Good morning, Chairman Allard, Senator Reed and members of the Subcommittee. It is a pleasure to be here. I am Leland C. Brendsel, Chairman and Chief Executive Officer of the Federal Home Loan Mortgage Corporation, known as Freddie Mac.
EXECUTIVE SUMMARY
Freddie Mac plays a vital role in financing homeownership and rental housing for the nation’s families. Mortgage funds are available whenever and wherever they are needed. Mortgage rates are lower, saving homeowners thousands of dollars in interest payments. Thirty-year fixed-rate mortgages are plentiful, protecting families from unexpected interest-rate increases. In addition, the availability of low-downpayment loans has helped open the door of homeownership to more low- and moderate-income families.
Freddie Mac’s ability to continue to provide these benefits rests on our financial strength. As a result of our superior risk management capabilities, strong capital position and state-of-the-art information disclosure, Freddie Mac is unquestionably a safe and sound financial institution. Freddie Mac is fiercely committed to maintaining the confidence of Congress, investors and the public in our financial strength because that’s what we need to meet our mission.
Last October, Freddie Mac made six commitments that keep us at the vanguard of world financial practices. These commitments are significant. They outpace the financial management practices of other institutions; they meet or exceed recommendations of international experts in financial risk and capital management; and they set a new standard for global financial institutions. We made these commitments voluntarily. There can be no doubt that Freddie Mac will be able to serve our vital mission in a safe and sound manner for generations to come.
I. FREDDIE MAC BRINGS TREMENDOUS BENEFITS TO CONSUMERS
Freddie Mac is a shareholder-owned corporation chartered by Congress in 1970 to create a stable flow of funds to mortgage lenders in support of homeownership and rental housing. We bring tremendous benefits to America’s families.
Constant availability. There is never a shortage of mortgage money. Freddie Mac’s high-quality, liquid mortgage and debt securities attract global investors to finance America’s housing. A diversified investor base makes the housing finance system highly resilient and stable.
When other markets face disruption – as they did during the global financial turmoil in the fall of 1998 – there is no disruption whatsoever in the mortgage market we serve.
Low cost. By linking local communities with global investors, Freddie Mac enables homebuyers to compete for funds in the capital markets alongside the largest corporations. As a result, families save thousands of dollars in mortgage interest. In a recent report, former Office of Management and Budget Director Dr. Jim Miller and fellow economist Dr. James Pearce totaled the savings to America’s families to between $8 billion and $23 billion each year.
Perhaps the best evidence of how we save consumers money is in the weekly real estate section of major newspapers. For example, in its Saturday Real Estate section, The Washington Post provides two sets of mortgage interest rates: those for conforming mortgages, which are eligible for Freddie Mac purchase (currently up to $275,000 for a single-family home), and those for higher-balance jumbo loans. Invariably, rates on conforming mortgages are lower than those on jumbo loans by as much as 50 basis points. Furthermore, Freddie Mac’s activities lower mortgage interest rates on all conforming loans, not simply the ones we purchase. Whether a conforming loan is held in portfolio by a bank or a credit union, mortgage rates are lower for all conforming market borrowers.
Uniformity. Freddie Mac purchases mortgages in every community in the country. As a result, a borrower in Denver pays the same for a mortgage as a borrower in Providence. This stands in sharp contrast to 1970 when mortgage interest rates differed by as much as one and a half percentage points across the country.
Product choice. America’s families choose from a broad array of mortgage products, including the 30-year fixed-rate mortgage with a low downpayment. In many other countries, this type of mortgage is simply not available.
Innovation. From the development of the mortgage securities market in the 1970s to the development of automated underwriting in the 1990s, Freddie Mac has been at the forefront of innovation in the mortgage market. Borrowers are the direct beneficiaries of Freddie Mac’s innovation.
In 1995, Freddie Mac introduced automated underwriting to the market with our Loan Prospector® automated underwriting service. Loan Prospector has revolutionized the mortgage origination process, reducing the time and expense of getting a loan. Automated underwriting also brings greater objectivity and fairness to lending decisions. Every piece of information is evaluated the same way for every borrower, every time, with an accuracy no human underwriter can match. This high degree of accuracy has led to the development of new products that would have been deemed too risky a few years ago. The Joint Center for Housing Studies at Harvard University concludes that these products enable "more income-constrained and cash-strapped borrowers at the margin to qualify for mortgage loans."
High standards. By bringing competition, standardization and accountability to the mortgage market, Freddie Mac promotes responsible lending. We have taken a leadership role in combating predatory lending practices.
Economic stability. Freddie Mac’s activities also play a vital role in stabilizing our nation’s economy. When the economy weakens, we deliver lower interest rates to the mortgage market. This, in turn, boosts housing activity, which is often just the spark the economy needs. According to Barron’s:
If the Fed has staved off a recession, some of the credit should go to Freddie Mac and Fannie Mae. By helping to transmit the benefits of the central bank’s rate cuts to the mortgage market, these agencies have done their part in cushioning the impact of the Nasdaq knockdown on the American consumer.
Lower mortgage rates also enable existing homeowners to refinance their mortgages, putting real money back into their pockets. The easing of mortgage interest costs and the strength of the housing market are among the bright spots on today’s economic horizon.
Homeownership. The stability, efficiency and innovation that Freddie Mac brings to the mortgage market turn homeownership dreams into reality. Since our inception, Freddie Mac has purchased more than $2 trillion in residential mortgages, financing homes for more than 27 million families. In so doing, we have contributed to an all-time high homeownership rate. Today, more than two-thirds of America’s families are homeowners, building wealth and brighter prospects for their future.
Freddie Mac brings tremendous benefits to the nation. They far outweigh any benefits we derive from our Congressional charter. America’s homebuyers can depend on Freddie Mac because we are safe, sound and strong.
II. SUPERIOR RISK MANAGEMENT
Freddie Mac has a 30-year record of successfully managing our business in a rigorous and disciplined way. The tools we have developed to manage both credit and interest-rate risk are second to none, and our exposure to these risks remains at very low levels.
Credit risk management: Freddie Mac operates in only one business – residential mortgages. This business has low credit risk, which is the risk that borrowers will default on their loans. Because of the value attached to homeownership, families pay their monthly mortgage payment first and faithfully. More than $500 billion in home equity stands between Freddie Mac and the risk of default on the mortgages we own. We are further protected through the use of third-party credit enhancements on a large share of our mortgage purchases. These enhancements include recourse arrangements with our lenders and mortgage insurance on low-downpayment loans. Finally, by funding mortgages nationwide, geographic diversity mitigates the risk of local economic downturns.
These extensive loss protections support mortgages that are underwritten and managed using state-of-the-art statistical tools. Loan Prospector is used by thousands of lenders to originate mortgages that Freddie Mac purchases; in fact, Loan Prospector recently processed its 10 millionth loan. Automated underwriting’s sophisticated evaluation of risks allows us to purchase mortgages with low downpayments in a safe and sound manner. Freddie Mac further mitigates credit losses by actively seeking alternatives to foreclosure. Our loss mitigation techniques reduce credit costs and in many cases enable struggling borrowers to keep their homes.
Our credit risk management techniques have produced extraordinarily low credit losses. Freddie Mac’s mortgage delinquency rates are consistently and significantly lower than the overall conventional market, and much lower than those of the Federal Housing Administration. Our loan charge-offs are significantly lower than those of banks and thrifts. We maintain loan loss reserves that are seven times our credit losses, and hold capital against credit losses sufficient to withstand severe losses.
Interest-rate risk management: Freddie Mac also is a leader in managing interest-rate risk. Interest-rate risk is the risk that changes in the level of interest rates could adversely affect the value of a portfolio and could lead to mismatches in the expected cash flows between assets and liabilities. Freddie Mac’s interest-rate risk exposure results primarily from the uncertainty as to when borrowers will pay off their mortgages. When mortgage interest rates decline, borrowers tend to prepay their mortgages by refinancing into lower-cost loans. This creates financing challenges for mortgage investors who must find alternative investment instruments in a lower-yield environment.
Freddie Mac manages this risk on the mortgages we buy using extremely disciplined standards. First, we fund our mortgage investments with an appropriate mix of bullet debt, callable debt and effective callable debt. We closely monitor the sensitivity of our portfolio to changes in the interest-rate environment and rebalance our portfolio as needed. We regularly reassess the accuracy of our prepayment models.
III. STRONG CAPITAL MANAGEMENT AND SUPERVISORY OVERSIGHT
Not only is Freddie Mac highly skilled at managing risk, we are extremely well capitalized for the risks we take. We manage our business to hold enough capital to withstand ten years of economic stress resembling the Great Depression. In addition to our own rigorous capital management, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the GSE Act) subjects us to both a minimum capital requirement and a stringent risk-based capital standard. The minimum capital requirement applies to both on-balance-sheet and off-balance-sheet assets, unlike bank capital standards. The risk-based capital standard is the industry’s toughest, requiring us to withstand ten years of extremely severe stress.
Our safety and soundness regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), currently assesses our financial strength using the minimum capital standard. Each quarter since OFHEO began assessing Freddie Mac’s capital in 1993, our regulator has determined that Freddie Mac is adequately capitalized, which is the highest rating. OFHEO is required to communicate examination results as well as its determination of our capital strength in an annual report to Congress.
The risk-based stress test required by the GSE Act is innovative, stringent, dynamic and more responsive to risk than any ratio-based capital regulation. It requires Freddie Mac to maintain sufficient capital to withstand a ten-year period of extreme swings in both credit and interest-rate risks.
The credit risk portion of the stress test is based on the assumption that defaults and losses on mortgages occur throughout the United States at a rate and severity equal to the highest default rates experienced in a regional downturn. In implementing this extremely severe scenario, OFHEO intends to subject Freddie Mac’s entire mortgage portfolio to the actual default experience of the collapse of real estate in the oil-belt states in the 1980s. The default rates on mortgages with low downpayments during this period were approximately 25 percent; loss rates were approximately 60 percent.
The interest-rate risk portion of the test mandates a stress test in which yields on 10-year Treasury bonds fall or rise by as much as 600 basis points.
Further, the GSE Act requires a 30 percent add-on to required stress test capital to account for management and operations risk.
A pioneer in the use of risk-based stress tests, Freddie Mac believes that a well-implemented regulation would meet four key criteria:
Freddie Mac is working with OFHEO toward final risk-based capital regulations that will be a model for the industry.
OFHEO currently carries out a detailed and comprehensive examination program, which includes continuous on-site examinations and quarterly capital determinations. OFHEO’s highly regarded examination staff focuses all day, every day on two companies in one line of business. By comparison, examiners of large banks must inspect activities ranging from annuities to foreign currencies to commercial loans to credit cards taking place at hundreds of subsidiaries here and around the world. Despite the monoline nature of Freddie Mac’s business, there are roughly the same number of examiners reviewing Freddie Mac as there are reviewing a large bank’s dozens of business lines.
IV. COMPREHENSIVE DISCLOSURE THAT PROMOTES MARKET DISCIPLINE
We disclose more information to the public about the risks we face and our effectiveness at managing them than almost any other financial institution. The annual report and quarterly information statement supplements of Freddie Mac provide comprehensive information related to credit risk. They include extensive discussion, analysis and quantification of types of credit risk exposures, such as the "at-risk" share of delinquent loans, loan-to-value ratios and geographic concentrations.
Freddie Mac’s interest-rate risk disclosures are similarly comprehensive. Our quantitative methodologies measure the change in portfolio market value that would be caused by immediate upward or downward shifts in interest rates. Freddie Mac provides these disclosures on a regular basis, exceeding the annual disclosure requirements required of financial institutions by the Securities and Exchange Commission (SEC).
Last year, Freddie Mac requested that PriceWaterhouseCoopers (PWC) compare our public risk disclosures to those of selected financial institutions generally recognized to be providing best-in-class risk management disclosures. PWC found that our risk management disclosures "are among the best of the risk management disclosures provided by the recognized best-in-class group included in this study."
Greater transparency through information disclosure exposes an institution to the rigorous discipline of financial markets. If investors perceive that a company’s financial condition has deteriorated, they will require higher yields on their investments to assume the higher risk.
Market discipline is not a replacement for strong capital and vigilant oversight, but is a necessary and desirable complement. Recently, Federal Reserve Chairman Alan Greenspan called market discipline the "first line of regulatory defense." In a speech to the American Bankers Association, he stated that:
We are moving toward a system in which … public disclosure and market discipline are going to play increasing roles, especially at our large institutions, as a necessity to avoid expansion of invasive and burdensome supervision and regulation. Bank regulators are perforce being pressed to depend increasingly on greater and more sophisticated private market discipline, the still most effective form of regulation.
OFHEO also has endorsed market discipline as an important component of a comprehensive regulatory framework. In its most recent annual report to Congress, OFHEO stated:
If creditors have accurate and timely information on the financial risks of Fannie Mae and Freddie Mac and believe that they are exposed to material risk of loss if the Enterprises get into financial trouble, they will take steps to ensure that the Enterprises strike an appropriate balance between risk and return.
V. SIX COMMITMENTS SET A NEW STANDARD IN FINANCIAL MANAGEMENT
Freddie Mac is a leader in risk and capital management and information disclosure. Last October, Freddie Mac made six commitments that keep us at the vanguard of evolving worldwide practices. In developing these commitments, we sought out the best practices among financial institutions. We looked at the recommendations of global financial regulators, including the Basel Committee on Banking Supervision. In its first revision to the ten-year-old Basel Accord, the Committee embraced a "Three Pillars" framework for financial regulation. The pillars are Capital, Supervisory Oversight and Market Discipline. Viewed against these three pillars, Freddie Mac already is among the "best in class" for risk and capital management and disclosure practices.
Since we announced our six-point plan, other regulatory experts have voiced support for similar principles and best practices:
These reports and recommendations provide strong affirmation that Freddie Mac’s six commitments are aligned with the best and most up-to-date thinking on financial risk management.
Freddie Mac asked William Seidman, the former Chairman of the FDIC, for his assessment of our commitments. He concluded:
Your package of disclosures and standards puts [Freddie Mac] in a position of providing more and better public information than any another financial institution, both regulated and non-regulated, of which I am aware.
Our six commitments set the pace for other institutions to adopt similar practices and to enhance their public disclosures. In fact, Moody’s Investors Service said that the commitments "set new standards not only for themselves [Freddie Mac and Fannie Mae], but for the global financial market." They added:
The leadership shown by Freddie Mac and Fannie Mae could prove difficult for other firms to ignore, and could usher in a wave of enhanced financial risk disclosure. This may prove to be one of the most important ramifications of the GSEs’ initiatives.
Freddie Mac met all six commitments in just six months. I will briefly describe each commitment and how it sets a new standard in financial practices and disclosure.
Commitment 1: Public Disclosure of Independent Rating
What we accomplished. On February 27, 2001, we released our "AA-" risk-to-the-government rating from Standard & Poor’s (S&P). We originally pledged to obtain a rating once a year. Now Freddie Mac is going beyond that. We have asked S&P for a continuous "surveillance" rating. This means that S&P will be obligated to notify the public if there is ever a change in our financial position that affects the rating.
Why it’s important. Independent ratings are crucial to our financial system. Every day, millions of securities change hands on the basis of rating agency opinions of financial quality. Freddie Mac’s commitment to seek an annual independent rating provides a readily discernible measure of capital strength that promotes market discipline. Ratings provide an independent early warning signal to the public, Congress and investors regarding our financial condition.
In the preamble of the joint agency proposed rulemaking on risk-based capital standards for recourse and direct credit substitute transactions, the federal bank and thrift regulatory agencies stated:
In the opinion of the agencies, ratings have the advantages of being relatively objective, widely used and relied upon by investors and other participants in the financial markets. Ratings provide a flexible, efficient, market-oriented way to measure credit risk.
How we measure up. A risk-to-the-government rating of AA- places Freddie Mac in the top tier of financial institutions. To put this in perspective, of the ten largest bank holding companies, only two have earned a rating this high on their senior debt – and none has a higher rating.
Commitment 2: Liquidity Management and Contingency Planning
What we accomplished. On March 8, 2001, we announced that we met our liquidity commitment. Freddie Mac holds enough liquid, high-quality assets so that we can meet all of our financial obligations, even in the event of a market disruption so severe that we are unable to issue debt for three months. With this commitment, we also are meeting the Basel Committee’s 14 principles of sound liquidity management for large banks.
Why it’s important. Liquidity is the lifeblood of any financial institution and of any financial market. We take it for granted until it’s gone. Freddie Mac’s liquidity commitment, together with public disclosure, will provide strong assurances to investors about Freddie Mac’s financial strength. Regardless of disruptions in the capital markets that may make it impossible to borrow, Freddie Mac has the means to meet our financial obligations for at least three months.
How we measure up. Freddie Mac’s ability to withstand three months without access to debt markets and still meet our financial commitments is an extraordinary indication of our financial strength and liquidity. It is unlikely that many other financial institutions can meet this standard.
In its 1999 liquidity paper, the Basel Committee suggested that large institutions be prepared to weather a liquidity crisis of between one and three months. We chose the more stringent three months.
Our liquidity commitment also exceeds current market practices and represents a new best practice for financial institutions. For example, the Federal Housing Finance Board recently adopted a minimum liquidity requirement for the Federal Home Loan Banks. The rule requires the FHLBs to withstand only five days without access to the debt markets.
Commitment 3: Periodic Issuance of Subordinated Debt
What we accomplished. On March 21, 2001, we met our subordinated debt commitment with the issuance of $2 billion of 10-year subordinated debt securities, known as Freddie SUBSSM. This will create a supplement to our already strong capital position. The amount of subordinated debt we issue, when combined with our core capital, will equal at least 4 percent of on-balance-sheet assets. We expect that within three years, there will be an additional $8 billion to $10 billion of investor funds standing in front of our senior debt holders.
Why it’s important. Subordinated debt is a tool for market discipline. Subordinated debt is paid to the holders only after all other debt instruments are paid. Interest payments on Freddie Mac SUBS will be suspended and allowed to accumulate for up to five years if Freddie Mac’s core capital deteriorates materially. As a result, the yield at which our subordinated debt trades will provide a market-based indication of our financial strength.
Chairman Greenspan has likened the use of subordinated debt to a "canary in the mine," alerting investors and the public of potential financial weakness well before any regulatory or other governmental intervention would be needed. Similarly, the December 2000 joint report by the Federal Reserve and the Treasury concluded that issuing subordinated debt contributes to market discipline. While the report stopped short of recommending mandatory issuance by banks, Freddie Mac stepped up to the challenge of frequent, large issues.
How we measure up. Freddie Mac’s subordinated debt commitment exceeds practices of other financial institutions. According to the joint report and a 1999 Federal Reserve study, typically only the largest banks and bank holding companies issue subordinated debt, and most banks’ subordinated debt is not publicly traded. Moreover, no bank has voluntarily committed to issue publicly traded subordinated debt on a regular basis to enhance its transparency and market discipline.
Commitment 4: Interim Implementation of Risk-Based Capital Stress Test
What we accomplished. We met this commitment on March 26, 2001, when we announced that we passed the risk-based capital stress test envisioned in GSE Act. Our interim disclosure will not substitute for OFHEO’s regulatory process. We are working with OFHEO toward final risk-based capital regulations that will be a model for the industry.
Why it’s important. Adequate capital is critical to an institution’s ability to weather adverse circumstances. Freddie Mac’s commitment to implement the risk-based stress test and disclose the outcome ensures that we are adequately capitalized for the risks we take.
How we measure up. Freddie Mac’s statutory risk-based capital stress test is the toughest test in the financial industry and is entirely consistent with the 2001 New Basel Capital Accord. A 1999 study conducted by the economic consulting firm IPS-Sendero concluded that the thrift industry would run out of capital after five years of this stress test and would need to triple its capital to survive.
Commitment 5: New Quarterly Credit Risk Disclosures
What we accomplished. We met this commitment on March 26, 2001, when we disclosed the impact on Freddie Mac of a 5 percent decline in house prices everywhere around the country. Since we began keeping track of house-price changes in 1975, there has not been a nationwide decline of this magnitude. Our new disclosure demonstrates the outstanding credit quality of Freddie Mac’s portfolio.
Why it’s important. Freddie Mac’s commitment to disclose quarterly our exposure to credit risk represents a new best practice for financial institutions. Most credit risk disclosure is backward looking, focusing on charge-offs and loans that are already delinquent and in default. This type of information is useful, and Freddie Mac will continue to report it. The addition of our new credit-risk disclosure, which predicts exposure to a worsening economy, provides forward-looking insights into our business.
How we measure up. By subjecting ourselves to this test, Freddie Mac has set a new standard in the measurement and reporting of mortgage credit risk. The Basel Committee issued a paper in July 1999 regarding best practices for credit risk disclosure stating the Committee’s expectation that banks disclose sufficient, timely and detailed information to allow market participants to perform meaningful evaluations of the bank’s credit risk profile. Our commitment is consistent with the Basel approach.
Commitment 6: New Monthly Interest-Rate Risk Disclosures
What we accomplished. On April 18, 2001, we began the monthly disclosure of interest-rate risk. We disclosed the impact on Freddie Mac of an abrupt change in our funding costs – both a 50 basis-point shift in interest rates and a 25 basis-point shift in the slope of the Treasury yield curve. The disclosure demonstrates Freddie Mac’s disciplined and skilled risk management, as our interest-rate risk exposure remained at very low levels in a volatile environment.
Why it’s important. In modern financial markets, interest-rate and other market risks can expand and contract at great speed. To understand the impact of rapidly changing interest-rate environments and manage their investment positions, investors need current information about their risk exposure.
How we measure up. Freddie Mac’s commitment to monthly disclosure of interest-rate risk significantly raises the bar; no banking institution reports interest-rate risk as frequently. Our commitment also exceeds the recommendation of the Shipley Commission. In its January report to the Federal Reserve, the SEC and the OCC, the Commission recommended quarterly disclosure of interest-rate risk. In supervisory guidance released on March 23, 2001, the Federal Reserve and the OCC urged large banking organizations to adopt Shipley recommendations to improve both their quantitative and qualitative disclosures. Institutions also were encouraged to seek new avenues, such as company websites, for disseminating financial information more frequently than regular annual or quarterly disclosures. Freddie Mac is using our website at freddiemac.com to give the public and our investors financial information about our six commitments.
Taken together, our six commitments represent a watershed in financial practices and disclosure.
VI. THE COMMITMENTS SUPPORT OUR VITAL MISSION
Freddie Mac is safe, sound and strong. We are committed to the highest standards in financial management and disclosure, because we are committed to opening doors to housing for more of America’s families.
Because of the high level of support provided by Freddie Mac and the secondary market, America enjoys the world’s best housing finance system. By attracting global capital to finance homeownership in America, we reduce mortgage costs, saving families billions of dollars. The extraordinary liquidity we bring to the nation’s mortgage markets also helps stabilize our nation’s economy.
To meet our mission, Freddie Mac is relentlessly wringing out every unnecessary cost and barrier to homeownership; we are pushing the limits of technology; and we are searching the globe to find the lowest costs funds for housing. As a result of our activities, more families than ever before can afford to buy a home. In addition, they compete on an equal footing with the largest corporations for low-cost funds in the world’s capital markets.
America is projected to grow by 30 million people over the next 10 years. The country is expected to form 1 million new households yearly. All told, America’s families will need an additional $6 trillion to finance their homes over the next decade. Freddie Mac will open doors of opportunity for the homebuyer of the future, who is more likely to be a low-income, minority or immigrant family, eager to realize the American dream.
Recently, HUD Secretary Martinez captured the essence of why housing holds a special place in the nation. He said:
We believe that if you help a man or a woman buy a home, you’re helping to make a better citizen. Homeownership is vital in creating strong communities. It helps average Americans build equity and increase their household wealth.
Freddie Mac’s strength and vitality ensure that we are able to meet the housing finance needs of the future. Our superior risk management capabilities, strong capital position and state-of-the-art information disclosure make Freddie Mac unquestionably a safe and sound financial institution. The six commitments demonstrate our determination to stay that way, so that we can finance housing for generations to come.
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Thank you for the opportunity to appear today. Freddie Mac is a great Congressional success story. I look forward to working closely with Chairman Allard, Senator Reed and the members of this Subcommittee to ensure that Congress is confident that Freddie Mac is meeting our very important mission in a safe and sound manner. Together we will secure the future of our housing finance system and, with it, the dreams of millions of families.
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