June 15, 2006
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Remarks of Emil W. Henry, Jr.
Assistant Secretary for Financial Institutions
U.S. Department of the Treasury

Before the Real Estate Roundtable

Washington, DC -  Thank you for inviting me to address your conference today.  I have spoken to the Real Estate Roundtable in the past and I am happy that my performance was adequate enough to earn me another invitation.  As a relative newcomer to Washington, D.C., that is very comforting.

I know from my past experience with your group that the Real Estate Roundtable is very interested in a great number of the issues that concern us at the Treasury.

There are a few items I would like to discuss today.  First, I feel compelled to discuss some factors about our robust economy with you.  Second, I would like to build on recent comments on the Treasury's latest thinking in and around the Government Sponsored Enterprise (GSE) reform debate.  Third, I will discuss very briefly the status of the TRIA report due on September 30 of this year.

United States Economic Performance

It is a good time for a Treasury official to discuss our economy.  First, and most obviously, economic indicators are so strong that it is a delightful task to elaborate upon them in some detail.  It is like bringing home a great report card to your parents. Secondly, the timing is fortuitous.  We recently celebrated the third anniversary of the signing of the Jobs and Growth Tax Relief Reconciliation Act -- legislation that proved to be essential in creating an economic environment that fostered economic growth and permitted individuals and businesses to thrive.

As many of you know, this legislation provided a number of pro-growth tools.  Chief among them were lower tax rates.  These lower tax rates have led to more investing, job development and historically low unemployment.  This Administration, with the able assistance of Congress, reduced tax rates on dividends and capital gains, accelerated increases in the child tax credit, accelerated the scheduled reduction in income tax rates, increased expensing provisions for new investment by small businesses, and accelerated the reduction in the so-called marriage penalty.

Just recently, the Treasury along with Council of Economic Advisors and Office of Management and Budget released an updated U.S. economic forecast that bears out the statistical evidence of our robust economy.  Here are some of the highpoints:

Let's begin with GDP and business investing.  Since mid-2003, the economy has grown at a 4 percent annual rate, and in the first quarter of 2006 alone, real GDP grew at a 5.3 percent annual rate, well above the average of about 3 percent over the last 15 years. Similarly, business equipment and software spending has expanded at an annual rate of nearly 11 percent since mid-2003 compared with a 15-year average growth rate of about 7 percent.

Such growth has driven robust job creation.  After the 2003 tax relief took effect and business investment picked up, job growth accelerated as well.  Since the Jobs and Growth Act passed in 2003, more than 5.3 million new jobs have been created.

Similarly, the unemployment rate has fallen to historically low levels.  The current unemployment rate of 4.6 percent is lower than the average unemployment rate of any decade since the 1950s.  In addition, we have seen a number of other positive indicators of a strong economy.  Household net worth has been trending higher as have average hourly earnings.  The federal deficit as a percent of GDP last year was about 2.6 percent--a fairly moderate level by historical standards.  The deficit as a percent of GDP in the current fiscal year will move lower still and projected deficits are on track to meet the President's goal to cut the deficit in half early.  And, importantly, tax receipts have been higher than expected in both 2004 and 2005.  Individual non-withheld tax receipts this year were the second highest on record and corporate tax receipts continue to run very strong.  Let me restate this important point – the Treasury is seeing record revenues after significant tax cuts were enacted.  This fact, and it is undisputable, conflicts directly with the arguments made by those who opposed the Administration's tax cut proposals.

So, that is some good news.  The news that we are learning about the GSEs, however, is less welcome. 

GSEs

The most significant domestic finance policy issue in the coming months is the GSE reform effort.  While issues of improving the regulation of the housing GSEs have been debated for a number of years, the accounting and corporate governance scandals at both Freddie Mac and Fannie Mae have brought this issue to the forefront in recent years. 

Most recently, two major reports have been released, the "Rudman Report" prepared at the request of the Fannie Mae board by former Senator Warren Rudman, and the Office of Federal Housing Enterprise Oversight (OFHEO) report.  Both reports call into question Fannie Mae's corporate governance, internal controls, and risk management.  From Treasury's perspective, perhaps the most disturbing conclusion from the OFHEO report is that Fannie Mae was not able to manage the risks inherent in its outsized portfolio and that Fannie Mae was more focused on creating an image of being low-risk instead of focusing on sound risk management practices.  

As if these reports were not enough, on the same day that OFHEO released its report, Fannie Mae entered into a settlement agreement with OFHEO and the Securities and Exchange Commission (SEC).  In this settlement, Fannie Mae agreed to pay one of the largest fines ever imposed on a financial institution and certainly the largest on an enterprise created for a public purpose.  Equally important, as a central condition of the agreement with OFHEO, Fannie Mae agreed to cap its investment portfolio at essentially current levels.  This groundbreaking settlement demonstrates that Fannie Mae did not have adequate controls in place in the past, but also that the current state of Fannie Mae's business operations and risk management regime is not adequate to allow for the growth of its investment portfolio business.  

I should emphasize here that the fact that OFHEO was able to extract a commitment from its regulatee does not in any way suggest that statutory guidance to limit the GSEs outsized investment portfolios is not needed.  By its terms, this cap is temporary.  So it seems very clear to us that this recent action is not a substitute for statutory guidance to limit the GSEs' investment portfolios.  And, importantly, these actions do not address the Administration's fundamental long-term concerns regarding the systemic risk presented by the GSEs' investment portfolios. 

At the same time, we are seeing new and troubling revelations that Freddie Mac's accounting and internal controls continue to be in disarray.  They have recently reported that they can "begin" the registration process with the SEC only after it releases full-year 2006 results.  Is it reasonable for Freddie Mac to begin this process over five years after announcing that they would register with the SEC?   Just as troubling is Freddie Mac's recent announcement that it needs to limit the number of internal controls initiatives and defer "lower priority" internal control efforts.  While it is not clear exactly what actions will be limited or deferred, given the scope of Freddie Mac's ongoing problems any lack of full attention on internal control efforts has to raise questions of the appropriate allocation of resources.  

Over the course of the past three years, it has been revealed that Fannie Mae and Freddie Mac managed their earnings to hit specific targets while misleading the public as to their financial health.  They have documented failings in accounting, corporate governance, risk management, and internal controls.  The desire to provide large compensation packages trumped the desire to behave ethically.  Despite some admirable efforts to make things better, some of these failings continue even in the post-Sarbanes-Oxley world in which every single public company is undergoing enhanced scrutiny and oversight of these critical areas. 

After Freddie Mac's problems were brought to light in 2003, Fannie Mae executives continued to insist that Fannie Mae would not have the same problems.  Knowing what we know now clearly shows that management at Fannie Mae must have somehow thought that Fannie Mae should not or would not be held to the same standard as other public companies and that their significant internal abuses would never come to light.  I suppose one aspect of their thinking was correct – financial markets continue to react with indifference to the GSEs' accounting problems and lack of financial reporting.  As a former Wall Street banker, I can tell you that I cannot imagine any non-GSE company being able to maintain its status in the capital markets with such an unremedied speckled past.  Indeed, one sad irony of this situation is that the two entities that impose some of the most systemic risk to our system are held to some of the lowest standards of accountability.

Thus far, legislative reform efforts have not been successful.  You might be asking yourself, what other shoe needs to drop?  Throughout my career, I have relied on the markets to react accordingly to these types of facts.  But, it seems clear that the markets do not treat these enterprises in the same way as other public companies.  First, they continue to enjoy a significant funding advantage over similarly-situated non-GSE competitors.  This continues to be the case despite the fact that the Treasury Department and other government officials have made it abundantly clear that the federal government does NOT guarantee the housing GSE debt.  Indeed, the GSEs are required to place such disclosures on the securities that they issue.   So it is somewhat difficult to understand fully why the market's perception of some sort of federal backstop for the GSEs continues to persist and why these enterprises can tap the capital markets at preferential levels. 

I suppose one aspect that continues to foster this incorrect belief is Fannie Mae's and Freddie Mac's line of credit with the Treasury Department.  But a $2.25 billion line of credit is insignificant and virtually meaningless in the context of outstanding debt obligations of $766 billion for Fannie Mae and $749 billion for Freddie Mac, not to mention the additional $2.6 trillion of mortgage-backed securities that they guarantee. Moreover, at least in the context of GSE reform legislation, the Treasury Department is on record suggesting that this line of credit will only be utilized under very limited circumstances such as a GSE emerging from receivership. 

I suppose another aspect that fosters this incorrect belief is that the federal government has provided assistance to the GSEs in the past.  In particular, in the late 1980s the federal government created a mechanism to provide financial assistance to troubled Farm Credit System institutions.  However, as we all know, past actions, especially in the case of government bailouts, are not a good predictor of future actions.  And, do we really want to continue down a path that could lead to irresponsible calls for an unnecessary and preventable GSE bailout?  We are, of course, not going to solve this riddle today, but it seems clear that the GSEs present us with a unique set of circumstances that requires a carefully crafted response.   

Because of the myriad of concerns noted above, it is critically important that appropriate GSE reform legislation pass.  Our principal focus continues to be finding a legislative solution.  However, considering what we now know about the operation of the GSEs – the weaknesses of their risk management systems and practices, their governance and accounting failures, the level to which they are interconnected with our financial system as a whole, and the extent to which the retained investment portfolio concentrates the various risks associated with mortgages and mortgage-backed instruments, we also must consider how this should affect our ongoing responsibilities.

Therefore, as Under Secretary Quarles noted on Tuesday, Treasury is currently reviewing its GSE debt approval process.  I want to reiterate that we have no doubts about our authority regarding approving GSE debt, which we do on a regular basis, but we are rethinking the process by which Treasury uses that authority.

As you know, the Treasury Department's debt approval authority is contained in Fannie Mae's and Freddie Mac's charter acts.  The requirement for this approval is long-standing, and the GSEs seek and obtain the approval of the Treasury for their debt issuances, as they must under their charters.  In that regard, it seems clear that the GSEs themselves acknowledge that Treasury has this authority, as they come to us for approval for their debt issuances. 

The process whereby Treasury has administered this authority has changed over time and should be continually evaluated to ensure that we are acting as appropriate custodians of this authority.  As we undergo our debt approval process review, I thought it would be helpful to provide you with some context about our current process and how it has changed over time.  In the mid-1990s, Treasury was actively involved in the scheduling of GSE debt issuances, and every GSE individual debt issuance was submitted to Treasury for prior approval.  This process was cumbersome, caused considerable strain on Treasury staff's resources, and provided questionable return for this investment of time and staff.  Because of these concerns, Treasury announced a new process that eliminated the need for Treasury to schedule each of the GSEs' securities offerings.  This new process was characterized as a voluntary, cooperative process that would provide the GSEs more flexibility to time and size their borrowing transactions.  Treasury also made other process changes during this time period.  AT THAT TIME, these changes were viewed as an appropriate response to a process that had become outmoded, especially as the scope of the GSEs' operations was increasing and certain issuances were becoming more routine and regularized.               

Since these changes, the debt approval process has continued to evolve.  While Treasury continues to administer this authority responsibly, the process we use differs for each of the GSEs and has become less standardized.  Depending on the particular GSE, we have developed different procedures as to how their debt issuances are approved.  The procedures vary from weekly notices to quarterly notices.  Some of these procedures involve notice of expected versus actual debt issuances.  The manner in which Treasury conveys its approval also varies among the GSEs. 

So, at this point, as we digest all of the information that we have learned about the GSEs in the past few years, we believe it is important to reconsider how our debt approval authority is administered.  Similar to the evaluation that took place in the mid 1990s, this is a healthy exercise to ensure that the Treasury Department's process corresponds adequately to the importance of our responsibility, in light of the current condition of our economy and our financial markets. 

Make no mistake, this is no small task, but it is one of the highest priorities of the Domestic Finance team because, as the process has evolved over time, the individual borrowing practices of the GSEs have become increasingly complex.  A more standardized process will help Treasury better manage its responsibilities.  We are currently evaluating how the process could change.  In addition, as part of this review, we will evaluate a number of specific issues.  We will consider what should be the appropriate timing of the GSEs approval requests.   Consistent with our debt approval authorities, we will consider whether we would want additional information, such as:  the amount of total debt outstanding; the estimated rate that the debt will be offered; and the maturity of the debt obligations.  This is, of course, not an exhaustive list of what we will consider as our review goes forward.  We have made no conclusions at this time about whether or not a process change is necessary, but in some sense, everything is on the table.

This is a project that we plan to complete as quickly as possible.  This action in no way should be viewed as distracting or interfering with our primary objective of supporting the legislative GSE reform effort.   

Terrorism Risk Insurance

Let me now turn to another issue of great importance to the Roundtable – the Terrorism Risk Insurance Act (TRIA).  As you all know, in December of last year, TRIA was extended for an additional two years until December 31, 2007.  The TRIA Extension Act met a number of the Administration's key priorities, such as maintaining the program as temporary, increasing insurer retentions, and limiting the scope of the program.

The TRIA extension also included a provision that requires the President's Working Group on Financial Markets, known as the PWG, to analyze the long-term availability and affordability of terrorism insurance, including group life coverage and coverage for chemical, nuclear, biological, and radiological events.  This report by the PWG is due to Congress by September 30, 2006.

As you might imagine, given this short time frame, Treasury and other members of the PWG have been moving quickly to meet this mandate.  Treasury, as chair of the PWG, published a Notice in the Federal Register seeking comments concerning the long-term availability and affordability of terrorism risk insurance.  The comment period closed at the end of April and approximately 40 comments were received.  We have been evaluating those comments and moving forward on producing our report.  We look forward to the completion of this task and ongoing dialogue on the appropriate role of the federal government in the terrorism risk insurance market.

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