functioning of the economy overall, systemic risk must
be treated extremely seriously. Systemic risk also can arise
when a large financial institution begins to suffer funding
problems. That is, it experiences difficulty and high costs in
rolling over its debt because the financial market fears that
the institution might be sliding toward insolvency.
That situation arose in the fall of 1998 when a large,
highly leveraged hedge fund, Long-Term Capital Management,
experienced a funding problem. Although LTCM apparently never
was actually insolvent on a mark-to-market basis, there were
grave doubts about its solvency in the aftermath of the Russian
debt market default in the summer of 1998.
Due only to the intervention of the New York Fed, Long-Term
Capital Management was able to keep rolling over its debt in
sufficient quantities to enable it to shrink itself in an
orderly manner.
Had LTCM been forced to sell its assets at fire sale prices
in order to pay its maturing debts, chaos would have reigned in
the financial markets. Those fire sale prices would have caused
tremendous mark-to-market losses for other financial firms,
possibly rendering some of them insolvent. A cascade of losses
could have wracked global economic havoc.
I mention LTCM because as big as it was, its outstanding
debt at the time of its troubles was less than one-seventh of
the amount of debt Fannie and Freddie combined had outstanding
at the end of last year. Adding in their MBS, the total
outstanding obligations of Fannie and Freddie at the end of
1999, $2.125 trillion, was 17 times LTCM's obligations when it
crashed. Unquestionably, Fannie and Freddie pose serious
systemic risks. Clearly, they are too-big-to-fail institutions.
The fact that Fannie and Freddie are GSEs makes it nearly
certain that the Federal Government will rescue them should
they experience financial problems. History bears out this
statement. In 1988, Congress threw a $4 billion life ring to
the much smaller Farm Credit System, even though it was solvent
on a book value basis, after yields on FCS debt over longer
Treasuries went above 100 basis points, signalling that new FCS
debt might become virtually unmarketable.
In 1996, Congress averted a possible default on FICO bonds
by extending the FICO interest bond assessment from S&Ls to all
federally-insured depository institutions. And, of course,
Congress coughed up approximately $160 billion drawn from
various sources to ensure that the Federal deposit insurance
commitment would be met for all failed S&Ls.
Much has been made in hearings held earlier this year by
the Capital Markets Subcommittee of the House Banking Committee
that a statutorily required stress test will prevent Fannie or
Freddie from reaching insolvency. Although OFHEO has strived
valiantly to implement this stress test, the test will not
prevent either Fannie or Freddie from creating systemic risk.
This is a most important point that Representative Richard
Baker, chairman of the Capital Markets Subcommittee, made in a
hearing last Thursday. This is the case because any meaningful
deterioration in the financial condition of either Fannie or
Freddie, even if neither is insolvent, will create funding
problems for both GSEs since they are, for all practical
purposes, Siamese twins.
According to a recent American Banker article, over two-
thirds of federally-insured banks and thrifts hold more GSE
debt and MBS, relative to their capital, than would be
permissible for them to hold if GSE obligations were held to
the same loan-to-one borrower and investment-per-company rules
that apply to credit extensions by banks and thrifts to
genuinely private organizations.
Due to data limitations, it is not possible to identify the
specific GSEs for which banks and thrifts have exceeded the
credit limits applicable to private entities. However, given
their enormous size relative to the other GSEs, most banks and
thrifts are overexposed to Fannie and Freddie obligations.
This overexposure has undoubtedly created solvency concerns
about banks and thrifts heavily invested in GSE debt and MBS
should Fannie or Freddie get into trouble. This is the case
because if funding problems drove down the market value of GSE
debt, that drop would cause capital reductions in banks and
thrifts that would trigger regulatory sanctions that in turn
would force banks and thrifts to reduce their lending to
consumers and businesses. The resulting credit crunch could
easily cause a recession, which would magnify the downward
spiral.
If banks and thrifts continue to hold a proportionate share
of the total amount of Fannie and Freddie obligations, then
Fannie's and Freddie's continued growth will increase the
systemic risk they pose to America's banks and thrifts.
Ironically, the growing presence of Fannie and Freddie
obligations on bank and thrift balance sheets further increases
the likelihood that the Federal Government will rescue the GSEs
should they experience funding problems because of the adverse
effects that those problems would have on federally-insured
depository institutions.
Although the reforms Congress enacted in the early 1990's
have essentially eliminated the taxpayer risk posed by Federal
deposit insurance, Congress would still understandably be
concerned about the credit crunch effects of Fannie and
Freddie's funding problems.
While GSE obligations owned by banks and thrifts should be
subject to the same loan and investment limitations applicable
to the obligations of private sector firms, forcing banks and
thrifts to trim their Fannie and Freddie obligations would
merely shift systemic risk elsewhere in the financial system,
not eliminate it. In any event, the GSE exception to these
limitations should be of less concern to Congress than the
enormous and increasing size of these two undercapitalized
GSEs.
Until such time as Fannie and Freddie can be transformed
into genuinely private sector firms by eliminating their
special privileges, Congress must ensure that a reliable
mechanism is in place to rescue Fannie or Freddie should one of
them stumble financially. Because there are innumerable reasons
why they might stumble, some of which lie outside the U.S.
financial system, it would be pointless to try to prevent an
external event. Instead, if needed, a rescue mission should be
executed as quickly and smoothly as possible.
It would be foolhardy to rely upon ``market discipline'' to
prevent a stumble because the exercise of market discipline
could collapse the financial markets. We got a whiff of that
potential effect in the aftermath of Treasury Under Secretary
Gary Gensler's testimony in March before the Capital Markets
Subcommittee when yields on Fannie and Freddie debt shot up at
the mere suggestion that they are not government-backed
institutions.
The two existing rescue mechanisms are grossly inadequate.
First, Fannie's and Freddie's Treasury lines of credit, at
$2.25 billion for each institution, pale in light of the total
amount of their outstanding debt in MBS. Fannie's line of
credit is less than .2 percent of its outstanding obligations.
The comparable figure for Freddie is about 2.5 percent, or in
effect one-four-hundredth of its outstanding obligations.
Second, if Congress were out of session and the Treasury
lines of credit had been fully drawn down, then presumably the
Fed could lend to Fannie and Freddie or buy their securities.
But to do so, the Fed would have to sell a like amount of
Treasury securities. Massive sales of Treasury debt could be
highly disruptive to the financial markets.
Key, therefore, to dealing with a Fannie or Freddie funding
crisis would be congressional enactment of a line of credit
comparable to the life ring Congress tossed to the Farm Credit
System in 1988 that the Treasury Department could draw upon to
keep the financial markets funding Fannie and Freddie even if
these GSEs were experiencing financial difficulties.
That action would give Congress time resolve their problems
in a manner that would minimize the cost of any rescue. As
distasteful as this recommendation may seem, going forward with
the present limited rescue resources is playing Russian
roulette with the U.S. economy.
Mr. Chairman and members of the Task Force, I thank you for
your time, and I welcome your questions.
[The prepared statement and other submitted materials of
Bert Ely follows:]
Prepared Statement of Bert Ely, Ely & Co., Inc.
economic implications of debt issued by government-sponsored
enterprises
Mr. Chairman and members of the Task Force on Housing and
Infrastructure, I am pleased to testify this morning on the economic
implications of debt issued by government-sponsored enterprises, or
GSEs. I request permission to submit additional material to the
Committee for inclusion in the record of this hearing, specifically a
monograph I co-authored recently, titled ``Nationalizing Mortgage Risk:
The Growth of Fannie Mae and Freddie Mac.'' Also, I am testifying today
in my own behalf. The statements I will make and the opinions I will
offer are my alone and do not necessarily reflect those of any client.
I will begin by addressing the issue of the systemic risk posed by
the GSEs, and specifically Fannie Mae and Freddie Mac. Within that
context, I will then discuss the amount of GSE obligations federally
insured banks and thrifts hold relative to their capital. GSE
obligations include mortgage-backed securities, or MBS, the GSEs have
guaranteed as well as the debt they have issued. I will close by
offering a recommendation.
systemic risk
Systemic risk arises when the failure of a large financial
institution, due to its actual or apparent insolvency, threatens the
stability of the financial markets. While the failure of a small
institution would not threaten financial stability, the failure of a
large institution could. Hence, size matters. Because stable financial
markets are essential to the smooth functioning of the economy overall,
systemic risk must be treated extremely seriously.
Systemic risk also can arise when a large financial institution
begins to suffer funding problems; that is, it experiences difficulty
and high cost in rolling over its debt because of financial market
fears that the institution might be sliding toward insolvency. That
situation arose in the fall of 1998 when a large, highly leveraged
hedge fund, Long Term Capital Management, or LTCM, experienced a
funding problem. Although LTCM apparently never was actually insolvent,
on a mark-to-market basis, there were grave doubts about its solvency
in the aftermath of the Russian debt default in the summer of 1998.
Due only to the intervention of the Federal Reserve Bank of New
York, LTCM was able to keep rolling over its debt in sufficient
quantities to enable it to shrink itself in an orderly manner. Had LTCM
been forced to sell its assets at fire-sale prices, in order to pay its
maturing debt, chaos would have reigned in the financial markets. Those
fire-sale prices would have caused tremendous mark-to-market losses for
other financial firms, possibly rendering some of them insolvent. A
cascade of losses could have wracked global economic havoc.
I mention LTCM because as big as it was, its outstanding debt at
the time of its troubles was less than one-seventh of the amount of
debt Fannie and Freddie combined had outstanding at the end of last
year. Adding in their MBS, the total outstanding obligations of Fannie
and Freddie at the end of 1999, $2.125 trillion, was 17 times LTCM's
obligations when it crashed. Unquestionably, Fannie and Freddie pose
serious systemic risks. Clearly, they are too-big-to-fail financial
institutions.
The fact that Fannie and Freddie are GSEs makes it nearly certain
that the Federal Government will rescue them should they experience
financial problems. History bears out this statement. In January 1988,
Congress threw a $4 billion life ring to the much smaller Farm Credit
System, or FCS, even though it was solvent on a book-value basis, after
yields on FCS debt over longer term Treasuries went above 100 basis
points, signalling that new FCS debt might become virtually
unmarketable. In September 1996, Congress averted a possible default on
the so-called FICO bonds by extending the FICO bond interest assessment
from savings-and-loans, or S&Ls, to all federally insured depository
institutions. And of course, starting in 1989, Congress coughed up
approximately $160 billion, drawn from various sources, to ensure that
the Federal deposit insurance commitment would be met for all failed
S&Ls.
Much has been made in hearings held earlier this year by the
Capital Markets Subcommittee of the House Banking Committee that a
statutorily required stress test will prevent Fannie or Freddie from
reaching insolvency. Although the Office of Federal Housing Enterprise
Oversight, or OFHEO, has strived valiantly to implement this stress
test, the test will not prevent either Fannie or Freddie from creating
systemic risk. This is a most important point that Rep. Richard Baker,
Chairman of the Capital Markets Subcommittee, made in a hearing last
Thursday. This is the case because any meaningful deterioration in the
financial condition of either Fannie or Freddie, even if neither is
insolvent, will create funding problems for both GSEs since they are,
for all practical purposes, Siamese twins.
investments by banks and thrifts in gse obligations
According to a recent (April 14, 2000) American Banker article,
over two-thirds of federally insured banks and thrifts hold more GSE
debt and MBS, relative to their capital, than would be permissible for
them to hold if GSEs obligations were held to the same loan-to-one-
borrower and investment-per-company rules that apply to credit
extensions by banks and thrifts to genuinely private organizations. Due
to data limitations, it is not possible to identify the specific GSEs
for which banks and thrifts have exceeded the credit limits applicable
to private entities. However, given their enormous size, relative to
the other GSEs, most banks and thrifts are most overexposed to Fannie
and Freddie obligations.
This overexposure has understandably created solvency concerns
about banks and thrifts heavily invested in GSE debt and MBS should
Fannie or Freddie get into trouble. This is the case because if funding
problems drove down the market value of GSE debt, that drop would cause
capital reductions in banks and thrifts that would trigger regulatory
sanctions that, in turn, would force banks and thrifts to reduce their
lending to consumers and businesses. The resulting credit crunch could
easily cause a recession, which would magnify the downward spiral. If
banks and thrifts continue to hold a proportionate share of the total
amount of Fannie and Freddie obligations, then Fannie's and Freddie's
continued growth will increase the systemic risk they pose to America's
banks and thrifts.
Ironically, the growing presence of Fannie and Freddie obligations
on bank and thrift balance sheets further increases the likelihood that
the Federal Government will rescue the GSEs should they experience
funding problems because of the adverse effect those problems would
have on federally insured depository institutions. Although reforms
Congress enacted in the early 1990's have essentially eliminated the
taxpayer risk posed by Federal deposit insurance, as I explain in a
paper titled ``Banks Do Not Receive a Federal Safety Net Subsidy,''
Congress would still understandably be concerned about the credit-
crunch effects of Fannie's and Freddie's funding problems.
While GSE obligations owned by banks and thrifts should be subject
to the same loan and investment limitations applicable to the
obligations of private-sector firms, forcing banks and thrifts to trim
their Fannie and Freddie obligations would merely shift systemic risk
elsewhere in the financial system, not eliminate it. In any event, the
GSE exception to these limitations should be of less concern to
Congress than the enormous and ever increasing size of the two
undercapitalized GSEs.
what to do about the systemic risks fannie and freddie pose
Until such time as Fannie and Freddie can be transformed into
genuinely private-sector firms by eliminating their special privileges,
Congress must ensure that a reliable mechanism is in place to rescue
Fannie and Freddie should one of them stumble financially. Because
there are innumerable reasons why they might stumble, some of which lie
outside the U.S. financial system, it would be pointless to try to
prevent an external event. Instead, if needed, a rescue mission should
be executed as quickly and smoothly as possible.
It would be foolhardy to rely upon ``market discipline'' to prevent
a stumble because the exercise of market discipline could collapse the
financial markets. We got a whiff of that potential effect in the
aftermath of Treasury Under Secretary Gary Gensler's testimony in March
before the Capital Markets Subcommittee when yields on Fannie and
Freddie debt shot up at the mere suggestion that they are not
government-backed institutions.
The two existing rescue mechanisms are grossly inadequate. First,
Fannie's and Freddie's Treasury lines of credit, at $2.25 billion for
each institution, pale in light of the total amount of their
outstanding debt and MBS. Fannie's line of credit is less than .2
percent of its outstanding obligations; the comparable figure for
Freddie is about .25 percent. Second, if Congress were out of session
and the Treasury lines of credit had been fully drawn, then presumably
the Fed could lend to Fannie and Freddie or buy their securities, but
to do so, the Fed would have to sell a like amount of Treasury
securities. Massive sales of Treasury debt could be highly disruptive
to the financial markets.
Key, therefore, to dealing with a Fannie or Freddie funding crisis
would be congressional enactment of a line of credit, comparable to the
life ring Congress tossed to the Farm Credit System in 1988, that the
Treasury Department could draw upon to keep the financial markets
funding Fannie and Freddie even if these GSEs were experiencing
financial difficulties. That action would give Congress time to resolve
their problems in a manner that would minimize the cost of any rescue.
As distasteful as this recommendation may seem, going forward with the
present limited rescue resources is playing Russian roulette with the
U.S. economy.
Mr. Chairman and members of the Task Force, I thank you for your
time. I welcome your questions.
Ely & Company, Inc.,
Financial Institutions and Monetary Policy Consulting,
Alexandria, VA, July 29, 2000.
Hon. Eva M. Clayton,
U.S. House of Representatives, Washington, DC.
Dear Ms. Clayton: I am writing to clarify an answer I gave to a
question you posed to me at the Budget Committee's Housing and
Infrastructure Task Force hearing on Tuesday about the GSEs. I stated
something to the effect that I do not believe that the lower interest
rates Fannie Mae and Freddie Mac provide are necessarily beneficial to
housing finance. However, I am not an advocate of high mortgage
interest rates. Instead, I fear that the interest rate subsidy Fannie
and Freddie deliver may actually harm housing affordability if that
subsidy gets overcapitalized in housing prices. Let me explain.
At present interest rate levels, a .25 percent reduction in the
rate on a 30-year fixed-rate mortgage enables a borrower to finance a
mortgage approximately 2.4 percent larger than the borrower could
finance without that interest rate reduction; a .375 percent rate
reduction will finance an approximately 3.6 percent larger mortgage.
While that may seem desirable, if the existence of the Fannie/Freddie
subsidy causes housing prices to rise by more than 2.4 percent to 3.6
percent, then it is the seller of a house, rather than the buyer, who
receives the benefit of the mortgage subsidy. My research suggests that
at times, and perhaps much of the time, Fannie and Freddie's interest
rate subsidy has been overcapitalized in housing prices, thus making it
more difficult for moderate income people to buy a home. In my opinion,
a more much effective and lower cost housing finance subsidy would
target the subsidy to just those homebuyers on the cusp of home
ownership.
I would welcome the opportunity to meet with you to discuss in
greater depth the issues you raised at the hearing.
Very truly yours,
Bert Ely.
Nationalizing Mortgage Risk: The Growth of Fannie Mae and Freddie Mac
Peter J. Wallison and Bert Ely
1. introduction
Fannie Mae and Freddie Mac are today the largest financial
institutions in the United States. Many economic studies, including one
by the Congressional Budget Office (CBO), have concluded that these
government-sponsored enterprises (GSEs) receive an implicit government
subsidy arising out of the statutory benefits they retained at the time
they were ``privatized'' (Fannie in 1970, Freddie in the 1980's). In
1996, the CBO estimated the value of that subsidy at $6.5 billion for
the previous year, and the subsidy has grown substantially larger since
then.
According to the CBO, only a portion of that subsidy is actually
passed along to the mortgage markets.\1\ The balance, almost a third,
is retained for the share-holders and managements of the two companies,
accounting for more than 40 percent of their 1995 profits (which ranked
them among the most profitable publicly held companies in the United
States).
---------------------------------------------------------------------------
\1\ In its 1996 report, Assessing the Public Costs and Benefits of
Fannie Mae and Freddie Mac, CBO concluded that the GSEs reduced
interest rates in the conventional/conforming market by passing along
about two-thirds of the implicit subsidy they received from the
government, while retaining the balance for themselves. CBO estimated
that subsidy as $6.5 billion in 1995, a figure that was derived by
estimating the GSEs' funding cost savings as a result of their implicit
government backing. Prior assessments of the GSEs' credit quality had
concluded that, without government backing, Fannie and Freddie would
have private-sector credit ratings in the Aa range. That permited CBO
to estimate the savings attributable to the government's implicit
credit enhancement by computing the difference between the costs the
GSEs would have faced without government backing and the costs they
actually paid. That savings was estimated at about 50 basis points for
each dollar of funds acquired. CBO then noted that the difference
between interest rates in the jumbo market and those in the
conventional/conforming market amounted to approximately 35 basis
points, and concluded that the GSEs were retaining about 15 basis
points, or about one-third of their implicit subsidy.
---------------------------------------------------------------------------
The lower interest rates that Fannie and Freddie can command
because of their government backing permit them to out-compete any
private-sector rival and to dominate any market they are permitted to
enter. Although their charters are supposed to limit their activities
preventing them from competing with companies that must raise their
funds without government backing the vagueness of the charters and the
political power of Fannie and Freddie have enabled them to expand with
few constraints. That they can and do make soft-money political
contributions, hire legions of lobbyists, and employ people with close
ties to Congress as top management further ensures their insulation
from scrutiny.
Meanwhile, their dominance of the residential mortgage markets
grows ever greater. Reasonable projections based on statements by
Franklin Raines, the chairman of Fannie Mae, suggest that, by the end
of 2003, the two companies will have assumed the risk associated with
almost half of all the residential mortgages in the United States. That
means that the taxpayers, who ultimately stand behind the obligations
of these two companies, will have unwittingly become responsible for
almost $3 trillion of residential mortgage risk that should be on the
books of private sector firms.
An important decision point lies immediately ahead. As shown in
this analysis, in 4 years, Fannie and Freddie will have either acquired
for their portfolios or guaranteed more than 91 percent of all the
conventional/conforming mortgages in the United States. Those are the
high-quality loans on middle-class homes that have until now been
virtually the only mortgages the GSEs would purchase. As they grow
beyond their traditional market segment, Fannie and Freddie will have
to purchase increasing amounts of lower-quality loans and hold more of
those loans in portfolio, increasing their risks. If they fully hedge
those risks, their extraordinary profitability will decline.
The question is whether Fannie and Freddie will (1) slow their
growth to reduce the risks they take on; (2) continue their growth at
the rate Franklin Raines predicted, but accept reduced profitability by
hedging those risks; or (3) continue the growth in both those assets
and risks in order to achieve high profitability. The evidence is that
they are pursuing the third course.
To be sure, there is nothing wrong with growth, risk, or
profitability. But the growth of the GSEs--aided as it is by government
support--creates enormous risks for taxpayers only a decade after the
savings and loan bailout, and it threatens to drive a whole sector of
the private financial community out of the residential mortgage market.
Those factors raise serious policy issues. The purpose of this study is
to examine the implications of that growth for the mortgage market, for
those who compete with Fannie and Freddie, and for the nation's
taxpayers.
Chapter 2 provides background on the GSEs and the mortgage markets.
It outlines the statutory links to the Federal Government that have led
the financial markets to conclude that Fannie and Freddie will not be
allowed to fail, describes the mortgage market in the United States,
and summarizes both the functions and growth of the GSEs.
Chapter 3 contains detailed information on the structure of the
residential mortgage market today, the growth of Fannie and Freddie's
share of that market since 1995, and (if the forecasts of Fannie's
chairman are correct) the share they will hold together and separately
at the end of 2003. It shows that the GSEs' total risk including both
the mortgages they will own and those they have guaranteed will
increase from somewhat more than a third of the market today to almost
half of a much larger market 4 years hence.
The growth of Fannie and Freddie in relation to the growth of the
conventional/conforming sector of the market is examined in chapter 4.
It shows that, beginning in 1998, they were already acquiring more net
mortgage assets in each year than the total net principal amount of the
conventional/conforming loans made in that year. The data presented in
chapter 4 also show that, by the end of 1998, Fannie and Freddie were
holding in portfolio or had guaranteed more than 73 percent of all
conventional/conforming mortgages, and that figure could reach almost
92 percent by 2003.
The implications of that growth are addressed in chapter 5, which
discusses the possibility that to make up for the absence of sufficient
conventional/conforming mortgages--Fannie and Freddie will have to
drive deeper into the subprime markets, taking more risk and displacing
more of the genuine private-sector lenders who have traditionally made
these loans. The chapter also discusses other financial services that
Fannie and Freddie might be preparing to offer if their charters are
not more strictly interpreted.
Chapter 6 continues the analysis of the implications of GSE growth,
focusing on the risks to taxpayers that will be associated with the
nationalization of almost half the residential mortgage market by 2003.
The chapter points out that Fannie and Freddie have a choice--to hedge
the greater risks they will be taking and reduce their profitability,
or to maintain their level of profit growth by taking greater risk. It
suggests that the incentives of management and the pressures of the
financial markets will push the two GSEs toward greater risk-taking.
The study's conclusion notes that there is an inherent conflict
between the GSEs' status as private, profit-making companies and the
government mission they are expected to perform. There is ample
evidence that their government mission is no longer necessary, and that
they are using the subsidy they receive primarily to enhance their
profitability and to dominate their market. Even if that were not true,
the risks they are creating for taxpayers and the threat they represent
to non-subsidized private-sector competitors would argue strongly for
more strictly confining them to limited areas of activity, eliminating
their links to the government, or taking steps toward recapturing their
subsidy through a complete privatization.
2. background
The Federal National Mortgage Association (popularly known as
Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac) are two government-chartered and government-sponsored corporations
that have been assigned the statutory mission of improving liquidity in
the middle-class residential mortgage markets by buying and selling
residential mortgages.
Fannie Mae and Freddie Mac carry on their functions in two ways--by
purchasing and holding mortgages originated by mortgage lenders, and by
placing their guarantee on securities (mortgage-backed securities, or
MBSs) that represent an interest in pools of mortgages they have
assembled. Whether they are holding mortgage loans or MBSs in their
portfolio or are guaranteeing MBSs that are then sold to investors,
they are assuming the credit risk associated with those loans.
Although initially established to enhance liquidity in the mortgage
markets, it is doubtful that Fannie and Freddie are necessary for that
purpose today. Many private organizations are now capable of purchasing
mortgages from originators and selling them--either directly or through
securitization--into the capital markets. However, Fannie and Freddie
now argue that they perform their public mission by reducing interest
rates on the mortgages they are permitted to buy, and thus help
homebuyers to obtain lower-cost financing. That claim is dubious;
economists believe that the lower rates attributable to the GSEs'
subsidized borrowing are simply capitalized into the cost of the homes,
thus benefiting developers and home sellers rather than buyers.
Fannie and Freddie were originally government agencies but were
``privatized'' when they were permitted to sell shares to the public.
Today, both companies are among the largest and most profitable
financial institutions in the world, with their securities listed on
the New York Stock Exchange.
The unusual thing about their privatization, however, is that
Fannie and Freddie continue to retain a large number of connections to
the government, as well as various privileges and immunities that no
genuinely private company can claim:
The president appoints up to five members (a minority) of
their boards of directors.
The secretary of the Treasury is authorized to invest up
to $2.25 billion in their securities, and to approve their issuance of
debt.
They are exempt from state and local income taxes and from
the requirement to register their securities with the Securities and
Exchange Commission.
Their debt securities are eligible for open-market
transactions by the Federal Reserve Board and for investment by insured
banks.
Their debt securities are eligible collateral for the
Federal Government's deposits of tax revenues in banks.
Their securities require only a 20 percent risk weighting
(versus 100 percent for the securities and debt of private companies)
under the Basel risk-based capital standards applicable to banks.
Those extraordinary advantages have convinced the capital markets
that the Federal Government will never allow Fannie and Freddie to
fail. Thus, they are able to sell their debt securities at interest
rates that are consistently better than any AAA-rated corporation in
the world and just slightly above the rate paid by the Treasury itself.
Moreover, that favored position allows them to operate with capital
levels that are much lower than those of other financial
intermediaries, since the capital markets are not concerned that those
low capital levels will ever mean losses to the holders of their debt
or their MBSs.
the market in which the gses operate
The residential mortgage market is composed of a number of
segments--government-guaranteed Veterans Administration (VA) and
Federal Housing Administration (FHA) loans; multifamily housing loans;
middle-class mortgages (known as conventional/conforming mortgages, the
basic loans that Fannie Mae and Freddie Mac purchase or guarantee);
subprime loans (loans with credit deficiencies); home equity loans; and
so-called jumbo loans, which exceed the size limit on conventional/
conforming loans.
According to Federal Reserve data, FHA and VA loans constitute
about 11 percent of the total market. Although similarly authoritative
numbers are difficult to obtain for jumbo loans, most observers agree
that those mortgages constitute another 15 percent of the market.
Fannie and Freddie cannot compete for most FHA and VA loans, since
those are purchased and marketed by the Government National Mortgage
Association (known as Ginnie Mae), an on-budget government agency that
obtains its funds at Treasury rates and thus can offer lower rates than
can Fannie and Freddie.\2\ Nor can Fannie and Freddie compete for jumbo
mortgages, which have initial loan amounts above $252,700, the limit on
the size of the loans Fannie and Freddie can purchase in the year
2000.\3\
---------------------------------------------------------------------------
\2\ Although Ginnie Mae can borrow at a lower rate than Fannie and
Freddie, the GSEs have been able, from time to time, to offer a lower
mortgage rate to many subprime borrowers eligible for FHA and VA loans.
That may be a consequence of the fact that Fannie and Freddie's MBSs
have greater liquidity than Ginnie Mae's, and perhaps shorter duration.
It may also be attributable to better underwriting skills at Fannie and
Freddie, which might leave Ginnie with higher credit losses. It remains
to be seen whether Fannie and Freddie will be able to maintain a
permanent beachhead in the FHA/VA market.
\3\ The limit, which is keyed to housing prices, was $240,000 in
1999.
---------------------------------------------------------------------------
That leaves 74 percent of the total residential market in which
Fannie and Freddie can invest. Of that portion, most are conventional/
conforming loans; the balance are subprime, home equity, and
multifamily housing loans.
In the past, the GSEs purchased almost exclusively conventional/
conforming loans, because those are the best credits available in the
middle-class market. But increasingly in recent years--as they have
foreseen that their need for assets will outstrip the conventional/
conforming market--the GSEs have entered the market for subprime, home
equity, and multifamily housing loans. Those assets are riskier middle-
class credits, since they represent loans to borrowers with impaired
credit (subprime loans), subordinated debt (home equity loans), and
rental housing (multifamily).
gse growth
In a statement to a September 1999 financial conference, Franklin
Raines predicted that by the end of 2003 Fannie Mae will have 28
percent of the U.S. residential mortgage market, and that its
profitability will have doubled. Raines's forecast implies an 11.3
percent annual rate of growth in risk and a 15 percent annual rate of
growth in profitability during 1999 and over the following 4 years.\4\
---------------------------------------------------------------------------
\4\ Not to be outdone, in a November 1999 statement to securities
analysts, Leland Brendsel, the chairman of Freddie Mac, also predicted
a mid-teens growth in profitability, without specifying the period over
which that would occur.
---------------------------------------------------------------------------
The Raines statement provides a valuable benchmark for assessing
both the steps that Fannie Mae must take to achieve that goal and the
shape of the residential mortgage market in 2003, if the goal has then
been achieved.
At the end of 1999, the residential mortgage market--that is, all
outstanding residential mortgage loans in the United States--had an
aggregate book value of just over $5 trillion. In 1998 and 1999, that
market grew strongly--by more than 8 percent each year. But its long-
term growth rate has been about 6 percent. If we make the conservative
assumption that the residential mortgage market will grow at that rate
for the next 4 years, it will have a total value of about $6.4 trillion
in the year 2003.
Thus, when its chairman predicts that Fannie Mae will have 28
percent of the residential mortgage market in 2003, he is saying that
it will in that year have assumed the risk of mortgage loans with an
aggregate value of more than $1.8 trillion. At that size, Fannie Mae
may or may not be the largest financial institution in the world--
depending on the size of future mergers among the world's largest
banks--but it will unquestionably be the largest S&L the world has ever
seen.
And in second place will be Freddie Mac, which in 1999 was about
two-thirds the size of Fannie. If we assume that that relative size
differential will continue through 2003, then Freddie Mac will hold in
portfolio, or will have guaranteed, mortgages with an aggregate value
of more than $1.2 trillion, a growth rate of 11.4 percent between 1998
and 2003.
Together, then, the GSEs in 2003 will be bearing the risk
associated with more than $3 trillion in residential mortgages, or
almost 48 percent of all home mortgages in the United States. The
balance of the market--barely more than half--will be left to the
thousands of private, non-subsidized lenders who have traditionally
provided mortgage finance in the United States.
Those extraordinary facts have a number of equally startling
corollaries:
Since the U.S. government stands behind the obligations of
the GSEs, the nation's taxpayers--rather than the shareholders of
private sector mortgage lenders--will ultimately bear the risks
associated with almost half of all the residential mortgage debt
outstanding in the United States.
If the total residential mortgage market is growing at 6
percent a year, and Fannie and Freddie are growing, respectively, at
11.3 percent and 11.4 percent a year, then the GSEs cannot achieve
their growth goals solely within their traditional segment of the
residential mortgage market. They will have to strike out into other
areas.
The current private-sector sources of mortgage finance
will be forced to consolidate and will gradually be squeezed out of the
residential market; in effect, half of that sector of the economy will
have been nationalized.
Just as ominously, achieving a 15 percent annual rate of
profit growth will require that Fannie and Freddie take on and retain
more financial risk--in a process reminiscent of the S&L industry's
ultimately fatal effort to achieve high levels of profitability only
fifteen years ago.
3. market shares
Table 3-1 shows the growth of the residential mortgage markets
since 1995. The data for the size of the FHA/VA market (line 3),
multifamily mortgages (line 5), and the mortgage market as a whole
(line 6), during the years 1995 through 1998, are taken from reports
published by the Federal Reserve Board. Information on the size of the
jumbo market (line 1) and the conventional/conforming market (line 2)
was derived from industry sources. Other one-to-four-family mortgages
(line 4), a residual figure, consists primarily of subprime and home
equity loans. For the purpose of this study, those loans and
multifamily loans (loans for apartment buildings) have been combined
into a category called ``all other.''
assumptions and data
The projections for 1999 through 2003 are based on our judgment
that the very strong residential real estate market during 1998 and
1999 will return gradually over the next 4 years to its historical
pattern. Thus, although the market grew by 9.3 percent in 1998, we
project that it will have grown by about 8 percent when all the data on
1999 are in, by 7 percent in 2000, and by 6 percent in each of the 3
years thereafter.
Historically, total residential real estate mortgage debt has grown
slightly faster than nominal gross domestic product (GDP). In that
context, residential mortgage debt's extraordinary growth in 1998
cannot be expected to continue. If we assume that the market will
gradually return to its historic growth pattern in relation to GDP,
that would reinforce the projection of a gradual return to a 6 percent
growth rate beginning in 2001.
TABLE 3-1.--SIZE OF THE RESIDENTIAL MORTGAGE MARKET, PAST, PRESENT, AND PROJECTED, 1995-2003
[Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
History (year-end) Projection (year-end) Annual Annual
------------------------------------------------------------------------------------------------------------ growth growth Growth
rate: rate: rate
1995 1996 1997 1998 1999 2000 2001 2002 2003 1995-1998 1998-2003 difference
(%) (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Composition of outstanding mortgage market:
1. Jumbo mortgages............................ 568,008 602,069 639,797 699,485 755,444 808,325 856,825 908,234 962,728 7.2 6.6 -0.6
2. Conventional/conforming.................... 1,969,096 2,087,172 2,217,961 2,424,882 2,618,873 2,802,194 2,970,326 3,148,545 3,337,458 7.2 6.6 -0.6
3. FHA/VA mortgages........................... 466,620 497,684 525,000 524,354 546,377 566,456 584,300 602,705 621,690 4.0 3.5 -0.5
4. Other 1- 4-family mortgages................ 505,997 532,085 572,096 673,732 747,556 818,051 883,279 952,928 1,027,281 10.0 8.8 -1.2
5. Multifamily: all kinds..................... 277,002 294,783 310,456 340,782 368,045 393,808 417,436 442,482 469,031 7.2 6.6 -0.6
6. Total residential mortgages................ 3,786,723 4,013,793 4,265,310 4,663,235 5,036,294 5,388,834 5,712,164 6,054,894 6,418,188 7.2 6.6 -0.6
7. Annual growth rate (%)..................... 4.3 6.0 6.3 9.3 8.0 7.0 6.0 6.0 6.0
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: For all tables, historic data sources are as follows: Federal Reserve Bulletin, December 1999; periodic financial reports issued by Fannie Mae and Freddie Mac; and industry
nestimates. Projected data are the projections of Peter J. Wallison and Bert Ely.
The division of the market into four subcategories--jumbo,
conventional/conforming, FHA/VA, and all other (subprime, home equity,
and multifamily loans)--is necessarily somewhat arbitrary. There are no
official or government estimates of the size of key market segments;
apart from FHA/VA and multifamily mortgages, there are no formally
recognized and defined subcategories into which the market has been
divided for purposes of official reporting.
Although official figures are lacking, there is a wide variety of
unofficial market breakdowns.\5\ The data we have received from market
sources, however, indicate that jumbo loans account for about 15
percent of the market and FHA-VA loans for about 11 percent.
Accordingly, conventional/conforming plus all other loans--the loans in
which Fannie and Freddie can invest--account for about 74 percent.\6\
---------------------------------------------------------------------------
\5\ In a recent statement, Fannie chairman Franklin Raines divided
the residential mortgage market into seven subcategories: conventional/
conforming (49 percent), FHA/VA (11 percent), jumbo (19 percent),
subprime (6 percent), home equity loans (6 percent), seller-financed (2
percent), and multifamily (7 percent).
\6\ If Mr. Raines is correct that the jumbo market is 19 percent of
the total, that would indicate that Fannie and Freddie have an even
larger percentage of the total eligible market.
---------------------------------------------------------------------------
fannie and freddie market shares
Table 3-2 contains data on the respective market shares of Fannie
and Freddie. The information on their shares between 1995 and 1998 was
derived by comparing the information in their financial statements to
known market totals. For the years after 1998, we assumed a growth rate
in market shares that would permit Fannie Mae to reach the 28 percent
market share projected by Franklin Raines for the year 2003. We then
assumed that Freddie's growth rate would be such as to maintain its
market share in relation to Fannie. That means that Fannie, which had
grown at a rate of 11.2 percent annually between 1995 and 1998 (line
11), would have to grow at a slightly greater rate, 11.3 percent, from
1999 through 2003, and that Freddie would have to increase its growth
rate from 9 percent to 11.4 percent (line 17).
TABLE 3-2.--FANNIE MAE AND FREDDIE MAC MARKET SHARES, PAST, PRESENT, AND PROJECTED, 1995-2003
[Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
History (year-end) Projection (year-end) Annual Annual
------------------------------------------------------------------------------------------------------------ growth growth Growth
rate: rate: rate
1995 1996 1997 1998 1999 2000 2001 2002 2003 1995-1998 1998-2003 difference
(%) (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Fannie/Freddie retained portfolios, total
mortgages outstanding:
Fannie Mae:
8. Retained portfolio:.................... 252,868 286,527 316,592 415,434 528,811 635,882 754,006 877,960 1,020,492 18.0 19.7 1.7
9. Total residential (%).................. 6.7 7.1 7.4 8.9 10.5 11.8 13.2 14.5 15.9
10. Conventional/conforming & all other 9.2 9.8 10.2 12.1 14.2 15.8 17.7 19.3 21.1
(%)......................................
11. Retained + guaranteed:................ 766,098 834,700 895,730 1,052,577 1,208,711 1,347,209 1,485,163 1,634,821 1,797,093 11.2 11.3 0.1
12. Total residential (%)................. 20.2 20.8 20.9 22.5 24.0 25.0 26.0 27.0 28.0
13. Conventional/conforming & all other 27.8 28.6 28.9 30.6 32.4 33.6 34.8 36.0 37.2
(%)......................................
Freddie Mac:
14. Retained portfolio:................... 107,706 137,826 164,543 255,670 337,432 420,329 506,383 605,489 712,419 33.4 22.7 -10.7
15. Total residential (%)................. 2.8 3.4 3.8 5.5 6.7 7.8 8.9 10.0 11.1
16. Conventional/conforming & all other 3.9 4.7 5.3 7.4 9.0 10.5 11.9 13.3 14.7
(%)......................................
17. Retained + guaranteed:................ 566,751 610,891 640,528 734,021 846,097 943,046 1,039,614 1,144,375 1,257,965 9.0 11.4 2.4
18. Total residential (%)................. 15.0 15.2 15.0 15.7 16.8 17.5 18.2 18.9 19.6
19. Conventional/conforming & all other 20.6 21.0 20.7 21.3 22.7 23.5 24.3 25.2 26.0
(%)......................................
Fannie + Freddie:
20. Retained portfolio:................... 360,574 424,353 481,135 671,104 866,243 1,056,212 1,262,388 1,483,449 1,732,911 23.0 20.9 -2.1
21. Total residential (%)................. 9.5 10.6 11.2 14.3 17.2 19.6 22.1 24.5 27.0
22. Conventional/conforming & all other 13.1 14.6 15.5 19.5 23.2 26.3 29.6 32.6 35.9
(%)......................................
23. Retained + guaranteed:................ 1,332,849 1,445,591 1,536,258 1,786,598 2,054,808 2,290,255 2,524,777 2,779,196 3,055,057 10.3 11.3 1.1
24. Total residential (%)................. 35.2 35.9 35.9 38.2 40.8 42.5 44.2 45.9 47.6
25. Conventional/conforming & all other 48.4 49.6 49.5 51.9 55.0 57.1 59.1 61.2 63.2
(%)......................................
26. Conventional/conforming only (%)...... 67.7 69.3 69.3 73.7 78.5 81.7 85.0 88.3 91.5
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Table 3-2 displays market share data in two ways: (1) the
respective mortgage portfolios of Fannie and Freddie as a percentage of
the market as a whole, and (2) those mortgage portfolios plus the
principal amount of the mortgage-backed securities that Fannie and
Freddie have guaranteed--again, as a percentage of the market as a
whole. We show those data separately for two reasons.
First, while there is no significant difference between the credit
risk of guaranteeing MBSs and the risk of holding whole mortgages,
there is a substantial difference in profitability. Fannie and Freddie
earn considerably more from retaining mortgages in their portfolios
than from receiving guarantee fees on MBSs. That is because they assume
an additional risk--interest-rate risk--when they retain mortgages.
Accordingly, as Fannie strives to meet Franklin Raines's forecast of 15
percent annual profitability growth, we would expect to see greater
proportional growth in its mortgage portfolio than in its guarantees of
MBSs.\7\ That differential is reflected in our projections.
---------------------------------------------------------------------------
\7\ Serious questions arise if Fannie and Freddie are now meeting
their growth objectives by purchasing MBSs that are already outstanding
in the market. If their purchases of MBSs are made in sufficient
amounts to increase prices and decrease yields on outstanding MBSs,
then Fannie and Freddie will be reducing the spread between their
borrowing costs and the yield they receive on their MBS portfolios.
That in itself will raise their risks. If their purchases do not
substantially affect yields in the MBS market, however, it is
questionable whether that activity has any salutary effect on mortgage
rates for homebuyers. Unless they can show such an effect, Fannie and
Freddie will be hard put to explain why that use of subsidized funds
qualifies as anything more than a strategy to maintain their targeted
earnings growth rate. Indeed, it seems unlikely that Fannie and
Freddie's purchases will appreciably influence MBS market yields. If
they reduce homebuyers' interest rates by only about 30 basis points
when they transfer two-thirds of their annual subsidy directly into the
mortgage markets, the indirect effect of their purchase of outstanding
MBSs in the $3 trillion MBS market should be even smaller.
---------------------------------------------------------------------------
Indeed, just such a trend is visible between 1995 and 1998, when
Fannie's mortgage portfolio grew by 18 percent (line 8), while its
total risk (mortgages plus MBSs it had guaranteed) increased by only
11.2 percent (line 11). We believe that trend will continue and will
become more pronounced from 1999 to 2003, with Fannie's portfolio of
mortgages increasing by 19.7 percent on an annualized basis during that
period.
We project a different trend for Freddie, which (starting at a much
lower base than Fannie) grew its portfolio at the unsustainable rate of
33.4 percent annually between 1995 and 1998. Since we are assuming that
for 1999 and the next 4 years Freddie will remain about two-thirds the
size of Fannie, we are projecting that Freddie will reduce the rate of
growth of its retained mortgage portfolio to 22.7 percent (line 14)--a
rate that will still be higher than Fannie's but will bring Freddie in
2003 to a position at which its retained mortgage portfolio will be
roughly 70 percent the size of Fannie's.
Second, making a distinction between mortgages retained in
portfolio and mortgages guaranteed through MBSs reveals that Fannie and
Freddie have only a limited range of options available to them. When
Franklin Raines predicted that Fannie Mae would reach 28 percent of the
total residential mortgage market in 2003 (line 12), he could have been
referring to substantial growth in Fannie's issuance of MBSs, with much
lower growth in the company's mortgage portfolio. However, when he
forecast that Fannie would double its profitability during that period,
he could only have been talking about a substantial increase in
Fannie's mortgage portfolio, since only by enlarging that portfolio can
a 28 percent market share be consistent with a 15 percent year-over-
year rate of profit growth.
Fannie's options are further limited by the fact that the GSEs are
permitted to purchase or guarantee only those mortgages with an initial
principal amount that (in 2000) does not exceed $252,700. As noted
above, that limitation essentially confines them to 74 percent of the
total residential market, which for ease of reference we shall call the
middle-class mortgage market. Accordingly, table 3-2 also shows the
growth in the GSEs' risk (mortgages and MBSs) as a proportion of that
market.
Those data indicate that by 2003, Fannie is likely to hold in its
portfolio 21 percent of all mortgages in that segment (line 10), and it
will have assumed the risk (through holding mortgages in its portfolio
or guaranteeing MBSs) of 37 percent of that market (line 13). In that
same year, Fannie and Freddie together will hold in their portfolios
about 36 percent of all middle-class mortgages outstanding (line 22),
and will bear the risk (through ownership of the underlying mortgages
or guarantees of MBSs) of 63 percent of that entire market segment
(line 25).
The numbers are even more dramatic if we consider only the
conventional/conforming portion of the market. In that case, by the end
of 1998, Fannie and Freddie had purchased and retained or guaranteed
almost 74 percent of all the conventional/conforming mortgages
outstanding (line 26). We project that by 2003 they will have assumed
the risk of virtually all these mortgages--91.5 percent. It is no
wonder, then, that Fannie and Freddie are advertising their efforts to
acquire loans in the subprime categories. They are making a virtue of
necessity, since their growth requirements leave them no choice.
Thus, if Fannie remains on the growth path forecast by Franklin
Raines and if Freddie keeps pace, by the end of 2003 they will hold in
their portfolios more than one-third of all middle-class residential
mortgages in the United States (line 22), and more than a quarter (line
21) of all residential mortgages of any kind. Moreover, if we include
their guarantees of MBSs, these two companies will be bearing the
credit and other risk that is associated with almost half of all the
mortgages outstanding (line 24), almost two-thirds of all middle-class
mortgages (line 25), and more than 91 percent of all conventional/
conforming mortgages (line 26).
In chapter 4 of this study, as those percentages suggest, we show
that Fannie and Freddie can meet their growth objectives in the years
ahead only by purchasing the riskier loans in the subprime, home
equity, and multifamily categories. There will simply not be a
sufficient amount of the higher quality, conventional/conforming
mortgages to meet their needs. So in addition to assuming a greater
degree of risk simply through their growth over the next 4 years, the
GSEs will also be increasing their overall risk by going more deeply
into the lower-quality sectors of the market that until now have been
served satisfactorily by non-subsidized lenders. We explore the nature
and possible consequences of the GSEs' growing risk profiles in chapter
6 of this study.
Also, as the GSEs move into the lower-quality market sectors they
have previously shunned, they will reduce the portfolio assets,
revenues, and profits of thousands of mortgage lenders now active in
that market. Although some might think that mortgage lenders will have
a choice whether to sell the mortgages they originate to Fannie and
Freddie, that is not really the case. Because the GSEs can offer lower
government supported rates for the mortgages they are willing to buy,
no lender can offer a competitive rate against another lender who is
willing to sell the resulting loan to Fannie or Freddie. Their lower
rates also permit Fannie and Freddie to skim the cream from the
mortgage markets, leaving other lenders with riskier loans to weaker
borrowers. That problem will become more severe as Fannie and Freddie
drive deeper into the subprime market.
In other words, if Fannie and Freddie are permitted to continue
their growth, even if they don't move outside the secondary mortgage
market itself, they will gradually strangle the other participants in
the mortgage markets. Those markets will become more concentrated and
less diverse than any other financial market in the United States and,
increasingly, an obligation of the Federal Government rather than of
the private sector. The impact on competition of Fannie and Freddie's
growth is discussed in detail in chapter 5 of this study.
4. growth
Table 4-1 presents data on the year-to-year growth in the mortgage
assets of Fannie Mae and Freddie Mac since 1995. The information for
the years 1995 through 1998 is taken from their financial statements;
the projections for the years 1999 through 2003 are derived from the
assumptions that were used in chapter 3 to project their asset totals
for those years.
The data show Fannie and Freddie's growth as a percentage of the
growth of: (1) the entire residential mortgage market (line 29); (2)
the conventional/conforming portion of the market (line 32); and (3)
the conventional/conforming plus ``all other'' portion of the market
(line 35).
By presenting the information in that way, we are able to show
that, as Fannie and Freddie grow in the year ahead, they will have to
drive deeper and deeper into the subprime loan categories in order to
find the assets their growth requires. Clearly, Fannie and Freddie
cannot continue to grow indefinitely by purchasing and guaranteeing
conventional/conforming mortgages. If the conventional/conforming loan
market grows at the same rate as the market as a whole in each of the
next 4 years, conventional/conforming mortgages outstanding will
increase by $720 billion. But to maintain their projected growth rates,
Fannie and Freddie will have to increase their mortgage investments and
guarantees by $1 trillion. At the end of 1998, they had retained in
their portfolios or guaranteed 74 percent of those loans, and we
project that by 2003 they will have retained or guaranteed almost 92
percent.
Thus, beginning in 1998, Fannie and Freddie together, to meet their
combined growth goals, were required to add new assets at a rate that
exceeded the growth in conventional/conforming mortgages that year.
Line 30 of table 4-1 shows that in 1998, the total amount of
conventional/conforming mortgage debt outstanding increased by $207
billion. But in that same year, Fannie and Freddie together added $250
billion in new mortgage assets and guarantees to their balance sheets,
so that their increase in mortgage credit risk was 121 percent of the
net increase in the conventional/conforming market (line 32). By 2003,
Fannie and Freddie's need for new assets will equal 146 percent of all
net new conventional/conforming loans.
Accordingly, unless they can break into the jumbo market through a
change in law, or out-compete Ginnie Mae for a substantial share of the
FHA-VA market, the only recourse for Fannie and Freddie is the subprime
market.
However, the subprime market, as its name implies, involves
considerably greater credit risk than does the conventional/conforming
market. By entering that market, Fannie and Freddie will be taking on
more risk than they have in the past--risk that may be only partially
compensated by the higher interest rates and guarantee fees those
mortgages generally yield. We cover that issue more fully in chapter 6.
TABLE 4-1.--GROWTH IN RESIDENTIAL MORTGAGES: FANNIE MAE AND FREDDIE MAC VERSUS THE MORTGAGE TOTALS, PAST, PRESENT, AND PROJECTED, 1995-2003
[Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
History (year-end) Projection (year-end) Annual Annual
------------------------------------------------------------------------------------------------------------ growth growth Growth
rate: rate: rate
1995 1996 1997 1998 1999 2000 2001 2002 2003 1995-1998 1998-2003 difference
(%) (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
27. Annual growth in residential mortgage market-- 227,070 251,517 397,925 373,059 352,541 323,330 342,730 363,294 32.4 -1.8 -34.2
total............................................
28. Growth in GSE portion......................... 112,742 90,667 250,340 268,210 235,447 234,522 254,420 275,861 49.0 2.0 -47.1
29. GSE portion of total (%)...................... 49.7 36.0 62.9 71.9 66.8 72.5 74.2 75.9
30. Growth in conventional/conforming--total...... 118,076 130,789 206,921 193,991 183,321 168,132 178,220 188,913 32.4 -1.8 -34.2
31. Growth in GSE portion......................... 112,742 90,667 250,340 268,210 235,447 234,522 254,420 275,861 49.0 2.0 -47.1
32. GSE portion of total (%)...................... 95.5 69.3 121.0 138.3 128.4 139.5 142.8 146.0
33. Growth in conventional/conforming & all other 161,945 186,473 338,882 295,077 279,580 256,987 272,915 289,814 44.7 -3.1 -47.7
mortgages--total.................................
34. Growth in GSE portion......................... 112,742 90,667 250,340 276,079 236,348 235,420 255,394 276,917 49.0 2.0 -47.0
35. GSE portion of total (%)...................... 69.6 48.6 73.9 93.6 84.5 91.6 93.6 95.5
36. Nominal GDP--4th quarter...................... 7,529,300 7,981,400 8,453,000 8,947,600 9,394,980 9,864,729 10,357,965 10,875,864 11,419,657 5.9 5.0 -0.9
37. GDP annual growth rate (%).................... 6.0 5.9 5.9 5.0 5.0 5.0 5.0 5.0
38. Assumed growth rate after 1998 (%)............ 5.0
39. Total mortgages outstanding/GDP (%)........... 50.3 50.3 50.5 52.1 53.6 54.6 55.1 55.7 56.2
40. Change in mortgage/GDP ratio (%).............. 0.6 0.0 0.2 1.7 1.5 1.0 0.5 0.5 0.5
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
5. threat to private-sector competitors
Since Fannie and Freddie are growing faster than the mortgage
market itself, their growth comes from taking market share, revenue,
and profits from genuinely private-sector mortgage lenders. As shown
earlier, to maintain the rate of profit growth on which their stock
price depends, Fannie and Freddie must encroach further and further on
the private sector. Although they had previously concentrated on the
best and most creditworthy loans within the conventional/conforming
sector--leaving to the banks, S&Ls, and other non-subsidized lenders
the subprime, home equity, and multifamily loans that represent greater
default risks--they are now compelled to wade into that market and
begin to take market share from the companies that are already there.
The figures in table 3-2 illustrate quite well the problem that
confronts Fannie and Freddie's private sector competitors. As shown by
line 22, the GSEs' share of all residential mortgages (conventional/
conforming and ``all other'') will grow from 19.5 percent at the end of
1998 to almost 36 percent at the end of 2003. That increase of 16.4
percentage points would equal approximately $800 billion, or 12.4
percent of the aggregate principal amount of all mortgages outstanding
at the end of 2003. In other words, in 4 years, $800 billion in
principal amount of mortgages--which would otherwise be in the
portfolios of private-sector lenders now operating in those markets--
will instead be in the portfolios of Fannie and Freddie. That will
substantially reduce the mortgage supply for the lenders now in the
market, and will force many of them to leave the mortgage lending
business entirely.
In effect, the growth of Fannie and Freddie is leading to a steady
nationalization of the residential mortgage markets in the United
States, without any debate--or even apparent awareness--by Congress.
As shown by lines 29, 32, and 35 of table 4-1, Fannie and Freddie
must take most of the growth in mortgages outstanding if they are to
meet their market share, revenue, and earnings growth objectives. Since
they cannot meet their needs for product solely out of the
conventional/conforming mortgages that will come to market between 1999
and 2003, they must look elsewhere for product.
One easy target would be the jumbo market, which will become
available if Congress can be induced to eliminate the ceiling on
conventional/conforming mortgages. Opening the door for Fannie and
Freddie to enter the jumbo mortgage market would, by 2003, give them
access to almost $1 trillion of mortgages that are now off-limits.
Other mortgage markets beckon to Fannie and Freddie, including
those to be accessed by dipping deeper into the subprime loan pool and
assuming the higher credit risks associated with those loans; by
expanding more aggressively into the financing of multifamily housing
designed for renters, not homeowners; and by acquiring home equity
loans in addition to first mortgages. But those can be merely stopgaps.
Our projections extend only through 2003; if the growth of Fannie and
Freddie continues beyond that year at the rate Frank Raines has
forecast, they will at some point acquire all the available residential
mortgage product in the United States. As the practical limits of the
residential mortgage market are reached, one can easily envision Fannie
and Freddie arguing that they should extend their skills and cost
advantages into the commercial mortgage market. After all, many office
building and shopping center owners would welcome the taxpayer subsidy
Fannie and Freddie can deliver.
Fannie and Freddie's other opportunity for growth outside the
residential mortgage market is to provide financial services generally,
especially consumer credit services. Home equity loans, for example,
provide a ready entry into consumer financial services. Once the GSEs
hold a home equity loan, they have the opportunity to use it as a
revolving loan fund with which Fannie and Freddie would be able to
supply credit directly to the homeowner/borrower. Although in one sense
that might be considered loan origination, such a determination would
have to be made by the Department of Housing and Urban Development
(HUD)--which in the past has shown little appetite for challenging
Fannie and Freddie's expansion. If in fact that activity goes
unchallenged by HUD, the GSEs could become very large sources of
consumer credit, and through their implicit government subsidy they
would be able to offer consumers better rates than banks and other
consumer lenders.
Perhaps the greatest competitive threat, however, remains in the
mortgage origination process. Although Fannie and Freddie vigorously
deny that they have any intention to originate mortgages, pointing out
that they lack the statutory authority to do so, what exactly
constitutes origination of a mortgage is a matter of interpretation. If
Fannie and Freddie were to open their automated underwriting facilities
to direct borrower access over the Internet, it might be possible for
them to provide the prospective homebuyer with a certification that his
or her mortgage would qualify for purchase by Fannie or Freddie. At
that point, the actual lender would have little to do except to perform
the ministerial acts necessary to fund the loan and deliver it to one
or another of the GSEs. The compensation for that role would, of
course, be small.
In a November 1999 speech to securities analysts, Leland Brendsel,
the chairman of Freddie Mac, referred in rather vague terms to major
changes in the offing for the mortgage market:
I can safely predict that within a few short years, the mortgage
industry will change dramatically. When the dust settles in the
mortgage market, we will be left with an industry structure where
investor funds flow to consumers with little drag from antiquated,
inefficient processes. Consumers will be able to tap global capital
markets at even lower cost than they can today.
And later in the same statement he was even more explicit. Citing
the potential of technology ``to streamline the entire mortgage process
and eliminate inefficiency in the housing finance system,'' he
continued:
Freddie Mac has brought tremendous efficiency to the mortgage
market, but the industry still generates significant costs from
redundant operations and expensive transfer of information through all
the steps in the mortgage process. As technology wrings out remaining
inefficiencies, Freddie Mac's role will be enhanced, as we deliver low-
cost funds to consumers even faster and more effectively.
There can be little doubt that Mr. Brendsel was describing a
mortgage industry in which, through technology, Freddie Mac would be
dealing directly with borrowers and perhaps with consumers generally.
6. risks
It is impossible to understand the risks that Fannie and Freddie
create for the government and taxpayers without understanding their
similarities to the S&Ls that collapsed at the end of the 1980's. Like
the S&Ls,
their principal investments are home mortgages, long-term
assets that can abruptly become short-term assets when a home is sold
or refinanced;
they can borrow at government-assisted rates that do not
substantially increase as they take on more risk;
they are unable to manage risk through asset
diversification because virtually all their assets are home mortgages.
But Fannie and Freddie are like 1980's S&Ls in another significant
way. Scholars reviewing the S&L collapse have shown that it came about
in substantial part because the industry was seeking high profits in
order to recover the capital depleted by losses during the high-
interest-rate period at the beginning of the 1980's. To achieve that
profitability, through a process ultimately called ``gambling for
resurrection,'' the S&Ls reached for greater and greater risk. Although
the debt market usually requires much higher interest rates from
companies that are taking on increased risk--if those companies can
access the debt market at all--that was not true for the S&Ls. Because
their deposits were backed by the government, weak and failing S&Ls
were able to raise the necessary funds to keep on gambling--ultimately
causing immense losses to the government and the taxpayers.
Of course, Fannie and Freddie are not weak companies, and they have
no need to take risks to restore their capital. But they have strong--
indeed, compelling--reasons to continue increasing their profitability.
That circumstance creates the same incentives to take on risk that the
managements of weak S&Ls confronted fifteen years ago.
The incentives are clear. Fannie and Freddie are public companies;
their shares are listed on the New York Stock Exchange and are closely
monitored by the investment community. The value that investors place
on their stock at any given moment is not only a vote on their earnings
growth prospects and the quality of their management, but also directly
affects management's compensation. Like the managements of most large,
publicly held companies, the managements of Fannie and Freddie are
compensated in part through stock options, which in turn acquire
increasing value only if the price of their stock increases.
That creates a strong incentive for the managements of the GSEs,
like those of conventional private firms, to increase their profits and
to impress investors with their potential for profit growth. For
example, at the Merrill Lynch investor conference in September 1999,
Fannie Mae chairman Franklin Raines projected that Fannie Mae would
achieve annual earnings growth of 15 percent in 1999 and over the next
4 years. But profit growth at that rate is highly unusual. Fannie
already boasts that it is one of only eight companies in the S&P 500
that can claim to have had a double-digit rate of earnings growth for
twelve straight years. Continuing that growth in profitability--and
indeed increasing it--would be extraordinary for any company in today's
low-inflation environment.
We can only speculate why Mr. Raines would place such a burden on
himself and his management. Possibly it is because he wants to be seen
as a highly capable manager, or he feels an obligation to match the
success of his predecessors. However, the fact that his compensation
and that of the top managers at Fannie Mae are tied to increases in
Fannie's stock price also provides a substantial incentive to impress
the financial markets.
Once we look at Fannie and Freddie as gigantic S&Ls that are
seeking an almost unprecedented rate of profitability growth, we can
begin to see why they create risks for the government and the taxpayers
that parallel the risks created by the S&Ls in the 1980's. Because of
their government backing, they are essentially exempt from debt market
discipline--just like the insured S&Ls of the 1980's.
The incentives may be different, but the objectives are the same--
to increase profitability by issuing debt at a government-backed rate,
while achieving higher profitability through taking on greater risk. In
the 1980's, S&Ls tried to do that to replenish their capital; Fannie
and Freddie are doing it to maintain the profit growth that sustains a
growing market valuation of their stock.
To be sure, Congress has attempted to address the question of GSE
risk, using the familiar device of a regulatory agency. In 1991,
Congress established the Office of Federal Housing Enterprise Oversight
(OFHEO), a regulatory agency charged with supervising the GSEs the way
banking regulators supervise banks and S&Ls. Given the experience of
the 1980's--not only with the S&Ls but with banks themselves--we should
be skeptical about the effectiveness of regulators in controlling the
risks of the companies they regulate.
For one thing, there is always the question of asymmetric
information--the regulated company knows more than its supervisor about
the risks it is taking on. For another, as demonstrated in the case of
the S&L industry, the regulated companies frequently have more power to
influence Congress than has the regulatory agency, and they are
frequently successful in limiting the agency's resources. It is useful
to recall that Congress repeatedly supported the S&L industry's efforts
to avoid regulatory restriction on its activities. As it happens, in
the case of OFHEO, that phenomenon was clearly demonstrated in 1999,
when a Senate committee initially capped OFHEO's appropriation at the
previous year's $16 million level--despite an administration request
for a 20 percent increase. Although an increase to $19 million was
ultimately voted, the special effort that was required sent a signal to
OFHEO about how much congressional support it will receive if it
seriously attempts to control Fannie and Freddie's behavior.
Even without those negative signals, there are good reasons to
believe that OFHEO will not act to reduce the GSEs' risk-taking. For
example, if Fannie or Freddie's capital ratios slipped too low, OFHEO
could direct the troubled GSE to reduce its assets as part of a plan to
strengthen its capital position. Shrinkage, however, implies that the
GSE in question would sharply reduce its buying and guaranteeing of
mortgages. It might even be required to sell assets. That would improve
its capital ratios, but the cutback and asset sales could force an
increase in mortgage interest rates and a sudden, sharp reduction in
housing construction, with secondary effects throughout the economy.
The possibility that there might be severe macro-economic
consequences as a result of an OFHEO regulatory action should raise
both systemic--risk concerns about OFHEO's new capital regulations and
doubts about the likelihood that they will ever be effectively applied.
If OFHEO's capital regulations are believed to threaten severe
macroeconomic consequences--and certainly Fannie and Freddie will not
be shy about pointing that out--it is easily foreseeable that Congress
will act to prevent the enforcement of the regulations. That example,
not at all far-fetched, suggests how difficult it will be for OFHEO to
be an effective source of discipline over Fannie and Freddie. And
without OFHEO, there is effectively no means of controlling their risk-
taking.
Nevertheless, OFHEO has proposed a regulation intended to control
the riskiness of Fannie and Freddie--including a risk-based capital
requirement that imposes capital penalties when risks are not
adequately hedged. Undoubtedly, Fannie and Freddie will cite those
regulations as a basis for quelling congressional concerns. The
question, however, is whether it is reasonable to believe that Fannie
and Freddie can achieve the extraordinary rates of growth they are
projecting while keeping their risks within tolerable levels. If they
do so, they will be unusual companies indeed.
The GSEs' sagging stock prices demonstrate that Wall Street is
skeptical on that score. As shown on lines 52 and 55 of table 6-1, both
GSEs have experienced a significant decline, per dollar of portfolio
investment, since 1995. We project that that trend will continue
through 2003. On January 12, 2000, Fannie's common stock closed 20
percent below its twelve-month high, while Freddie closed down a more
troubling 28 percent for the same period. That development seems to be
puzzling to Fannie Mae chairman Raines, who asked at the Merrill Lynch
conference, ``So why does the market trade Fannie Mae at a discount to
the other companies with similar growth rates?''
There are two possible reasons.
First, some investors may have recognized that Fannie and Freddie
are simply running out of room to grow by purchasing the high-quality
conventional/conforming mortgages that have been their traditional
assets, and that the cost of hedging the risks of lower-quality product
may reduce their profitability.
Second, and more ominously, Fannie and Freddie's lagging stock
prices may reflect a growing concern in the equity markets that the
GSEs are not adequately hedging their risks, so that their future
earnings may be hit by losses on the riskier mortgages they are
purchasing or guaranteeing today.
In addition to their inherent lack of diversification, Fannie and
Freddie face a number of other risks as guarantors of MBSs and as
holders of large portfolios of mortgages and MBSs. Those risks include
credit risk, interest-rate risk, counter-party risk, and spread-
compression risk, all of which are discussed more fully below. As we
will show, each of those risks can be reduced or hedged, but doing so
is costly and will inevitably reduce Fannie and Freddie's
profitability. To compensate for those costs--while trying to maintain
and surpass their past levels of profitability--they must take on still
more risk, always keeping one step ahead of their regulator.
Credit Risk. In common with all housing lenders, the GSEs have
enjoyed a substantial decline in their credit losses in recent years.
Fannie's pre-tax losses, per mortgage dollar owned or guaranteed,
dropped from 5.3 basis points in 1996 to 2.9 basis points in 1998
(table 6-2, line 59); Freddie's pre-tax credit losses dropped from 10.5
basis points in 1996 to 5.1 basis points in 1998 (line 65).
But the housing market is historically volatile, and it regularly
passes through boom and bust periods related to national economic
conditions, interest rates, and other factors. Completely exogenous
factors--an example might be a change in the tax system that alters the
deductibility of mortgage interest in a significant way--could have
seriously adverse effects, for which the participants have no effective
way to prepare. It is important to keep in mind that Fannie and Freddie
will be more exposed to the risks of the housing market than any
lenders in history, since their already unprecedented market shares
will--as discussed earlier in this study--grow even larger in the
future.
TABLE 6-1.--FANNIE MAE AND FREDDIE MAC NET INCOME BY LINE OF BUSINESS, PAST, PRESENT, AND PROJECTED, 1995-2003
[Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
History (year-end) Projection (year-end) Annual Annual
------------------------------------------------------------------------------------------------------------ growth growth Growth
rate: rate: rate
1995 1996 1997 1998 1999 2000 2001 2002 2003 1995-1998 1998-2003 difference
(%) (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Net income by line of business (basis points):
Fannie Mae:
41. Portfolio investment.................. 1,369 1,694 1,894 1,878 2,219 2,621 2,988 3,346 3,702 11.1 14.5 3.4
42. Credit guarantee...................... 1,003 1,031 1,162 1,540 1,583 1,661 1,770 1,872 1,973 15.4 5.1 -10.3
43. Total................................. 2,372 2,725 3,056 3,418 3,802 4,282 4,758 5,218 5,675 12.9 10.7 -2.3
44. Federal tax rate (%).................. 28.0 29.5 29.3 25.9
Freddie Mac:
45. Portfolio investment.................. N.A. 785 892 1,021 1,305 1,591 1,857 2,116 2,372 14.0 18.4 4.3
46. Credit guarantee...................... N.A. 458 503 679 751 760 793 819 841 21.8 4.4 -17.4
47. Total................................. 1,091 1,243 1,395 1,700 2,055 2,352 2,650 2,935 3,213 15.9 13.6 -2.4
48. Federal tax rate (%).................. 31.2 30.0 29.0 27.8
Fannie + Freddie:
49. Portfolio investment.................. N.A. 2,479 2,786 2,899 3,524 4,212 4,846 5,462 6,074 8.1 15.9 7.8
50. Credit guarantee...................... N.A. 1,489 1,665 2,219 2,333 2,422 2,563 2,691 2,814 22.1 4.9 -17.2
51. Total................................. 3,463 3,968 4,451 5,118 5,857 6,634 7,409 8,153 8,888 13.9 11.7 -2.2
Net income per $ of business (basis points):
Fannie Mae:
52. Portfolio investment.................. 62.8 62.8 51.3 47.0 45.0 43.0 41.0 39.0
53. Credit guarantee \1\.................. 13.3 14.0 16.9 14.0 13.0 12.5 12.0 11.5
54. Total................................. 34.0 35.3 35.1 33.6 33.5 33.6 33.4 33.1
Freddie Mac:
55. Portfolio investment.................. 63.9 59.0 48.6 44.0 42.0 40.0 38.0 36.0
56. Credit guarantee \1\.................. 7.9 8.2 10.2 9.5 8.5 8.0 7.5 7.0
57. Total................................. 21.1 22.3 24.7 26.0 26.3 26.7 26.9 26.7
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Assumes no credit risk on GSE/government-guaranteed debt held in portfolio.
N.A. = Not available.
Obviously, credit risk is closely related to conditions in the
general economy. In recent years, a sustained economic expansion, soon
to be the longest in U.S. history, has brought unemployment to record
lows while boosting incomes. Both of those factors have led to a steady
rise in housing prices. Rising prices in turn have given homeowners
more equity in their homes, which protects mortgage lenders and
guarantors, notably Fannie and Freddie. However, an economic down-turn
could depress housing prices while causing a jump in mortgage
delinquencies as the unemployment rate rises. Mortgage foreclosures
would increase, substantially raising Fannie and Freddie's credit
losses.
As Fannie and Freddie are also diving deeper into the pool of
subprime mortgages, they will be in largely uncharted waters. Although
Fannie and Freddie claim that technology has greatly increased their
loan-underwriting capabilities, thereby lowering their risks in sub-
prime lending, that assertion has not been tested by a recession.
Further, because of lower down payments from more financially
challenged borrowers on properties that may not hold their values well
during an economic downturn, losses on subprime lending could be much
higher than on higher-quality loans.
Unlike their deep knowledge of and databases on conventional/
conforming loans, the GSEs' relative inexperience with the subprime
market makes their judgments concerning the risks they are assuming
much less sure. Thus, Fannie and Freddie face not only higher likely
losses in subprime loans per dollar lent or guaranteed but also greater
uncertainty as to how high those losses will be. To cover their risks
in those cases, Fannie and Freddie have in the past relied in part on
private mortgage insurance, but recently they have been exploring
various devices that would enable them to assume more of the mortgage
insurer's risk and thus keep more of the profit for themselves. That is
consistent with their desire to increase their profits, but obviously
it will also increase their risks of loss in the event of a market
turndown.
TABLE 6-2.--CREDIT-RELATED EXPENSES FOR FANNIE MAE AND FREDDIE MAC, 1995-
1998
------------------------------------------------------------------------
History (year-end)
-------------------------------------------
1995 1996 1997 1998
------------------------------------------------------------------------
Fannie Mae:
58. Pre-tax credit- 409 375 261
related expenses ($, in
millions)..............
59. Pre-tax credit cost 5.3 4.5 2.9
(B.P.).................
60. Credit guaranty tax 31.4 31.1 24.3
rate (%)...............
61. After-tax credit 281 258 198
cost ($, in millions)..
62. After-tax credit 3.6 3.1 2.2
cost (B.P.)............
63. Credit income before 16.9 17.1 19.1
credit expense (B.P.)..
Freddie Mac:
64. Pre-tax credit- 608 529 342
related expenses ($, in
millions)..............
65. Pre-tax credit cost 10.5 8.6 5.1
(B.P.).................
66. Credit guaranty tax 28.2 28.4 28.2
rate (%)...............
67. After-tax credit 437 379 246
cost ($, in millions)..
68. After-tax credit 7.5 6.2 3.7
cost (B.P.)............
69. Credit income before 15.4 14.4 13.9
credit expense (B.P.)..
70. Difference: line 63 1.5 2.7 5.2
1 line 69 (B.P.).......
Fannie Mae ($, in 22,200 29,200 43,200 83,600
millions)..........
% of total 8.8 10.2 13.6 20.1
portfolio......
Freddie Mac ($, in 7,665 10,056 12,567 29,817
millions)..........
% of total 7.1 7.3 7.6 11.7
portfolio......
------------------------------------------------------------------------
B.P. = Basis points. 1 B.P. = .01%.
Memoranda data--government/GSE securities in portfolio. They presumably
have no credit risk.
Finally, Fannie is seeking substantial loan growth in the
multifamily housing market, specifically to meet affordable housing
goals. Multifamily mortgages can be much riskier than those for owner-
occupied, single-family homes, as Freddie learned to its regret a few
years ago, because tenant income is more vulnerable to economic
downturns and rental property deterioration can be more severe than
owner-occupied housing.
Credit-guarantee fees, per dollar of risk assumed, declined during
1999 for both Fannie and Freddie, reflecting lower credit costs as well
as increased competition between them for the business of large
mortgage originators. A decline in fees is probably only the visible
portion of the competition between the GSEs for that business. It is
likely that they are also placing their guarantees on MBSs that are
backed by somewhat riskier pools of mortgages, for which they are also
attempting to assume more of the risk previously taken by mortgage
insurers. A sharp and largely unpredictable upswing in credit losses a
few years hence could therefore result in substantial losses in their
guarantee business.
Interest-Rate Risk. Fannie and Freddie's potential interest-rate
risk is growing rapidly as they grow their mortgage portfolios. Those
portfolios consist of both whole mortgages and MBSs. In just twenty-one
months, from the end of 1997 to September 30, 1999, Fannie increased
its mortgage investments by 59 percent, or $188 billion; Freddie's
increase was 91 percent, or $150 billion.
Like the S&Ls before them, Fannie and Freddie are heavily dependent
on short-term funding to finance the long-term, fixed-rate mortgages
they own. That is the classic borrow-short-to-lend-long strategy that
S&Ls pursued, with disastrous consequences, when interest rates
skyrocketed in the early 1980's. On September 30, 1999, 41 percent of
Fannie's debt matured within 1 year. Freddie was worse off on that
date, with 51 percent of its debt due within 1 year. The two GSEs have
tried to lessen their maturity mismatching through various devices,
such as callable debt and interest-rate hedging. But such devices are
costly, as discussed below, and their extensive use will reduce the
GSEs' profitability.
Theoretically, Fannie and Freddie can minimize their interest-rate
risk in two ways. First, they can ``match fund'' their mortgage
portfolios. That is, they can sell debt that matches the maturity of
their mortgage investments. Maturity matching is complicated, though,
by mortgage prepayments, which are not as predictable as risk managers
would like. Because the ease and cost of mortgage refinancing have come
down in recent years, mortgage prepayments accelerate dramatically
whenever longer-term interest rates decline even moderately.
Prepayments create a maturity mismatch because longer-term funding
now exceeds longer-term assets. To some extent, Fannie and Freddie can
neutralize maturity mismatching by issuing debt that can be called, or
repaid, before maturity. But callable debt carries a higher interest
rate than non-callable debt, so Fannie and Freddie pay a price for that
form of interest-rate risk protection.
The reverse form of interest-rate risk occurs when interest rates
rise. In that case, there is likely to be a sharp slowdown in home
sales and mortgage refinancing, so that low-rate mortgages remain on
the GSEs' books longer than anticipated and have to be supported with
higher-rate liabilities. That can result in substantial losses or
profit reduction and is exactly what happened to the S&L industry when
interest rates spiked in the late 1970's and early 1980's.
Second, Fannie and Freddie have reduced their exposure to higher
rates through the use of various financial derivatives, largely
interest-rate swaps. That is, for a fee, the two GSEs shift some of
their interest-rate risk to third parties. That practice enables them
to increase their reliance on cheaper short-term funding. But
derivatives can be costly, particularly when interest-rate volatility
causes significant changes in the shape of the interest-rate yield
curve.
Counterparty Risk. Hedging interest-rate risk through derivatives
raises a separate risk--counterparty risk, which is essentially a form
of credit risk. That is, will the counterparty be able to pay when
called on to do so under a swap agreement or other form of derivative
contract? Counterparty-risk assessment is not a simple process, though,
particularly when the counterparty is another financial institution
that has entered into many other financial contracts.
The increasing challenge Fannie and Freddie face as they grow
larger is finding sufficient counterparty capacity among highly rated
potential counterparties: that is, firms with AAA or AA credit ratings.
At the end of 1998, 32 percent of Fannie's counterparty risk was with
entities rated less than AA; 7 percent of its counterparty risk was
with entities rated less than A. Freddie is less forthcoming about its
counterparty risk, merely stating that at the end of 1998, its five
largest counterparties, which accounted for 60 percent of its total
counterparty exposure, were rated at least A+. Consequently, as Fannie
and Freddie's risk-hedging needs grow, they may have to pay steadily
higher fees for a given amount of protection while relying increasingly
on less creditworthy counterparties.
Spread-Compression Risk. In terms of their desire to maintain their
profitability, the most serious risk the two GSEs now confront is
spread compression: that is, a narrowing of their interest margins.
Spread compression has become quite evident at both companies, as
reflected in the net income they earn on their portfolio investments
per dollar of investment. In 1996, Fannie's net income (excluding the
cost of credit risk) per dollar of portfolio investment was 62.8 basis
points (table 6-1, line 52); for the first half of 1999, that profit
margin had declined to 49.3 basis points. Freddie has experienced a
similar reduction--its net income, per dollar of portfolio investment,
declined from 63.9 basis points in 1996 (table 6-1, line 55) to 46.6
basis points during the first half of 1999. During the third quarter of
1999, Freddie's interest margin declined seven points from the second
quarter, which suggests that its net income per dollar of portfolio
investment declined again.
Spread compression is occurring for two reasons. First, as Fannie
and Freddie continue to grow, their sheer size and the demands they
impose on the financial markets will force up their cost of obtaining
credit and interest-rate protection, per dollar of protection obtained.
Second, Fannie and Freddie's purchases of mortgages and MBSs will drive
up mortgage prices, thereby reducing mortgage yields, as their mortgage
portfolio growth reaches and then exceeds the growth in those portions
of the mortgage market where they can lawfully participate. That spread
compression will negatively affect Fannie and Freddie's earnings growth
and return on equity capital. For Fannie, those data will be found in
table 6-1, line 43, and table 6-3, line 85; the comparable data for
Freddie are in table 6-1, line 47, and table 6-3, line 100. Lower
mortgage and MBS yields in the face of rising risk-protection costs
will squeeze Fannie and Freddie's net interest margins. Unless they can
trim their operating costs to fully offset that squeeze, which is
unlikely, they will experience even less net income per dollar of
portfolio investment. That decline will lower their return on equity
capital and slow their earnings growth. In the face of that inevitable
spread compression, Fannie and Freddie's managements will
understandably be tempted to take greater risks--specifically, greater
credit risk and increased interest-rate risk.
TABLE 6-3.--FANNIE MAE AND FREDDIE MAC CAPITAL REQUIREMENTS, PAST, PRESENT, AND PROJECTED, 1995-2003
[Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
History (year-end) Projection (year-end) Annual Annual
------------------------------------------------------------------------------------------------------------ growth growth Growth
rate: rate: rate
1995 1996 1997 1998 1999 2000 2001 2002 2003 1995-1998 1998-2003 difference
(%) (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Fannie Mae:
71. Core capital (OFHEO-defined).............. 10,959 12,773 13,793 15,465 18,668 22,109 25,811 29,456 33,602 12.2 16.8 4.6
72. Required minimum capital.................. 10,451 11,466 12,703 15,334 18,168 21,359 24,811 28,456 32,602 13.6 16.3 2.7
73. Core-required minimum..................... 508 1,307 1,090 131 500 750 1,000 1,000 1,000
74. Mortgage portfolio (net).................. 252,588 286,259 316,316 415,223 528,811 635,882 754,006 877,960 1,020,492 18.0 19.7 1.7
75. Other assets.............................. 63,962 64,782 75,357 69,791 61,007 73,360 86,987 101,287 117,730 2.9 11.0 8.1
76. Total assets on B/S....................... 316,550 351,041 391,673 485,014 589,818 709,242 840,993 979,247 1,138,222 15.3 18.6 3.3
77. Other assets/total assets (%)............. 20.2 18.5 19.2 14.4 10.3 10.3 10.3 10.3 10.3
78. Calculated minimum capital: Assets on B/S 7,914 8,776 9,792 12,125 14,745 17,731 21,025 24,481 28,456 15.3 18.6 3.3
(2.5%).......................................
79. MBS, other off-B/S (.45%)................. 2,310 2,467 2,606 2,867 3,060 3,201 3,290 3,406 3,495 7.5 4.0 -3.4
80. Other capital requirement................. 228 223 305 342 363 427 496 569 652 14.5 13.8 -0.7
81. Other/total capital required (%).......... 2.2 1.9 2.4 2.2 2.0 2.0 2.0 2.0 2.0
82. After-tax income for dividends, stock buy- 911 2,036 1,746 599 841 1,056 1,573 1,529
backs, other.................................
83. Net income (%)............................ 33.4 66.6 51.1 15.7 19.6 22.2 30.1 26.9
84. Dividend payout rate (%) \1\.............. 31.5 30.9 30.9
85. After-tax return on core capital, before 23.0 23.0 23.4 22.3 21.0 19.9 18.9 18.0
preferred dividends (%)......................
Freddie Mac:
86. Core capital (OFHEO-defined).............. 5,829 6,743 7,376 10,715 12,229 14,728 17,248 20,019 23,062 22.5 16.6 -5.9
87. Required minimum capital.................. 5,584 6,517 7,082 10,333 11,829 14,228 16,748 19,519 22,562 22.8 16.9 -5.9
88. Core-required minimum..................... 245 226 294 382 400 500 500 500 500
89. Mortgage portfolio (net).................. 107,424 137,520 164,250 255,348 337,432 420,329 508,383 605,489 712,419 33.5 22.8 -10.7
90. Other assets.............................. 29,757 36,346 30,347 66,073 37,492 46,703 56,487 67,277 79,158 30.5 3.7 -26.8
91. Total assets on B/S....................... 137,181 173,866 194,597 321,421 374,924 467,632 564,870 672,766 791,577 32.8 19.8 -13.1
92. Other assets/total assets (%)............. 21.7 20.9 15.6 20.6 10.0 10.0 10.0 10.0 10.0
93. Calculated minimum capital: Assets on B/S 3,430 4,347 4,865 8,036 9,373 11,676 14,122 16,819 19,789 32.8 19.8 -13.1
(2.5%).......................................
94. MBS, other off-B/S (.45%)................. 2,066 2,129 2,142 2,153 2,289 2,352 2,391 2,425 2,455 1.4 2.7 1.3
95. Other capital requirement................. 89 42 75 145 167 200 236 275 318 17.7 17.0 -0.7
96. Other/total capital required (%).......... 1.6 0.6 1.1 1.4 2.0 2.0 2.0 2.0 2.0
97. A-T income for dividends, stock buy-backs, 329 762 (1,639) 542 (148) 131 164 170
other........................................
98. Net income (%)............................ 26.5 54.6 196.4 26.4 16.3 4.9 5.6 5.3
99. Dividend payout rate (%) \1\.............. 26.0 26.5 26.3
100. After-tax return on core capital, before 19.8 19.8 18.8 17.9 17.4 16.6 15.8 14.9
preferred dividends (%)......................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Common + preferred dividends as a percentage of net income.
B/S = balance sheet.
That temptation is troubling, given their extremely thin capital
cushions. Under existing regulations, Fannie and Freddie must have, at
a minimum, equity capital (common stock, permanent preferred stock,
paid-in capital, and retained earnings) equal to 2.5 percent of on-
balance-sheet assets plus .45 percent of outstanding MBS and other off-
balance-sheet obligations. The on-balance-sheet capital ratio is one-
half the leverage capital ratio equired for commercial banks considered
to be well capitalized for regulatory purposes. Worse, as is clear from
table 6-3, lines 73 and 88, Fannie and Freddie operate much closer to
their minimum capital ratio requirement than is generally true for
well-capitalized banks, which generally have risk-based capital of 10
percent. Therefore, increased risk-taking, which might not be
immediately evident to regulators and stock market analysts, could set
up either company--or both--for serious financial difficulties.
Systemic Risk. As Fannie and Freddie continue to grow, they will
pose increased systemic risk to the U.S. financial markets. They had
$866 billion of debt outstanding as of September 30, 1999. By the end
of 2003, that amount will increase by almost $1 trillion, rising to
$1.8 trillion (table 6-4, line 105). At that point, or shortly
thereafter, the combined debt of the two GSEs may exceed the Treasury
debt held by the general public--if budget surpluses continue to shrink
the amount of Treasury debt outstanding.
Recently, Fannie and Freddie have been attempting to emphasize the
similarity of their debt to Treasury securities, by mimicking
Treasury's frequent, regular issuances of new debt. Indeed, at one
point Fannie Mae's website contained the statement that its debt
securities ``will often provide investors with a spread pickup to the
Treasury structure.'' In other words, investors can receive
substantially the same security as Treasury debt with an interest-rate
premium. If those marketing efforts are successful, actual losses at
either of the GSEs--or a perception in the markets of a sudden increase
in their riskiness--could result in a serious systemic problem for the
economy as a whole.
TABLE 6-4.--FANNIE MAE AND FREDDIE MAC INTEREST-BEARING DEBT OUTSTANDING, PAST, PRESENT, AND PROJECTED, 1995-2003
[Dollars, in millions]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
History (year-end) Projection (year-end) Annual Annual
------------------------------------------------------------------------------------------------------------ growth growth Growth
rate: rate: rate
1995 1996 1997 1998 1999 2000 2001 2002 2003 1995-1998 1998-2003 difference
(%) (%)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Fannie Mae:
101 Interest-bearing debt O/S................. 299,174 331,270 369,774 460,291 560,327 673,780 798,943 930,285 1,081,311 15.4 18.6 3.2
102 O/S debt as percentage of total assets.... 94.5 94.4 94.4 94.9 95.0 95.0 95.0 95.0 95.0
Freddie Mac:
103 Interest-bearing debt O/S................. 119,328 156,491 172,321 287,234 337,432 420,329 508,383 605,489 712,419 34.0 19.9 -14.1
104 O/S debt as percentage of total assets.... 87.0 90.0 88.6 89.4 90.0 90.0 90.0 90.0 90.0
105 Total O/S interest-bearing Fannie and 418,502 487,761 542,095 747,525 897,759 1,094,109 1,307,326 1,535,774 1,793,730 21.3 19.1 -2.2
Freddie debt.................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
O/S = outstanding.
Despite their efforts to present their securities as substitutes
for Treasury securities, Fannie and Freddie are not the Treasury. Their
securities are only implicitly backed by the U.S. government; they do
not carry the full-faith-and-credit promise of the United States.
Indeed, the GSEs' securities are by statute required to state that they
are not obligations of the United States. They are able to obtain
favorable financing because the markets do not believe--given the GSEs'
many connections with the U.S. government--that they will be allowed to
fail.
But it is important to understand that that condition still leaves
some room for doubt. Ultimately the GSEs' ability to fund themselves in
the financial markets depends on their ability to manage their risks as
well as on conditions in the U.S. housing markets. The housing markets,
in turn, are subject to risks--such as changes in the tax code--that
cannot be anticipated. An adverse change in the GSEs' financial
condition could lead to an increase in the yield spread of the GSEs'
debt over Treasury debt. That could be a gradual rise, as the market
worries about whether their implicit backing will turn into a bailout,
or it could reflect a sudden shift in market perceptions. In the case
of Farm Credit System (FCS) debt in 1987, a gradual rise was followed
by a sudden tipping point, when the market fled to quality. In the case
of the Farm Credit System, the yield spread over longer-term Treasuries
went above 100 basis points, signaling that new FCS debt might become
unmarketable.\8\
---------------------------------------------------------------------------
\8\ Bert Ely and Vicki Vanderhoff, ``The Farm Credit System:
Reckless Lender to Rural America'' (Alexandria, Va.: Ely & Company,
Inc., November 1990).
---------------------------------------------------------------------------
If a similar phenomenon should affect Fannie or Freddie's
securities, the financial intermediaries that are currently holding
that debt instead of Treasuries may find that they can sell only at
substantial losses; the losses would then raise questions about their
own financial stability, and a systemic crisis would arise. To be sure,
Congress could resolve the crisis, but a great deal of damage would
then have been done to the economy as the market fled to quality and
credit sources dried up. The U.S. financial markets experienced that
phenomenon during the fall of 1998, in the aftermath of the Russian
debt crisis and the Long-Term Capital Management debacle.
Of course, the effect of a Fannie and Freddie crisis would be even
more calamitous for the housing markets. If those GSEs were to face
substantially higher interest costs in marketing their debt, the costs
would be transmitted immediately to the housing market--slowing home
purchases and new home construction dramatically. That in itself would
have a severely adverse effect on the general health of the U.S.
economy.
Fannie and Freddie can contain their risks, but at the cost of
reduced profitability. There is no indication in their behavior thus
far that they are willing to accept that result.
7. conclusion
Fannie Mae and Freddie Mac are fast becoming a problem that can no
longer be ignored. By 2003, they will have assumed the risk--either
through ownership or guarantees--of almost one-half of all residential
housing mortgages in the United States. In effect, the residential
mortgage market will have been partially nationalized, with the
taxpayers bearing a risk that should be borne by private stockholders
and creditors.
Moreover, we project that in 2003, Fannie and Freddie will own or
have guaranteed 91.5 percent of all conventional/conforming mortgages,
justifying the concern of private mortgage lenders throughout the
United States that they will gradually be squeezed out of their
traditional markets, and that Fannie and Freddie are planning to extend
their activities to some form of direct relationship with the public.
It seems clear that the problem here is the peculiar structure of
Fannie and Freddie--profit-seeking companies that have been granted
special status to pursue a public mission. Those objectives are
contradictory. Whatever balance Congress initially thought could be
achieved between them has been lost.
What are the benefits that Fannie Mae and Freddie Mac claim to
provide, and are those benefits worth the cost in taxpayer risk and
competition for non-subsidized mortgage lenders?
Although the GSEs do contribute to liquidity in the mortgage
markets, they are no longer necessary for that purpose; private firms
now routinely acquire and securitize portfolios of jumbo mortgages--
which exceed the size that Fannie and Freddie may purchase--and those
private firms could certainly do the same for conventional/conforming
loans.
Recognizing the validity of that argument, Fannie and Freddie now
claim that their purpose is to reduce middle-class mortgage rates, and
point to the fact that those rates are about 30 basis points lower than
rates in the jumbo market. However, many economists have noted that
that saving for homebuyers is an illusion: the lower interest rate is
immediately capitalized into the cost of the home, so that the real
benefit of the implicit subsidy goes to developers and home sellers
rather than to the homebuyers whom congress presumably intended to
assist.
Weighed against those highly conjectural benefits are the real
taxpayer risks that Fannie and Freddie create, and the real danger that
they will eventually evict private non-subsidized lenders from the
residential mortgage market.
Policymakers have a number of appropriate potential responses: true
privatization of Fannie and Freddie through cutting their links to the
Federal Government; tighter statutory and regulatory restrictions on
their efforts to expand their activities; limitations on their use of
lobbyists, their political contributions, and their other efforts to
manipulate the legislative process; free sale of identical GSE
franchises, or the imposition of special taxes, affordable housing
burdens, or other costs that would enable the government to recapture
their implicit subsidy; forbidding the tying of management compensation
to their stock price; and even returning them to their former status as
on-budget Federal agencies.
Whatever the course ultimately adopted, it is important to
recognize that options are foreclosed and solutions become more
difficult as Fannie Mae and Freddie Mac continue their de facto
nationalization of the residential mortgage market.
Banks Do Not Receive a Federal Safety Net Subsidy: A Paper Prepared for
the Financial Services Roundtable by Bert Ely, May 1999
For several years, the Federal Reserve, and its chairman, Alan
Greenspan, have argued with extreme forcefulness that banks benefit
from a substantial, but apparently unquantifiable taxpayer subsidy. Mr.
Greenspan contends that in order to minimize the competitive
distortions caused by this alleged subsidy, expanded powers for banking
companies should be exercised only through non-bank affiliates of bank
holding companies regulated by the Fed and barred for operating
subsidiaries of national banks regulated by the Treasury Department's
Office of the Comptroller of the Currency.
The Fed cannot quantify the amount of this alleged subsidy because
there is, in fact, no such subsidy. Instead, a subsidy of at least $1.5
billion annually flows in the opposite direction, in the form of non-
interest-bearing loans banks have been forced to make to the Federal
Government through the Fed and the Federal Deposit Insurance
Corporation.
What some contend is a Federal subsidy to banks in fact is not, for
two reasons. First, deposit insurance delivers genuine economic value
to banks due to its inherent risk-spreading nature which is common to
all insurances. That is, deposit insurance protects deposits against
bank failure because, through the premium charged for it, deposit
insurance effectively spreads bank insolvency risk over a far broader
equity capital base than just the capital of the bank holding those
deposits. Deposit insurance therefore permits each insured bank to
utilize expensive equity capital more efficiently than it otherwise
could; that is, a bank with deposit insurance can operate with higher
leverage than it could without it. The fact that the Federal Government
currently operates the deposit insurance system does not negate this
inherent value of deposit insurance. Non-bank firms must, of necessity,
operate with lower leverage because they do not have insolvency
protection for their creditors comparable to deposit insurance.
Second, taxpayers do not subsidize Federal deposit insurance
because over the last decade Congress has made deposit insurance as
risk-free as possible to taxpayers by creating mechanisms which impose
all deposit insurance losses on the banking industry, even in
circumstances far worse than the S&L crisis. Because of the reforms
Congress enacted, deposit insurance is no longer simply a government
guarantee, as it was during the S&L crisis--it has been transformed
into a genuine insurance mechanism which can stand on its own without
Federal backing. Ironically, these taxpayer safeguards have greatly
magnified the highly undesirable cross-subsidy within deposit insurance
which flows from sound, well-managed banks to poorly capitalized and
badly run banks. Unfortunately, the existence of this cross-subsidy has
been masked by Mr. Greenspan's false assertion that taxpayers subsidize
Federal deposit insurance. Worse, his false assertion has inflicted
significant and possibly lasting harm on the banking industry by making
it more politically vulnerable to the imposition of yet more social
welfare obligations beyond those which already burden it, but not its
non-bank competition.
Interestingly, this analysis of the subsidy argument reveals that
non-banks, and specifically securities firms, receive a significant
taxpayer subsidy--free access to the Fed's discount window during times
of economic duress. Arguably, permitting this access achieves a public
good--systemic stability, but that good does not warrant a subsidy for
securities firms any more than the public good of Federal deposit
insurance would warrant a taxpayer subsidy for banks.
Although banks do not receive a taxpayer subsidy, the Fed's amazing
success in propounding this fiction has raised the question of how best
to contain the alleged subsidy. Careful analysis indicates that even if
a subsidy existed, it would flow with equal ease to operating
subsidiaries of banks and non-bank subsidiaries of holding companies.
Therefore, whether there is a subsidy or not, there is no rationale for
limiting the organizational flexibility of banks by requiring that
certain activities be conducted only in non-bank subsidiaries of Fed-
regulated holding companies. Mr. Greenspan's argument that the holding
company structure better contains the fictional subsidy is entirely
without merit.
introduction
Contrary to frequent assertions by Federal Reserve Chairman Alan
Greenspan, banks do not receive a so-called Federal ``safety net
subsidy,'' as this paper will demonstrate. Instead, banks pay all costs
of banking's Federal safety net, including the Federal Government's
cost of regulating banks. What is alleged to be a safety net subsidy,
specifically that banks can operate with higher leverage than non-
banks, in fact represents the consequence of the risk-spreading nature
of deposit insurance. That is, banks can operate with higher leverage
ratios than their non-bank competitors because banks participate in,
and pay for the entire cost of, a risk-spreading mechanism that safely
permits higher leverage.
This paper will first explain what a Federal safety net subsidy
would be if banks did receive such a subsidy. It will then explain the
structure of banking's Federal safety net to demonstrate that any
taxpayer risk, and therefore any subsidy flowing from this safety net,
is concentrated in Federal deposit insurance. The next portion of the
paper will describe various actions Congress has taken over the last 10
years to eliminate taxpayer risk from deposit insurance by imposing all
of that risk on the capital of the entire banking system. The paper
will then explain how deposit insurance works as a risk-spreading
mechanism so as to permit higher leverage for banks insured by the
Federal Deposit Insurance Corporation (FDIC). At the same time, as the
paper will demonstrate, the banking industry pays what amounts to a
subsidy to the Federal Government of at least $1.5 billion annually.
Unfortunately, as the paper will explain, Federal deposit insurance has
created an unhealthy cross-subsidy within the banking industry which
flows from healthy, well-managed banks to weak, poorly managed banks.
At the same time, large non-bank financial firms receive an important
Federal safety net subsidy in the form of free access to the Federal
Reserve's discount window. Finally, the paper will conclude that while
banks do not receive a Federal safety net subsidy, if there were one it
would be equally well contained in a bank-operating subsidiary
structure as in a holding company-affiliate structure.
Two other points regarding this paper are in order. First, the term
``banks'' refers, unless otherwise indicated, to all FDIC-insured
institutions, including savings-and-loans and savings banks. However,
the term does not encompass credit unions. Second, the paper assumes
that the alleged Federal safety net subsidy ultimately is paid by
taxpayers. It is highly unlikely that there is another source for such
a subsidy.
what a safety net subsidy would be if there were a subsidy
The threshold question in the debate over whether or not banks
receive a Federal safety net subsidy is what would constitute a
taxpayer subsidy to banks if a subsidy actually existed. That is, how
would banks actually reap that subsidy? There appear to be four ways in
which a taxpayer subsidy could be transmitted to banks--direct payment
of taxpayer funds to banks, using taxpayer funds to protect depositors
and others from bank insolvency losses, using taxpayer funds to pay the
cost of banking regulation, and higher interest rates on the Federal
debt because of the contingent taxpayer liability posed by Federal
deposit insurance. None of these potential sources of a Federal safety
net subsidy exist, as will be discussed shortly. The absence of any
subsidy is reinforced by the fact that the Fed has never quantified the
dollar amount of this subsidy. As recently as April 28, 1999, when Mr.
Greenspan contended that permitting operating subsidiaries to engage in
non-bank activities as a principal would lead to ``greater Federal
subsidization'' (Greenspan, 1999), he did not quantify the amount of
that increased subsidy. Surely, if a subsidy existed, Fed economists
could at least estimate its size.
direct payment of taxpayer funds to banks
The Federal Government does not directly subsidize banking
activities by making explicit payments to banks. For example, the
government does not pay banks to maintain branches in low-income
communities nor does it subsidize banks operating in remote locations.
Further, any services which the Federal Government purchases from banks
are priced at competitive market rates.
using taxpayer funds to protect depositors in failed banks
Although the S&L crisis cost general taxpayers $125 billion, \1\
steps Congress has taken since then, notably the 1991 enactment of the
Federal Deposit Insurance Corporation Improvement Act (FDICIA), have
effectively eliminated the risk Federal deposit insurance poses to
taxpayers. These protections are summarized below, starting on page 6,
in the discussion of Federal deposit insurance.
using taxpayer funds to pay the cost of federal banking regulation
Federal banking regulation cost almost $1.7 billion in 1997; \2\
figures are not yet available for 1998. The Office of the Comptroller
of the Currency (OCC), the regulator of national banks, is supported
entirely by examination and application fees paid by banks. The same is
true for the Office of Thrift Supervision (OTS), the Federal regulator
of thrift institutions (savings-and-loans and savings banks). As will
be discussed further below, the expenses and insurance losses of the
FDIC are fully covered by deposit insurance premium assessments and
interest earned on the fund balance of the FDIC's two deposit insurance
funds, the Bank Insurance Fund (BIF) and the Savings Association
Insurance Fund (SAIF). The expenses of the Federal Financial
Institutions Examination Council, the regulators' coordinating body,
are charged to the regulatory agencies.
At the Fed, the income value of non-interest-bearing reserves which
banks maintain on deposit at the Fed was approximately $653 million in
1997, \3\ or $136 million more than the cost of the Fed's supervision
and regulation activities in 1997. As is widely recognized, the present
reserve requirement on checkable deposits is simply a tax on those
deposits. The Fed does not use these reserves to execute monetary
policy since it long ago elected to instead be an interest-rate
signaler (Ely, 1997a). Although reserve balances are declining because
of bank sweep accounts (average reserve balances declined 11 percent in
1998), the income value of reserve accounts should continue to exceed
the cost of Fed supervision and regulation for the foreseeable future.
Any shortfall, though, at the Fed will be more than covered by the
FDIC's net income, as noted below in the discussion, starting on page
12, of the banking industry's forced loan to the FDIC.
increased cost of financing the federal debt
Although it cannot be proven, it is highly unlikely that the
Federal Government's contingent liability under Federal deposit
insurance has raised the cost of financing the Federal debt, for two
reasons. Arguably, any increase in this financing cost could be viewed
as a subsidy to the banking industry. First, the Federal Government's
debt has unambiguously been rated AAA for many years. In fact, Treasury
securities, despite any contingent Federal deposit insurance liability,
are widely viewed as the closest thing to risk-free debt that exists
anywhere in the world. Therefore, it is difficult to imagine that
Federal deposit insurance has raised yields on Treasury securities.
Second, as will be discussed below, starting on page 6, over the
last decade Congress has made Federal deposit insurance essentially
risk-free to Federal taxpayers. Any perceived cost advantage banks have
in obtaining insured deposits therefore is a product of the soundness
of banking's self-financed insurance safety net. Also, bank deposits
appear to be a relatively cheap source of bank funding largely, if not
entirely, because of the expense banks incur in gathering deposits
through branch offices and in the substantial regulatory costs banks
must pass through to their depositors.
the structure of banking's federal safety net
Banking's Federal safety net has three components--banks' ability
to borrow at the Fed's discount window, the Fed's guarantee of payment
finality on payments transmitted through the Fed, and Federal deposit
insurance. As a practical matter, if banks receive a safety net
subsidy, it comes only through Federal deposit insurance because the
Fed operates the other two components of this safety net on a risk-free
basis to itself and therefore to the taxpayer.
the fed discount window
The Fed discount window does not provide banks with a safety net
subsidy although it does provide banks, and especially small rural
banks, with a very slight funding subsidy comparable to the funding
subsidy that the Federal Home Loan Banks deliver to their members. For
the 1992-98 period, discount window loans outstanding averaged $208
million--$74 million for adjustment loans (used to meet reserve
requirements and other short-term liquidity needs) and $134 million for
seasonal loans to small agricultural banks; for 1998, the comparable
numbers were $162 million, $67 million, and $95 million.\4\ Given that
the Fed's lending or discount rate for adjustment and seasonal loans is
a below-market rate, this funding subsidy would equal approximately $2
million annually if a market rate was 1 percent higher and $4 million
if it was 2 percent higher. Although indefensible, in the larger scheme
of things, this is an extremely modest subsidy.
The Fed should not suffer any losses as a lender since it lends to
banks only on a fully collateralized basis; acceptable collateral is
specified in the Fed's Regulation A.\5\ Further, because the Fed can be
a very demanding lender, it can insist on substantial
overcollateralization of its loans and can demand the posting of
additional collateral should the posted collateral lose market value.
Any losses the Fed did experience as a lender would be borne by
taxpayers because these losses would reduce, dollar-for-dollar, the
earnings the Fed sends back to the Treasury every year. Any loss the
Fed experienced on its discount window lending would occur only because
Fed officials failed to monitor the market value of the Fed's loan
collateral in a timely manner. Also, under Sec. 142 of FDICIA, the Fed
could be liable to the FDIC in a failed bank situation for any
increased loss to the FDIC as a result of the Fed failing to demand
payment of outstanding discount window loans within 5 days after the
failed bank became ``critically undercapitalized.'' However, such a
loss should be a fairly easy bullet for the Fed to dodge.
Therefore, because of its essentially risk-free nature and the
modest amount lent, the Fed's discount window does not gift a safety-
net subsidy to the banking industry. Even its funding subsidy, a few
million dollars per year at most, is extremely modest compared to the
funding subsidies provided by the Federal Home Loan Banks.
the fed's payment system
The Fed provides payment finality on interbank payments made
through the Fed, thereby eliminating interbank credit risk for those
banks which directly access the Fed's payment system. These interbank
payments generally take the form of checks deposited in the Fed for
collection from other banks, automated clearinghouse (ACH) payments,
and Fedwire funds transfers. In effect, when the Fed grants payment
finality to a bank for a payment the Fed has not yet collected from
another bank, the Fed has assumed a credit risk on the bank upon which
the payment was drawn while the payment is being processed through the
Fed's payments system. However, this credit risk is extremely short-
term, lasting just a few minutes to a few hours for any single payment.
The Fed has recognized this payment system risk by establishing
daylight overdraft limits; that is, a limit on the amount that a bank
can be overdrawn at any point in time in its reserve or clearing
account at the Fed. Further, the Fed can charge interest on intraday
overdrafts; that interest effectively compensates the Fed for the
intraday credit risk it assumes by providing payment finality at the
time a payment is presented to it for collection.\6\
Operating in a real-time environment, the Fed can effectively
eliminate its payment system risk in two ways. First, it can refuse to
accept payment requests presented to it which are drawn on weak banks.
Second, it can accept such payment requests only to the extent to which
a weak bank has covered any intraday overdraft at the Fed by borrowing
at the discount window on a fully collateralized basis. In other words,
through proper, timely management, the Fed can eliminate its payment
system risk and therefore any subsidy that direct access to the Fed's
payment system would provide to the banking system. As a practical
matter, the Fed has always operated its payment system on a risk-free
basis, which means that the Fed has not subsidized the banking system
in this manner.
Contrary to the Monetary Control Act of 1980, which bars the Fed
from subsidizing the priced services (principally collecting checks,
processing ACH payments, and executing Fedwire transfers) it offers to
banks, the Fed in fact does subsidize these services by using a portion
of its annual ``pension cost credit'' to lower its service prices. In
1997 (the most recent year for which figures are available), the Fed
recognized a pension cost credit of $200.8 million.\7\ While $138
million of this cost credit was turned over to the U.S. Treasury, the
Fed retained approximately $62.8 million of this credit to subsidize
its priced-services activities.\8\ However, this subsidy is not a
safety net subsidy. Instead, it represents a conscious effort by the
Fed to use funds that would otherwise go to the U.S. Treasury to gain a
competitive edge, through lower prices, over private-sector providers
of payment services.\9\ An amendment to S. 900, the financial services
modernization bill passed by the Senate on May 6, 1999, will bar the
Fed from using any portion of its pension cost credit to subsidize its
priced services activities.
the federal reserve portion of the safety net poses no taxpayer risk
Clearly, Fed operations, and specifically its discount window
lending and the operation of its payment system, are designed to
operate on a risk-free, and therefore loss-free, basis. To the best of
the author's knowledge, the Fed has never incurred a loss from a bank
failure. The run on and subsequent failure of Continental Illinois in
May 1984 best dramatizes the ability of the Fed to avoid losses in
failed banks. Fed advances to Continental Illinois peaked at $7.6
billion in August 1984 (Continental Illinois Corporation, 1984, p. 2),
yet the Fed did not lose a penny on that loan, or at least the Fed has
never admitted to any such loss, yet the FDIC spent $1.1 billion \10\
protecting depositors and other Continental creditors against any loss
whatsoever. Clearly, losses incurred under banking's Federal safety net
are focused on Federal deposit insurance and the FDIC.
federal deposit insurance
Federal deposit insurance for banks, which is offered exclusively
through the FDIC, represents the third component of banking's Federal
safety net. Federal deposit insurance is a contingent liability of the
Federal Government; as a practical matter, though, numerous safeguards
Congress has enacted since the S&L crisis have eliminated any risk
Federal deposit insurance might otherwise pose to taxpayers.
Federal deposit insurance creates the potential for a taxpayer
subsidy only to the extent that the FDIC incurs losses in protecting
depositors of failed banks. If banks never failed or always failed
without losses to the BIF or SAIF, then there would be no losses to be
subsidized. Banks do fail, though, even in good times, and sometimes
with substantial losses. However, those losses will not be borne, or in
effect be subsidized, by taxpayers if they instead are paid by healthy
banks through deposit insurance premiums. Despite suffering $37.1
billion in losses from 1934 to 1997,\11\ the BIF and its predecessor,
the FDIC fund, have not received a single dollar of taxpayer
assistance. Instead, all BIF/FDIC losses as well as FDIC operating
expenses have been covered by deposit insurance assessments, which
totaled $46.4 billion through the end of 1997,\12\ and earnings of the
BIF/FDIC fund. Even the Federal Government's initial $289 million
capitalization of the FDIC was repaid in 1947 and 1948, with
interest.\13\ At the end of 1998, BIF had a fund balance (unaudited) of
$29.6 billion (Federal Deposit Insurance Corporation, 1998a, p.17).
SAIF, the successor to the Federal Savings and Loan Insurance
Corporation (FSLIC), which has had a comparable experience since 1989,
reached an unaudited fund balance of $9.8 billion at the end of 1998
(Federal Deposit Insurance Corporation, 1998a, p.17).
Stung by the S&L crisis, and its enormous cost to taxpayers, as
well as by the commercial banking problems of the 1980's and early
1990's, Congress enacted numerous reforms which directly or indirectly
have eliminated the taxpayer risk in Federal deposit insurance. These
reforms were intended, and to date have performed, to minimize deposit
insurance losses while ensuring that all such losses will be imposed to
the maximum extent possible on banks which do not fail. By eliminating
the taxpayer risk previously posed by Federal deposit insurance,
Congress transformed Federal deposit insurance from a government
guarantee program into a genuine insurance mechanism, albeit a
mechanism with serious cross-subsidy problems discussed below in the
section on mispriced deposit insurance premiums, which starts on page
13.
The seven principal reforms divide into two broad categories--
minimizing deposit insurance losses and imposing all deposit insurance
losses on bank capital.
minimizing deposit insurance losses
Cross-guarantees among affiliated banks (1989) The Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA),
which launched the resolution of the S&L crisis and FSLIC's bankruptcy,
included a ``cross-guarantee'' provision (Sec. 206, enacting 12 U.S.C.
1815(e)). This provision made all ``commonly controlled'' banks liable
for the FDIC's share of an insolvency loss in any one of the commonly
controlled institutions. That is, the FDIC experiences an actual loss
in a failed bank only to the extent that it cannot recover its
potential loss from affiliated banks of the failed bank. As a practical
matter, the amount of this potential recovery is limited to the market
value of the affiliated banks. Hence, for deposit insurance purposes,
all banks in a multi-bank holding company or otherwise under common
ownership or control are treated as if they were one bank for the
purpose of absorbing at least some portion of the FDIC's share of a
failed bank's insolvency loss. To some extent, the value of this
provision to the FDIC has been diminished by interstate branching,
which was authorized in 1994 (and is discussed on the next page).
Nonetheless, it was an important first step which Congress took to
minimize FDIC losses and remains an important loss-minimization tool
for the FDIC.
Prompt regulatory action/least-cost resolution (1991) In many ways,
prompt regulatory action (often referred to as prompt corrective
action, or PCA) and least cost resolution (LCR), are the heart of
FDICIA,\14\ which Congress enacted on November 27, 1991. Together, PCA
and LCR represent the most important tool the Federal Government has to
minimize deposit insurance losses in banks which have sunk into
insolvency. At the same time, they reflect a fundamental and
understandable congressional distrust of the bank regulators in the
aftermath of the S&L crisis and problems in the commercial banking
industry. Briefly, regulations issued under the authority of PCA set
trigger points in a bank's slide toward insolvency. These triggers are
intended to force regulators to take timely corrective action in a
failing situation or, barring a turnaround, to force the closure of a
bank before it becomes insolvent. LCR is designed to minimize the
FDIC's use of purchase-and-assumption transactions in failed bank
situations because such transactions can protect the uninsured portion
of deposits, which has the effect of raising the cost of a bank
failure. Although not fully tested during a severe economic crisis, in
theory PCA and LCR should minimize deposit insurance losses even during
a crisis. A discussion of the workings of PCA and LCR lies beyond the
scope of this paper.
Depositor preference in failed banks (1993) Although enacted as
part of the 1993 budget reconciliation bill as a spending reduction
measure and with no debate whatsoever over its deposit insurance
implications, the depositor preference provision of the Federal Deposit
Insurance Act \15\ serves as a potentially significant legal device for
reducing FDIC losses in failed banks. Briefly, depositor preference
gives both insured and uninsured deposits in domestic branches of a
bank a liquidation preference over deposits in that bank's foreign
offices as well as all other general, unsecured claims on that bank.
Consequently, general unsecured claims which are not domestic deposits
will absorb all of a failed bank's insolvency loss before the first
dollar of loss will be borne by domestic deposits, and specifically by
the FDIC as the insurer of the insured portion of domestic deposits.
Depositor preference already is playing a role in reducing the FDIC's
loss in the relative handful of banks which have failed in recent
years.
Interstate banking and branching (1994) Although intended primarily
to improve the operating efficiency and customer service of commercial
banks, the Interstate Banking and Branching Efficiency Act of 1994
greatly improved the safety-and-soundness of the banking system by
permitting large banks to operate regionally or nationally. The banking
problems in Texas and other states during the 1980's as well as the
banking crisis of 1930-33, during which time 9,000 mostly small, single
office banks failed (Federal Deposit Insurance Corporation, 1983, table
on p. 41) were greatly aggravated by state and national banking and
branching restrictions and prohibitions. It is highly unlikely that
even a future regional banking crisis, such as that which struck the
Southwest in the mid-1980's or the New England banking crisis of the
late 1980's and early 1990's, would be as severe, in terms of deposit
insurance losses, as those crises were.
imposing all deposit insurance losses on banks
Recapitalizing the deposit insurance funds Sec. 104 of FDICIA
established the framework for building the BIF to a ``designated
reserve ratio'' (presently 1.25 percent of insured deposits) and
maintaining that ratio. FIRREA, which created the BIF and SAIF,
established similar requirements for the SAIF. Under the guise of the
designated reserve ratio, the FDIC was able to levy a substantial tax
on banks to build the BIF and SAIF to a 1.25 percent reserve ratio.
Although not used solely to build the BIF to a 1.25 percent ratio, the
FDIC levied $27.9 billion of premiums on BIF-insured institutions from
1990 to 1995 (Federal Deposit Insurance Corporation, 1997, p. 105).
From 1991 to 1996, the FDIC levied $8.5 billion of premiums, including
$5.2 billion in 1996, on SAIF-insured institutions to build that fund
to a 1.25 percent ratio (Federal Deposit Insurance Corporation, 1997,
p. 107). These huge assessments cannot be tapped to pay future deposit
insurance losses, as is discussed in the next paragraph. Hence, they
form a permanent investment base which generates the interest savings
on financing the Federal debt that provides much of the special subsidy
discussed below, starting on page 12, which flows from the banking
industry to the Federal Government.
Unlimited FDIC assessment power Of particular importance to
taxpayers, Sec. 103 of FDICIA gave the FDIC a blank check, through the
authorization of emergency special assessments, on the capital of all
of the institutions insured by a particular fund to quickly rebuild
that fund to the designated reserve ratio should prior losses have
driven that ratio below the designated minimum. This unlimited
assessment power gives the FDIC the power to draw heavily on the
capital of the banking industry to cover deposit insurance losses
should cross-guarantees, PCA, LCR, and depositor preference fail to
minimize those losses. To the extent that the FDIC has to draw upon its
$30 billion line-of-credit at the U.S. Treasury to meet short-term
liquidity needs, those interest-bearing borrowings will effectively be
repaid from future FDIC assessments.\16\ At December 31, 1998, the book
value of the equity capital of all FDIC-insured institutions was $556.7
billion (Federal Deposit Insurance Corporation, 1998, p. 16), almost
three times the amount of the insolvency losses suffered by Federal
deposit insurance since the S&L crisis first erupted in the early
1980's.
Special ``systemic risk'' or too-big-to-fail assessments In
addition to the emergency special assessment powers of FDICIA's Sec.
103, FDICIA's Sec. 141 codified the concept of too-big-to-fail (TBTF)
and provided the means to pay for it. Specifically, this systemic risk
provision (the so-called ``systemic risk exception '') authorizes the
Fed and FDIC, with the concurrence of the Secretary of the Treasury and
the President, to declare a bank TBTF. The FDIC may then protect, if
necessary, all the liabilities of that bank against loss in order to
``avoid or mitigate'' the ``serious adverse effects on economic
conditions or financial stability'' if the bank were liquidated under
FDICIA's LCR provisions. The systemic risk provision of FDICIA also
authorizes the FDIC to levy one or more emergency special assessments
on the other members of the insurance fund to which the failed TBTF
bank belonged to cover the cost of protecting the failed institution's
creditors. Because of this provision, healthy banks, not taxpayers,
will bear the cost of protecting uninsured creditors of TBTF banks from
any loss.
federal deposit insurance permits higher leverage, which is not a
subsidy
Integral to the contention that banks receive a deposit insurance
subsidy is the argument that this subsidy permits banks to operate with
higher leverage than non-bank institutions. Kwast and Passmore (1997,
pp. 16-27) present substantial evidence that non-banks, with the
possible exception of large investment banks, operate with less
leverage than banks. They close the discussion of their leverage
contention by opining that ``these differences [in leverage ratios] are
quite likely due, in substantial part, to the fact that banks have
direct access to the Federal safety net'' (Kwast and Passmore, 1997, p.
27) without explaining the linkage between this direct access to the
safety net, the subsidy the safety net allegedly provides, and the
higher leverage banks enjoy. Interestingly, they ignore the fact that
non-bank firms can access one important element of the safety net, the
Federal Reserve discount window, as will be discussed below, starting
on page 13. What is especially intriguing about the Kwast/Passmore
paper is that it ignores an explanation as to why banks can safely
operate with higher leverage--the insurance value of deposit
insurance--that this author explained in the American Banker (Ely,
1997b) 3 months prior to the publication of the Kwast/Passmore paper.
all forms of insurance permit higher leverage
A central element in the subsidy debate is the indisputable fact
that all forms of insurance permit an insured to operate with higher
leverage than the insured could enjoy without insurance. That is,
higher feasible leverage is an inherent byproduct of the risk-spreading
nature of any form of insurance. This statement holds true for
businesses, which banks are, as well as for individuals. In effect,
insurance prevents the bankruptcy of businesses and individuals who
have partially financed their assets with debt if their assets suffer
an insurance-covered decline in value which exceeds the insured's net
worth. Viewed from another perspective, insurance is a credit
enhancement device an insured obtains in exchange for a fee called an
insurance premium.
A simple example will illustrate this crucial point. An individual
with a net worth of $100,000 purchases a home for $200,000 that is
partially financed with a $160,000 mortgage. Having used $40,000 of her
net worth to make a down payment on the house, she has $60,000 worth of
other assets. Hence, she has total assets of $260,000 which have been
financed by a $160,000 mortgage and her $100,000 of net worth. If her
home then suffers a $150,000 uninsured fire loss, she will now have
assets worth $110,000 and a negative net worth of $50,000 (assets of
$110,000 minus the $160,000 mortgage). Personal bankruptcy will occur,
which means the mortgage holder will incur a loss of at least $50,000.
The risk of this type of loss is precisely why lenders insist that
borrowers insure mortgaged assets for at least the amount of the
mortgage. Consequently, a person who cannot obtain property insurance
cannot leverage herself as highly as someone who can obtain such
insurance. In effect, insurance exists not just to protect the net
worth of the insured, but equally important to protect lenders against
loan losses. In the context of this paper, a depositor is a lender to a
bank.
Insurance works properly, from the perspective of ensuring insurer
solvency, if the risks of loss it has assumed are diversified
sufficiently; insurance premiums are priced properly so as to cover the
insurer's losses, operating expenses, and profits (thereby deterring
moral hazard on the part of insureds); and the insurer has enough net
worth of its own to absorb extraordinarily high or unanticipated losses
and pricing errors. In effect, insurance pools the risk of loss of many
insureds in return for a premium. Consequently, by using insurance to
shift the risk of a substantial loss to an unrelated party, an insured
can own more assets than she otherwise could own since her net worth
will not become negative if she suffers an insured loss. Put another
way, an insurance contract is an option contract which give the insured
an option on its insurer's net worth and loss reserves should the
insured suffer an insured loss. An insurance premium therefore is the
price of that option contract.
insurance theory applied to deposit insurance
This theory of insurance, which reflects the reality of insurance,
is applicable to all types of financial institutions. The creditors of
banks and insurance companies are, to some extent, protected by
insurance mechanisms. The creditors of other types of financial firms,
such as investment banks and finance companies, generally speaking do
not enjoy similar insurance protection.\17\ Therefore, all other things
being equal, firms with insurance which protects their creditors
against loss can operate with greater leverage than firms without that
type of insurance. Claims on insurance companies are protected by state
guaranty funds; a discussion of these funds lies beyond the scope of
this paper. Instead, the balance of this paper will focus only on
Federal deposit insurance and the protection it provides to bank
creditors, specifically depositors.
Although deposit insurance is characterized as protecting
depositors, or at least the first $100,000 of a depositor's balance in
a bank, against loss, in actuality Federal deposit insurance works in a
slightly different manner. A bank fails because it becomes insolvent;
that is, it has a negative net worth because the book value of its
liabilities exceeds the market value of its assets. A bank becomes
insolvent, and therefore a failed bank, when asset losses and operating
losses (current expenses exceed current income) consume any positive
net worth it had. When the FDIC takes over a failed bank, it places it
in a receivership. The FDIC then advances to the receivership
sufficient funds to ensure that insured deposits are made whole, either
through a direct payment to depositors or a transfer of the insured
deposits to another bank. The FDIC then assumes, under the law of
subrogation, a claim on the failed bank's receivership in proportion to
the amount of insured deposits it protected to the total amount of
domestic deposits. The payment the FDIC makes into the failed bank's
receivership is functionally equivalent to the payment an insurance
company makes to a homeowner who has suffered a fire loss or, if so
specified in the insurance contract, to the holder of the mortgage on
the home.
Insured deposits permit a bank to operate with higher leverage than
it could without deposit insurance because deposit insurance shifts to
other banks, through FDIC premium assessments, the bank's insolvency
risk that otherwise would be borne by the insured deposits. Unlike a
money market mutual fund, though, a bank cannot operate with infinite
leverage, that is zero capital. Instead, it must hold some capital
which effectively operates as an insurance deductible that provides
some insolvency risk protection for the FDIC and therefore for other
banks. The fact that most banks today are not paying explicit premiums
to the FDIC does not negate the fact that they are paying for their
FDIC insurance, as will be discussed below, starting on the next page.
This insolvency risk protection potentially extends to all liabilities
in banks that most likely are TBTF although the uncertainty as to which
banks are TBTF (the so-called ``constructive ambiguity'' favored by
regulators) undermines the credit-enhancing value of TBTF protection.
Like any insurance entity, the FDIC must have sufficiently
dispersed risks in order to be a sound, viable insurance mechanism. The
FDIC is a very viable insurer given that it insured 8,554 banking
companies at the end of 1998 (Federal Deposit Insurance Corporation,
1998b, p. 62).\18\ The fact that the FDIC operates two insurance funds,
the BIF and the SAIF, does not threaten the FDIC's viability as an
insurer since Congress intends to merge the two funds and in any event
would quickly merge them if one of them began to suffer high losses.
The largest individual FDIC insurance risk, BankAmerica, accounted
for just 5.9 percent ($163.5 billion) of the FDIC's insured deposits at
September 30, 1998 (the latest date for which this data is
available).\19\ BankAmerica's insured deposits equaled just 29.6
percent of the total capital of FDIC-insured banks on that date ($163.5
billion/$556.7 billion). Given its size, the diversity of its assets,
and its geographical spread, in the extremely unlikely event that
BankAmerica should become insolvent, the FDIC's loss in resolving its
subsidiary banks would be a tiny fraction of their insured deposits.
For example, if BankAmerica incurred an insolvency loss equal to 5
percent of its liabilities, it would cost the FDIC $8.2 billion ($163.5
billion x .05) to protect BankAmerica's insured deposits against any
loss; that amount equals just 1.5 percent of total bank capital ($8.2
billion/$556.7 billion). If BankAmerica were declared to be TBTF, which
almost certainly would be the case, a loss equal to 5 percent of the
total amount of liabilities to be protected might be as high as $27-$28
billion, or approximately 5 percent of total bank capital. While
enormous (and reflective of massive regulatory failure), a loss of that
magnitude nonetheless could be borne entirely by the banking system.
Creditors of a non-bank financial firm operating without creditor
insurance do not have a third-party standing by to make them whole if
the firm becomes insolvent. Therefore, creditors of such a firm can
look only to the net worth of the firm itself to protect them against
insolvency. Accordingly, without that third-party protection, creditors
properly insist that an uninsured firm operate with less leverage.
However, there is nothing to prevent non-bank financial firms from
establishing insurance mechanisms comparable to deposit insurance if
their managements desired to operate with higher leverage.
the bank safety net actually subsidizes the federal government
Contrary to Mr. Greenspan's assertion that Federal deposit
insurance provides banks with a Federal taxpayer safety net subsidy,
the reverse is true--banks effectively provide a special subsidy to the
Federal Government and hence to taxpayers. This subsidy takes three
forms--two financial and one non-financial.
banks' low-interest-rate loans to bif and saif
The Federal Deposit Insurance Act effectively bars BIF and SAIF
from dropping below a designated reserve ratio, which the FDIC Board
has set at 1.25 percent of insured deposits. That is, if the fund
balance in the BIF or the SAIF drops below 1.25 percent of insured
deposits, either because of deposit insurance losses or growth in the
total amount of insured deposits, then the FDIC Board of Directors must
adopt a recapitalization plan for that fund. Key to raising a fund
above a 1.25 percent reserve ratio is levying higher deposit insurance
premium assessments on the members of that fund. This recapitalization
requirement effectively means that the entire fund balance below the
1.25 percent requirement is not available to absorb deposit insurance
losses, except over the very short term. In effect, then, the required
reserve balance in each fund represents what is tantamount to a forced,
low-interest-rate loan from the banking industry to the Federal
Government. Banks extended that loan to the Federal Government through
the high deposit insurance assessments they paid in the early and mid-
1990's that built the BIF and SAIF to their 1.25 percent reserve
ratios. These premium payments constituted a permanent loan to the
Federal Government because the FDIC is ``on budget,'' \20\
A portion of the interest on this loan, which accrues to the FDIC
as income earned on its portfolio of Treasury securities, pays for FDIC
losses and expenses in excess of its deposit insurance premium
assessments and other sources of income from outside the Federal
Government. The portion of its interest income the FDIC spends
effectively constitutes interest banks earn on the forced loan. That
interest, which banks never collect, in turn, is in lieu of making cash
premium payments to the FDIC.
The unspent portion of the FDIC's interest income on its Treasury
securities represents the net income value to the Federal Government of
the banking industry's forced loan. Banks receive absolutely nothing in
return for this foregone income. In 1997, this loan lowered the cost of
financing the Federal debt by approximately $1.4 billion; \21\ 1998
figures are not yet available. If Congress had put the FDIC on a pure
pay-as-you-go financing basis, banks would not have had to pay heavy
premium assessments to build the essentially untouchable portion of the
BIF and SAIF fund balances. That portion, at the designated reserve
ratio of 1.25 percent, reached $35.6 billion at the end of 1998.\22\
Arguably, the banking industry delivers another $800 million
annually to Federal taxpayers in the form of the interest banks pay on
the FICO bonds issued during the 1987-89 period to finance a limited
disposal of failed S&Ls. This interest is paid entirely by a special
assessment on bank and S&L deposits. Because the S&L crisis was rooted
in numerous failed public policies reaching back to the 1930's (Ely and
Vanderhoff, 1991), the case can be made that FICO bond interest should
be paid from general taxpayer funds rather than with a special
assessment on bank deposits.
banks' non-interest bearing reserves
As noted on page 2, the income value of required reserves actually
on deposit at the Fed exceeded the Fed's bank supervision expenses by
$136 million in 1997. Given that banks probably hold more vault cash
than they would if interest was paid on reserves on deposit at the Fed,
the excess of the Fed's income on required reserves over Fed
supervision and regulation expenses is somewhat higher. However,
reserves on deposit at the Fed have been dropping due to sweep
accounts, so the income value of these reserves has been declining and
would disappear if the Fed opted to pay interest on reserves (contrary
to popular belief, the Fed is not explicitly barred by law from paying
interest on reserves).\23\ The time may arrive when the Fed's
supervision and regulation expenses will exceed the income value of
required reserves. However, even if the Fed held no non-interest-
bearing reserves, its supervision and regulation expenses would be
substantially less than the interest savings the Federal Government
enjoys by virtue of the forced loan the banking industry has made to
the FDIC, and hence to the Federal Government.
non-financial subsidies
Because Congress views Federal deposit insurance as a great benefit
to the banking industry, it has imposed social welfare obligations on
banks that effectively save the Federal Government substantial sums. It
lies beyond the scope of this paper to quantify those sums. The
Community Reinvestment Act (CRA) is one obvious obligation. While there
is great debate over whether banks make or lose money when meeting
their CRA obligations, it is highly unlikely that CRA lending and
service obligations earn the target rates of return that banks set for
other products and services, especially when considering the
substantial administrative costs banks incur in complying with the CRA.
Other laws, such as the Bank Secrecy Act, which impose obligations on
banks but not on other types of financial institutions, effectively
represent a special tax on banks and therefore a subsidy to the
government.
Adding it all up, the banking industry effectively provided a cash
subsidy to the Federal Government of $1.5 billion in 1997 plus payment
of FICO interest and an incalculable amount of social welfare services,
specifically in the form of CRA lending.
federal deposit insurance creates an undesirable cross-subsidy within
banking
While banks do not, contrary to Mr. Greenspan's assertion, receive
a Federal safety net subsidy, Federal deposit insurance has created a
highly undesirable cross-subsidy within the banking industry which
flows from healthy, well-managed banks to weak, poorly managed banks.
This cross-subsidy takes three forms--mispriced deposit insurance
premiums, excessive capital requirements for low-risk assets and well-
managed banks, and excessive regulatory compliance costs.
mispriced deposit insurance premiums
Although it may seem odd to contend that healthy banks pay too much
for their deposit insurance while weak banks pay too little given that
almost 95 percent of the banks will pay no deposit insurance premium
for the first half of 1999,\24\ that in fact is the case, for this
reason: The annual income foregone by banks on the deposit insurance
premiums they paid to the FDIC to build the BIF and SAIF to a 1.25
percent reserve ratio, as discussed above, effectively is an implicit
deposit insurance premium. Assuming banks could earn a 6 percent yield
on this forced loan to the government, this foregone income is
equivalent to almost a 6 basis point deposit insurance premium.\25\
Hence, effective premiums for FDIC-insured deposits range from 6 basis
points to 33 basis points since explicit premium rates presently range
from zero to 27 basis points. In the author's opinion, based on his
substantial research on the pricing of deposit insurance, this premium
range is too narrow. The safest banks should pay no more than two basis
points for insurance of all of their deposits while the riskiest banks
should pay as much as 70-100 basis points.
The very serious problem caused by mispriced deposit insurance
premiums is that they do not deter bad banking while also causing a
misallocation of credit. Thus, the pernicious nature of mispriced
deposit insurance reaches far beyond banks to the functioning of the
entire economy, as became evident in the aftermath of the S&L crisis
and the commercial banking difficulties of the 1980's and early 1990's.
Unfortunately, the very real problem of the cross-subsidy within the
banking industry caused by mispriced deposit insurance has been masked
by the debate over whether or not banks, taken as a whole, receive a
Federal safety net subsidy.
The FDIC itself has acknowledged the shortcomings of its premium
rate structure. Earlier this year, it considered charging a higher
premium rate to as many as 573 banks, almost all of which did not pay
any premium in 1998. The premium increase would have been levied on
banks with CAMELS ratings of 3, 4, or 5 for bank management or asset
quality (Barancik, 1999a) However, in response to a strong negative
reaction to this proposal, the FDIC quickly announced that it was
backing off from its initial proposal, having ``decided to revise and
delay until next year a plan to make more institutions pay for deposit
insurance'' (Barancik, 1999b). This retreat by the FDIC does not negate
the fact that deposit insurance premiums are underpriced for riskier
banks. The FDIC's problem is that as a government monopoly it cannot
properly price deposit insurance premiums because prices can be
properly established only in private, competitive marketplaces where
both buyers and sellers, or insureds and insurers, have a choice as to
whom they do business with.
excess capital requirements
Implicitly acknowledging that neither government banking regulation
nor government pricing of deposit insurance will prevent unwise
banking, Congress effectively mandated the Basle risk-based capital
standards with regulations which tie prompt regulatory action,
discussed above, to various measures of bank capital. Yet like FDIC
insurance premiums, risk-based capital standards only very crudely
reflect the actual riskiness of bank assets. This is particularly
evident for loans to private-sector firms where no distinction in
capital requirements is made between firms which are AAA-rated and
those which have a junk bond status. Worse, capital ratios have been
set high enough to minimize banking failures caused by a combination of
inept management and regulatory failure,\26\ which means that capital
ratios are too high for well-managed banks. Undifferentiated capital
requirements for private-sector credit risks, coupled with the
inability of regulators to sufficiently differentiate good banking from
bad in establishing risk-based deposit insurance premiums, are the
principal reasons why banking has steadily lost market share as a
channel of financial intermediation. In effect, regulatory
inefficiencies have created substantial regulatory arbitrage
opportunities which financial services entrepreneurs, utilizing
electronic technology, have increasingly capitalized upon, at banking's
expense.
excess regulatory compliance costs
Because of the regulatory shortcomings cited above and
congressional distrust of the competency of the banking regulators, as
FDICIA effectively proclaimed, Congress and the banking regulators have
geared regulatory compliance burdens to the lowest common denominator
in banking; that is, the poorly managed banks which are most likely to
fail. This compliance burden is made worse by the inherent, one-size-
must-fit-all nature of government banking regulation. This burden,
which imposes higher operating costs on banks as well as regulatory
straitjackets which impair the managerial flexibility of bank managers,
further harms banking's competitiveness. All of these costs are borne
by banks and are in no way subsidized by the Federal Government.
large non-bank financial firms receive an implicit safety net subsidy
While banks pay for the entire cost of their Federal safety net, as
demonstrated above, large non-bank financial firms do not pay for their
Federal financial safety net, which is the ability to borrow at the
Fed's discount window in ``unusual and exigent circumstances.'' \27\
Although the Fed has not lent in such circumstances for at least fifty
years, it can lend to a large insurance company or investment banking
firm facing severe liquidity problems. The importance of this standby
lending authority for the Fed was evidenced by a little-noticed
provision in FDICIA (Sec. 473, Emergency Liquidity) which effectively
broadened the types of collateral which the Fed could accept in lending
to non-bank firms to include marketable securities. This amendment
reportedly was sparked by the liquidity problems some securities firms
faced in the aftermath of the 1987 stock market crash. The report
accompanying the Senate version of FDICIA made clear that this
amendment to 12 U.S.C. Sec. 343 was intended to make it easier for the
Fed to lend to temporarily illiquid investment banking firms.
Unpublished reports also indicate that there have been times,
specifically in the mid-1970's and the late 1980's, when insurance
companies suffering liquidity problems approached the Fed about
borrowing at the discount window. According to these reports, the Fed
did not lend to these insurers, but that does not mean the Fed could
not have lent to them. That insurers occasionally face liquidity crises
illustrates one of the great weaknesses of the state guaranty funds for
insurers--the lack of an equivalent to the Fed's discount window.
Another close call for the Fed may have been Long Term Capital
Management (LTCM). Although the New York Fed did lean on LTCM's
principal creditors to provide additional liquidity to LTCM during its
late-summer crisis last year, had that liquidity not been forthcoming,
the Fed might have been forced to lend directly to LTCM in order to
prevent a liquidity freeze-up in the global capital markets.
While the Fed theoretically would demand sufficient collateral when
lending to a non-bank to protect itself against any loss, there is the
danger that the Fed could not obtain enough collateral fast enough if
the market value of the pledged securities was falling rapidly, as
occurred during the 1987 stock market crash and again last summer
following Russia's domestic debt default and LTCM's subsequent
problems. This collateralization problem is compounded by the fact that
most marketable securities of investment banking firms already have
been pledged as collateral for the loans financing the purchase of
those securities. In such a case, the Fed can only obtain a junior, and
very thin, lien on such securities. Consequently, the Fed's risk of
loss on discount window lending to non-bank firms may be much greater
than it is on loans to banks which have substantial unobligated assets.
Far worse in the case of non-bank firms, the Fed does not have an FDIC
to look to for a bailout. As the Continental Illinois caper discussed
on page 5 so clearly illustrates, the Fed can hide behind the FDIC when
lending to a troubled bank. Sec. 142 of FDICIA further exaggerated this
difference by limiting the length of time the Fed can lend to a
troubled bank; \28\ no comparable limit applies to non-bank discount
window loans.
Non-bank financial firms which have legal access to the Fed's
discount window do not have to pay a commitment fee in advance for that
right of access nor has Congress established an after-the-fact
mechanism, comparable to the FDIC's unlimited assessment powers, to
assess surviving non-bank financial firms for any losses the Fed might
incur in lending to non-bank firms. The absence of a commitment fee and
assessment power effectively has gifted non-bank financial firms with a
valuable Federal financial safety net subsidy that has been denied to
banks through their forced participation in an unsubsidized Federal
deposit insurance scheme. Arguably, a public good--systemic stability--
flows from non-bank access to the discount window. However, that good
does not warrant this subsidy any more than the public good of Federal
deposit insurance would warrant a taxpayer subsidy for banks.
if there were a bank safety net subsidy, the operating subsidiary
structure would be preferable to the holding company structure
As should be clear by this point, banks do not receive a Federal
safety net subsidy financed by taxpayers. Consequently, it should be a
moot question as to whether the ``op-sub'' or the ``holding company''
structure of a banking organization can better contain a safety net
subsidy. Unfortunately, this is not a moot question because of the
amazing success Mr. Greenspan has had in promoting the fiction that
banks receive a safety net subsidy. Therefore, the balance of this
paper will examine the containment issue.
organizational differences underlying the op-sub debate
The op-sub organizational structure is one in which a banking
company conducts what have traditionally been viewed as non-bank
activities in an operating subsidiary of the bank; hence, the term op-
sub. Notable among these non-bank activities are securities and
insurance underwriting and brokerage. An op-sub, because it is owned
by, and therefore is capitalized by, its parent bank, is subject to the
regulatory oversight of the bank's regulator. In effect, the op-sub's
equity capital, and therefore its capacity to absorb losses, flows from
the bank's owner or owners through the bank to the op-sub.
Under rules proposed by the OCC, for the purpose of measuring a
national bank's compliance with its regulatory capital requirements, a
bank's equity capital investment in an op-sub must be fully deducted
from the bank's capital. This deduction will eliminate any double-
counting of capital and therefore any ``double-leveraging'' whereby
debt of the parent is counted as equity capital in a subsidiary. Some
degree of double-leveraging is still evident in capital arrangements
between bank holding companies and their subsidiary banks, but not to
the extent it once was. Still, the OCC's proposed rule represents a
more conservative approach to op-sub capitalization than now governs
the capitalization of banks by Fed-regulated bank holding companies.
In the holding company structure, non-traditional activities,
specifically securities and insurance underwriting, are conducted in a
direct subsidiary of the bank holding company. Therefore, such a
subsidiary is a side-by-side, non-bank affiliate of the bank. That is,
the bank and its non-bank affiliate have a common parent, which is
regulated by the Fed as a bank holding company. The capital invested in
the non-bank affiliate comes from the holding company, possibly with
some degree of double-leverage. This structural alternative is referred
to as the non-bank affiliate structure.
In addition to its equity capital investment, a bank can engage in
other types of financial transactions with an op-sub, specifically
lending to it or buying assets from it. Likewise, a bank can engage in
similar transactions with a non-bank affiliate. In the latter case,
Sec. 23A and 23B of the Federal Reserve Act limit the financial
dealings between a bank and its non-bank affiliates; the OCC has
proposed to apply the same restrictions to dealings between a bank and
its op-subs. Therefore, the op-sub debate focuses on equity capital
issues and not on debt or other types of financial transactions.
greenspan's safety net subsidy assertion
Mr. Greenspan, with almost no support outside of the Fed, asserts
that banks receive a safety net subsidy which banking companies can use
to greater competitive advantage in the op-sub structure than in an
affiliate structure. The fact that the OCC becomes the key banking
regulator of a banking company opting for the op-sub structure while
the Fed is the key banking regulator of a banking company electing the
affiliate structure has no bearing, of course, on Mr. Greenspan's
position in this debate.
There are two sequential pieces to Mr. Greenspan's safety net
subsidy assertion. First, he contends that banks generate ``subsidized
equity capital.'' Apparently, based on a conversation the author had
with a Fed economist familiar with Mr. Greenspan's thinking on this
subject, subsidized equity capital represents the above-market rate of
return banks earn on their equity capital by virtue of their safety-net
access. There apparently are two sources for this additional rate of
return.
The first source is that banks can lower their weighted average
cost-of-funds by operating on a more highly leveraged basis than non-
banks. This favorable cost-of-funds differential generates the
additional return on equity that banks supposedly earn. It is true that
banks can operate on a more highly leveraged basis than non-banks, but
that advantage does not constitute a taxpayer subsidy. Instead, as was
explained above, it represents the insurance value of any form of
insurance. As noted above, if non-banks want to capture the risk-
spreading benefit of insurance, they should create private insurance
vehicles comparable to Federal deposit insurance. As the author has
explained in numerous fora, the cross-guarantee concept can be utilized
to privatize bank deposit insurance and can be broadened to insure the
liabilities of non-bank firms.\29\
The second source of above-market returns that banks supposedly
earn stems from the Federal Government's guarantee of the FDIC's
insurance obligation. Because of this guarantee, Mr. Greenspan
contends, interest rates on bank deposits do not reflect a sufficient
FDIC insolvency risk premium; that is, depositors would demand higher
interest rates if the FDIC's insurance obligations were not federally
guaranteed. Presumably this absence of an FDIC risk premium extends to
the non-deposit liabilities of TBTF banks implicitly protected under
the FDICIA systemic risk exception discussed above. However, there is
no need for such a risk premium because the congressional reforms
discussed above, starting on page 6, have essentially eliminated the
FDIC insolvency risk.
The author readily agrees that deposit insurance is mispriced on a
bank-by-bank basis, and grievously so in some cases, but the FDIC's
unlimited assessment powers, which underpin the substantial cross-
subsidy in deposit insurance pricing discussed above, readily trump the
effect of the bank-by-bank mispricing of Federal deposit insurance.
That is, while some banks may benefit competitively for a time by being
undercharged for their deposit insurance, eventually their sins will
sink them, as we saw most recently in the BestBank failure.\30\ Over
time, though, the competitive damage of mispriced deposit insurance
falls most heavily on the stronger banks which are hurt by the
overpriced deposit insurance premiums they pay, excessive capital
requirements, and the regulatory burdens discussed above. Hence, while
mispriced deposit insurance and banking regulation adversely distort
the financial marketplace, the net effect of these distortions is far
more detrimental than helpful to well-managed banks.
The second sequential piece of the Greenspan assertion is that
having once captured extraordinary profits, thereby creating subsidized
equity capital, banks can then more easily downstream that subsidized
capital into op-subs than it can funnel that capital up to the bank's
parent holding company, which would then invest that capital in non-
bank affiliates. However, that argument simply does not wash because it
is just as easy, given the tax neutrality of moving earnings around
within a banking company, for the management of the banking company to
invest bank earnings downstream into an op-sub as it is to dividend
bank earnings up to the holding company for reinvestment in a non-bank
affiliate. This equality will be strengthened by the OCC's proposed
rule to require that all capital a national bank invests in an op-sub
be deducted from the bank's capital for regulatory purposes.\31\
other arguments favoring the op-sub structure
Other arguments favor the op-sub structure over the non-bank
affiliate structure, including the inherently greater operating
efficiency of op-subs. Also, op-subs will strengthen banks, if the 100
percent capital deduction rule is in place, while non-bank affiliates
could harm affiliated banks, particularly if the corporate veil between
a bank and a non-bank affiliate can be pierced if the affiliate becomes
insolvent. These arguments lie beyond the scope of this paper. However,
an article by Longstreth and Mattei (1997) does an excellent job of
demonstrating the legal superiority of the op-sub structure.
conclusion
The contention that banks receive, and therefore benefit
competitively, from a Federal safety net subsidy, is simply false.
There is no subsidy because banks are subject to FDIC assessments which
will pay for the full cost of the banking industry's safety net even in
circumstances far worse than the S&L crisis. Further, various reforms
enacted by Congress over the last decade have so dramatically reduced
the potential for such a crisis that the reoccurrence of a crisis of
that magnitude would represent unconscionable regulatory failure,
partly by the very agency which argues that banks enjoy a Federal
safety net subsidy.
references
Barancik, Scott. (1999a) ``FDIC Staff is Developing A System to Make
Some
Well-Capitalized Banks Pay.'' American Banker, January 4, p. 2.
----. (1999b) ``FDIC Puts Off Charging Riskier Banks More.'' American
Banker, February 16, p. 4.
Board of Governors of the Federal Reserve System. (1997) 84th Annual
Report.
Committee on Banking and Financial Services. (1997) U.S. House of
Representatives, Subcommittee on Domestic and International
Monetary Policy, Federal Payment System, Hearing, 105th
Congress, First Session, Serial No. 105-31, September 16,
Washington, D.C.
Continental Illinois Corporation. (1984) Annual Report.
Ely, Bert. (1997a) ``Let the Market Set Interest Rates.'' The Wall
Street Journal, May 20.
----. (1997b) ``Greenspan's Deposit Insurance Subsidy Argument is
Nonsense.'' American Banker, June 6.
----. (1997c) ``Regulatory Moral Hazard: The Real Moral Hazard in
Federal Deposit Insurance.'' A paper presented on November
22, 1997, at the annual meeting of the Southern Finance
Association. Forthcoming in The Independent Review: A
Journal of Political Economy.
---- and Vicki Vanderhoff. (1991) ``Lessons Learned from the S&L
Debacle: The Price of Failed Public Policy.'' The Institute
for Policy Innovation, Lewisville, Texas.
Federal Deposit Insurance Corporation. (1980) Annual Report.
----. (1983) Annual Report.
----. (1997) Annual Report.
----. (1998a) FDIC Quarterly Banking Profile. Fourth Quarter 1998.
----. (1998b) FDIC Quarterly Banking Profile Graph Book. Fourth Quarter
1998.
----. (1999) ``Material Loss Review: The Failure of Best Bank, Boulder,
Colorado.'' Audit report No. 99-005, January 22.
Greenspan, Alan. (1999) Testimony before the Subcommittee on Finance
and Hazardous Materials, Committee on Commerce, U.S. House
of Representatives, April 28.
Kwast, Myron L. and S. Wayne Passmore. (1997) ``The Subsidy Provided by
the Federal Safety Net: Theory, Measurement and
Containment.'' Board of Governors of the Federal Reserve
System, September, Mimeograph.
Longstreth, Bevis and Ivan Mattei. (1997) Columbia Law Review 36 (4)
October, pg. 1895.
Petri, Tom, and Bert Ely. (1995) ``Better Banking for America: The 100
Percent
Cross-Guarantee Solution.'' Common Sense, Fall 1995.
endnotes
1. Author's calculation.
2. These costs, which totaled $1.692 billion, break down by agency
as follows: Federal Reserve System--$517 million; Federal Deposit
Insurance Corporation (including administrative costs of the deposit
insurance funds)--$677 million; Office of the Comptroller of the
Currency--$350 million; Office of Thrift Supervision--$148 million.
3. Reserves on deposit at the Fed in 1997 (excluding compensating
balances for services provided by the Fed) averaged $10.792 billion
(calculated from the monthly Federal Reserve Bulletin, Table A6). The
average yield on the Fed's securities portfolio in 1997 was estimated
to be 6.05 percent (calculated from Board of Governors of the Federal
Reserve System (1997), Statistical Tables 6 and 14). $10.792 billion x
.0605 = $653 million.
4. Calculated from data published in the monthly Federal Reserve
Bulletin, various issues, Table 1.12, ``Reserves and Borrowings.''
5. Codified as 12 CFR 201.
6. It is not necessary for the Fed to include a cost-of-funds
element in its intraday interest rate since it pays no interest to
banks which accumulate positive intraday account balances at the Fed.
7. Board of Governors of the Federal Reserve System (1997), Pg.
288, Table 6, footnote 1.
8. Ibid., p. 264, footnote 2 to the financial statements for priced
services provided by Federal Reserve banks.
9. The pension cost credit is describe more fully in a report by
the author, titled ``An Analysis of the Fed's Priced Services
Activities,'' appended to testimony by Mr. Eric Roy, on behalf of the
Association of Bank Couriers (Committee on Banking and Financial
Services, 1997, pp. 249-250). This report also discusses other ways in
which the Fed effectively utilizes taxpayer funds to subsidize the
services which it provides to banks.
10. This estimate was obtained in a March 31, 1999, telephone call
to the Division of Finance at the Federal Deposit Insurance
Corporation.
11. Federal Deposit Insurance Corporation (1997), Table on
Recoveries and Losses for All Cases, p. 104.
12. Ibid., Table of Income and Expenses, p. 105.
13. Federal Deposit Insurance Corporation (1980), p. 299, Table
127, Footnote 3.
14. Prompt Regulatory Action constitutes Subtitle D of Title I of
FDICIA (Sec. 131-133) while Least-Cost Resolution follows in Subtitle E
(Sec. 141-143).
15. Depositor preference was enacted as Sec. 3001 of Public Law
103-66 and is codified as 12 U.S.C. ?1821(d)(11).
16. This line of credit is authorized by 12 U.S.C. Sec. 1824(a). In
addition, Sec. 1824(b) authorizes the FDIC to borrow from the Treasury
Department's Federal Financing Bank.
Sec. 1824(c) governs the repayment schedule for any such
borrowings. Presumably, the interest rate on these borrowings will not
be less than Treasury's borrowing rate given that, in setting the
interest rate on Treasury loans to the FDIC, the Secretary of the
Treasury will take ``into consideration current market yields on
outstanding marketable obligations of the United States of comparable
maturity.'' This provision in Sec. 1824(a) should bar any taxpayer
subsidy to banks through this borrowing channel. Given the capital
strength of the banking industry today, this line of credit could
safely be canceled.
17. One exception: the Securities Investor Protection Corporation
(SIPC), which is a creature of the Federal Government. It protects the
cash and securities account balances of customers of insolvent broker/
dealers against fraud, up to statutorily specified limits.
18. Although there were 10,461 FDIC-insured banks at the end of
1998 (Federal Deposit Insurance Corporation, 1998b, p. 63), the cross-
guarantee provision of FIRREA discussed on page 6 effectively
consolidates the banking industry into a smaller number of institutions
for deposit insurance purposes.
19. Calculated from call reports filed with the FDIC by
BankAmerica's ten subsidiary depository institutions.
20. The FDIC is ``on-budget'' for this reason: for the purpose of
calculating the Federal Government's revenues, spending, and therefore
its annual surplus or deficit, the FDIC's revenues from outside the
government, such as the premiums it collects, count as Federal revenues
while its cash outlays count as Federal spending. It is this inclusion
of the FDIC's revenues and spending in the government's financial
statements which makes the FDIC an on-budget Federal agency. The
interest the FDIC earns on its portfolio of Treasury securities does
not count as Federal revenue because it is merely a bookkeeping
transfer within the Federal Government, from the Treasury to the FDIC.
21. BIF and SAIF combined net income of $1.918 billion ($1.438
billion for BIF plus $480 million for the SAIF) for 1997 minus a non-
cash reversal of prior years' loss provisions of $506 million equals
$1.412 billion.
22. Total insured deposits of BIF and SAIF equaled $2.85 trillion
at the end of 1998 (Federal Deposit Insurance Corporation, 1998a, p.
17). 1.25 percent of that amount equals $35.63 billion.
23. According to several observers on the scene at the time, in
1978, when interest rates were rising, the Fed proposed to pay interest
on required reserves so as to arrest a decline in Fed membership as
state-chartered banks dropped their Fed membership. Because the Federal
Reserve Act does not specifically bar the Fed from paying interest on
reserves, the Fed opined that it could pay that interest. However,
members of the House and Senate Banking Committees strongly opposed
this proposal, partly because payment of interest on reserves would
have added substantially to the Federal budget deficit. The banking
committees reportedly backed up their position with a legal opinion
from the Congressional Research Service of the Library of Congress
stating that the Fed did not have statutory authority to pay interest
on reserves; the author has not yet located that document. Faced with
this extremely negative congressional reaction, the Fed backed off from
its proposal. Congress later solved the Fed's membership problem by
mandating, in the Monetary Control Act of 1980, that all depository
institutions maintain reserves at the Fed regardless of whether they
belong to the Fed. Congress's views in 1978 were set forth in a June 5
letter to then Fed Chairman G. William Miller from Henry S. Reuss, then
chairman of the House Banking Committee, and William Proxmire, then
Chairman of the Senate Banking Committee, and in a June 28 letter from
Reuss to Miller.
24. For the first semiannual assessment period in 1999, 95.0
percent of all BIF-insured institutions will not pay an insurance
premium while that will be the case for 93.4 percent of all SAIF-
insured institutions. Just eleven FDIC-insured institutions will pay
the highest premium rate of 27 basis points (Federal Deposit Insurance
Corporation, 1998a, p. 19).
25. FDIC-insured deposits equaled 74.7 percent of total domestic
deposits at the end of 1998 ($2.85 trillion/$3.814 trillion), as
calculated from Federal Deposit Insurance Corporation (1998a), pp. 4,
16, and 17. The FDIC earned approximately a 6 percent yield on its
Treasury securities in 1997 (1998 data is not yet available), as
calculated from Federal Deposit Insurance Corporation (1997), pp. 47,
48, 63, and 64. Assuming a minimum reserve ratio of 1.25 percent: .0125
x .06 x .747 = 5.6 basis points.
26. The shortcomings of government banking regulation are the real
moral hazard in Federal deposit insurance (Ely, 1997c).
27. 12 U.S.C. Sec. 343, second paragraph. Unlike banks, which can
borrow at the discount window of a Federal Reserve bank without prior
approval by the Board of Governors of the Federal Reserve System, loans
to non-bank firms require an affirmative vote of five members of the
Board of Governors.
28. 12 U.S.C. 347b(b)(1), as amended by Sec. 142 of FDICIA,
provides that ``[e]xcept as provided in paragraph (2), no advances to
any undercapitalized depository institution by any Federal Reserve bank
under this section may be outstanding for more than 60 days in any 120-
day period.''
29. See for example, Petri and Ely (1995). Other articles and
papers on the cross-guarantee concept are posted on the Ely & Company
website at http://www.ely-co.com.
30. On July 23, 1998, the BestBank of Boulder, Colorado, failed
with total assets of $314 million. The FDIC's estimated loss in
BestBank, as of the end of 1998, was $171.6 million, or 55 percent of
assets; that loss percentage may go higher. As spelled out in a 74-page
report issued by the FDIC's Inspector General (Federal Deposit
Insurance Corporation, 1999), BestBank represents an extremely serious
regulatory failure by the FDIC.
31. An amendment to H.R. 10, as reported by the House Banking
Committee on March 11, 1999, would require that this capital deduction
include all retained earnings in the op-sub.
Chairman Sununu. Thank you very much to each of our
witnesses.
Let me begin with Ms. Miles.
Could you please talk in slightly more specific terms about
the trends in the size of the portfolios held by the GSEs, both
whole loans and their own mortgage-backed securities?
In relative terms, what has been the size of the increase
over the past decade? Is it a new trend or are the portfolios
they hold essentially the same size as they have held
historically?
Your comments.
Ms. Miles. You have two separate trends going on.
Historically, until about the middle 1980's, Fannie Mae was a
portfolio holder and they did not start issuing mortgage-backed
securities until about 1980 and they were not a significant
size until a few years after that.
Freddie Mac, by contrast, started life as a mortgage-backed
securities issuer and held very small portfolios. That started
changing.
Chairman Sununu. Started changing when?
Ms. Miles. Again in the 1980's and significantly in the
1990's. At this point, I am going to have to check my memory
here. I know Tom has some numbers in front of him. I believe
that Freddie Mac is up to about--not quite one-third of its
assets in the form of its portfolio or repurchased mortgage-
backed securities and about two-thirds in mortgage-backed
securities.
Chairman Sununu. Mr. McCool, did you want to offer some
specifics?
Mr. McCool. That is about what we have. For Freddie Mac, it
is about one-third in portfolio and two-thirds as MBS
outstanding and for Fannie Mae it is about 43 percent in
portfolio.
Chairman Sununu. Let's stay focused on their portfolios,
when you say 43 percent in portfolio.
Mr. McCool. That means that they hold either as whole
mortgages or as repurchased mortgage-backed securities about 43
percent of the total outstanding obligations are in their
portfolio rather than as outstanding mortgage-backed securities
that somebody else holds.
Chairman Sununu. And for Fannie Mae in particular, that
amount would be approximately $550 billion currently? Is that
right?
Mr. McCool. Well, 522 at the end of 1999.
Chairman Sununu. You mentioned both whole loans and
mortgage-backed securities. What are the differences in risks
that the holder of those securities are exposed to? In other
words, from the standpoint of systematic risk, interest rate
risk, prepayment risk, is there any difference in whether or
not the GSEs or any other financial institution chooses to hold
whole loans versus mortgage-backed securities?
Ms. Miles. Would choose to hold them?
Chairman Sununu. Yes.
Ms. Miles. If you are holding them, you have all the risks.
The advantage of mortgage-backed securities, when you sell
them, you are selling mortgages off your books. You are
retaining the credit risk, but you are pushing off onto someone
else the interest rate risk.
One of the reasons they are less profitable than holding
whole loans is that in the process of giving someone else the
interest rate risk you also have to give them the profitability
that attaches to that. But when you buy them back on your
books, you are essentially repatriating all that risk.
Chairman Sununu. My question is: For the purposes of us
assessing a change in the risk profile, should it matter to us
whether Fannie Mae, say, previously held $100 billion in whole
loans and today holds $100 billion in mortgage-backed
securities? They are still taking the credit risk on both and
because they choose to hold them, they are holding interest
rate risk and prepayment risk, correct?
Mr. McCool. Interest rate and prepayment risk. Right.
Mr. Ely. Mr. Chairman, if I could add to that, there is
cause for concern because when they do take back the interest
rate risk, particularly if they buy back mortgage-backed
securities that they or someone else has previously issued,
they take back the interest rate risk and they bring back the
prepayment risk. This gets to what is, I think, of concern with
regard to their balance sheets. That is, they become like the
traditional S&L of the 1960's and 1970's, that is, they
significantly maturity mismatch on their balance sheet in terms
of how they fund themselves.
Now, they hedge a lot of that risk by buying interest rate
swaps and other forms----
Chairman Sununu. If you could hold up there, believe me, I
will get to hedging, but for the purposes of laying out
information, I want to proceed with a little bit of order,
whether it is order in my own mind only.
Mr. McCool, you talked a little bit about new product
issuance and about HUD's proposed regulations regarding new
products to make housing more available to lower income people.
Question one is how do new products that might be offered
by the GSEs affect their risk profile and their credit risk
profile in particular. And maybe comment regarding the 3
percent down payment product which is just one new product that
has been in the news and been marketed pretty heavily.
Mr. McCool. The effect on the risk profile would obviously
depend on the product, but in cases where, you know, you are
moving toward lower down payment products, then it would tend
to increase the credit risk, to the extent it is not hedged.
Chairman Sununu. You also discussed investment in, I guess,
non-mission-related vehicles, cash value life insurance and
other investments. Why has there been a delay in issuing
regulations regarding those investments?
Mr. McCool. Well, you would have to ask HUD that. We have
been sort of--we have recommended that HUD issue regulations to
establish criteria, as I said, in our 1998 report and they did
put out an advance notice and they did get some comment back
but they have not actually gone forward with the regulations to
set forth criteria.
Chairman Sununu. Is it your contention, as you addressed
those issues in your testimony, that those investments in non-
mission-related securities increases the risk profile of the
GSEs?
Mr. McCool. Well, actually, some of them might be quite
safe and sound, let's put it that way. For example, some of the
non-mortgage investments that Freddie Mac purchased were
actually from a safety and soundness perspective probably
pretty good, but they had nothing much to do with what Freddie
Mac was in business from the GSE perspective.
So that is part of the issue, are they mission-related in
the sense that the GSEs were given privileges to achieve a
mission and the question is whether they are doing that. So
they could be safe and sound and not mission-related, they
could be both risky and non-mission related, I guess. We have
not seen too many examples of that, but that is also feasible.
Chairman Sununu. Ms. Miles, Mr. Ely mentioned mismatch, the
concern that long-term liabilities might be funded with short-
term assets. Have you made any effort to quantify the degree to
which the portfolios held by the GSEs are well matched and how
do we as policy makers better understand whether or not there
is an appropriate level of matching in these portfolios?
Ms. Miles. I have not attempted to do that recently. We
have some horrendous examples from the past, including one that
I gave you in my written testimony about what happened when
Fannie Mae in the late 1970's and early 1980's was in fact our
largest savings and loan association. They were not well
matched at that point.
They did what every S&L did. They used the relatively short
end of the yield curve in order to fund mortgages at the longer
end and according to a study done by HUD in 1986, on a mark-to-
market basis, they were insolvent every single year from 1978
through 1984 and only came out of trouble in 1985, generally
because of regulatory forbearance.
Having said that, I do not think anyone sees anything quite
like that now and the best people to ask that question are here
today. I would ask OFHEO and also the Federal Housing Finance
Board what those matches are.
Chairman Sununu. Mr. Ely, you raised the case of Long-Term
Capital Management and I would like to address that a little
bit, in a little bit more detail.
You mentioned that their debt was only one-seventh of the
GSEs'. Does that include their exposure as a result of their
trading on margin?
Mr. Ely. Yes, because this was a very highly leveraged
institution. In effect, it largely financed its asset portfolio
with, if you will, margin debt. It may not have been called
that as such, but effectively it was very highly leveraged.
Chairman Sununu. But they do not actually hold their margin
exposure on their books as debt, correct?
Mr. Ely. I have never seen their financial statements. I am
not sure they have ever been published. But as I understand it,
they owned assets, a variety of securities, that were financed
with debt that was on their balance sheet. They also had some
off balance sheet exposures, too. As I understand it----
Chairman Sununu. But this is a not insignificant point.
They had debt obligations to a number of financial institutions
that eventually came and were willing to roll over their debt
in order to facilitate the orderly liquidation. And I assume
that is the debt that you talk about being one-seventh the size
of the GSE debt.
Mr. Ely. That is correct.
Chairman Sununu. It would seem to me that that would not
include, however, their exposure to margin calls which a margin
call does not necessarily require the entry of a debt or an
obligation on your books. So it would seem to me that there is
at least something of a difference here and there was an
enormous exposure to margin calls in the case of Long-Term
Capital Management that I hope, assuming that the non-mission
related-investments are more or less focused, the GSEs are not
exposed to. I do not know of any GSE being exposed to a margin
call, do you?
Mr. Ely. I am not aware of that.
Chairman Sununu. Long-Term Capital Management, they also, I
know, traded quite heavily in currencies and currency futures.
That is obviously a very volatile market that GSEs are not
really exposed to. Is that correct?
Mr. Ely. Except that they do raise funds in foreign
markets, so whether or not any of that is in foreign
currencies, I do not know, but they do sell their debt on a
global basis so that the extent to which we worry about
systemic risks, we have to think not only in terms of how U.S.
investors are reacting, but also about foreign owners of their
debt.
Chairman Sununu. If they were effective at managing their
risk exposure, I assume they would just swap out of any
exposure to foreign currencies, correct?
Mr. Ely. That is a reasonable assumption.
Chairman Sununu. In the same way that they would swap out
of exposure to short-term rates if they wanted to balance their
portfolio appropriately.
Mr. Ely. That is correct. But what that does is create
counterparty risk, which is a form of credit risk. In other
words, the underlying assumption in any kind of swap or
derivative arrangement is the counterparty will be able to
perform if and when called upon to do so. One of the things
discussed in the report I co-authored on nationalizing mortgage
risk is that the footnote disclosures by both Fannie and
Freddie, in my opinion, do not provide enough insight into the
counterparty risk that they have under all of their swap and
derivative arrangements.
Chairman Sununu. What is riskier, holding a whole loan or
holding a mortgage-backed security? To an individual, for
example to me. Let's start with that.
Mr. Ely. It depends on who issues the mortgage-backed
security. If the mortgage-backed security is issued by one of
the GSEs, by Fannie or Freddie, then I would argue that that is
less risky than holding a whole mortgage because of the
implicit backing of the Federal Government.
Chairman Sununu. I mean, it says pretty clearly that it is
not backed, so let's assume that to be the case.
What about for a financial institution? What is riskier for
the bank in my hometown, Bedford or Manchester, New Hampshire,
what would be riskier, holding a whole loan or holding a
mortgage-backed security?
Mr. Ely. If you leave aside even the Federal guarantee,
presumably it is riskier to hold a whole mortgage if the bank
has a large concentration of mortgages it has originated
locally because one of the benefits of mortgage-backed
securities, whether they are issued by a GSE or privately, is
that they provide geographical risk dispersion.
Chairman Sununu. Should we be concerned, and should we
include in these discussions, then, the fact that the whole
loans held by the bank and thrift industry still dwarf the
number of mortgage-backed securities held by the bank and
thrift industry, I think by a factor of two to one or three to
one?
Mr. Ely. Well, again, that also is a function of what the
capital levels are at the banks and thrifts. In other words,
there may be risk in the form of a geographical concentration,
but if the bank or thrift holds enough capital, then that can
offset the risk. That is the tradeoff. And basically, banks and
thrifts are held to a higher capital standard to reflect the
fact that they have some degree of concentration of risk.
Although it is not widely used, there is an instrument,
known as a credit derivative that represents another tool for
trying to diversify geographical risk concentrations.
Chairman Sununu. Thank you.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Let me go back just for a second to this question of risk.
It seems to me there are two types of risk related to a
mortgage, whether it is in the form of a whole loan or
mortgage-backed securities, and you all have said this, but
just to clarify, there is credit risk related to the asset
itself and there is interest rate risk. Both entities, both
instruments, carry some form of that type of risk.
But I think we need to also consider the fact it is not--I
do not think we can just say because Fannie and Freddie have
the implicit guarantee of the Federal Government, which I
totally concur with, that we also have to give some credit to
underwriting standards, whether they be Fannie and Freddie's
underwriting standards or the bank's underwriting standards or
whoever's underwriting standards. So I think there are other
factors that come into play as to what the risk is.
I also need to say, and I think the chairman was commenting
on this, I realize we like to use Long-Term Capital Management
as a comparison. I think that is a red herring.
And, Bert, you made this clear in your comments in response
to the chairman, that the types of investments that LTCM was
in, which I do not have objection with them doing that, are far
different in most respects with the types of investments that
the GSEs are in, just as the GSE investments are different in
many respects to the types of asset investments on the part of
banks, on the part of mutual funds, et cetera.
Now, the question is the concentration, which I think is
where you make a bigger point and the question of is there too
much concentration in the mortgage market on the part of the
GSEs with a potential for systemic risk and how that flows back
to the taxpayer.
Now, let me ask a couple of questions. One issue that we
have sort of talked around which I think was sort of the
initial focus of this hearing and that is what is the risk to
the taxpayer compounded by the fact that the GSEs in addition
to issuing corporate debt with which they use the proceeds to
purchase whole loans and then the corpus of which is pledged
against that corporate debt, is that risk compounded when the
GSEs enter the secondary market and purchase back mortgage-
backed securities which they issued?
And, second of all, how much of that purchase is for the
purpose of supporting the primary market price of the
securities itself that they are issuing and how much of it is,
for lack of a better term, an arbitrage play because their
ability to--because of both the price of the security in the
market and the cost of their capital?
And if it is such a play, how much of that--and I am not
going to ask you to quantify the difference today, but how much
of that spread, if you will, enures back to the benefit, if
any, to the homeowner in terms of lower mortgage costs? Or does
it all go to the shareholder? Or do you know?
Mr. Ely. Well, to address a couple of points, in my
opinion, you do not have to have Fannie and Freddie to maintain
liquidity in the secondary market. That market is big enough
that private sector firms, specifically broker dealers, could
do that job.
In my opinion, the MBS buyback is to take advantage of
arbitrage. It is an arbitrage play. Driving it, in my opinion,
is that Fannie and Freddie have made a commitment to the
financial markets, Fannie more strongly than Freddie, to grow
their earnings at 15 percent a year, to double their earnings
every 5 years.
The mortgage market is not growing that fast and so they
have to figure out how to grow their revenues faster than the
market is growing. A good way to do that is to buy back MBS, to
get the interest rate spread, which is significantly greater
for carrying interest rate risk than carrying credit risk.
Our assessment is that on a net profit basis, depending on
which GSE you are looking at, they get about four to six times
as much net profit, per mortgage dollar outstanding, if they
assume the interest rate risk which they get by buying back the
MBS. So ultimately their MBS buybacks are driven by the
earnings growth commitment that they have made to Wall Street.
Now, in terms of where that benefit goes, that is something
I have not assessed. It would be a good question to pose to CBO
in the context of the study that they are doing to update their
1996 report on Fannie and Freddie. At that time, CBO made an
estimate as to how much of the overall subsidy that Fannie and
Freddie have flows through to homeowners and how much of it
stays with stockholders and management.
Mr. Bentsen. And I want to hear your comment, but I want to
follow up with Bert here because we----
Is the reason, in your opinion, that Fannie and Freddie--
let's say Fannie, is the commitment to the capital markets of
the 15 percent annual return because the structure of the
entity is such that the Federal Government wanted to jump start
the secondary market and ease the ability to gain a mortgage
and in effect leverage private capital, that the entities have
to be able to raise private capital at a competitive rate of
return and the fact that, criticism notwithstanding, the
ability for the GSEs to expand into non-mortgage investments in
any marked way, as opposed to a nominal sense, is limited by
the fact that HUD oversees them and there may be legislation,
et cetera, has this created sort of a Hobson's choice for us of
whether we want to have--of the type of entity that we have
here?
Is this part of our own creation, that they are forced to
earn returns where they can in order to meet their mission and
satisfy those who are putting capital into it?
Mr. Ely. Well, there are two issues here. First, in terms
of the rate of return, they clearly are earning above-market
rates of return on their equity capital. ROEs of 22 and 24
percent are earned on a steady basis, which are quite handsome
compared to genuine private sector firms.
What is the motivation here is that it is the promise of
such significant growth in earnings, that is 15 percent a year,
doubling earnings every 5 years, that is key to driving up
their stock price. That is what motivates Fannie and Freddie--
not so much the striving for high ROE as it is the earnings
growth rate.
And, again, the problem they face, and maybe it is their
Hobson's choice, is that they have made a commitment to the
financial markets to grow their earnings faster per year than
the mortgage market as a whole is growing, which means they
have to assume a larger and larger market share, if you will,
of the total interest spread that exists in the mortgage
market.
This is increasingly a dilemma for them. My sense is that
the stock market is increasingly skeptical of their ability to
maintain that earnings growth rate, which is again separate
from the ROE question.
Mr. Bentsen. But without sufficient capital, they are
unable to purchase more mortgages in the secondary market at a
rate competitive enough to meet the missions that Congress set
out when they were created in the 1930's and in the 1960's. Is
that correct?
Mr. Ely. Well, that is true, except that a lack of capital
has not been a problem for them. At times, Fannie particularly
has been buying back stock. Given what their stock prices have
been, at least until very recently, they would certainly have
no problem in issuing additional capital stock. So I do not
think----
Mr. Bentsen. So it is not that stock buyback--it is not
necessarily a bad thing. I mean, we would expect in a
corporation that has sufficient capital that it ought to
support a stock price at a relatively good price through a
buyback. I mean, that would be something--that would be
considered a good corporate practice in most cases, right?
Mr. Ely. That is true, but a stock buyback suggests that a
corporation has more capital than it needs rather than being
short of capital, so I do not think that Fannie and Freddie
have suffered from a lack of capital.
Mr. Bentsen. Do you all have any comment?
Ms. Miles or Mr. McCool?
Mr. McCool. Well, I think just getting to your question, I
think it is fairly clear that holding mortgages in a portfolio,
whether it be MBS or whole loans, is both more profitable and
riskier than issuing MBS. I think that is true. What is done
with the profits is something that is very difficult to know.
I think that the question about a Hobson's choice, in our
work on mission regulation, we talk about it as the tension
between increasing shareholder value and fulfilling the mission
and I think it is fairly clear that that tension exists. That
is why mission regulation is so important.
Ms. Miles. I think as far as the repurchase of mortgage-
backed securities goes, it is difficult for me to understand
what that is supposed to do for housing markets because if you
believe that capital markets are well integrated, then what you
are talking about is a GSE taking one form of its means of
financing mortgages and simply substituting it for another form
of financing mortgages. In other words, issuing general GSE
debt in order to buy back mortgage-backed securities, which are
the other way of financing them, and you should end up with a
wash.
Mr. Bentsen. Thank you, Mr. Chairman.
Chairman Sununu. Thank you.
One brief point to clarify. A wash in terms of both
interest cost and liquidity?
Ms. Miles. In terms of what it is that the GSE has actually
done. I mean, if you finance the mortgages by buying them
through GSE debt or if you finance them through selling
mortgage-backed securities, those are both means of financing
mortgages. And if you simply substitute one for the other while
you change who is holding the risk, you still have the same
amount of mortgage money sitting out there in the market.
Mr. Bentsen. Mr. Chairman, if you will yield, that is true
except for the ability, I think, to buy--if you are able to go
back into the market and buy the MBS at a discount, at a deeper
discount than the issuance price, the question is what do you
do with the spread on the discount.
We know that MBSs fluctuate in price based upon interest
rate changes which are obviously beyond the control of Fannie
and Freddie, or I think they are, and the guy who is doing that
is testifying over at the banking committee now, they are over
there.
And the question comes back to, again, is taking advantage
of that spread doing one of two things: is it supporting the
initial issuance price of the future MBS or the current MBS and
that may or may not be the case, although issuers do do that
from time to time, support their product in the secondary
market, both private and Fannie and Freddie, but the other is
what are you doing with the spread and is the spread somehow
affecting the price of the future issuance and thus the price
of the mortgage to the consumer, which is the original mission.
Ms. Miles. Again, that depends on what you believe about
the substitutability of these instruments.
Chairman Sununu. Thank you.
Mr. Hoekstra.
Mr. Hoekstra. I thank the chairman. I thank you for doing
this hearing.
Ms. Miles, I would just like to go to some testimony on
page 3 of your testimony and I want to get an elaboration or
expansion of your comments at the bottom of the page where it
talks about market power.
``By most accounts,'' and I am quoting, ``By most accounts,
the problems that gave rise to creation of the housing GSEs
have been corrected. Correction is generally measured in terms
of the degree.''
So are you saying that the circumstances and conditions
that gave rise to GSEs in this area are no longer out there,
that the need no longer exists?
Ms. Miles. The academic studies that have been done on this
would say yes, that is correct. The argument then becomes one
of does the market failure reappear if you remove GSE status
from the market and that is where most of the argument would be
today.
Mr. Hoekstra. OK.
Mr. Ely. If I could add something to that?
Mr. Hoekstra. Yes.
Mr. Ely. We have a substantial amount of asset
securitization in this country that has nothing to do with the
GSEs, in the jumbo mortgage market, credit cards, and auto
loans. The markets have learned how to securitize assets. If
Fannie and Freddie went away, the markets would still be able
to securitize mortgages.
Mr. Hoekstra. Thank you.
Ms. Miles. And if I could pick up on one thing there. I do
not know of anyone who is actually advocating that Fannie and
Freddie go away. I have heard a lot of advocacy that they
simply graduate out of their GSE status, which is a different
question.
Mr. Hoekstra. Right. And they graduate out of GSEs to move
them away from the benefits that I think all three of you
talked about in your testimony that they receive as being
identified as a GSE.
And I would also assume if we moved them away from a GSE we
would also perhaps move away some of the risk that is
associated with the taxpayer. Would that be safe to say?
Mr. Ely. Yes.
Mr. Hoekstra. OK. Because I think where I then start
getting some concerns, I think, again, Ms. Miles, on page 5 of
your testimony, you talk about them repurchasing their
mortgage-backed securities and it is toward the bottom of the
page.
``While it is clear that this increases shareholder value,
it is difficult to understand what, if anything, it does for
mortgage markets.''
So this really--what I see at least I think all three of
you talking about in your testimony, you are seeing behavior
out of these GSEs that is not associated with their primary
mission, but is associated with their mission to their
shareholders of meeting the commitments that they have made to
their financial markets.
Is that what you are saying here on page 5?
Ms. Miles. That is correct. And one of the things to bear
in mind is when we set up GSEs, I tried to make clear right up
front, we set up something that has an inherent contradiction
in it. Because while it has a public purpose and those charters
are intended to be tools to take care of that public purpose,
we also set them up as private enterprises with a fiduciary, a
legal responsibility to their shareholders. There is a tension
there.
Mr. Hoekstra. That is right.
And then, Mr. McCool, in your testimony on page 6, you are
using the same type of examples. ``We pointed out that the
enterprises have incentives to use the funding advantage
associated with their government sponsorship to make non-
mortgage investments, such as corporate bond purchases, that
may result in arbitrage profits.''
Again, you conclude, ``However, our report concluded that
the relationship between long-term non-mortgage investments and
the enterprise housing mission is not entirely clear.''
So you are saying the same thing, that there is not--
activity that the GSEs are engaged in may or may not be
directly related to their primary mission.
Mr. McCool. There are cases where that is very true. There
are cases where non-mortgage investments are necessary to
maintain liquidity and there are other cases, we suggest, where
that relationship is not clear.
Mr. Hoekstra. And then at the bottom of page 6, you go on
to talk about, ``For example, in our March 1998 report, we
pointed out that HUD approved a new mortgage program Fannie Mae
that would involve Fannie Mae in purchasing cash value life
insurance, which is essentially a non-mortgage investment. HUD
officials told us that they lacked expertise in cash value life
insurance when they approved the Fannie Mae program.''
We are seeing these organizations move into an area where
it may be higher risk to the taxpayer, it gets to be even
higher risk if the people that have oversight over them do not
understand the activities that they are engaging in. Is that
what you are saying in this section?
Mr. McCool. Well, part of the issue there was we thought it
would have been prudent for HUD to talk to, in this case,
Treasury, who actually does understand cash value life
insurance and, in particular, the tax treatment thereof, which
was one of the issues. But in this case, that discussion did
not occur.
Mr. Hoekstra. Well, what you are saying is that for an
organization whose debt approaches that of Treasury and in some
form is overseen by HUD, HUD is approving activities and
actions that it does not understand.
Mr. McCool. In this particular case, I think that was true.
Mr. Hoekstra. Mr. Chairman, I have no more questions. Thank
you.
Chairman Sununu. Thank you, Mr. Hoekstra.
Mrs. Clayton.
Mrs. Clayton. Thank you, Mr. Chairman. I also think this is
a significant hearing. I would also ask if my opening statement
may be a part of the record.
Chairman Sununu. Without objection.
[The prepared statement of Eva M. Clayton follows:]
Prepared Statement of Hon. Eva M. Clayton, a Representative in Congress
From the State of North Carolina
Chairman Sununu, this is the latest in a series of hearings and
other activity that have focused on this important subject.
On July 18, our colleague, Congressman Peter Hoekstra, issued a
``Dear Colleague'' calling for ``A Healthy Debate on the Future of
GSEs.''
That call came on the heels of five hearings on GSEs that have been
conducted in Congress, this session.
Those hearings centered around a Bill, H.R. 3703, that has been
introduced by our colleague, Congressman Richard Baker.
Despite those hearings, it appears that we are still searching for
the right thing to do in this situation--There is no emerging
consensus.
I believe it is important and useful that Congress exercise its
oversight authority, especially on a matter--housing--that affects all
of our citizens.
Home ownership rates in the United States have reached historic
levels.
One of the questions I hope this hearing will help answer is
whether the role of the GSEs has substantially and significantly
contributed to this desirable rise in home ownership?
And, if so, will the call for reform help or hurt this role?
No one likes debt.
But, another question I hope this hearing will answer is whether
the debt of GSEs is something about which we should be concerned to the
point of panic.
It is fair to say that, while comparison of GSE debt to Treasury
debt is of some use, the comparison is not exact.
They are not the same.
Still another question I hope this hearing will help to answer is
whether the GSEs, by their activities, are exposing our Government to
unreasonable and unacceptable risk?
Not all risk is unreasonable and unacceptable.
A related question is whether the GSEs, through their debt, are
adding to or contributing to the debt of the United States.
We have worked hard to eliminate the national debt, and we are on
track to do just that by 2013, and activity that impedes that progress
must be closely scrutinized.
What is the fundamental role of the GSEs, and can that role be
better performed by some other entity?
Is the current arrangement with the GSEs in need of repair,
restructuring, radical change?
And, finally, I hope this hearing will help us to answer the
question, what is best for the consumer--- what is best for the
American people?
Can we have home ownership, without debt?
Can we ensure that every citizen, regardless of their station in
life, with hard work, determination and careful budgeting, has a chance
to own a home, without the involvement of the GSEs?
While home ownership has reached historic levels in America, still,
for many, it is out of reach.
Like home ownership generally, minority home ownership has grown.
Yet, despite that growth, home ownership among African- Americans
today stands at just over 47 percent.
And home ownership among Hispanics stands at roughly the same
amount.
Yet, the home ownership rate among whites is close to 75 percent.
Home ownership, Mr. Chairman, is the backbone of this Nation's way
of life.
Whatever we do, we must promote that important goal.
Before we change anything, we must be clear as to whether what we
have now is a benefit or a burden.
And, even if it is a burden, when weighed against the good it does,
is it a necessary burden.
Under current law, Fannie Mae and Freddie Mac face strict
supervision and examination by OFHEO, which has a staff of 95, whose
full-time responsibility is to oversee these two entities.
Fannie Mae and Freddie Mac will argue that they employ
sophisticated interest-rate and credit risk management strategies,
strategies, they will say, which provide more than adequate protection.
Fannie Mae will argue that it is limited by charter to investing in
residential mortgages only
They will point out that In the 1980's, most S & Ls failed because,
through deregulation, they were allowed to invest in endeavors far
beyond home mortgages.
Most of the S & Ls that stayed with their traditional mortgage
business recovered, they say.
And, finally, Fannie Mae will argue that any increase in its debt
does not in any way increase the indebtedness of the U.S. government.
Their obligations, they say, are not in any way backed by the full
faith and credit of the United States Government.
In fact, they argue, the law requires that the front page of all
their 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.
Indeed, I have heard nothing to this point to suggest that the GSEs
are not doing a good job.
Moreover, I have seen no evidence that they are not well managed.
Indeed, for example, the OFHEO 2000 Report concludes, ``At year-
end 1999, Fannie Mae exceeded safety and soundness standards in all
examination program areas.
Mr. Chairman, I believe first and foremost, we must maintain our
ability to encourage home ownership opportunities in America--for
everyone.
I look forward to the testimony of our witnesses.
Mrs. Clayton. I guess I want to pick up on Mr. Hoekstra's
remarks. Let me just make a statement also.
I think we are indeed enjoying historical highs in terms of
people enjoying the American way of home ownership, and I think
that is a good thing. I think indeed people have calculated
making debt no one likes but taking a risk and having access in
their homes, they think that is a worthwhile activity. And so
we are having historical highs right now where people are
making the calculation, buying a home, and I certainly
encourage that, but I think I would be remiss to suggest that
the issue has been addressed sufficiently.
When you look at those historical highs, there is a
disproportional benefit. Minorities are not increasing their
homes at the same rate. Working middle class are now having
stress. There is a recent article, I guess about 3 weeks ago,
in the high tech areas where working people who are making 60
and $75,000 a year are finding it difficult to afford homes. So
there is a constraint in the market.
I think we acknowledge great things are happening for many
Americans, but to suggest that there is not a need for these
entities that provide for an easy way for most Americans to get
housing I think is inaccurate, so I want to challenge that.
And I do not know if you are saying that you feel that
there is no longer any problem in the marketplace, I want to
suggest there is a problem in the marketplace. Contrarily, I
think because we are indeed enjoying great prosperity in
certain areas, you ask people in Silicon Valley, you ask people
in Oakland, you ask people in the Washington area, you ask
people where there is opportunity for growth, they are not able
to afford a home. So that prosperity has almost driven the
value of the land itself and house to move and there is great
genderfication going on right now, so I do not want it to be
missed in this hearing or any other hearing that we have
addressed all the housing areas.
Having said that, also, the testimony for all three of you
seemed to suggest that the risk of the debt is not--well, I
take exception, Mr. Ely, you do not suggest that because your
very point is indeed that debt is a risk--but it would seem to
me that you are--both of you have indicated, the GAO as well,
tell us that the debt itself is not as much of a risk.
Am I right in assuming that?
Mr. McCool. Well, we have not actually made an explicit
statement about that, I do not think. I mean, I guess----
Mrs. Clayton. Well, let me ask you----
Mr. McCool. The issue really comes down----
Mrs. Clayton. Is the debt that Fannie Mae and Freddie Mac
hold implied to be risky and therefore we should indeed think
about restructuring, changing the structure drastically? Is
that a sufficient concern we ought to look at it? Is it fair to
compare the debt of those entities with the United States? The
debts are quite different, so is it really a serious problem?
Mr. McCool. Well, again, the debt or the securities and
mortgages that Fannie and Freddie hold are somewhat more risky
than issuing mortgage-backed securities, but the point is that
OFHEO is charged with overseeing their activities to make sure
that the risks are managed well, hedged well, and that they
have a risk-based capital standard in place that would protect
the interests of the government. So the risks are relative.
Mrs. Clayton. The risks are relative to the management and
having instruments----
Mr. McCool. And being well regulated.
Mrs. Clayton. How different is that, Mr. Ely, since you
think that Fannie Mae and Freddie Mac debt is really troubling
and how different is the risk of the banks that have this
same--they buy back securities, they have whole loans. My
understanding, you represent them. How are you advising them
about their debt?
Mr. Ely. Well, I am not advising banks with regard to that.
I just----
Mrs. Clayton. No, you advise the banks.
Mr. Ely. I am a student of what their practices are. What
concerns me about the GSEs, particularly relative to the banks,
is twofold. Number one, they are more thinly capitalized,
particularly with regard to credit risk. The second thing is
that they are less diversified. This is a point that the other
witnesses made. Fannie and Freddie are focused on just one
sector of the economy.
Mrs. Clayton. Let me stop you there. They are less
diversified. I thought they were chartered for an explicit
mission, to encourage their instruments, and the advantage they
had of being chartered to direct most of their attention to the
mortgage financing of homes. So their less diversification is
consistent with their mission.
Mr. Ely. Well, that is true, but we have to understand that
there is a down side to that and that is the lack of asset
diversification, the concentration in housing finance.
The fact that they are buying mortgages and guaranteeing
mortgages from all over the country helps to diversify that
risk, but we cannot lose sight of the fact that they are
focused strictly on housing finance whereas commercial banks
generally have a broader range of assets. That is why, when you
combine the higher capital levels of banks and thrifts with
their greater asset diversification and their balance sheets--
and also the fact that Federal deposit insurance has been
essentially set up as an industry self-insurance mechanism, the
banking and thrift industries do not pose the taxpayer risk
that Fannie and Freddie do.
Mrs. Clayton. Banks do have some subsidy. I do not want you
to suggest that they do not have some. I think it is a matter
of judgment as to which of the ones pose a risk, but banks do.
That is part of what we give the depositor, that the government
does indeed back some of their deposits to a certain level. So
to suggest that only the entities that are GSEs are posing a
great risk, I think that is inappropriate.
Mr. Ely. Well, if I could address that question, I would
like to file a paper with the committee which argues that
actually the banking industry, the nation's banks and thrifts,
do not receive any Federal subsidy at all. If anything, the
subsidy actually flows the other way.
Chairman Sununu. Thank you, Mrs. Clayton.
Mr. Toomey.
Mr. Toomey. Thank you, Mr. Chairman.
I would like to follow up on a question that is
tangentially related to what we were just discussing. Certainly
if you look at the cost of funds relative to capitalization,
there is a subsidy going on for the GSEs. I think that is
pretty clear.
I am interested in pursuing a point that Ms. Miles raises
in her testimony on page 4 in particular, where there seems to
be a dynamic here that I was hoping you would comment and
elaborate on a little bit and that is as follows.
The magnitude and the value of the subsidy, the implied
guarantee, the various government benefits conferred upon the
GSEs, clearly grows with their size and that creates an added
incentive for these institutions to grow, arguably above and
beyond the normal incentive that every corporation has to grow.
When any company grows, certainly a publicly traded
company, certainly a company that issues debt, there are a
number of market forces that put a check on that growth, that
that growth be prudent and that there be sufficient capital to
sustain that growth. And if a company does not have--if there
are concerns, then the market will impose costs on a company
such as a higher cost of funds, a lower price of its share,
various mechanisms that the market has to keep that growth in
check in a sustainable level.
When we have an implied government guarantee and when the
market is convinced that the government is backing these
institutions and it would not be allowed to fail, you raise the
point that maybe that normal market discipline is weaker than
it would be with another company, a company without such an
affiliation.
So my question is have we created an inherently unstable
dynamic, where we have created extra incentives to grow and we
have reduced the market discipline that normally holds that
growth in check and requires that to be done in a prudent
fashion? Is that not an inherently long-term unstable
situation?
Ms. Miles. It certainly can be. Bear one thing in mind. As
long as the GSEs do have positive shareholder value, they have
plenty of reason to exercise their own discipline and not go
into an area where they would jeopardize that. If, however,
they lose that value, they then have no reason not to gamble
and go in for very big risks, knowing that they have lost
everything they can lose. A big risk gives you the opportunity
of getting back out of trouble and restoring shareholder value,
but if you lose everything, you basically put it back on
somebody else.
That is where it becomes very unstable and that was
essentially what did happen with the savings and loan industry
in the 1980's.
Mr. Toomey. So if I could sort of summarize what you are
saying, in good times and when things are going well, this
dynamic may not be very dangerous. The problem is sort of----
Ms. Miles. When things do not go well.
Mr. Toomey.--leveraging up and doubling up your bet when
things are looking rather grim.
Ms. Miles. That is correct. The less capital you are
carrying the more quickly that kind of situation can come upon
you.
Mr. Ely. If I could add something to that, there is a
second form of discipline and that is credit market discipline.
In other words, the debt markets. One of my real concerns is
that the credit markets are not providing the discipline over
Fannie and Freddie that they should, which is very important
given how highly they are leveraged, because of their implicit
Federal guarantee.
Mr. Toomey. Al right.
Mr. Ely, you mentioned, if I recall, during your testimony
that there are numerous reasons why Fannie Mae or Freddie Mac
might run into financial problems, including events outside the
U.S. financial system.
Did I understand you correctly? If so, could you elaborate
on what some of those exogenous events might be?
Mr. Ely. Well, you know, I could sit here all day long and
come up with examples and not hit the mark. One of the problems
with the world is that problems can come out of left field that
no one anticipated and yet they have a disruptive effect on the
market.
The impact of the Russian debt crisis in the summer of 1998
is a very good example. It caught a lot of people unawares. It
did have magnification effects in the U.S. financial markets.
Mr. Toomey. Specifically did it have any impact on interest
rates associated with mortgage-backed securities? Or the whole
loan market for that matter?
Mr. Ely. In that particular case, there was a flight to
quality, and Fannie and Freddie were beneficiaries----
Mr. Toomey. It was actually a good thing for the mortgage-
backed securities market.
Mr. Ely. At that time, but there were other credit markets
that suffered quite a bit, particularly the junk bond market.
Next time, it could play differently.
I will give you one example that I worry about a lot and
have written about and that is the Japanese financial
situation. You have a country that is increasingly indebted,
and with very weak financial institutions.
If there is some kind of accident in Japan, I could see
global effects of that. And next time, it may not inure to the
benefit of Fannie and Freddie. So we just cannot expect the
same kind of reactions to the next crisis that we have had in
the past.
Mr. Toomey. Thank you.
Thank you, Mr. Chairman.
Chairman Sununu. Thank you, Mr. Toomey.
Mr. Minge.
Mr. Minge. I would like to ask two questions. First, to
what extent do you believe the interest rates on residential
mortgages are lower because of Fannie Mae and Freddie Mac and
the Federal Home Loan Bank institutions?
And I would ask this of any of you.
Mr. Ely, I will start with you.
Mr. Ely. They may be lower, but that is only half the
equation. The other question is, and this is one again I have
explored a little bit, to what extent are the lower interest
rates capitalized or possibly even overcapitalized in housing
prices? In other words, you can afford to pay more for a house
because the interest rate is lower?
Some work I have done with Fed Flow of Funds Data suggests
that at times we have possibly had an overcapitalization of the
subsidy in housing prices. Specifically, overcapitalization is
reflected in the residual value of land underlying owner-
occupied housing.
So it is not enough to say that rates are lower. You also
have to look at what the effect of lower rates is on housing
prices because if lower interest rates have been capitalized in
housing prices, then the beneficiaries of the subsidy, if you
will, are the sellers of homes, not the buyers.
Mr. Minge. I assume that observation, then, would apply to
the availability of housing credit generally, that if we have
housing programs we might make it easier for people to finance
housing which in turn would drive up the price of housing
because of greater demand.
I do not want to debate this, except to say that I think
that you can take that to its logical extreme.
Mr. Ely. Well, you have put your finger on a fundamental
policy issue. The broader a subsidy is the more likely it is to
be capitalized in the price of assets. A targeted subsidy is
less likely to have that effect, which is why I believe that
one of the issues that needs to be addressed in the housing
finance area is to what extent the subsidy is misdirected and
going to people who do not need it, versus those who are
presumably at the cusp of home ownership and therefore warrant
a subsidy.
Mr. Minge. So maybe we should have high interest loans so
we do not have a lot of competition for housing and we keep the
price of housing down.
Mr. Ely. No, I am not arguing for that at all.
Mr. Minge. Mr. McCool, let me direct that same--not the
little exchange that we have just had, but the question of
whether or not----
Mr. McCool. We estimated in our privatization report of
1996 that the housing enterprises probably reduced mortgage
rates by something in the range of a quarter--about 25 basis
points, about a quarter of a percent.
Mr. Minge. Ms. Miles.
Ms. Miles. I pretty much agree with that. One of the ways
to measure that is to look at the difference between the jumbo
market where Fannie and Freddie cannot purchase mortgages and
the conforming market, and it is generally 25 to 30 basis
points. That might not be the whole story.
In fact, I would argue that the great success story that is
involved here is that we have far better integration of housing
finance markets and capital markets generally and that is
something that has occurred for a variety of reasons. You no
longer get the great curtailments of mortgage financing
whenever interest rates rise, but you will get some arguments
as to whether that was all Fannie and Freddie's doing.
Mr. Minge. Another question I would like to ask, if I can,
and this guy is sitting here with a clock, so I get just a
little sliver of this time----
Chairman Sununu. I will be as generous as possible.
Mr. Minge. Well, thank you.
I am concerned with Fannie Mae and Freddie Mac and the
others, when they issue their securities and the collateral is
series of mortgages that they are holding on residential
property, with a right of prepayment under certain
circumstances, there may be generally, then the question is do
they match that up with the right to call those bonds without
penalty?
What have you observed in that respect? And I guess the
interest rate risk that we are talking about to some extent is
whether or not there is a match between the prepayment risk
that occurs and the ability to call bonds so as to issue new
bonds at a lower interest rate or more competitive interest
rate to keep these interest rates in synch.
Mr. Ely.
Mr. Ely. Well, both agencies do issue callable debt which
helps to protect them if rates are going down. They also enter
into interest rate swaps to protect themselves if interest
rates are going up. If interest rates are going up, the
prepayment rate drops off. But what is important to realize
here is that these mechanisms do not work perfectly. While
callable debt is a good way to handle the increased prepayment
rate due to a decline in rates, if rates are moving up, I have
a greater concern because that introduces counterparty risk
into the equation.
Mr. Minge. OK. But if the interest rates are moving up,
then I suppose that Fannie Mae or Freddie Mac would decide not
to call those bonds, leave those bonds out there and homeowners
are not going to go out and refinance under those
circumstances, so you would have a level of stability just
based upon the nature of the market in that setting.
Mr. Ely. That is correct.
Mr. Minge. I am also quite intrigued with the advantage
that you have identified, sort of an arbitrage advantage to
Fannie Mae and Freddie Mac investing in their own securities
for the purposes of internalizing the interest rate risk is, I
believe, how you described it.
Now, maybe I have mis-identified this. To those of us that
do not come from such rarified financial backgrounds, it has a
certain mysterious side to it and I am wondering if you can
offer any additional explanation that would help us better
understand how this creates profitability and, secondly, how it
increases risk.
Mr. Ely. Well, if you take a look at the two basic risks,
the credit risk and the interest rate risk, when mortgages get
securitized, mortgage-backed securities are issued and the
interest rate and prepayment risks are shifted to whomever buys
the mortgage-backed securities.
When Fannie or Freddie buy back their own MBS, they take
that risk back in or to use Ms. Miles' term, they repatriate
the risk. So they have brought the interest rate risk back on
their balance sheet, but they are earning additional interest
income spread to compensate for that risk.
The great question is are they earning enough additional
spread to compensate for the interest rate risk that they have
reassumed.
Chairman Sununu. Thank you, Mr. Minge.
Mr. Ryan.
Mr. Ryan. I think that this has been a very helpful
hearing. I am on the relevant banking subcommittee which goes
over these issues and I do not think I have heard a more in
depth discussion about GSE debt per se. So I am intrigued with
the depth that we have gone into in this.
Mr. Bentsen basically asked precisely the question that I
was going to ask, but I would like to go back to this issue of
repurchasing mortgage-backed securities and ask each of you a
question.
Number one, I think when you look at GSE debt, and that is
the scope of this hearing, you can kind of divide it into two
areas, mission critical debt which is used to securitize the
secondary market, which would obviously grow as the mortgage
market grows, then you have what some people call excessive
debt, which is the debt that is issued solely for the
repurchasing of mortgage-backed securities or retaining
mortgage-backed securities on the books. It involves a new kind
of risk, an interest rate risk or a prepayment risk. There is
an arbitrage activity that is occurring which clearly is profit
derived. I think we have established that here.
I would like to ask you does the repurchasing of mortgage-
backed securities, specifically the alarming pace of the
repurchasing of mortgage-backed securities, I think 4.6 percent
in 1992 was retained, now it is about 30 percent of mortgage-
backed securities are retained by both Freddie and Fannie, does
that in any way notably extend and advance home ownership?
Does it put a new person in a home? Is it mission critical?
And then I have a follow-up, but if you can answer that quickly
I would appreciate it.
Barbara, why don't we start with you?
Ms. Miles. How brief can I be? I would say no, I do not
think so.
Mr. Ryan. That is great. Thanks.
Mr. McCool. We would, I think, agree that there is no clear
advancement of the mortgage market by repurchasing mortgage-
backed securities.
Mr. Ely. Mortgage repurchases are not mission critical.
Mr. Ryan. OK. So repurchasing the mortgage-backed
securities you would then say is clearly done for the ROE, for
profit, for the shareholder directive. Would you concur with
that?
Barbara.
Ms. Miles. By and large.
Mr. McCool. Again, we have not really studied that
specifically, but I would suspect that, again, it is a risk/
return tradeoff that is probably driving it.
Mr. Ely. Yes.
Mr. Ryan. OK. So if we are establishing that repurchasing
mortgage-backed securities is done with an arbitrage activity
for the ROE, it kind of goes down to the issue that we have a
contradictory mandate, a structure that is inherently
contradictory, Hobson's choice, whatever you may say, mission
critical housing mandate by Congress overseen by OFHEO which is
to securitize the secondary market, but now you have the
repurchasing of these mortgage-backed securities which clearly
adds to the ROE, something you cannot really fault a company
that has shareholders as well, but something that raises very
interesting questions because there is an implied guarantee.
Our job is to steward and watch over taxpayer risk.
Do you believe that this prepayment risk is sufficient
hedged against? Do you believe that the mortgage-backed
security risk, the interest rate risk is sufficiently addressed
or do we even know whether it is sufficiently addressed and do
you think OFHEO is capable of calculating whether or not that
risk is sufficiently hedged or offset?
We will start with you, Barbara.
Ms. Miles. That is really a question I hope you ask OFHEO.
They have what looks to me to be a very nice capital standard
model. It is not yet in effect, there are a lot of questions
about it. By and large, it appears to handle within certain
bounds the kinds of limits you would want it to handle.
The question I would have is will it give you a signal
quickly enough if things really go badly. And given that we are
talking about relatively low capital levels, I cannot give you
a good answer to that.
Mr. Ryan. Mr. McCool.
Mr. McCool. Again, I think that that is a question for
OFHEO, as Barbara has suggested. And, in fact, I mean, again,
this whole idea of the GSEs buying back mortgage-backed
securities and having more risk on their portfolio should be
certainly into account by their risk-based capital standard.
And it is. So a lot of that should all be played out in their
risk-based capital standard and in OFHEO's examination process.
But that is a question, as I said, to ask them.
Mr. Ely. In my opinion, outsiders cannot judge how well
Fannie and Freddie are managing that risk based on the
information that is publicly available. I find it troubling
that there is not sufficient information available to the
public, specifically to the investment community, to judge that
risk and its management.
Mr. Ryan. Thank you. I think it is important, and I will
briefly summarize here.
Did you want to interject?
Chairman Sununu. No, I just wanted to ask specifically can
you give an example of what information is not available that
would enable that judgment to be made?
Mr. Ely. In my opinion, based on the footnote disclosures
that I read, that we get kind of bits and pieces of
information. We are not presented with a total picture in a
comprehensive way, even though it may be summarized, as to how
they are managing the risk and what the risk characteristics
are particularly of their counterparties.
Mr. Ryan. If I could interject, I think it also goes to the
question that we really do not know how reliable the hedging
techniques are. Hedges have obviously advanced since the early
1990's, but no one including OFHEO or any of us know if this is
properly hedged, how well the hedges would work and, you know,
we had a similar problem where we had paper insolvency of
Fannie Mae in the 1980's where you had an interest rate
problem, you had an interest rate risk, Freddie did not engage
in the same kind of activity and also missed out on having the
paper insolvency. So I think it is an interesting issue.
What is interesting that I think we have established here
in this hearing is that the debt which is relative to mortgage-
backed securities in retaining or repurchasing the mortgage-
backed securities, repurchasing is a term that has been in
question, but it is a term that is used in Freddie Mac's annual
report, so I will use the repurchasing of mortgage-backed
securities, the debt associated with that is by and large it
seems like our panel has agreed to is excessive debt, non-
mission-related debt and debt that is more or less used for
profit.
Thank you. I yield back my time.
Chairman Sununu. Thank you, Mr. Ryan.
Mr. Ely, for clarification, the example you gave of
information that is not disclosed to the extent that you would
like it to be to render judgment about risks is counterparty
risk. I assume you are talking about the counterparty risk
involved in primarily the interest rate swaps that the GSEs use
to hedge their debt.
Can you give an example or are there examples of other
publicly traded companies that disclose counterparty exposure
in their hedging strategies?
Mr. Ely. One could argue that there is no such thing as
enough disclosure. It has been my experience, as I read their
footnote disclosures, that I do not get as much and I do not
get as complete a picture as I would like to see.
Chairman Sununu. Is there a difference between getting as
much information as you would like and getting as much
information as you would get from a comparable firm or from a
firm that is not regulated or sponsored in any way by the
mortgage-backed securities?
Mr. Ely. In my opinion, bank holding companies basically
provide a more complete disclosure than Fannie and Freddie do.
Chairman Sununu. Bank holding companies disclose
counterparty exposure in interest rate swaps?
Mr. Ely. They provide more insight into the nature of the
risks, into the nature of their counterparties, and in other
regards to the swaps. You basically get more numbers, you get
more detail. Although I will say this, it is not comparable
across the different companies. You can find fault with any one
company's disclosure.
One difference is that the bank holding companies and other
financial firms issue financial statements that are subject to
SEC oversight, which is lacking in the case of Fannie and
Freddie.
Chairman Sununu. Fair point. Thank you.
Mr. Smith.
Mr. Smith. Mr. Chairman, just briefly.
Again, would you give me your impression of the assumed
liability of the Federal Government in terms of what is
anticipated from those buying these bundles from Fannie Mae or
Freddie Mac? Is there implied liability of the Federal
Government in terms of expectations of the government somehow
bailing out Freddie Mac or Fannie Mae if they were to go into
trouble?
Ms. Miles. I always try to be really careful how I answer
that because we officially deny that there is any
responsibility at all. But if you take a look at the list of
ties, links to the Federal Government, they clearly imply
something and the market infers something. The market believes,
obviously, in the way they price Fannie Mae and Freddie Mac
paper, and for that matter the Federal Home Loan Banks as well,
that there is a sufficient nexus that the government would do
something. And any time the market believes that relationship
is being challenged, things change. We had an example of that
in March.
We had a little bit of a decrease in spreads between GSE
paper and triple-A paper. Not a big one, but it is still there.
So there is something that is being inferred. I do not want
to be in a position of measuring it, but something is there.
Beyond some point, presumably, the market perception may also
break. At that point, the government might decide to step in.
Again, Bert's example of the Farm Credit System.
Mr. Smith. And Tom and Bert?
Mr. McCool. Well, again, I would echo Barbara's idea that
clearly the market perceives there is some connection. But, I
mean, the extent to which there is or is not a government
bailout should that ever arise is up to the administration and
Congress to decide. I mean, that would be a decision for you
folks.
Mr. Ely. As I said in my testimony, we have two clear cut
examples of a GSE rescue: the Farm Credit System back in 1988
and then the FICO bonds in 1996. When I talk to people in the
Wall Street community and ask them this question, they have no
doubt in their minds whatsoever that if there was a problem
with any of the GSEs, the Federal Government, in one way or
another, would ride to the rescue to protect creditors, that is
holders of debt and MBS, against any kind of loss.
There is a totally different story for stockholders.
Stockholders might get wiped out, but the belief in the credit
markets is the Federal Government would ride to their rescue.
Given their size today, the government would ride to the rescue
sooner rather than later.
Mr. Smith. It just seems based on your answers, Mr.
Chairman, maybe there are two alternative actions of the
Federal Government, either to charge Freddie Mac and Fannie Mae
a fee for this underwriting, if you will, or to somehow take
action to make it clear that they are independent organizations
and even though they are a government-sponsored enterprise, the
Federal Government is not underwriting any liability that might
develop.
If we were to do the latter, what kind of action might the
Federal Government take to send out a signal to the marketplace
that we are not going to underwrite them if they have problems?
Mr. Ely. I will jump into that. I do not think there is any
credible action the Federal Government could take. Fannie and
Freddie are government-sponsored enterprises. As long as they
are creatures of Congress, they are subject to special Federal
oversight. In my opinion, you cannot credibly say that they are
not backed by the U.S. Treasury and the U.S. taxpayer.
Mr. Smith. Then, Mr. Chairman, I would come down on the
side of starting to charge them a 1 percent fee for that
insurance that probably is more real than implied and, again
thank the witnesses and yield back.
Chairman Sununu. Thank you, Mr. Smith.
Mr. Bentsen had some follow-up questions.
Mr. Bentsen. Thank you, Mr. Chairman.
My colleague will probably be getting some mail as a result
of this.
Mr. Ely made a good point, we need to remember this, that
the fact that the GSEs are in this position today did not just
happen out of the blue. It happened because Congress
established this with a purpose in mind in the 1930's and with
a purpose in mind in the 1960's.
And I know there has been discussion about the fact that
banks and thrifts hold a GSE debt in a greater proportion than
they would be allowed to hold the debt of a single corporate
interest or if it were a loan to an individual. But that is
also because Congress in the Bank Holding Company Act and other
subsequent acts included GSE debt as a qualified investment, I
believe, if I am correct about that.
There are reasons why we did that. We, being the royal we,
did that because we believed that through the GSE structure we
were in effect establishing a subsidy for the benefit of the
American people to get into home ownership.
Has that worked, is the first question.
Second of all, if it could have been done without, which I
am not sure that it could have, that you could have had the
same stable mortgage market at least up until the 1980's when
the mortgage-backed securities market came about in the extent
that we see it today, would you have had the same stable
interest rate environment for mortgage finance and the ability
of Americans to get into homes?
And if that were the case, if in fact we did not need to do
this at all, if you can make that argument, would the risk
still exist because the ultimate risk we are talking about here
is the risk to the American mortgage market.
The systemic risk that might--and I say might--come from
Freddie and Fannie has to come from the standpoint that--in two
instances, it seems to be, one would be bad management practice
on the part of the GSEs themselves, and we assume through
shareholder vigilance and OFHEO's job and HUD's job and
Congress ultimately that that is watched.
The other is the credit risk associated and interest rate
risk associated with the general economy. If we were to
eliminate the GSEs tomorrow and assume that there were still 67
percent home ownership rate in the United States, somebody
would have to hold that paper, including the banks and thrifts
who might not be holding as permitted or qualified investments
GSE debt or MBS, but would be holding a very high level of
whole loans and portfolios or privately issued MBSs. So the
risk would still exist.
Would the systemic risk still exist as well as a result of
that, that U.S. banks and thrifts might be more susceptible to
a meltdown in the mortgage market?
Mr. Ely. Well, I will stick my neck out on that one.
Obviously, the market would be different. We would see,
first of all, a lot of privately issued MBS, just like we do in
the jumbo mortgage market now, so there would be at least a
geographical spreading of the credit risk.
What we might see is possibly a somewhat less leveraged
investment in housing and finance. I, for one, am troubled by
the fact that as part of the overall debt build-up in the
economy, we are seeing steadily increasing leverage in housing
finance. That in itself is potentially destabilizing. So I
think we might see greater equity in homes.
But I would like to come back to your point about the
subsidy. The question is: should there be a subsidy and, if so,
what is the best way to deliver it? This question should be
addressed in the coming years in Congress. Do the GSEs
represent the best way to deliver the subsidy or are there
alternative mechanisms for delivering the subsidy that focus it
on those who, for whatever reason, are most deserving of the
subsidy?
The CBO study in 1966 suggested that in effect Fannie and
Freddie were not very efficient in delivering the subsidy. What
they did not say, and I am sorry they did not----
Mr. Bentsen. Excuse me, in 1996 or 1966?
Mr. Ely. I am sorry, 1996. I misspoke. The study from 4
years ago. What CBO did not get into is the extent to which the
subsidy that Fannie and Freddie deliver is going to people that
do not need a subsidy. They are middle income and above.
So there really are two policy issues that have to be dealt
with here, one of which you touched on and that is the whole
issue of financial stability generally, no matter how the
financial markets are structured. The other is the issue of
what is the best, most efficient, fairest way to deliver
whatever housing finance subsidy is needed in this country in
order to promote home ownership.
Mr. Bentsen. Bert, can I just ask you to follow up on that?
Would we have achieved the same home ownership rate, say, by
1980 without the GSEs compared to what we did achieve, in your
opinion?
Mr. Ely. Sheer speculation, I could not have an answer on
that, but I do not believe we had to have the GSEs in order to
get home ownership to where it is today. For instance, if we
had a subsidy targeted to just those people who are on the cusp
of home ownership, where they need a subsidy in order to move
from being a renter to a buyer or homeowner, then you would get
that increase.
The problem with much of the subsidy today is it is going
to people who are going to be homeowners anyway. They may end
up being able to afford a somewhat more expensive, larger home,
but they still would be homeowners.
So, again, the question is: are there alternatives for
delivering the subsidy other than through the GSEs?
Mr. Bentsen. Thank you.
Thank you, Mr. Chairman.
Chairman Sununu. Thank you, Mr. Bentsen.
I am sure we could question or badger, depending on your
terminology, this panel all day, but that would not be fair to
our remaining witnesses.
I want to thank our witnesses on this panel for their
testimony and remind members that they have 5 days to submit
written testimony for the record and call forward our second
panel: Armando Falcon, the director of OFHEO, and William
Apgar, the HUD designee to the Federal Housing Finance Board.
Thank you for being here, gentlemen.
Mr. Falcon, since the phrase ``That would be a good
question for OFHEO'' was uttered more than ``That would be a
good question for the Finance Board,'' we will be pleased to
begin with your testimony whenever you are prepared.
Again, welcome.
STATEMENTS OF ARMANDO FALCON, JR., DIRECTOR, OFFICE OF FEDERAL
HOUSING ENTERPRISE OVERSIGHT; AND WILLIAM C. APGAR, HOUSING AND
URBAN DEVELOPMENT DESIGNEE TO THE FEDERAL HOUSING FINANCE BOARD
STATEMENT OF ARMANDO FALCON, JR.
Mr. Falcon. Thank you, Mr. Chairman. I did catch most of
those references to OFHEO. I am pleased to begin.
Thank you, members of the Task Force. As you are aware, the
Office of Federal Housing Enterprise Oversight, or OFHEO, was
established in 1992 as an independent entity within the
Department of Housing and Urban Development. OFHEO's primary
mission is to ensure the capital adequacy and safety and
soundness of the two government-sponsored enterprises, Fannie
Mae and Freddie Mac.
To fulfill this mission, OFHEO has regulatory authority
similar to those of other Federal financial regulators, such as
the FDIC and the Federal Reserve. Those authorities include
annual examinations, broad rulemaking authority, setting
capital standards, enforcement actions and research.
Fannie Mae and Freddie Mac were established to create a
secondary mortgage market to ensure a ready supply of mortgage
funds for affordable housing for American home buyers.
To assist Fannie Mae and Freddie Mac in achieving their
public mission, they receive numerous explicit benefits from
the Federal Government. The most important benefit the
enterprises receive is the special treatment the market bestows
on their securities. Because of investors' belief in an implied
U.S. Government guarantee on their securities, the enterprises
have been able to borrow money more cheaply and without the
practical volume restrictions faced by any fully private
triple-A rated company.
This market perception allows the enterprises to safely
operate with a higher degree of leverage than fully private
firms are able to do. There is no doubt that the GSEs are large
and rapidly growing. As they grow, the implications to the
economy, if they were to fail, also increases. However, the
actual likelihood of any failure depends critically on how they
are managed and supervised.
I want to assure you, Mr. Chairman, and members of the Task
Force, that Fannie Mae and Freddie Mac are currently in
excellent financial condition and OFHEO has a strong regulatory
program in place to ensure their continued safe and sound
operation. If the need ever arose, OFHEO would move quickly and
forcefully to correct any financial problems at the
enterprises.
OFHEO supervises the enterprises primarily through its
extensive and continuous examination work. Our experts maintain
a physical presence at the enterprises at all times and have
unlimited access to all levels of management and highly
sensitive corporate records. By staying apprised of the
enterprises' risk and business activities on an almost real
time basis, the examiners are able to evaluate an extensive
array of risk related factors and assess the enterprises'
financial safety and soundness.
Each quarter, OFHEO examinations staff issue conclusions
related to more than 150 separate components of financial
safety and soundness and thereby provide me with a
comprehensive picture of the enterprises' financial condition.
Examiners meet frequently with management to discuss and
assess business strategies and plans, financial performance
results, risk management structure and practices, and each
enterprises' overall risk profile.
Through our risk focused examination work, OFHEO constantly
evaluates such critical areas as the enterprises' overall risk
management practices, the composition of the risk profile and
significant trends in the enterprises' retained and guaranteed
mortgage portfolios, the enterprises' ability to effectively
manage interest rate risk and other key financial exposures,
the enterprises' ability to efficiently issue debt and hedge
financial exposures and the quality of financial performance-
related information and market-related information on which the
enterprises' board and management rely in reaching key
decisions.
In summary, the examination group provides us with an
accurate and timely understanding of the enterprises' financial
condition.
Fannie Mae and Freddie Mac have two major lines of
business. First, they guarantee mortgage-backed securities,
which are, of course, securities backed by pools of residential
mortgages. Enterprise mortgage-backed securities are highly
regarded by investors and can be issued at interest rates very
close to those of mortgage-backed securities with an explicit
government guarantee.
This guarantee business has been quite profitable for the
enterprises, but mortgage borrowers receive most of the benefit
from these lower borrowing costs. While there is no precise way
to measure these savings, recent estimates have generally
centered around 25 to 30 basis points, I think as was mentioned
by the previous panel as well.
The enterprises' second major line of business is portfolio
investment in mortgage-backed securities and, to a lesser
extent, in whole mortgages. The enterprises fund these
investments primarily by issuing debt.
Both of these business lines have been growing at the
enterprises, particularly their portfolio investment business.
Since the end of 1991, the enterprises' mortgage assets have
swelled from $155 billion to $900 billion, an increase of
approximately 475 percent. A majority of the increase reflects
purchases of mortgage securities they had previously
guaranteed.
Now, to fund the growth of these assets, the enterprises
have increased their debt outstanding at a comparable rate from
$164 billion to $963 billion over the same time period.
The guarantee business has also increased significantly.
Total mortgage-backed securities guaranteed, both those held
privately as well as those held in portfolio, has more than
doubled from $731 billion 1991 to over $1.76 trillion today.
Enterprise debt and mortgage-backed securities outstanding
now amounts to $2.2 trillion. Adding in the debt of the other
GSEs, the total debt of all GSEs rises to $3 trillion.
Federal reserve estimates for holdings of what is known as
agency debt, about 85 percent of which is issued or guaranteed
by GSEs, shows the following breakdown:
Depository institutions hold 27 percent.
Households, mutual funds, trusts and estates hold 21
percent.
Public and private retirement funds hold 16 percent.
Foreign investors, which includes over 60 central banks,
holds 12 percent.
Insurance firms hold 9.
State and local governments hold 5.
The balance remaining is 10 percent.
As should be apparent from this data, a financial crisis at
the enterprises could have a disruptive impact on investors and
the economy. Accordingly, OFHEO has developed and continues to
improve upon a strong supervisory program.
OFHEO is aggressively fulfilling its obligation as a strong
and effective regulator. By fulfilling our core mission well,
OFHEO protects against systemic risk posed by Fannie Mae and
Freddie Mac.
As I have stated before, OFHEO takes a three-pronged
approach to accomplish this goal: examinations, capital
regulation and research. I have already spoken about our strong
examination program, so I will address our capital standards.
OFHEO's minimum capital standard, one that is built on
traditional ratio based approaches, ensures a base level of
enterprise capital to protect against risk.
Also, we are on track to complete our risk-based capital
standard by the end of the year. This standard will be the
first to explicitly link capital and risk through the use of a
model that simulates financial performance of the enterprises
under stress. Let me say here we will complete this rule by the
end of the year, Mr. Chairman. While we will have a final
capital rule, let me differentiate here between a final capital
and a final stress test.
The stress test will be by its nature evolving and
constantly changing to take into account the different risk
profile of the enterprises at any point in time. The risk-based
capital standard has to adjust itself to reflect different
activities, different programs of the enterprises, to make sure
it always accurately ties capital to risk, given what the risk
profile of an enterprise is at any particular point in time.
Any risk-based capital standard like this would be obsolete
if it was not constantly evolving, so part of OFHEO's job is to
ensure that we consistently and constantly update the risk-
based capital requirement, although at the same time
accommodating the enterprises' uncertainty as to what their
capital requirement will be and how it is calculated. It will
be a state of the art capital regulation and I look forward to
having it in place, as I am sure the committee does.
Finally, OFHEO is continuing to strengthen its research and
analytical capability. We must stay on top of the changes
taking place in the quickly evolving secondary and primary
mortgage markets. This important research and analysis serves
to better inform our examination and capital regulation
efforts.
In summary, the enterprises' rapid growth raises important
policy issues regarding their mission and the risk they pose to
the financial system. However, because OFHEO is fulfilling its
responsibilities, this discussion takes place not in a climate
of urgency, but at a time when the enterprises are financially
sound and well regulated.
Thank you, Mr. Chairman.
[The prepared statement of Armando Falcon, Jr. follows:]
Prepared Statement of Hon. Armando Falcon, Jr., Director, Office of
Federal Housing Enterprise Oversight*
Thank you Chairman Sununu, Ranking Member Bentsen, and members of
the Task Force. As you are aware, the Office of Federal Housing
Enterprise Oversight (OFHEO) was established in 1992 as an independent
entity within the Department of Housing and Urban Development. OFHEO's
primary mission is to ensure the capital adequacy and safety and
soundness of two government-sponsored enterprises (GSEs)--Fannie Mae
and Freddie Mac. To fulfill this mission, OFHEO has regulatory
authority similar to other Federal financial regulators such as the
Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve
Board. Those authorities include annual examinations, broad rulemaking
authority, setting capital standards, enforcement actions, and
research.
---------------------------------------------------------------------------
*This testimony represents the view of the OFHEO Director, which
are not necessarily those of the President or Secretary of Housing and
Urban Development.
---------------------------------------------------------------------------
The Task Force has taken an important step in convening this
hearing to consider the economic implications of the size and scope of
the housing GSEs activities. Because Assistant Secretary Apgar is here
today representing the Federal Housing Finance Board, I will focus my
discussion on the two entities within my jurisdiction.
In considering these issues, it is important to understand what the
GSEs do and how they operate.
who are fannie mae and freddie mac?
Fannie Mae and Freddie Mac are publicly-held companies chartered by
Congress. They were established to create a secondary mortgage market
to ensure a ready supply of mortgage funds for affordable housing for
American homebuyers. They fulfill this very important public mission by
buying mortgages from commercial banks, thrift institutions, mortgage
banks, and other primary lenders, and either hold these mortgages in
their own portfolios or package them into mortgage-backed securities
(MBS) for resale to investors. They have become two of the world's
largest financial institutions.
To assist Fannie Mae and Freddie Mac in achieving their public
mission, they receive numerous explicit benefits from the Federal
Government, including an exemption from state and local taxation, an
exemption from the registration requirements of the Securities and
Exchange Commission, and each firm has a potential credit line with the
U.S. Treasury.
However, the most important benefit the Enterprises receive as a
result of their GSE status is the special treatment the market bestows
on their securities. Because of investors' belief in an implied U.S.
government guarantee on their securities, the Enterprises have been
able to borrow money more cheaply and without the practical volume
restrictions faced by any fully-private triple-A rated company. This
market perception allows the Enterprises to safely operate with a
higher degree of leverage than fully private firms are able to do.
There is no doubt that the GSEs are large and rapidly growing. As
they grow, the implications to the economy if they were to fail also
increases. However, the actual likelihood of any failure depends
critically on how they are managed and supervised. I want to assure you
that both Fannie Mae and Freddie Mac are currently in excellent
financial condition, are well-managed, and have exceeded minimum
capital requirements every quarter that the requirement has been in
place. And OFHEO has a strong regulatory program in place to ensure
their continued safe and sound operation. If the need ever arose, OFHEO
would move quickly and forcefully to correct any financial problems at
the Enterprises.
OFHEO supervises the Enterprises primarily through its extensive,
and continuous, examination work. Our examiners possess impressive
skills and backgrounds, and came to OFHEO from banking and thrift
regulatory bodies and from the mortgage industry itself. Our experts
maintain a physical presence at the Enterprises at all times, and have
unlimited access to all levels of management and to highly-sensitive
corporate records. By staying apprised of the Enterprises' risks and
business activities on an almost real-time basis, the examiners are
able to evaluate an extensive array of risk-related factors and to
assess the Enterprises' financial safety and soundness.
Each quarter, the OFHEO examination staff issue conclusions
relating to more than 150 separate components of financial safety and
soundness, and thereby provide me with a comprehensive picture of the
Enterprises' financial condition. These conclusions pertain to such key
risk management areas as credit risk, interest rate risk, liquidity
risk, information technology, internal controls, business process
controls, internal and external audit, management information and
process, and board of director governance and activities.
Examiners meet frequently with management to discuss and assess
business strategies and plans, financial performance results, risk
management structure and practices, and each Enterprise's overall risk
profile. These discussions include future trends and management's
controls and practices to anticipate and prepare for potentially
adverse trends in any risk areas, or combination of risk areas.
Examination teams identify opportunities for improvements in
existing Enterprise risk management practices and work directly with
management to address identified opportunities to enhance financial
safety and soundness. Through our risk-focused examination framework,
OFHEO constantly evaluates such critical areas as:
The Enterprises' overall risk management practices
The composition, risk profile, and significant trends in
the Enterprises' retained, and guaranteed, mortgage portfolios
The Enterprises' ability to effectively manage interest
rate risk and other key financial exposures
The Enterprises' ability to efficiently issue debt and
hedge financial exposures
The quality of financial performance-related information
and market-related information on which the Enterprises' boards and
management rely in reaching key decisions
In summary, the examination group provides us with an accurate and
timely understanding of the Enterprises' financial condition.
what do the enterprises do?
Fannie Mae and Freddie Mac have two major lines of business. First,
they guarantee mortgage-backed securities: securities backed by pools
of residential mortgages. When investors purchase a mortgage-backed
security they are entitled to the principal and interest payments made
by the mortgage borrower, except for portions earned by mortgage
servicers and by the Enterprise which guarantee the payment of
principal and interest. In return for the portion the Enterprise earns,
they agree to protect investors against losses caused by borrower
defaults. Enterprise mortgage-backed securities are highly regarded by
investors and can be issued at interest rates very close to a mortgage-
backed securities with explicit government guarantees. This guarantee
business has been quite profitable for the Enterprises, but mortgage
borrowers receive most of the benefit from these lower borrowing costs.
While there is no precise way to measure these savings, recent
estimates are generally centered around 25 to 30 basis points.
The Enterprises' second major line of business is portfolio
investment in mortgage-backed securities and, to a lesser extent, whole
mortgages that are purchased directly from lenders and are not parts of
pools backing mortgage securities. The Enterprises fund these
investments primarily by issuing debt. The characteristics of the debt
issues are designed so that, in combination with a variety of
derivatives contracts and other hedges entered into by the Enterprises,
the values of the debt and the mortgage securities will be similarly
affected by interest rate changes. This help protect the Enterprises
from a mismatch between the cost of funding its operations and the
income derived from those operations.
Another risk in the portfolio business is that changes in
borrowers' prepayment behavior, often in response to interest rate
changes, are not fully predictable and may affect mortgage security
values differently than expected.
Portfolio investment has been more profitable than the guarantee
business. This activity may create additional interest savings for
mortgage borrowers, though such savings would be much smaller than
those created by the guarantee business. Because empirical data on this
issue is scarce, OFHEO intends further study of this topic.
Both of these business lines have been growing at the Enterprises,
particularly their portfolio investment business. Since the end of
1991, the Enterprises' mortgage assets have swelled from $155 billion
to $900 billion, an increase of approximately 475 percent. The majority
of the increase reflects purchases of mortgage securities they had
previously guaranteed. To fund the growth in these assets, the
Enterprises have increased their debt outstanding at a comparable rate
from $164 billion to $963 billion over the same period.
Their guarantee business has also increased significantly. Total
mortgage-backed securities guaranteed--both those held privately as
well as those held in portfolio--has more than doubled from $731
billion in 1991 to over $1.76 trillion today. Although the Enterprises
purchased roughly half of the increase in their guaranteed mortgage
securities in recent years, the amounts held by other investors has
still grown 73 percent to $1.2 trillion over that period.
The Enterprises debt and mortgage-backed securities outstanding now
amounts to $2.2 trillion. Adding in the debt of the other GSEs, the
total debt of all GSEs rises to $3 trillion, substantially above the
total privately held, marketable debt of the U.S. Treasury. (Further
detail about Enterprise mortgage portfolios, debt, and mortgage-backed
securities outstanding can be found in the attached tables.)
who holds the debt?
Federal Reserve estimates for holdings of what is known as agency
debt, about 85 percent of which is issued or guaranteed by GSEs, shows
the following breakdown:
Depository Institutions........................................... 27%
Households, Mutual Fund, Trusts & Estates......................... 21%
Public & Private Retirement Funds................................. 16%
Foreign Investors (including 60+ central banks)................... 12%
Insurance Firms................................................... 9%
State & Local Governments......................................... 5%
Others............................................................ 10%
As should be apparent from these data, a financial crisis at the
Enterprises could have a disruptive impact on investors and the
economy. OFHEO has developed and continues to improve upon a strong
supervisory program.
The Enterprises' business lines will likely continue to grow.
Recently Fannie Mae announced its continued desire to double earnings
per share over the next 5 years. Freddie Mac has predicted double digit
earnings growth over a similar period. These earnings targets will only
lead to increased pressure to generate new revenues. The prudence and
competence with which the Enterprises manage and balance their assets
and liabilities becomes that much more important, the larger they grow.
In order for the Enterprises to continue to grow their asset
portfolios, they have expanded the markets for their debt securities,
and built demand for debt instruments, such as callable debt, that help
them manage interest rate risk. They have expanded their domestic and
international investor base, developing new products to appeal to
different investor profiles. The introduction of debt issuance programs
modeled after those of the U.S. Treasury is the most recent development
in these efforts.
what is ofheo's role?
OFHEO is aggressively fulfilling its obligation as a strong and
effective regulator. By fulfilling our core mission well, OFHEO
protects against systemic risks posed by Fannie Mae and Freddie Mac. As
I have stated before, OFHEO takes a three-pronged approach to
accomplish this goal-examinations, capital regulation, and research.
I have already spoken about our strong examination program, so I
will next address our capital standards. OFHEO's minimum capital
standard, one that is built on traditional, ratio-based approaches to
regulation of insured depository institutions, ensures a base level of
Enterprise capital to protect against risk.
Since our inception, we have imposed and enforced a minimum capital
standard on the Enterprises. The Enterprises have met that standard
every quarter and we are reviewing the necessity of updating the
standard.
We are on track to complete our long-awaited Risk-Based Capital
Standard by the end of the year. This standard will be the first to
explicitly link capital and risk through use of a model that simulates
the financial performance of the Enterprises under stress. This is my
top priority and we will meet my deadline.
Finally, OFHEO is continuing to strengthen its research and
analytical capability. We must stay on top of the changes taking place
in the quickly evolving secondary and primary mortgage markets. This
important research and analysis serves to better inform our examination
and capital regulation efforts. In summary, the Enterprises' rapid
growth raises important policy issues regarding their mission and the
systemic risks they pose. However, because OFHEO is aggressively
fulfilling its responsibilities, this discussion takes place not in a
climate of urgency, but at a time when the Enterprises are financially
sound and well regulated.
Chairman Sununu. Thank you, Mr. Falcon.
Mr. Apgar.
STATEMENT OF WILLIAM C. APGAR
Mr. Apgar. Thank you. Since the resignation of Chairman
Bruce Morrison on the 4th of July, I hold the delegated
authority of Chairman of the Finance Board, and I testify today
in that role. I would like to emphasize my intention to
maintain the continuity of the Finance Board's recent actions
with respect to safety and soundness oversight, as well as
actions to foster innovation in the Home Loan Banks and
competition among the various GSEs.
I should point out, however, that the board of directors of
the Federal Housing Finance Board has not reviewed my
testimony, nor does it represent the administration's position.
As you know, Congress created the Federal Home Loan Bank
System in 1932 to improve on the availability of funds to
support home ownership. The Federal Home Loan Banks are
cooperatively owned by their member bank stockholders and they
operate by enhancing member lending at the local level.
The Home Loan Banks offer as their primary product a
readily available, low cost source of funds, called an advance,
to member institutions and housing associates. Advances enhance
the lending of members both by passing through the Home Loan
Banks' cost-of-funds advantage in the debt markets and by
having the Home Loan Banks manage interest rate risk. To the
Finance Board, activities that assist and enhance lending by
members are consistent with the Home Loan Bank mission.
Congress originally granted access to the Home Loan Bank
advances primarily to thrift institutions. In response to the
thrift crisis of the 1980's, Congress enacted FIRREA in 1989 to
change the Federal Home Loan Bank System, most significantly by
expanding membership eligibility to include commercial banks
and credit unions.
In 1989, Congress also imposed a $300 million per year
assessment on the Home Loan Banks to help pay for the cost of
the thrift bailout. In addition, Congress imposed a requirement
that 10 percent of Home Loan Bank net earnings go to support
the Affordable Housing Program each year. Last year, the system
made $199 million in AHP contributions and grants nationwide.
In November 1999, with the enactment of the Gramm-Leach-
Bliley legislation, Congress in a singular vote of confidence,
made many changes to enhance the capacity of the Home Loan
Banks to carry out their housing finance and community and
economic development mission.
Gramm-Leach-Bliley charged the system with supporting
access to low cost funds for community financial institutions
to support small businesses, small farm and small agri-business
lending.
Moreover, by changing the fixed $300 million REFCORP
assessment to one based on a percentage of Home Loan Bank
income by reforming the Home Loan Banks' capital structure,
this legislation has truly positioned the Home Loan Bank System
to promote competition in housing finance, serve as a central
bank for community institutions, and serve under served
populations.
I would also stress that through both proposed and final
regulation including the recently proposed regulation on a new
risk-based capital structure, the Finance Board has implemented
all the statutory requirements of Gramm-Leach-Bliley.
As of June 30, 2000, the assets of the Home Loan Bank
System totaled $621 billion. There were more than 7500 members
on that date.
The bonds issued to support the assets of the bank system
are expressly not obligations of the United States, but they do
benefit from the favorable investor perception associated with
the Home Loan Banks' status as a government-sponsored
enterprise.
The Home Loan Bank Act makes it clear that it is the
Finance Board's primary duty to ensure the safety and soundness
of the bank system and, consistent with that primary duty, to
ensure that the Home Loan Banks carry out their housing finance
mission.
To control the Home Loan Bank System's risk exposure, the
Finance Board has established regulations and policies that
Home Loan Banks must follow to evaluate and manage their credit
and interest rate risk. The principal defenses against credit
interest rate risk are sound risk-based management policies and
practices, vigilant supervision, and over $30 billion in Home
Loan Bank System capital.
Among the most notable regulatory requirements are:
Collectively the Home Loan Bank must maintain a triple-A
credit rating on their consolidated debt.
Each individual Home Loan Bank must maintain a double-A
credit rating.
Each Home Loan Bank must establish and implement risk
management policies and controls consistent with Finance Board
requirements, file compliance reports and have external and
internal auditors.
Each Home Loan Bank and the office of finance must be
subject to an annual on-site examination by the Finance Board.
And, finally, the Finance Board has recently articulated a
new set of state-of-the-art duties and responsibilities of the
audit committee of each of the Home Loan Bank boards of
directors along with standards for corporate governance and
internal controls that the boards must comply with.
Risk management is central to this oversight. For example,
the Finance Board limits the interest rate risk of mortgage-
backed securities owned by the Home Loan Banks. Moreover, the
size the Home Loan Banks' mortgage-backed securities holdings
is limited to no more than three times Home Loan Bank capital
or less than $90 billion today.
The general approach of the Home Loan Banks toward managing
interest rate risk is to acquire and maintain a portfolio of
assets and liabilities, which, together with their associated
interest rate exchange agreements, limit the exposure to future
interest rate changes.
With respect to credit risk, it is important to note that
in the 68-year history of the Home Loan Bank no Home Loan Bank
has ever experienced a credit loss on an advance to a member.
While the Home Loan Banks face minimal credit risk on
advances, they are subject to credit risk on some investments.
Each Home Loan Bank must comply with limits established by the
Finance Board and its directors on the amounts of unsecured
extensions of credit, whether on or off balance sheet.
The Finance Board also limits the amounts and terms of
unsecured debt exposure to any counterpart other than the
United States Government. Unsecured credit exposure to any
counterparty is limited by the credit quality and capital level
of the counterparty and the capital level of the bank.
The Finance Board views these risk management requirements
to be more than adequate to protect against any potential loss
exposure to the taxpayer.
In exchange for public support, of course, the American
taxpayer has the right to expect responsible behavior by the
GSEs. It is critically important to protect the taxpayer from
any potential loss by monitoring and regulating GSE financial
risk. It is also critically important to ensure that the low
cost-of-funds and other advantages bestowed on the GSEs are
well directed and ultimately reach their intended
beneficiaries.
There is a risk that much of the government-owned benefit
could be absorbed as profits within the GSE conduit. But one of
the unique factors and features of the Home Loan Bank System,
namely, its cooperative structure, inherently protects against
such an event. Because the members and shareholders are one and
the same and because the public benefit of the Federal Home
Loan Bank System is delivered by members' retail lending, the
members' financial incentives to get the lowest cost of funds
is entirely consistent with maximizing public benefit. In
addition, mission regulation helps ensure this valuable GSE
benefit is focused on assisting member lending.
Mission regulation is closely linked to safety and
soundness regulation. Many assets are perfectly safe and sound
from a financial point of view, but because the GSEs were
created for specific purposes and GSEs are supported by agency
debt, only some assets are consistent with the mission of those
GSEs.
The Finance Board has been focusing on the Home Loan Bank
core mission activities. In the past, some level of non-mission
investments were necessary for the banks to meet their REFCORP
obligation of $300 million per year and to fund the Affordable
Housing Program.
This activity where the Home Loan Banks borrow at close to
Treasury rates to purchase higher yielding assets in the
capital markets such as MBS and earn a profit from the spread
has been the subject of bipartisan criticism for many years.
Indeed, the arbitrage issue has been at the top of the list of
many Members of Congress and the Treasury Department, and
rightfully so.
Five years ago, approximately 40 percent of Home Loan Bank
assets reflected core mission activities as we defined here. I
am pleased to report that through a combination of advances,
growth and Finance Board actions, the ratio is now
approximately 75 percent.
Recently, Finance Board actions along with reforms passed
in Gramm-Leach-Bliley that eliminated the major drivers of
arbitrage, such as the flat REFCORP assessment and
subscription-based capital, provide the best opportunity in a
decade to focus the activity of the Home Loan Banks on their
mission and reduce their dependence on arbitrage investment.
On June 29, the Finance Board passed the Core Mission
Assets/Acquired Member Assets rule. This rule establishes a
framework for the Home Loan Bank System to pursue a totally
mission-related balance sheet. The rule has two parts.
It makes permanent Acquired Member Assets, or AMA programs,
such as the so-called Chicago pilot or the Mortgage Partnership
Finance, which is the most prominent of acquired mortgage
assets. As you know, this as proved to be a very successful
program to date involving over $10.5 billion worth of assets.
Each of the 12 member banks is now offering or will soon
offer an MPF or similar program that will divide the risk of
the mortgage between a member bank and a Home Loan Bank
partner. Simply stated, the member bank manages the credit risk
and the Home Loan Bank, experts at hedging interest rate risk,
will assume and manage that risk.
These partnerships provide true competition with the
secondary market GSEs. Instead of credit risk being
concentrated in those two housing GSEs, the risk can now be
dispersed through over 7500 Home Loan Bank members.
These programs serve to de-concentrate the risk of a $4
trillion housing finance market and put the rewards in the
right place, with those who take the risk, to offer what is
truly a third way home for member institutions.
The rule also defines Core Mission Assets as assets
including advances, Acquired Member Assets and certain smaller
classes of securities. If there is any meaning to the mandate
that the Finance Board must ensure mission achievement, it is
incumbent on the Finance Board to state in regulatory form
which activities and assets actually advance that mission.
The development of the Acquired Member Asset programs will
help the Home Loan Banks to develop Core Mission Assets to
replace arbitrage investments and at the same time increase
competition in the secondary market.
Of course, these new activities must be supported by a
strong capital base. For this reason as well as for purposes of
capitalizing other new Home Loan Bank activities, Gramm-Leach-
Bliley has mandated the establishment of a new risk-based
capital structure that will allow the banks to adjust their
capital to the actual risk that they have on their balance
sheet.
I am pleased to report that on July 13th the Finance Board
proposed a state-of-the-art risk based capital rule as required
by Gramm-Leach-Bliley which is currently out for a 90-day
comment period. The legislation requires the Finance Board to
issue its final capital rule in November and we are making
progress toward that goal.
In summary, as a result of Gramm-Leach-Bliley and the
regulatory initiatives that I have described, the Home Loan
Banks can play an even broader and more important role in the
future than they have in the past and do so in a way that is
mindful of the financial interests of the American taxpayers.
Thank you.
[The prepared statement of William C. Apgar follows:]
Prepared Statement of William C. Apgar, HUD Designee to the Federal
Housing Finance Board
Good morning Mr. Chairman, and members of the Task Force. I would
like to thank you for the opportunity to appear today to testify before
the Task Force on Housing and Infrastructure of the House Budget
Committee on the subject of economic implications of debt held by
government sponsored enterprises. I should point out that the Board of
Directors of the Federal Housing Finance Board has not reviewed my
testimony nor does it represent the Administration's position.
The Federal Housing Finance Board (Finance Board) is an independent
agency in the Executive Branch. It is both the mission and safety and
soundness regulator for the 12 regional Federal Home Loan Banks
(FHLBanks) and the regulator of the Office of Finance, which serves as
the debt issuance facility for the consolidated obligations of the
FHLBanks. The Finance Board is funded through assessments made on the
FHLBanks and is not subject to the congressional appropriations
process.
Since the resignation of Bruce Morrison as Chairman on July 4,
2000, I have held the delegated authority of Chairman of the Finance
Board as Secretary Cuomo's designee. I would like to emphasize my
intention to maintain the continuity of the Finance Board's recent
actions with respect both to safety and soundness and to innovation by
the FHLBanks and competition among the government sponsored enterprises
(GSEs) as a means of maximizing their public benefit.
Congress created the FHLBank System in 1932 to improve the
availability of funds to support homeownership. The FHLBanks are
cooperatively owned by their member-bank stockholders and they operate
by enhancing member lending at the local level. The FHLBanks offer as
their primary product, a readily available, low-cost source of funds,
called an advance, to its member institutions and housing associates.
Advances enhance lending by members both by passing through the
FHLBanks' cost-of-funds advantage in the debt markets, and by having
FHLBanks manage interest rate risk. To the Finance Board, activities
that assist and enhance lending by members are consistent with the
FHLBanks' mission.
Congress originally granted access to FHLBank advances primarily to
thrift institutions. In response to the thrift crisis of the 1980s,
Congress enacted FIRREA in 1989 to change the FHLBank System, most
significantly by expanding membership eligibility to include commercial
banks and credit unions.
In 1989, Congress also imposed a $300 million per year assessment
on the FHLBanks to help pay for the costs of the thrift bailout. In
addition, Congress imposed a requirement that 10 percent of FHLBank net
earnings go to support an Affordable Housing Program (AHP) each year.
The AHP is designed to enhance the availability of affordable housing
for very low- to moderate-income families. Last year the FHLBank System
made $199 million in AHP contributions and grants nationwide. The
combination of these new financial obligations, the decline in the
thrift population, and the time lag for commercial banking institutions
to join the FHLBank System and take down advances, understandably drove
the FHLBanks in the 1990s to supplement earnings by increasing
arbitrage activities.
In November 1999, by enacting Title VI of the Gramm-Leach-Bliley
Act--the first comprehensive legislation since FIRREA to affect the
FHLBank System--Congress, in a singular vote of confidence, made many
changes to enhance the capacity of the FHLBanks to carry out their
housing finance and community and economic development mission as part
of the modernized financial services world of the 21st century.
Significant, among other changes, is that the FHLBank System has now
been charged with supporting access to low-cost funds for community
financial institutions to support small business, small farm and small
agri-business lending. Moreover, by changing the fixed $300 million
REFCORP assessment to one based on a percentage of FHLBank income and
by reforming the FHLBanks' capital structure, this legislation has
truly positioned the FHLBank System to add value to consumers and to
the financial system in three critical areas: providing competition in
housing finance; serving as central bank to community institutions; and
serving underserved populations. I would also stress that, through both
proposed and final regulations, including a recently proposed
regulation on the new risk-based capital structure, the Finance Board
has implemented all the statutory requirements of Gramm-Leach-Bliley--
as well as exercising its discretionary authority to strengthen mission
regulation--in a timely and expeditious fashion, and I would like to
commend the Finance Board staff on their efforts in this regard.
As of June 30, 2000 the assets of the FHLBank System totaled $621
billion. There were more than 7500 members as of that date. The bonds
issued to support the assets of the FHLBank System are expressly not
obligations of the United States, but they do benefit from the
favorable investor perception associated with the FHLBanks' status as a
GSE. The Federal Home Loan Bank Act makes clear that it is the Finance
Board's primary duty to ensure the safety and soundness of the FHLBank
System and, consistent with that primary duty, to ensure that the
FHLBanks carry out their housing finance mission.
As noted, the fundamental business of the FHLBanks is to provide
member institutions with advances and other credit products in a wide
range of maturities and terms to meet member demand. Lending and
investing funds and engaging in off-balance-sheet interest-rate
exchange agreements have the potential for exposing the FHLBanks to
credit and interest-rate risk. The principal defenses against credit
and interest-rate risk are sound risk-management policies and
practices, vigilant supervision, and the over $30 billion of FHLBank
System capital.
To control the FHLBank System's risk exposure, the Finance Board
has established regulations and policies that FHLBanks must follow to
evaluate and manage their credit and interest-rate risk. Among the most
notable regulatory requirements are:
The FHLBanks must have, and take whatever actions are
necessary to maintain, a triple-A credit rating on their consolidated
debt.
Each FHLBank must have, and take whatever actions are
necessary to maintain, a double-A credit rating that is a meaningful
measure of the individual FHLBank's financial strength and stability.
Each FHLBank must establish and implement risk management
policies and controls that comport with Finance Board requirements and
conduct periodic assessments of these controls.
Each FHLBank and the Office of Finance must be subject to
an annual on-site examination by the Finance Board, as well as off-site
analyses.
Each FHLBank must file periodic compliance reports with
the Finance Board.
Each FHLBank must have both an external and an internal
auditor, and the Finance Board has recently articulated a new set of
state-of-the-art duties and responsibilities of the audit committee of
each FHLBank's board of directors along with standards for corporate
governance and internal controls that the boards must comply with.
Managing Interest-Rate Risk. Interest-rate risk is the risk that
relative and absolute changes in interest rates may adversely affect an
institution's financial condition. The goal of an interest-rate risk
management strategy is not necessarily to eliminate interest-rate risk
but to manage it by setting appropriate limits.
The Finance Board has adopted comprehensive policies that strictly
limit the amount of interest-rate risk a FHLBank may assume. Most of
the FHLBanks have adopted internal interest-rate risk limits that are
even more conservative than the strict limits required by the Finance
Board. To further limit interest-rate risk that could arise when a
member prepays an advance, the Finance Board requires that each FHLBank
generally charge a prepayment fee that makes it financially indifferent
to a member's decision to prepay an advance.
The Finance Board limits the interest-rate risk of mortgage-backed
securities (MBS) owned by the FHLBanks by restricting the types of MBS
to those with limited average life changes (and hence limited price
change) under certain interest-rate shock scenarios. Moreover, the size
of the FHLBanks' MBS holdings is limited to no more than three times
the FHLBanks' capital (or less than $90 billion today).
The general approach of the FHLBanks toward managing interest-rate
risk is to acquire and maintain a portfolio of assets and liabilities,
which, together with their associated interest-rate exchange
agreements, limit the exposure to future interest rate changes.
Managing Credit Risk. Credit risk is the risk of loss due to
default. The FHLBank System protects against credit risk through
collateralization of all advances. In addition, each FHLBank can call
for additional or substitute collateral during the life of an advance
to protect its security interest. In the 68-year history of the FHLBank
System, no FHLBank has ever experienced a credit loss on an advance to
a member.
While the FHLBanks face minimal credit risk on advances, they are
subject to credit risk on some investments. Each FHLBank must comply
with limits established by the Finance Board and its board of directors
on the amounts of unsecured extensions of credit, whether on- or off-
balance sheet. The Finance Board also limits the amounts and terms of
unsecured credit exposure to any counterpart other than to the U.S.
Government. Unsecured credit exposure to any counterparty is limited by
the credit quality and capital level of the counterparty and by the
capital level of the FHLBank.
The Finance Board views these risk management requirements to be
more than adequate to protect against any potential loss exposure to
the taxpayer. Even so, the taxpayer has a right to expect certain
benefits for taking any potential risk and for bestowing certain
advantages on the GSEs.
Congress long ago decided that promoting homeownership is desirable
and worth the cost of granting special advantages to homebuyers, such
as the mortgage interest tax deduction, and the establishment of
specially advantaged GSEs to facilitate housing finance and other
socially desirable activities. In exchange for public support, the
American taxpayer has the right to expect responsible behavior by the
GSEs. It is obvious that it is critically important to protect the
taxpayer from any potential loss by monitoring and regulating GSE
financial risk. It is also critically important to ensure that the low
cost-of-funds and other advantages bestowed upon the GSEs are well
directed and ultimately reach their intended beneficiaries. There is a
risk that much of the government-bestowed benefit could be absorbed as
profits within the GSE conduit.
One unique characteristic of the FHLBank System--namely, its
cooperative structure--inherently protects against such an event.
Because members and shareholders are one and the same, and because the
public benefit of the FHLBanks System is delivered by members' retail
lending, the members' financial incentives to get the lowest cost of
funds is entirely consistent with maximizing the public's benefit. In
addition, mission regulation helps to ensure that this valuable GSE
benefit is focused on assisting member lending.
Congress created GSEs to accomplish statutorily prescribed missions
and provided them with advantages, including a U.S. Treasury line of
credit, which enables them to benefit from a lower cost of funds and
operations. It is up to the regulator to ensure that the public, in
turn, receives the benefits of that lower cost and to ensure,
consistent with safety and soundness, that the public mission of the
GSE is achieved.
Mission regulation, while controversial, is closely related to
safety and soundness regulation. Many assets are perfectly safe and
sound from a financial point of view. But because the GSEs were created
for very specific purposes, and GSE assets are supported by agency
debt, only some assets are consistent with the mission of those GSEs.
The Finance Board has been focusing the FHLBanks on core mission
activities. In the past, some level of non-mission investments were
necessary for the FHLBanks to meet their REFCORP obligation of $300
million per year and to fund AHP. This arbitrage activity, where the
FHLBanks borrow at close to Treasury rates to purchase higher yielding
assets in the capital markets, such as MBS, and earn a profit from the
spread, has been the subject of bi-partisan criticism for many years.
Investments supported by agency debt and ultimately guaranteed by the
taxpayer simply to earn a profit are much less useful than activities
that would more directly benefit members and their borrowers.
Indeed, the ``arbitrage issue'' has been at the top of the list of
concerns of many Members of Congress and the Treasury Department, and
rightly so. Five years ago approximately 40 percent of FHLBank assets
reflected Core Mission Activity as we have recently defined the term. I
am pleased to report that through a combination of advances growth and
Finance Board actions, that ratio is now approximately 75 percent.
Recent Finance Board actions along with the reforms passed in
Gramm-Leach-Bliley that eliminated the major drivers of arbitrage, such
as the flat REFCORP assessment and subscription based capital, provide
the best opportunity in a decade to focus the activities of the
FHLBanks on their mission and reduce their dependence on arbitrage
investments. On June 29, the Finance Board passed the ``Core Mission
Assets/Acquired Member Assets'' rule. This rule establishes the
framework for the FHLBank System to pursue a totally mission-related
balance sheet. The rule has two parts:
1. It makes permanent the Acquired Member Assets, or AMA programs,
and removes the $9 billion cap on the ``Chicago Pilot'' (MPF), which is
the most prominent of acquired member asset programs. MPF has proven to
be very successful and has to date acquired over $10.5 billion of
assets. Each of the 12 FHLBanks is now offering, or will soon offer,
MPF or a similar program that will divide the risks of mortgages
between a member bank and its FHLBank partner. Rather than sell the
mortgage and all its attendant risks in the secondary market, a FHLBank
member will have the option of retaining the credit risk and being
rewarded for good underwriting by receiving a credit enhancement fee.
The FHLBanks, experts at hedging interest rate risks, will assume and
manage the market risk.
These partnership programs provide true competition with the two
secondary market GSEs. Instead of credit risk being concentrated in
these two housing GSEs, the risks can now be dispersed through the
FHLBanks to their 7,500 members. These programs de-concentrate the
risks of a $4 trillion housing finance market and put the rewards in
the right place--with those who take the risk--to offer what is truly a
``third way home.''
Rather than rail against the housing GSEs and the advantages they
have been afforded, I believe we should instead focus on how to
introduce competition among them, decrease risk to the public sector,
and focus mission to maximize the public benefit. The FHLBanks' AMA
programs accomplish these objectives.
2. The proposed rule defines Core Mission Assets (CMA) as assets
(including advances, AMA and certain smaller classes of targeted
assets) that the FHLBanks are encouraged to hold. If there is any
meaning to the mandate that the Finance Board ``ensure'' mission
achievement, it is incumbent on the Finance Board to state in
regulatory form which activities and assets actually advance that
mission. Rather than imposing a constraint, the definition of Core
Mission Assets simply specifies what we consider to be the most
productive, value-added assets as tools for business and capital
purchase purposes.
The development of Acquired Member Asset programs will help the
FHLBanks to develop core mission assets to replace arbitrage
investments and, at the same time, increase competition in the
secondary market. By doing so, AMA should increase mortgage market
share for depository institutions, help disperse the credit risk of the
$4 trillion mortgage market from the two large secondary market GSEs to
the more than 7,500 FHLBank member institutions and, most importantly,
reduce mortgage costs for American homebuyers.
These new AMA activities must be supported by a strong capital
base. For this reason, as well as for the purposes of capitalizing
other new FHLBank activities, and creating consistency with rules
applied to other regulated financial institutions, Gramm-Leach-Bliley
has mandated the establishment of a new risk-based capital structure,
that will allow the FHLBanks to adjust their capital to the actual
risks that they have on their balance sheets.
Currently, members are required to buy an amount of FHLBank stock
based on the size of their balance sheets and the amount of their
advance borrowings from the FHLBanks. This has resulted in systematic
over-capitalization of the FHLBanks. The FHLBanks have been servicing
this excess capital with arbitrage-derived profits. Risk-based capital
will match required capital to actual acquired risk and therefore
alleviate the need for extraneous arbitrage earnings. Risk-based
capital offers greater protection to the System and therefore greater
protection to the taxpayer. Another way of looking at the issue of
capital is as follows: member institutions can think of the FHLBanks as
their capital markets affiliate and make a rational decision as to how
much capital they wish to put up for the FHLBanks to be able to conduct
members' business. The size of the balance sheet need be no larger than
what is actually required for business, not for arbitrary, non-mission
related arbitrage. Again, this is another vital tool to minimize risk
while assuring maximum pass-through of public benefit. The Finance
Board on July 13 proposed a state-of-the-art risk-based capital rule as
required by Gramm-Leach-Bliley, which is currently out for a 90-day
comment period. The legislation requires the Finance Board to issue its
final capital rule by November 12 of this year, and we are making
progress toward that goal.
In summary, as a result of both Gramm-Leach-Bliley and the
regulatory initiatives that I have described, the FHLBanks can play an
even broader and more important role in the future than they have in
the past. The FHLBanks have new authority to expand into small business
and agricultural lending to their smaller members, to expand non-
mortgage lending to all members and to offer new mortgage products that
enhance competition among the housing GSEs and disperse the credit
risks of mortgage finance. The FHLBanks now have a regulatory incentive
to focus on activities that create value for members and thus for
consumers, and have the prospect of more permanence in the FHLBank
capital base than has previously been the case. In all these ways, the
FHLBanks are extraordinarily well-positioned to work with their rapidly
growing membership base. Consumers of financial services all across
America will benefit if we stay this public policy course and authorize
the FHLBanks to play these important roles in the future.
Chairman Sununu. Thank you very much, Mr. Apgar.
Mr. Falcon, a lot of discussion in the previous panel
centered around matching the GSE portfolios in order to
minimize their exposure to risk. To what extent are the long-
term assets within the GSE portfolios funded by short-term
debt? How well matched are the portfolios?
Mr. Falcon. Right now, Mr. Chairman, we consider the
portfolios to be very well matched. The majority of the debt
that they issue is long term and the short-term debt that they
do have is through the use of derivatives converted to
effective long-term debt and then the majority of that long-
term debt has callable or adjustment features in it which
protect the enterprises from changes in interest rates.
Chairman Sununu. How do you quantify or how do you measure
the degree to which the portfolio might be mismatched, that
there might be some gap in duration?
Mr. Falcon. Well, you have to take into account, Mr.
Chairman, the prepayment risk associated with mortgages and
there is a well established body of research about prepayment
speeds on mortgages. And it depends on the various state of
interest rates as to whether or not mortgages will be prepaid
at a certain rate, as opposed to earlier rather than later.
Chairman Sununu. In trying to forecast prepayment risk, do
you benefit from the GSEs' considerable database of
information? I would guess that no one has better historical
records than the GSEs. Do you benefit from that information in
trying to estimate yourself what the potential for prepayment
is?
Mr. Falcon. Yes. Absolutely. In fact, we have a broader
base than either one of the GSEs, since we have both GSEs'
databases. We can look at them in the aggregate in addition to
individually.
Chairman Sununu. Could you for a little bit of history
describe the mismatch that occurred in the early 1980's that
was mentioned by the previous panel and the degree to which
that could or could not happen again due to changes in the
policy at the GSEs?
Mr. Falcon. Certainly I would never say that anything could
never happen again, Mr. Chairman, but I think through our
supervisory program I am comfortable with the way they are
managing their interest rate risk at the current time.
Certainly--and I worked for the House Banking Committee for
8 years, Mr. Chairman, and worked with that committee to help
deal with the savings and loan crisis, so I am well aware of
what is required of a regulator in order to try to prevent that
from ever happening again with any financial institution.
So I think what you had there was basically, as the
previous panel described, you had long-term assets funded with
short-term sources of funds. And that is why it is so critical
to the enterprises to ensure that there is a match in duration
of assets and liabilities.
Chairman Sununu. Who had responsibility for oversight at
that--and that's before S&Ls even existed, correct?
Mr. Falcon. Yes, Mr. Chairman.
Chairman Sununu. So who was primarily responsible for
oversight or for trying to help identify whether or not a
mismatch existed in the early 1980's?
Mr. Falcon. With the enterprises?
Chairman Sununu. Yes.
Mr. Falcon. At that time, I think HUD had some general
regulatory responsibility, but I think that was the extent of
it.
Chairman Sununu. Could you talk a little bit about the
risk-based capital stress test? What are the principles that
are at the core of that test that you have developed and are in
the process of implementing?
Mr. Falcon. I certainly enjoy talking about risk-based
capital because I think it would be a very valuable tool for
OFHEO in achieving its responsibilities.
It is intended to complement our examination program and
our research program. They are all, I think, critical
components to OFHEO achieving its mission.
Risk-based capital is simply placing the enterprises'
balance sheets under stressful economic conditions, both
stressful credit losses as well as big swings in interest rates
and then seeing how their balance sheets would fare under a 10-
year scenario at those stressful levels.
We are in the process right now of combing through the
comments. In fact, we have concluded review of all the comments
on the proposal and we are in the process right now of writing
a final rule to reflect any changes that have been made and we
will also have to make changes to the computer model.
This involves not just writing the rule, but involves
writing very sophisticated computer code to make sure that we
adequately and properly model the assets and liabilities of the
enterprises.
Chairman Sununu. What elements of risk cannot be adequately
captured in this kind of a model?
Mr. Falcon. I think management and operations risk is
certainly one of them, but that is why the risk based capital
requirement will have a 30 percent add on in addition to
whatever is produced by the stress test. So there is a very
generous add on that is included to the stress test capital
requirement.
Chairman Sununu. Is that 30 percent intended to cover bad
management?
Mr. Falcon. No, just to--well, to ensure that if there were
any lapses in management or unforeseen circumstances, this is
just an add on to ensure that to the next something cannot be
modeled in the risk-based capital regulation there is a cushion
in addition to that requirement which is produced by the stress
test.
Chairman Sununu. How does OFHEO deal with oversight of risk
management strategies in hedging?
Mr. Falcon. Our examination staff, which I think consists
of very talented and experienced examiners, look at the
policies of the enterprises and not just their policies but the
actual practices of the enterprises in trying to hedge against
risk. They will look at very specific transactions that are
entered into, to accommodate changes in interest rate.
I think, Mr. Chairman, this will be complemented by our
risk-based capital standard, but as great as the risk-based
capital standard will be when we get it completed at the end of
the year, I do not ever want to downplay how important it is
for our examiners to be there at the enterprises, understanding
everything that the enterprises do.
We never substitute our business judgment for what they
have decided to do in running their businesses, but we
certainly look at everything that they do and try to make
certain that the risk is properly managed.
Chairman Sununu. As the size of the portfolio held by the
GSE grows, the GSE needs to engage in a greater volume of
interest rate swaps and utilization of option-embedded
securities in order to keep that portfolio in balance. Is that
correct?
Mr. Falcon. Yes. As they add mortgage-backed securities
into their portfolio, their retained portfolio, they do take on
the interest rate risk.
Chairman Sununu. Does the increase in the utilization of
derivatives in that situation in and of itself require a higher
level of capitalization or reserves?
Mr. Falcon. I think any increase in the use of derivatives
certainly requires increased supervision because you then have
to deal with counterparty risk and counterparty risk is dealt
with in our risk-based capital standard as well as in our
examination program. We will look at the nature of the
counterparties, we will try to make sure that there is not any
concentration in any one or two counterparties, but, yes, it is
an important part of our supervision.
Chairman Sununu. Mr. Ely was disappointed that he did not
have access to more information regarding that counterparty
exposure but for the purposes of regulation, is there any
information regarding counterparty exposure that you do not
have access to?
Mr. Falcon. No, sir.
Chairman Sununu. Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman, and thank our panel
for being here. I am sorry I missed your testimony.
I want to say I am always happy to see Mr. Falcon testify
because a lot of what we are talking about with respect to the
GSEs and whether or not there is sufficient oversight and risk-
based capital rules and all is sitting on Mr. Falcon's front
doorstep and we eagerly await the publication of the final
rules with respect to that and I, for one, am eager to see
Congress allow Mr. Falcon and the agency that he represents the
ability at least to carry out what we passed in 1992 before we
go and change it all again, maybe at least for a month or two,
if not longer.
Let me ask just a couple of questions.
One, to Mr. Ely's question on derivative information, when
OFHEO conducts its analysis of the GSEs, in which case you will
be looking at counterparty risk and the like, will that
information, will your final analysis including some of that
information, become part of the public domain and thus be
available to the public, whether it is the general public,
concerned investors or whatever?
Mr. Falcon. I think generally I would like to foster
greater understanding of the GSEs and the secondary mortgage
market. To the extent we can provide any increased transparency
to their operations, especially in this area, I think it would
be of benefit to the mortgage market and to the public.
However, we have to balance that against the requirements of
the Trade Secrets Act and ensure that we do not release any
proprietary information of the enterprises, but certainly I
think that that is a very worthwhile goal.
Mr. Bentsen. It is tough in the area of derivatives, there
is no real Federal standard as it relates to disclosure of
derivative investments, even in the banking industry we have
had a battle going on over FASB rules and how derivatives
should be handled and disclosure rules, but I would hope that
OFHEO's analysis that it is disclosed to the public is useful
analysis, I guess is the best way to put it.
How would you compare in establishing your risk-based
capital standards and your stress test to those that were
established under FIRREA for savings and loans? You were
involved in the passage of both pieces of legislation as
counsel on the banking committee. FIRREA sought to impose
tighter investment standards on thrifts both in the purchase of
mortgages, mortgage securities, and other types of non-mortgage
investments. Do you think the standards you are establishing
are comparable to that?
Mr. Falcon. The standards which eventually resulted from
FIRREA and FIDCIA were risk-based capital standards, but they
were more of a ratio or leverage type risk-based capital
standard, where assets were placed in buckets and the buckets
had a risk weighting and the resulting capital would be their
risk-based capital standard.
This was in addition to the straight forward leverage
capital standard that the banks and thrifts have applied to
them.
What OFHEO is doing under the 1992 act is something which
is entirely different. I do not mean to imply that one is
better than the other. I think that comparing banks and thrifts
and the enterprises, it may be that one is appropriate for
banks and thrifts and this is appropriate for the GSEs. What we
do is we actually place the balance sheets of the enterprises
under stressful conditions, big interest rate swings, severe
credit losses, we give them credit for hedging activities, and
we make sure that they can remain solvent over that entire 10-
year period under those stressful conditions.
If at any point in any quarter during that 10-year period
they do not have sufficient capital to remain solvent, then we
will increase their capital requirement to make sure that they
always maintain that level of minimum capital.
So we try to simulate through this risk-based capital
regulation and the stress test what would happen under severe
economic times and I think that is an entirely different way of
imposing a risk-based capital requirement and, in fact, we have
been educating the banking regulators on how this would work.
There may be some aspects of it that they are trying to
understand better to see if there is any applicability.
Mr. Bentsen. Do you take into consideration geographic
economic dislocation and how it affects the mortgage portfolio?
I know a lot has been talked about the farm crisis and the
impact it had on the Farm Credit System in the mid 1980's.
Obviously, there was an economic problem broadly in the farm
system.
Do you all take into account--I mean, short of just an
overall economic decline in the United States, the geographic
changes in the real estate market?
Mr. Falcon. Well, the worst credit losses that are built
into the stress test actually are the worst credit losses for a
specific region of the country, so to the extent that we did
pick the severest credit losses for a geographic region of the
country and implied those losses and that experience to the
entire portfolio of the enterprises, so Congressman, I think in
that sense we are trying to not just take a national average of
credit experience, but actually a more focused worst case
scenario.
Mr. Bentsen. I just have a couple more questions, Mr.
Chairman.
If you find that there is under capitalization or potential
under capitalization or non-adherence to stress test risk out
there, your examiners are in the GSEs and they find there is a
problem with the portfolio or a systemic problem, what
authority do you have to correct that problem?
Mr. Falcon. We have pretty broad authority in our statute
and we have adequate authority, I believe, to step in and
require the corrective action to address the problem and we
will move quickly to do that. I would never want to place this
committee, this Congress, in any position where they have to
consider a deteriorating condition of the enterprises. So we
would move quickly, we would move forcefully, utilizing all the
authorities we have to ensure that we exercise prompt,
corrective action.
Mr. Bentsen. Do you have similar sort of cease and desist
authority in the same way the Comptroller of the Currency or
the Federal Reserve has in bank regulation?
Mr. Falcon. Yes.
Chairman Sununu. Finally, for Mr. Apgar and Mr. Falcon,
there has been a lot of discussion about GSE debt and we will
just talk about aggregate debt, both GSE corporate debt and
mortgage-backed security debt, and how fast it is growing.
Is GSE debt--the vast majority of which is mortgage debt, I
believe, in one way or the other--is it growing more rapidly
than housing debt would grow as a whole to meet housing market
demand?
The point is--and this is sort of where I think the big
question we are leading to is--do the GSEs have access to so
much cheap money out there that they have issued a dramatic
amount of debt far greater than the demand they have for buying
mortgages, either through direct purchase or through the MBS
function?
Mr. Apgar. Well, you heard earlier that the mortgage market
is a mature market, growing only so fast, and the GSEs for a
variety of reasons, the secondary market GSEs particularly, are
growing even faster in their purchase of debt.
I think the more relevant question is is it growing faster
than maybe Congress or anybody anticipated when they laid down
the regulatory frameworks in 1992. And so I think it is a fair
question to review whether the oversight mechanisms are
appropriate. I have high confidence that in the case of the
Federal Housing Finance Board we are doing an adequate job.
I have testified earlier concerning the job that OFHEO and
HUD is doing in its oversight of Fannie and Freddie, but I do
think it is an appropriate question given the fact that it is
growing, I believe, faster than people would have anticipated
that would review these regulatory structures.
Mr. Bentsen. I would just add--and that is a fair question,
I agree with you, that is a question we need to be focusing on.
But my initial question is a risk-related question.
The argument is that there is substantial risk associated
with the rise in GSE debt. The question is is that debt rising
to meet housing market demand or is it rising faster than
housing market demand would otherwise require?
And if there is a spread there, then is that where the risk
would be?
Mr. Apgar. Well, it is clearly----
Mr. Bentsen. Assuming that the housing market is relatively
stable.
Mr. Apgar. It is what does housing market demand require,
which is the question of how much do the GSEs need in order to
maintain their operations and that is the important question
that we have been discussing.
Clearly, in order to maintain their role as secondary
market activity, they need to do some purchasing of securities
to maintain price and other things. The question is whether
they have been involved in excessive purchases, some way
defined, and I do not have a specific answer on that.
Mr. Bentsen. Thank you.
Thank you, Mr. Chairman.
Chairman Sununu. Mr. Smith.
Mr. Smith. Thank you, Mr. Chairman.
I happen to chair one of the science subcommittees in
research and we have been looking at the effect of the new
technology and our ability through computers and websites to
communicate and I am somewhat familiar with a couple of
innovations such as the muniauction.com and other websites that
tend to make sure that the market is in place as far as buyers
and sellers in terms of trying to make this system a little
more efficient.
What do you see as the impact of this kind of advance
communication in terms of bringing the lowest possible interest
rates or the lowest possible--the best possible service to the
ultimate homeowner?
Mr. Apgar. Well, as was noted earlier, capital markets are
emerging, they are integrated into the world, housing finance
markets into the world, capital markets. The innovations in
delivery of mortgage products are astounding. And so I think
that all enures to the benefit of the American home buyer.
Mr. Smith. Mr. Falcon, any comments?
Mr. Falcon. I agree generally with what Secretary Apgar
said.
Technology as it evolves, and I would recommend to you our
annual report which discussed this at some length, could change
the way the mortgage delivery system is used right now. I think
you are seeing some efforts by the enterprises to try to
position themselves accordingly. They are developing
relationships with others such as the Freddie Mac-Microsoft
joint venture to have a single delivery mechanism for mortgages
through the Internet.
So I think it is an area that we are studying carefully.
Mr. Smith. And, Mr. Falcon, let me ask you a question about
hedging. When asked about the credit risk and interest rate
risk as a result of mortgages and MBSs in the portfolio, GSEs
are quick to point out that they have a great hedging system
and so my question is is there an adequate framework in place
for OFHEO to assess and review these hedging systems to look at
what is going to be the best way to do it? How do you assess
it? Are you assessing them?
Mr. Falcon. Absolutely, Congressman. We look at their
overall policies with regards to how they use hedging,
derivatives for hedging purposes. They engage in derivative
usage for hedging purposes and do not engage in the use of
derivatives for speculative purposes. And we do look closely at
how they use hedges to deal with any possible interest rate
risk that they have with respect to their portfolio or any
other line of business that they have.
Mr. Smith. And another question is Fannie Mae has stated on
several occasions that a bank or a thrift institution would
require much more capital if they were going to meet the risk-
based capital requirements of OFHEO. Give me your reaction.
Mr. Falcon. You really cannot compare them, Congressman.
They are two entirely different types of capital regulations,
the risk-based capital we are working on versus the risk-based
capital regulation that banks and thrifts have applied to them.
And the nature of their businesses are very different as well.
So I do not know that you could readily compare the capital
requirements of banks and thrifts to the capital requirement
that we will have for Fannie or Freddie under a risk-based
capital regulation.
Mr. Smith. And maybe a final question would be each of your
assessment or your evaluation of the ultimate responsibility of
the Federal Government, how much of a real obligation would
there be for the Federal Government to underwrite, would it be
a political obligation?
Do you see anything that is implied in any of the laws or
any of the regulations that might go further in implying some
underwriting by the Federal Government if the GSEs run into
trouble?
Mr. Apgar. Well, as was noted, we are starting with
securities that say in plain English that these are not
guaranteed by the Federal Government, but that does not undue
the 60, 70-year history of Federal involvement in each entity.
And so clearly there is an investor perception.
What it would take to change investor perceptions is
difficult to assess, but among other things, investors could
perceive that because of the size of these organizations alone,
independent of this history of Federal involvement, that any
substantial financial difficulties because of the magnitude and
number of people that would be affected by that would require
some Federal action.
Mr. Falcon. I agree totally, Congressman. You could remove
the enterprises' line of credit and you could take away their
Federal charter, you could subject them to State and local
taxation, you could take away all the explicit Federal
benefits, but you still have the question before you of would
they be considered too big to fail.
This is a question that Congress has before it, not just
with respect to Fannie or Freddie or the Federal Home Loan Bank
System, but with respect to any large financial institution.
So would repealing the explicit benefits they receive
address the issue of the implied Federal guarantee? I am not
certain it would because of the issue of too big to fail.
Mr. Smith. And so to what extent does this implied
responsibility of the Federal Government add to the profits of
Fannie Mae and Freddie Mac?
Mr. Falcon. It certainly makes our jobs all the more
important, to make sure that we are adequately supervising the
enterprises. The benefits they receive, as I outlined in my
testimony, there is benefit that enures to homeowners. If you
look at the comparison of the conforming mortgage interest rate
to jumbos, there is certainly a difference in what it would
cost the homeowner to get a home loan.
Chairman Sununu. If you could elaborate on that, to what
extent is that disparity driven by the participation of the
GSEs and to what extent is it driven by market liquidity at the
sort of higher end and the larger size mortgages that might be
less common?
Mr. Falcon. Well, I think certainly the enterprises' lower
cost of funds by virtue of the GSE status is what results in
some of that differential. Whether or not all of the
differential gets passed on to homeowners is a question. I
believe it was CBO several years ago opined that roughly half
of it was passed on to the homeowners and the rest was for the
benefit for shareholders.
I would like to do some more research on the subject, Mr.
Chairman, on your specific question.
Mr. Smith. Mr. Chairman, can I just do a quick final
question?
Chairman Sununu. Sure.
Mr. Smith. To what extent is this implied support and
underwriting by the Federal Government jeopardizing additional
competition or participation in the secondary mortgage market
by other totally private organizations?
Mr. Falcon. Well, there is a healthy amount of business
done by private label mortgage-backed securitizers and Ginnie
Mae certainly engages in mortgage-backed securities of FHA
loans. There is an issue here about competition. I am not
prepared to say a lot about it, but it is one that I think is
appropriate for Congress to consider.
Generally, I think competition is good.
Mr. Smith. So are you saying it does to some extent give
Fannie Mae and Freddie Mac somewhat additional advantage?
Mr. Falcon. Without a doubt, Congressman. The existence of
the GSE status on Fannie and Freddie does give them a
competitive advantage over any competitor that does not have
GSE status. That is certainly true.
Chairman Sununu. Thank you, Mr. Smith.
Mrs. Clayton.
Mrs. Clayton. Thank you.
To follow up, I think that the reason and the rationale for
creating and giving the advantage was that indeed there was a
need for generating tools that would enhance the affordability
for housing. Is that not right?
Mr. Falcon. Yes. That was Congress' purpose in establishing
the GSEs.
Mrs. Clayton. And knowingly they gave it an advantage
because there was a public good for which there was a need,
otherwise, they would not have done that.
Mr. Falcon. Yes, that is right.
Mrs. Clayton. All of the previous panelists indicated that
the buying back of mortgage-backed securities is perhaps not
mission driven and one, I think Ms. Miles, said it may be a
wash, yet Mr. Ely argued that the absence of a diversified
portfolio increased the risk exposure of the GSEs.
Can it be said that to buy back mortgage-backed securities
really decreases or increases the risk?
Mr. Falcon. I think certainly buying back mortgages does
help the enterprises in the sense that it increases the
liquidity for their mortgage-backed securities. Whether or not
that is--it is Congress' judgment to consider whether or not
that is or is not a mission-related right of the enterprises to
do that, but certainly it is a sound business practice to
increase the liquidity of the securities and to the extent that
this does increase the liquidity, I do not have a concern about
it from a safety and soundness standpoint.
Now, as a mission-related standpoint, that is something I
think is appropriate for Congress to consider.
Mrs. Clayton. But you do not have any questions about it
undermining the mission?
Mr. Falcon. No, ma'am.
Mrs. Clayton. You do not question that the buying back
would undermine the mission. You do see the value in that it
strengthens the liquidity of the GSE and therefore reduces the
risk which is the opposite of what Mr. Ely said.
Mr. Falcon. Yes, Congresswoman. It does not undermine the
mission of the enterprises.
Mrs. Clayton. On the matter of the implied obligation of
the U.S. Government to the creditors or the investors of the
GSEs, the fact is that the line of credit that has been argued,
again, Mr. Ely, really is very low as it relates to the
portfolio, so indeed of that being an issue to undermine the
government's debt, can you comment on that?
Mr. Falcon. The two and a quarter billion dollars line of
credit which each enterprise has is symbolic. Given their size,
that amount of money would not really do them much good if they
were to experience some severe economic troubles.
Chairman Sununu. Mrs. Clayton, if you would yield on that
point for a moment?
Mrs. Clayton. Yes.
Chairman Sununu. That begs the question what does it
symbolize?
Mr. Falcon. I remember this came up, Mr. Chairman, in the
hearing before Congressman Baker as well. And I think it is a
matter for discussion and debate by this Task Force, by the
Congress, as to whether or not Congress wants to begin to take
away some of the explicit benefits that the GSEs have.
Removing it would take away some of the aura of the implied
government guarantee. Would it have any adverse effect on
homeowners? That remains to be seen and it might be an avenue
for further search.
Mrs. Clayton. The implied obligation on the part of the
government, is that enforceable?
Mr. Falcon. It is enforceable only by Congress. If
something were to happen to the enterprises----
Mrs. Clayton. What about a court? Is it enforceable by a
court order?
Mr. Falcon. No, ma'am. The statute--in fact, the 1992 act
which created OFHEO explicitly says that the liabilities of the
enterprises are not backed by the full faith and credit of the
Federal Government. It would take an act of Congress to step in
and bail out the creditors of the enterprises if it wanted to
do so.
Mrs. Clayton. Follow on. Should we really be concerned with
GSEs, their debt or about their safety and soundness if the two
are not the same?
Mr. Falcon. I'm sorry?
Mrs. Clayton. Should we really be concerned about the
extent of their debt or we should we be concerned about their
safety and soundness, the security of the GSEs, since the two
are not necessarily the same?
Mr. Falcon. Right. Two issues here. One is the size of
their debt. Certainly you would be more concerned about
entities like this which have $2.2 trillion in debts and MBS
outstanding as opposed to whether or not it was $10 million. So
size is important here with respect to the implications to the
financial system, should one of the enterprises ever become
insolvent.
However, equally or more important is the nature to which
those risks are managed and supervised. That is why OFHEO has a
very extensive examination program, that is why we have a
minimum capital regulation, we will soon have a risk-based
capital regulation in place.
I think with the tools and adequate regulation we can
ensure that those risks are properly managed and that there is
not an undue risk to the financial system. That is OFHEO's
role.
Mrs. Clayton. You say you can, but you have found that.
Haven't you found that they are sound?
Mr. Falcon. Yes, ma'am. Absolutely.
Mrs. Clayton. OK. And so the structure or the soundness of
the management has been established and you have evaluated that
to be the case. Is that correct?
Mr. Falcon. Yes. They are financially healthy. They are
well managed institutions.
Mr. Apgar. Excuse me. Just with respect to the Home Loan
Bank System, I would echo the same thing. I think today, there
is no reason for concern about risks that the system poses to
the American taxpayer.
Mrs. Clayton. I think also, Mr. Chairman, that the implied
advantage given to the GSEs is also an implied advantage given
to the consumer and I would just question what the interest
rate would be for our loans generated if we did not have that.
So I do not know, since we are looking for studies, we may
want to look at what that implication would be and how the
interest rate would be somewhere else if we did not have the
intervention of GSEs in the marketplace. So I think there is
great value in having them there.
Thank you.
Chairman Sununu. Thank you very much, Mrs. Clayton.
A few final questions.
Mr. Falcon, you seemed to suggest just a few minutes ago
that safety and soundness was not related to the size of the
mortgage portfolio held by one of the GSEs. Now, it would seem
to me that by purchasing mortgage-backed securities or whole
loans and holding them that GSEs expose themselves to the risks
we have talked about, interest rate risk and the prepayment
risk, that they were not exposed to before they held those
securities on their own balance sheet.
So that would impact their safety and soundness, with the
appropriate caveat that they would hedge and manage those risks
in an appropriate way. But clearly the existence of the
portfolio does have an effect on and is intertwined with safety
and soundness in your evaluation of that in support of the
safety and soundness.
Mr. Falcon. Yes. You are right. What I meant to say, if I
did not say it clearly, was the existence of a retained
portfolio and their purchase of mortgage-backed securities is
not in and of itself unsafe and unsound. It is more a question
of how they manage the risk inherent with that activity.
Chairman Sununu. And at least in your most recent report, I
think it is a 2000 report, you certainly took those increased
risks and risk management strategies into consideration in
issuing the support for their safety and soundness that you
did, correct?
Mr. Falcon. Yes, Mr. Chairman.
Chairman Sununu. Could you comment briefly on whether you
think there would be some efficiencies to be gained if we
combined your mission regarding safety and soundness with the
mission regulation of the GSEs?
Mr. Falcon. I am not sure what efficiencies would be
gained. There could be some. But I would say that having
mission regulation is not essential to an effective safety and
soundness regulation. We work well with HUD. We are under the
HUD umbrella as an independent agency within HUD and we are
constantly discussing GSE issues amongst ourselves.
Chairman Sununu. One case, though, where there would seem
to be an interrelationship is in the discussion of appropriate
investment vehicles and, in particular, the case of the whole
cash value life insurance policies. There was a well publicized
example, I think, several years back of investment in some
equities, tobacco securities or equities or something along
those lines.
Those investments are reviewed, as I understand it, by
those looking at mission, but they would ultimately have an
effect on safety and soundness as well. Could both of you
comment on that?
Mr. Apgar. Yes. With respect to non-mortgage investments,
you know, clearly, we need to look at the safety and soundness
implications and so as we do our non-mortgage investments
review, which take place on the HUD side of the ledger, we
coordinate very carefully with OFHEO.
Chairman Sununu. Why not allow OFHEO to have jurisdiction
over those issues as well?
Mr. Apgar. Because there are other issues with respect to
non-mortgage investment in terms of what types of--as well as
with mortgage investments as to whether or not they enhance the
overall effectiveness of the mission, whether they are in the
broad public value, we have a three-part test of which safety
and soundness is just one of the criteria we use.
Mr. Falcon. And HUD does approach us on these issues and we
do offer a very thorough analysis to them about the safety and
soundness implications of any activities of the enterprises,
Mr. Chairman.
Chairman Sununu. There was some discussion on the previous
panel about global market disruptions such as the Russian
devaluation, the series of Asian currency devaluations, and the
fact that these kinds of global economic disruptions or
downturns could have an impact on the safety and soundness of
the GSEs.
Now, it seems to me in considering both of those crises
that the market reaction would be one of a flight to quality,
which would have the effect of lowering interest rates or at
least supporting demand for both GSE debt and perhaps mortgage-
backed securities that are viewed as a generally less risky
investment as compared to many others that are in the
marketplace.
Mr. Falcon, could you comment on whether or not there are
international economic disturbances that have been seen to have
a negative impact on the risk profile of the GSEs, one, and,
two, are the potentials for global economic disruptions,
international disruptions included in the risk-based capital
standard that you are soon to release?
Mr. Falcon. Let me start with the risk-based capital
standard. We have very lengthy historic data that we use that
we built into our risk-based capital regulation, issues like
the credit risk where you might have defaults associated with
mortgages of the enterprises.
That is built into those numbers that we use to model the
likelihood of default and the severity of credit losses in the
event that there were defaults on mortgages.
Chairman Sununu. Just to be clear, you include historical
information about international interest rates and currency
values as well?
Mr. Falcon. We think--not specifically international
currency values or international economic scenarios. We think
that is all built into the historical averages that we use on
default rates and loss severities on mortgages that the
enterprises are involved in.
We could look at whether or not we would want to include
specific international economic problems, but that would
require us to get into a lot of speculative modeling on how
much of an impact a crisis in Asia might have on mortgage
performance in the United States, that kind of very
hypothetical exercise. We try to stay away from that and make
sure that this rule matches known risk to capital.
On the first part of your question, with respect to the
risk to the enterprises from possible international crises and
the flight to quality, in 1998 there was such an event and
there was a flight to quality and, in fact, Fannie Mae and
Freddie Mac used their mortgage portfolio to be the market
essentially for their securities. That helped their MBSs, their
debt remain very liquid and part of a quality investment.
Chairman Sununu. Are there any financial instruments that
you are aware of aside from treasuries that have the level of
market liquidity that the GSEs' mortgage-backed securities do?
I mean even outside of that extraordinary case in 1998.
Mr. Falcon. Sure. Sure. Some would point to some triple-A
rated corporate debt of some very large companies.
Chairman Sununu. That have higher liquidity, similar
liquidity or nearly the same liquidity?
Mr. Falcon. That are regarded as nearly as risk--that have
the same risk level as the enterprises. But they trade closely
to GSE debt. But none of those come to mind really.
Chairman Sununu. Thank you very much.
We thank both witnesses again. And the good news--the bad
news, rather, is you are not Alan Greenspan, but the good news
is you were able to keep a room full for about 3 hours.
Thank you for your patience and for all of the information
you provided the Task Force.
We are adjourned.
[Whereupon, at 1 p.m., the Task Force was adjourned.]