Thank you Chairman Allard, Ranking Member Reed, and Members of the Subcommittee. My name is Franklin D. Raines, and I am the Chairman and Chief Executive Officer of Fannie Mae. I appreciate the opportunity to speak to the Subcommittee about Fannie Mae, our role in the marketplace, and our regulatory structure. I would also like to commend the Subcommittee for the very active role it has played in its stewardship of our housing finance system.
The last time I appeared before the Banking Committee was in March 1996, when as Vice Chairman of Fannie Mae I testified on the implementation of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 ("the Act"). In preparing for today’s hearing, I reviewed my testimony from 1996 to see where we are relative to the course we articulated five years ago.
In 1996, I reported to the Subcommittee on Fannie Mae’s progress in meeting the statutory housing goals, expanding homeownership and affordable rental housing, and strengthening the company’s capital reserves and risk management. I told the Subcommittee that Fannie Mae would invest in technology to reduce the costs of buying a home, help lenders provide services to underserved areas of the country, and help small lenders succeed in a competitive market. Interpreted by any measure the 1992 Act was a success because it recognized that American homebuyers, and particularly first-time homebuyers, are the beneficiaries of the careful balance of obligations and benefits that defines Fannie Mae’s unique role in the housing finance system.
Today, I am pleased to report to the Subcommittee that Fannie Mae has made tremendous progress in each of the areas on which I reported to you five years ago:
In all, our record over the last five years shows that the compact that Congress designed in 1992 between private investors and the federal government to achieve the public goal of expanded homeownership using private capital continues to be a spectacular public policy success.
Fannie Mae: A Private Company with a Public Mission
Congress articulated Fannie Mae’s specific public mission clearly in the 1992 Act:
The business defined by our charter is designed to attract private capital to achieve these public purposes. The private individuals and firms that hold 1.038 billion shares of Fannie Mae common and preferred stock invest their capital in a company with a limited, specific public and business mission. In exchange, the federal government embraces that mission -- through Fannie Mae’s Congressional charter -- and oversees the companies to ensure they operate in a safe and sound manner.
The charter includes certain specific benefits that support the efficiency of the business venture and indicate the government’s commitment to the specific public purposes it has asked Fannie Mae to pursue. These benefits in and of themselves are not sufficient to attract the private capital necessary to achieve the public goals. It is also necessary for Fannie Mae’s management to translate the public mission into a profitable and sustainable business proposition. We do that through expert risk management, constant innovation in every part of the business, a tight rein on expenses, and dedication to a strategic business plan aimed at expanding homeownership and affordable rental housing.
Because Congress wanted to focus Fannie Mae’s use of its benefits on reducing costs for low-, moderate-, and middle-income homebuyers and on improving market liquidity, Congress defined how Fannie Mae may use these benefits. We are in a single line of business -- U.S. residential mortgages at or below the conforming loan limit (currently $275,000 for single family homes). Within that business, we participate in the secondary market; we do not originate mortgage loans. We have specific authorizations to deal in government-insured and conventional single-family mortgages, second mortgages, and energy efficiency loans. We operate under a rigorous risk-based capital standard, one that most banks and thrifts could not meet. We are affirmatively obligated by law to operate in all markets under all economic conditions and to meet three specific percent-of-business affordable housing goals. Congress also requires Fannie Mae to tell investors explicitly that our debt and MBS securities are not guaranteed by the federal government.
The focus of Fannie Mae’s charter is reflected in the composition of our assets, which are dominated by single family mortgages. Of our $701 billion in on-balance sheet assets at the end of the first quarter of 2001, 89 percent were single-family mortgages, 3 percent were multifamily mortgages, 6 percent were cash and other liquid assets, and 2 percent were other assets. In contrast, commercial banks hold a much greater variety of assets.
To ensure we pursue our mission and do so in a safe and sound manner, Congress established a comprehensive regulatory regime for Fannie Mae and Freddie Mac. That regime places responsibility for safety and soundness oversight with the Office of Federal Housing Enterprise Oversight (OFHEO) and responsibility for mission oversight with the Department of Housing and Urban Development (HUD).
OFHEO has been conducting a comprehensive, continuous, on-site examination program since 1994, the scope and rigor of which equals or exceeds that to which any other regulated financial institution is subject. OFHEO devotes more staff resources to its examination program of Fannie Mae and Freddie Mac than the OCC and the Federal Reserve devote to large and far more complex banking institutions. In addition, Congress required that the results of OFHEO’s examinations be made public in OFHEO’s Annual Report to Congress. Other financial regulators issue annual reports to Congress, but only OFHEO reports on individual companies’ exam results.
OFHEO is also responsible for implementing the minimum and risk-based capital standards in the 1992 Act. The Act requires that Fannie Mae meet a ratio-based minimum capital standard as well as a stress-test requirement. Under the leverage requirement, we must have capital equal to 2.50 percent of on-balance sheet assets. We must also hold capital equal to 0.45 percent for off-balance sheet assets. Fannie Mae must meet this minimum capital requirement using "core capital" -- common stock, perpetual noncumulative preferred stock, paid-in capital and retained earnings.
The 1992 Act also includes a forward-looking capital standard for Fannie Mae and Freddie Mac. The risk-based capital standard requires the two companies to be able to withstand severe economic conditions that are far more catastrophic and persist far longer than those of the thrift crisis in the 1980s. As stated in the statute, the standard requires each company to hold enough capital to withstand a 10-year stress period characterized by unprecedented interest rate movements and credit losses occurring simultaneously, with an additional capital requirement to cover management and operations risk. The standard is truly extraordinary, and Fannie Mae and Freddie Mac are unique in having to meet such a test. Fannie Mae designed its own stress test from the specifications in the statute in 1993 and has complied with that risk-based capital test ever since. OFHEO is in the final stages of promulgating regulations to implement the standard in the 1992 Act. The agency has made a great deal of progress recently on the rule, and we hope to see the final risk-based capital standard in place as soon as possible.
With regard to mission regulation, HUD is responsible for ensuring that Fannie Mae and Freddie Mac carry out their housing missions and comply with their charters. HUD sets the annual percent-of-business housing goals for our service to low- and moderate-income borrowers, to residents of central cities and other underserved areas, and to very low-income borrowers. Regulations promulgated by HUD last year take effect in 2001 and have raised all three goals substantially. HUD also regulates the companies with regard to the fair lending laws, and must give its prior approval to new conventional mortgage programs that are significantly different than those in place before 1992.
Fannie Mae’s Business
Fannie Mae achieves the purposes in our Congressional charter through our two primary lines of business. In our credit guaranty business, we create mortgage-backed securities (MBS) from pools of mortgage loans originated and owned by lenders. We guarantee timely payment of principal and interest on the loans in the MBS, which enables lenders to sell the MBS more easily to investors. For taking on this credit risk, Fannie Mae earns a guaranty fee on the MBS from the lenders who originate the loans. As of March 31, 2001, Fannie Mae’s outstanding MBS -- the MBS on which we provide a credit guarantee but do not hold in portfolio -- totaled $726 billion.
Our second business is our mortgage investment business, in which we buy mortgages from lenders in order to replenish the lender’s supply of cash to make new mortgage loans. We fund these mortgage purchases by issuing debt in the global capital markets, and we earn income on the spread between our cost of debt and the yield on the mortgages we buy. As of March 31, 2001, Fannie Mae’s mortgage portfolio investments totaled $641 billion.
Fannie Mae’s credit guaranty and mortgage investment businesses draw additional investment capital from around the world to the U.S. mortgage market, which increases the funds available for homeownership and reduces mortgage rates for consumers:
It is important to note that Fannie Mae’s debt securities draw investors to the U.S. mortgage market who would not otherwise invest in mortgages. Investors who purchase Fannie Mae debt want securities with less prepayment risk than MBS and are willing to accept lower yields to avoid such risk. Without Fannie Mae debt in the market as an available investment, these investors would turn to other instruments. The result would be lower demand for less capital available to the U.S. mortgage market and higher mortgage rates for U.S. homeowners.
A Housing Finance System That Is The Envy Of The World
The unique combination of obligations and benefits in Fannie Mae’s charter has given rise to a housing finance system that is the envy of the world -- one that is safe, sound and extraordinarily stable. The system also provides U.S. consumers with the types of mortgages they prefer: long-term, fixed-rate mortgages with a refinancing option. We estimate that, of the $5.2 trillion in U.S. single family mortgage debt outstanding at the end of 2000, 75 percent was in the form of first-lien, fixed-rate mortgages with terms of at least five years. In most of the world, the predominant mortgages available to consumers are adjustable-rate or balloon mortgages.
American consumers can obtain mortgages with lower downpayments and lower interest rates than their counterparts in the rest of the industrialized world. In the United Kingdom, downpayments are generally more than 20 percent, and in Japan and France, they are more than 30 percent. In the U.S., homebuyers can put as little as three percent down, and increasingly zero-percent downpayment mortgages are becoming available. In the United Kingdom, the majority of homebuyers’ monthly mortgage payments change as mortgage rates change, and most U.K. homebuyers do not know from one month to the next whether they will be paying more or less than the month before. In Spain, approximately 90 percent of mortgages have variable rates. In the Netherlands, where fixed-rate mortgages with low downpayments are available (although the rate may be fixed only for an initial period), homebuyers may pay a penalty if they prepay or refinance their mortgages. Prepayment penalties in the U.K. can be as high as 6 percent of the unpaid balance of the loan or 6 months of interest. In the U.S., very few mortgages outside of the subprime market carry prepayment penalties. The contrast with our system could not be more stark.
In countries other than the U.S., mortgage finance systems developed in different ways to solve the same problem: who should accept the prepayment, or interest rate, risk? In the United Kingdom, homebuyers take the risk -- and see their payments change as rates change -- because the financial institutions that fund mortgages have historically not had access to long-term funding. In Germany, the government takes the interest rate risk, and in return requires that homebuyers make downpayments of 40 percent on their first liens. In Mexico, homebuyers bear some or all of the interest rate risk because lenders and the government will not accept the rate uncertainty stemming from inflation; if rates rise quickly, the extra interest homebuyers owe as a result is added to their unpaid balances.
The housing finance system that Congress designed works very differently. Our ability to issue debt across the yield curve, combined with our expertise in matching the durations of our debt liabilities with those of our long-term fixed-rate mortgage assets, has allowed us to build a specialization in managing the risk on the fixed-rate mortgages U.S. consumers prefer. In contrast, banks and thrifts specialize in the short-term adjustable-rate and home equity loans that match the short-term federally-insured deposits that make up half of their liabilities.
To see this difference in specialization, one only has to contrast the composition of the mortgages held by Fannie Mae and commercial banks. Nearly all -- 95.7 percent -- of the single-family mortgages Fannie Mae holds in its portfolio are fixed-rate. Another 4.1 percent are adjustable-rate, and only a very small amount -- 0.2 percent -- are home equity or second mortgages.
In contrast, our estimates show that commercial banks and thrifts hold a considerably lower percentage of fixed-rate mortgages (58.0 percent) than Fannie Mae, and more adjustable-rate mortgages (28.3 percent) and home equity and second mortgages (13.8 percent). This reflects the advantage in short-term funding that depositories have over Fannie Mae and Freddie Mac by virtue of their access to low-cost deposits insured by the federal government and advances from their own government-sponsored enterprise, the Federal Home Loan Bank System.
The difference in specialization between Fannie Mae and depositories becomes even more apparent when looked at by mortgage type. Reflecting their short-term funding advantage, depositories have an 83.8 percent share of the market for home equity loans and second mortgages, compared with Fannie Mae’s 0.8 percent share. For adjustable-rate mortgages, depositories have a 67.5 percent share compared with Fannie Mae’s 2.9 percent share. Only in the fixed-rate segment is Fannie Mae competitive – with a 14.3 percent share compared with depositories’ 32.8 percent share.
Because of our presence in the market, consumers can not only get the mortgage the long-term fixed-rate mortgage they prefer, but they can also choose among many innovative products to find the fixed-rate mortgage that best fits their financial profile. For example, Fannie Mae’s Flexible 97 is a 30-year, fixed-rate mortgage that requires a down payment of as little as 3 percent, and those funds may be in the form of grants, gifts, and secured loans. Likewise, many of the products under our Community Home Buyers Program offer fixed-rate mortgages under more flexible underwriting criteria including lower income requirements, lower cash reserve requirements, and lower closing costs. Timely Payment Rewards is a mortgage option that allows borrowers with slightly impaired credit the chance to finance their home at a mortgage rate as much as two percent lower than what credit-impaired borrowers typically pay, with an even lower rate after 24 months of on-time payments.
Safety and Soundness
Because Fannie Mae and Freddie Mac play a critical role in providing consumers access to the long-term, fixed rate financing they prefer, it is essential that the two companies remain at the forefront of global safety and soundness practices.
In 2000, we recognized that there were additional measures we could put in place that would assure policymakers that our safety and soundness protections are at the forefront of evolving world practices. To formulate these measures we turned to the experts: the reports and studies of the Basel Committee on Banking Supervision, OFHEO, the Federal Reserve, and other policymakers and market participants who analyze risk in the financial markets.
After a comprehensive review of these recommendations, Fannie Mae and Freddie Mac, in conjunction with policymakers, crafted a set of initiatives designed to place the two companies at the leading edge of safety and soundness practices. These commitments were announced with Congressman Richard Baker, Congressman Paul Kanjorski, and other Members of the House of Representatives last October. Fannie Mae committed to issue subordinated debt, obtain an annual credit rating, enhance our liquidity planning, disclose more information about interest rate risk and credit risk sensitivity, and implement and disclose the results of an interim risk-based capital standard. Together, these initiatives will give investors and policymakers more information about Fannie Mae’s risk exposure -- and confidence that Fannie Mae can manage that exposure -- than they can get from any other financial institution. I am happy to announce that Fannie Mae has implemented all six of these commitments.
These six new voluntary measures, combined with the regulatory mechanisms Congress enacted in 1992, place Fannie Mae at the vanguard of risk management and disclosure practices worldwide, with cutting-edge regulatory discipline bolstered by cutting-edge market discipline.
Subordinated Debt. In October, we committed to issue publicly traded and externally rated subordinated debt. We included subordinated debt because it offers real benefits to the market and policymakers. First, it is an important way to crystallize the views of thousands of investors into a clear signal to policymakers as to how investors view the company’s financial condition. Second, it provides an incentive for subordinated debt holders to monitor our risk position very carefully. Because subordinated debt interest is suspended in the event of significant capital erosion, large shifts in the yield of Fannie Mae subordinated debt will signal to OFHEO that the company may have increased its risk position. Last, it serves as an additional cushion of capital on top of Fannie Mae’s required equity capital as defined by our statutorily-required minimum levels and our risk-based capital stress test.
In January 2001, Fannie Mae issued $1.5 billion of subordinated debt with a maturity of 10 years, and last week we priced our second issue of $1.5 billion in five-year subordinated debt. We also signaled our intention, consistent with our commitment in October, to issue subordinated debt quarterly during 2001 and on at least a semi-annual basis thereafter. We expect that by 2003 we will have $12 to $15 billion in subordinated debt outstanding, with an average maturity of at least five years.
Our first two subordinated debt issues received Aa2 ratings from Moody’s Investors Service and AA- ratings from Standard and Poor’s (S&P). The rating agencies rated the subordinated debt separate and apart from Fannie Mae’s relationship with the federal government. In assigning its AA- rating, S&P stressed that they did not regard the Subordinated Notes as being backed by the government. They wrote:
"Unlike Standard & Poor’s triple-‘A’ rating on the senior obligations of Fannie Mae, which incorporates implied government support, the rating on the subordinated debt assumes that the government would not intervene to prevent payment default on the instrument."
Moody’s said that:
"the debt ratings assigned to the GSEs have the exact same meaning as those assigned to all other firms in the USA and elsewhere. They express Moody’s opinion of the ultimate credit risks of a particular debt instrument taking into consideration all relevant factors."
By the terms of the subordinated debt Fannie Mae issued, interest payments will automatically suspend if certain capital tripwires are activated and, should the company experience difficulties, holders of subordinated debt securities will stand in line behind senior debt creditors and MBS investors to recover their principal. Unlike other subordinated debt issues, the interest deferral cannot be delayed by Fannie Mae or any other party if the defined conditions occur. For these reasons, the consensus of market analysts was that Fannie Mae subordinated debt would be regarded by the market as different from its senior debt and would trade at a discount to our senior debt. This has proven to be the case.
The prices at which our subordinated debt has traded indicate that the market is behaving consistently with analyst expectations. Our first issuance was initially priced at 98 basis points over the 10-year U.S. Treasury and 22 basis points over the November 2010 Fannie Mae Benchmark Note. Since issuance, our 10-year subordinated debt has traded actively in the secondary market, with pricing ranging from 18 to 28 basis points higher in yield than our senior debt. Our second issuance of 5-year subordinated debt was priced on May 2, 2001, at 71 basis points over the 5-year U.S. Treasury and 18 basis points over our February 2006 Fannie Mae Benchmark Note.
Moody’s summarized the beneficial results from subordinated debt, emphasizing the difference between it and Fannie Mae’s and Freddie Mac’s senior securities:
"The subordinated debt issued by Freddie Mac and Fannie Mae will, in combination with common and preferred equity, improve senior debtholders’ position in the highly unlikely event of a liquidation or similar event. This should help to alleviate concerns about the systemic risks from GSE failure and help to provide an early warning signal to the marketplace in times of stress…. The GSEs’ proposed subordinated debt also would not benefit from the same degree of implied support that senior enjoys and could face mandatory interest payment suspension."
Our planned, regular, and large-size issuances of subordinated debt validate the idea of a dynamic and active subordinate debt market as a means of market discipline. Fannie Mae expects that the market will use its collective expertise in measuring our risk profile, capital adequacy and financial health each time we bring new issues of Subordinated Benchmark Notes to market, as well as in ongoing trading in the secondary market. In doing so, Subordinated Benchmark Notes will truly be the "canary in the coal mine" that is crucial to establishing Fannie Mae at the forefront of financial institutions globally in adhering to the highest standards of market discipline.
As Morgan Stanley wrote recently:
"Spreads between the Subordinated Benchmark Notes and its senior Benchmark Notes will provide a real time indicator of investors’ perceptions of the adequacy of Fannie Mae’s capital relative to the risks it faces. Going forward Fannie Mae will have an additional yardstick with which to gauge the success of its capital policies. In striving to keep these spreads stable, Fannie Mae will have an incentive to communicate more extensively about the risks it faces and how it manages its capital in relation to these risks. This increased transparency to which Fannie Mae is already committed will enable investors to better assess Fannie Mae’s risk and the adequacy of its capital."
Annual Rating. We also committed in October to obtain an annual rating from a nationally recognized statistical rating organization of our "risk-to-the-government" or independent financial strength, and that we would disclose this rating to the public.
On February 27, 2001, S&P assigned a AA- "risk to the government" rating to Fannie Mae. Only five commercial bank holding companies, and no thrifts, have a rating this high on their senior debt. This rating, according to S&P, "refers to the inherent default risk of a federally-related entity operating under its authorizing legislation, but without assuming an infusion of cash from the government." S&P incorporates into the rating such criteria as an evaluation of Fannie Mae’s business fundamentals, including the company’s competitive position, evaluation of management and its strategies, and examination of relevant financial measures.
At Fannie Mae’s request, S&P’s "risk to the government" rating will be maintained on a continuous, "surveillance" basis. This goes beyond the annual rating that Fannie Mae committed to obtain last October. Under a surveillance rating, S&P will continuously monitor our financial position and change the rating -- with an accompanying press release -- if our risk posture changes.
In summarizing its analysis of Fannie Mae’s credit strength, S&P wrote:
"Fannie Mae has demonstrated consistently good operating performance over a sustained period of time, testifying to its ability to manage the risks inherent in holding a portfolio of mortgage loans and the strength of its franchise as one of two government sponsored mortgage guaranty agencies. It has successfully weathered changing conditions in the demand for mortgage guaranties, several regional housing market declines, and changing interest rate environments. Asset quality is very strong, and the risk profile of its portfolio of mortgages remains very low. Capitalization has been stable, and is expected to remain so given the regulated nature of the company."
With this "risk to the government" rating, Fannie Mae now has outstanding a full range of ratings, including those on senior debt, subordinated debt and preferred stock. This suite of ratings gives investors a clear, comprehensive, and ongoing assessment of Fannie Mae’s credit position. And combined with the daily updates to the prices of our subordinated debt, Fannie Mae now has more signals than any other company of how market professionals view the company’s risk posture.
Liquidity. The third initiative from the October package was an enhancement of Fannie Mae’s liquidity management. When we looked at the recommendations from the Basel Committee, we noted an emphasis on liquidity management. In its February 2000 paper recommending enhanced liquidity management for banks, the Basel Committee noted that:
Liquidity, or the ability to fund increases in assets and meet obligations as they come due, is crucial to the ongoing viability of any banking organisation…. Sound liquidity management can reduce the probability of serious problems. Indeed, the importance of liquidity transcends the individual bank, since a liquidity shortfall at a single institution can have system-wide repercussions.
Based on the discussions of safety and soundness that we had with the House Subcommittee and other policymakers last year, Fannie Mae wanted to ensure that we met the very highest standards of liquidity management. As a result, we committed to:
In mid-March 2001, Fannie Mae announced that we had met this commitment. We have a contingency plan in place to ensure that we could meet our funding needs for three months without access to the agency debt markets. We are maintaining more than five percent of our on-balance sheet assets in high-quality, liquid, non-mortgage securities. In fact, Fannie Mae’s ratio of liquid assets to total assets was 6.3 percent as of March 31, 2001, and we are disclosing this ratio to the public on a quarterly basis. And last, our liquidity plan meets the 14 principles for sound liquidity management set forth by the Basel Committee and satisfies our safety and soundness regulator. We have briefed OFHEO on our liquidity plan, and OFHEO has confirmed that the plan would ensure that Fannie Mae could function for three months without access to the new issue debt markets.
These commitments are in addition to a rigorous liquidity program already in place at Fannie Mae. We begin with a close cash-flow match between our assets and liabilities. In addition, we manage our liquid assets under strict investment guidelines approved by our Board of Directors. Under these limits, liquid assets have an explicit goal of zero credit losses. Fannie Mae’s typical liquid assets are money market paper and AAA-rated securities. Understandably, the margins on these high quality, liquid investments are much lower than those Fannie Mae earns on our mortgage portfolio, but that is the opportunity cost the company pays to maintain a safe cushion of liquidity.
By virtue of the company’s sound liquidity practices and our commitment to maintain more than three months worth of liquid assets, Fannie Mae is positioned not only to withstand swings in the markets, but also to provide liquidity to the market when other financial firms withdraw. Thus, for example, during the market turbulence in the second half of 1998, when other investors withdrew from the market, Fannie Mae stepped up our mortgage purchases -- largely by drawing down liquid assets -- which maintained the stability of the mortgage market and kept mortgage rates at historic lows for homebuyers.
New Risk Disclosures. Our subordinated debt issuance and annual ratings can serve as excellent signals to policymakers and investors, but the company has added additional transparency that puts it at the leading edge of risk disclosures. The fourth and fifth of our October initiatives were our new monthly interest rate risk sensitivity disclosures and new quarterly credit risk disclosures.
We committed to disclose on a monthly basis the impact on Fannie Mae’s financial condition of a plus or minus 50 basis point instantaneous change in interest rates and an instantaneous 25 basis point shift in the slope of the yield curve in both directions. On March 26, 2001, we made our first monthly interest rate risk disclosure under this commitment to investors and the public. Going beyond the commitment we made in October, Fannie Mae released the two primary measures of interest rate risk that the company uses in managing our interest rate business: portfolio net interest income at risk and effective asset/liability duration gap.
Fannie Mae’s net interest income at risk measure discloses the sensitivity of Fannie Mae’s projected net interest income to an immediate 50 basis point increase or decrease in interest rates and a 25 basis point increase or decrease in the slope of yield curve. Net interest income at risk compares projected net interest income under the more adverse of the interest rate and yield curve scenarios with projected net interest income without the interest rate shocks. We are disclosing our net interest income at risk over both a one- and four-year period. For the four-year disclosure, the net interest income at risk calculation reflects the percentage difference in cumulative net interest income over the period.
As of March 31, 2001, the company’s net interest income at risk from a 50 basis point change in interest rates was 3.8 percent over the next one year, and 3.2 percent over the next four years. The company’s net interest income at risk from a 25 basis point change in the slope of the yield curve was 3.1 percent over the next one year, and 4.7 percent over the next four years.
These changes in interest rates and in the slope of the yield curve encompass about 95 percent of the actual changes that are likely to occur over the one-month reporting period. Fannie Mae generally expects our net income at risk measures to range between one and five percent.
In addition, we are supplementing our net interest income at risk disclosure with monthly disclosure of the company’s effective asset/liability duration gap. Effective duration is a measure of the sensitivity of a security’s value to changes in interest rates, and is commonly used in fixed-income portfolio management. Fannie Mae has successfully used effective duration gap as an internal risk management tool for a number of years, and we report on duration management to our Board of Directors. We also report this information as of year-end in our Annual Report to shareholders.
As of March 31, 2001, the effective duration gap of our mortgage portfolio was a positive one month. A positive duration gap indicates that the effective duration of the portfolio’s assets exceeds the effective duration of its liabilities by that amount, while a positive duration gap indicates the opposite. Fannie Mae has a target range for our effective duration gap of plus or minus six months. When the duration gap moves outside this range -- which it can do if interest rates move quickly or by large amounts -- we rebalance our assets and liabilities to bring the duration gap within the target band.
Fannie Mae’s interest rate risk disclosures follow the recommendations of the New Basel Accord and the report of the Working Group on Public Disclosure, headed by Walter V. Shipley. Both recommend that risk disclosures be consistent with internal risk management practices. Net interest income at risk and duration gap are the primary portfolio risk measures at Fannie Mae. Basel further proposes that disclosures incorporate expected future activity, and that sophisticated disclosures use multiple simulations of interest rates. Fannie Mae’s net interest income at risk measure is based on projected future activity over the next one and four years, and both net interest income at risk and duration gap are calculated using at least three hundred interest rate paths.
We also committed in October to disclose on a quarterly basis the sensitivity of expected credit losses from a five percent drop in property values. On March 26, 2001, Fannie Mae released our first quarterly credit risk disclosure under this commitment.
To calculate our credit risk sensitivity, Fannie Mae uses internal credit models, as recommended by Basel, to project the present value of future credit losses. We then calculate the present value of losses assuming an immediate five percent decline in the value of all properties securing mortgages owned or guaranteed by Fannie Mae. Following this decline, home prices are assumed to increase at the same long-run rate embedded in the company’s credit pricing models. Projected default incidence and loss severity are consistent with the assumed changes in home prices. The sensitivity of future credit losses is the dollar difference between credit losses in the baseline scenario and credit losses assuming the immediate five percentage point home price decline.
As of December 31, 2000, the company’s net sensitivity of future credit losses, taking into account the effect of credit enhancements, was $295 million. This figure reflects a gross credit loss sensitivity of $1,065 million without the effect of credit enhancements, and is net of projected credit risk sharing proceeds from mortgage insurance companies, lenders, and others of $770 million.
Fannie Mae’s current low level of sensitivity to credit losses reflects the quality of our existing book of business, the impact of our loss mitigation techniques, and the effectiveness of our credit enhancement and risk-sharing strategies. While slightly less than 40 percent of Fannie Mae’s single family portfolio as of December 31, 2000, was covered by credit enhancements, we project that our credit enhancement counterparties would absorb $770 million, or 72 percent, of the increase in credit losses that would result from a five percent home price shock.
We expect our credit risk sensitivity to vary over time based on a number of factors, including the composition of the company’s credit portfolio, recent home price changes, the level of interest rates, and the amount of mortgage insurance and other credit enhancements that reduce Fannie Mae’s losses.
Interim Implementation of the Risk-Based Capital Rule. The final component of the October 2000 voluntary initiatives is our commitment to implement on an interim basis the risk-based capital stress test included in the 1992 Act and disclose to the public whether we passed or failed the test. We will run this interim implementation only until the final risk-based capital standard is adopted by OFHEO.
The stress test spelled out in the 1992 Act requires Fannie Mae to hold sufficient capital to withstand an unprecedentedly severe economic and financial shock that extends for ten years, without defaulting on our obligations. The test includes severe adverse interest-rate movements and nationwide depression-level conditions in residential real estate lasting throughout the decade-long period. The required level of current capital is an amount sufficient for Fannie Mae to remain solvent in every quarter throughout the ten-year span of adverse economic conditions plus, for good measure, an additional 30 percent to account for operations risk.
The possibility of these two credit and interest-rate scenarios happening simultaneously is extremely small, and very few companies could survive for ten years the type of environment assumed in Fannie Mae’s stress test. Indeed, a study commissioned by Fannie Mae found that the thrift industry would have to boost its capital base by sixty to ninety percent to be able to survive the type of scenario envisioned by Fannie Mae’s stress test.
Fannie Mae has run our own internal version of the risk-based capital stress test since 1993, and has built capital and managed our business to remain in compliance with that test. For purposes of the voluntary disclosure, Fannie Mae constructed an interim implementation of the risk-based capital test using OFHEO’s Notice of Public Rulemaking 2 (NPR2) as a basis, modified to reflect subsequent changes implemented or suggested both by OFHEO and the company.
OFHEO’s NPR2 was published in the Federal Register in April 1999, and is extensively documented. Since April 1999, OFHEO has made corrections to NPR2, and the corrections are noted on the OFHEO website. In constructing our interim stress test, Fannie Mae incorporated OFHEO’s NPR2 changes along with the changes we recommended in our March 10, 2000, comment letter to OFHEO and other refinements enumerated on our website (www.fanniemae.com). Fannie Mae will disclose whether we have passed or failed our interim risk-based capital test as of the end of each quarter, and also give an indication of the amount by which our total capital exceeds or falls short of the calculated risk-based requirement.
In March 2001, we announced that we had sufficient capital to pass our interim version of the OFHEO risk-based capital test as of December 31, 2000, and that our capital cushion on that date was between 10 and 30 percent of total capital. We were able to pass the interim risk-based capital test because of the substantial amount of hedging and loss-sharing arrangements in which we engage. Typically between 45 and 50 percent of Fannie Mae’s liabilities consist of callable debt or other option-based instruments. Our reliance on mortgage insurance and credit risk sharing arrangements reduce credit risk exposure and allow the company to withstand the stresses in the risk-based capital test.
Fannie Mae’s interest rate risk and credit risk disclosures complement the results of our quarterly stress test. In summarizing the value of the package of disclosures to which Fannie Mae and Freddie Mac committed themselves, Moody’s stated:
"These financial disclosure commitments by Fannie Mae and Freddie Mac set new standards not only for them, but also for the global financial market.
"The provision by Fannie Mae and Freddie Mac of periodic, detailed risk information to the broad market will permit better independent reviews and monitoring of their risk profiles and should substantially reduce the uncertainty about their actual financial health as well as dampen any systemic risks they present.
"The regular disclosure of their interest and credit risk exposure, combined with stress testing of their capital base, should significantly increase market comfort with their risk management disciplines and capital adequacy. The stress test, in particular, will show whether the two GSEs have sufficient capital to withstand very harsh market developments over a long period."
A generation ago, the housing industry was more cyclical than it is today, and when the economy slowed, housing slowed as well. Today, the housing sector -- which makes up about 8 percent of annual gross domestic product -- is more stable than other sectors of the economy. Indeed, while the manufacturing sector is in a downturn, overall job growth has slowed sharply and orders for high-tech equipment have dropped significantly, housing activity has remained robust. Total home sales in the first quarter of 2001 were at a record level -- with new sales in March at an all-time high and existing sales at their second highest level ever.
The strength of the housing industry translates into greater financial stability for American families. Strong home price appreciation in recent years has increased the average net worth of homeowners, and these gains in housing wealth have helped offset declines in equity wealth. With the declining trend in mortgage rates -- from 8.62 percent last May to the current rate of slightly over 7 percent -- many homeowners have refinanced, allowing them to reduce their monthly mortgage payments. The extra cash from refinancing has enabled households to increase their spending, which has helped cushion the slowing economy. We estimate conservatively that consumer spending may increase by $40 billion this year as a result of refinancing activity.
The financing that Fannie Mae provides through all types of economic circumstances is one reason that housing is so stable. Despite stagnating home prices in California in the first half of the 1990s and in New England in early 1990s, Fannie Mae delivered a steady supply of financing to lenders across the country and consistent earnings to our investors. Our strong financial performance over time is a key factor in drawing investors from around the world to invest their capital in U.S. housing finance.
This financial strength means that we are ready to meet the housing finance challenges ahead. The homeownership rate in America today stands at a record 67.5 percent, but the gap between whites and minorities is huge. Seventy-four percent of white Americans own their homes, but that figure is less than 50 percent for minorities. We have the best housing finance system in the world. Now we must make it work for more American families.
In this context, I would like to propose a straightforward test for examining policy proposals that affect the housing finance system:
I proposed a test similar to this in 1996, when I testified before the Banking Committee, and they remain relevant, particularly in view of the challenges we continue to face in expanding homeownership opportunities for all Americans.
Thanks to Congress’ wisdom in understanding the power of private enterprise to meet this critical public purpose -- and in crafting a compact with private investors -- no single company in America is focusing more capital and commitment to closing the homeownership gap than Fannie Mae. We are in the American Dream business, and our mission is to "tear down barriers, lower costs and increase the opportunities for homeownership and affordable rental housing for all Americans." In partnership with mortgage lenders, elected leaders, housing leaders, community groups, and many others, Fannie Mae will bring more homeownership to more people and places than ever.
Thank you for inviting me to testify before you today. I look forward to working with the Subcommittee on these important issues.
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