ROYCE: Thank you, Mr. Chairman.

Chairman Bernanke, I think the -- the risk -- risk weighting at the end of the day is -- is only as good as the metrics that we develop. I'm thinking back to Basel I. And now we're looking at the final Basel III. The Basel III includes a risk weighting of 20 percent for debt issued by Fannie Mae and Freddie Mac. And the rule includes a risk weighting of zero for -- unconditional debt issued by Ireland, by port -- by Portugal, by Spain, by other OECD countries with no country risk classification.

Both of these risk weightings are, in my memory, identical to the risk -- risk weightings under the original Basel I. So my -- my concern is that we should have learned a few things about those metrics given the -- consequences of -- of the clear failure. And yet, here we have the accord of 1988 looking an awful lot like this particular accord. Given what we have experienced, the failure of the GSEs, the propping up of many European economies, do you think these weightings accurately reflect the actual risk posed by these exposures?

BERNANKE: So Basel III and all Basel agreements are international -- you know, international agreements. And each country can take that floor and do whatever it wants, you know, above that floor. We would not allow a U.S. bank to hold Greek debt at zero weight, I assure you.

ROYCE: Yeah.

BERNANKE: In terms of GSEs, the GSE mortgage-backed securities have not created any loss whatsoever. They have to the taxpayer, but not to the holders of those securities. So that, I don't think, has been a problem. It's not just risk weights, though. But Basel III also has significantly increased the amount of high-quality capital that banks have to hold for a given set of risk -- risky assets.

Nearly three and a half years after the GSEs entered conservatorship, policymakers have reached no consensus about the future structure of the GSEs and the role the government should play in the mortgage market. Private capital might be reluctant to enter the market until the future parameters of government support are resolved.

There should be strong encouragement for the GSEs to focus on the housing recovery so home buyers and those that already have loans can fully benefit from the lower interest rates generated by our monetary policy action. Given that Fannie Mae and Freddie Mac are currently under conservatorship by the U.S. government, I believe they should play a larger role in achieving the public policy goals inherent in addressing these housing-market problems.

The extent of Congressional meddling in this market has been astonishing to the point where one can barely identify what the private sector outcomes would be in the absence of intervention.

To the extent possible, we need to let the private sector provide the bulk of U.S. housing finance going forward, without the incentive‐distorting set of government programs and taxpayer guarantees that caused our current system to collapse. Those programs meant well, but ended up costing everyone dearly.

The Federal Reserve, I think, was one of the more vocal commenters on Fannie and Freddie for many years, and we were very concerned about their stability and whether they had enough capital to support those large portfolios that they had, and it turned out they didn't, and we're paying the cost of that right now.

We would not support -- let me be careful. I think we would be very cautious about supporting a return to the existing structure, where you have this potential conflict between private shareholders and the public objectives.

I think there are alternatives, and I provided some of them in a speech I gave a year and a half ago -- I'd be happy to provide you -- which would be a more stable long-term solution, including either a privatization approach with government guarantees or a public utility approach. Those are two options that you could consider.

From the House Q&A session on Wednesday

I think there that returning to a more market-oriented financial sector is a top priority, and we are, in fact, doing that. For example, all the big banks have now paid back their TARP money, and we are trying as quickly as we can to get those banks financed by private capital, which they have raised a great deal of private capital. It's very important.   AIG, of course, is very problematic, but they are selling off assets in order to pay us back, and they're making progress on that.  And our objective there, of course, is to put them back in the private sector.

We talked earlier about Fannie and Freddie, and I do think that we have to get away from this neither fish nor fowl situation where they're part-public, part-private. I think, you know, one solution would be to privatize those firms, and I think that's an interesting direction to go.

From the Q&A session in the Senate on Thursday

When I talked to you in December, I explained that HERA gave the Treasury Department authority to support Freddie and Fannie. (SLIDE 7) Treasury’s Senior Preferred Stock facility, originally $100 billion each but now set at up to $200 billion each, as part of the President’s Homeowner Affordability Plan, provides an effective guarantee of the Enterprises’ debt and mortgage-backed securities by ensuring the Enterprises have a positive net worth. This facility protects not only present senior and subordinated debt holders and MBS holders but also any future debt and MBS holders, with no expiration date.

On the fiscal side, it is possible that Fannie Mae and Freddie Mac could play a more significant role in restoring liquidity and providing a secondary market for mortgages that reflect the lower cost of funds in many credit markets. Further exploration of the GSEs’ options for pricing and programs may result in additional support to the mortgage market.

On the monetary policy side, the Federal Reserve announced on November 25 that it would be buying up to $100 billion in GSE direct obligations, and up to $500 billion in mortgage-backed securities.[Footnote 9] A subsequent announcement on December 30 provided more details.[Footnote 10] Since the announcement of the program, designed to reduce the recently widening rate spreads on GSE debt and on GSE-guaranteed mortgages, mortgage rates have declined (see Figure 8). Some mortgages in Boston are now available for under 5 percent.

...

Since stabilizing the housing market is critical, expanded use of policies that address the cost of housing finance may give further impetus for new home buyers and existing mortgage holders to take advantage of what are very low rates by historical standards.

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.  Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.¹ We will continue to explore ways to keep the effective federal funds rate closer to the target.

_________________________________

1.  Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

Our task now is to begin thinking about how to best reestablish a link between homebuyers and capital markets in a way that addresses the weaknesses of the old system.  In light of the central role that the GSEs played, and still play, any such analysis must pay particular attention to how those institutions should evolve.

Developing an effective securitization model is not easy--according to one economic historian, mortgage securitization schemes were tried and abandoned at least six times between 1870 and 1940.¹  Eventually, experience provided three principles for successful mortgage securitization.  First, for the ultimate investors to be willing to acquire and trade mortgage-backed securities, they must be persuaded that the credit quality of the underlying mortgages is high and that the origination-to-distribution process is managed so that originators, such as mortgage brokers and bankers, have an incentive to undertake careful underwriting.  Second, because the pools of assets underlying mortgage-backed securities have highly correlated risks, including interest rate, prepayment, and credit risks, the institutions and other investors that hold these securities must have the capacity to manage their risks carefully.  Finally, because mortgage-backed securities are complex amalgamations of underlying mortgages that may themselves be complex to price, transparency about both the underlying assets and the mortgage-backed security itself is essential.

A public utility model offers one possibility for incorporating private ownership.  In such a model, the GSE remains a corporation with shareholders but is overseen by a public board.  Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders.  Public utility regulation itself, of course, has numerous challenges and drawbacks, such as reduced incentives to control costs.  Nor does this model completely eliminate the private-public conflict of the current GSE structure.  But a public utility model might allow the enterprise to retain some of the flexibility and innovation associated with private-sector enterprises in which management is accountable to its shareholders.  And, although I have noted the problems associated with private-public conflict, that conflict is not always counterproductive; an entity with private shareholders may be better able to resist political influences, which, under some circumstances, may lead to better market outcomes.

If private shareholders are excluded, several possibilities worth exploring remain.  One approach would be to structure a quasi-public corporation without shareholders that would engage in the provision of mortgage insurance generally.  Here, perhaps, one might envision the consolidation of the GSEs and the FHA, with all securitization undertaken by a Ginnie Mae-type organization.  Private mortgage insurers could still participate in this framework, though the role of the government in supporting mortgage insurance and securitization would become more explicit than it is today.  Finally, one might consider cooperative ownership structures, where the originators of mortgages must hold the capital in the government-sponsored enterprises, analogous to the current structure of the Federal Home Loan Banks.

It is important to remember that as part of the Treasury's actions regarding Fannie Mae and Freddie Mac and in consultation with FHFA, the GSEs entered into a Preferred Stock Purchase Agreement with Treasury that effectively guarantees all debt issued by the GSEs, both existing and to be issued. The U.S. Government stands behind these enterprises, their debt and the mortgage backed securities they guarantee. Their mission is critical to the housing markets in the United States and no one will deny the importance of these institutions in assisting our housing markets in this downturn.

Original text at 10:00:  

 "The most important facilities are the $100 billion each Senior Preferred Agreements, which ensure that the Enterprises have a positive net worth. This facility is well over three times the statutory minimum capital requirements and lasts until all liabilities are repaid or it is exhausted. Effectively, it is a government guarantee of their debt and MBS. Under this facility, they can grow their portfolios by about $100 billion each, which will further support the market. "

'Media Advirsory:  Clarification to Testimony'  from an FHFA spokesperson at 16:50:  

To clarify the last paragraph of page 3 of Director Lockhart’s testimony, the testimony should read:  “The conservatorship and the access to credit from the U.S. Treasury provide an effective guarantee to existing and future debt holders of Fannie Mae and Freddie Mac as there is an explicit commitment by the U.S. Treasury to provide up to $100 billion in senior preferred stock for each Enterprise.”

If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka and people know you've got it, you may not have to take it out. You're not likely to take it out. I just say that by having something that's unspecified, it will increase confidence and by increasing confidence it will greatly reduce the likelihood it will ever be used.

As reported by Reuters.

I agree that the GSEs are playing a critical role. They're at this point a very big part of the existing mortgage market.  I think they could an even better job if they were better supervised and better capitalized.

With respect to supervision, I support the call for GSE reform that's been discussed.

With respect to capitalization, I believe that they are well capitalized now in the sense -- a regulatory sense. But I think as we've called upon all financial institutions to expand their capital bases so that they can be even more proactive in providing credit and support for the economy. So I would include the GSEs in that broad call for increased capital.

From the Q&A session