Government-Sponsored Enterprises: The Government's Exposure to Risks

Published by the Government Accountability Office on 1990-08-15.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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                                                                    The Government’s
                                                                    Exposure to Risks


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    General Government Division


    August 15,199O

    The President of the Senate and the
    Speaker of the House of Representatives

    This report presents the initial results of our review of financial institutions known as
    government-sponsored enterprises (GSES). The Financial Institutions Reform, Recovery, and
    Enforcement Act required us to study the risks undertaken by eight GSESand the appropriate
    levels of capital for such enterprises consistent with financial soundness and stability and
    with minimizing the potential financial exposure of the federal government.

    This report discusses the risks undertaken, capital levels, and federal regulation of Farm
    Credit Banks, Banks for Cooperatives, Federal Home Loan Banks, Federal National Mortgage
    Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Student
    Loan Marketing Association (Sallie Mae), College Construction Loan Insurance Corporation
    (Connie Lee), and Federal Agricultural Mortgage Corporation (Farmer Mac).

    We are providing copies of the report to interested Members of Congress, appropriate
    committees and executive branch agencies, the GSES,and the public.

    This report was prepared under the direction of Craig A. Simmons, Director, Financial
    Institutions and Markets Issues, who may be reached on 275-8678 if there are any questions.
    Other major contributors are listed in appendix XIII.

                             -                 K
    Charles A. Bowsher
    Comptroller General
    of the United States
Executive Summaxy

                   Government-sponsored financial enterprises hold hundreds of billions of
Purpose            dollars in obligations. The large losses of the thrift industry have raised
                   concerns about the government’s exposure should any of these govern-
                   ment-sponsored enterprises fail. The Financial Institutions Reform,
                   Recovery, and Enforcement Act of 1989 required GAO to study the risk-
                   taking and capital of these enterprises.

                   This is the first of two reports required by the act. For this report, GAO
                   studied (1) each enterprise’s measures and controls for interest rate
                   risk, credit risk, management and operations risk, and business risk
                   using unverified information supplied by the enterprises and (2) current
                   federal supervisory structures and capital requirements that control
                   enterprise risk-taking and capital. GAO'S final report will examine these
                   issues further.

                   Congress created government-sponsored enterprises to help make          credit
Background         reliably available to farmers, homeowners, colleges, and students.       Con-
                   gress made the enterprises privately owned and operated, limited        their
                   activities to specified economic sectors, and gave them benefits to     help
                   accomplish their public goals.

                   GAO studied eight enterprises. Three promote agricultural   lending-
                   Farm Credit Banks, Banks for Cooperatives, and Federal Agricultural
                   Mortgage Corporation (Farmer Mac); three promote home lending-Fed-
                   eral Home Loan Banks, Federal National Mortgage Association (Fannie
                   Mae), and Federal Home Loan Mortgage Corporation (Freddie Mac); and
                   two promote higher education lending-Student       Loan Marketing Associ-
                   ation (Sallie Mae) and College Construction Loan Insurance Association
                   (Connie Lee). These enterprises make loans, buy loans from other
                   lenders, and/or guarantee financial products. Three other temporary
                   government-sponsored enterprises established to finance the resolutions
                   of the Farm Credit and thrift crises were not included in this study.

                   Like any private financial firm, enterprises are subject to financial risk.
                   For example, enterprises can lose money when borrowers do not repay
                   their loans. They are also exposed to losses from poor management deci-
                   sions and unfavorable  business conditions.   Finally,   some ai%?~~p~&3    t6
                   losses from changes in interest rates.

                   The sheer size of government-sponsored enterprises’ financial obliga-
Results in Brief   tions of over $800 billion, their public policy purposes, and the

                   Page 2                                GAO/GGD-SO-97 Government’s Risks From GSEs
      Executive Summary

      probability that the federal government would assist a financially
      troubled enterprise, make it appropriate for the government to (1)
      supervise their risk-taking activities and (2) establish minimum levels of

      The government supervises some enterprises but not others. The agri-
      cultural enterprises and the Federal Home Loan Banks each have a regu-
      lator with certain authorities to monitor risk-taking and enforce capital
      rules. Connie Lee’s activities, like those of other private insurers, are
      regulated by state authorities and also appear to be disciplined by pri-
      vate creditors. However, Fannie Mae’s, Freddie Mac’s, and Sallie Mae’s
      risk-taking and capital levels are not closely supervised by the govern-
      ment. Furthermore, enterprise ties with the government have weakened
      the discipline that creditors normally provide to completely private
      financial firms.

      With private creditor discipline weakened, enterprise boards of direc-
      tors and managers are largely free to set levels of capital as they wish
      unless minimum capital levels are established by law or regulation. In
      financially troubled times after capital is depleted, owners and man-
      agers may have incentives to take unusual risks in a last-ditch effort to
      recover. General creditors may be willing to lend enterprises the funds
      needed to take these unusual risks because they expect to be protected
      from loss by the federal government.

      The Farm Credit and thrift crises vividly demonstrate the effects of
      inadequate federal supervision of the risk-taking and capital levels of
      financial institutions. The government did not have the monitoring or
      forecasting capability or capital rules in place to learn about the Farm
      Credit crisis in time to prevent it from becoming serious. For thrifts,
      capital regulations were largely unenforced, and oversight and supervi-
      sion were weak. As a result, the crisis reached unprecedented propor-
      tions After each financial crisis, legislation reformed and strengthened
      the supervisory role of the financial regulators, making them indepen-
      dent and responsible for establishing risk-based capital rules. But the
      regulatory reforms were enacted too late to avoid large taxpayer assis-
      tance programs.

      While GAO did not become aware of anything in its preliminary review to
      suggest that any enterprise is at risk of immediate failure, GAO did not
      conduct an independent test of the financial vulnerabilities of govern-
      ment-sponsored enterprises. The information GAO reviewed suggested
      that certain Farm Credit institutions continue to have serious financial

      Page 3                              GAO/GGD90-97 Government’s Risks From GSEs
                             Executive   Summary

                             difficulties. Furthermore, changes in management strategies, economic
                             downturns, or other adverse events could precipitate future enterprise
                             losses. The speed with which a firm can go from an apparently sound
                             position to one that, is financially imperiled was seen in the thrift
                             industry, the Farm Credit System, and Fannie Mae in the early 1980s.
                             Thus, caution dictates that the government not wait for a crisis before
                             protecting its interests. By strengthening oversight and establishing
                             risk-based capital rules in the current favorable environment, the poten-
                             tial for future financial crises can be reduced.

                             GAO believes a better system of monitoring, some reasonable capital
                             rules, and appropriate enforcement authorities are needed for Fannie
                             Mae, Freddie Mac, and Sallie Mae. In general, this system needs to
                             ensure that the federal government obtains timely information on the
                             risks undertaken by enterprises and provides proper oversight,
                             including congressional oversight. This system should be designed to
                             keep emerging problems from imposing losses on taxpayers and develop
                             appropriate responses quickly so that major unanticipated losses can be
                             contained. GAO has not yet formed an opinion on the precise way this
                             can best be accomplished. GAO plans to continue its analysis and make
                             recommendations in this regard in its final report.

Principal Findings

Elements of Bank             GAO compared the monitoring and capital regulatory structure used for
                             banks with that used for government-sponsored enterprises because
Regulation Provide a Basis   both groups present similar concerns to the government. In both situa-
for Comparison               tions, the government is interested in the financial firm’s viability in
                             part because the government may suffer financial losses from large-
                             scale failure. In addition, federal ties can promote unsafe risk-taking on
                             the part of banks, just as they can with government-sponsored

                             Supervision of banks typically includes (1) minimum levels of owner
                             investment or capital, (2) limits on risk-taking, (3) monitoring of the
                             bank’s financial performance, and (4) authorities for the regulator to
                             enforce rules. GAO believes that the elements of safety and soundness
                             supervision used for banks provide a conceptual framework for devel-
                             oping a structure that will better enable the federal government to pro-
                             tect its financial interests in government-sponsored enterprises. GAO

                             Page 4                               GAO/GGD-9087 Government’s Risks From GSEs
                           Executive Summary

                           recognizes that the structure must accommodate the distinctive enter-
                           prise characteristics- specifically their limited lines of business and
                           their large, nationwide operations-that     make them different from

Enterprise Regulatory      The government actively supervises the risk-taking and capital levels of
Oversight Inconsistent     some enterprises but not others. The Farm Credit Administration has
                           been established as an independent financial regulator of the Farm
                           Credit Banks and their related associations, Banks for Cooperatives, and
                           Farmer Mac. Congress has amended the Farm Credit Administration’s
                           authorities over time, and they now resemble the key ingredients of
                           financial supervision that are used to promote safe and sound banking
                           operations. All Farm Credit institutions, except Farmer Mac, must meet
                           risk-based capital standards modeled after bank capital rules. It is
                           unclear whether the Farm Credit Administration can require Farmer
                           Mac to meet capital requirements that are based on the risks under-
                           taken. For this report, GAO did not evaluate the Farm Credit Administra-
                           tion’s effectiveness, but GAO plans to conduct such work in the future.

                           The Federal Housing Finance Board regulates the Federal Home Loan
                           Banks. This regulatory body was created in August 1989 and has
                           adopted preexisting rules that resemble the elements of bank regulation.
                           As of June 1990, two board members had been nominated but none had
                           been confirmed, so the Secretary of Housing and Urban Development
                           had full powers of the Board. Consequently, it is unclear how the Fed-
                           eral Housing Finance Board will implement its authorities and whether
                           it will be effective as an independent regulator for safety and

                           The Department of Housing and Urban Development has had authority
                           to regulate Fannie Mae since 1968 and received such authority over
                           Freddie Mac in 1989. However, the Department has not provided the
                           kind of safety and soundness supervisory controls normally imposed by
                           banking regulators. GAO reported in 1985 that the Department’s regula-
                           tion of Fannie Mae was inadequate. The Department’s regulation of
                           Fannie Mae has not changed significantly since 1985. In addition,
                           although the Department became Freddie Mac’s regulator in August
                           1989, it has not yet promulgated rules covering Freddie Mac’s opera-
                           tions. Specific examples of inadequate regulation include the following:

                         . The Department has never used its authority to audit Fannie Mae. The
                           Department first established a Fannie Mae oversight unit in 1978, only

                           Page 5                              GAO/GGD-90-97   Government’s Risks From GSEs
                           Executive Summary

                         to disband it in 1981 when Fannie Mae was facing serious financial
                       l The Department does not have the full range of authorities (particularly
                         enforcement authorities) typically available to bank regulators.
                       . Inherent conflicts could exist between the Department’s short-term
                         housing policy goals and its goals as a financial regulator. Recent history
                         of the thrift and Farm Credit crises has illustrated the disastrous effects
                         of having regulators responsible for both promoting an industry and
                         overseeing it.
                       l The Department does not have clear authority to apply capital rules to
                         Fannie Mae and Freddie Mac that are more stringent than those set by
                         statute. The statutory debt-to-capital standards currently applied to
                         Fannie Mae and Freddie Mac are not based on the risks they undertake.
                         For example, no equity capital is required for risks associated with
                         guarantees of their $500 billion in mortgage-backed securities, although
                         management may choose to hold such capital. Fannie Mae and Freddie
                         Mac can also increase their interest rate risk exposure without holding
                         additional capital. Furthermore, capital is broadly defined by statute to
                         include equally owner equity, loss reserves, and subordinated debt.
                         Owner equity represents the best protection to the government against
                         unexpected losses because owners have incentives to protect their per-
                         sonal investments from losses. By contrast, loss reserves account for
                         expected loan defaults, and subordinated debt involves borrowings from
                         creditors that must be repaid to avoid default. In effect, Fannie Mae and
                         Freddie Mac can increase their risks without a commensurate increase in
                         equity capital.

                           Sallie Mae has no federal regulator to oversee the safety and soundness
                           of its financial activities or set minimum capital requirements.

                           Although Connie Lee has no federal regulator, it is subject to state insur-
                           ance regulation. Unlike other enterprises, Connie Lee has no federal ties
                           that may promote unsafe risk-taking and expose the federal government
                           to losses.

Enterprise Risks and       GAO studied risks undertaken by government-sponsored     enterprises by
                           reviewing information from enterprises, interviewing enterprise offi-
Capital Vary               cials and regulators, reviewing reports prepared by regulators, and
                           reviewing reports and analyses done by third-parties such as external
             ”             auditors, enterprise consultants, and private analysts, GAO did not inde-
                           pendently develop data on the level of risks undertaken by enterprises,
                           or independently verify their data or assertions made in their reports.

                           Page ii                              GAO/GGD-90-97 Government’s Risks From GSEs
    Executive Summary

    GAO anticipates testing certain GSE risk control procedures in the second
    phase of its study.

    From a consolidated perspective, the Farm Credit System of Farm Credit
    Banks and their related associations and Banks for Cooperatives were
    able to eliminate losses from operations in 1989 and reported a profit in
    both 1988 and 1989 after 3 years of losses resulting from (1) defaults
    and declines in asset values caused by a serious agricultural recession,
    (2) high exposure to interest rate risk, and (3) management weaknesses.
    The Jackson Federal Land Bank was assisted and then closed in 1988,
    and three other Farm Credit institutions have required an infusion of
    federal financial assistance to remain viable. The Agricultural Credit
    Act of 1987 provided System institutions up to $4 billion in government-
    guaranteed bonds, which has alleviated any immediate concerns about
    System viability. However, System institutions still face substantial
    amounts of risk. For example,

. audited financial statements indicate 14 percent of the $49 billion in
  loans outstanding are high-risk loans;
l the Farm Credit Administration has identified weaknesses in the man-
  agement of institutions that hold over 60 percent of the System’s assets;
. System institutions face continual business risks, e.g., potential crop
  failures caused by uncontrollable factors such as the weather.

    Historically, the Federal Home Loan Banks have presented little risk of
    failure. They have been profitable, have never reported credit losses,
    and typically have returned healthy earnings to their owner-borrowers
    (primarily thrifts). The Federal Home Loan Banks were insulated from
    the effects of record numbers of thrift failures by conservative lending
    policies and collateral. At the end of 1989, they had capital equal to
    about 8 percent of assets. (See p. 78.) However, future profitability will
    be dampened because their earnings will be used to help pay the costs of
    thrift failures and to fund new programs for affordable housing. The
    shrinking of the thrift industry also represents a risk to the Federal
    Home Loan Banks because it could mean loss of borrowers and

    Fannie Mae’s financial performance has swung from substantial losses
    in the early 1980s to record profits in 1989. Its financial losses resulted
    primarily from interest rate changes. Fannie Mae’s past business
    strategy of borrowing short-term debt to fund long-term mortgages
    proved costly when interest rates rose dramatically in the late 1970s

    Page 7                               GAO/GGDBO-97 Govenunent’s Risks From GSEs
Executive Summary

and early 1980s. Lower interest rates and a new business strategy ena-
bled Fannie Mae to reverse the losses. Fannie Mae now reports that its
exposure to interest rate risk has been greatly lessened, although not
eliminated. Its seriously delinquent loans have also declined from unusu-
ally high levels experienced in the mid-1980s.

Without an effective capital requirement that is risk-based, Fannie Mae
has a good deal of discretion in determining the amount and composition
of its capital. Fannie Mae has been increasing its capital holdings from a
depleted level and now reports that its capital is sufficient to withstand
nationwide losses comparable to the high rate of defaults it experienced
from loans made in Texas in 1981 and 1982. However, Fannie Mae’s
equity capital has been less than 1 percent of its assets and mortgage-
backed securities over the past 5 years, ranging from a low of 0.61 per-
cent at the end of 1986 to 0.88 percent at the end of 1989. (See p. SO.)

Freddie Mac has been consistently profitable during the 1980s. Freddie
Mac avoids most interest rate risk, and available evidence indicates that
its credit losses have been lower than industry averages. Most of
Freddie Mac’s credit risk comes from mortgage-backed securities, which,
like those of Fannie Mae, are not considered under its statutory capital
requirement. Freddie Mac’s capital has also been less than 1 percent of
its assets and mortgage-backed securities over the past 5 years, ranging
from a low of 0.50 percent at the end of 1986 and 1987 to 0.62 percent
at the end of 1989. (See p. 81.) However, Freddie Mac reports that its
current capital levels are designed to enable it to withstand losses from
mortgage defaults comparable to those experienced during the Great
Depression. Freddie Mac also has a good deal of discretion over the
amount and composition of capital.

Sallie Mae’s financial performance has been consistently profitable. Its
student loans are typically guaranteed by state and non-profit agencies
and reinsured by the Department of Education, resulting in no material
credit losses to Sallie Mae. Sallie Mae reports that it attempts to avoid
losses from interest rate changes by borrowing funds with interest rate
payments that adjust parallel with the interest earned on student loans.
Sallie Mae has decreased its capital holdings as a percentage of its assets
from about 5 percent in 1985 to about 3 percent currently. Sallie Mae
officials believe the enterprise’s capital levels would comply with bank
risk-based capital standards. (See p. 82.)

Page 8                              GAO/GGD-90-97 Government’s Risks From GSEs
                           Executive Summary

                           Connie Lee expects few or no losses from either interest rate risk or
                           credit risk in its current business of bond reinsurance. Connie Lee’s cap-
                           ital level is set by management to conform to private market standards
                           for the highest quality bond reinsurers.

                           Farmer Mac has been preparing standards and methods of operation for
                           its financial operations, which are not yet underway.

Rationale for Overseeing   Without overseeing enterprise risk-taking, the government has little
Enterprise Risk-Taking     ability to identify, prevent, or contain the effects of the kinds of
                           problems that have led to taxpayer losses in the past. The government
and Capital                has helped enterprises in financial trouble even though it was not legally
                           obligated to do so. Fannie Mae suffered cumulative net losses of over
                           $350 million in 1981, 1982, 1984, and 1985. In 1982, Congress passed a
                           law that extended Fannie Mae’s tax loss carryback period. Fannie Mae
                           estimated the value of this benefit to date at $25 million. In 1988, the
                           government authorized $4 billion in federally guaranteed bonds to assist
                           the troubled Farm Credit System, which had reported cumulative net
                           losses of $4.6 billion from 1985 to 1987.

                           Federal capital standards are appropriate for enterprises because pri-
                           vate markets allow enterprises to borrow with relatively low levels of
                           capital. These enterprises can continue to borrow money in private mar-
                           kets even when performing poorly. In 1981, for example, the estimated
                           market value of Fannie Mae’s net worth was reported to have declined
                           to a negative $11 billion. Under these circumstances, a wholly private
                           firm would typically be blocked from borrowing or would be permitted
                           to borrow only at extremely high rates of interest. Indeed, some private
                           firms in that situation would be forced into liquidation once the general
                           creditors learned the facts. Fannie Mae, however, was able to continue
                           borrowing very large amounts ($31 billion in long-term debt and $64
                           billion in short-term funds in 1981 and 1982) with only a brief increase
                           in its borrowing costs. Throughout the episode, Fannie Mae retained the
                           highest credit rating possible, and borrowing costs returned to levels
                           typified by “safe” investments by the end of 1982. Similarly, while
                           Farm Credit institutions were incurring massive losses, they continued
                           borrowing albeit at higher interest rates. It seems clear that, with
                           respect to government-sponsored enterprises, the federal ties cause
                           investors to behave like insured depositors who believe their invest-
                           ments to be very safe.

                           Page 9                              GAO/GGD-90-97 Government’s Risks From GSEs

                  Enterprise officials and analysts have suggested that investors in enter-
                  prise securities expect the federal government to back their investment,
                  so they do not fully evaluate the quality of the enterprises’ borrowings.
                  However, the one enterprise for which federal assistance is deemed
                  unlikely is Connie Lee, which does not have federal ties comparable to
                  other enterprises and appears to have the same types of private creditor
                  discipline as other private financial firms.

                  Since most enterprises can continue to borrow funds even when finan-
                  cially troubled, they could have an incentive and have the ability to
                  increase the government’s risk should heavy losses occur. After most
                  private capital is depleted, enterprise managers might have the incen-
                  tive of using their ties to the government to continue borrowing and
                  undertake highly risky activities in order to recoup losses. This situation
                  would resemble the risk-taking incentives that increased the govern-
                  ment’s costs from under-capitalized thrifts with deposit insurance. With
                  thrifts, the government took steps to improve its supervision of risk-
                  ta,king and capital.

                      believes that additional oversight of Fannie Mae’s, Freddie Mac’s,
Recommendations   GAO
                  and Sallie Mae’s risk-taking and capital levels is needed. GAO will make
                  specific recommendations to accomplish this in its final report. GAO may
                  have further recommendations as a result of its ongoing work on

                       obtained written comments on a draft of this report from all the
Agency Comments   GAO
                  enterprises, their regulators, and the departments of Agriculture and
                  Education. A summary of the overall comments and GAO'S evaluation
                  appear in chapter 5. The written comments appear in appendixes I
                  through XII.

                  Generally, the enterprises and federal departments and regulatory agen-
                  cies expressed a desire for GAO to emphasize more strongly certain posi-
                  tive aspects of their operations, risk management, or capital.

                  The Department of Housing and Urban Development disagreed with cer-
                  tain conclusions in the report. The Department believed it inappropriate
                  for GAO to say that regulatory capital requirements imposed on Fannie
                  Mae and Freddie Mac are inadequate without saying what an acceptable
                  standard would be. It agreed that the statutory capital requirement does
                  not adequately address the risks of these enterprises but was unclear

                  Page10                               GAO/GGD9987Government'sRidsFromGSEs
about the Department’s authority to establish more stringent capital
requirements. GAO believes it is appropriate to report now on concerns
with current capital standards and oversight and plans to recommend
solutions in its final report.

Freddie Mac said GAO should have concluded that it is a very strong,
well-capitalized institution, Further, Freddie Mac believed GAO should
have endorsed the stress tests that it uses to determine capital adequacy
and the use of market value accounting in measuring capital. GAO plans
to continue to examine these issues.

Freddie Mac also said that all the necessary elements for its regulation
are in place and that the Department of Housing and Urban,Develop-
ment has sufficient powers to regulate Freddie Mac. The Department
also believes it is the appropriate regulator of Fannie Mae and Freddie
Mac. Fannie Mae said it believes it should be regulated but did not take a
position on whether the Department is the appropriate regulator. Both
Freddie Mac and the Department believe it is unnecessary to separate
the safety and soundness oversight function from the public policy func-
tion. GAO believes that the Department has not exercised its regulatory
authority and that the government cannot depend on the Department to
reconcile its role as a safety and soundness regulator with its role as a
promoter of housing.

Sallie Mae said it is unfair for the report to conclude that increased over-
sight is needed because of the perception that the government would
assist a failed enterprise without making the granting of such assistance
explicit, Sallie Mae also said that unquantifiable benefits arising from an
enterprise’s federal ties do not warrant such oversight. GAO reports the
effects of both existing ties between the federal government and the
enterprises as well as past government assistance actions as support for
concluding that the government could face losses if an enterprise failed.
GAO also cites these ties as reasons why private market discipline is
imperfect in the case of enterprises. Thus, GAO believes it is prudent for
the government to establish adequate oversight of enterprises.

Page 11                              GAO/GGD-90-97 Government’s Risks From GSEs

Executive Summary                                                                                         2

Chapter 1                                                                                               16
Introduction                  Background                                                                16
                              How the GSEs Operate                                                      20
                              GSEs Have Large Debts                                                     27
                              Objectives, Scope, and Methodology                                        28

Chapter 2                                                                                               31
Risk Identification and Credit
                                      Risk                                                              31
Management              Business Risk                                                                   55
                              Management Risk                                                           59
                              Conclusions                                                               73

Chapter 3                                                                                                75
Loss Reservesand              Current GSE Capital and Loss Reserves
                              Creditor Discipline of GSE Capital and Risk-Taking
Capital: Buffers                  Weakened by Government Ties
Against Loss                  Conclusions                                                                89

Chapter 4                                                                                                90
Federal Government     Why GSE Risk-Taking and Capital Should Be Overseen
                       Protecting the Taxpayers’ Interests in GSE Risk-Taking
Inadequately           Comparing GSE Monitoring and Capital Rules to Banking                             97
Monitoring Risks and        Regulation
                       Bank Regulatory Structure Can Be Modified for GSEs                              104
Capital of Fannie Mae, Conclusions                                                                     107
Freddie Mac, and
Sallie Mae
Chapter 5                                                                                               109
Agency Comments and           Comments From
                                               FCS, FCA, and the Department of                          109
Our Evaluation                Comments From    FHFB and FHLBs                                           113
                              Comments From    HUD, Freddie Mac, and Fannie Mae                         115
                              Comments From    the Department of Education and Sallie                   121
               ”                 Mae
                              Comments From    Connie Lee and Farmer Mac                                123

                               Page 12                             GAO/GGD90-97 Government’s Risks From GSEs

Appendixes             Appendix I: Comments From the Farm Credit System                      126
                       Appendix II: Comments From the Farm Credit                            132
                       Appendix III: Comments From the Department of                         134
                       Appendix IV: Comments From the Federal Housing                        144
                           Finance Board
                       Appendix V: Comments From the Federal Home Loan                       145
                       Appendix VI: Comments From the Department of Housing                  151
                           and Urban Development
                       Appendix VII: Comments From Freddie Mac                               154
                       Appendix VIII: Comments From Fannie Mae                               160
                       Appendix IX: Comments From the Department of                          164
                       Appendix X: Comments From Sallie Mae                                  165
                       Appendix XI: Comments From Connie Lee                                 167
                       Appendix XII: Comments From Farmer Mac                                168
                       Appendix XIII: Major Contributors to This Report                      170

Related GAO Products                                                                         172

Tables                 Table 1.1: GSEs Included in This Study                                  18
                       Table 2.1: Fannie Mae’s Duration Gap                                    39
                       Table 2.2: FCS Loan Quality and Loss Measures (As of                    47
                           December 31 of Each Year)
                       Table 2.3: Fannie Mae Single Family Conventional                        49
                           Mortgage Delinquencies (As of December 31 of Each
                       Table 2.4: Fannie Mae Credit Losses (As of December 31                  50
                           of Each Year)
                       Table 2.5: Freddie Mac Conventional Mortgage                            51
                           Delinquencies (As of December 31 of Each Year)
                       Table 2.6: Freddie Mac Credit Losses (As of December 31                 62
                           of Each Year)
                       Table 2.7: Return on Average Assets                                     63
                       Table 2.8: Return on Average Equity                                     64
                       Table 3.1: FCS Capital (As of December 31 of Each Year)                 78
                       Table 3.2: FHLBs Capital (As of December 31 of Each                     78

                       Page 13                           GAO/GGD-90-97 Govemment’s RIska From GSES

          Table 3.3: Fannie Mae Capital (As of December 31 of Each                  80
          Table 3.4: Freddie Mac Capital (As of December 31 of                      81
              Each Year)
          Table 3.5: Sallie Mae Capital (As of December 31 of Each                  82
          Table 4.1: Percent of GSE Debt Securities Held by Insured                 94
              Depository Institutions (As of June 1989)

Figures   Figure 1.1: Operations of FCS, FHLBs, and Sallie Mae                      21
          Figure 1.2: Operations of Connie Lee and Farmer Mac                       24
          Figure 1.3: Operations of Fannie Mae and Freddie Mac                      26
          Figure 1.4: Growth of GSE Debt and Guarantees                             28
          Figure 2.1: Farm Credit System’s Net Income, 19851989                     61
          Figure 2.2: Federal Home Loan Banks’ Net Income, 1985-                    61
          Figure 2.3: Fannie Mae’s Net Income, 1985-1989                            62
          Figure 2.4: Freddie Mac’s Net Income, 1985-1989                           62
          Figure 2.6: Sallie Mae’s Net Income, 1985-1989                            63
          Figure 3.1: FCS and Fannie Mae Cost of Funds Relative to                  88
               Comparable Treasury Debt


          EC         Bank for Cooperatives
          CEO        Chief Executive Officer
          CPA        Certified Public Accountant
          FCA        Farm Credit Administration
          FCB        Farm Credit Bank
          FCS        Farm Credit System
          FHFB       Federal Housing Finance Board
          FHLB       Federal Home Loan Bank
          FIRREA     Financial Institutions Reform, Recovery, and Enforcement Act
          GAAP       generally accepted accounting principles
          GSE        government-sponsored enterprise
          HUD        Department of Housing and Urban Development
          LTV        loan-to-value
          MBS        mortgage-backed securities
          RTC        Resolution Trust Corporation
          SEC        U.S. Securities and Exchange Commission
          s&P        Standard and Poor’s Corporation

          Page 14                             GAO/GGD90-97 Government’s Risks From GSEs
Page 15   GAO/GGDM-97 Government’s Risks From GSEs
Chapter 1                                                                                    n


                   The Financial Institutions Reform, Recovery, and Enforcement Act
                   (FIRREA) requires that we study the risks undertaken by financial insti-
                   tutions known as government-sponsored enterprises (GSE).As used in
                   this report, a GSEis a federally chartered, privately owned corporation
                   designed to provide a continuing source of credit nationwide to a spe-
                   cific economic sector. Congress wanted information about whether GSES
                   could face problems similar to those causing widespread thrift failures.

                   Congress created GSESbetween 1916 and 1988 because it wanted to
Background         ensure that reasonably priced credit was available for borrowers
                   seeking to finance homes, agricultural businesses, and college educa-
                   tions. The GSESare just part of the government’s overall assistance to
                   the economic sectors it has consistently given national priority-
                   housing, agriculture, and higher education. These sectors receive assis-
                   tance in the form of grants, price supports, direct loans, guaranteed
                   loans, and other subsidies.

                   The GSESwere created to correct what were perceived as flaws in the
                   credit markets. First, there was an uneven availability of credit in
                   various regions, which resulted directly from banking laws and regula-
                   tions. These laws and regulations limited the activities and geographic
                   diversification of various segments of the financial industry, especially
                   banks and thrifts. Interstate banking and intrastate branching were
                   largely prohibited. As a result, most bank and thrift funds came from
                   local deposits, and most of their borrowers were local residents. These
                   restrictions made credit unevenly available in different parts of the
                   country because local deposits did not always meet local demand for

                   Second, agriculture, housing, and higher education loans were not very
                   appealing to large-scale investors. These investors generally prefer
                   investments that (1) can easily be sold and converted into cash (this
                   attribute is referred to as liquidity) and (2) are sold in relatively large
                   denominations. Individual mortgages, student loans, and agricultural
                   loans generally did not meet these criteria because

               l   they were characterized by relatively small principal amounts, could be
                   prepaid at unpredictable times, and required constant attention and pos-
                   sibly difficult collection procedures;

                   Page 16                               GAO/GGD90-97 Government’s Risks From GSEs
                               Chapter 1

                           l   efficient national markets where these loans could be bought and sold
                               did not exist;’
                           l   investors could not easily compare the loan quality among different
                               lenders; and
                           l   the risks inherent in such investments were difficult to evaluate and

                               Third, banks preferred commercial loans over housing, agriculture, and
                               education loans. Commercial loans were perceived to be more profitable,
                               easier to administer, and safer. Given banks’ short-term funding sources,
                               longer-term mortgage loans were riskier than shorter-term commercial
                               loans. Agricultural businesses were more volatile than many other com-
                               mercial businesses, making small farmers a higher risk population. Fed-
                               erally guaranteed student loans had strict administrative requirements.
                               In addition, local banks and thrifts tended to withdraw from these sec-
                               tors when the need for funds was the greatest-i.e., when the economy
                               worsened for that particular sector.

GSEsCreated as National        Congress created GSES to overcome these basic problems with credit
Financial Institu .tions       availability. GSES would operate nationally to make funds available in all
                               regions of the country. They would bridge the gap between local bor-
                               rowers’, local lenders’, and large investors’ needs by offering securities
                               on Wall Street that were highly liquid, were sold in large denominations,
                               carried known maturities, and were considered relatively safe. In addi-
                               tion, they would make agriculture, housing, and education loans more
                               appealing to lenders by creating efficient secondary markets for resale
                               of the loans in both good and bad economic times. As shown in table 1.1,
                               three GSES included in the study are involved in the housing market, two
                               in the agricultural market, one in the agricultural and rural housing
                               markets, and two in the higher education market. Three other GSEs
                               established to finance the resolutions of the Farm Credit and thrift
                               crises were not included in this study. The three are the Financing Cor-
                               poration, the Financial Assistance Corporation, and the Resolution
                               Funding Corporation. They were created in 1987, 1988, and 1989,

                               ‘These markets are commonly referred to as secondary markets. The primary market is where an
                               institution makes a loan or borrows money by selling a debt security to an investor. A debt security is
                               a document in which the institution promises to pay back the principal in a certain number of days,
                               months, or years, commonly referred to as the security’s maturity. Interest is paid on the security’s
                               principal amount either periodically or at the end of its maturity. The secondary market is where the
                               loan documents and securities are sold to third-party investors and can be bought and sold at any
                               time before their maturity.

                               Page 17                                           GAO/GGD-99-97 Government’s Risks From GSEs
                                         Chapter 1

Table 1.1: GSEs Included in This Study
                                         GSE name                                                Year created   Market sector
                                         Farm Credit System Banks
                                           Farm Credit Banks                                     1916/1988      Aariculture
                                           Banks for Cooperatives                                1933           Agriculture
                                                                                                                    ____            -
                                         Federal  Home Loan Banks
                                             .~____~                                             1932           Housing
                                         Federal National Mortgage Association                   1938/l 968     Housing
                                         Federal Home Loan Mortgage Corporation                  1970           Housing     -.....-
                                         Student Loan Marketing Association                      1972           Education
                                         College Construction Loan Insurance Association         1986           Education _-.--
                                         Federal Agricultural Mortgage Corporation               1988           Agriculture

Federal Ties Both                        GSEStypically are subject to a number of federal controls that have no
Constrain and Benefi.t                   private sector parallels. For example, most GSEboards of directors have
                                         some members who are appointed by the President of the United States,
                                         not strictly by the shareholders. The Student Loan Marketing Associa-
                                         tion’s (Sallie Mae) Chairman of the Board is selected by the President.
                                         Each Federal Home Loan Bank (FHLB) has a minority of directors
                                         appointed by its federal regulator, the Federal Housing Finance Board
                                         (FIIFB). In addition, FHFBannually designates each Bank’s chairman and
                                         vice-chairman, Directors have an ongoing responsibility to ensure that
                                         GSESoperate within their charters. Some GSESare also subject to over-
                                         sight by federal agencies, such as the Farm Credit Administration (FCA),
                                         which regulates and examines the agricultural GSES,and the Department
                                         of Housing and Urban Development (HUD), which generally oversees the
                                         Federal National Mortgage Association (Fannie Mae) and the Federal
                                         Home Loan Mortgage Corporation (Freddie Mac). Furthermore, the Sec-
                                         retary of the Treasury is authorized to approve or disapprove the issu-
                                         ance of FIILB System, Fannie Mae, Freddie Mac, and Sallie Mae debt
                                         securities. FCAhas such authority over Farm Credit System (FCS) securi-
                                         ties, and the FHFBalso has authority over FHLBsecurities. In addition, FCS
                                         banks must consult with the Secretary of the Treasury on securities

                                         Each GSE’s charter, except the Federal Agricultural Mortgage Corpora-
                                         tion (Farmer Mac), limits it to certain permissible activities related to
                                         one line of business-either housing, education, or agriculture. Farmer
                                         Mac is limited to agriculture and rural housing. New GSEactivities
                                         related to its defined market may also be restricted until it obtains legal
                                         or regulatory authority. For example, FCAheld hearings in June 1989 to

                                         Page 18                                     GAO/GGD90-97 Government’s Risks From GSEs
Chapter 1

consider whether FCSinstitutions should be allowed to offer additional
financially related services to their agricultural customers. FCAhas not
allowed FCSinstitutions to expand the services they offer on the basis of
these hearings. Such oversight is meant to ensure that GSESoperate
safely and devote their energies to the public policy purposes for which
they were created.

Legislation also provides numerous operating privileges that generally
increase the GSES'profitability by lowering costs of operations and
increasing the liquidity of the GSES'securities. First, most GSEShave
access to federal funding should it ever be needed. Each GSE,except the
College Construction Loan Insurance Association (Connie Lee), Farm
Credit Banks (FCB), and Banks for Cooperatives (BC) can borrow money
from the Treasury. The line of credit ranges widely: $4 billion for.FHLns,
$2.26 billion each for Fannie Mae and Freddie Mac, $1.5 billion for
Farmer Mac, and $1 billion for Sallie Mae. Except for Farmer Mac, the
lines of credit are at Treasury’s discretion, and Treasury officials said
they have no rules or guidelines governing situations when such credit
may be granted or denied.

FCSinstitutions have access to federal assistance that differs slightly
from the GSEnorm. Farmer Mac is eligible to draw on its Treasury line of
credit of $1.5 billion under specific conditions outlined in the Agricul-
tural Credit Act of 1987. Other FCSinstitutions facing serious financial
difficulties do not have direct lines of credit with Treasury but can
obtain federal financial assistance through the FCSAssistance Board.
Through September 30, 1992, the Assistance Board may authorize FCS
institutions up to $4 billion in assistance. Government-guaranteed bonds
provide funds for the assistance, and the government pays part of the
interest. The principal of the bonds is supposed to be repaid by the
assisted institution, and the interest the government pays is to be repaid
by FCSinstitutions. After 1992, the FCSInsurance Corporation will have
authority to assist troubled FCSinstitutions.

The GSESalso enjoy certain cost-saving benefits from their federal ties.
First, most GSEShave certain tax exemptions. FCBSand some of their
associations and FHLBSpay no federal, state, or local taxes other than
real property taxes. BCSand specific types of FCBassociations are fully
taxable. Fannie Mae, Freddie Mac, and Sallie Mae are exempt from state
and local income taxes but not taxes on real property. Second, FCBS,BCS,
FHLBS,and Sallie Mae save money because investors in their debt securi-
ties pay no state or local income tax on interest earned from the securi-
ties. All other things being equal, investors will accept lower returns

Page 19                             GAO/GGD-90-97 Government’s Risks From GSEs
                      Chapter 1

                      (that is, a lower borrowing cost to the GSE)on tax-exempt securities than
                      on taxable ones. Third, all GSES,except Farmer Mac and Connie Lee, are
                      explicitly exempted from registering their debt securities and asset-
                      backed securities with the U.S. Securities and Exchange Commission
                      (SEC), saving them administrative fees.’

                      Congress also gave certain GSESbenefits that enhanced the liquidity of
                      their debt and asset-backed securities.” These GSEsecurities can be used
                      as collateral for public deposits and for borrowing from Federal Reserve
                      Banks and FHLBS;this makes them attractive investments for banks and
                      thrifts. In addition, hypothetically, these GSE securities can be held in
                      unlimited amounts by national banks, and the Federal Reserve can buy
                      and sell them in open market operations. Finally, these GSEsecurities are
                      issued and payable through the Federal Reserve’s book-entry system,
                      which allows funds and securities to be electronically traded.

                      The GSES in our study use two basic operating styles-portfolio    lending
How the GSEsOperate   and credit enhancement through financial guarantees. FCBS,BCS,FHLBS,
                      and Sallie Mae operate primarily as portfolio lenders that either buy or
                      make loans and then hold them to earn interest. Connie Lee and Farmer
                      Mac operate primarily as guarantors of securities. Freddie Mac operates
                      primarily as a guarantor of securities but also holds a portfolio of mort-
                      gages. Fannie Mae operates as both a portfolio lender and guarantor of

Portfolio Lenders     GSESthat operate as portfolio lenders either purchase assets to hold in
                      portfolio, make loans, or do both of these activities. They obtain most of
                      their operating funds by selling to investors debt securities (bonds and
                      notes) that are general obligations of the GSE.In general, portfolio
                      lenders try to maximize the difference between the interest earned on
                      their loans and other assets and the interest paid on debt securities and
                      other liabilities-this is net interest income. FCSbanks, FHLBS,and Sallie
                      Mae are primarily portfolio lenders. Figure 1.1 shows the basic oper-
                      ating methods of these GSES.

                      “(inlike Fannie Mae and Freddie Mac, Farmer Mac is designed to act principally as a guarantor of
                      asset-backed securities, not as a.nissuer. Farmer Mac guaranteed asset-backed securities must be reg-
                      istered with the SEC.
                      %nnie Lee and Farmer Mac have not issued debt securities or asset-backed securities.

                      Page 20                                          GAO/GGD-9087 Goverument’s Risks From GSEs
                                                    Chapter 1

Figure 1 .I: Operations        ot FCS, FHLBa, and Sallie Mae



                           I                                         I                                      I
                      Sell10 Mae                             Consolidated                             Consolidated
                    Debt Securities                               Debt                                     Debt
                        Issued                                  Issued                                   Issued

                           I          .                  I           I         ,   -                            -
                                                                                        Farm Credit                   Banks for
                      Sallie Mae                             Federal Home                  Banks
GSEe                  Buys Loans                              Loan Banks                                             Cooperatives
                                                             Finance Loans                Make and                    Make Loans
                    Finances Loans                                                     Finance Loans

                r-J-- J- r-J--
                     Credit Unions
                                                             Thrifts, Banks,
                                                               & Others
                                                                                        Farm Credit

Borrowers              Student
                                                         I      Homeowner
                                                                                   r-J-- I

Farm Credit System                                 FCSis a nationwide network, which, as of December 31, 1989, comprised
                                                    11 operating FCBS and 1 Federal Intermediate Credit Bank and their 283
                                                   associations that lend money to farmers and ranchers, and 3 BCS that
                                                   lend money to agricultural-related cooperatives and rural utility sys-
                                                   tems-the National Bank for Cooperatives (CoBank), the Springfield
                                                   Bank for Cooperatives, and the St. Paul Bank for Cooperatives. Each
                                                   institution is owned by its borrowers, and the borrowers elect directors.
                                                   The directors then select one public director. The resulting board of

                                                   Page 21                                            GAO/GGD-9087 Government’s Risks From GSEs
                  Chapter 1

                  directors, in turn, selects the institution’s top management. For example,
                  each association is owned and controlled by its farmer-borrowers, and
                  each FCBis owned and controlled by its associations. FCBSand BCSraise
                  operating funds by selling System-wide consolidated debt securities to
                  investors through the Federal Farm Credit Banks Funding Corporation
                  in New York. Each bank is liable for the securities issued on its behalf,
                  and all the banks together are “jointly and severally” liable should any
                  issuing bank fail to repay its securities. FCBSmake loans both directly to
                  farmers and to FCBassociations that, in turn, loan the funds to farmers.
                  BCSmake loans directly to agricultural cooperatives, individuals
                  involved in international agricultural transactions, and rural utilities. As
                  of December 31,1989, FCSinstitutions had combined loans of about $49
                  billion to farmers and related businesses.

FHLB System       The FHLBSystem encompasses 12 districts, each with its own FHLB. FHLBS
                  are owned and controlled by thrifts and other financial institutions
                  (members) in each district. Each FHLBhas a separate management and
                  board of directors. The System’s Office of Finance raises operating
                  funds for the FHLBSby selling debt securities to investors in the national
                  credit markets. Similar to FCSdebt, all 12 banks are jointly and severally
                  liable for these securities, FHLBSloan funds to their members that, in
                  turn, make direct loans to customers for housing and other purposes. As
                  of December 31,1989, FHLBShad combined loans to members, called
                  advances, of about $142 billion.

Sallie Mae        Sallie Mae is a single institution that is owned and controlled by private
                  stockholders. The President of the United States appoints 7 of the board
                  of directors’ 21 members and selects the chairman. Sallie Mae generally
                  raises funds by selling debt securities to investors or raising equity cap-
                  ital. These funds are used to (1) purchase student loans from banks and
                  other financial institutions; (2) make loans to financial institutions so
                  they can make additional student loans; (3) guarantee student loan rev-
                  enue bonds; and (4) invest in academic facility bonds, student loan rev-
                  enue obligations, and other liquid assets. As of December 31, 1989, Sallie
                  Mae’s portfolio included about $16 billion in student loans, about $9 bil-
                  lion in loans to financial institutions, and about $10 billion in cash and

Guarantors        The second operating style GSESuse is to act as financial guarantors.
              Y   Farmer Mac operates primarily as a guarantor of asset-backed securi-
                  ties, and Connie Lee operates primarily as a bond reinsurer. Unlike port-
                  folio lending, this operating style does not necessarily require the GSESto

                  Page 22                              GAO/GGD-90-97 Government’s Risks From GSEs
Chapter 1

borrow funds with debt securities. These GSES earn income through fees.
GSES providing financial guarantees need to accurately evaluate and
price risks associated with the securities, primarily the risk that the
underlying loans or bonds will default. Figure 1.2 shows the basic opera-
tions of Connie Lee and Farmer Mac.

An asset-backed security is created through a process known as pooling.
In this process, a GSEor other financial institution groups or “pools”
loans (assets) with similar maturities, interest rates, and underlying col-
lateral. This group of loans is held in trust, usually by the pooler, and
used as collateral to create a new security of a specified maturity and
interest rate that can be bought and sold. The GSEguarantees that the
interest and principal on the security will be paid according to schedule.
The original lender or another institution services the loans by collecting
loan payments from the borrowers and passing them on to the pooler. In
turn, the pooler pays the interest and principal on the asset-backed
security to the investor who holds the security. Each party in the trans-
action -loan servicer, pooler, and security guarantor-receives       a fee
for its services.

Bond insurers are another type of guarantor. Bond insurance guarantees
the bond-holder that payment of principal and interest will be made as
scheduled. Institutions issuing bonds may buy such insurance to reduce
their interest expense and to broaden the bonds’ appeal. Investors are
willing to accept lower interest and to purchase bonds from relatively
smaller and less familiar entities if the bonds are insured. Primary bond
insurers deal directly with the institution and can provide insurance for
the whole amount of a bond. Reinsurers enter into contracts with the
primary insurer to reimburse the primary insurer for part of any default
loss on the bond. Both primary insurers and reinsurers earn fees for the
bond insurance.

Page 23                              GAO/GGD90-97 Government’s Risks From GSEs
                                          Chapter 1

Figure 1.2: Operations of Connie Lee and Farmer Mac


                                                                    I    Farmer Mac
                                                                        Security Issued

-l.- A--
   Connie Lee
 Provides Partial
 Bond Insurance
                             College or
                                                                    I        Poolers
                                                                          6”; I Loans
                                                                                ---.._ to
                                                                                                               Farmer Mac

                              Hospital                                  Create-2 40~1 fritv                     Guarantee
    Coverage                                                                                                    For a Fee

                                                                    A--      Lenders
                                                                           Farm Credit


                                          Page 24                                             GAO/GGD99-97 Government’s Risks From GSEs
                             Chapter 1

ConnieLee                    Connie Lee is a private insurance holding company incorporated in the
                             District of Columbia with a fully-owned subsidiary insurance company
                             incorporated in Wisconsin. As such, it must comply with insurance regu-
                             lations in all states in which it does business. Sallie Mae currently owns
                             about 76 percent of Connie Lee’s common stock, and the Department of
                             Education owns the other 25 percent. Connie Lee’s 1 l-member board of
                             directors has 2 members appointed by the Department of Education, 2
                             appointed by the Department of the Treasury, 3 appointed by Sallie
                             Mae, and 4 elected by stockholders. Connie Lee currently reinsures aca-
                             demic facility bonds and plans to become a primary insurer during 1990.
                             It is financed with the proceeds from stock sales and operating revenues
                             and does not intend to issue debt securities. As of December 31, 1989,
                             Connie Lee had an outstanding exposure of about $1.7 billion from
                             insured bonds.

Farmer Mac                   The Agricultural Credit Act of 1987 established Farmer Mac to create a
                             secondary market for agricultural real estate and rural housing loans.
                             Its 15-member board of directors includes 5 members appointed by the
                             President of the United States, 5 members elected by stockholders that
                             are FCSinstitutions, and 5 members elected by stockholders that are non-
                             KS financial institutions. Start-up of Farmer Mac has been financed
                             with capital contributions. As of December 31,1989, Farmer Mac had
                             stockholder equity of about $20 million but had not guaranteed any

                             Farmer Mac was established to guarantee timely payment of interest
                             and principal on securities backed by a pool of agricultural real estate
                             and/or rural housing loans. Farmer Mac is to certify certain other finan-
                             cial institutions to act as the poolers that will buy agricultural and rural
                             housing mortgage loans, form loan pools, and issue and sell securities
                             backed by the pools. The statutory authority requires that the pooler
                             establish either a subordinated security class or a cash reserve to pro-
                             vide a cushion for Farmer Mac of at least the first 10 percent of losses.

Both Portfolio Lenders and   Fannie Mae and Freddie Mac make up a third group of GSES.This group
Guarantors                   operates using characteristics of both portfolio lenders and security
                             guarantors. They act as both poolers and guarantors for securities
                             backed by pools of mortgages, which we refer to as mortgage-backed
                             securities (MBS). About 95 percent of Freddie Mac’s mortgage business is
              Y              in MBSand 5 percent is in portfolio lending. Figure 1.3 shows the basic
                             operating styles of Fannie Mae and Freddie Mac.

                             Page 25                              GAO/GGD-90-97 Government’s Risks From GSEs
                                           Chapter 1

Figure 1.3: Operations of Fannie Mae and Freddie Mac



             GSE                          Freddie Mac

             Lenders                        Mortgage
                                          Credit Unions


                                             Page 26      GAO/GGDSO-97 Government’s Risks From GSEs
                 Chapter 1

                 Fannie Mae and Freddie Mac are corporations, each owned and con-
                 trolled by private stockholders with an l&member board of directors, 5
                 of whom are appointed by the President. Before the Federal Home Loan
                 Bank Board was abolished in 1989, it served as Freddie Mac’s board.
                 Fannie Mae’s and Freddie Mac’s operations provide a secondary market
                 where mortgages can be bought and sold.

Fannie Mae       Fannie Mae operates as both a portfolio lender and MEK3   guarantor,
                 earning profits from both interest income and fees. It raises funds for
                 portfolio purchases primarily by selling debt securities. As of December
                 31, 1989, Fannie Mae had a net mortgage portfolio of almost $108 billion
                 and MBSof about $228 billion.

Freddie Mac      Freddie Mac operates primarily as an ME%guarantor but also has a port-
                 folio of loans. As of December 31, 1989, it held a net mortgage portfolio
                 of about $15 billion and had outstanding MBSof about $272 billion.
                 Freddie Mac’s earnings also come primarily from fees and interest
                 income. However, it only pays for part of its portfolio with debt securi-
                 ties. Freddie Mac funds the remainder of its portfolio with equity, mort-
                 gage-related securities, and the interest and principal it collects for
                 mortgages in MBSpools. Instead of passing the principal and interest on
                 to MBSsecurity holders immediately, it temporarily uses the money to
                 fund its portfolio. However, Freddie Mac’s funding strategy may be
                 changing. Freddie Mac recently announced it will pass payments on new
                 securities through to investors more quickly.

                 The GSEShave begun to attract public interest because in total they grew
GSEsHave Large   so rapidly during the 1980s. As shown in figure 1.4, debt and MBSguar-
Debts            antees outstanding totaled over $800 billion by the end of 1989, about a
                 250-percent increase from 1984. The figure excludes Connie Lee and
                 Farmer Mac, which were created in the latter half of the decade.

                 Page 27                             GAO/GGB99-97Government’s Risks From GSEs
                                     Chapter 1

Figure 1.4: Growth of QSE Debt and
                                     1000      Dollars in billions

                                      900                                                                                                 .- *.-- .--
                                                                                                                          *c-- ---
                                                                                                                 .- .--
                                      500                                                                 *I--
                                                                                  l -
                                                                       .- .-
                                      400                   .I---



                                        1994                        1995                   1996                   1957               1999               1999
                                        Calendar yean

                                               -           Debt
                                               -1-1        Debtplus guarantees

                                     FIRREArequired that we study the risks undertaken by the eight GSES and
Objectives, Scope,and                the appropriate levels of capital for such enterprises consistent with
Methodology                          financial soundness and stability and with minimizing the potential
                                     financial exposure of the federal government. FIRREAalso required the
                                     Treasury Department to do a similar study.4 We coordinated our work
                                     with Treasury’s efforts by jointly attending meetings and sharing infor-
                                     mation whenever possible.

                                     FIRREArequired us to submit two reports to Congress on the study’s
                                     results-an interim report in May 1990 and the final report in May
                                     1991. We designed the interim report to describe the risks undertaken
                                     by GSES,how they control and measure these risks, the capital they hold
                                     to guard against risks of losses, their relationship with the federal gov-
                                     ernment, and how their operations are regulated for financial safety and
                                     soundness. In our final report, we plan to (1) provide our independent
                                     evaluation of the GSES’ key risk-control mechanisms, (2) recommend
                                     appropriate techniques for setting minimum capital levels, and (3)

                                     “See Treasury’s report entitled Report of the Secretary of the Treasury on Government Sponsored
                                     Enterprises (May 31, 1990).

                                     Page 28                                                             GAO/GGD-90-97 Government’s Risks From GSEs
    Chapter 1

    examine the quality and timeliness of information available concerning

    To address the above objectives, we reviewed relevant literature, con-
    gressional testimony, external studies, information statements, credit
    reports, investment research from Wall Street firms, and news releases.
    We also interviewed officials from Standard and Poor’s Corporation
    (SW) and Moody’s Investors Service to determine the basis for their
    assessment of GSErisk.

    Our detailed work at each GSEwas tailored to the GSE'Sunique circum-
    stances. At Fannie Mae, Freddie Mac, and Sallie Mae we obtained most
    of our information from (1) written and oral responses to specific ques-
    tions and (2) supporting data provided by top and mid-level managers.
    We toured Freddie Mac’s and Fannie Mae’s facilities and observed
    various activities, such as buying mortgages and selling MBS,as they
    happened. To determine their risk management practices, current cap-
    ital positions and strategies, and exposures to each type of risk, we

l reviewed corporate policies and standards, including seller and servicer
l obtained data on their current financial condition and operating results,
  such as default rates and profit margins;
. reviewed the GSES'methodologies for determining capital adequacy,
  pricing, sensitivity to interest rate changes, sensitivity to economic
  stress, and management information systems; and
l examined copies of external auditor reports and management letters
  that highlighted internal control weaknesses.

    Because the FI-ILBSystem and FCSinclude numerous institutions spread
    over the United States, we relied on our most recent reports concerning
    these GSES and data and opinions from their federal regulators-Fm%
    and F--and      the KS Funding Corporation and FHLBSystem’s Office of
    Finance for overall information on the status of these GSES.To obtain
    first-hand information about individual institutions, we met with offi-
    cials from two FHLRS,two FCBS,one BC, and one FCSassociation; and we
    visited one FCB.

    We also restricted our work concerning Connie Lee and Farmer Mac
    because of their limited operations. In addition, Connie Lee does not
    have the same characteristics as other GSES,and the officials we con-
    tacted did not consider Connie Lee to be a typical GSE.We plan to include

    Page 29                             GAO/GGD-90-97Government’s Risks From GSEs
Chapter I

the status of Farmer Mac in our final report but plan no further review
of Connie Lee.

We did not independently verify the information supplied by the GSESor
others, but we discussed internal controls over their data collection and
reporting and tried to resolve inconsistencies in the information col-
lected from various sources. The work underlying this report was done
between October 1989 and March 1990 using generally accepted govern-
ment auditing standards. The Farm Credit Council, FHLBS, Fannie Mae,
Freddie Mac, Sallie Mae, Connie Lee, Farmer Mac, FCA,FHFB, and the
departments of Agriculture, Housing and Urban Development and Edu-
cation provided written comments on a draft of this report. Their tech-
nical comments have been added to the text where appropriate and their
overall comments are presented and evaluated in chapter 5. The written
comments are reproduced in appendixes I through XII.

Page 30                             GAO/GGIMMb97 Government’s Risks From GSEs
Chapter 2

Risk Identification and Management

                     GSESfulfill their public policy purposes and earn profits by taking risks.
                     Like other private companies, GSESface risks from changes in market
                     interest rates; loan defaults and other credit problems; external business
                     factors such as natural disasters, industry competition, changes in tech-
                     nology, demographics, or legislation; and improper management deci-
                     sions that may adversely affect a firm’s profitability. FIRREA required
                     that we study and report on the GSES' exposure to these risks.

                     Each of the GSEScurrently manages these risks somewhat differently
                     and has changed its risk management strategies over time in response to
                     economic and other external factors. On the basis of (1) unverified infor-
                     mation provided by the GSESand their federal regulators and (2) reports
                     and analyses done by third parties such as external auditors, GSE consul-
                     tants, and private analysts, we found that each GSE generally manages
                     its business in ways that avoid certain risks and attempts to control
                     losses from other risks. We found they had been generally successful in
                     minimizing losses from the risks taken and did not find any risk control
                     problem or financial condition that would indicate a current threat to
                     the viability of a WE. However, certain FCS institutions remain weak, and
                     we cannot predict what effects future external economic conditions and
                     internal management practices and changes might have on the risk-
                     taking strategies or the financial health of any GSE. Because the risk con-
                     trol mechanisms cannot eliminate all risk, the government and GSESneed
                     to be concerned with protecting against unexpected adverse events. We
                     discuss how this is currently done in chapters 3 and 4.

                     Like banks and thrifts, GSESengaged in portfolio lending are exposed to
Interest Rate Risk   possible losses and changes in the value of the GSE arising from changes
                     in interest rates, called interest rate risk. The GSESuse a number of tech-
                     niques to control interest rate risk. Currently available data indicate
                     that Fcs institutions’ capabilities and practices in managing interest rate
                     risk are inconsistent. The data indicate that Fannie Mae has greatly
                     decreased its interest rate risk exposure since the early 1980s. Finally,
                     the data indicate that FHLBS, Freddie Mac, and Sallie Mae each manage
                     their business in ways that result in very little interest rate risk. How- ’
                     ever, constant monitoring and adjustment of the control techniques is
                     necessary to avoid increases in a GSE'S exposure to interest rate risk,
                     which changes over time as the economy, the GSE'S portfolio, and tech-
                     nology change.

                     To illustrate how changes in interest rates can create gains and losses,
                     suppose a GSE made a $100,000 loan with a fixed interest rate of 10

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percent and a 5-year maturity. To keep the example simple, assume the
loan requires the borrower to make only interest payments until the
maturity date. At that time, the principal is to be fully repaid. Now sup-
pose the GSE obtained the funds to make this loan by selling a $100,000,
l-year note on which it paid a rate of 9 percent. Thus, a long-term fixed-
rate loan is funded with a short-term fixed-rate liability. For the first
year, the GSE would earn 10 percent on its loan, pay 9 percent on its
liability, and have the difference, commonly referred to as the net
interest margin, to pay its expenses and retain as profit. At the end of
the year, the GSEwould have to repay the note but would not receive the
loan principal, so it would have to borrow another $100,000. If interest
rates decreased during the year such that it now costs 8 percent to refi-
nance the note, the GSE'S net interest margin would increase to 2 percent,
increasing profits. Suppose, however, interest rates had risen to 11 per-
cent. The GSE'S net interest margin would be negative 1 percent, and the
GSE would be losing money on this loan.

A second element of interest rate risk occurs when a GSE uses long-term
fixed-rate liabilities to fund short-term fixed-rate assets. Losses can
occur when interest rates fall, and a GSE with high cost, long-term debt
has to replace loans that prepay or mature with lower interest rate
loans. As an example of a prepayment, suppose a GSE made a 5-year loan
for $100,000 at 10 percent and funded it with a 5-year note at 9 percent.
If interest rates decline 2 percent during the first year, the borrower
may decide to refinance the loan, i.e., pay off the existing loan and take
a new loan at a lower interest rate. (To keep the example simple, sup-
pose the new &percent loan is made with the same GSE). Thus the GSE
must continue to pay 9 percent for the next 4 years while earning only 8
percent on the new loan. Therefore, the ability of a borrower to prepay a
loan without penalty provides an additional element of interest rate risk
for the lender. This element of interest rate risk is particularly impor-
tant for mortgage loans because of their long time to maturity and their
tendency to be prepaid when rates fall,

A third element of interest rate risk occurs when borrowers hold long-
term loans, such as mortgages, longer than expected. Suppose a GSE
makes many 30-year, fixed-rate mortgage loans and from experience
knows the typical homeowner will sell the house and repay the loan in 7
years. On the basis of this experience, the GSE may fund the mortgages
with liabilities that mature in 7 years. If interest rates then increase,
homeowners will have less incentive to sell their homes because the
interest rate on a mortgage for their new home will be higher. For the

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                          Risk Identification   and Management

                          same reason, there will be fewer potential home buyers. Therefore, bor-
                          rowers may delay selling their homes until rates fall, thereby length-
                          ening the actual life of the mortgages beyond the lender’s expectations.
                          After 7 years, the GSE must refinance its liabilities and begin paying a
                          higher interest rate on its funds than it receives on its assets.1

Measurement of Interest   Four techniques used by GSES to measure interest rate risk are maturity
Rate Risk                 gaps, duration gaps, market value sensitivity, and computer simulations.

Maturity Gaps             Comparing maturities of assets and liabilities gives a financial firm a
                          partial view of its interest rate risk exposure. One such technique, called
                          the maturity gap, groups assets and liabilities into time intervals based
                          on when they repay or reprice. For example, intervals used could be 1 to
                          30 days, 31 to 90 days, 91 to 180 days, 181 to 365 days, 1 to 3 years, etc.
                          Comparing the dollar volume of assets and the dollar volume of liabili-
                          ties maturing in a particular interval shows the relative interest rate
                          sensitivity of that segment of the portfolio. If the dollar volume of liabil-
                          ities is more than the dollar volume of assets in a particular interval,
                          then during that interval interest expenses will likely change more than
                          interest earnings if interest rates change.

                          Although useful, maturity gap analysis has significant shortcomings for
                          adequately measuring interest rate risk in certain portfolios. First, it
                          classifies assets and liabilities by (1) the date interest rates change if the
                          asset or liability has a variable interest rate or (2) the date they repay, if
                          the interest rate is fixed, thereby ignoring all payments required before
                          those times. This shortcoming is particularly important for amortized
                          loans, such as mortgages, where the sum of the intermediate cash flows
                          is much larger than the final payment2 Second, the number of time
                          intervals selected is arbitrary. The wider the time intervals used, the
                          fewer and thus more manageable but less precise the measurements. For
                          example, a l- to 3-year interval could have assets with 3-year maturities
                          and liabilities with l-year maturities in the same interval. Third,
                          maturity gap analysis usually cannot be used to measure the interest
                          rate sensitivity of the overall portfolio because it is interval-specific.

                          ‘Prepayment patterns may differ from lenders’ expectations for reasons other than interest rate
                          changes. In a stable interest rate environment, though, the potential losses arising from prepayments
                          are considerably reduced because prepayment patterns are more easily predicted.
                          ‘An amortized loan is one with equal periodic payments calculated to repay all the loan principal at
                          the end of a fixed time period. The principal balance is repaid over the time period, and interest is
                          paid on the outstanding principal balance.

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                Risk Identification   and Management

                Fourth, managing risk exposure using these measurements is difficult
                because it requires different management strategies for each interval
                rather than an overall strategy for the whole portfolio.

Duration Gaps   To overcome the shortcomings of maturity gaps, some firms now use
                duration gaps to measure interest rate risk. Duration gaps measure the
                average economic life of a whole portfolio rather than the time to final
                payment for each asset or each liability. Asset duration is a single
                number, measured as a unit of time, that identifies the average economic
                life of the asset portfolio (for example, 27 months). The duration mea-
                sure accounts for all intermediate cash flows associated with each
                asset-not just the final payment-by        estimating the present value of
                each asset paymentZ3 Likewise, liability duration measures the average
                economic life of liabilities. The difference between a firm’s asset and lia-
                bility durations is called its duration gap.

                The duration gap measures the overall interest rate risk exposure of a
                GSE. The larger the gap in absolute value, the greater the GSE’S exposure
                to interest rate risk. For example, a GSE where the average economic life
                of its assets is 2 years greater than the average economic life of its liabil-
                ities has a duration gap of 2 years. Should interest rates rise, the GSE’S
                net interest income will fall because interest expenses will rise sooner
                than interest income. Some GSES try to avoid interest rate risk by man-
                aging their portfolios to keep their duration gaps at or near zero.

                Management of a GSE’S exposure to interest rate fluctuations requires
                continual monitoring and adjusting. Durations change when interest
                rates change, and they change over time even in stable rate environ-
                ments. As discussed, durations are based on the present value of a
                security’s future cash flows. If interest rates change, the rate used to
                discount the cash flows also changes. Also, as time passes, the remaining
                cash flows are closer to being realized, so the duration declines.

                 A major shortcoming of duration analysis is the difficulty of computing
                duration for certain types of assets and liabilities. Duration is useful for
                judging sensitivity to small interest rate changes, but it is less useful for
                 large interest rate shifts because it is more difficult to predict the effects
                 of large shifts. Further, duration gaps are often difficult to measure pre-
                 cisely because a number of forecasts and assumptions must be made.
                 First, duration measurements require complete information on each
                 asset’s and liability’s cash flows as well as estimates of possible changes

                “The present value of a cash payment in the future is the value of that future cash if paid today.

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                           to the expected cash flows, such as from prepayments. Second, securi-
                           ties with changing rates or that may be prepaid require interest rate
                           projections. Third, payment failures, taxes, and other factors may add
                           to the inaccuracy of duration measures.

                           In summary, duration gap analysis is a more sophisticated approach to
                           measuring interest rate risk than maturity gap analysis. Proper use of
                           duration requires complete data and a comprehensive understanding of
                           the securities involved, including proper consideration of factors such as
                           loan prepayments. It also requires continual monitoring of changes in
                           the duration gap and a timely response to observed changes.

Market Value Sensitivity   A third technique used in measuring interest rate risk is to estimate the
                           sensitivity of a GSE'S market value net worth to various changes in
                           interest rates. Market value net worth provides a measure of the GSE'S
                           ability to absorb losses. Financial firms report their income statements
                           and balance sheets according to generally accepted accounting principles
                           (GAAP). GAAP relies primarily on the historical (book) value of financial
                           assets and liabilities rather than on their current market value. The
                           market value of such assets and liabilities is affected by current interest
                           rates but also can change if the likelihood of prepayment or repayment
                           changes. The market value of assets minus the market value of liabili-
                           ties provides the market value of net worth.

                           For example, using GAAP a bank carries a 5-year, lo-percent loan at the
                           amount of unpaid principal over the life of the loan. If interest rates
                           decrease, the market value of the loan increases because the loan earns
                           a rate higher than the bank could earn on a new loan. Likewise, the
                           market value declines if interest rates rise because the bank could earn
                           more on a new loan. One method of monitoring a firm’s exposure to
                           interest rate risk then is to regularly determine the market value of the
                           firm’s assets and liabilities (marking-to-market) and project how market
                           value would change for assumed changes in interest rates.

                           While a valuable tool for measuring a GSE'S ability to bear risk, market
                           value sensitivity has certain limitations. It estimates the liquidation
                           value of a firm and therefore does not capture the value of a firm as a
                           going concern. Also, there are no set standards for determining the
                           market value of all types of assets and liabilities.

ComputerSimulations        A fourth method of measuring interest rate risk is to simulate a port-
                           folio’s profitability under various interest rate environments. The GSES

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                           Risk Identification   and Management

                           used various complex methods to develop these simulations that fol-
                           lowed three general steps. First, a random number generator is used to
                           produce several hundred interest rate paths of some predetermined
                           length into the future. Second, a computer model is then used to esti-
                           mate the value of the firm over each path by estimating the loan
                           defaults and prepayments that occur over each path. The average of the
                           results is the estimated market value of the firm. Third, interest rate
                           risk can then be measured by using this type of simulation to estimate
                           the effects of different funding strategies and interest rate changes on
                           the expected value of the firm. On the basis of the information provided
                           by the GSES,national credit rating agencies, and other recognized
                           experts, we believe these types of simulations are a reasonable method
                           of measuring interest rate risk.

Control of Interest Rate   Once it is measured, managers can change the interest rate risk exposure
Risk                       of their firms by lengthening or shortening the expected maturity of
                           their assets and liabilities so that payment streams on assets and liabili-
                           ties behave similarly. They also may issue assets and liabilities with fea-
                           tures that reduce interest rate risk. For example, a GSE might encourage
                           the origination of variable-rate loans where the interest rate charged the
                           borrowers changes at scheduled intervals according to current market
                           rates, known as repricing. The GSE can then match these assets with lia-
                           bilities that mature at the same intervals the loans are repriced. Still
                           another technique allows GSESto issue liabilities with variable maturity
                           terms, or call features. Callable debt allows the GSEto prepay its bonds
                           after a specified time frame- a useful option to GSESin case interest
                           rates decline. Another technique available to certain GSESis to levy pre-
                           payment penalties or restrictions on borrowers who prepay their loans
                           when rates fall.

Management of Interest     The GSESdiffer widely in their exposure to and management of interest
Rate Risk                  rate risk. Management of interest rate risk is especially important at EY=S
                           institutions, FHLBS, Fannie Mae, and Sallie Mae because of their large
                           loan portfolios. As discussed below, FHLBS and Sallie Mae avoid much of
                           the interest rate risk associated with portfolio lending by closely
                           matching the interest rate sensitivity of their assets and liabilities. FCS
                           institutions and Fannie Mae have assets and liabilities that are less well
                           matched and have greater exposure to interest rate risk. Freddie Mac

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                         Risk Identification   and Muagement

                         largely avoids interest rate risk by minimizing its portfolio lending, con-
                         centrating instead on MBS that transfer the interest rate risk to the inves-
                         tors. Connie Lee and Farmer Mac do not directly undertake interest rate

The Farm Credit System   During the mid-1980s, FCS suffered significant losses due in part to
                         interest rate risk exposure. FCS institutions had used some high cost,
                         long-term debt to fund mostly variable rate loans that repriced adminis-
                         tratively rather than via an index. When interest rates dropped sharply,
                         these institutions had to continue paying the high cost debt but did not
                         reprice loans proportionately and thus earned lower interest rates on
                         their loans. According to an FCA official, the current capabilities and
                         practices of FCS institutions to manage interest rate risk vary widely.
                         Today, some FCS institutions still have high-rate debt issued in the mid-
                         1980s. On the basis of the information presented below, we believe FCS
                         as a whole has improved its asset and liability management. However,
                         FCHS manage liabilities but share management of assets with their
                         associations, making interest rate risk management difficult, and pos-
                         sibly exposing some institutions to significant interest rate risk.

                         As discussed in an earlier report,4 FCS developed a strategy in 1986 to
                         address its past failure to effectively manage interest rate risk. To aid
                         the FCBS and BCS, the Funding Corporation monitors each FCB’S and BC’S
                         interest rate risk exposure and assists with asset and liability manage-
                         ment. Quarterly, the FCBS and BCS report maturity gaps and duration
                         gaps to the Funding Corporation, which identifies interest rate mis-
                         matches, CoBank and 10 of the 11 FCBS also use a simulation model to
                         measure interest rate risk exposure. Using this model, a bank will calcu-
                         late its portfolio’s market value and its duration gap. The FCBS usethese
                         measures to determine their interest rate risk exposure and to evaluate
                         alternate methods of reducing that exposure.

                         Representatives of the Funding Corporation described for us how they
                         assist the banks in their asset and liability management. They said that
                         all the banks now have committees that oversee asset and liability man-
                         agement. They said that each bank provides the Funding Corporation
                         data concerning its duration gaps but the Funding Corporation has not
                         verified those data or tested them for reliability, We have not indepen-
                         dently examined the interest rate risk management of any FCB or BC.

                         4Farm Credit Actions Needed on Major Management Issues (GAO/GGD-87-61, Apr. 1, 1987).

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                         FC%interest rate risk management is complicated by fragmented respon-
                         sibilities and prepayment uncertainties. Within FCS districts, the FCBS
                         control liability management and share control over asset management
                         with their related associations. The FCBS borrow money from capital
                         markets and manage the liabilities of the district. The FCBS and bor-
                         rower-owned associations share control over the assets by making direct
                         loans and setting the rates and terms for those loans. The fragmented
                         responsibilities and borrower pressures to limit rate increases could
                         make it difficult for managers to assure that the behavior of the liabili-
                         ties corresponds closely to the behavior of the assets.

                         Loan prepayments further complicate FCS interest rate risk manage-
                         ment. FCS loan prepayments are very difficult to predict, primarily
                         because the terms of the loans and the characteristics of agricultural
                         activities differ among borrowers. Good historical data do not exist to
                         help predict agricultural loan prepayments.

Federal HomeLoan Banks   The FHLBS fund large portfolios of loans to member institutions prima-
                         rily with fixed-rate debt. According to representatives of the FHLB
                         System’s Office of Finance, which issues all debt for the System, FHLBS
                         have little interest rate risk exposure because they (1) charge prepay-
                         ment fees on fixed-rate loan prepayments and (2) match the repricing of
                         their assets and liabilities closely. The representatives said the maturity
                         gaps for all FHLBsare close to zero.

                         According to FHFB guidelines, the prepayment fees must compensate the
                         FHLB for at least 90 percent of the economic loss arising from the pre-
                         payment. Also, according to a Moody’s credit report, the FHLBS use a
                         combination of sophisticated hedging techniques, such as interest rate
                         swaps and futures contracts, to align the durations of their assets and

Fannie Mae               Fannie Mae has not always been successful in managing interest rate
                         risk. After 13 profitable years, Fannie Mae reported cumulative net
                         losses of over $350 million during 1981, 1982, 1984, and 1985. These
                         were caused primarily by the failure of Fannie Mae’s asset and liability
                         management strategy in the unprecedented interest rate environment in
                         the early 1980s. In the 1960s and 1970s Fannie Mae had followed an
                         asset and liability management strategy of funding long-term fixed-rate
                         mortgages with relatively short-term debt. As interest rates rose sharply
                         in 1980 and 1981, Fannie Mae had to pay much higher interest rates as

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                                       Rbk Identification    and Management

                                       it refinanced its debt. But the interest Fannie Mae earned on the mort-
                                       gages already in its portfolio remained constant. Fannie Mae officials
                                       said that other outmoded strategies also contributed to the losses.

                                       More recently, Fannie Mae appears to have improved its ability to with-
                                       stand fluctuations in interest rates by more closely matching durations
                                       of assets and liabilities. At the end of 1989, Fannie Mae held a $108
                                       billion portfolio of mortgages, funded with a variety of debt securities. It
                                       measures its interest rate risk by calculating the duration gap of its
                                       portfolio. This gap was 29 months at the end of 1984 but had declined to
                                       approximately 6 months at the end of 1989 (see table 2.1). Fannie Mae
                                       officials told us their target duration gap has been 6 to 12 months. They
                                       said this is the appropriate range because, in a falling interest rate envi-
                                       ronment, prepayments cause mortgage durations to fall quickly while
                                       liability durations actually increase. They said that maintaining an asset
                                       duration of 6 to 12 months greater than the liability duration compen-
                                       sates for this effect.

Table 2.1: Fannie Mae’s Duration Gap
                                                     1984          1985               1986              1987     1988 -__       1989
                                                                                                                             - ..-.-
                                       Duration        29             18                 11                8       10             6
                                       Note: Numbers are approximations    of year-end duration gaps.
                                       Source: Fannie Mae.

                                       Rather than avoiding interest rate risk, Fannie Mae actively manages its
                                       exposure to such risk to make a profit. According to a Fannie Mae offi-
                                       cial, Fannie Mae attempts to fund its portfolio with a mixture of liabili-
                                       ties that meet its targeted duration gap. When Fannie Mae buys
                                       mortgages for its portfolio, it uses computer models to determine the
                                       price it will pay for the mortgages, project the expected returns on the
                                       mortgages, and identify a funding strategy to meet its duration gap
                                       target. Since, as discussed earlier, durations change even in stable
                                       interest rate environments, Fannie Mae must continually monitor its gap
                                       and make adjustments in response to interest rate changes.

                                       Fannie Mae buys mortgages for its portfolio only when the returns are
                                       high enough to cover expected interest rate risk losses from those mort-
                                       gages and provide a targeted return on equity. If the expected interest
                                       earnings on mortgages are judged insufficient to bear the interest rate
                                       risk, Fannie Mae buys mortgages and creates MBS, passing the interest
                                       rate risk on to investors.

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              To further control its interest rate risk, in the past few years Fannie
              Mae started expanding the type of debt securities it issues. It first issued
              callable debt as part of an asset and liability management strategy in
              1983. In 1988, Fannie Mae began what officials called a programmed
              effort to regularly issue callable debt. Callable debt allows Fannie Mae
              to refinance its liabilities when interest rates fall and home owners are
              more likely to refinance their mortgages. In comments on a draft of this
              report, Fannie Mae said that as they add more callable debt to their lia-
              bility structure, their optimal duration gap will approach zero. In 1988,
              Fannie Mae also began issuing debt that repays more quickly when
              interest rates fall and repays more slowly when rates rise, giving it
              repayment characteristics similar to those of mortgages. According to
              Fannie Mae, in 1989 these two types of securities accounted for about 30
              percent of all long-term debt issued. Fannie Mae officials said they plan
              to increase the use of these debt securities in the future.

              Fannie Mae officials provided us with written and oral descriptions of
              how they measure Fannie Mae’s interest rate risk exposure by using
              computer simulations to examine the effects of changes in interest rates
              on its net interest earnings. We have not verified the accuracy or relia-
              bility of the data and computer models used or the assumptions made
              for these simulations. As discussed earlier, the simulations estimate the
              firm’s value and test the effects of alternate funding strategies on the
              portfolio’s performance. According to Fannie Mae, the first stress test
              scenario replicated the interest rate experience of 1978 through 1982,
              when the United States had the highest average, and most extreme
              swings in interest rates in the last 100 years. The second test simulated
              an interest rate increase of 600 basis points” over 12 months starting
              from November 1989 levels. Interest rates were then held at that level
              for 4 years. A Fannie Mae official said that the stress tests show that
              Fannie Mae would continue to have positive net interest earnings in each
              year of either simulation.

Freddie Mac   Freddie Mac’s policy is to largely avoid interest rate risk. Their interest
              rate risk management strategy helped to keep Freddie Mac profitable
              throughout the 198Os, even when interest rates were extremely volatile.

              Freddie Mac’s interest rate risk management strategy is based on
              pooling about 95 percent of the mortgages it buys into MBS that pass the
              interest rate risk on to the security holder. As a result, Freddie Mac’s

              “A basis point is l/lOOth of a percentage point, so an increase of 600 basis points is equal to an
              increase of 6 percentage points.

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             Chapter 2
             RI& IdentIflcntion   and Management

             possible exposure is generally limited to interest rate risk on the
             remaining 5 percent of the mortgages it holds in its portfolio. Freddie
             Mac retains these mortgages in its portfolio as inventory to facilitate the
             creation of new MBS and to fund new mortgage purchase programs
             where volume has not yet reached a level sufficient to create an MBS. At
             the end of 1989, Freddie Mac held about $15 billion of mortgages in
             portfolio, and an additional $5.6 billion financed with mortgage-related
             debt securities.”

             Freddie Mac officials provided us with written and oral descriptions
             explaining that Freddie Mac measures the interest rate risk of its total
             operations in three steps. First, it computes its market value net worth
             quarterly. Second, it computes the interest rate sensitivity of its market
             value by calculating the expected value of the firm under a range of
             simulated interest rate environments ranging from plus 500 basis points
             to minus 500 basis points. When running the simulation assuming
             replacement of repaid mortgages, Freddie Mac reports that market value
             rises as interest rates decline, and declines as interest rates rise.
             According to Freddie Mac’s simulation results, its market value would
             remain greater than $4 billion if interest rates rose 600 basis points.
             Third, Freddie Mac simulates how its accounting value changes by com-
             puting how the interest rate changes would alter the firm’s expected
             cash flow.

             Freddie Mac uses these techniques to decide how to alter its operations
             to reduce interest rate risk. In particular, it uses the various measures in
             deciding how to fund the mortgages it retains in its portfolio. Part of its
             interest rate control procedures is to update these measurements at least

Sallie Mae   According to Sallie Mae, as of September 30, 1989,82 percent of Sallie
             Mae’s assets would reprice within 3 months, and all but $221 million-
             less than 1 percent -of those assets were matched with debt repricing
             within the same period. They said this condition is typical of Sallie
             Mae’s assets over time. Since assets and liabilities reprice at about the
             same time, Sallie Mae’s net interest margin should remain roughly con-
             stant, other factors remaining the same. The maturities of the remaining
             assets and liabilities were also fairly closely matched. As a result, Sallie
             Mae had little interest rate risk.

             “For a discussion of Fannie Mae’s and Freddie Mac’s issuance of multi-class, mortgage-related securi-
             ties, see Housing Finance: Agency Issuance of Real Estate Mortgage Investment Conduits (GAO/
             GGD-88-111, Sept. 2, 1988).

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                           Sallie Mae measures its interest rate risk sensitivity using maturity gaps.
                           We believe Sallie Mae does not encounter the shortcomings normally
                           associated with this measurement technique because the vast majority
                           of its assets and liabilities reprice in 3 months or less. According to Sallie
                           Mae officials and Sallie Mae’s audited financial report, Sallie Mae elimi-
                           nates most of its interest rate risk by funding its assets with debt securi-
                           ties that have characteristics similar to its assets. First, fixed-rate loans
                           are usually funded with fixed-rate debt of like duration. Second, it funds
                           its variable-rate loans with variable-rate debt. Third, it often issues
                           fixed-rate debt and then enters interest rate exchange agreements
                           (interest rate swaps) with other financial institutions that result in it
                           being liable for interest payments with characteristics similar to the
                           interest earned on its assets.

                           Sallie Mae initiated the first U.S. interest rate swap in 1982, and data
                           show it has since used this technique extensively in controlling its
                           interest rate risk. An interest rate swap is simply an exchange of
                           interest payment streams between two parties. For example, Sallie Mae
                           may issue a 5-year, fixed-rate debt, and a bank may issue certificates of
                           deposit paying interest tied to 91-day Treasury bill rates. Sallie Mae may
                           swap its interest payments on the 5-year bond for the bank’s variable
                           rate interest payments. Such agreements benefit both parties by effec-
                           tively giving them liabilities with characteristics resembling those of
                           their assets. The exchange agreements are particularly beneficial to
                           Sallie Mae during times when it can easily raise fixed-rate, medium-term
                           debt. Such agreements typically also benefit the party that may have
                           variable-rate liabilities like deposits but fixed-rate assets like mortgages
                           and may have difficulty raising medium-term debt. In making such swap
                           arrangements, Sallie Mae must take care that its swap partners are
                           financially able to live up to the swap agreement.

Ca-mieLee and Farmer Mac   Connie Lee officials said that because of regulatory and market prefer-
                           ences for equity financing, Connie Lee does not anticipate issuing debt
                           securities as part of its normal operations. Therefore, Connie Lee does
                           not incur interest rate risk. Since Farmer Mac has not begun operations,
                           it is not clear what interest rate risk, if any, it will undertake.

                           Credit risk is the risk of loss arising from borrowers failing to repay
Credit Risk                their loans and/or other parties failing to meet their obligations to
              Y            administer or guarantee loans. Credit risk is inherent in the daily opera-
                           tions of all financial firms, including all eight GSES.The raw exposure of
                           GSESto credit risk is very large-over      $800 billion-but  through a

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                             Chapter 2
                             Risk Identlflcation   and Management

                             variety of control techniques they strive to assure that their actual
                             losses are relatively well controlled. Data provided to us show that the
                             GSEs use generally accepted methods for controlling losses from credit
                             risk and have generally been very successful in controlling these losses.
                             However, in stressful economic environments, such as the real estate
                             downturn in the Southwest and the agricultural recession of the mid-
                             1980s some GSEShave experienced unusually large and sometimes
                             serious losses from credit risk. Any change in strategy toward more
                             risky practices or the failure to adequately predict or prepare for eco-
                             nomic downturns could subject most of the GSESto large additional
                             credit losses.

Measuresof Credit Risk       There are two basic measures of credit risk-the volume of loans or
                             insured bonds that are not performing according to the contractual
                             agreement and the dollar losses to the firm resulting from such
                             nonperforming loans or bonds,

                             Typically, when a borrower fails to make a scheduled payment, the loan
                             is termed delinquent. Delinquency rates are an early indicator of credit
                             problems. After a period of continuing delinquency, the lender or GSE
                             may act to recover the loan principal by foreclosing on the property
                             and/or filing a claim with any party that insured or guaranteed the loan.
                             At the time of foreclosure, the loan is said to have defaulted. Only a
                             fraction of delinquent loans default.

                             The financial losses from defaults include any principal of the loan (or
                             bond) not repaid, interest not paid, and expenses to foreclose or restruc-
                             ture, adjusted by recoveries from collateral sales and insurance. GSES
                             generally use sophisticated automated systems to price their services to
                             cover expected credit losses. Generally, default and loss rates are a ret-
                             rospective rather than a prospective measure of credit risk. However,
                             default and loss rates can be predicted by GSESwhen they have histor-
                             ical default and loss data for similar types of loans in various economic
                             circumstances. With new products, defaults and losses are difficult to
                             predict accurately, and product performance must be monitored care-
                             fully to control credit risk.

Methods to Cq-ttrol Credit   GSESmanage credit risk by trying to control the number of defaults and
Risk                         minimize the losses that result from defaults. Most GSEScontrol defaults
                             through underwriting standards that provide a quality control over the
                             credit risks they take and help them prevent defaults. To minimize

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                           Chapter 2
                           l&k Identification   and Management

                           losses from any defaults that do occur, GSES use techniques called credit
                           enhancements that allow them to recover all or portions of their poten-
                           tial losses from collateral or from third parties such as lenders, loan
                           insurers, or loan guarantors.

Underwriting   Standards   Underwriting is the process of identifying the potential risks of loss
                           associated with financial activities to allow pricing of such risks. Under-
                           writing is an integral part of business and financial transactions that
                           occur daily throughout the private and public sectors of the economy
                           and involve the transfer and pricing of risk. The underwriting process is
                           used for evaluating and pricing many types of financial instruments
                           that GSES buy and sell, such as insurance policies, stocks, bonds, and
                           loans. Underwriting standards are guidelines used to (1) limit the type
                           and amount of risk of loss permitted in a financial portfolio and (2)
                           establish methods to control such risks.7

                           Before a GSE purchases a loan, guarantees a security, or insures a bond,
                           certain underwriting standards must be met. Such standards are devel-
                           oped by GSESor others based on the default experience of similar finan-
                           cial products. Underwriting standards cover numerous borrower and
                           property characteristics that help GSESevaluate the likelihood of
                           defaults and the severity of related losses. For example, GSES that buy
                           mortgages typically have underwriting standards to indicate that a bor-
                           rower has sufficient income to make the scheduled payments and a
                           credit history suggesting that the borrower has met past obligations in
                           an acceptable manner. Another common mortgage standard is a max-
                           imum loan-to-value (LTV) ratio that measures the borrower’s equity
                           (down payment) in the property. Experience has shown that borrowers
                           with low amounts of equity in the property, and thus high LTV ratios, are
                           more likely to default than borrowers with high amounts of equity. GSES
                           also have established appraisal standards that are used to estimate the
                           value of the property serving as collateral for the mortgage.

                           Because most GSESdo not typically make loans directly, standards are
                           also used to qualify other parties to participate in their credit activities.
                           For example, GSES involved in the mortgage and student loan businesses
                           have established standards for lenders and loan servicers. Such stan-
                           dards may include measures of financial strength, past performance
                           indicators, and management quality. Lenders and servicers expose the

                           7For a comprehensive description of the elements of underwriting standards used in today’s sec-
                           ondary markets, see our report entitled Federal Agricultural Mortgage Corporation: Underwriting
                           Standards Issues Facing the New Secondary Market (GAO/RClTX39-106BR, May 5, 1989).

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                          Chapter 2
                          Rlak Identification   and Management

                          GSEto risk of default to the extent that they fail to follow standards
                          adequately when making the loan or fail to collect payments diligently.
                          GSEs have also established audit and quality control procedures to mon-
                          itor the performance of lenders and servicers. Some GSESalso set stan-
                          dards for firms with which they share financial risk. For example, when
                          a GSE enters an interest rate swap agreement, there is a credit risk that
                          the other party may fail to meet its obligation. To mitigate such risk, a
                          GSE will typically set minimum standards of financial strength for such

                          Although GSESestablish standards to limit the risk of defaults, officials
                          from some GSESsaid they often waive or modify their standards to give
                          themselves flexibility in dealing with unique transactions. Before doing
                          so, they said, they assess whether such unique transactions would mate-
                          rially alter credit losses. GSE officials said they impose alternative ways
                          to offset the risks and also price such transactions to compensate the
                          GSESfor any increase in the amount of credit risk undertaken as a result
                          of the modified standards. Also, the officials said they often negotiate
                          for credit enhancements when entering into such transactions.

Credit Enhancements       Credit enhancements are vehicles for GSESto control their losses from
                          default. Through credit enhancements, GSEStransfer their credit risk to
                          other parties. Described below are some common credit enhancements:

                      l Guarantees are commitments by third parties to pay principal, interest,
                        and related costs should the borrower fail to make loan payments. For
                        example, state guaranty agencies and a federal agency supply student
                        loan guarantees.
                      . Private mortgage insurance is obtained by borrowers for an annual pre-
                        mium. Lenders or GSEStypically require such insurance coverage for
                        borrowers who have made low down payments. Should the borrower
                        default, the private mortgage insurer is typically obligated to pay the
                        GSE a percentage of the unpaid principal balance, accrued interest, and
                        foreclosure costs.
                      . Collateral is property or financial assets pledged as security for a debt,
                        such as a mortgage or other loan. When a loan defaults, the holder of the
                        loan takes possession of any collateral pledged for the loan.
                      . Recourse is an agreement between a GSE and a lender or servicer that
                        obliges the lender to cover some or all of the losses arising from loans
                        sold to the GSE. Some recourse agreements are supported by collateral,
                        such as Treasury securities.

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                          Risk Identification   and Management

                          GSESare exposed to the risk of default losses from parties providing
                          credit enhancement on loans that they buy. For example, Fannie Mae
                          and Freddie Mac suffered losses when mortgages they owned or guaran-
                          teed defaulted and the private mortgage insurer that provided credit
                          enhancement for those mortgages-TICOR Mortgage Insurance Com-
                          pany-failed    in the 1980s. GSESmanage this risk by establishing stan-
                          dards for these parties to ensure they are financially sound and reliable
                          and are able to meet contractual commitments with the GSE. GSESmon-
                          itor these firms’ financial and business performance through financial
                          reports and on-site audits.

GSEManagement of Credit   GSE exposure to credit risk varies, since the activities, markets, and cus-
Risk                      tomers of the GSESare different. On the basis of the information dis-
                          cussed below and discussions with national credit rating agencies and
                          other recognized experts, it appears to us that the FHLBS and Sallie Mae
                          are exposed to the least amount of credit risk because of their high
                          quality assets, conservative credit policies, and for Sallie Mae the guar-
                          antees backing its student loans and backing the collateral for its
                          advances to banks. Fannie Mae and Freddie Mac face moderate credit
                          risk compared to the other GSESbecause (1) mortgages are generally
                          more risky than fully guaranteed loans and less risky than agricultural
                          loans and (2) the GSESuse underwriting standards and credit enhance-
                          ments to control losses from credit risk. FCS faces a higher amount of
                          credit risk relative to the other GSESbecause its loan repayments are
                          based on a borrower’s agricultural income, which is more unpredictable
                          than residential mortgage repayments and guaranteed student loan
                          repayments. Connie Lee officials said it has limited exposure to credit
                          risk because educational institution bonds that qualify for insurance
                          have high standards and rarely default. Also, they said that credit risk
                          is limited in any given year to the payments due that year because the
                          entire principal does not become due when payments are missed. When
                          Farmer Mac begins operations, it plans to use underwriting standards
                          and to require loan poolers and originators to assume responsibility for
                          the first 10 percent of credit losses from each pool.

Farm Credit System        During the agricultural recession in the mid-1980s, FCS experienced
                          defaults and serious credit-related losses at levels unprecedented since
                          the 1930s. During the decline in the agricultural sector, the BCS' losses
                          were not significant enough to endanger their existence, but some other
                          FCS institutions experienced severe problems. Table 2.2 illustrates
                          improvements in FCS loan quality as the agricultural sector improved
                          after 1986.

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                                       chapter 2
                                       RI& Identiflcatlon     and Management

Table 2.2: FCS Loan Quality and Loss
Measures (As of December 31 of Each
Year)                                  -Dollars in millions
                                                                     Net loan    Nonaccrual       High-risk
                                       Year                          principal        loans          loansa Net loan losses
                                       1985           ____---          $66,615       $5,323          $9,578          $1,105
                                       1986 -___                        54,614        7,066          13,171           1,352
                                       1987                             49,547        5,234          10,828             488
                                       --                               49,570        3,329           7,895       -__ 413
                                       1989                             49,129        2.553           7,093               (5)
                                       %cludes nonaccrual loans.
                                       Source: FCS Funding Corporation.

                                       Major indicators show that the quality of FCS’ aggregate loan portfolio
                                       has improved every year since FCS recorded its most extensive losses in
                                       1985 and 1986. Nonaccrual loan volume decreased about $4.5 billion
                                       from December 1986 to December 1989. Nonaccrual loans generally
                                       include (1) loans for which interest or principal payments are delin-
                                       quent for 90 days and (2) loans for which circumstances indicate that
                                       collection of principal or interest is in doubt. Coupled with the shrinking
                                       FCS loan volume, the reduction in nonaccrual loan volume represents a
                                       decrease in the percentage of nonaccrual loans to net loan volume from
                                       about 13 percent in 1986 to about 5 percent in 1989. FCS’ high-risk loan
                                       volume also decreased from $13.2 billion in 1986 to $7.1 billion in 1989.
                                       High-risk loans include nonaccrual loans, loans with restructured terms,
                                       and potential problem loans exhibiting serious credit weaknesses and
                                       requiring more than normal servicing. Loan losses net of any proceeds
                                       recovered from the loans declined from $1.35 billion in 1986 to a net
                                       recovery of $5 million in 1989.

                                       The changes in FCS loan portfolio quality followed fluctuations in the
                                       agricultural economy and efforts of FCS institutions to adapt to economic
                                       changes. The increase in high-risk loans during the mid-1980s reflected
                                       the depressed agricultural sector and declines in farmland value.
                                       Decreasing high-risk loan volumes since 1986 followed improvements in
                                       the agricultural sector and efforts of FCS institutions to work with finan-
                                       cially stressed borrowers to improve the credit quality of their loans.
                                       Loan delinquencies declined; certain loans in nonaccrual status were
                                       completely or partially repaid; and a substantial number of loans were
                                       restructured or reinstated to accrual status. Agricultural loans are risky
                                       because their repayment depends on (1) the unpredictable nature of the
                                       agricultural business, which varies from growing crops to raising live-
                                       stock or processing food products; (2) the cash flow from the property,

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                          which can be affected by changes in federal farm policy-such as sub-
                          sidy payments-and the weather; and (3) the value of agricultural loan
                          collateral, which fluctuates relative to the income it produces.

                          F~A has established basic credit standards, but officials said that man-
                          agement varies among FCS institutions because the standards allow for
                          local adaptation to district philosophies. FCSofficials said that recently
                          improvements have been made because most institutions now evaluate
                          the cash-producing ability of the borrower’s property, in addition to the
                          highly volatile LTV ratio, the borrower’s financial condition, and other

                          The BCS have had better asset quality than the FCBS because they did not
                          have large real estate mortgage portfolios and the agricultural coopera-
                          tives to which they lend have a better record of repaying loans than
                          individual farmers with agricultural mortgage loans. CoBank also uses
                          federal guarantees as credit enhancements for part of its loan portfolio.
                          Eighty-five percent of CoBank’s international loans and 26 percent of its
                          domestic loans have federal guarantees.

Federal Home Loan Banks   The FHLBS have suffered no credit losses since their creation. This loss
                          history reflects their conservative credit standards and the use of collat-
                          eral as a credit enhancement.

                          Each FHLB establishes its credit policy under regulations and broad
                          credit policies issued by the former Federal Home Loan Bank Board and
                          adopted by the FHFB. FHFB allows each FHLB discretion as to how to
                          implement the credit policies. F+HFB officials said that FHLBS are exposed
                          to some credit risk from parties with which they do interest rate swaps,
                          but they have controls to evaluate and monitor these parties. An FHLB
                          official said that most FHLBS exceed FHFB guidelines to limit such credit
                          risk, and that all interest rate swaps are collateralized.

                          Legislation, FHFB guidelines, and FHLB policies and regulations require
                          the FHLBS to reduce their risk of loss from their advances by obtaining
                          collateral with a current market value of at least 110 percent of the
                          advance. FHLBS are permitted to set higher levels of collateral, depending
                          on the financial strength of their members. Eligible collateral, as defined
                          by statute, consists only of high quality assets such as first mortgages,
                          U.S. Treasury or agency securities, deposits at an FHLB, and a limited
                          amount of other real estate-related collateral if it is acceptable to the
                          FHLB. FHFB officials said the FHLBS determine the market value of this

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                                       collateral on a regular basis, and if the market value falls below the
                                       required level, additional collateral must be provided.

                                       Although many thrifts have failed in recent years, the FHLBS incurred no
                                       default losses. According to several FHLB officials, the FHLBS have never
                                       experienced a default-related loss on an advance because the FHLBS have
                                       always had sufficient collateral backing advances made to thrifts that
                                       later failed. As a result, they said it is in the receiver’s interest to repay
                                       such advances and assume ownership of the collateral. Furthermore,
                                       they said FHLESShave priority over most other creditors in the event of a
                                       thrift failure. Additionally, receivers have typically paid any associated
                                       prepayment fees.

Fannie Mae                             Fannie Mae’s delinquency rates have been decreasing over the past 5
                                       years. From 1980 through 1984, Fannie Mae’s delinquencies were higher
                                       than those reported by other mortgage-lending institutions in a Mort-
                                       gage Bankers Association survey of mortgage industry participants. At
                                       December 1989, Fannie Mae’s single-family delinquency rates were
                                       lower than those reported in the survey. Table 2.3 presents Fannie
                                       Mae’s delinquencies for single-family conventional fixed-rate and adjust-
                                       able-rate mortgages as a percentage of all these loans from 1985 through
                                       1989. Fannie Mae does not publicly report multifamily delinquency data
                                       comparable to the single-family data it reports. Data have been reported
                                       to investors showing that 30-day or more multifamily loan delinquencies
                                       as a percentage of the unpaid principal balance of multifamily loans
                                       have ranged from a high of about 6 percent in 1987 to about 2 percent in

Table 2.3: Fannie Mae Single Family
Conventional Mortga e DelInquenciesa   Percent of the total number of loans
(As of December 31 of I! ach Year)     -----.
                                                                                                                     Percent Delinquent
                                       Year                                                                          Portfolio        MBSb
                                       1985                                                                                  1.6                1.0
                                       1986                                                                                  1.7-__-          .--0.6
                                       1987----                                                                              1.7               0.5
                                       1988                                                                                  1.3         -~--- 0.5
                                       1989                                                                                  1.1               0.4
                                       “Includes loans delinquent 3 or more monthly payments, in relief, and in foreclosure. MBS data for years
                                       before 1988 for loans in relief only includes loans pooled from portfolio. Such data for loans pooled from
                                       lenders was not available.

                                       ‘Excludes loans where lender has primary credit risk (recourse business) and multifamily and govern-
                                       ment guaranteed loans.
                                       Source: Fannie Mae.

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                                          While both Fannie Mae’s portfolio and MBS delinquency rates have
                                          declined since 1986, its portfolio delinquencies have been significantly
                                          higher than its MBS delinquencies. Fannie Mae explained that most of its
                                          delinquent portfolio loans were originated before 1986 under its earlier
                                          underwriting standards, which did not protect against credit risk as well
                                          as current standards do. Fannie Mae officials said that its portfolio and
                                          MESSloans originated since 1985 are actually of comparable credit

                                          Fannie Mae’s average delinquency rate has historically been higher than
                                          that experienced by Freddie Mac. According to Fannie Mae officials, the
                                          difference in delinquency performance is primarily because in the early
                                          1980s Fannie Mae dealt more with mortgage banking institutions that
                                          sold it unseasoned, higher risk adjustable-rate mortgages while Freddie
                                          Mac dealt with thrift institutions that sold it seasoned, lower risk fixed-
                                          rate mortgages. Fannie Mae officials believe such differences will be
                                          much narrower in the future because Freddie Mac and Fannie Mae have
                                          generally competed for the same institutional lenders and loans since
                                          1986. Freddie Mac officials said the difference in delinquency perform-
                                          ance before 1986 resulted from using stricter underwriting standards
                                          than Fannie Mae.

                                          Table 2.4 presents Fannie Mae’s credit loss experience for the past 5
                                          years. Total losses have increased since 1985 but have remained rela-
                                          tively constant as a percentage of total mortgage unpaid principal.

Table 2.4: Fannie Mae Credit Losses (As
of December 31 of Each Year)              Dollars in millions
                                                                         Total unpaid                         Losses as a percent oi
                                          Year                               principal      Credit losses                  principal
                                          1985                               $153,663                $170                       0.11
                                          1986                                195,195                 201                       0.10
                                          1907                                239,219                 285                       0.12
                                          1988                                   282,408              315                       0.11
                                          1989                                   340,847              243                       0.07

                                          Source: Fannie Mae

                                          Fannie Mae officials said the use of recourse may be curtailed as new
                                          risk-based capital rules require mortgage lenders to hold capital for MBS
                                          for which they retain some credit risk and thus discourage lenders from
                                          selling mortgages to Fannie Mae with recourse. At the end of 1989,
                                          approximately 31 percent of Fannie Mae’s outstanding loans in portfolio
                                          and MISShad recourse. Since Fannie Mae’s charter and standards require

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                                                       lenders to provide recourse or private mortgage insurance for conven-
                                                       tional mortgages with LTV ratios greater than 80 percent, for those mort-
                                                       gages, mortgage insurance or comparable credit enhancements would be
                                                       substituted for recourse.

                                                       Fannie Mae officials said that its revised credit standards, implemented
                                                       in 1985, improved its overall credit quality. Fannie Mae’s delinquency
                                                       rates appear to bear this out. However, the loans originated since 1985
                                                       have just entered the period-3 to 6 years-in which Fannie Mae offi-
                                                       cials said defaults are most likely. The revised standards increased the
                                                       amount of income that high LTV borrowers needed to qualify for a mort-
                                                       gage loan. Other changes included limits on the amount a home seller
                                                       could contribute to the borrower’s down payment or closing costs to
                                                       ensure appraisal validity, requiring that the minimum 6 percent down
                                                       payment come from the borrower’s assets, and requiring an excellent
                                                       credit history. Fannie Mae said they assure themselves that these stan-
                                                       dards are being implemented by reviewing samples of purchased loans.
                                                       The samples are selected on the basis of loan characteristics, past lender
                                                       activities, and property location.

Reddie Mac                                             Freddie Mac’s predominant risk exposure comes from credit risk.
                                                       Freddie Mac’s delinquency and default rates have traditionally been
                                                       lower than the housing industry average and vary significantly among
                                                       mortgage product lines. Table 2.5 presents Freddie Mac’s delinquencies
                                                       from 1985 through 1989.

Table 2.5: Freddie Mac Conventional Mortgage Delinquenciesa (As of December 31 of Each Year)
Numberofloansinthousands                           -...-__-__-
                                                     Single-Family Fixed-Rate                 Adjustable-Rate                           Multifamily       -
                                                                         Percent                             Percent                                 Percent
Year                                                 Total~-loans    delinquent           Total loans     delinquent         Total loans          delinquent
1985                                                    -__
                                                                                   0.40           24               1.84                    6              0.51
1986                         __I____                         3,853
                                              -.-_____ -.._-.--                    0.37           43               1.65                    7              0.74
1987 _.___
         .__- ..__--... _-      ---.---                      4,294                 0.34           90               0.71                   10              1.22
..I  ._        _. ..-~ .-~~-___--...__-                      4,409
                                          - ___.___ -.---. __---.-^-_--.   --I__   0.33          149               0.66                   10              1.29
1989                                                         4.717                 0.35          315               0.54                   11              1.59
                                                       %cludes loans delinquent three or more payments and foreclosures   in process.
                                                       Source: Freddie Mac.

                                                       Delinquencies among the majority of Freddie Mac’s mortgages-conven-
                                                       tional single-family, fixed-rate mortgages-have declined slightly since
                                                       1985. Delinquencies on adjustable-rate mortgages, although higher than

                                                       Page 51                                          GAO/GGD99-97 Government’s Risks From GSEs
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                                           the rate for fixed-rate products, have dropped from 1.84 percent in 1985
                                           to .54 percent in 1989. Freddie Mac has had a higher delinquency rate
                                           on its multifamily mortgages than on its other mortgages. This delin-
                                           quency rate has been rising in the last 5 years. As a result, Freddie Mac
                                           decreased the maximum LTV ratio acceptable from 85 percent to 70 per-
                                           cent and requires credit enhancement for all multifamily mortgages with
                                           I,TV ratios above 70 percent. According to a February 1990 report, multi-
                                           family mortgages account for about 3 percent of Freddie Mac’s portfolio.

                                           Credit losses over the past 4 years have been the highest in Freddie
                                           Mac’s history. Table 2.6 shows credit losses as a percentage of mortgage
                                           volume over the past 5 years.

Table 2.6: Freddie Mac Credit LOSS88 (As
of December31   of Each Year)              Dollars in~____--...-
                                                                            Total unpaid         Total credit    Losses as a percent of
                                           Year                                 principal             losses                  principal
                                           1985                                 $114,529                 $42    _~----~            0.04
                                           1986                                  182,936                  53                       0.03
                                           1907                                  225,507                 144                       0.05
                                           1988                                  243,831                 165                       0.06
                                           1989                                  294,722                 207                       0.06
                                           Source: Freddie Mac.

                                           Freddie Mac officials said the large increase in losses starting in 1987
                                           resulted from timing differences based on Freddie Mac’s rapid growth in
                                           MBS, which started in 1985. They said that mortgage losses have a life
                                           cycle of low losses initially, increasing for about 5 years, and then drop-
                                           ping off for the remainder of the mortgage’s life.

                                           Freddie Mac officials said they evaluate credit risk prospectively by
                                           analyzing Freddie Mac’s current mortgages in terms of current market
                                           value LTV ratios. They said that homeowner equity is the major determi-
                                           nant of defaults. They have estimated Freddie Mac’s current LTV ratio
                                           based on indices of changing home values, not new appraisals of its

                                           During 1987 and 1988, most mortgages sold to Freddie Mac were sold
                                           without recourse. Freddie Mac faces the same situation as Fannie Mae in
                                           that the new risk-based capital standards would tend to discourage
                                           banks and thrifts from selling mortgages with recourse to Freddie Mac.

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             Freddie Mac has controls similar to those used by Fannie Mae for mini-
             mizing credit risk. In addition, Freddie Mac has published eligibility and
             reporting requirements for its private mortgage insurers and does
             annual on-site reviews of the insurers.

Sallie Mae   Sallie Mae’s cumulative student loan default rate as of December 3 1,
             1988, was 12.2 percent compared to the national average of 13.3 per-
             cent. This figure represents total defaults since inception of the program
             as a percentage of total loans that have entered repayment. Since Sallie
             Mae’s student loans are guaranteed or privately insured, default rates
             are not an accurate measure of Sallie Mae’s credit risk. Losses to Sallie
             Mae as a result of defaults have been immaterial-about      $4 million
             since 1979.

             Because most of Sallie Mae’s student loans are guaranteed by state and
             non-profit agencies and reinsured by the Department of Education,
             Sallie Mae is exposed to losses from these loans only to the extent that
             they are inadequately originated or serviced. In such cases, the govern-
             ment may not honor the guarantee. To control this risk, Sallie Mae has               ’
             standards for buying, making, and servicing its loans. Sallie Mae screens
             loans before purchasing and rejects those where the guarantee may be
             in jeopardy because of improper origination or servicing.

             Sallie Mae’s major techniques to control credit risk associated losses are
             (1) establishing servicing standards, (2) monitoring servicers, and (3)
             servicing an increasing proportion of loans in-house. Sallie Mae officials
             said Sallie Mae currently services about 60 percent of its student loans
             through its five regional servicing centers and dedicates a division to
             reviewing third party servicers. Sallie Mae also reviews the financial
             condition of all counter-parties to its interest rate swap transactions.

             Sallie Mae requires at least 100 percent collateral on its loans to lenders
             of guaranteed student loans. The collateral on these loans includes guar-
             anteed student loans, U.S. Treasury or agency securities, or other
             acceptable collateral. Sallie Mae sets the required type and amount of
             collateral based on the credit standing of the lender.

ConnieLee    Since it began providing reinsurance in 1988, Connie Lee has experi-
             enced no defaults. Connie Lee officials expect few defaults in the future
             because historically, education institution bonds that meet insurance
             standards have rarely defaulted. Connie Lee officials said that, unlike
             other forms of insurance or bank loans, municipal bond insurance is

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             written to a standard of no losses. In addition, they said that institu-
             tional bond defaults are handled differently than mortgage defaults. A
             default does not result in the whole debt becoming due. The payment of
             principal and interest is paid in accordance with the original maturity
             schedule. The maximum liability in any single year is established in
             accordance with the original schedules of the bonds-insured or rein-
             sured-and is a small fraction of the total liability. Insurers and rein-
             surers rarely pay a significant amount in claims-even after default-
             due to reliance on reserves and debt restructuring.

             As a reinsurer, Connie Lee shares the overall risk of default with the
             primary insurers. Connie Lee officials said its policy is to reinsure up to
             50 percent of default risk, and typically it bears about 10 to 20 percent
             of the total risk. They said that to control for credit risk Connie Lee
             reviews the characteristics of bonds it reinsures and evaluates and
             monitors the primary insurers’ credit policies, loss reserves, and finan-
             cial condition. S&P, a major rating agency, has approved Connie Lee’s
             credit standards as consistent with maintaining the highest rating for
             the bonds it reinsures.

Farmer Mac   Farmer Mac has not yet certified any poolers or guaranteed any loan
             pools, so it has no default experience. To limit future default risk,
             Farmer Mac has established credit, appraisal, and servicing standards
             that its program participants must follow. The standards require that
             poolers monitor the activities of lenders and servicers. In addition,
             Farmer Mac plans to review the poolers’ operations.

             To provide reserves against default losses, Farmer Mac plans to assess
             the poolers an initial fee of 50 basis points of the original security prin-
             cipal and an annual fee of 25 basis points of the unpaid principal bal-
             ance. Farmer Mac also plans to adjust the level of credit enhancement
             provided by poolers to reflect expected losses. Legislation requires that
             Farmer Mac poolers-with       optional participation by original lenders-
             establish a cash reserve fund or retain an interest in the pool equal to at
             least 10 percent of the principal amount of loans in the pool. Before the
             Farmer Mac guarantee can be used to offset default losses, full recourse
             must be taken against the cash reserves or retained interests.

             Farmer Mac officials said Farmer Mac has developed a computer-simu-
             lated stress test to analyze the financial performance of proposed pools
             of loans under historical stressful periods in agriculture. It plans to use
             the results of the stress tests to decide whether to guarantee the pool

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                and whether to require more than the minimum 10 percent reserve or
                participation interest.

                We defined business risk as the risk that factors largely beyond an
Business Risk   organization’s control could lead to unexpected changes in earnings,
                growth, or capital. Examples of external factors that pose business risk
                to the GSESinclude (1) changes in legislation or regulation governing
                their lines of business and (2) changes in demand for their products.
                GSESalso have business risk associated with operating single lines of
                business. Business risk cannot be easily measured, and many business
                risk factors are difficult to anticipate and control. The GSESappear to
                use similar methods to manage their exposure to business risk.

                All the GSESface risk associated with legislative or regulatory changes
                that could force them into new markets, eliminate old markets, or other-
                wise raise their cost of doing business. For example, Congress increased
                costs for certain GSESwhen it eliminated their exemption from paying
                federal income taxes. Current administration proposals that could
                increase costs include assessing user fees on certain GSE activities.

                GSESface business risk because of uncertainties in the markets they
                serve. Such market risks include the possibilities that demand for their
                products or services could shrink; interest rates could increase their cost
                of doing business; specific geographic regions could face serious eco-
                nomic stress and cause losses; and competitors using innovative technol-
                ogies could create new products or services that consumers prefer.

                All GSESare limited in their abilities to manage their business risk expo-
                sure by legislation that requires them to serve specific public missions.
                GSEs’ charters require that their activities, for the most part, be concen-
                trated in a single line of business, such as buying and selling residential
                mortgage loans, buying and selling guaranteed student loans, loaning to
                member institutions, making or guaranteeing agricultural related loans,
                or insuring college construction loans. These requirements for single
                lines of business prohibit the GSESfrom seeking alternative business
                opportunities to supplement, diversify, or replace current business when
                economic conditions or the promise of higher returns would lead a pri-
                vate firm into other lines of business. However, GSEScan shift assets into
                new products and investments within their given line of business.

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Methods of Managing             As indicated, GSEScannot, for the most part, control business risk fac-
Exposure to Business Risk       tors such as changing demand, competition, legislation, and technology
                                because these factors are external to the firms’ operations. However, the
                                GSEShave used techniques such as the following to manage their expo-
                                sure to external threats and react to business environment changes:

                            l   GSESattempt to influence risk from changing legislation and regulation
                                by lobbying Congress for favorable legislative treatment. Four GSEShave
                              an organizational unit specifically dedicated to congressional relations,
                              and FCS and Fannie Mae have established political action committees to
                              provide campaign contributions.
                            l GSESgenerally use economic, political, and market research data and
                              analytical information to assess their market position and to predict
                              how future conditions will affect their operations. The analysis of
                              resulting data helps managers formulate corporate strategies and mea-
                              sure their performance and customer satisfaction,
                            . GSESdevelop new products and enter new markets within their legisla-
                              tive or regulatory limitations to respond to changes in their external
                              environments and to help manage their business risk exposures.
                            . GSESdiversify geographically and, in some cases, by product line to miti-
                              gate business risk exposure. Legislation requires the GSESto operate
                              nationwide, and their geographic diversification helps them to avoid
                              large exposures to regional economic shocks. Economic downturns like
                              the late 1970s recession in the rust belt states and the 1980s recession in
                              the Southwest oil industry states often have occurred on a regional
                              basis. Some GSESalso diversify the characteristics of their products. For
                              example, nationally, FCS makes loans for different agricultural commodi-
                              ties. In addition, both Fannie Mae and Freddie Mac have diversified into
                              numerous variations of fixed-rate, adjustable-rate, and multifamily
                              mortgages. While         can diversify their product lines somewhat, all

                                GSESare limited to product lines that fall within their respective

GSEs’Business Risk              Fannie Mae, Freddie Mac, Sallie Mae, Connie Lee, one FCB, and one FHLB
Vulnerabilities                 provided us with written and verbal descriptions showing they gener-
                                ally use all the methods described above to manage business risk. As
                                discussed below, we did not find any material weaknesses in their
                                efforts to manage business risk. We did not meet with officials from all
            Y                   FCSinstitutions and all FHLBS, so we cannot make generalizations about
                                their efforts to control business risk. Nevertheless, GSES,like all financial
                                firms, cannot manage every potential risk in every possible environment
                                at all times. Because any financial firm cannot control factors external

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                                  to its organization, GSESalways will be vulnerable to certain risks. Fol-
                                  lowing are some vulnerabilities we identified as facing the GSESnow and
                                  in the near future.

Farm Credit System                A major business risk to FCS is its shrinking market and potentially
                                  shrinking market share. FCS' loan portfolio has shrunk from a high of
                                  about $82 billion in 1983 to about $49 billion at the end of 1989. How-
                                  ever, FCA officials said the shrinkage of the agricultural credit market is
                                  largely completed. The liquidity provided by Farmer Mac, which was
                                  not operating at the time of this report, may allow commercial banks
                                  easier entry into the long-term agricultural loan market, which has his-
                                  torically been dominated by FCS.

                                  FCSalso faces business risk from the unpredictable nature of the agricul-
                                  tural sector. Agriculture is subject to drought, disease, and other natural
                                  occurrences that can affect the supply of and demand for agricultural
                                  products. In addition, FCS faces certain economic risks such as decreases
                                  in the international demand for U.S. agricultural products. FCS also faces
                                  business risk such as upcoming agriculture legislation that will govern
                                  $40 billion to $50 billion in annual federal spending for the nation’s
                                  farm program. The level of federal agricultural subsidies can directly
                                  affect the ability of farmers and ranchers to repay their FCS loans.

                                  FCS must also respond to the Agricultural Credit Act of 1987 that will
                                  tap earnings to meet higher capital standards and newly levied insur-
                                  ance premiums. Failure to meet these standards would raise safety and
                                  soundness concerns and could result in FCA sanctions that could curtail
                                  growth in bank lending operations. In commenting on a draft of this
                                  report, FCA said that new operations and possible new independent
                                  funding sources for FCS associations may be a greater risk than the risks
                                  arising from the weak financial conditions of some FCS banks.

Federal HomeLoan Bank System Weaknesses in the thrift industry pose a major business risk for            FHLBS.
                                  Two FHLB officials and a FHFB written statement said that the higher
                                  thrift capital standards and other FIRREA reforms are reducing the size
                                  of the thrift industry. As a result, the FHLBS expect fewer members,
                                  expect these members to contribute less capital to the FHLBS, and expect
                                  to make fewer loans to their members. Thus, the FHLBS' interest income,
                                  capital, and ability to pay dividends may be diminished.

                                  The FHLB System also faces business risk from uncertainty regarding
                                  thrift bailout legislation. As part of FIRREA'S financing measures, the
                                  FHLB System must contribute $2.1 billion of retained earnings plus $300

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              million per year from FHLB System income for 40 years to pay the prin-
              cipal and some of the interest on bonds issued by the Resolution Funding
              Corporation to finance the liquidation of insolvent thrifts. FIRREA also
              required FI-ILBS to fund an Affordable Housing Program with at least $50
              million annually, increasing to $100 million annually in 1995. Should the
              government’s costs of rescuing the thrift industry rise above authorized
              amounts (and it appears they will), the FHLB System could be required to
              make further contributions to the rescue, although current law does not
              authorize such contributions.

              The Dallas FHLB has proposed a new program that would allow it to par-
              ticipate in thrifts’ loans to developers. The FHLB would then sell 90 per-
              cent of its participating interests in the loans to outside investors. This
              program could increase the Dallas FHLB'S risk exposure because it would
              require the FHLB to evaluate and underwrite construction loans, which
              have inherently greater credit risks than mortgages. None of the other
              FHLBS has endorsed this proposal.

Fannie Mae    The evidence indicates that Fannie Mae currently faces a variety of bus-
              iness risks. First, it operates in a constantly changing market that forces
              it to continuously develop, evaluate, and price new types of mortgages
              and securities. Most past mortgage purchases have been 30-year, fixed-
              rate mortgages which have had fairly predictable payment, default, and
              foreclosure experience. However, because new products generally have
              limited loss experience, they may result in higher risks than established
              products until adequate loss controls can be developed.

              Second, Fannie Mae faces competitive pressures from Freddie Mac. The
              ways Fannie Mae responds to any increase in competition could increase
              its overall risk structure.

              Third, although Fannie Mae’s mortgages and MBS are diversified nation-
              ally, a relatively high concentration of loans in California makes Fannie
              Mae vulnerable to regional economic shocks and local natural disasters.
              However, officials said California’s economy is more diversified than
              that of many states and California has a high number of mortgages com-
              pared to many other states.

Freddie Mac   Freddie Mac faces similar business risks to Fannie Mae’s. In addition,
              Freddie Mac faces possible changes in its operations because of uncer-
              tainty about how its new stockholders and Board of Directors will exert
              control over Freddie Mac’s business. For example, it is possible that the
              new Board, facing sharp competition from Fannie Mae, could redirect

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                  Freddie Mac’s strategic goals and operations, although the Chairman
                  believes the Board is satisfied with Freddie Mac’s traditional strategy.

Sallie Mae        Sallie Mae officials said their largest business risk stems from the highly
                  regulated nature of guaranteed student loans. The value of a student
                  loan is determined by its terms: rate structure, borrower eligibility, and
                  collection procedures. These terms are set legislatively by Congress or
                  administratively by the Department of Education, not by the market-
                  place or by Sallie Mae. For example, in 1986 Congress reduced the spe-
                  cial allowance that is used to determine the federal interest subsidy for
                  holders of student loans from 350 to 325 basis points.

                  Sallie Mae officials said that increased competition from commercial
                  banks also poses a business risk because banks are starting to retain
                  their guaranteed student loans rather than sell them to Sallie Mae.

Cbnie Lee         Connie Lee faces the same business risks and uncertainties that all new
                  businesses face. Although it has hired managers with experience in bond
                  insurance and financial services, it has little experience as an entity.
                  Also, Connie Lee plans to offer primary bond insurance soon and will
                  then have to compete with primary bond insurers with which it cur-
                  rently has reinsurance contracts.

Farmer Mac        Farmer Mac has developed underwriting standards and an operating
                  manual but has not yet begun operations. It faces an unclear market
                  with an uncertain future. Demand for Farmer Mac’s services is uncer-
                  tain, and questions exist about how the markets will respond to this new

                  Management and operations risk (subsequently referred to as manage-
Management Risk   ment risk) is the potential for losses resulting from the decisions or inde-
                  cisiveness of a company’s managers. In many respects, management risk
                  encompasses all the risks faced by corporations, including credit,
                  interest rate, and business risks. For example, since GSE managers estab-
                  lish loan standards and financing policies, their decisions determine
                  their firms’ exposure to credit and interest rate risk. Generally, man-
                  agers can expose their firms to losses through incompetence, inadequate
                  planning, poor internal controls, risky business strategies, fraud and
                  negligence, and other forms of mismanagement.

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Measuring Overall        Management risk is less measurable than credit and interest rate risks.
Management Performance   However, examining a firm’s overall performance over time provides a
                         retrospective picture of how well that firm has managed the sum of all
                         its risks. Long-term profitability is one of the best me&sures of corporate
                         performance. Specific profitability measures include net income and
                         various financial ratios such as return on average assets and return on
                         average equity. An FCS official said that, because FCSinstitutions are
                         borrower-owned, owner returns could also be provided through lower
                         initial loan rates to shareholders. In general, corporate managers seek
                         long-term improvements in their firms’ incomes and returns. However,
                         strong financial ratios do not always prove that a firm has effective
                         management, nor do weak ratios prove that a firm has ineffective man-
                         agement. Strong economic and market conditions could enable ineffec-
                         tively managed corporations to report profits, and weak conditions
                         could cause effectively managed corporations to show losses. Profit-
                         ability indicators should therefore be used in conjunction with other
                         indicators, such as evaluations of internal controls and corporate plan-
                         ning and opinions of external auditors, to measure current management

                         As figures 2.1 through 2.5 illustrate, the GSES have generally shown
                         increasing net profits between 1985 and 1989. Although FCS and Fannie
                         Mae did not post profits in every year, they have shown a general trend
                         of decreasing losses and increasing profits during this period. Because
                         net income results do not account for inflation or the size of the GSE,
                         financial analysts generally use financial ratios to judge financial
                         results, Tables 2.7 and 2.8 illustrate that these profits as a percentage of
                         average assets and average equity were generally positive but fluctu-
                         ated over time and among GSES.

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                                       Risk Identification          and Management

Figure 2.1: Farm Credit Syetem’s Net
income, 1985-l 989
                                        1000       Dollars in Millions








                                                    1985          1996   1997    1966   1989

                                       Source, Farm Credit System’s 1989 Annual Information Statement

Figure 2.2: Federal Home Loan Banks’
Net Income, 1985-l 989
                                       2009       Dollars In Mllllons









                                         0     1  1995


                                       Source: Federal Home Loan Bank Board’s 1987 Annual Report and the Federal Housing Finance Board.

                                       Page 81                                            GAO/GGD-SO-97 Government’s Risks From GSEs
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                                        Risk Identification       and Management

Figure 2.3: Fannie Mae’e Net Income,
                                        1000       Dollan In Mllllonm












                                                   1965       1985      1957   1988   1989

                                        Source: Fannie Mae’s 1989 Annual Report

Figure 2.4: Freddie Mac’s Net Income,
1985-l 989
                                        SW        Dollan In Millions











                                                  1985       1986       1987   1988   1989

                                        Source: Freddie Mac’s 1989 Annual Report.

                                        Page 62                                          GAO/GGD+W97 Govemment’s Riiks From GSEs
                                       Chapter 2
                                       Risk Identifbtion         and Management

Figure 2.5: Sallie Mae’s Net Income,
1985-l 969
                                       300     Dollara in Mllliom





                                               1955       1956        1997      1959    1999
                                       Source: Sallie Mae’s 1989 Annual Report.

Table 2.7: Return on Average Asset@
                                       In basis pointsb
                                       GSE                                   1985      1986       1987      1988         1989           average
                                       FCSc                ______.-          (322)      G-4          (3)      114          111                 (71)
                                       FHLBs                                  104       120         93         88          100                101
                                       Fannie Mae                               0         6         17         19           26                 14
                                       --______ Mac--___
                                       Freddie                                 21        16         14         15           15                 16
                                       Sallie Mae .-..
                                       -..-______-                             95        88         88         87           80                 88
                                       Banksd                                  70        63         12         82           52                 56
                                       Lame bank9                              49        55         (66)        96          11                 29
                                       “Does not include off-balance sheet assets except MBS for Fannie Mae and Freddie Mac. MBS typically
                                       has lower risk and profit margins than loans held in portfolio. Return is after taxes. Average assets were
                                       calculated by summing beginning and ending assets and dividing by two. For banks and large banks,
                                       year end assets were used.
                                       bA basis point IS one hundredth of a percentage point (1 basis point = .Ol%)
                                       “Additions to loan loss provisions were greater than net losses in 1985 and were 94 percent of net
                                       losses in 1986. Reversals in loan loss provision accounted for 97 percent and 41 percent of FCS net
                                       profits in 1988 and 1989, respectively, and reduced 1987 losses by 5184 million.

                                       “All federally Insured commercial banks

                                       eBanks with assets greater than $10 billion.
                                       Source: GAO calculations based on GSEs’ annual reports.

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                            In percent
                            GSE                             1965      1966        1967       1966       1969          average
                            FCS                             (26.6)    (27.31         (0.3)   20.0        24.1               (2.0)
                            FHLBs                            11.5      13.3          10.4     9.9        12.0              11.4
                            Fannie Mae                        (0.7)     9.6          25.1    24.9        30.7              17.9
                            Freddie Mac                      30.0      28.5          28.2    27.5        25.0              27.8
                            Sallie Mae                       19.7      21.7          27.0    30.3        28.0              25.3
                            Banksb                           11.3      10.0           2.0    13.3         8.1      ____.--- 8.9
                            Large banksC                     N/A       N/A           N/A      N/A         2.2               N/A
                            aAverage equity was calculated by summing beginning and ending equity and dividing by two. Return is
                            after taxes. For banks and large banks, year-end equrty was used. Equity capital excludes FCS’ pro-
                            tected stock for 1988 and 1989.

                            bAll federally insured commercial banks

                            ‘Banks with assets greater than $10 billion.
                            Source: GAO calculations based on GSEs’ annual reoorts

Methods Used by GSEsto      On the basis of profits and returns on assets over the last 5 years, most
                            GSESgenerally appear to have controlled their management risks by
Control Management Risk     using various available methods. However, we have no basis for deter-
                            mining whether profits resulted from effective management or other
                            factors-such as favorable economic conditions. Also, because managers
                            cannot control factors such as external economic and market shocks,
                            there is always a level of uncertainty about how well existing controls
                            will work when such shocks occur.

                            The GSESdescribed various techniques they use to control their expo-
                            sures to management risk. Previous sections discussed the methods GSES
                            used to manage or control interest rate, credit, and business risks-all
                            specific forms of management risk. This section will address the general
                            techniques to control overall management risk. These techniques include
                            (1) proper personnel practices, (2) strategic and operational planning,
                            (3) accounting and management information systems, (4) internal con-
                            trol systems, and (5) internal and external audits.

Proper PersonnelPractices   Competent, informed, and ethical managers and employees are essential
                            for protecting GSESagainst all types of risk. A corporation’s personnel
                            policies- recruiting, training, and evaluating-play    an important role in
                            controlling all corporate risks,

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                            All GSESwe visited cited hiring, training, and personnel evaluations as
                            key controls over management risk. GSEofficials said they control man-
                            agement risk primarily by selecting experienced and knowledgeable per-
                            sonnel for critical positions. The directors of most GSEShave financial,
                            legal, academic, or other specific backgrounds related to their GSE'S oper-
                            ations. Also, on the basis of our preliminary review of GSE personnel
                            qualifications and after numerous briefings and discussions with top GSE
                            managers, it appeared that the GSESwe visited generally had hired quali-
                            fied, experienced, and well-informed managers. For example, Sallie
                            Mae’s former President and Chief Executive Officer (CEO) (who recently
                            resigned) held the same position for 17 years. Also, Connie Lee’s Presi-
                            dent and CEO worked for Sallie Mae for 14 years, including 3 years as an
                            executive vice president. At the GSESwe visited, managers appeared
                            well-informed during numerous interviews. Most of the GSESoffered
                            internal or external training to improve the knowledge and skills of their
                            employees and managers.

                            Available information showed that the managements at some FCS insti-
                            tutions have not proved as effective in controlling risks as the manage-
                            ments of other GSES.We did not visit the individual FCS institutions
                            because of their number and locations. However, we reviewed Moody’s
                            October 1989 report on FCS banks and discussed FCS management per-
                            formance with FCA and rating agency officials. These sources highlighted
                            serious concerns about FCSmanagement performance. The rating agency
                            reported that FCS “has not generally been run on a very businesslike
                            basis.” FCA officials said that several FCS institutions now have CEOSwith
                            financial backgrounds but that several others still operate under man-
                            agement philosophies similar to the ones that caused large losses in the
                            mid-1980s. The officials said that, because of the cooperative nature of
                            FCS, the boards of directors that hire and fire CEOSgenerally have
                            farming backgrounds, not banking or financial backgrounds. In addition,
                            an FCA official told us that about 60 percent of FCSassets are owned by
                            institutions that are under FCA enforcement actions that require them to
                            address specific problems. Management weaknesses that resulted in
                            these problems could expose FCS institutions to serious losses. FCA offi-
                            cials also said that Agricultural Credit Act of 1987 changes to the FCS
                            structure, such as increasing lending authority at local associations,
                            could place additional risk at the local level.

Strategic and Operational   Effective planning enables an organization to visualize its future, set
Planning         ”          goals and objectives to achieve its vision, develop and evaluate alterna-
                            tive strategies to accomplish its goals and objectives, and choose an

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appropriate course of action. GSESuse long- and short-term planning
processes to accomplish these tasks to varying degrees.

We discussed the planning process with officials from six GSES-Fannie
Mae, Freddie Mac, Sallie Mae, Connie Lee, an FCB,and an FHLB-and FCA.
The six GSESused two principal types of planning-strategic      and opera-
tional. Strategic plans focused on the firms’ broader policy issues and
covered 3 to 5 years. Operational planning focused on how various com-
ponents will implement strategic objectives and usually covered 1 year.

The six GSESlimited strategic decision-making authority to senior man-
agers and boards of directors. Senior managers developed the plans and
either the top managers (i.e., the president and/or chief executive
officer) or the board approved them. FCAhas developed planning guide-
lines for FCSinstitutions, and it reviews the institutions’ plans to ensure
compliance with the regulations. FHFBalso reviews FHLBS' strategic plans
and has approval authority over their annual plans.

The six GSESwe visited had the same approval requirements for both
operating plans and strategic plans. In the operating plans, the GSES’
senior managers set corporate priorities for the year, such as which new
products the GSESwill pursue. The operating plans generally established
objectives for certain individuals or business units and provided some
measures to evaluate progress toward the goals. For example, the
annual plans of the FCBwe visited listed individual responsibilities and
deadlines for completing each planned objective. Most GSESset divisional
and departmental goals and made the division or department head
responsible for accomplishing them.

Most of these GSESused their corporate plans to evaluate actual per-
formance during the year. Some GSESreviewed divisional and corporate
performance every quarter, while others had annual reviews. GSE offi-
cials said that the performance reviews influenced decisions about com-
pensation for managers.

The GSESgenerally augmented their strategic and operational plans with
frequent operational planning sessions. Officials said that division
heads, department heads, and unit managers met regularly to discuss
production issues and plan short-term operations.

GSEmanagers also plan how their firms will handle disaster recovery
operations and data backups for automated systems to cover potential
destruction of their facilities. For example, Fannie Mae and Freddie Mac

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                            had extensive backup systems, including complete off-site duplicates of
                            records, to keep their critical automated data systems running in case a
                            catastrophe were to destroy their headquarters. All of the other GSES
                            had similar backup systems and disaster recovery plans for their auto-
                            mated systems operations.

Accounting and Management   Managers use information provided by accounting and management
Information Systems         information systems to make critical decisions. Therefore, the systems
                            must provide accurate and timely data to help managers control corpo-
                            rate risks. Senior managers use information from the databases to deter-
                            mine operating costs, forecast economic events and conditions, establish
                            budgets and objectives, monitor compliance with budgets, and compare
                            actual performance to objectives. For managers to make reliable busi-
                            ness decisions, the automated systems must produce reliable data. This
                            means that system transactions must be properly recorded, classified,
                            and reported and that accountability over assets and liabilities must be

                            All of the GSESuse automated systems for tracking information such as
                            loan characteristics and payments, monitoring loan servicing, and
                            tracking risk exposures of loans and security guarantees. For example,
                            Fannie Mae designed its LASER database to make loan management
                            easier for itself and its lenders. Officials said that LASER maintains
                            about 240 information fields for Fannie Mae’s approximately 5.5 million
                            loans, and managers can manipulate the LASER data for various pur-
                            poses. Likewise, Freddie Mac’s MIDAS system is designed to integrate its
                            entire mortgage and security processing functions from loan acquisition
                            to principal and interest receipts to investor payments. Officials said the
                            MIDAS database contains over 7 million loans and provides information
                            for functions such as pricing and default analyses.

                            Another example of how GSESuse automated systems is one FHLB'S
                            financial asset and liability management system that tracks the bank’s
                            advances to its member institutions. The system monitors data elements
                            for each loan. Bank personnel also use the system to help make loan
                            decisions and produce various marketing and forecasting reports. The
                            other GSESalso use automated systems to track operational data.

Internal Control System     An organization’s internal control system consists of policies and proce-
                            dures established by senior management to provide reasonable assur-
                            ance that specific objectives and goals will be achieved. Internal controls

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provide management with the tools to help ensure that corporate direc-
tion and control will be maintained. Management internal controls per-
tain to the economy and effectiveness of management decision-making.
Accounting controls pertain to the organization’s ability to record, pro-
cess, summarize, and report financial data accurately, promptly, and in
conformity with GAAP.Segregation of duties within an organization and
safeguarding of the assets are usually categorized as accounting

Internal control policies and procedures at the six GSESwe visited
included those that controlled credit and interest rate risk, the two most
serious risks facing GSES.Because of the magnitude of those risks, we
discussed their measurement and control in separate sections of this
chapter. The policies and procedures discussed here are primarily
accounting controls, including controls over the GSES'information

Internal control policies are needed to cover development and introduc-
tion of new products because of the uncertainties about the success of
untested products. At each of the six GSESwe visited, such policies-or,
in the case of FCSinstitutions, FCAregulations-required   testing to
verify that demand existed for the new product before the expense of
product development was incurred and that the GSEhad the capacity to
control the new business activity and associated risk. For example,
Fannie Mae officials said that they exercise control over the four risks
associated with new products- credit, pricing, legal, and systems con-
trol-by forming a production development team made up of personnel
from their operating divisions. Freddie Mac and Sallie Mae officials said
they used similar approaches for developing new products.

Placing limitations on managers’ authority, multiple reviews of con-
tracts, and segregation of duties are control policies that help ensure
that managers adhere to the organization’s credit policies. For example,
Freddie Mac and Fannie Mae limited the size of deals that their regional
account executives could negotiate with lenders, thus preventing any
one person from committing the organization to an undue amount of
risk. Freddie Mac also required its regional vice presidents to review all
contracts negotiated between the Freddie Mac account executives and
lenders. Freddie Mac and Fannie Mae segregated duties by having head-
quarters risk management officials review and approve all deals above
certain dollar amounts negotiated in the field before they became
binding. Both GSESwere organized to separate sales and marketing func-
tions from risk management, This separation was to provide a check and

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Risk Identincation   and Management

balance between the possibly conflicting missions of maximizing sales
and minimizing risk. At Fannie Mae, policy provided that any conflict
between the two divisions would be settled by the Credit Policy Com-
mittee, which is chaired by the Chief Credit Officer.

The six GSESexercised control procedures over the management of
interest rate risk by monitoring the process. As discussed earlier in this
chapter, the duration matching method is used by some GSESto manage
interest rate risk. This method does not lend itself well to control proce-
dures because it is dependent on subjective judgments and assumptions.
Officials of one FHLBsaid its internal auditors review the bank’s dura-
tion management strategy, including the reliability of the data used to
calculate duration. Officials of an FCBsaid that they exercised control by
annually contracting with a recognized outside expert to review asset
and liability matching methodology and procedures.

Since all six of the GSESrely so heavily on automated accounting and
management information systems in their operations and decision-
making, the most vital internal controls may be those that provide
assurance that the information in their systems is accurate and timely.
The six GSESused similar controls, primarily built-in edit checks, to
verify the accuracy of data in their systems. These checks prevent infor-
mation or transactions not meeting various preset conditions from
entering the systems. Transactions failing the edit checks are listed on
daily or periodic error reports and must be corrected and reentered.

Officials at Fannie Mae, Freddie Mac, and Sallie Mae told us that
accounting staff reconciled actual principal and interest receipts for
loans held in portfolio and in MBSwith expected principal and interest
receipts based on the loan terms, At Fannie Mae and Freddie Mac, unrec-
onciled discrepancies over 1 month old reflect unfavorably in accounting
staff performance appraisals. Officials from an FHLBsaid that their bank
has incorporated a number of edit checks into its data systems to iden-
tify possible errors concerning loans to member institutions. Their
system produced daily reports with details on the bank’s loans; these
reports were verified against the original transaction forms to ensure
data accuracy. Connie Lee officials said that in addition to edit checks,
Connie Lee’s small number of transactions allows its staff, if necessary,
to manually verify each transaction entering its system.

F’CAofficials said that FCSfinancial information has improved substan-
tially in the last few years. However, they still had some concerns about
the integrity of data in some FCSinstitutions’ data systems.

Page 69                               GAO/GGD-99-97 Government’s Risks Prom GSEs
                               chapter 2
                               Rbk Identlflcation   and Management

Internal and External Audits   The objectives of internal and external audits differ, but both help con-
                               trol management risk by providing assurance that internal controls
                               function adequately and that financial statements present fairly the
                               operating results and financial position of a corporation. An external
                               auditor’s primary objective in a financial statement audit is to express
                               an opinion on the financial statements of an organization. An external
                               auditor evaluates the internal controls to the extent the external auditor
                               deems necessary to comply with generally accepted auditing standards
                               but does not render an opinion on the system of internal control. An
                               internal auditor’s objectives are to evaluate the adequacy of the internal
                               controls over certain business activities and the organization as a whole.
                               In carrying out internal control evaluations, internal auditors also verify
                               that the financial transactions are recorded accurately and promptly in
                               the general ledger. Both auditors should privately report their results
                               and findings to the audit committees of the boards of directors.

                               The boards of directors, through their audit committees, should have
                               ultimate corporate responsibility for internal controls, according to the
                               National Commission on Fraudulent Financial Reporting, also known as
                               the Treadway Commission. The Commission, a multi-organizational
                               effort funded by the American Institute of Certified Public Accountants
                               and other accounting organizations, was established to respond to
                               increasing allegations of financial reporting fraud and to SECfraud
                               enforcement actions. In its October 1987 report, the Treadway Commis-
                               sion made several recommendations concerning boards of directors’
                               audit committees and corporate internal audit departments. One recom-
                               mendation was that the audit committee, as part of its internal control
                               responsibilities, should monitor compliance with company codes of con-
                               duct. The Treadway Commission also recommended that audit commit-
                               tees have necessary resources for their job and suggested that the
                               internal auditors could be their staff. The Treadway Commission further
                               recommended that audit committees be responsible for communicating
                               to senior management control weaknesses identified by the internal and
                               external auditors, The Treadway Commission viewed the audit com-
                               mittee of a board of directors as the “key to vigilant and informed over-
                               sight of the financial reporting process, including the company’s system
                               of internal control.”

                               Consistent with the Treadway Commission recommendations, according
                               to GSEand FHFBofficials, the audit committees of FHLBS,Fannie Mae,
                               Freddie Mac, and Sallie Mae are independent from top management and
                               have responsibility for internal controls, financial reporting, and conflict
                               of interest standards, In addition, Fannie Mae and Freddie Mac officials

                               Page 70                               GAO/GGD-90-97 Government’s Risks From GSEs
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Risk IdenUflcaUon and Management

said that the audit committees meet periodically with both the internal
and external auditors and top management. Officials of the three GSES
said that both internal and external auditors have direct, easy, and pri-
vate access to the audit committees.

The FCSaudit committee, based on our review of its charter, is also con-
sistent with the Treadway Commission recommendations. The com-
mittee is to be independent and is responsible for reviewing internal
controls, accounting, and financial reporting for the entire FCS.The audit
committee is to meet four times per year.

The Treadway Commission also believed that an effective internal audit
function must be independent and objective. Officials at an FCB,an FHLB,
Fannie Mae, and Freddie Mac said that their audit departments were
designed to be consistent with the Treadway Commission standards. The
auditors at these GSESand Sallie Mae used procedures designed to objec-
tively determine the GSES'riskiest business activities and targeted their
audit efforts toward those activities, Connie Lee did not have an
internal audit department,R and Farmer Mac was not operating yet.

The internal auditors’ reporting requirements appear to further demon-
strate the independence and objectivity of the audit departments. The
policies of Fannie Mae, Freddie Mac, Sallie Mae, an FHLB, and an FCB
require that audit reports be addressed to the vice president of the busi-
ness activity being audited, with copies to the GSE'Spresident and/or
chief executive officer. According to the vice presidents in charge of the
five GSES'audit departments, management must respond to any identi-
fied deficiencies, usually with a plan of corrective action. The audit
departments are to follow up on the deficiencies to ensure that correc-
tive actions are taken. In addition, the vice presidents of Fannie Mae and
Sallie Mae said their audit departments prepared reports and discussed
their report findings and follow-up results in their meetings with the
audit committees.

The education and certifications of the audit departments’ staff indi-
cated professionalism. Officials said that many of the professional staff
at Fannie Mae, Freddie Mac, and Sallie Mae had advanced degrees. Each
department also had specialized electronic data processing auditors
trained in computer programming and operating systems. In addition,

sConnie Lee’s CEO said Connie Lee employs about 26 people and has sufficient controls over accounts
and management actions so that it currently has no real need for an internal audit department.

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Risk Identification   and Management

most of the staffs had some type of professional certification, usually as
a certified public accountant (CPA).

Coordination of external auditors with internal auditors was another
recommendation of the Treadway Commission. The external auditors of
an FCB,Fannie Mae, Freddie Mac, and Sallie Mae provided a check on the
quality of the internal audit departments. According to the vice presi-
dents in charge of the four GSES'audit departments, the external audi-
tors coordinate extensively with the internal auditors and consider
internal findings and conclusions in order to avoid duplication of effort.
The FHFBsaid that FHLBS'external auditors also do these tasks. As
required by professional auditing standards, GSES'external auditors
have satisfied themselves in recent audits that the internal auditors’
work was reliable. External auditors gained this assurance by reviewing
the internal audit departments’ independence, staff qualifications, poli-
cies and procedures, and workpaper evidence.

The external auditors provided an independent review of the eight GSES'
internal controls and financial statements. However, because their
reviews of internal controls were part of a financial statement audit,
they only evaluated the controls necessary for their audit of the finan-
cial statements. The external auditors concluded that the audited finan-
cial statements of all GSESpresented fairly, in all material respects, the
results of 1989 operations and the financial positions as of December 31,

We also reviewed the most recent external auditors’ letters to the man-
agement of Fannie Mae, Freddie Mac, Sallie Mae, Connie Lee, and the
FHLBS.These letters discussed internal control weaknesses that, based on
the auditors’ judgment, require management attention. Most of the
weaknesses were related to the accounting and management information
systems, which are considered by professional auditing standards to be
a major element of a firm’s overall internal control system.

In 1988 Fannie Mae’s external auditor reported some limitations in the
Foreclosure Claims System, which is considered to be one of LASER’s
five critical applications. The auditor’s concerns included issues such as
impaired progress in charging off claims and foreclosed properties and a
lack of agreement between system summary reports and underlying
database information. Fannie Mae officials said they recognized their
system’s weaknesses before the external auditor reported them. They
said that addressing weaknesses in the Foreclosure Claims System is a
priority issue for 1990.

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               Rbk Identification   and Management

               For fiscal year 1989, Freddie Mac’s external auditors reported that
               Freddie Mac staff were not complying with some of Freddie Mac’s guide-
               lines for managing credit risk. The external auditors found that the poli-
               cies and goals in the area of credit compliance were reasonable, but the
               implementation, execution, and management of the process needed
               strengthening. They recommended that Freddie Mac management
               review the area and revise procedures appropriately. Freddie Mac’s
               management agreed with the finding and recommendation. Freddie Mac
               had also identified opportunities for improvement in credit compliance
               during a 1989 internal study. Freddie Mac officials said that action had
               been taken to correct the problems. Freddie Mac noted, however, that
               the weakness had not adversely affected its loan quality and that its
               default experience continued to be very favorable.

               The external auditors at an FHLBreported that accounting-related weak-
               nesses resulted in misstatements of $3.5 million and $6.2 million in two
               general ledger accounts at the end of 1989. While these amounts were
               not considered material with respect to the FHLB'Sbalance sheet, the
               auditors recommended that procedures be implemented at the end of
               each quarter and year-end to ensure that account amounts are properly
               recorded. The FHFBsaid that corrective actions are being implemented.

               Our review of Sallie Mae’s 1988 and Connie Lee’s 1989 management let-
               ters revealed no significant weaknesses. Connie Lee’s external auditor
               strongly recommended that automated controls be built into their auto-
               mated systems. Connie Lee officials told us that they had developed con-
               trols for both of its systems and were in the process of documenting the
               controls in an accounting procedures manual.

               We did not receive the management letter from the FCBwe visited. How-
               ever, we discussed FCS'information systems with FCAofficials. FCA'S
               examination of FCSinstitutions may include a review of automated
               system operations. FCAofficials said that FCSinstitutions do not use con-
               sistent computer systems or databases that we believe could facilitate
               oversight and provide for more consistent operations among districts.
               The officials said that FCSinstitutions have been responsive to FCA'S
               comments and suggestions for improving their automated systems, but
               the systems still need improvements.

               Our review of the information provided by the GSESon the risks they
Conclusions’   undertake, which we did not verify, uncovered nothing to indicate that
               any GSEis currently at risk of failure or serious financial losses. GSES

               Page 73                               GAO/GGD-90-97 Government’s Risks From GSEs
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basically face the same risks as other private financial institutions-
interest rate, credit, business, and management risk. Each GSEemploys a
different strategy to manage its risks. The information provided by the
GSESindicates that they are currently either avoiding certain risks alto-
gether or trying to manage the risks to maximize long-term profits.
While the various strategies employed by the GSESover time have gener-
ally been profitable, FCSencountered serious losses in the mid-1980s
because of failures to properly manage interest rate and credit risks,
and Fannie Mae reported large losses in the early 1980s caused by its
earlier interest rate risk management strategy.

Although available information indicates certain FCSinstitutions are still
having serious financial difficulties, the information provided us indi-
cates that FCSas a whole is taking steps to recover from its past risk
control problems. Information provided by Fannie Mae indicates it has
greatly reduced its exposure to interest rate risk and could withstand
large interest rate changes for several years. We plan to evaluate some
of these risk control efforts and the efforts of the other GSESin more
detail in our second report.

Although we did not identify alarming problems for the GSESin the cur-
rently benign economy and relatively good financial conditions, one
cannot assume that today’s management philosophies and financial con-
ditions are a prologue for the future. Changes in management strategies,
economic downturns, or other adverse events could precipitate future
GSElosses or even failures. Because the GSEScannot control the future,
the GSESand the government need to be prepared for any adverse
changes. The remainder of this report will discuss how well the govern-
ment and the GSESare prepared for dealing with possible problems.

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Chapter 3

Loss Reservesand Capital: Buffers Against Lms

                      When GSESexperience unforeseen losses, they depend on their capital to
                      keep from becoming insolvent. Judgments about the appropriateness of
                      capital levels are fundamentally subjective. The evidence presented in
                      this chapter suggests that GSES (1) apply different philosophies in set-
                     ting their target capital levels and (2) change their philosophies toward
                      capital levels in different circumstances. For the most part, each GSE
                     supplied us with reasonable rationale for its current capital strategy. We
                      have not yet sufficiently evaluated the capital levels held by GSES to
                     judge their adequacy for protecting the government against current
                      levels of risk.

                     For private firms without federal ties, capital holdings are usually influ-
                     enced by the credit markets. Firms with too little capital to safely cover
                     their risks pay higher prices to borrow than firms that are well-capital-
                     ized. However, GSE capital levels and risk-taking are not as well regu-
                     lated by credit markets. Except for short-term rate increases, creditors
                     have treated GSE securities as very safe investments almost irrespective
                     of the GSE'S financial health. With private creditor discipline weakened,
                     GSE Boards of Directors and managers are largely free to set levels of
                     capital as they wish unless minimum capital levels are established by
                     law or regulation.

                     The government’s interest in a GSE'S risk-taking and capital differs some-
                     what from the interest of GSE managers and owners. Both parties want
                     to avoid loss. However, the government’s primary interest is achieving
                     specific public policy purposes while GSEowners and managers, except
                     for those of FCS institutions, are primarily concerned with maximizing
                     shareholder value. In this chapter, we discuss the private mechanisms
                     for setting capital levels. In chapter 4, we discuss how the government
                     imposes capital requirements as part of its safety and soundness

                     GSESand other financial institutions   establish capital and loan loss
Current GSECapital   reserves as buffers against loss. A well-capitalized GSE can remain sol-
and Loss Reserves    vent through several years of adversity. A weakly capitalized GSE is far
                     less able to withstand adversity. The problems experienced by FCS in the
                     mid-1980s demonstrated how capital can quickly erode in certain
                     adverse economic environments. Interest rate changes and a severe
                     downturn in the agricultural economy in the mid-1980s caused losses of
                     $4.6 billion and, along with other factors such as borrower-stockholders
                     leaving FCS, depleted FCS capital to the point where government assis-
                     tance was needed to prevent the failure of several institutions. Violent

                     Page78                                 GAO/GGD-99-97Government'stikaFromGSEs
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                     Loss Reserves and Capital: Buffers
                     Against Loss

                     fluctuations in interest rates and high regional default rates also caused
                     Fannie Mae to experience losses of over $350 million in the early 1980s
                     and depleted capital to the point that, considering the market value of
                     assets and liabilities, HUD'S 1986 annual report on Fannie Mae said that
                     the estimated market value of its net worth was almost negative $11
                     billion in 1981,

                     Generally, equity capital includes stock, paid-in capital, and retained
                     earnings. Some GSES' statutes define capital to include subordinated
                     debt. Subordinated debt is like other debt, except its holders receive
                     payment only after the firm repays all its other creditors.

                     Each GSE'S senior management establishes internal capital guidelines
                     based on the GSE'S funding strategy and the nature of its operations and
                     risks. Current GSE capital guidelines are largely based on the judgment of
                     senior management and on variants of techniques used by independent
                     rating agencies to evaluate the capital adequacy of firms engaged in
                     businesses similar to those of GSES.FCS institutions, FHLBS, Fannie Mae,
                     and Freddie Mac also have minimum regulatory capital requirements.

                     GSE loss reserves are established based on past loss experience and must
                     conform to regulations and/or GAAP standards. GSESmaintain loan loss
                     reserves specifically to cover expected losses from defaults and these
                     reserves are not related to interest rate or other risks. Loss reserves do
                     not control credit risk; they provide financial reserves to cover expected
                     losses from credit risk. GSESdetermine loss reserve levels based on fac-
                     tors such as economic conditions, geographic concentrations, loan char-
                     acteristics, and historical loan loss experience. GAAP standards and
                     applicable regulatory accounting principles require that loss reserves be
                     established if losses are probable and can be reasonably estimated. Each
                     GSE'S loss reserves are reviewed by its CPA, its regulator, or both.

Farm Credit System   FCS capital differs from capital held by most financial institutions    in that
                     not all stockholder equity is at risk in the event of failure. As coopera-
                     tive owners, FCSborrowers are required to be stockholders. Before
                     October 1988, FCS associations retired the stock when the borrower
                     repaid the loan, The Agricultural Credit Act of 1987 and FCA regulations
                     require that FCS institutions can retire stock that is issued after October
                     5, 1988, only if, after the retirement, the institution’s capital will remain
                     above its regulatory capital requirement. However, the 1987 act pro-
                     tected preexisting borrower stock against loss, regardless of the finan-
                     cial condition of the institution issuing the stock. As a result, the federal

                     Page 76                                GAO/GGD90-97 Govenunent’s Risks From GSEs
Chapter 3
Loss Reserves and Capital: Buffers
Against Loss

government should consider such protected stock as actually a liability
of FCS, not a buffer against loss.

The Agricultural Credit Act of 1987 directed each bank and association
board of directors to develop a capitalization policy. These policies must
meet or exceed the minimum risk-based capital requirement set by FCA.’
Individual FCBS decide how capital will be accumulated, either by issuing
borrower stock and participation certificates, retaining earnings, or

Officials from CoBank said they set internal capital requirements based
on loan volume. CoBank borrowers must hold capital in CoBank based
on their outstanding loan volume over a period of years. CoBank’s board
of directors reviews capital adequacy and may retire stock quarterly.
The borrowers are responsible for contributing their share based on
their loan volume over a 5-year period.

FCArequires that each institution maintain adequate reserves for losses
on its loan portfolio, sales contracts, notes and accounts receivable, and
acquired properties. These reserves must be maintained according to
GAAP and regulatory accounting procedures prescribed by legislation
and FCAregulations. According to FCA, FCS institutions’ reserve policies
should include at least two elements: (1) a detailed analysis of individual
loans and acquired properties to estimate specific losses and (2) an anal-
ysis of the entire loan portfolio to estimate nonspecific losses. FCB and BC
reserves are examined by FCA at least once a year and are included in
financial statements audited by CPAS.

Table 3.1 shows FCS' total assets, loss reserves, and capital as of the end
of 1985 through 1989. Capital levels vary across different FCS

’ Regulatory capital requirements for each GSE are described in chapter 4.

Page 77                                          GAO/GGDgO-97 Government’s W&E From GSEs
                                            Chapter 3
                                            Lees Reserves and Capital: Buffers
                                            Agdnst Loss

Table 3.1: FCS Capital (As of December 31
of Each Year)
                                            -Dollars in billions
                                                                                                                                  Capital and
                                                                                                                   Capital as a reserves as a
                                                                     Total              Loss          Equity        percent of     percent of
                                            Year                    assets          reserves          capital           assets         assets
                                            1985                       $80                $3.2           $8.4               10.5                 13.9
                                            1986                       $70                $3.6           $5.6                8.0                 12.6
                                            ~--                        $62                $3.0           $5.0                8.1                 12.2
                                            1988                   __- $62                $1.9           $2.0a               3.P                  6.1"
                                            1989                       $64                $1.6           $3.8b               5.9b                 8.1b
                                            %eginning in 1988, protected stock was not considered equity capital. FCS also had $3.3 billion of
                                            protected capital.
                                            bFCS also had $1.7 billion of protected capital.
                                            Source: FCA.

Federal Home Loan Banks                     Statutory and regulatory rules, discussed in chapter 4, largely determine
                                            capital levels for FHLBS. FHFB is responsible for assuring that capital
                                            requirements are met, and each FHLB'S CPA is supposed to review capital
                                            surplus as part of the bank’s annual audit. FHLB management may, at its
                                            discretion, increase capital levels above the regulatory minimum but
                                            currently has a strong incentive not to do SO-FIRREA took most of the
                                            FHLBS' capital surplus to pay for the thrift crisis, and the government
                                            may be tempted to do so again if surplus capital is available. As dis-
                                            cussed previously, FHLBS have experienced no default-related losses.
                                            Consequently, FHLBS have not established reserves for loan losses. How-
                                            ever, the Federal Home Loan Bank Act required FHLBS to maintain a
                                            legal reserve account. FIRREA removed this requirement, effective after
                                            1991. Table 3.2 shows the FHLB System’s total assets and capital.

Table 3.2: FHLBs Capital (As of December
31 of Each Year)                            Dollars in billions
                                                                                                                                     Capital as a
                                                                                                           Total          Equity      percent of
                                            Year                   -__--.-                               assets           capital         assets
                                            i985                                                            $112            %lO.l                 9.0
                                            i986                                                            $132            $11.8                 9.0
                                            1387                                                            $154            $13.7                 8.9
                                            1988                                                            $175            $15.5                 8.9
                                            1989                                                            $180            $14.2                 7.9
                                            Source: FHLB System’s Office of Finance

                                            Page 78                                              GAO/GGD-90-97 Government’s Risks From GSEs
             Chapter 3
             Loee Reserves and Capital: Bul’fere
             Against Lose

Fannie Mae   According to Fannie Mae officials, Fannie Mae uses stress tests as guide-
             lines for setting risk-based capital. In particular, Fannie Mae runs stress
             tests involving a severe depression and high levels of defaults in the
             housing market (credit risk stress test) and a sharp increase in interest
             rates (interest rate risk stress test). The capital guideline is established
             by first determining the amount of total capital needed to “pass” both
             the credit risk and interest rate risk stress tests. Senior managers then
             consider other factors not covered in the stress tests, such as business
             risk, and set actual capital targets.

             Fannie Mae tests its capital adequacy for credit risk by applying the
             effects of the default experience for its Texas mortgages originated in
             1981 and 1982 to its entire portfolio and MBS.~ According to Fannie Mae
             officials, applying that default experience to its current mortgages
             results in a 9 percent nationwide default rate. Fannie Mae uses the level
             of capital necessary to survive this “Texas-like” depression nationwide
             as the appropriate capital level for credit risk. Fannie Mae officials said
             they have more than enough capital to withstand this stress.

             Fannie Mae also runs several simulations of rapid and sustained
             increases in interest rates (described in ch. 2) to test its capital adequacy
             in such environments. For each simulation, Fannie Mae officials
             reported an overall positive net interest margin during each year of the
             5-year period analyzed.

             Fannie Mae’s loss reserve policy is to base the amount of loss reserve on
             the risk characteristics of the loan type: government insured or guaran-
             teed, single-family, or multifamily. Fannie Mae estimates and provides
             for conventional, single-family losses at the time of loan purchase or
             during the first several years following issuance of ME% According to
             Fannie Mae, it adjusts reserves to ensure that they are appropriate.
             Fannie Mae’s reserves are to be reviewed as part of its annual audit by a

             ‘Since nearly all the mortgages that Fannie Mae purchased that originated in Texas in those years
             were 36year fixed-rate mortgages, it uses default and prepayment experience of those mortgages to
             derive default rates for each product type in this stress test, The percentage default rates experl-
             enced by Fannie Mae on such loans through September 30,1989, and projected lifetime, by LTV at
             time of origination, are:

             LTV rate:                                z-90   >80r90      >75180      >70576      >60570       ~60

             Default rate:                            25.4        14.2         9.0         3.8         1.9     0.7

             Projected lifetime:                      28.0        16.0        10.0         4.5         2.2     0.8

             Page 79                                           GAO/GGD-90-97 Government’s Risks From GSEs
                                                      Chapter 3
                                                      Loss Reeervm and Capital: Buffers
                                                      Against Lose

                                                      Table 3.3 shows Fannie Mae’s total assets and MBS, loan loss reserves,
                                                      subordinated debt, and equity capital. Fannie Mae recently announced
                                                      its plans to increase its equity capital and loan loss reserves by about $2
                                                      to $2.5 billion during 1990 and 1991.

Table 3.3: Fannie Mae Capital (As of December 31 of Each Year)
Dollars in billions
                                                                                                                         subordinated debt,
                                                                                                          Capital as a      and capital as a
                                     Total assets               Loss Subordinated         Equity     percent of assets    percent of assets
Year                  .~   -~           and MBS             reserves         debt         capital            and MBS               and MBS
1985                                           $154              $0.2           $2.1         $1 .o                0.66                   2.2
1986                                           $195
                                ..-.-~-_________                 $0.3           $1.8         $1.2                 0.61                   1.7
1987                                          $239               $0.3           $2.1         $1.8                 0.76                   1.8
1988                                          $282               $0.4           $2.6         $2.3                 0.80                   1.9
1989                                          $341               $0.5           $2.3         $3.0                 0.88                   1.7
                                                      Source: Fannie Mae.

Freddie Mac                                           Freddie Mac officials said economic stress tests offer the best measure
                                                      of Freddie Mac’s risk and capital adequacy. Freddie Mac’s goal is to sur-
                                                      vive during these simulations for at least 7 years, the equivalent of a
                                                      high-quality investment-grade credit rating. Freddie Mac officials use
                                                      the results of these stress tests and their considerations of other factors
                                                      not incorporated in the stress tests to set Freddie Mac’s capital target.

                                                      Freddie Mac uses a modified version of Moody’s depression scenario to
                                                      test its ability to survive massive credit losses in a severe economic envi-
                                                      ronment. Instead of the Texas default rate, falling housing prices and
                                                      declining interest rates drive Freddie Mac’s depression scenario-prices
                                                      fall 10 percent per year for 4 years. The depression environment gener-
                                                      ates damaging defaults and prepayments. According to Freddie Mac
                                                      officials, running the scenario with year-end 1989 data, it survived for
                                                      10.6 years, sufficient for the highest quality investment-grade credit
                                                      rating. Freddie Mac also runs a stress test for a high interest rate envi-
                                                      ronment. Because it passes nearly all interest rate risk on to investors
                                                      who purchase MBS, Freddie Mac easily passes this test.

                                                      Freddie Mac calculates default loss reserves for different loan types
                                                      with the riskier loans requiring greater reserves. Multifamily loans are
                                                      considered to be the riskiest and have the highest reserve. Single-family

                                                      Page 80                                   GAO/GGLMO-97 Govemment’s Risks From GSEs
                                                Chapter 3
                                                Loss Reserves and Capital: Buffers
                                                Against Loss

                                                adjustable-rate loans require the next highest reserves, and single-
                                                family fixed-rate loans require the lowest reserve level. As with the
                                                other GSES,Freddie Mac’s reserve levels are subject to audit as part of its
                                                annual external audit, Table 3.4 shows Freddie Mac’s total assets and
                                                ME%and its loan loss reserves, subordinated debt, and capital.

Table 3.4: Freddie Mac Capital (As of December 31 of Each Year)
Dollars In billions
                                                                                                                   subordinated debt,
                                                                                                    Capital as a    and capital as a a
                                 Total assets             Loss Subordinated           Equity   percent ;ffdsfse;    percent of assets
Year                    -   ..-~.--- and MBS          reserves         debt          capital                                 and MBS
1985                                    $116               $0.2            $1 .o        $0.8                0.67                   1.7
1986                                    $192               $0.3            $2.0         ii.0                0.50                   1.7
1987                                    $238               $0.3            $2.1         $1.2                0.50                   1.5
1988                                    $261               $0.4            $2.0         $1.6                0.61                   1.5
1989                                    $308               $0.5            $2.0         $1.9                0.62                   1.4
                                                Source: Freddie Mac.

                                                Beginning with its 1989 third quarter results, Freddie Mac made its
                                                market value balance sheet public. At the end of 1989, it estimated a
                                                market value net worth of $4 billion after taxes, compared to a book
                                                value net worth of $1.9 billion. The difference arose mostly from
                                                Freddie Mac’s valuation of the future stream of guarantee fees from its
                                                existing MBS. Freddie Mac strongly believes the market value net worth
                                                is a more accurate reflection of its ability to absorb losses than the book
                                                value of its capital. Freddie Mac also advocates the use of mark-to-
                                                market accounting for regulatory purposes. Because nearly all of
                                                Freddie Mac’s business is guaranteeing MBS, its balance sheet does not
                                                fully reflect the value of its off-balance sheet activity.

Sallie Mae                                      Sallie Mae’s senior officials said their principal consideration in deter-
                                                mining capital adequacy is the highest quality investment-grade credit
                                                rating. Sallie Mae determines its necessary capital level primarily
                                                through discussions with rating agencies, investment banking firms, and
                                                by monitoring its stock price and earnings per share. According to Sallie
                                                Mae officials, inappropriately high capital levels disadvantage stock-
                                                holders by reducing their return on investment, and inappropriately low
                                                capital levels disadvantage creditors by increasing the risk of losses on
                                                their investment. In either case, they said the private market would

                                                Page 81                                    GAO/GGD99-97 Government’s Bisks From GSEs
                                             Chapter 3
                                             Loss Reserves and Capitak Buffers
                                             Against Loss

                                             force Sallie Mae to make adjustments to form a balance between the two
                                             types of investors. As discussed later in this chapter, we believe GSES'
                                             ties with the government affect creditor behavior, thus allowing stock-
                                             holders to obtain low credit costs without maintaining capital levels nor-
                                             mally required by creditors. However, representatives of the rating
                                             agencies said that Sallie Mae’s capital is currently high enough to obtain
                                             a high investment-grade rating independent of its agency status. We
                                             have not formed an opinion on the adequacy of Sallie Mae’s capital.

                                             According to Sallie Mae officials, some student loans may not be prop-
                                             erly serviced and will not qualify for federal or state insurance. Based
                                             on past experience, Sallie Mae believes that losses resulting from the
                                             failure to qualify for insurance will be immaterial, but they maintain a
                                             loss reserve of about $12 million based on these expected losses. Table
                     *i                      3.5 shows Sallie Mae assets, subordinated debt, and capital.

Table 3.5: Sallie Mae Capital (As of December 31 of Each Year)
Dollars In bdlions
                                                                                                                   Subordinated debt
                                                Total    Subordinated            Equity     Capital as a percent     and capital as a
Year                                          assets              debt           capital               of assets    percent of assets
1985                                             $14                 $0.2           $0.7                     4.7                  6.1
1986                                             $18                 $0.2           $0.7                     3.6                  4.7
1987                                .~     -_ . .$23
                                                   .             --- $0.2           $0.7                     3.0                  3.9
1988                                             $29                 $0.2           $0.8                     2.8                  3.5
1989                                             $35                 $0.0           $1 .o                    2.9                  2.9
                                             Source: Salhe Mae

Connie Lee                                   Connie Lee’s senior management said that state insurance regulators set
                                             capital ratios to ensure the adequacy of capital to meet claims. However,
                                             the credit rating agencies generally apply more stringent capital guide-
                                             lines to bond reinsurers before they will give them the highest credit
                                             rating. These guidelines result in higher capital requirements than the
                                             state regulatory minimum so Connie Lee’s capital policy is almost
                                             entirely driven by its credit rating. According to Connie Lee officials,
                                             Connie Lee cannot function as a primary insurer or reinsurer without
                                             the highest credit rating because capital markets for such bonds gener-
                                             ally do not support a bond backed by less than the highest investment-

                                             Page 82                                        GAO/GGD90-97 Government’s Risks From GSEs
                         Chapter 3
                         JAWSReserves and Capital; Buffers
                         Against Less

                         Connie Lee contracts with a major rating agency to conduct a formal
                         credit evaluation. S&P evaluates Connie Lee like it evaluates other
                         municipal bond insurers. Within the evaluation, S&P subjects Connie Lee
                         to a simulated “worst case” environment, where Connie Lee’s portfolio
                         of assets lose value either through reduced future cash flows or a reduc-
                         tion in the market value of its collateral. The test measures total capital
                         needed for transactions that are already insured and for anticipated
                         future business. Officials from both S&P and Moody’s agreed that the
                         rating given Connie Lee, unlike those given other GSES,is independent of
                         any association with the federal government. They said Connie Lee’s
                         rating is done on the same basis and with the same criteria as that
                         applied to fully private bond reinsurers.

                         Connie Lee officials said that when they believe bond defaults are prob-
                         able, a provision for unpaid claims and claims adjustment expense sim-
                         ilar to a loss reserve will be made. To date, no claims or claims
                         adjustment provisions have been made. Also, Connie Lee is required by
                         state law to hold a contingency reserve for losses. As of December 3 1,
                         1989, Connie Lee was exposed to about .$1.7 billion of bond reinsurance
                         and had shareholders surplus and contingency reserves of $54 million.

Farmer Mac               Farmer Mac accumulated start-up capital through the sale of common
                         stock to eligible commercial banks, insurance companies, and FCS institu-
                         tions. The initial stock sale yielded approximately $22 million in capital.
                         According to Farmer Mac officials, their current plans for requiring
                         credit enhancements and reserves should prevent Farmer Mac from suf-
                         fering losses greater than the guarantee fees and credit enhancements it
                         will receive from poolers and lenders, Farmer Mac has not reserved for
                         expected losses because it has not, yet guaranteed any securities.

                         GSES' risk-taking   and capital adequacy are not disciplined to the same
Creditor Discipline of   degree that creditors discipline fully private firms. Because GSEShave
GSECapital and Risk-     ties to the government, rating agencies and creditors believe that the
Taking Weakenedby        federal government would likely assist the GSESthrough any financial
                         difficulty. Such assistance is expected to insulate creditors against
Government Ties          losses. In effect, the marketplace will allow a GSEto undertake risky
                         activities at less cost than would otherwise be assessed because credi-
                         tors believe that the government, not they, will suffer any resulting
             ”           losses. This situation is somewhat analogous to federally insured deposi-
                         tory institutions where depositors know their insured funds are safe

                         Page 83                              GAO/GGD-90-9’7 Government’s Risks From GSEs
                             Chapter 3
                             Loss Reserves and Capital; Buffers
                             Against   Loss

                             and know they need not be concerned about risky activities by the insti-
                             tutions.:’ This creditor behavior reduces the incentives for GSE managers
                             to increase capital levels as the level of risk rises.

Rating Agenci.es             Two major rating agencies, S&P and Moody’s, categorize the credit
Influenced by Federal Ties   quality of GYE senior debt securities they rate as equivalent to that of the
4-n                          highest quality securities issued by private firms. However, S&P’s cri-
t/v fLc?l7c?
    UUU~                     teria rely heavily on the GSES’ links to the federal government and past
                             evidence of government support. Moody’s ratings also include a detailed
                             analysis of the government’s relationship to each GSE. Moody’s said they
                             rate the senior debt of some GSES as the highest quality, in part because
                             they expect the government to assist a troubled GSE’S creditors.4 Were
                             these rating agencies to apply a credit assessment without considering
                             the government ties, only Connie Lee and probably FHLBS and Sallie Mae
                             would earn the highest rating.

                             Both S&P and Moody’s rate debt securities on a relative scale of default
                             risk for investors. They typically base their ratings for financial institu-
                             tions on asset composition and quality, management of interest rate risk,
                             liquidity, earnings trends and profitability, relevant economic forecasts,
                             quality of overall management, and capital adequacy. While GSESdo not
                             typically contract with private rating firms, S&P and Moody’s often rate
                             GSES’ senior debt securities as a service to, or at the request of, investors.

                             Both S&P and Moody’s officials said that the GSES' links to the govern-
                             ment influenced the rating that these firms receive, in some cases more
                             than others. GSE securities typically include disclaimers saying that such
                             securities are not backed by the full faith and credit of the U.S. govern-
                             ment. However, the rating agencies believe the government would assist
                             a GSE whenever its financial viability is threatened because (1) the gov-
                             ernment would feel a moral obligation to assist the GSES it has created;
                             (2) the GSES have dominant roles in national housing, education, and
                             agricultural finance that would be missed; and (3) domestic and interna-
                             tional banks and other investors that hold GSE debt securities would
                             pressure the government to prevent default. For each individual GSE,

                             “For a more detailed discussion of the lack of depositor discipline, see Deposit Insurance: Analysis of
                             Reform Proposals (GAO/GGD-86-32A, Sept. 30,1986).

                             ‘A Moody’s official noted that it is not unusual for government ties to affect ratings of other private
                             firms when there is a perception of government support for those firms. For example, the ratings of
                             large banks may be affected by perceived government support for their continued operation.

                             Page 84                                            GAO/GGD90-97 Government’s Risks From GSEs
                             Chapter 3
                             Lose Reserves and Capital: Buffers
                             Algahst Lose

                             this assessment is based on a review of the GSE'S legislation, its impor-
                             tance to the economy, the strength of its political constituency, and any
                             previous assistance provided by the government. Even when FCS and
                             Fannie Mae experienced serious financial difficulties, the credit quality
                             of their senior debt securities continued to be assessed as the highest

                             The rating agencies have testified publicly and told us privately that
                             without federal ties the senior debt securities of several GSES would be
                             considered less than the highest quality investments.” Based on informa-
                             tion provided by the GSES, regulators, and others, Moody’s and S&P offi-
                             cials told us that FHLB System and Sallie Mae senior debt securities
                             would be at the high end of investment-grade. They said Freddie Mac
                             and Fannie Mae senior debt securities would be at the lower end of
                             investment-grade. Both rating agencies perceived Freddie Mac’s debt
                             securities to be somewhat safer, without federal ties, than Fannie Mae’s.
                             FCSdebt would rate at the high end of speculative-grade. Neither agency
                             has rated Farmer Mac because it has not yet guaranteed securities.

                             Connie Lee contracts with S&P to receive a rating in the same way fully
                             private commercial bond insurers do.” In S&P’s opinion, the ties between
                             Connie Lee and the government do not indicate a likelihood that the gov-
                             ernment would assist the firm should it become financially troubled.
                             Consequently, Connie Lee’s AAA rating is based on S&P's assessment
                             that the firm has high quality management and sufficient capital to
                             meet its commitments as a bond reinsurer in a worst case scenario.
                             Moody’s has not issued a rating on Connie Lee.

Creditor Behavior            The GSESborrow funds at rates that suggest that creditors believe GSE
Indicates Federal Ties Are   securities to be quite safe. Analysts and GSE officials explain that credi-
                             tors expect a GSE would likely receive federal assistance should one
Key                          become seriously troubled. Consequently, creditors do not discipline the

                             “Both rating agencies use an alphabetic scale to rate bonds There are two general categories of
                             investment. The lower-risk/higher-quality category is called investment-grade. For example, S&I’
                             bond ratings from the highest to lowest investment-grade are AAA, AA, A, and BBB. Riskier catego-
                             ries of bonds are called speculative-grade. S&P’s alphabetic range from highest to lowest grade of
                             speculative debt are BB, B, CCC, CC, C, and D. Moody’s investment-grade ratings are Aaa, Aa, A, and
                             Baa, and their speculative-grade ratings are Ba, B, Caa, Ca, and C. Moody’s describes an Aaa rating as
                             meaning the interest payments are protected by a large or exceptionally stable margin and the prin-
                             cipal is secure. Further, foreseeable changes are unlikely to impair the fundamentally strong position
                             of such bonds.
                             “Most of the individual FHLBs also contracted with a rating agency to obtain a rating on letter of
                             credit obligations.

                             Page 86                                           GAO/GGD-90-97 Government’s Risks From GSEs
AI#irwt Ibe6

risk-taking or capital levels of GSES as rigorously as completely private
firms. For example, when Fannie Mae and FCSbecame financially
troubled, their borrowing costs rose temporarily, indicating some mea-
sure of creditor uncertainty about federal assistance. Overall, however,
each was able to continue to borrow at relatively favorable rates.

By comparing issuers’ costs of funds, one can get a sense of the market’s
perception of a security’s risk. When a GSE issues a debt security to
finance its activities, it pays creditors interest on the funds borrowed.
These interest costs, called “cost of funds” for the GSE, or alternatively
“yield” to the investors, are a measure that can be used to gauge
investor perception of the risk of any given security. The best compari-
sons among securities can be made when other characteristics that could
influence the cost of funds-such as the maturity and issue date of the
security-are    similar or nearly identical.

Creditors obtain information on the risk of losses arising from a firm’s
potential failure to repay its borrowings from several sources, including
the financial firm itself, security analysts, and rating agencies. Two pri-
mary considerations for creditors are the firm’s overall risk exposure
and the adequacy of its capital to protect against such risks. Other
things being equal, as the level of risk increases, creditors demand
increasingly higher yields on their investment, higher levels of capital,
or both. Creditors may refuse to extend further credit when repayment
seems uncertain. Consequently, creditors provide a level of discipline to
most financial firms seeking to borrow at reasonable rates by
demanding increased capital when they increase their risks.

To determine how creditors treated GSE debt, we reviewed data on GSES'
cost of funds over the 1980s provided by the GSES as well as cost of
funds data provided by Salomon Brothers, Inc., an investment firm. The
data generally indicate that GSES borrow funds at rates above those on
U.S. Treasury securities. GSE debt costs were generally comparable to
fully private AAA firms, ranging from 30 basis points less to 30 basis
points more than those paid by AAA firms.

In our view, the noteworthy evidence from examining GSES' costs of
funds is that creditors do not react to deterioration in the financial con-
dition of a GSE the same way they react to a similar change in a private
firm. Creditors have demanded a higher return when they learn of dete-
rioration of a GSE'S financial condition, but the GSES have retained their
AAA ratings, and creditors have continued to purchase debt securities
even when the GSES were in serious financial difficulty. For example,

Page86                               GAO/GGD90-97Govemment'sRiskaFromGSEs
Chapter 8
LQSSReserves and Capital: Buff’em
Against Loss

figure 3.1 shows Fannie Mae’s cost of funds for 3-month debt obligations
from 1980 to 1989. When interest rates rose in the early 19809, Fannie
Mae sustained large losses. According to a 1986 HUD report, the esti-
mated market value of Fannie Mae’s net worth was almost negative $11
billion in 1981. During these years, its spread over Treasury securities
temporarily increased-at one point reaching 200 basis points. Fannie
Mae, however, was able to continue borrowing, raising about $31 billion
in bonds and debentures and over $64 billion in short-term notes during
 1981 and 1982. During this time, Fannie Mae actually increased its bor-
rowings because it wanted to purchase a high volume of high-yielding
mortgages as part of its strategy to reverse its losses. In our view, com-
pletely private firms facing similar financial problems would have
needed federal guarantees to find such willing creditors and avoid

Figure 3.1 shows similar widening of FCS spreads when several of its
institutions were in danger of failing during the mid-1980s. FCS’ 1985
losses were $2.7 billion, and its 1986 losses were $1.9 billion. FCS costs
on 6-month debt obligations reached about 85 basis points above compa-
rable Treasury securities in the fall of 1985 before the Farm Credit
Amendments of 1985 were enacted, and then peaked again at roughly
 115 basis points over Treasury securities for short-term debt before a
financial assistance package became law in January 1988.

Page 87                             GAO/GGD-9087 Government’s Risks From GSEs
                                                           Lose Reserves and Capital: Buffem
                                                           Against L4Em

Figure 3.1: FCS and Fannie Mae Cost of Funds Relative to Comparable Treasury Debt
200        Beala Pointe Ovr Tryrury                Dob~
160                                      I'
                                        ' :
                                        I I
                                        1 I
                                        1 I
                                       1    I
                                       1    1
140                                   1      I
                                      '       I
                                     I        I
                                     I        I
120                                 .1         I

 80              I
      1;          I
      'I           '
 w\                 '



  lse0                       1881                   1982   1963          1984            1966           1086         1987         1888        1989
           -              FCS Short Term Debt
           -I      I, -   Fannie Mae Short Term Debt

                                                           Source: GAO, based on data from FCA and Fannie Mae

                                                           These data indicate some degree of creditor uncertainty about the ulti-
                                                           mate outcome of the particular GSE'S stress, including uncertainty over
                                                           the actual nature of a possible federal response. We believe, however, as
                                                           others have said before, that Fannie Mae and FCSwould have faced
                                                           much higher costs of funds or been denied credit entirely during their
                                                           periods of stress without the likelihood of federal assistance. We find
                                                           this situation somewhat analogous to federally insured banks and

                                                           Page 88                                       GAO/GGD-90-97Government’s Riska From GSJ%
              Chaptar a
              Leea Reee~ea and Capitak Buffers

              thrifts that, despite being insolvent, were able to continue obtaining
              deposits and taking risks in a last-ditch effort to recover their depleted
              capital. In that case, creditors (depositors) knew that explicit federal
              guarantees protected their insured funds regardless of the risks under-
              taken by the bank or thrift.

               The GSE9 establish their capital levels on the basis of both private and
Conclusions    regulatory considerations. We discuss the regulatory considerations in
               chapter 4. The private considerations have led to various capital levels
               among the GSES.We did not develop a basis sufficient to form an opinion
               on the adequacy of current capital levels for protecting the govern-
               ment’s interest. However, each GSE supplied us with reasonable rationale
               for its current capital strategy from a private standpoint. Fannie Mae
               and Freddie Mac generally based their private capital targets on the sub-
              jective judgments of their managers, guided by capital adequacy tests
              similar to those used by credit rating agencies. Sallie Mae based its
              target on its management’s judgment and discussions with rating agen-
              cies. The capital levels for FCS and FHLBS were primarily influenced by
              legislation and regulation. Connie Lee generally operates within capital
              adequacy limits established by S&P. Farmer Mac had not started oper-
              ating, and thus its capital level could not be evaluated.

              The GSESestablish loss reserves by comparing the characteristics of cur-
              rent assets and MBS with historical losses. We did not form an indepen-
              dent opinion on the adequacy of these reserves but noted that the
              reserve levels, if any, are subject to audit by independent CPAS for all
              GSESand by federal regulators for FCS and FHLB System institutions.

              GSES' ties with the government have weakened the discipline that credi-
              tors normally provide to completely private financial firms. In some
              cases, creditors accept lower interest rates from a GSE'S debt securities
              than they would normally accept given the GSE'S capital and risk levels.
              They also have continued to lend to GSESthat were encountering severe
              financial stress and were perceived as in danger of failing. These actions
              reduce the incentives for GSE managers to increase capital as risks
              increase because the cost of debt does not rise concurrently with the
              level of risk.

              Page 89                              GAO/GGD-90-97 Government’s Risks From GSEs
Chapter 4

Federal GovernmentInadequately Monitoring
Risks and Capital of Fannie Mae,Freddie Mac,
and Sallie Mae
                             Fannie Mae, Freddie Mac, and Sallie Mae are not subject to (1) adequate
                             federal monitoring of their risk-taking, (2) minimum capital rules that
                             are risk-based, or (3) adequate enforcement authorities. We are con-
                             cerned that the government would not be prepared to prevent or miti-
                             gate losses from a future crisis facing Fannie Mae, Freddie Mac, or Sallie

                             Unless the government oversees GSE risk-taking and capital levels, it has
Why GSE Risk-Taking          little capability to prevent taxpayer losses that may arise from GSE
and Capital Should Be        failure.

The Government Has           In the past, the government has provided assistance to GSES, private
Assisted i’roubled GSEs      nonfinancial firms, and large banks facing financial difficulties even
                             when not legally obligated to do so. Such action suggests that in certain
and Other Large Firms and    circumstances the government was unwilling to suffer the consequences
Municipalities in the Past   of these firms’ failures,

                             Legislative and regulatory relief along with lower interest rates and a
                             new business strategy helped Fannie Mae recover from financial diffi-
                             culties it experienced in the early 1980s. Fannie Mae reported losses in
                             1981, 1982, 1984, and 1985 totaling over $350 million.’ Fannie Mae did
                             not request financial assistance from the Treasury. However, in October
                             1982, legislation was enacted that lengthened the tax loss carryback
                             period for Fannie Mae, permitting earlier recovery of taxes previously
                             paid and resulting in tax benefits its officials estimated at $25 million.
                             Such action decreased federal revenue from what it would have other-
                             wise been. HUD also decreased Fannie Mae’s minimum capital require-
                             ment at the time of its difficulties by increasing Fannie Mae’s maximum
                             debt-to-capital ratio from 25:l to 30:1, indicating its willingness to for-
                             bear during Fannie Mae’s time of stress,

                             The agricultural recession and high interest rates during the early 1980s
                             created an FCScrisis that was exacerbated by management weaknesses.
                             Several FCS institutions were nearly insolvent, and some failed. FCS as a

                             ‘In December 1986 the Financial Accounting Standards Board issued FAS 91, which requires that
                             most commitment fees be treated as an adjustment to interest income and amortized over the life of
                             the related mortgages. Accordingly, Fannie Mae acljusted its 1986 commitment fees retroactively,
                             which resulted in a $7 million loss in 1985.

                             Page 90                                          GAO/G&D-SO-97 Government’s Risks From GSEs
                       Chapter 4
                       Federal Government Inadequately
                       Monitoring Risks and Capital of Fannie Mae,
                       Freddie Mac, and Sallie Mae

                       whole reported losses totaling $4.6 billion from 1986 to 1987. Legisla-
                       tion enacted in 1988 authorized up to $4 billion in federally guaranteed
                       bonds for FCS institutions-$1.2   billion had been used as of June 12,
                       1990. Also, in the 198Os, reforms were enacted to strengthen FCA'S regu-
                       latory effectiveness and lessen the need for future federal assistance.

                       The government has also assisted certain troubled corporations and
                       municipalities- e.g., Chrysler, Lockheed, Conrail, and the City of New
                       York-when      no federal obligation existed. Furthermore, federal bank
                       regulators have chosen to provide financial assistance to large, failing
                       banks rather than suffer the aftershocks of a large bank’s liquidation.
                       Their actions have provided de facto protection to some creditors
                       without deposit insurance.

                       The appropriateness of such financial assistance has been strongly
                        debated. On one hand, such assistance is thought to undermine the disci-
                        plining forces involved in failure-particularly  the weeding’out of eco-
                        nomically inefficient firms. On the other hand, assistance is often
                       justified as preventing the potentially damaging and costly aftershocks
                        of such a failure.

ReasonableChance of    For private firms without federal ties the government could choose to do
                       nothing about impending failure, allowing creditors and bankruptcy
Future Assistance      courts to resolve various claims, For GSES,the.government would need to
                       respond in some affirmative way-by either helping the troubled GSE or
                       acting to close it. We believe that assistance will be viewed as a viable
                       option because allowing a GSEto fail would threaten its public policy
                       mission and would possibly threaten the solvency of other financial
                       institutions that invest in GSE securities.

Resolving GSE Crisis   The government would likely become involved in a future GSE crisis
                       because there are no clear-cut legislative or regulatory mechanisms to
                       resolve certain GSES’ financial difficulties. Fannie Mae, Freddie Mac, and
                       Farmer Mac cannot be dissolved unless by action of law. Each of these
                       three GSEScould request that Treasury exercise its authority to purchase
                       GSE obligations, but the Secretary’s authority is discretionary for all GSES
                       but Farmer Mac. A Treasury official told us that decisions to purchase a
                       GSE'S obligations would be made on an ad hoc basis when requested and
                       that there are no rules or procedures governing the extension or denial

                       Page 91                                       GAO/GGD-90-97 Govemment’s Risks From GSEs
    Chapter 4
    Federal Government Inadequately
    Monitmlng Risks and Capital of Fannie Mae,
    Freddie Mac, and Sallie Mae

    of such a line of credit. Fannie Mae, Freddie Mac,2 and Farmer Mac have
    never used their Treasury lines of credit in an emergency situation.
    However, Fannie Mae used its line of credit to assist in its transition
    from public to private status in 1968.3

    Certain    GSES can     be assisted or closed by their regulators. For example,

l ncs, FCBS, and their related associations, when facing financial difficul-
  ties, can request financial assistance from the FCSAssistance Board.
  Four institutions have been granted such assistance. If assistance is
  denied, an insolvent institution can be placed under conservatorship or
  receivership by FCA, which then assigns the affected territory to another
  institution. After 1992, the FCS Insurance Corporation will have the
  authority to provide assistance to troubled FCS institutions. The Insur-
  ance Corporation will be largely funded with premiums assessed on                                  FCS

  institutions. The Insurance Corporation will insure the timely payment
  of principal and interest on System debt obligations. Joint and several
  liability of System institutions will be maintained but will be triggered
  only if all the monies in the insurance fund are exhausted.
. FIIFB has authority to liquidate or reorganize any FHLEL FHLBS could also
  request to use their Treasury line of credit, No FHLB has been liquidated
  or reorganized because of financial difficulty by FHFB or the former Fed-
  eral Home Loan Bank Boarda
. Connie Lee’s insurance subsidiary must be licensed by state authorities
  to offer insurance, and any state can withdraw its license. The assets of
  Connie Lee’s insurance company are subject to insolvency provisions of
  state insurance laws. As a holding company incorporated in the District
  of Columbia, Connie Lee would be subject to federal bankruptcy

    The possible resolution mechanisms for Fannie Mae, Freddie Mac, and
    Sallie Mae are not clear. Neither Fannie Mae, Freddie Mac, nor Sallie
    Mae has a regulator with explicit authority to assist or liquidate the
    firm. Furthermore, although the Federal Bankruptcy Act may apply to

    “FIRREA provided Freddie Mac with a $2.26 billion line of credit with Treasury. Before FIRREA was
    enacted in 1989, Freddie Mac could borrow from FHLBs. Freddie Mac officials said that as part of a
    special government program to subsidize housing, Freddie Mac borrowed $1.6 billion from the FHLB
    System in May 1974 to buy mortgages in an effort to stimulate a slack mortgage market. The FHLB
    System in turn borrowed this money by accessing its line of credit with Treasury.

    :‘Before 1968, Fannie Mae typically relied upon Treasury for partial funding of its operations. This
    practice was phased out by June 30,1969.
    “An FHLB official said that the former Los Angeles FHLB was liquidated in 1946 because of a dispute
    with the former Federal Home Loan Bank Board, but not due to any financial problem.

    Page 92                                           GAO/GGD-9@97 Government’s Risks From GSEs
                            Chapter 4
                            Federal Government Inadequately
                            Monitoring Risks and Capital of Fannie Mae,
                            Freddie Mac, and Sallie Mae

                            Sallie Mae, it does not appear to apply either to Fannie Mae or Freddie

                            Should a GSE be in a situation where it cannot resolve its problems, then
                            the government would be faced with a situation similar to what it faced
                            when large numbers of insolvent thrifts could not be closed until Con-
                            gress acted. Options for resolving a GSE crisis would include (1) assisting
                            the firm through its difficulties, (2) restructuring the firm, (3) liqui-
                            dating the firm, or (4) some combination of these three. Any of these
                            options could be executed in ways that either protect investors or force
                            them to suffer losses.

                            There is no formal government policy on providing assistance to large
                            firms facing failure that might clarify the government’s likely response
                            to a future GSE crisis. In choosing a response to an impending failure of a
                            large firm or municipality, we have suggested that the government (1)
                            identify the problem, (2) determine how the national interest can be
                            served by various alternative actions, (3) establish clear congressional
                            goals for the alternative chosen, and (4) structure any assistance to pro-
                            tect the government’s financial interest.” We suggested that these steps
                            be taken in responding to the FCS crisis and believe they would be
                            equally applicable to any future GSE crisis.

GovernmentAssistanceWould   There are a number of reasons why we believe assistance would be a
E3ea Viable Option for a    viable option for resolving a GSE crisis. First, the government may feel a
F’inanciallyTroubled G-SE   moral responsibility to protect creditors because of the numerous fed-
                            eral ties between GSES and the government that were described in
                            chapter 1.

                            Second, government decision-makers may view assistance favorably
                            because financial assistance would renew a GSE'S capability to continue
                            its public policy purpose. Any GSE failure would likely happen when the
                            GSE is needed the most. Housing, agricultural, or educational crises might
                            provoke difficulties for GSESas well as difficulties for borrowers. For
                            example, FCS had difficulty offering competitive loans to farmers in the
                            mid-1980s when both farmers and Fcs were facing financial difficulties.
                            In such times, the government may favor financial assistance if it wants
                            a GSE to maintain or increase its activities to help achieve national goals.

                            “Freddie Mac believes that a 1J.S.district court could appoint a receiver for Freddie Mac under
                            common law practice.
                            “For a more detailed discussion, see GAO report Guidelines for Rescuing Large Failing Firms and
                            Municipalities (GAO/GGD-84-34, Mar. 29, 1984).

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                                        By contrast, a GSE failure may exacerbate an already difficult situation
                                        in a given market sector.

                                        Another reason that government decision-makers may assist a finan-
                                        cially troubled GSE in the future would be to prevent resulting financial
                                        difficulties for GSE creditors. Currently, a significant proportion of GSE
                                        securities are held by institutions with federal insurance. Federally
                                        insured national banks and thrifts are hypothetically allowed to hold
                                  :     almost unlimited amounts of GSE securities in their portfolios. Should
                                        these institutions become insolvent as the result of a GSE'S failure, the
                                        government would have a legal obligation to protect depositors with fed-
                                        erally insured accounts. The government may judge the costs of direct
                                        assistance to a troubled GSEto be less than the indirect costs arising
                                        from a GSE'S faihre.

                                        Precise data on who owns debt and other securities of each GSE is
                                        unavailable, so it is difficult to project the effects of GSE failure on the
                                        financial condition of other firms. However, HUD periodically surveys a
                                        sample of financial institutions regarding their housing related GSE debt
                                        security holdings. Table 4.1 shows the estimated percentage of FHLB,
                                        Fannie Mae, and Freddie Mac debt securities held by insured depository
                                        institutions based on the sample of institutions.

Table 4.1: Percent of GSE Debt
Securities Held by Insured Qepository   Dollars in billions
Institutions (As of June 1989)                                                                   FHLB    Fannie Mae Freddie Mac
                                        Outstandina debt                                          $154         $106           $22
                                        Percentage of securities held by
                                             _....--------.- banks                                26.6          49.9          16.1
                                           Savinas banks                                           1.4           2.9           1.3
                                            Savings and loans
                                        __--_                                                      4.5           9.0           3.9
                                        Total insured depositories                                32.5          61.8          21.3
                                        Source: HUD survey.

                                        Facing possible insolvencies of banks and thrifts, poor reactions from
                                        overseas investors, and possible disruption of securities markets, the
                                        government may decide in the future, as it has in the past, to assist a
                                        troubled GSE.

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                        We believe the elements of bank regulation provide a basis for com-
Protecting the          paring the adequacy of government monitoring of GSE risk-taking and
Taxpayers’ Interests    capital regulation because the government is exposed to similar risk
in GSE Risk-Taking      characteristics with both types of entities, Banks and GSESboth take
                        interest rate, credit, business, and management risks and use similar
                        methods to protect themselves against losses from these risks. In both
                        cases, the government does not directly suffer losses when these firms
                        lose money but instead is affected by large-scale failures. In the case of
                        banks, the government becomes exposed td’these risks when losses from
                        impending bank failures are large enough to deplete the deposit insur-
                        ance fund. With GSES,the government could be exposed to losses when a
                        GSE'S viability is threatened. Furthermore, creditor discipline is weak-
                        ened for banks having federally insured deposits just as it is weakened
                        for GSES.In the case of both banks and GSES,risk-taking and capital
                        levels are not adequately restricted by private creditors because they
                        expect that in most cases, the government, not they, will suffer the
                        resulting losses.

                        Because of the similar risks, we believe the government needs to oversee
                        GSESby applying the same principles it uses for banks. To protect its
                        financial interest and control inappropriate risk-taking by banks, the
                        federal government (1) sets minimum risk-based capital requirements,
                        (2) establishes rules to limit risk-taking, (3) monitors the financial per-
                        formance of the institution and its compliance with the rules, and (4)
                        enforces the rules by imposing sanctions should a bank operate in an
                        unsafe manner.

                        Just as GSESattempt to prevent losses from various kinds of risks
                        through control and measurement mechanisms, bank regulators estab-
                        lish the bounds of safe operations to prevent taxpayer losses caused by
                        unsafe practices- losses that would be large enough to endanger the
                        bank’s viability and thus put the government at risk. For example, bank
                        regulators promulgate regulations that define unsafe practices and then
                        take actions to ensure the regulations are followed. Bank regulators are
                        also responsible for resolving failures should they occur. The cost of reg-
                        ulation is normally borne by the banks.

Capital Standards for   Bank regulators set minimum capital requirements to give appropriate
Banks                   incentives to bank owners and reduce the government’s exposure to
                s       losses arising from the federal deposit guarantee. Capital is like a
                        deductible on the government’s insurance of a bank’s deposits. That is,
                        before the government guarantee is called, the institution must exhaust

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                             its capital (pay the deductible). Other things being equal, the greater a
                             bank’s capital, the less risk to the government.

                             Setting minimum capital levels is ultimately a judgment based on the
                             level of risk a firm should be able to withstand. Past regulations estab-
                             lished minimum capital as a fixed percentage of a bank’s balance sheet
                             assets. Currently, new risk-based capital requirements are being phased
                             in. Under these requirements, capital is the higher of (1) a percentage of
                             the bank’s credit risk-adjusted on-and off-balance sheet assets, or (2) a
                             percentage of the bank’s total balance sheet assets.

                             The risk-based formula provides the bank’s owners and managers with
                             incentives to control the risks they take-the higher the risk, the higher
                             the capital they have to hold. The second part of the capital regulation
                             prescribes an absolute capital floor, regardless of the credit risk of a
                             bank’s assets. This additional requirement ensures that a bank has some
                             minimum level of capital for interest rate, management, and other risks.
                             Regulatory capital standards typically establish a minimum capital
                             level, not an optimum level. The optimum capital decision is normally
                             left to bank owners, who are free to hold higher levels of capital based
                             on their internal guidelines,

Other Regu.latory Controls   Another element of banking regulation is limiting certain highly risky
for Banks                    activities. For example, regulators place restrictions on the amount a
                             bank may lend to any one borrower. This limits the exposure of the
                             bank to the financial fortunes of any one firm or individual. Regulators
                             may also require approval for a bank to engage in a new activity or
                             issue a new type of financial security. Regulations may also be set that
                             govern a bank’s transactions, such as those with an affiliate. These con-
                             trols are meant to ensure the safe and sound operation of the bank. To
                             enable the government to identify and react to problem situations,
                             banking regulation typically involves monitoring a bank’s financial per-
                             formance through reports and examinations. The regulator typically has
                             authority to obtain and evaluate detailed private information on the
                             bank’s operations.

                             Bank regulators also have enforcement authorities that they may use to
                             prevent unsafe and unsound practices. Formal enforcement actions can
                             include such deterrents as (1) fines, (2) cease and desist orders requiring
                             a firm to take specific steps to return to regulatory compliance, or (3)
                             replacing a bank’s management. Formal enforcement actions are typi-
                             cally used after informal means fail to correct problems identified by the

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                     regulator. Bank regulators also have authority to place a bank under
                     conservatorship (placing it under new management to conserve its
                     assets) or receivership when it becomes insolvent and unable to recover
                     from its losses. In addition, the Federal Deposit Insurance Corporation
                     can withdraw its insurance as a result of unsafe and unsound practices.

                     Fannie Mae, Freddie Mac, and Sallie Mae are subjected to much weaker
Comparing GSE        monitoring, capital rules, and enforcement actions than banks. Although
Monitoring and       specific details on oversight of Farmer Mac have not yet been decided,
Capital Rules to     we have no immediate concerns about the oversight structure in place
                     for FCS, FHLBS and Farmer Mac. Connie Lee has no strong, ongoing ties to
Banking Regulation   the government and is regulated by state insurance regulators, so sup-
                     plemental federal regulatory controls seem unwarranted.

                     The Treasury has authority to approve the amount and types of securi-
                     ties issued by certain GSES.It has exercised this function as a way of
                     regulating the timing of GSE security issues so as not to disrupt the gov-
                     ernment securities market and as a way of protecting its taxing func-
                     tions. This activity does not control the risk-taking activities of the GSES.

                     We find the situation of inadequate monitoring and supervision of
                     Fannie Mae, Freddie Mac, and Sallie Mae reminiscent of FCS oversight
                     before the 1985 amendments to the Farm Credit Act and thrift oversight
                     before FIRREA. Before 1985, FCA had inadequate authorities to supervise
                     risk-taking of FCS institutions. FCA did not have good information on
                     risks and had limited enforcement authorities over FCS institutions. As a
                     result, FCA was in a poor position to prevent problems. Legislation
                     passed in 1985 gave FCApowers very similar to those given bank regula-
                     tors and made it independent of FCS.However, this regulatory reform
                     was too late to address FCSmanagement, funding, and lending policies
                     before they contributed to huge FCSlosses.

                     For thrifts, the Federal Home Loan Bank Board had conflicts between its
                     role as regulator and its role as promoter of the industry. For example,
                     troubled thrifts were allowed to operate with inadequate capital, risking
                     insured deposits rather than owners’ equity. Weak supervision allowed
                     thrift managers and owners to use insured deposits to take high risk
                     ventures in a last-ditch effort to recoup losses. When unsuccessful, these
                     ventures resulted in additional losses that increased the eventual cost of
                     the taxpayer bailout. To correct these problems, FIRREA established the
                     Office of Thrift Supervision as an independent regulator, responsible for
                     establishing and enforcing risk-based capital rules.

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Farm Credit System   FCS is regulated by FCA using all four elements of bank regulation. We did
                     not evaluate the effectiveness of FCA'S regulation, including capital stan-
                     dards, for this report but plan to evaluate the effectiveness of key com-
                     ponents as part of our ongoing oversight of FCS and FCA.

                     FCS institutions   are the only GSESwith capital regulations approximating
                     those of banks. The Agricultural Credit Act of 1987 directed FCA to for-
                     mulate such risk-based capital standards. FCAmodeled its capital regula-
                     tions after bank regulations and set minimum capital at 7 percent of
                     risk-adjusted assets. The FCA capital standards are being phased in for
                     all FCS institutions from 1988 to 1993. At the end of 1989,5 of the 11
                     FCBS had already met the fully phased-in requirements, as had the Fed-
                     eral Intermediate Credit Bank of Jackson. Two of the BCS had met the
                     standards. FCA regulations require all institutions to develop a plan for
                     meeting the capital standards by 1993. According to FCA, all institutions
                     have generally met this requirement.

                     E%Aalso has authority to promulgate rules limiting the activities of FCS
                     institutions to ensure their safe and sound operations. FCAcontrols per-
                     missible activities by determining the specific authorities of the institu-
                     tions, such as the types of loans they can and cannot make. FCA also
                     limits other FCS activities, like restricting the amount of loans made to
                     one borrower.

                     FCAhas authority to monitor all aspects of FCS institutions’ operations. It
                     has imposed reporting requirements for FCS institutions and also regu-
                     larly examines institutions’ operations. FcA’s regulatory activities are
                     paid for by FCS.

                     FCAhas a full range of enforcement authorities available to it and places
                     FCS institutions under some type of formal supervisory action when they
                     are considered to be operating in an unsafe or unsound manner. FCA offi-
                     cials said that as of January 23, 1990, FCS institutions holding over 60
                     percent of FCS' assets were under some type of enforcement action.

                     At the time of the FCS financial crisis, the FCA system of monitoring,
                     oversight, supervision, and enforcement was significantly weaker than
                     the current system. The Farm Credit Amendments Act of 1985 estab-
                     lished FCAas an arms-length regulator and gave FCA new powers and
                     responsibilities, including the authority to take specific enforcement
                     actions against FCS institutions and individuals, such as the power to
                     issue cease and desist orders and the responsibility to examine all FCBS,

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                         ES, and direct lending associations at least annually and other associa-
                         tions every 3 years.

Federal Home Loan Bank   FIRREA created FHFB in August 1989 with authority    to regulate FHLBS
System                   using all four elements of bank regulation. As of April 1990, two FHFB
                         members had been nominated, but none had been confirmed. The Secre-
                         tary of HUD has served alone as the acting Chairman of the Board since
                         FHFB was created. It is unclear how FHFB will implement its authorities
                         and whether it will be effective. We plan to review the status of FHFB'S
                         implementation of its regulatory responsibilities in our next report.

                         FHLBS do not operate under risk-based capital requirements like banks
                         and thrifts. As discussed in chapter 2, FHLBS control their credit risk in
                         various ways and have never suffered losses from such risk. FHFB
                         requires FNLBS to operate under a debt-to-capital ratio that compares the
                         amount of consolidated obligations held by the FHLB to its paid-in capital
                         and legal reserves. The FHFB carried forward the former Federal Home
                         Loan Bank Board’s requirement for a 12-to-1 debt-to-capital ratio as its
                         capital standard. In addition, member thrifts may not borrow amounts
                         from their FHLB in excess of 20 times the amount of stock they have
                         purchased from their FHLB. These requirements treat all advances as
                         having the same credit risk and do not consider the interest rate risk
                         undertaken by an individual FHLB. FHFB policies require members to hold
                         FI-IIB stock and provide collateral on letters of credit as though the letter
                         of credit were an advance.

                         FHFB has general statutory authority to ensure the safe and sound opera-
                         tion of FIILBS. It carried forward the former Federal Home Loan Bank
                         Board’s regulations. These controls prohibit or limit certain activities
                         such as the ways letters of credit can be issued.

                         FHFB has authority  to monitor and examine the activities of FHLBS. FHFB
                         also has authority to enforce its rules that promote the safe and sound
                         operations of FHLBS, including specific authority to suspend or remove
                         FIILB managers or employees. FHFB costs are paid by the FHLBS.

Fannie Mae and Freddie   IIIJD has had authority to regulate Fannie Mae since 1968 and received
                         authority to regulate Freddie Mac in 1989 but does not explicitly have
Mac                      the full range of authorities, particularly enforcement authorities, typi-
                         tally available to bank regulators. Furthermore, HUD'S past monitoring

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    Freddie Mac, aud Sallie Mae

    of Fannie Mae’s risk-taking has been inadequate to alert the government
    to potential problems.

    Although Fannie Mae’s financial condition has improved since the early
    198Os, our current assessment of HUD’S monitoring of Fannie Mae’s risk-
    taking reconfirms a position we took in an April 1985 report on Fannie
    Mae’s activities.7 We concluded then that Fannie Mae’s ties to the gov-
    ernment expose the government to potentially large but ill-defined risks
    that were not adequately regulated by HUD. We recommended that Con-
    gress establish by legislation a permanent oversight function within HUD
    or some other regulatory entity to monitor, evaluate, and report to Con-
    gress about Fannie Mae’s activities. HUD’S regulation of Fannie Mae has
    not changed significantly since 1985. In addition, although HUD became
    Freddie Mac’s regulator in August 1989, it has not yet promulgated rules
    covering Freddie Mac’s operations.

    Unlike bank capital rules, Fannie Mae’s and Freddie Mac’s capital
    requirements offer little protection against risk-taking by these GSES.
    The capital rule legislatively applied to Fannie Mae and Freddie Mac

. very broadly defines capital to include subordinated debt and loss
  reserves, allowing owner equity to be a minor part of the total;
l does not consider the risk of off-balance sheet activities, a major portion
  of Fannie Mae’s and Freddie Mac’s business, or their exposure to
  interest rate risk; and
l does not consider the different risks involved in different types of

    Fannie Mae’s and Freddie Mac’s statutory debt-to-capital ratio is 15-to-l.
    This is analogous to the minimum capital-to-liabilities ratio that thrifts
    followed before FIRREA. The requirement simply means that the GSE may
    issue senior debt only when all its outstanding senior debt will be less
    than 15 times its capital. HUD has authority to lower the amount of cap-
    ital required by raising the ratio. For example, HUD currently allows
    Fannie Mae to issue debt up to 20 times its capital. It is unclear from the
    statutory language whether HUD could set capital at a higher level or set
    capital requirements that are risk-based.

    New bank capital regulations require a significant proportion of owner
    equity as capital, but Fannie Mae’s and Freddie Mac’s debt-to-capital

    7The Federal National Mortgage Association in a Changing Economic Environment (GAO/

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ratio does not. Owner equity represents the best protection to the gov-
ernment against unexpected losses because owners have incentives to
protect their personal investments. The definition of capital for Fannie
Mae and Freddie Mac differs from the one used for banks because subor-
dinated debt and loss reserves can be counted in full as capital. Fannie
Mae’s charter limited the allowable amount of subordinated debt to
twice the sum of equity capital- common stock, additional paid-in cap-
ital, and retained earnings. This limit was legislatively removed in 1982.
When subordinated debt issued before that legislation is retired, Fannie
Mae will not be limited in the amounts of subordinated debt it can count
as capital. Subordinated debt is not permanent owner capital; it is a lia-
bility of the GSEthat has to be repaid. It provides a cushion to senior
debt-holders. However, subordinated debt protects the government from
losses only if the government responds to a GSE crisis by allowing subor-
dinated debt-holders to suffer losses. Loan loss reserves are also less of
a cushion than owner’s equity because reserves are designed to cover
losses that are already expected in the portfolio, not unexpected losses.
Bank risk-based capital guidelines limit the amount of subordinated debt
and loan loss reserves that can be counted as part of capital.

Fannie Mae’s and Freddie Mac’s debt-to-capital ratios also do not cover
the credit risk associated with guaranteeing MBS and other off-balance
sheet activities, nor do they address interest rate risk. Together, Fannie
Mae and Freddie Mac guarantee over a half trillion dollars in MBS. These
off-balance sheet activities represent a majority of their business. Ironi-
cally, however, the reserves held to cover losses arising from defaults of
mortgages in MBS can be counted as capital, thereby inflating the capital
part of the ratio. As discussed in chapter 2, interest rate risk caused
losses large enough to threaten the solvency of Fannie Mae in the early
 1980s but such risks are not considered in the debt-to-capital ratio.

Finally, the regulatory debt-to-capital ratios do not account for the rela-
tive riskiness of different types of mortgages in Fannie Mae’s or Freddie
Mac’s portfolio. History indicates the credit risk associated with mort-
gages can vary greatly, depending on the mortgage type and terms.
Changes in the relative concentration of low and high risk mortgages
can significantly affect the whole portfolio’s risk profile without
affecting the debt-to-capital ratio. For example, multifamily and adjust-
able-rate mortgages have sustained higher default rates than single-
family conventional mortgages, but the debt-to-capital ratio does not
distinguish among portfolios regardless of the relative mix of these
types of mortgages.

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Freddie Mac, and Sallie Mae

HUD has general authority     to oversee Fannie Mae’s and Freddie Mac’s
fulfillment of their public missions. In particular, HUD has authority to
require Fannie Mae and Freddie Mac to devote a certain amount of their
activities to low and moderate income housing as long as the GSESearn a
reasonable rate of return from such activities. In addition, HUD must
approve new conventional mortgage purchase and sales programs
before they are undertaken by Fannie Mae and Freddie Mac. HUD'S role
in monitoring the risk-taking of Fannie Mae’s and Freddie Mac’s opera-
tions and its authority to promulgate effective risk-based capital rules
are not clear in the statutory language. HUD has limited experience as a
regulator of financial firms and has traditionally dedicated few staff
members to such functions. HUD first established a Fannie Mae oversight
unit in 1978, only to disband it in 1981 when Fannie Mae was facing
serious financial difficulties. A HUD official estimated that HUD had
devoted between 5 and 10 staff years to Fannie Mae oversight during
the last 10 years.

HUD has had the authority  to audit and examine the books and financial
transactions of Fannie Mae since 1968 but has not exercised the
authority. In 1989, FIRREA gave HUD similar authority over Freddie Mac.
HUD has asked Fannie Mae to submit various reports on a periodic basis,
but it has not examined Fannie Mae’s operations. In addition, no specific
funds have been appropriated for such regulatory purposes.

HUD has limited explicit enforcement authority  over Fannie Mae and
Freddie Mac. No statutory provisions exist governing enforcement
authorities except that HUD has the authority to limit dividend

The Secretary of HUD has established a Financial Institutions Regulatory
Board to advise him on (1) monitoring the operations of Fannie Mae and
Freddie Mac and (2) policy and regulatory oversight and review. HUD
officials say the Department is committed to monitoring the risk-taking
and capital adequacy of Fannie Mae and Freddie Mac in the future.

HUD officials were unable to specify how they will monitor and super-
vise Fannie Mae and Freddie Mac. They were studying various alterna-
tives for exercising their regulatory responsibilities. We reported in
1986 that HUD had not complied with its responsibility to prepare annual
reports on Fannie Mae. Since that time, HUD produced two reports-one

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                 for 1986 and another for 1987. HUD recently submitted reports to Con-
                 gress on Fannie Mae and Freddie Mac that discuss HUD'S plans for regu-
                 lating the two GSES.HUD also held public hearings on July 31, 1990, on
                 the regulation of Fannie Mae and Freddie Mac.

                 We asked HUD officials whether they were concerned about possible con-
                 flicts between HUD'S housing mission and its regulatory responsibilities
                 to oversee risk-taking. The Assistant Secretary for Policy Development
                 and Research said he believed the Department could successfully
                 manage such conflicts. This official said that it was too early for HUD to
                 conclude whether the Department would need added statutory authori-
                 ties to carry out its responsibilities.

Sallie Mae       Sallie Mae has neither a federal regulator nor federal regulatory capital
                 requirements. Further, its charter does not specify minimum capital
                 requirements. Sallie Mae’s charter requires it to submit a report of the
                 annual audit of its financial statements to the Secretary of the Treasury.
                 In turn, the Treasury must submit this annual audit to Congress and the
                 President together with Treasury’s report on the financial condition of
                 Sallie Mae. The Department of Education has audit authority over the
                 Guaranteed Student Loan Program. Treasury has audit authority over
                 Sallie Mae but like HUD has not exercised this authority. As a result, the
                 federal government relies heavily on Sallie Mae’s owners and managers
                 to avoid undue risk-taking and set appropriate capital levels.

Connie Lee       Connie Lee has no federal regulator but is regulated by state insurance
                 regulators, which specify minimum capital requirements. Connie Lee is
                 subject to reporting requirements, rules, and the enforcement authori-
                 ties of the states in which it is domiciled and does business. Because
                 Connie Lee (1) has no apparent federal benefits other than start-up cap-
                 ital, (2) appears to be regulated like other private insurers are regulated,
                 and (3) appears to be subject to the same private market discipline as
                 other private insurers, we find no compelling reason for providing fed-
                 eral monitoring and supervision of its activities.

Farmer Mac       Farmer Mac, while regulated by FCA, currently does not have any regula-
                 tory capital requirements. It is unclear at this point whether FCA will
             Y   establish capital standards for Farmer Mac. FCA also has general
                 authority to examine and regulate Farmer Mac and to enforce safe and

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                             sound operations. FCA recently completed its first examination of Farmer

                             We believe the elements of bank regulation-minimum        capital levels
Bank Regulatory              that are based on the risks undertaken, limits on risk-taking, monitoring
Structure Can Be             of financial performance, and authority to enforce rules-provide      a
Modified for GSEs            basis for comparison with GSE oversight. However, these elements prob-
                             ably need to be modified to account for characteristics such as their lim-
                             ited lines of business and large, nationwide operations that distinguish
                             GSESfrom banks. We have not yet developed opinions on how the bank
                             regulatory model should be adapted for Fannie Mae, Freddie Mac, and
                             Sallie Mae. We plan to study these issues further and discuss them in our
                             second report.

Conforming Risk-Based        To conform GSE capital standards to the principle that capital levels
Capital Rules to GSEs’       should be tied to the levels of risk taken, increased federal oversight
                             could include capital requirements that require minimum capital levels
Characteristics              to rise as risks increase for FHLBS, Fannie Mae, Freddie Mac, and Sallie
                             Mae. Depending on the specific requirements that would be set, these
                             GSESmay or may not need to increase their current capital holdings to
                             conform to the minimum requirement.

                             In principle, we would endorse minimum capital levels that are risk-
                             based. Requiring that capital holdings increase commensurate with cor-
                             porate risk-taking helps ensure that the stockholders and managers of
                             GSEStake risks with their own money rather than leveraging their fed-
                             eral ties. However, we are unconvinced that the bank risk-based capital
                             rules could simply be adopted for GSE capital holdings because of the
                             following shortcomings:

                         . The risk-based portion of the rules assesses only the credit risk of a
                           bank’s portfolio, not other sources of risk such as interest rates.
                         l The risk-based rules differentiate risk among various asset categories
                           but not variants within an asset category. Unlike banks, which hold
                           mortgages, commercial loans, and other assets that have relatively dif-
                           ferent risks, GSEShold most of their assets within a single category
                           where different types of assets can have very different risk characteris-
                           tics. For example, adjustable-rate and multifamily mortgages are in the
                           same asset category with single-family fixed-rate mortgages despite
                           their relative differences in riskiness.

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  Monitoring Risks and Capital of Fannie Mae,
  Freddie Mac, and Sallie Mae

. The risk rules used for banks are not based on inherent credit risk from
  empirical evidence of losses. Since the GSESspecialize in one category of
  assets, they have developed more refined measures of credit risk.
. The bank risk rules do not account for geographic diversification or
  other characteristics that may reduce overall credit risk.

  In general, bank capital rules were designed to provide a minimum cap-
  ital base for thousands of institutions with widely different credit
  quality and different exposures to management and business risks. Since
  GSES are few in number, customized rules that more precisely capture
  the sources and degrees of risk would seem more appropriate.

  Unfortunately,     there is no obvious alternative model to determine what
  GSE capital holdings should be. Certain GSESwould prefer to use the
  “stress tests” discussed in chapter 3 to model the financial performance
  of their businesses under extremely adverse conditions. This same kind
  of technique is used by rating agencies to evaluate the financial strength
  of firms and will be one of the options considered for establishing cap-
  ital regulations for GSESin our second report.

  Other issues also need to be considered in evaluating appropriate regula-
  tory capital levels for GSES.First, setting a minimum capital level
  involves determining the level of risk that one believes the firm needs to
  be able to withstand. This inevitably involves a judgment about whether
  the firm should be able to withstand a high amount of adversity for a
  moderate period of time, a moderate amount of adversity for a long
  period of time, or something more or less stringent. New capital require-
  ments may or may not impose added costs on the GSES,depending on
  whether a specific GSE would need to hold more capital than it currently
  does to meet the minimum level. We plan to consider the costs and bene-
  fits of various options on the GSES' profitability and achievement of their
  public policy objectives in our next report.

  Competitive equity issues are another consideration for setting capital
  levels, Risk-based capital rules have been developed under international
  agreements to provide some common treatment for banks operating
  internationally. One of the aims of bank risk-based capital rules is to
  prevent regulatory advantages and disadvantages among competing
  firms. GSEShold some of the same assets that banks hold and also par-
  ticipate in international transactions. For example, certain GSEShold
  mortgages and student loans in portfolio much the same as banks and
  thrifts do and have issued debt denominated in foreign currencies and
  have executed transactions with foreign institutions.

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                              Freddie Mac, and Sallie Mae

Modifying Other Aspects       Two fundamental differences between banks and most GSESalso indicate
of Regulatory Control         a need for tailoring bank regulatory elements to the specific GSEcircum-
                              stances. First, many of the depositors that use banks are generally less
                              sophisticated than the large-scale investors that buy GSEsecurities.
                              Second, there are thousands of banks and thrifts operating with federal
                              guarantees. The supervision, monitoring, and enforcement rules must
                              cover the variety of circumstances that could be practiced by so many
                              institutions. By contrast, Fannie Mae, Freddie Mac, and Sallie Mae each
                              operates a single line of business serving a single market.

                              Our evaluation of various options for improving monitoring of risk-
                              taking will start with the premises that

                          l federal oversight of GSESshould reflect the differences between GSESand
                          . monitoring of GSEactivities should focus on whether a GSE'Soperations
                            are consistent with its public policy purpose and whether such opera-
                            tions pose excessive risk to the government; and
                          . supervision need not inhibit private initiative, and GSEregulatory rules
                            need not be so detailed that they cover every conceivable circumstance.

                              Several GSEShave flourished without federal intervention, and we
                              believe they should have continued flexibility to accomplish their mis-
                              sions. In economically difficult times, certain GSEShave faced serious
                              difficulties, and their future success became quite uncertain. Both pos-
                              sibilities lead us to conclude that when GSESare well capitalized and
                              operating within the bounds of proven practices, federal oversight could
                              focus on non-intrusive, but effective monitoring of their ongoing condi-
                              tions. Novel practices and ventures that have proven to be riskier need
                              closer scrutiny. In times of declining profits, when capital is at risk of
                              being eroded, GSEScould receive more active oversight to ensure that the
                              government’s interests are protected in any reasonable way possible.

                              Increasing federal supervision has definite costs. Neither Fannie Mae,
                              Freddie Mac, nor Sallie Mae has borne the direct costs of routine over-
                              sight. Our evaluation of regulatory models will consider these costs and
                              be guided by the assumption that any regulatory structure adopted
                              must balance the desire of the federal government to be informed of
                              GSES’ risks while enabling GSESto structure their activities in a business-
                              like manner. GSEScannot function properly if they are blocked from
                              taking calculated risks, but the government must be apprised of these
                              risks in order to protect its interests.

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                           Freddie Mac, and Sallie Mae

Who Should Oversee,        Currently, we have no position on whether improved GSEoversight,
Supervise, and Enforce     supervision, and enforcement should be centralized within the govern-
                           ment or shared among several regulators. We believe, based on our work
Rules                      on the FCSand thrift crises, that a financial regulator should be indepen-
                           dent of other public policy considerations, As a result, we would find
                           HUDto be a less than satisfactory choice to regulate the financial affairs
                           of Fannie Mae and Freddie Mac. Some of the possibilities that could be
                           adopted will be evaluated in our next report. These include the

                           The government could create one or more entities with independent
                           boards responsible for supervising the safety and soundness of Fannie
                           Mae, Freddie Mac, and Sallie Mae.
                           Additional supervisory responsibility could be placed in Treasury. Trea-
                           sury has the needed financial expertise, is independent of the GSES'
                           public policy objectives, and already has responsibility for approving
                           GSEdebt issues.
                         . FIIFB could supervise Freddie Mac and Fannie Mae, in addition to its cur-
                           rent regulatory responsibility for FHLBS.This would place all the
                           housing-related GSESunder a single regulator. Another regulator would
                           be needed for Sallie Mae.
                         . A central regulator could be given responsibility to oversee all GSEsafety
                           and soundness issues. This would involve merging the current responsi-
                           bilities of KA and FHFRinto a single organization and enlarging the
                           responsibilities to cover Fannie Mae, Freddie Mac, and Sallie Mae.

                           The federal ties to GSESmay place the government at financial risk and
Conclusions                create a situation where private owners could act in ways that are
                           adverse to the government’s financial interest should a GSEencounter
                           severe financial distress. To attempt to avoid a financial crisis and to
                           prepare to handle one should it occur, the government would be prudent
                           to protect its interest in the financial health of the GSESby overseeing
                           their risk-taking, including congressional oversight, and setting min-
                           imum capital standards that are based on the levels of risk undertaken.
                           The similarities between GSESand banks, particularly the government’s
                           risk of financial loss and the possible mismatch between private incen-
                           tives and government interests, convince us that the four elements of
                           bank regulation-minimum         capital, rules limiting risk-taking, moni-
                           toring of financial performance, and enforcement authority-provide         a
                           conceptual framework for developing an oversight structure for GSES.
                           Our review showed that these elements are not currently in place to pro-
                           tect the government’s financial interest for Fannie Mae, Freddie Mac,

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Freddie Mac, and Sallie Mae

and Sallie Mae. Furthermore, the FHLBcapital standard is not based on
the level of risk undertaken.

We recognize that the elements of bank regulation might need to be mod-
ified to account for features that distinguish GSESfrom banks. We cannot
yet specify the exact nature of the regulatory approach we prefer. We
believe the approach should be designed to keep emerging problems
from imposing problems on taxpayers and to develop appropriate
responses to problems quickly so that major unanticipated losses can be
contained. In our next report, we plan to further evaluate specific regu-
latory issues such as regulatory authorities, capital levels, number of
supervisory agencies, and types of monitoring and examination,

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Agency Commentsand Our Evaluation

                            Each of the GSESincluded in this study and the regulators of these GSES
                            were asked to comment on a draft of this report. In addition, the depart-
                            ments of A.griculture and Education provided comments. The Treasury
                            Department published its May 31,1990, report on GSESand did not com-
                            ment officially on a draft of our report. The following sections summa-
                            rize these comments and give our evaluation of them. Technical
                            comments on specific passages in the report have been incorporated
                            directly into the text where appropriate.

Comments From FCS,
FCA, and the
Department of

Farm Credit Council and     The Council (FCStrade association that coordinated comments on this
Federal Farm Credit Banks   report) and Funding Corporation commented for the FCBSand BCS.Their
                            comments can be found in appendix I. They believe the draft report did
Funding Corporation         not go far enough in describing the positive changes that have occurred
                            in FCSsince 1985 and in describing the inherent risk FCSfaces because of
                            its congressional mandate to provide credit to agriculture on a consistent
                            basis. They strongly disagreed with our characterization of FCSmanage-
                            ment concerns that were expressed to us by FCAand national rating
                            agency officials. They said that over the past several years there have
                            been substantial changes and improvements in FCSmanagement.

                            We agree that FCS'statutory purpose of serving the agriculture industry
                            creates inherent risk not faced by certain other GSES.The report
                            describes this inherent risk, improvements to FCA's structure and author-
                            ities as an arms-length regulator, and the establishment of risk-based
                            capital rules, The report points out that FCSas a whole made a profit
                            from operations in 1989. However, the report also points out that we did
                            not evaluate KX’S effectiveness or the effectiveness of any improve-
                            ments that have been made in the institutions’ management. Because of
                            our time constraints and the size and number of FCSinstitutions, we had
                            to rely on FCA,the Funding Corporation, rating agencies, and published
                            reports to obtain evidence on FCSmanagement successes and concerns.
                            As discussed in the report, we found the opinions and information
                            obtained from these sources to consistently show that, overall, FCSman-
                            agement had improved, but management problems still existed. We

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Agency Comments and Our Evaluation

found it significant that FCAhas found it necessary to use enforcement
actions against many institutions’ management to have them change cer-
tain practices rather than these institutions changing these practices on
their own initiative.

The Council and Funding Corporation also wanted us to clarify our dis-
cussion of assistance authorized by the Agricultural Credit Act of 1987.
They stressed that the full $4 billion in assistance that the act author-
ized has not yet been and may never be provided. They also stressed
that the act provides for FCSinstitutions to repay all principal and
interest on the assistance. We state in the report that, as of June 12,
1990, $1.2 billion of the $4 billion allocated had been used. We want to
point out, however, that the government is ultimately liable for the
assistance principal and interest should FCSand the FCSInsurance Corpo-
ration be unable to repay it. We also note that the government incurs an
opportunity cost and interest costs on the money it borrows to make the
interest payments during the first 10 years of assistance, even if FCS
repays the interest payments.

The Council and Funding Corporation pointed out that the Farm Credit
Insurance Fund will act as a buffer between FCSlosses and government
costs. They also say that the ultimate size of the fund is not capped and
is in addition to the institutions’ risk-based capital requirements. We
agree that the insurance fund is designed to be a buffer in case institu-
tions fail to make System-wide bond payments or payments to the FCS
Financial Assistance Corporation required by the 1987 act. However,
the fund’s size is limited by the annual premiums that were established
by the act, less costs and payments.

The Council and Funding Corporation also believe that the government’s
exposure to losses from FCSoperations is reduced because (1) System-
wide debt is the joint and several liability of all FCSbanks; (2) each FCS
bank has to have and maintain collateral of eligible assets at least equal
in value to the total amount of debt securities outstanding for which it is
primarily liable; and (3) the Funding Corporation’s bank monitoring
system provides an early warning and loss prevention mechanism. We
agree that joint and several liability could be a buffer for the govern-
ment, However, this buffer disappears if, as occurred with passage of
the 1987 act, the government authorizes assistance that prevents joint
and several liability from being invoked. We also agree that the collat-
eral maintained to support debt securities does not insure the govern-
ment against loss but could preclude an undercollateralized institution
from issuing additional debt. Finally, while we agree that the Funding

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                            Agency Comments and Our Evaluation

                            Corporation’s bank monitoring system could provide an early warning
                            mechanism for losses, we have not evaluated the system and cannot
                            comment on its effectiveness.

Farm Credit                 FC4  commented that our report should emphasize FCA'Sactions to
Administration              address risk reduction and the future role of the FCSInsurance Corpora-
                            tion FCAsaid the FCSdiscussion should be refocused to emphasize poten-
                            tial risks for the future rather than carryover risks from recent history.
                            FCA’S comments can be found in appendix II.

                            We believe the factors that caused and amplified the problems in the
                            1980s-volatile agriculture economy and land values, unreliable market
                            forecasts, unwise management decisions and practices, etc.-are still
                            potential risks for the future. We believe the report does concentrate on
                            future risks by using historical problems as indicators of future risks. As
                            stated in FCA’S comments, we did not assess the effectiveness of F&I’S
                            past actions, and we cannot predict its future effectiveness. We have
                            expanded our discussion about the FCSInsurance Corporation to empha-
                            size its future role but find it premature to predict whether it will be
                            able to respond to future FCSfinancial problems.

                            FCA also suggested that we emphasize the need to apply the same risk
                            elements to Farmer Mac as to the other GSES.We agree that the same
                            regulatory elements are needed for Farmer Mac.

Department of Agriculture   The Secretary of Agriculture provided three general and several specific
                            comments that can be found in appendix III. First, the Department said
                            that the report should place greater emphasis on the quality and type of
                            capital at FCSinstitutions. It said that the cooperative structure of FCS
                            institutions in which borrowers are also the owners of institutions’ stock
                            exacerbated past financial problems because the borrowers simply paid
                            off their loans, which automatically retired their stock, and went else-
                            where for loans. This practice reduced the institutions’ capital during
                            difficult times.

                            The Department also said that the new at-risk stock created by the Agri-
                            cultural Credit Act of 1987 did not solve the fundamental problem that
                            borrower stock is not viewed as a long-term investment in the FCSinsti-
                            tutions but rather as a requirement for obtaining a loan. It said that
                            there is no reason to believe that the borrowers holding at-risk stock
                            would not attempt to have the government guarantee payment of their

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stock in future times of severe financial difficultly. It pointed out that
greater emphasis is now placed on retained earnings as a capital base.
We plan to continue our evaluation of these areas as part of our ongoing
oversight of FCS.

Second, the Department said that the report does not mention the
serious problem that all FCSinstitutions’ directors are borrowers and
have an incentive to select management for the institutions on the basis
of their willingness to obey the directors rather than their financial
ability. It said that the borrower/directors have little incentive to hire
management that will take responsible credit actions, raise interest
rates, or price loans to cover the government’s risk when those actions
may hurt the directors and the other borrowers who elected them. The
Department pointed out that these incentives may be particularly true
when the directors perceive that the government may provide assis-
tance to FCSinstitutions and protect their stock. It said that other finan-
cial regulators have restrictions on loans to directors and officers due to
the problems created by insider loan activities. We agree that the coop-
erative nature of FCSmakes it fundamentally different from a commer-
cial enterprise and could result in management having incentives that
increase the government’s risk during periods of financial stress.

Third, the Department said that investors in GSEdebt securities recently
have been more diligent in determining appropriate yields for GSEsecuri-
ties than during the GSEfinancial difficulties of the 1980s. In addition,
the Department said that rating agencies have been making investors
more aware of the financial conditions of the GSES.

The data used in the report from GSES,their regulators, and Salomon
Brothers showing yields for GSEdebt securities and Treasury securities,
do not show a clear pattern or marked difference between the early and
late 1980s. The rating agency officials to whom we spoke cited no such
differences in their approach or reporting. The spreads between FCSand
Treasury securities are discussed on pages 87-88 of the report, and the
rating agencies’ review of the GSES'risks is discussed on pages 84 and

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Comments From FHFB
and FHLBs

FHFB                      The FHFBgenerally agreed with the contents of our report but empha-
                          sized that many of our statements concerning FHLENwere based on state-
                          ments and information obtained from bfficials of only two banks. The
                          FHFBpointed out the difficulty of making FHLBSystem-wide generaliza-
                          tions based on such a small sample. Its detailed comments can be found
                          in appendix IV.

                          We agree that care should be taken when generalizing about bank opera-
                          tions and policies on the basis of limited contact with individual banks.
                          As noted in chapter 1, we also obtained System-wide and individual
                          bank information from the FHLBOffice of Finance-the System’s
                          funding arm-and the FHFB-the System’s regulator. We believe both
                          are in a good position to provide authoritative information on the gen-
                          eral risk management policies and procedures of the banks in the
                          System. Furthermore, we submitted an earlier draft of the report to all
                          12 FHLBSfor technical review and received comments from 6 of them.
                          Any discussion of System-wide condition or general bank policy was
                          based on information provided by these sources.

Federal Home Loan Banks   The FHLBSystem generally agreed with our assessment of the risks
                          facing FHLBSand the manner in which these risks are managed. The
                          FHLBSalso emphasized their excellent performance in managing interest
                          rate and credit risk. Their detailed comments can be found in appendix

Business Risk             The FHLBS questioned our assertion that the significant changes in the
                          System associated with the passage of FIRREA~ could introduce greater
                          risk to the System. Instead, the FHLBSbelieve that FIRREAstrengthened
                          their ties to housing finance by expanding the types of institutions eli-
                          gible for FHLBmembership.

                          We are not convinced that expanding eligibility for FHLB membership
                          will compensate for the shrinkage in the thrift industry-the System’s

                          ‘Significant Systemchangesassociatedwith FIRREAincluded (1) increasedcapital levels;(2) greater
                          restrictions on activities for thrifts, (3) shrinkageof the thrift industry-;and (4) the System’srequired
                          contribution to the bailout, which reducedits retainedearningsand limited its ability to pay divi-
                          dendson its stock.

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             traditional base. Unless FHLBSare able to generate sufficient income to
             resume their historically high dividend payments on the stock required
             for FIILH membership, eligible nonmember institutions will lack an
             important incentive to apply for membership. Consequently, the mem-
             bership base could continue to shrink, making it increasingly difficult to
             generate income.

             The FHLBSalso disagreed with our assertion in the draft report that they
             could be required to make further contributions to the thrift rescue.
             They commented that such statements can only be conjecture at this
             point and cited congressional testimony of the Secretary of the Treasury
             that indicated that the FHLBSwill not be called upon to further the thrift

             We agree that our statement concerning the possibility of an additional
             FHLBcontribution  to the thrift bailout is speculative. However, that is
             the nature of business risk as defined in our report-the   risk that fac-
             tors largely beyond an organization’s control could lead to unexpected
             changes in earnings, growth, or capital.

Regulation   Finally, the FHLBSbelieved that it is not too early to judge the effective-
             ness of their new regulator, FHFB.The FHLBSsaid that FIRREA'Sdirection
             that FHFBassume the authority of the Federal Home Loan Bank Board
             (the previous FHLBregulator) and FHFB'Sdecision to carry forward the
             Bank Board’s policies as its own merely constitute a continuation of the
             previous regulatory relationship and do not pose any additional risk.

             We believe that the creation of a new regulator creates significant uncer-
             tainties about the strategic direction that the new regulator will take
             and about how timely and effectively the new regulator will act to
             ensure FIILBS safety and soundness. We note that FHFBhas potentially
             conflicting responsibilities for both supervising the safety and sound-
             ness of FHLBSand for ensuring that they carry out their housing finance
             mission. The Federal Home Loan Bank Board had similar conflicting
             responsibilities of both promoting and regulating the thrift industry.
             Until the FHFBis fully established and has time to determine whether or
             not existing regulations are appropriate to insure the safety and sound-
             ness of FHLRS,no clear judgment of performance is possible.

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Comments From HUD,
Freddie Mac, and
Fannie Mae

HUD                  HUD'Scomments include six areas of concern. Its comments can be found
                     in detail in appendix VI.

                     First, HUDsaid that it is inconsistent and possibly misleading for us to
                     say that Fannie Mae’s and Freddie Mac’s capital standards are inade-
                     quate while deferring recommendations as to what should constitute
                     adequate capital.

                     HUD'Scomment suggests that it believes our report should not identify
                     problems until we have a proposed solution. We disagree. Our experi-
                     ence suggests that it is very useful to arrive at a common definition of a
                     problem before attempting to develop a specific solution. In the case of
                     Fannie Mae’s and Freddie Mac’s capital standards, we are troubled by
                     the fact that they do not relate to the levels of risks the GSESincur. Fur-
                     ther, this interim report was required by legislation even though our
                     work, which includes developing solutions, is unfinished.

                     Second, HUD commented that our report points toward a regulatory
                     structure that would include risk-based capital standards that would
                     have capital ratios that vary by mortgage risk category and would
                     include a capital standard for MBSand additional monitoring and super-
                     vision by a government regulatory agency. HUD said that the appropri-
                     ateness of such a structure is presumed but not defended and the nature
                     of the monitoring and supervision is not made clear. HUD suggested that
                     we consider (1) standards for duration matching and other standards to
                     limit interest rate risk, (2) the use of appropriately conservative under-
                     writing standards, and (3) ongoing attention to management controls as
                     an alternative to increased capital requirements.

                     HUD'Simpression that our report points toward risk-based capital stan-
                     dards with capital ratios that vary by risk category of mortgage is a
                     misinterpretation. We do say that capital should increase as risk
                     increases. We also believe that riskier mortgage holdings should require
                     more capital. We have not, however, endorsed ratios or any other spe-
                     cific method for accomplishing this aim. Various options will be studied
                     in the next,phase of our work.

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We disagree that our endorsement of the bank regulatory structure is
presumed but not defended. The report explains on page 95 that we
compared the existing regulatory structure for GSESto the four elements
of bank regulation because both situations present similar risks to the
government. We agree with HUDthat regulatory authorities to limit risk-
taking are necessary to prevent undue risk-taking. We do not agree with
HUD'Simplication that such rules eliminate the need for an appropriate
capital standard. Having an appropriate capital rule helps ensure that,
before a GSEundertakes additional risks, its owners must increase their
capital. Consequently, we believe both authorities are needed and
should be used in a way that allows the GSEflexibility to carry out its
operations in a business-like manner.

Third, HUDobjects to our conclusion that HUD'Sregulation of Fannie
Mae’s capital has been inadequate to alert the government to potential
problems, HUDpoints to its two reports on Fannie Mae since 1985 that
have documented the low levels of its capital despite compliance with
the regulatory capital requirement. HUDpoints to the statutory defini-
tion of capital as the source of ineffective control, not its oversight.

We have modified this report to say that HUD'Sauthority to apply more
stringent capital requirements is unclear. However, regardless of the
problems with the current statutory capital requirement, we believe
that HUD has not fully exercised its existing authorities. HUD'Spast over-
sight of Fannie Mae has been inadequate to protect the government’s
interest. For example, in our 1985 report on Fannie Mae, we concluded
that I-IUDor some other agency of the government should be overseeing
Fannie Mae risk-taking in a way that HUDwas not. In this report we
discuss how HUDhas still not audited Fannie Mae even though it has full
authority to do so.

Fourth, HUDsaid that our report is too quick to recommend separation of
policy from safety and soundness functions. HUDbelieves it is competent
to deal with the financial regulatory issues.

While we do not question HUD'Spotential capability to oversee Fannie
Mae and Freddie Mac, we note that the historical level of HUD'Seffort in
overseeing the safety and soundness of Fannie Mae has been minimal. In
the past, HUDhas argued that this is what Congress wanted. We are sug-
gesting that the taxpayers deserve greater protection. Since this func-
tion has not been well developed within HUD, we believe there would be
little lost by placing it elsewhere. In the past, the government has

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              assigned dual responsibilities- both programmatic and financial over-
              sight-to single agencies. In the final analysis, the government found
              the results of this arrangement to be very expensive in the cases of FCS
              and the thrift industry. We have suggested that the lessons learned from
              these two cases be applied to the regulatory structure for GSES.

              Fifth, HUD commented that       the report properly defers conclusions about
              capital levels and methods      of determining them. HUDsaid it is appro-
              priate to wait until its own    studies of Fannie Mae and Freddie Mac are
              released before considering      specific regulatory standards. We agree.

              Sixth, HUDsaid it is unfortunate that we did not attempt to verify finan-
              cial information provided by the GSES.Time constraints did not permit
              this, but we intend to verify certain key data, systems, and procedures
              during the second phase of our study. We are concerned not only about
              the reasonableness of assumptions in GSErisk-control and information
              systems, but also about the quality of data and the degree to which poli-
              cies are effectively practiced. We believe such verifications would nor-
              mally be a responsibility of the regulator, but HUDhas never audited the
              operations of Fannie Mae.

Freddie Mac   Freddie Mac said that several additional points should have been made
              in the report. See appendix VII for their comments.

              First, Freddie Mac noted that it is an extremely strong institution
              serving an important public mission without exposing the government to
              risk. Freddie Mac said that discussing its risks without discussing the
              housing benefits it provides is inappropriate. Freddie Mac pointed out
              that it could reduce its level of risk to almost nothing by very strict stan-
              dards but would then cease to accomplish its housing mission.

              Given the limitations of our scope of work, we are not prepared to
              express an opinion on Freddie Mac’s overall strength as an institution.
              Our discussion of risks did not attempt to establish a proper level of
              risks or the appropriate means to achieve its public purpose. We believe
              such determinations can best be made by GSEmanagers and owners
              within the bounds of safety and soundness oversight. We believe the
              government’s safety and soundness role must be one of establishing
              limits on unreasonable risk exposure, ensuring that risks are controlled
              and managed, and keeping capital at levels sufficiently high to absorb
              risks undertaken. Our study illuminated the fact that individual GSES

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have very different philosophies toward risk and public policy pur-
poses, and they may change their philosophies over time. Freddie Mac’s
comments imply that it takes the risks it does only to accomplish public
benefits. We believe Freddie Mac and others also take such risks because
they can earn profits and increase shareholder wealth.

Second, Freddie Mac believes the best way to measure capital adequacy
is through stress tests tailored to particular risks that Freddie Mac may
undertake. This Freddie Mac opinion is discussed on pages 80 and 81 of
this report, We have not yet formed an opinion on whether stress tests
are the best way to measure Freddie Mac’s capital adequacy. We note
that stress test results depend heavily on the assumptions used in the
stress model. Inappropriate assumptions can create misleading results,

Third, Freddie Mac believes that market value accounting is an impor-
tant tool for risk assessment by both managers and regulators. Market
value accounting is discussed in the report on page 35. We have added to
the report Freddie Mac’s belief that mark-to-market accounting is an
important tool for regulatory purposes, but we have not yet formed an
opinion on whether it should be a regulatory requirement.

Fourth, Freddie Mac believes that regulating Freddie Mac is not diffi-
cult, since its major risks can be easily monitored. Freddie Mac’s com-
ments pointed out that the four principles of bank regulation are
effectively in place today as a result of Freddie Mac’s internal risk man-
agement policies.

We do not agree that the four principles of bank regulation-minimum
risk-based capital requirements, limits on risk-taking, monitoring finan-
cial performance, and enforcement authorities-are      in place today. Not-
withstanding Freddie Mac’s risk control policies, there are no federal
regulations governing Freddie Mac. We do not believe that the govern-
ment should rely solely on Freddie Mac for protection as Freddie Mac’s
comments suggest. For example, Freddie Mac’s letter summarized its
stress tests and market value approach to measuring capital adequacy
and suggested that these techniques meet the criteria of capital being
held based on risks-the first element of bank regulation. In our
opinion, such internal capital guidelines are not the equivalent of having
a regulator establish minimum capital levels, including the measurement
techniques and assumptions. Internal capital guidelines and stress tests
can be changed at any time by Freddie Mac’s management. They are not
enforceable capital standards that have been adopted through public
policy debate or verified on a regular basis,

Page 118                             GAO/GGJMO-97 Govenunent’s Risks From GSEs
Chapter 6
Agency Comments and Our Evaluation

Similarly, while we understand that Freddie Mac is working with HUDto
define regulatory relationships, we are unconvinced that HUD should, as
suggested in Freddie Mac’s comments, simply accept Freddie Mac’s pro-
posed reporting indicators. We believe it is appropriate for a regulator to
define its information and oversight needs.

Fifth, Freddie Mac said that HUD has the ability and enforcement powers
to be an effective regulator. According to Freddie Mac, enforcement
authority is present in HUD'S general regulatory authority, and the Secre-
tary could seek a temporary restraining order or permanent court
injunction to prevent unsafe and unsound practices. Freddie Mac
believes all HUD needs is a structure in which to use its authority.

We are concerned that until HUD'S regulatory authority over Fannie Mae
and Freddie Mac is clarified with legislation, future Secretaries of HUD
may interpret their responsibilities in different ways. HUD has not had a
systematic approach in either its philosophy or the management of its
regulation of Fannie Mae. For example, at times, HUD has asserted an
active role. At other times, HUD has interpreted its authority very nar-
rowly and has engaged in passive oversight. In our opinion, large insti-
tutions like Fannie Mae and Freddie Mac should receive consistent
oversight by a federal regulator as long as there are federal ties. Freddie
Mac’s assertion that the Secretary of HUD could seek court orders to pre-
vent unsafe and unsound practices is literally true. However, this pro-
cess could be time-consuming. We see nothing in Freddie Mac’s
statement to suggest that any harm would be done by making such
enforcement authorities explicit in law rather than depending on court
interpretation of statutes.

Finally, Freddie Mac says that our proposal for separating the safety
and soundness regulator from the programmatic regulator does not
withstand in-depth analysis, Freddie Mac believes that placing regula-
tory authority within existing offices of the Treasury Department would
create conflicts at least as severe as HUD'S. Freddie Mac believes other
financial regulators such as the Federal Deposit Insurance Corporation
or the FHFB would have conflicts also. More than just organizational
placement, Freddie Mac said that it is worried about delays in decisions
that involve two regulators, suggesting that such delays could be costly.
Freddie Mac believes that its regulatory oversight should be carried out
by HUD, perhaps by placing the safety and soundness responsibilities in
a division of HUD that is separate from the program regulator.

Page 119                             GAO/GGD-9097 Government’s Risks Prom GSEs
             Chapter 6
             Agency Commenta and Our Evaluation

             We do not believe that the federal agency responsible for promoting a
             public policy purpose is the best agency to oversee safety and soundness
             of a financial institution because of the potential conflicts between
             accomplishing the public policy and maintaining safety and soundness.
             We see Freddie Mac fundamentally as more of a financial institution
             than a housing institution. Accordingly, we think that Freddie Mac’s
             safety and soundness regulation is most appropriately placed in an
             agency that is equipped to focus on the safety and soundness of Freddie
             Mac as a financial institution.

Fannie Mae   In its comments, Fannie Mae discussed its role as a secondary mortgage
             market participant, the benefits it provides to homeowners, the federal
             taxes it has paid, its status as a GSE,its problems in the 1980s and its
             strategy to recover from these problems. Fannie Mae’s comments also
             summarized the stress tests it uses to assess its risks and capital ade-
             quacy. Our views on stress tests are expressed in the discussion of
             Freddie Mac’s comments.

             In its comments, Fannie Mae concurred with our opinion that regulatory
             scrutiny over Fannie Mae is appropriate. However, Fannie Mae took no
             position on whether HUDshould continue as its regulator. Fannie Mae’s
             comments pointed out that Fannie Mae regularly provides information
             to HUD and to private investors and analysts. Fannie Mae said that HUD
             was given information, including business plans, during the early 1980s
             when Fannie Mae was experiencing serious financial difficulties. Fannie
             Mae’s detailed comments on these issues can be found in appendix VIII.

             Fannie Mae cited one specific item of disagreement with our report. It
             does not agree that GSEstatus creates incentives for management to take
             excessive risks. Fannie Mae pointed out that managers who are also
             shareholders have every interest in the long-term health and survival of
             Fannie Mae.

             We agree with Fannie Mae that under normal circumstances, when a GSE
             is well-capitalized and profitable, owners and managers are interested in
             protecting and increasing the value of stock. However, in times of finan-
             cial distress, when stock value has been seriously depleted, owners and
             managers may then have incentives to take unusual risks in order to
             recoup losses. Our report suggests that weakened creditor discipline
             would allow GSEowners and managers to take unusual risks because
             they can continue to borrow even when financially distressed. Further-
             more, we note that the borrowing costs of a GSEare not strongly tied to

             Page 120                             GAO/GGD-90-97 Government’s Risks From GSEs
                          Chapter 6
                          Agency Comment6 and Our Evaluation

                          the risks they undertake or the capital they hold, allowing GSEowners
                          and managers to increase risks without a commensurate increase in

Comments From the
Department of
Education and Sallie

Department of Education   The Department of Education generally agreed with our conclusion that
                          additional oversight of Fannie Mae’s, Freddie Mac’s, and Sallie Mae’s
                          risk-taking and capital levels is needed. Its comments can be found in
                          appendix IX.

Sallie Mae                Sallie Mae made four general observations about our report. Its detailed
                          comments can be found in appendix X.

                          First, Sallie Mae said it is unfair for our report to use the perception that
                          the federal government would assist a troubled GSEas justification for
                          increased regulation without making a promise of assistance explicit.

                          We do not agree. Our report attempts to disclose the nature and implica-
                          tions of GSEties to the government and how the government has
                          responded to GSEtroubles in the past. We understand that giving GSE
                          obligations the full faith and credit of the United States would resolve
                          the ambiguity surrounding GSEstatus. However, we see no clear benefit
                          to the government from taking such action. We expect that providing
                          full faith and credit to GSEobligations would eliminate whatever private
                          market discipline may exist because of the ambiguous status of GSESand
                          would create the need for very intrusive regulation, Since GSESare
                          neither fully private nor clearly public, we think their current status
                          suggests that both private market discipline and federal regulation are
                          appropriate. Our report attempts to note the weaknesses in both.

                          Second, Sallie Mae disagreed with the proposition that the unquantifi-
                          able benefits of agency status somehow warrant the application of
                          increased federal regulation. Sallie Mae believes that the firm does not
                          benefit in an economically significant way from its agency status. Sallie

                          Page 121                              GAO/GGD90-9’7 Government’s Risks From GSEs
Chapter 6
Agency Comments and Our Evaluation

Mae pointed to its high quality balance sheet and the effectiveness of its
corporate management as the key indicators of its credit standing in the
private markets. Sallie Mae said that it is arguable that the lost business
opportunities from its charter limitations would more than offset any
marginal cost savings it may experience in the credit markets.

Our report does not suggest that the federal oversight is needed because
of the unquantifiable benefits of agency status. We discuss the benefits
GSES receive as evidence of the federal ties that may provide an incen-
tive for the government to assist a troubled GSE.It is the risk to the gov-
ernment from GSEinsolvency, not GSEprofits, that provokes us to
conclude that additional oversight is needed for certain GSES.We agree
that Sallie Mae’s credit standing is quite high, and that there is no evi-
dence to suggest that Sallie Mae represents an imminent risk of failure
to the government. We would expect that federal oversight of Sallie Mae
would simply reinforce the prudent business practices that Sallie Mae
has traditionally employed and would not be overly intrusive.

In its third comment, Sallie Mae questioned the treatment of GSESas
analogous to banks, pointing out that the government’s interest in the
banking sector is more direct and more pervasive than its interest in
protecting GSEinvestors.

Our report drew analogies between GSESand banks but tried to make
clear that we did not believe that GSESshould be treated identically to
banks. We noted important similarities and differences between GSESand
banks that we believe argue for using the bank regulatory elements
while customizing them to suit each GSE.However, we believe that the
elements of safety and soundness oversight are appropriate for GSES.
The GSEs themselves use variants of these elements to manage the risks
that they assume from business counterparties. For example, in doing
business with another firm, Sallie Mae may require that the firm main-
tain minimum levels of capital or a minimum net worth; they may mon-
itor the firm’s performance under the business agreement, and they may
terminate contracts when the firm fails to satisfy the terms. Sallie Mae’s
purpose in doing so is to limit its own exposure to risk, not to protect the
interests of investors in the counterparty firms. Similarly, the govern-
ment’s purpose in overseeing Sallie Mae is to limit the government’s
exposure to risk, not to protect Sallie Mae’s investors.

In its final comment, Sallie Mae asked that we carefully consider the
wisdom of developing separate risk-based capital rules for each GSEor

Page 122                             GAO/GGD-99-97 Govermuent’s Risks From GSEs
                 Chapter 6
                 Agency Comments and Our Evaluation

                  allowing a federal regulator to create such rules in the absence of agree-
                  ment on objective standards. Sallie Mae said that after 17 years of exem-
                 plary risk management, the imposition of an outside regulator to
                 monitor and evaluate the adequacy of Sallie Mae’s capital does not
                  appear justified. With full disclosure of the financial risks undertaken
                 by GSES,Sallie Mae believes investors are able to make better-informed
                 judgments on investment risk in the context of current market condi-
                 tions than regulators would under static guidelines.

                 In our opinion, those who assume risks should evaluate the probability
                 of suffering losses from such risks. If private investors in GSEobligations
                 were to assume all risks, they would be likely to evaluate GSErisks more
                 thoroughly and perhaps more competently than a regulator. However,
                 the evidence suggests that GSEinvestors have not perceived the risk of
                 default of GSEdebt obligations and have not subjected GSESto high levels
                 of market discipline. We acknowledge that Sallie Mae has never needed
                 federal assistance in the past and does not expect to need it in the
                 future. But we do not believe that private markets have effectively dis-
                 ciplined GSErisk-taking. Unless the government would clearly demon-
                 strate its willingness to allow a GSEto fail and its creditors to suffer
                 losses, we would not expect the private markets to change their current
                 discipline of GSEsecurities. As a result, we are reluctant to rely on pri-
                 vate markets as a complete substitute for federal oversight.

Comments From
Connie Lee and
Farmer Mac

Connie Lee       Connie Lee agreed with the representations of Connie Lee contained in
                 the draft report. See appendix XI for Connie Lee’s comments.

Farmer Mac       Farmer Mac said that the discussion about Farmer Mac was generally
                 fair, accurate, thorough, and objective. Farmer Mac agreed that it has no
                 regulatory capital requirements but believes that it had other equity
                 requirements. Farmer Mac said that its statute requires that every pool
                 be backed by a cash reserve or a subordinated participation in the
                 security of at least 10 percent of the security and that this provision
                 should be considered as an equity requirement. Farmer Mac said that

                 Page 123                             GAO/GGD-90-97 Government’s Risks From GSEs
Chapter 6
Agency Comments and Our Evaluation

this requirement exceeds the capital requirements financial regulators,
rating agencies, and securities analysts use for other financial institu-
tions. See appendix XII for Farmer Mac’s comments.

While we believe the requirement for a lo-percent reserve or subordi-
nated interest is an important protection against credit risk for Farmer
Mac, we do not equate this requirement with an equity capital require-
ment. We believe the use of a reserve or subordinated interest in the
securities guaranteed by Farmer Mac is not unlike credit enhancements,
such as recourse with collateral, used by other GSEs to protect them-
selves against credit risk. However, equity capital would be the owners’
investment in Farmer Mac. It would provide both an additional buffer
against loss and Farmer Mac’s owners with an incentive not to take
excessive risks. Finally, we would point out that the value of farm land
was very volatile in the 1980s. To be effective in protecting the govern-
ment’s financial interest, the reserve or subordinated interest should be
accompanied by other buffers including conservative underwriting prac-
tices and equity capital.

Page 124                             GAO/GGDBB-97   Government’s Risks From GSEs
Page 125   GAO/GGD-90-97 Government’s Risks From GSEs
  Ppe    ’

&&t&s                        From the Farm Credit System

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.                               THEFARMCREDITCOLJNC'L
                                                    50 F STREET,   NW.   SUITE900. WASHINGTON,
                                                                                            DC2000l 2021’526~8710

                                                                                                                    DENVER OFFICE:
                                                                                                                    PO. BOX 5130
                                                                                                                    DENVER. COLORADO 80217
                                                                                                                    TE,k 303”40-4200

                               June 6,       1990

                               Mr. Richard L. Fogel
                               Assistant Comptroller General
                               United States General Accounting Office
                               Washington, D.C. 20548

                               Dear Mr. Fogel:

                               WC appreciate the opportunity to commenton the draft report,entitled Government-Sponsored
                               Enterprises: Government’sExposure to Risks. This letter summarizesthe comments by the
                               Banks of the Farm Credit System (System) about this report. Technical commentsare noted
                               directly on the attacheddraft of the report.

                               Initially, we note that the GeneralAccounting Office is not recommendingadditional government
                               oversight or higher capitalization of the System. We agreewith this conclusion. However, we
                               believe the report does not go far enough to highlight the positive changeswhich have taken
                               place in the Systemsince 1985and the significance of thesesubstantivechanges. These changes
                                         .           the establishmentof an independent,arms-length regulator,
                                         .           the strengthening of the regulator’s powers to ensure safety and soundnessof
                                                     System institutions,
                                         .           the establishmentof risk-based, permanentcapital standardssimilar to those of
                                                     Federally charteredbanks,
                                         .           the establishmentof a System-funded insurance fund,
                                         .           a significant reduction in operating costs, and
                                         .           major improvementsin the managementof System institutions.

                               The very reason for the Congressestablishing the System is the basis for one of your agency’s
                               primary concerns--inherent risk. The Congressrecognized theserisks when it authorized the

                                             Page 126                                          GAO/GGD-SO-97 Government’s Risks From GSEs
                         Appendix I
                         Comments From the Farm Credit System

                Mr. Richard Fogel
                June 6, 1990

                institutions of the System. The Congresswanted a single-purpose entity devoted to making
                credit available to farmers, ranchersand their cooperativesin order to assurean adequateand
                dependableflow of capital into rural areas. There is ampleevidencethat financial intermediaries
                that do not have this legislative mandatewill not make credit available on a consistent basis to
                meet the needsof rural America. The Systemhas fulfilled and will continue to fulfill this vital
                public purpose role in order to assurean abundant,competitively priced supply of food and fiber
                for the American public. In accomplishing this goal, there is no question that the System may
                encounter risks which are avoided by commercial lenders who choose not to serve agriculture
                or who do so sporadically.

                While there are risks in concentratedlending to one sector of the economy, the System is
See comment 1   effectively managingtheserisks. Improvedasset/liability management(ALM) hasbecomea high
                priority to ensurethat interest rate risk is minimized. Each SystemBank monitors and manages
                its interest rate risk through an Asset/Liability ManagementCommittee and on a day-to-day
                basis through application of sophisticatedALM techniquesand funding strategies. The report
                reflects a concern that if System Banks managethe debt issuances(liabilities) and direct-lender
                Associations make the loans (assets),there is an inherent problem in the ALM process. We
                disagreewith the premise that this is a problemthat cannotbe satisfactorily managed. Moreover,
                we note that the trend toward direct lending at the Association level, which was facilitated by
                the Agricultural Credit Act of 1987 (1987 Act), is consistent with the premisethat the System’s
                credit risk exposurewill be minimized by keeping the responsibility for credit judgments at the
                local level. The Banks and Associations can and do work together to ensure that the behavior
                of the System’sliabilities correspondsclosely with the behavior of the System’sassets.

                Your report cites the System’s regulator as limiting the System’s ability to mitigate its risks
See comment 2   through diversification. It is true that the Congresshas taken a cautious stancewith regard to
                lending authorities for the System;however, public commentsby the Farm Credit Administration
                (FCA) acknowledgethat greaterdiversification in the loan portfolios of Systeminstitutions will
                be necessaryin the future to reduce the financial risk to System institutions while at the same
                time continuing to fulfill the public policy for which the System was created. In addition the
                expansion of fee-based services provides a further opportunity to diversify income.

                In an additional effort by the System to prudently manageits risks, the System’s Banks and
                Associations voluntarily adopted National Credit, Review and Appraisal Standardswhich are
                managementpolicies and standardsthat are consistentwith thoseof well-run commercial banks.

                We strongly disagree with the conclusion reached that implicit Federal backing promotes
See comment 3   excessive risk taking. It is our opinion that there is evidencewhich can be cited to the contrary.
                As we have described,by its very nature and Congressionalmandate,the System is expectedto
                serve agriculture on a consistent basis. While there is an inherent risk in serving as a financial

                         Page 127                                        GAO/GGD-90-97 Government’s Risks From GSEs
                         Appendix I
                         CommentsFrom the Farm Credit System

                Mr. Richard Fogel
                June 6, 1990
                intermediary to this industry, it is our contention that the System is using all available credit,
                administrative and interest rate risk managementtools to lessenthat exposureso that operations
                are conducted in a safe and sound manner.

                History also shows that there is a market mechanismwhich becomesa factor when risks are
See comment 3   perceived to be too great. Even as a GSE, our cost of funds increasedsignificantly when risks
                were perceived to be greater. We are, therefore, very cognizant of properly managing our
                business, just like other lenders. We encouragethe GAO to become more familiar with the
                System’srisk-control mechanismsas it indicates it will do as a part of the preparation of its
                second report.

                We strongly disagreewith your conclusions regarding the managementof System institutions.
                Over the past several years there have beensubstantial changesin System management. This
                new managementhas done a remarkablejob of managinginstitutions during periods of extreme
                stress and have returned the System to profitability. We find it regrettable that the GAO has
                found an unbalanced view upon which it has based its conclusions regarding System
                management. It is our hope that as you begin PhaseII of your reporting project more direct
                communication and review of Systeminstitutions by GAO staff will provide a broaderbasefor
                evaluating managementeffectiveness.

                The financial assistanceauthority provided in the 1987Act is often misrepresentedas it is in this
                report. The perception has beencreatedthat the Systemhas received $4 billion in Federalmoney
                funded by America’s taxpayers. This is erroneous.The 1987Act provided a funding mechanism
                by which the Farm Credit SystemFinancial AssistanceCorporation can issue up to $4 billion of
                U.S. Treasury-guaranteed debt to assist financially stressed institutions, to retire protected
                borrower stock in liquidating institutions, to fund third quarter 1986 Capital Preservation
                accruals,and for other specified purposes. It is true that the interest paymentson portions of the
                debt issuedwill be funded for a limited period of time by the U.S. Treasury. However, the 1987
                Act requires 100 percent Systemrepaymentof all interest and principal. To characterizethe $4
                billion as direct Federal financial assistancenot only createsthe erroneousimpressionthat U. S.
                Government funds will not be repaid, it also createsthe incorrect impression that the U.S.
                Treasury has already written the Systema checkfor $4 billion. In fact, there hasbeenonly $847
                million in bonds issued to date, of which $371 million was for direct assistanceto four Banks,
                $415 million was for payment of Capital Preservationaccruals, and the balance was for other
                uses, including protected borrower stock retirement and Assistance Board expenses. We also
                anticipate issuance of approximately $325 million in the next week. We believe the financial
                assistanceshould be described as U. S. Government-guaranteedborrowing authority.

                        Page 128                                         GAO/GGD90-97 Government’s Risks From GSEs
         Appendix I
         Comments From the Farm Credit System

Mr. Richard Fogel
June 6, 1990

There are four points specifically addressingthe perceivedrisks to the U.S. Governmentthat have
not heen fully developedin the PhaseI Report: the Farm Credit Insurance Fund, the joint and
several liability of the SystemBanks,the collateral requirementfor issuing debt,and the System’s
internal Bank monitoring program.

The Farm Credit InsuranceFund was createdby the 1987 Act primarily to insure debt issued by
the System Banks. This fund will grow through the payment of premiums assessedto System
institutions. Since the ultimate size of the Fund is not capped, it will be a significant buffer
between any System lossesand the potential exposureof the U. S. Governmentto such losses.
Furthermore,this System-funded InsuranceFund is in addition to the 7 percentminimum, risk-
basedpermanentcapital requirementsproscribedby the FCA for System institutions.

Another significant buffer between exposureof the Federal Government to losses is joint and
several liability. All Systemwide debt issuancesare the joint’and several obligations of every
System Bank. Often cited as a major reason for investor confidence in the System,joint and
several liability is the line of defenseafter all of the assetsof the Insurance Fund have been

In addition, the draft report fails to note the statutory collateral requirement imposed on
Systemwide debt issues of System Banks. Each System Bank is to have at the time of debt
issuance,and to maintain thereafter,specified eligible assetsat least equal in value to the total
amount of debt securities outstanding for which it is primarily liable. The collateral consists of
notesand other obligations representingloans or real or personalproperty acquiredin connection
with loans and certain other assetsspecified in the Farm Credit Act and the FCA’s regulations.
While the collateral requirement does not ensure an investor or the U. S. Government against
loss, it does preclude an institution whose collateral has lost substantial value from continuing
to accessthe public debt market and thus possibly increasing the exposure of the Government.

Another important buffer to potential loss is the internal Bank monitoring program established
by the System through the Federal Farm Credit Banks Funding Corporation. The Farm Credit
Act recognizes the need for debt issuancecriteria and provides for performing internal Bank
reviews and analysis. The Federal Farm Credit Banks Funding Corporation has developed and
implemented a Market Accessand Risk Alert Program(MARAP). The MARAP is designedto
provide an early-warning and loss prevention mechanism.

        Page 129                                         GAO/GGD99-97 Govemment’s Risks From         GSEB
       Appendix I
       Comments     From the   Farm Credit System

Mr. Richard Fogel
June 6, 1990

Finally, we would like to reemphasizethe points that the GAO has made with respectto the
System’s regulator. The FCA has, as a result of the intensive Congressional scrutiny and
legislative action regarding the System, been empoweredwith authorities similar to those of
commercial bank regulators in order to regulate Systeminstitutions. These authorities require
the FCA to be an arms-length regulator and to enforce safety and soundnessat each System

Again, we appreciatethis opportunity to commenton your draft report. We respectfully remind
the GAO of the substantivedifferences in structure,administration and businesspurposesamong
the GSEs and requestthat the General Accounting Office be mindful of these differences as it
goes forward with its analysis. We are available at any time to respond to further questions or
provide additional information as required.


                                                    Peter C. Myers
                                                    Presidentand Chief Executive Officer
Federal Farm Credit Banks                           The Farm Credit Council
Funding Corporation


       Page 130                                         GAO/GGD-90-97 Government’s R.isks From GSEs
               Appendix I
               Comments From the Farm Credit System

               The following are GAO'Scomments on the Farm Credit Council’s June 6,
               1990 letter, which was also signed by the President and Chief Executive
               Officer of the Federal Farm Credit Banks Funding Corporation.

                1. We acknowledge in our report that the FCSas a whole has improved
GAO Comments   its asset and liability management. However, we believe that the frag-
               mented responsibilities for managing assets and liabilities make it diffi-
               cult for the FCBSto manage interest rate risk. While liabilities are
               managed by an FCBwith one group of managers and the corresponding
               loans to farmers are managed by associations with other managers that
               report to a board of directors chosen by the farmer-borrowers, there can
               be pressures to keep loan rate increases down even when liability rates

               2. We believe that the evidence presented in the report supports the con-
               clusion that GSES'ties to the government have weakened the discipline
               that creditors normally provide to completely private financial firms.
               We feel that the marketplace has allowed GSESto undertake risky activi-
               ties even when they were experiencing financial difficulties, because
               investors perceived that the government would suffer any resulting loss.

               The report acknowledges the widening of GSES'spreads over Treasury
               securities during periods of serious financial difficulty. However, even
               during these periods the GSESretained their AAA ratings, and creditors
               continued to purchase GSEdebt securities. In our view, creditors do not
               react to deterioration in a GSE'Sfinancial condition in the same way they
               react to a similar change in a completely private firm.

               3. The report does not imply that FCAlimits FCS'ability to mitigate its
               risks through diversification, It points out that a GSE'Scharter act limits
               it to certain permissible activities and that F&I provides oversight to
               ensure that FCSinstitutions operate safely while addressing their public
               policy purposes.

               Page 131                               GAO/GGD90-97 Govemment’s Risks From GSEs
Appendix II

CommentsFrom the Famn
Credit Administration

                  Farm Credit      Administration                  1501 Farm Credit Drive
                                                                   McLean, Virginia 22102.5090
                                                                   (703) 883-4000

                   June 4, 1990

                   Ms. Suzanne J. McCrory, Project      Director
                   General Government Division
                   U. S. General Accounting Office
                   Washington D.C. 20548
                   Dear Ms. McCrory:
                   Thank you for the opportunity      to review    the GAO draft   report.
                   This first  phase report provides a useful overview of GSE risk issues
                   and a reasonable framework for the second phase of the GAO study.      We
                   have a number of comments on the focus as well as on specific    technical
                   details.   We hope they will be useful to you both in editing  the current
                   draft and in conducting the second phase of your study.
                   We think ,the report inadequately   addresses both the FCA regulatory     role
                   and the future role of the FCS Insurance Corporation.      More generally,
                   the Executive  Surmnary should make a clearer distinction   between the GSEs
                   which have a federal financial    regulator  (Farm Credit Administration     or
                   the Federal Housing Finance Board) and those which do not.
                   We agree GAO inference that, among the GSEs, the FCS is not the primary
                   risk concern.    But we would propose that the FCS discussion          be refocused
                   to emphasize potential   risks for the future rather than carryover           risks
                   from the recent history.      To do otherwise does not provide an accurate
                   portrayal  of the prospective    regulatory     situation   for this GSE. The
                   result is to leave the impression that the FCS is not effectively
                   regulated,  despite the GAO assertion       that the first     phase of your study
                   did not attempt to assess the effectiveness           of FCA.
                   The current emphasis fails to recognize the steps FCA has taken to
                   address risk reduction since we have received additional         authorities.
                   As you note late in the repcrt,     FCA has implemented actions in each of
                   the major areas called for in the GAO draft.        It also fails    to recognize
                   the potential   impact of the FCS Insurance Corporation     in government risk
                   control.    We believe these forward-looking    factors are fundamental to
              I    any comparative     assessment of government risk arising   from the various


                        Page 132                                     GAO/GGD90-97 Government’s Risks From GSEs
      Appendix II
      Comments From the Farm
      Credit Administration


We would also agree with your observation       that the information  on   Farmer
mc is not all in, which implies that its government risk concern           level
cannot be inferred   from that of the FCS institutions.       We suggest   that
your revision   emphasize the need to apply the same risk standards        as you
indicate   are needed for Fannie Mae, Freddie Mac, and Sallie Mae.         We
draw your attention    to our comments specific     to Faner Mac.
We would also welcome an opportunity      to meet with GRO to discuss      any
questions  regarding the substantive    issues we have raised.

George D. Irwin, Deputy Director
Office of Financial Analysis

      Page 133                                 GAO/GGD-99-97 Government’s Risks From GSEs
Appendix III

CommentsFrom the Department of Agriculture

supplementing those in the
report text appear at the
end of this appendix.
                                                     DEPARTMENT       OF AeRICULTURE
                                                          OFFICE OF THE SECRETARY
                                                           WASHINOTON,   O.C. 201e)O

                             June 5, 1990

                             Mr. Richard L. Fogel
                             Assistant Comptroller General
                             General Accounting Office
                             Washington, D.C. 20568

                             Dear Mr. Fogel:

                             Enclosed are our commentson the draft report entitled p                              * .
                                                    re to IQ&    This report focuses on the risk-taking and capital of
                             certain government-sponsored enterprises (GSE). Our comments are restricted to and
                             focused on institutions of the Farm Credit System.

                             If you have any questions, please contact Mr. Eric Thor at 737-9255.


                                    Page 134                                    GAO/GGD-9@97 Government’s Risks From GSEs
      Appendix Ill
      Commenta From the Department
      of Agriculture


&ack of Qualitv       Capital     in FCS inetitutione
1. GAO focuses on risk-baaed capital aa an important buffer
bet-en      GSE losees and the taxpayers.              However, greater emphaeie
should be placed upon the quality and type of capital in these
institutions.        FCS inetitutione       are cooperative institution0
capitalized       by their borrower6 as LLcondition of borrowing.
Generally,      the borrower stock is retired automatically               upon
repayment of a loan.          During the period of financial           difficulty,
operating losses of FCS inetitutione                were exacerbated when
quality     borrowers paid off their loane seeking loans elsewhere
with more attractive        interest    rates, thue reducing the capital
available     to support PCS inatitutione             during difficult    times.
Such loan pay-downs dramatically             accelerated     when borrowers,
learning of the financial           condition of the institutions,           aought
to avoid losing their etock investment.
Although the Agricultural        Credit Act of 1987 required that etock
after a certain date muet be "at risk”         and that only "at rick”
stock would count toward meeting permanent rink-baeed capital
requirements,     the fundamental problem of long-term capital and
"non-investor"      capital haa not been eolved.      There ia no reason
to believe that farmer/borrowers        holding "at risk" stock will not
attempt to leave firet or have the government guarantee payment
of their stock in future times of severe financial          difficulty  of
FCS institutions.        The etatute doee permit lower borraeer capital
levels, which many Farm Credit dietricte         are using.    However, in
these cases, greater reliance ie placed upon retained earnings as
a capital baee.

Problems of Directore           aa Borrowera
2.     GAO recognizes that directors              of Syetem inetitutions,       which
select management and aet credit and loan pricing policies,                        are
farmere without banking or financial                  backgrounde.    The report
does not mention a more serious problem in that all directors                        are
borrowers and have greater incentive                  to select management baeed
on their willingness         to obey the directors           rather than focusing
on their financial         ability.        The borrower/directors       hava little
incentive    to hire management that will take reeponaible credit
ac;tione,   roiLme intereel:        xbtee,   or price loans to cover the
government rierk when thoee ootione                may hurt themeelvee and the
borrowere that elected them, Thin may be particularly                       true when
theee directore       perceive that the Federal government may provide
the FCS inetitutione         with aeeietance and protect their stock
inveetment.      Other financial           regul.atora and inetitutione        have
nubetantial     restrictions          on loans to directors       and officers     due
to the problems created by ineider loan activities.

       Page135                                     GAO/GGD.BO-97
                                                             Government’s        Ri&~FrornGSEe
                        ofAgriculture                                                                           Y

                3.   The report    diraounta the extent to whiah inventor6 charge
                greater spreads over comparable Trearury recuritier             in purchaeing
                GSE recuritier.       While inveetore do not demand rate6 that would
                be aharged commercial enterprise6 with comparable rink,             investors
                have been more diligent       in determining appropriate yields for GSE
                aecuritiee     than during the OS& financial     difficultiee     of the
                19806. In addition,        the independent rating agenciee have been
                making investors more aware of the financial           condition of the
                GSEe with very detailed explanation         of their operations.

                SPECIFIC CORMENTS
                                ON GAODRAFTREPORTON GSEe

                EDrmer                       ructure      and FCS Oraanizational         and
                                        8 Ac&lerated       Credit Crieie
Now on p. 3.    1. Page 6, "The government did not have the monitoring
                capability     or capital rulee in place to learn about the Farm
See comment 1   Credit crisis     in time to prevent it from becoming serioue"             does
                not provide a complete picture.            There may be more important
                cauoea, including       (1) that the regulatos wae governed by a body
                of Preeidentially       appointed nrepreeentativeeW of the banks that
                the agency regulated;         (2) that the borrower etock invested in the
                banks, clearly meeting etatutory           and regulatory     capital rulee,
                operated, due to the nature          of cooperative corporate structure,
                more like     compensating balances than true equity; and (3) that
                the farmer/borrower        directore    of System institution6      were not
                dieinterested     in matters affecting       borrower6 nor skilled      in
                financial     or agricultural      credit matters.
                The lack of independence of the former FCA Board insured that the
                regulator'n    monitoring of the Syrtem'e deteriorating                   financial
                condition was not given proper consideration                   until it was too
                late.     The nature of the cooperative borrower etock made the
                capital illusory      when the borrower stockholders paid down their
                loans to the amount of the offsetting               capital,     permitting      a "run"
                on these non-depository          inetitutione.        The ineider nature of
                borrowmr/directors       severely limited bank actions that would have
                stemmed the institutioner           financial     deterioration       but would have
                resulted in financial        difficulties       for the farmer/borrowers.             The
                nature of the Farm Credit banking structure                  ie one of the more
                serious    part and present financial           risks of the PCS to the
                Federal    government.      The lack of regulatory           enforcement to
                correct identified       probleme and the failure            to follow generally
                accepted accounting principles              aleo contributed        to the FCS
                financial    deterioration.


                         Page136                                     GAO/GGD-90.97Government'sRisksFromGSEs
                            Comment8    From the   Department

Now on p, 18.   2.    Page 29: The draft report separates Farm Credit Banks and
                Banks for Cooperatives as separate GSEe. This may be misleading
                given general focus of the report on the borrowing activities        of
                GSEs that implicitly    commit the United States to repay debt
                obligations.     Since 1978, the Farm Credit System Banks--including
                Federal    land banks, Federal intermediate   credit banks and Banks
                for cooperatives--have    issued Federal Farm Credit Banks Bonds
                joint and several obligations      of all Syetem Banks and have ceased
                to issue separate bank system securities.       The Federal land banks
                and Federal intermediate     credit banks merged in 1998 to become
                the Farm Credit Banks. Though the Farm Credit Banks and the
                Banks for Cooperatives are separate legal entities       they all
                borrow together through the issuance of Federal Farm Credit Bank
                bondo and notes, not independent debt obligations.         Thus, for
                purposes of the debt marketa and the potential       impact on the
                United States they should be considered together as one GSE, the
                Farm Credit    System banks.

Now on p, 18    3.   Page 30.     While the Secretary of the Treasury does not have
                specific    approval authority    over the issuance of Farm Credit
                securities,    the System banks, pursuant to 31 USC 9108, must
                consult with the Secretary of the Treasury on securities         lssuee.
                In practice,     this has required consultation    with Treasury when
                System banks have decided to ieeue a different         type of security
                rather than particular     issuee   of aecuritiea.

                        iration      of Bond Isauina      Authoritv
Nowonp.   19    4. Page 31. The draft report states that through 1992, the
                Aseiatance Board may authorise up to $4 billion      in federal
                assistance.     It should be noted that the Asaimtance Board's
                authority    to direct the Farm Credit System Financial Assistance
                Corporation to iaaue bond obliyations     to fund the aseiatance
                expires September 30, 1992. As a practical      matter, proviaion of
                assistance after that date is limited to funds then held in the
                Farm Credit    Aeeiatance Fund, which is not expected to be

                Current           FCS Oraanixational      Structure
Now on p. 21.   5. Page 34. The chart showm Farm                      Credit Banks as only financing
                loans.   This is true in only a few                   Farm Credit districta.     Most
                Farm Credit Banks continue to make                    loans directly   and to finance
                loans from associations  to farmers                   and ranchers as stated on page
Now on p. 21.   35 of the report.

                           Page137                                       GAO/GGD-90-97Government'sRisksFromGSEs
                              Appendix   III
                              Comments    Fromthe   Department
                              of Agriculture

                      Jackson FICB Lending
Nowonp    21.         6.  Page 35. The Federal Intermediate   Credit Bank of Jackson
                      does not make operating loans directly  to farmers and ranchers
                      but finances them through First South Production Credit
                      Association  and Northweet Louisiana Production Credit
                      :       t                            Vi
Now on p. 31.         7.    Page 49. Adding the phrase "practices      and" at the bottom    of
                      the page better covers most future activity        that could
                      significantly    impact the risks to FCS viability.       The sentence
                      would read, n However, certain FCS institutions         remain weak, and
                      we cannot predict what effects future external economic
                      conditions    and internal management practices and changem might
                      have on the risk-taking    strategies or the financial      health of any

                      FCB Asset Manaaement
Now on pp 37-38       8. Page 61-62. While it can generally be said that FCBs manage
                      the liabilities     and associations  service the assets, it is
                      misleading to state that the associations       manage all aspects of
                      the assets.     All FCBs that continue to have direct long-term
                      lending authority     manage those long-term assets.     In other cases,
                      the FCBs control the movementa in intereat       rates on long term
                      loans in most districts     and therefore,   have the authority  to
                      exert some control over the assets.
Now on p. 38.         9. Page 62.     The rates, terms and conditiona of the vast bulk of
                      long-term agricultural      real estate loans are set by the FCBs, not
See comment 2.        by the associations.      It in organizationally    possible under the
                      Agricultural   Credit Act of 1987 for Federal land credit
                      associations   and agricultural    credit asmociationa to make such
                      decisions,   but thie mode of operations is currently       present in
                      only a few districts.

                      m     Enforcement Actions
Now on p. 65          10.   Page 110. The report states that 60 percent of FCS aeeets
                      are   owned  by institutions     under FCA enforcement actiona.  Cur
                      understanding     is that most of these assets are subject to written
                      agreements with FCA which are not enforcement actions but may
                      subject the institution      to a notice of charges if the agreement
See comment 3         is violated.     m 12 USC 2261. The existence of such agreements
                      or the fact that the institution        is under an enforcement action
                      is important to recognize the risk exposure of the inetitution
                      but does not, by iteelf,       indicate that the current management is
                      inadequate.     In many cases, management has been replaced as a
                      result of the FCA actions and the new management is working to


                             Page138                             GAO/GGD-9097Goverruuent'sEisksFromGSEs
                           Comments Fromthe Department
                           of Agriculture

                    relrtore the inatitution*e          financial   condition     in order   to have
                    the actions removed.

                               of KJebt to CaDita!,
Now on pp. 76-70.   11. Page 133. The chart and accompanying analyeis                    does not look
                    at debt or liabilitiee aa a percentage of capital.                   Financial
                    analysts generally look at the debt to equity ratio                  aa an
                    indication of repayment capacity.

                    Meauacv of QW.itv            of PCS Capital
Now on p. 89.       12. Page 152-53. It ie a eignificant       weakness of the report
See comment 4.
                    that the adequacy of the GSE capitalieation     is not assessed. Aa
                    GSE capital is the buffer to U.S. government risk expoaure, a
                    real aaaeasment of that rick exposure cannot be evaluated
                    completely without a judgment on the adequacy of GSE
                    capitalization  and liability structure.

                         York Citv Bail-Out
Now on p. 91.       13. Page 156. The Federal government did not bail out the City
See comment 5.      of New York. President Ford affirmed in October 1975 that there
                    would not be a Federal bail-out       of New York City.  The State of
                    New York passed the Moratorium Act to allow the Municipal
                    Assistance Corporation,     eetabliahed to aasiat the City, to offer
                    bonds in exchange for defaulted obligations       or for a 3-year
                    principal   payment moratorium and reduced interest     package on the
                    defaulted obligations.      The Federal Reserve Board made clear   its
                    willingneea   to fulfill  ita role am lender of laat resort, though
                    no problem materialized.

                    pCS inatitutionk         Not Sublect    to Bankruvtcv   Act
Now on p 92         14. Page 157, 160. LFquidation of Farm Credit System
                    inetitutione     ie not: eubject to the Federal Bankruptcy Act or
                    state lawa. FCS inetitutiona         are liquidated  by the Farm Credit
                    Admin5.atration.     &$ Knox NatS.oh
                    w            300 U.S. 194 (1937). 3         alao 12nUSC 2?83t !l!hz'
                    Federal Land Bank of Jackson and ztmeroua production’credit
                    associations     have been liquidated    under thie etatutory  authority
                    during the past aeven 'years , not under the Federal Bankruptcy

                                       ued    Federal   SuQDozt of GSEa Neceeaarv
Now on p. 93.               Page 161. The report aeeumee without analyaia that the
See comment 6.      i%ll.c purpoae for each GSE continue8 to exist such that private
                    entities    reetricted to the same purposes would not provide the

                           Page139                                    GAO/GGD-90-97

                      mamefunction.         Such aesumption should be supported by data and
                      analyaie.      In view of United States rilrk exposure to GSEa, the
                      need for public aupported GSEa ahould be periodically        re-
                      evaluated to insure that continued government aupport is
                      neceeeary.      And if euch support ie not neceaeary, tranafer of
                      such riek to the private sector could greatly reduce government
                      risk    exposure.     For example, the atatement that the FCS had
                      difficulty     offering   competitive loans to farmere during the mid-
                      1980e auggeets that other entitiee        were providing competitive
                      loans and that credit was available.         Provision of funds to FCS
                      at that time must be eupported with analyaie that credit wan
                      unavailable     from the commercial sector to creditworthy     borrowera
                      or from FmHAaa lender of last resort.

Now on p, 97,         16. Page 168. Comparison of the lack of overeight of Fannie
                      Wae, Freddie Mac, and Sallie Mae to the oversight over PCS
                      inmtitutions     may not be entirely      appropriate.         FCS inatitutione
                      had virtually     no financial     marketplace checks on their activities
                      until the financial      deteriorat$on     was ao severe that Federal
                      assistance waa neceaeary to avoid significant                liquidation      of
See comment 7.        System inetitutione.        These other GSEa have marketplace impacts
                      on the price of their equities that require earlier                   reaponaea to
                      financial     downturn6 to avoid eignificant          depletions      of the value
                      of their capital through selling in the marketplace.                     Fannie Mae
                      experienced significant        financial   difficulty      in the earlier
                      198Os, but recognized the problema early, addreeaed them, and
                      avoided the neceseity of Federal aeaietance.
                      The FCS inatitutionqhad         regulatory    and examination overeight,
                      though not aa atrong am current authorities,            but no concomitant
                      marketplace impact.        Though limited in enforcement toola prior to
                      the 1985 legislation,        the FCA could have made ite findings public
                      mooner, and the results may have limited the ultimate loaaee of
                      FCS inatitutione      during thia period.       The ineffectiveneee     of the
                      regulator     prevented recognition      of the problems or their public
                      diecloeure.       The result wae a muoh later recognition         of financial
                      problems at a point that waa too late to avoid collapse without
                      Federal aaeiatance.         In addition,   if the FCS institution0      had
                      marketplace sensitive        equity, taxpayer loslrea may have been

                      PCS inet.i.tutiona    Monitored   ae Banks
Now on pp. 106-107.   17. Page 185-86. We agree that GAOevaluation        for improving
                      monitoring of risk-taking   muet coneider the differences    between
                      GSEa and banka. However, such evaluation     should aleo diatinguiah
                      FCS inetitutiona  from other GSEe in that the FCS are cooperative

                             Page140                                  GAO/GGD-90-97
                      CommentsFromthe Department
                      of Agriculture

Now on p. 107   18. Page 187. In the ctme of the PCS, the private owner0
                 (farmer/borrowere)      did act adverse to the governmen t's interest
                in time of financial        diatreee by paying down their loans and
                retiring    their capital or by not allowing the hired management to
                appropriately      raise intereet rates.     The current regulatory
                structure     based on standard banking regulatory      practicee cannot
                necesrarily     prevent this frm recurring.

                      Page141                              GAO/GGDBO-97Government’s Risks FromGSEs
               Appendix III
               Comments From the Department
               of Agriculture

               The following are GAO’S comments on the Department of Agriculture’s
               June 5, 1990, letter.

               1. We agree that the causes listed by the Department of Agriculture may
GAO Comments   have contributed to the FCS crisis. However, the intent of that section of
               the executive summary is to demonstrate the effects of inadequate fed-
               eral supervision of financial institutions. Furthermore, while we have no
               immediate concerns about FCS viability, as discussed in the report text,
               we believe that FCS institutions still face substantial amounts of risk.

               2. We modified the report to clarify that FCBS and their related associa-
               tions share responsibility for managing assets.

               3. While we did not review the actions ourselves, FCA officials told us
               that written agreements are considered enforcement actions. Regardless
               of the type of enforcement actions involved, we consider the fact that
               FCA has determined a need for such actions as an indication of risk expo-
               sure that requires changes from past practices. The fact that the
               enforcement actions are still in place indicates to us that the former
               practices have not been fully corrected.

               4. We recognize that the report does not express an opinion on the ade-
               quacy of current GSE capital levels for protecting the government’s
               interest. Several issues need to be considered in evaluating appropriate
               capital levels for GSES, such as determining the level of risk the GSE
               should be able to withstand and the effect of added costs that might be
               imposed on the GSES if higher capital levels are required. We plan to con-
               sider the costs and benefits of various options in our next report.

               5. We did not mean to imply that the federal government provided the
               same degree or type of assistance to all troubled financial firms and
               municipalities. We discuss New York City’s use of $2.3 billion in short-
               term federal loans and $1.65 billion in long-term loan guarantees in our
               report entitled Guidelines for Rescuing Large Failing Firms and Munici-
               palities (GAO/GGD-84-34, Mar. 29, 1984).

               6. The objective of our review was to study the risks undertaken by the
               eight GSES. We did not address the extent to which the GSES’ public policy
               purposes continue to exist.

               Page 142                             GAO/GGDBO-97 Government’s Risks From GSEs
Appendix III
Comments From the Department
of Agriculture

7. We believe that the evidence presented in the report text supports the
conclusion that GSES'ties to the government have weakened the disci-
pline that would normally be provided over completely private firms’
debt securities. We point out in the report text that FCSequity stock has
different characteristics from the stock of the other GSES.Also, legisla-
tive and regulatory relief helped both Fannie Mae and FCS recover from
the financial difficulties experienced in the 1980s.

Page 143                            GAO/GGD-BB-97 Government’s Risks From GSEs
Appendix   IV

CommentsFrom the Federal Housing

                              Federal Housing Finance Board
                                       1777 F Street, N.W., Washington,                D.C. 20006
                                 Telephone: (202) 408.2500                   Facsimile: (202)408-1435

                June    6,    1990

                Mr. Richard    L. Fogel
                Assistant    Comptroller     General
                U.S. General    Accounting     Office
                441 G Street,    N. W., Room 3858C
                Washington,    D. C.     20548
                Re :    Draft   of GAO Government-Sponsored        Enterprises  Report;
                        Request    for Federal Housing     Finance    Board Comment

                Dear    Mr.      Fogel:
                Thank you for the opportunity                     to comment on the U.S. General
                Accounting        Office’s      draft      report,     “Government-Sponsored
                Enterprises:           Government’s          Exposure     to Risks”.          As regulator
                of the Federal           Home Loan Banks (FHLBanks),                 the Federal
                Housing      Finance       Board is especially            pleased      with      the draft
                report’s       conclusions        that     the FHLBanks present             little     risk of
                failure      and are well         capitalized         and profitable.              The
                FHLBanks have a long record                   of profitable        and safe operation.

                while    in agreement       with   most conclusions         with   regard     to the
                FHLBanks,      we would add the caution          that      many of the report’s
                statements       were based on interviews          with     only two of the
                FHLBanks.        In addition     to important      similarities,         there     are
                many regional,       membership,       and other     differences       that     limit
                the applicability          of generalizations        to all      FHLBanks.
                Attached         are       further    technical        comments         on specific   sections.
                Thank      you     again       for   this   opportunity           to    comment.

                Sincerely,             T

                ‘&r/y    d Townsend
                 Director    of Examinations
                 Office    of Bank Supervision                    and Oversight


                       Page 144                                              GAO/GGDf!O-97 Government’s Risks Prom GSEs
Appendix     V

CommentsFrom the Federal HomeLoan Banks

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.                                                                                              907 WALNUT STREET
                                   FEDERAL      HOME LOAN BANK OF DES MOINES                                     DES MOINES. IOWA 50309

                                                                                            June 18, 1990

                             Mr. Richard L. Fogel
                             Assistant  Comptroller General
                             United States General Accounting              Office
                             Washington, D.C. 20548
                             Re:    Draft Report Entitled          “Government-Sponsored          Enterprises;       Government’s
                                    Exposure to Risks”

                             Dear Mr. Fogel:
                                    As Chairman of the Federal          Home Loan Bank Presidents’        Caucus, I
                             appreciate    this opportunity      to provide    the comments of the Federal       Home
                             Loan Banks (“Banks”) to the General Accounting Office (“GAO”) draft               report
                             entitled    “Government-Sponsored       Enterprises:     Government’s     Exposure     to
                             Risks” (“Report”).        The comments set forth below are separated into several
                             sections    -- one with        general    comments, one with     specific      comments
                             respecting    particular    pages of the Report, and two attachments -- one with
                             merely technical       comments and one with new membership data.

                                     As an initial        matter,    the Banks wish to emphasize the various
                             characteristics        of the Bank System which distinguish              it from certain of the
                             other government-sponsored            enterprises        (“GSEs”) and which minimize              any
                             undertaking      of risk by the Banks. The Banks make loans to their                         members
See comment 1                with recourse and secured by low-risk               eligible    collateral.       Such loans are
                             generally       priced    under a match-funding              methodology      with      appropriate
                             prepayment fees.          The Banks are thus able to virtually                    eliminate      both
                             credit and interest         rate risk.     Further, the Banks have over eight times as
                             much capital       as certain of the other GSEs and have historically                    held more
                             capital    than most other financial             institutions      of comparable size.            The
                             Banks are able. therefore,           to fulfill     their mission to fund economical home
                             finance in an effective          and financially       prudent manner.
                                      Additionally,        the Banks believe           that their     primary tie      to housing
                             finance has been enhanced with the passage of the Financial                              Institutions
                             Reform, Recovery and Enforcement Act of 1989 (“FIRREA”).                           FIRRP? expanded
                             the types of institutions               eligible      for Bank membership to include             certain
                             other depository            institutions        engaged in long-term         residential       finance,
                             such as commercial                banks and         credit     unions,    while    continuing          the
                             eligibility        of thrifts       and insurance companies.           Thus, while the shrinkage
                             of the thrift         industry is of concern to the Banks, thrifts                    and now other
                             depository       institutions          continue     the link between the Banks and home

                                   Page 145                                               GAO/GGD-90-97 Government’s Risks From GSEs
                                       Appendix V
                                       Comments From the Federal Home
                                       Loan Banks

                            FU)ERAL HOME LOAN BANK OF DES MOINES
                                                                                                                       Page 2

                                                                        SPECIFIC COMERTS
Nowonp    2                             On Page 3, we recommend that          the second sentence      of the second
                                 paragraph be modified to read as follows:           “To varying degrees and extents.
                                 these enterprises       make loans, buy loans from other lenders, and guarantee
                                 financial    products.”      By way of explanation,    the sentence currently   seems
                                 to indicate     that all of the CSEs. including       the Banks, engage in each of
                                 the activities      described in that sentence.
Now on pp. 5 and 99.                   On Pages 10 and 168, the Report indicates                that it    is premature   to
                                assess the effectiveness      of the regulation       of the Banks. FIRREA provides
                                that the Federal Housing Finance Board (“FHFB”) succeeds to the authority
                                of the Federal Home Loan Bank Board (“FHLBB”) with respect to the Banks.
                                As such, we believe that           Congress intended         the FHFB to exercise       its
                                oversight   function of the Banks in a manner similar               to that of the FHLBB.
                                To date, the FHFB has chosen to continue without interruption                  many of the
                                policies   and regulations     which its     predecessor,        the FHLBB, promulgated
                                concerning Bank operation          and governance.         In light       of a record of
                                regulatory   continuity     spanning nearly     sixty     years and in light         of the
                                strong capitalization       and financial    health of the Banks, we believe              it
                                should be possible       to assess the effectiveness          of the Banks’ regulatory
                                structure   notwithstanding     the FHFB’s fairly     brief tenure.
Now on pp. 7 and 57.                  On Pages 15 and 98, the report notes                 a risk to the Banks arising   from
                                the shrinkage of the thrift          industry.        As   noted above, while the shrinkage
                                of the thrift     industry is of concern, the              Banks’ primary tie is to housing
                                finance rather       than the thrift        industry         alone.  As FIRREA expanded the
                                types of depository       institutions        eligible       for Bank membership, the Banks
                                may continue their tie to economical home                  finance despite the shrinkage    of
                                the thrift    industry.
Now on p. 18.                          On Page 29. the Report notes that GSEs are subject to various        federal
                                controls   that have no private sector parallels.    The Report cites the fact
                                that the President appoints members of the board of directors        (“board”)    of
                                most GSEs as an example of these federal controls.         With respect to the
                                Banks, it should be noted that while approximately        three-fourths     of the
                                members of the board of the respective       Bank are elected by shareholders
                                (members 1, the other board members are appointed by the FHFB. At least two
                                of the appointed members of each Bank board represent consumer or community
Now on p, 43.                          On Page 72, the Report cites two measures of credit risk, but these
                                measures are not applicable         to the Banks.          First,     pursuant      to the
                                respective    Banks ’ advances and security    agreement, most of the Banks may
                                immediately call an advance if a member institution           defaults    on a payment.
                                Further, after such event of default,       the Banks have recourse both to the
                                member itself     as well as the underlying       collateral.         Additionally,       it
                                should be noted that       members of most of the Banks are prohibited                 from
                                securing advances at a Bank with collateral         which is more than 90 days
                                delinquent.     The Banks have never suffered a loss on an advance.
Now on p. 40.                          On Page 82, several         matters   warrant   consideration:

                                       a)    The Report        states that      the Banks operate  under broad credit
                                policies      adopted by       the FHFB.      It should be noted that   the Banks also

                                       Page 148                                             GAO/GGD-90-97 Government’s Risks From GSEs
                           Appendix V
                           Comments Prom the Federal Home
                           Loan Ranks

                                                                                                                Page 3

                     operate under regulations     which govern the extension   of credit    (See.
                     12 C.F.R. Part 9351 and each Bank’s board, within the guidelines  adopted by
                     the PHFB, establishes  a credit policy for the respective Bank.

                            b) With respect to credit risk            exposure on interest   rate swaps, the
See comment 2.       Banks’ credit risk on the exchange of interest               payments on fixed/floating
                     interest     rate swaps with members, is fully secured by low-risk               collateral
                     equal to a certain percentage of the notional              amount of the swap; and basis
                     (floating/floating)     interest     rate    swaps with members are also secured              in
                     accord with the credit        risk presented by the swap. In addition,             most of
                     the Banks have more stringent         requirements     to limit nonmember counter-party
                     risk than those established          by the FHFB. For instance,           certain of the
                     Banks require nonmember counterparties            rated below “AA” by the major rating
                     agencies to agree to deliver          collateral     should the counterparty’s        capital
                     fall below a prescribed       level.      The Banks, therefore,    assume minimal credit
                     risk in swap transactions.

                              c) Contrary to the Report, the Banks did not avoid default losses                        on
See comment 3.       advances during           the thrift     crisis     because the Federal        Savings and Loan
                     Insurance Corporation           (“FSLIC”)       “typically    paid off    the advance and took
                     responsibility        for    liquidating      the collateral         when regulators     closed    a
                     thrift.”       The Banks have never liquidated                collateral    in order   to cure a
                     borrower default on an advance because the Banks have always had sufficient
                     collateral      value to ensure that it was in a receiver’s                best interest     to pay
                     off advances and acquire the collateral.                    Further, FSLIC receivers      did not
                     liquidate      collateral       in order        to repay an advance,          but rather       FSLIC
                     receivers      repaid Bank advances and took a reassignment of the collateral
                     securing the advances,             which collateral        FSLIC receivers may subsequently
                     have liquidated         for greater value than the advances repaid.

                              d) The statement       that     “FHLBs collect   repayment before        a failed
                     thrift’s    other creditors”      is not fully accurate.      Pursuant to Section 10(f)
                     of the Federal      Home Loan Bank Act (“Bank Act”),            the Banks have priority
                     over all other      creditors     of a failed thrift    with an exception for those
                     having a priority      interest     under otherwise applicable     law and for those who
                     are actual      bona fide     purchasers.      As a practical     matter,    receivers    of
                     failed thrifts     generally     repay advances in order to obtain the collateral
                     securing     such advances,         which    collateral   often    comprises     the   most
                     marketable assets of the failed thrift.

Now on p. 58.               On Page 99, several       matters    warrant   consideration:
                            a) Statements regarding the likelihood           that the Bank System “could be
                     required to make further contributions          to the [thrift].rescue”      can only be
                     conjecture      at this point in time.     Furthermore,     such statements    contradict
                     the recent         Congressional  testimony       of Secretary       of Treasury     Brady
                     indicating      that the Bank System will not be called upon to further fund the
                     thrift    bailout.
                              b) The reference to the proposal of the Dallas Bank to participate     in
                     thrifts’    loans to developers should be deleted as it is not indicative       of
                     the current risks       facing the Bank System; furthermore,   the proposal    has
                     not, as yet, received         the approvals necessary prior  to implementation.
                     None of the other Banks has endorsed this proposal.

                           Page 147                                            GAO/GGD-90-97 Government’s Risks From GSEs
                            Appendix V
                            Comments From      the   Federal Home
                            Loan Banks

                                                                                                              Page 4

Now on p 99                On Page 171, the Report notes that the Banks do not presently                 operate
                    under risk-based,      capital     guidelines.       However, it  should be noted that
                    Banks are only authorized           to make investments      in low-risk   instruments     or
                    obligations      (12 U.S.C. S 1431(h)), and to make loans to their members fully
                    secured with low-risk       collateral      (12 U.S.C. 5 1430(a)).      Such loans,    being
                    over-collateralized       (collateral       with a market value        in excess of the
                    principal     amount of the outstanding         loans granted to a member is pledged to
                    the Bank to secure the loan) pose minimal risk to the Banks as reflected                   by
                    the fact that no Bank has ever suffered a loss on a loan.

Now on p. 99.              The meaning of the first          paragraph      on Page 172 is unclear.          That
                    paragraph       apparently      states    that     the    12:l   debt-to-capital        ratio
                    (hereinafter      “leverage     ratio”),    applicable     to the issuance       of certain
                    consolidated      obligations      of the Banks, does not appropriately              address
                    interest     rate    risk of the Banks.         Further, the Report states         that    the
                    statutory     prohibition     on the extension of advances to any member in excess
                    of 20 times the member’s Bank stock does not adequately address the credit
                    exposure of each Bank.

                            The Banks agree that       the leverage ratio,        which was first     adopted in
                    1946 and never revised        since that time, is not an appropriate             measure of
See comment 4       the default       risk     of the Banks.          As the GAO and federal            financial
                    institutions      regulators     indicate,      the      default     risk  of a     financial
                    institution     should be measured by the interest                 rate   and credit     risks
                    associated with asset deployment, rather than by the relative                  split between
                    debt and equity in the capital           structure.       Thus, the leverage ratio is an
                    inappropriate     constraint    which may result in the ineffective             use of Bank
                    capital.      Nevertheless.   it     should be noted that because the Banks use a
                    match-funded      methodology      to    price     their     advances     and also      employ
                    sophisticated     and extensive        hedging     techniques,     the Banks assume only
                    minimal, if any, interest        rate risk.      Additionally,       it should be noted that
                    the leverage      ratio is only applicable            to consolidated      Bank debt issued
                    under Section 11(c) of the Bank Act.               Currently     Section 11(c) debt is the
                    only type of Bank debt outstanding.             However, pursuant to Section II(a)            of
                    the Bank Act, each individual          Bank is authorized,        with the approval of the
                    FHFB, to issue individual        Bank debt not subject to the leverage ratio.

                            With respect to the credit risk exposure of the Banks, it should be
                    noted that Bank stock is not the primary collateral                        for Bank advances;
                    rather such advances are required to be fully                       secured by the types of
                    eligible    collateral      (other than Bank stock)           set forth in Section 10(a) of
                    the Bank Act.          Thus, Bank stock          only serves as a secondary           source of
                    security    for an advance.         Additionally.       the credit policies     adopted by each
                    Bank’s board may further              eliminate      any credit       risk  by distinguishing
                    between the credit          risk inherent        in advances to different         members.     For
                    instance,      certain      of the Banks          assign    a lower collateral         value    to
                    collateral     located      in economically        distressed     regions,    or to collateral
                    pledged by financially           troubled members. These policies,              in addition     to
                    the full collateralization           of advances with recourse to the member, result
                    in the virtual       elimination     of credit risk for the Banks.

                            Page   148                                        GAO/GGD-90-97 Government’s Risks From GSEs
          Appendix v
          Commenta From the Federal Home

                                                                                 Page 5
           This report clearly      involved extensive    effort on behalf   of the GAO
    staff.     I would like    to thank you, on behalf of all      of the Federal    Home
    Loan Banks, for this opportunity        to comment on the Report and wo hope our
    comments will be helpful        in the preparation   of the final report.      Please
    call me if you have any questions         or would like to further discuss any of
    these comments.
                                                Very truly   yours,

                                                Thurman C. Connell
                                                Bank Presidents’   Caucus

    cc:    PHLB Presidents

          Page 149                                  GAO/GGD-99-97 Government’s Risks From GSEs
                 Appendix V
                 Comments From the Federal Home
                 Loan Banks

                 The following are GAO'Scomments on the Federal Home Loan Banks’
                 June 18, 1990, letter.

                 1. We modified the report to clarify that an FHLBofficial said that
GAO Con-unents   interest rate swaps are collateralized.

                 2. We modified the report text to clarify that FHLBofficials said that,
                 because of the collateral backing advances made to thrifts, the receivers
                 for failed thrifts have repaid the advances and assumed ownership of
                 the collateral.

                 3. In chapter 2, we describe the credit risk management practices of the
                 FIILBS. We describe how advances are over-collateralized and how the
                 FHLBShave never suffered a loss from a loan default.

                 4. We do not agree with the FHLBS'interpretation of our report text con-
                 cerning the FHLBS'required debt-to-capital ratio and stock requirement.
                 We do not mean to judge the adequacy of these standards. The report
                 text simply points out that the standards use fixed percentages that are
                 not based on any empirical evaluation of credit or interest rate risk. The
                 report notes that FHLBSoperate on an asset and liability maturity-
                 matched basis and that credit risk is small.

                 We agree that it is possible for individual banks, with FHFB'Sapproval,
                 to issue debt not subject to the debt-to-capital ratio. However, such debt
                 has never been issued in the past. Should an individual bank request to
                 issue such debt in the future, we would expect FHFBto take appropriate
                 actions to ensure the overall safety and soundness and capital adequacy
                 of the bank.

                 Page 150                             GAO/GGDSO-97 Government’s Risks From GSEs
Appendix VI

CommentsFrom the Department of Housing
and Urban Development

                                                   THE UNDER SECRETARY
                                     US. DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
                                                 WASHINGTON. D.C. 20410-0050
                                                            June 6, 1990

              Mr.    Richard     L. Fo el
              Assistant        Comptro   3 ler     General
              General      Government        Division
              U.S.     General     Accounting         Office
              Washington.        D.C.      20548

              Dear     Mr.     Fogel:

                      I am pleased      to provide                    the     following         comments    on the
              draft    report,    Government-Sponsored                             Enterprises:         Government's
              Exposure      to Risks:

                                1. The report            draws       attention             to key public              policy
              issues.           For example,           HUD agrees            that       current         statutory
              capital         standards        ignore        the     risk      associated             with      off-balance
              sheet       guarantees,          lines       of business              which        have     become        very
              important           for    FHLMC and FNMA.                  The report             was not able              to
              reach       more definitive              conclusions             about         capital        adequacy          at
              this      time.         No doubt       the     second        report         will       be a significant
              contribution             to this       major       issue.           In this          regard,        it    is
              inconsistent             and probably            misleading            to say that              capital
              standards           are inadequate             while        deferring            recommendations                as
              to what         should      constitute           adequate           capital.

                              2. The report           points       toward        a regulatory             structure
              for     FNMA and FHLMC that               would      Include         (a)     a “risk-based"
              capital       standard        that,     like     the     standards           currently          applied
              to banks        and thrifts,          would      have      capitalization               ratios        that
              vary     by risk       category       of mortgage            and would           include        also     a
              capital       standard        for   the MBSs.          and (b)         additional           monitoring
              and supervision             by a government              regulatory            agency.          The
              appropriateness             of such        a structure           is presumed            but not
              defended,         and the nature             of the monitoring                 and supervision
              is not made clear.

                                     In your        next     report       I recommend            that     alternative
              approaches           be considered,              especially          those       that      may be more
              effective.             For example,             specific       standards           for     duration-
              matching          and other         measures         to minimize           interest         rate      risk,
              the     use of appropriately                   conservative            underwriting             standards
              to reduce          credit      risk,        and ongoing          attention           to the agencies'
              management           controls         could      be identified             as elements            of a
              greater         oversight         alternatlve            to increased            capital
              requirements,             since       the     adequacy       of any amount               of capital
              depends         on corporate            policy       in these        areas.          Such a regula-
              tory       standard       would       be more complicated                  than      a simple         formula

                     Page 151                                                       GAO/GGD9097 Government’s Risks From GSEs
                               Appendix VI
                               Comments From the Department of Housing
                               and Urban Development


                         analogous      to the       bank    and thrift           standards.          Rut such        an
                         approach     might       both    be more effective                 in protecting         the
                         Government's         interest       considering            the     agencies'     size      and
                         importance,        and feasible           given      that      there     are only      two
                         agencies.        In general,          the     report       should      more clearly
                         distinguish        between       regulating          thousands         of banks      or thrifts
                         and regulating           one or two large              GSEs.

                                           3. The report               claims         that     HUD's        regulation            of FNMA's
                         capftal         has been          "inadequate              to alert          the     government            to
Nowon   pp 99-100.       potential           problems"           (p.      173).         This      ignores         two major            HUD
                         reports         on FNMA since               1985 that           have       documented           the      thinness
                         of FNMA's           capitalization                despite         complfance             with     the
                         regulatory            capital         requirement.                 In the        same context,                the GAO
                         report        effectively             explains           how the         inclusion           of subordinated
                         debt      and exclusion               of risk          from     off-balance              sheet       activities
                         in the        statutory           deffnitfon             of capital            for     FNMA (and           FHLMC)
                         make the          debt-to-capital                 ratio        an ineffective                control          over
                         capitalfzation.                   With      this       in mind,          I cannot          see how the
                         report        can say that              HUD "has           not     applied         stringent          capital
Nowon p 6.               rules"        to FNMA and FHLMC (p.                        11).

                                         4. On the       issue      of potential             conflict         between
                         Federal      oversight        of the agencies'              risk-taking              and Federal
                         oversight         of the agencies'             compliance           wfth     their       statutory
                         public      purposes,       the     report       is too     quick         to recommend
                         separation          of oversight         functions.           Potential            conflict
                         between       the     two dimensions           of agency         performance             may
                         occur.       Dividing       the oversight             responsibilities                 leaves
                         ambiguous         how and where          the     balance      between          them is

                                                 HUD has substantial                  capacity         to oversee              these
                         agencies          comprehensively,                 as evidenced           by the        following:
                         FIRREA        restructured             Federal        oversight         of the housing                  finance
                         system,         vesting         important          new responsibilities                    in the
                         Secretary           of HUD.          The Department             has already             established             a
                         Financial           Institutions            Regulatory          Board       to coordinate                  its
                         various         oversight          responsibilities               and plans           to create              a new
                         Office        of Regulatory              Functions         to support           these        efforts.           We
                         have      the     capability           for    sophisticated             modeling          of financial
                         risks;        our models           have     been      used     by the Treasury                 Department
                         in its        analysis          of the GSEs.              These     models        exemplify             and
                         demonstrate             HUD's      competence           to deal       with      the     financial
                         regulatory            issues       with     which       GAO and others              are concerned.
                         The forthcoming                 new HUD reports              on FNMA and FHLMC will
                         indicate          our     planned        regulatory          approach.

                                       5. The report         properly       defers     conclusions        about
                         capital     levels        and methods      of determining          them.       HUD‘s
                         studies     of FNMA and FHLMC will                address     these     issues,      as
                         does    the   recently-released            Report      of the    Secretary       of the


                               Page 162                                                       GAO/GGD90-97 Government’s Riske From GSEs
                             Appendix VI
                             Comments From the Department of Housing
                             and Urban Development


                      Treasury.            It       is appropriate       to      wait     until        all    of        these
                      reports        are        released     to consider          specific           regulatory

                                       6. It       is unfortunate              that     GAO did       not     attempt
                      to evaluate            information            provided         by the GSEs.             Such a
                      verification             effort        would      be appropriate,             either        before       this
                      report       is released             in flnal        form      or prior       to next        year's        GAO
                      report.          This      is particularly               important       in regard            to capital
                      adequacy.           Stress        test      results,         for   example,         are sensitive             to
                      parameter          values       and assumptions                and the      sensitivity            of the
                      results        to these         assumptions            are     as important           as the       results
                      themselves.              Moreover,          results        based     on different            assumptions
                      or significantly                different           methodologies           are     not comparable.

Now on pp. 102-103.                   7. Two minor          corrections           should      be made on page 178:
                      HUD's     previous       FNMA reports             were    for    1986 and 1987,          not     1986
                      and 1988 as stated.                 HUD's       next     FNMA report         will    be released
                      this     summer     and will        cover       the    two years        1988-1989;
                      simultaneously,            the   first        HUD report         on FHLMC will         be issued,
                      covering        1989.      Secondly,          please      note     that    the correct        title
                      is Assistant          Secretary         for     Policy      Development           and Research
                      (without        commas).

                               We are           pleased    to   have      had    the      opportunity              to    comment    on
                      this     report.
                                                                              Sincerely           yours,

                                                                             Alfred        A.     DelliBovi

                             Page 153                                                     GAO/GGD-90-97 Government’s Risks From GSEs
Appendix   VII

timments From Freddie Mac

                                                          Leland C Bnndwl
                                                          Chawman 8 Chief Ereculwe Officer

                 June 4. 1990

                 Mr. Richard L. Pogel
                 Assistant  Comptroller General
                 General Accounting Office
                 441 G Street, N.W.
                 Washington, D.C. 20548

                 Dear Mr. Fogelr
                 Thank you for the opportunity  to review and comment on the GAO’S first
                 of two annual studies of government-sponsored   enterprises (GSES). We
                 enjoyed working with GAO and are happy to receive the GAO’s analysis
                 and input concerning Freddie Mac's management of risk.
                 We   are pleased that the report draws several conclusions          with which we
                 agree,     specifically:    that Freddie   Mac poses no imminent risk             of
                 failure1    that each GSE is unique and should be regulated           in a manner
                 consistent     with its mission, risks and operations;       that the risk-based
                 capital    rules that apply to depository   institutions      are not applicable
                 to the GSEs; that Freddie Mac has virtually          no interest   rate risk; and
                 that its credit risk experience,     as measured by default       and foreclosure
                 rates, are below the industry    averages.
                 We feel,     however,     that   the following      points       should have been made:

                 (1)        Freddie   Mac io an extremely     strong    institution       serving     an
                            important public mission -- providing    stable,      affordable    credit
                            for housing -- without exposing the government to risk.

                 (2)        The best way          to measure Freddie Mac's capital                          adequacy is
                            through stress        tests tailored to the particular                       risks   Freddie
                            Mac takes.

                 (3)        Mark-to-market  capital is an important                     tool    for    risk   assessment
                            by both managers and regulators.

                 (4)        Regulating   Freddie Mac is           not difficult,             since    our major    risks
                            can be easily monitored.

                 (5)        HUD     has   both the ability     and enforcement                       powers   to   be an
                            effective     regulator for Freddie Mac.

                 (6)        Having separate        regulators   for program fulfillment        and                   for
                            safety    and soundness Will         create  stalemates,    conflicts                     of
                            interest,   and inefficiencies    in Freddie Mac's operations.

                       Paye154                                                GAO/GGD-9097Govemment's               RisksFromGSEs
      Appendix VII
      Comments From Freddie Mac

Mr. Richard Pogel
June 4, 1990
Page 2


We    believe     the report      understates      both the financial     strength      of
Freddie Mac and the importance of the public policy mission it serves.
Freddie Mac is not simply in "no immediate threat of failure":                   we are
one of the strongest           corporations      in the country,   with one of the
lowest levels        of risk exposure.        We have a 20 year unbroken string of
profits,      credit    losses    significantly       below the industry       average.
virtually     no interest     rate risk,      and an extremely high quality    mortgage
Our   current   and continued high credit     quality   is due to a number of
factors.      We are limited    to one line of business - the purchase of
high-quality     residential  loans.    Our mortgage-related     obligations of
$280 billion     are backed by over $500 billion       in American homes. For
Freddie Mac to become a liability      to the government. the value of these
homes would have to drop precipitiously        and our market value capital  of
over $S billion        would have to be exhausted.          This would take a
nationwide economic catastrophe      worse than the Great Depression.
Such a nationwide     depression     is extremely unlikely     to happen, although
it may occur   in regional    markets      from time to time.    Our national    base
of operations    insulates    ue from      these regional   economic fluctuations.
This geographic diversity      significantly      reduces the chance that we will
need to draw on our capital          and distinguishes    us from other financial
We believe       the report  deserves   a more    fullsome      discussion   of the
missions that the GSEs were created to serve.              The duty to fulfill        a
specific    mission brings with it the duty to take reasonable risks.               It
is    inappropriate     to discusa    Freddie   Mac's       risks    without   fully
discussing     the housing benefits   we provide.       In the case of housing,
there is no doubt that Freddie Mac could reduce its level of risk to a
pe R&&&S level by making our standards so strict               that we would cease
to accomplish our housing mission.
Our   efficiency       plus our Federal charter      allow us to save the homebuyer
approximately         one-half   of a percentage     point on the cost of a home
mortgage       without exposing the government        to risk.   In addition to this
significant        savings,    Freddie Mac insures      that the supply of mortgage
credit       is uninterrupted,        whether  the    national  economy is weak or

      Page 155                                        GAO/GGD-90-97 Govemment'sRisksFromGSEs
         Appendix M

Mr. Richard Fogel
June 4, lQQ0
Page 3


The GAO discusses        that while Freddie Mac is not like a thrift                 or a
bank, the bank supervision          model is a u6eful way to think about how to
regulate    Freddie Mac.         GAO proposes      four components of regulation:
minimum levels       of    capital,     limit6    on ri6k       taking,   monitoring   of
performance,     and authority        to enforce      ruler.       A8 dercribed    in the
following    discussion,     these four principle6           are consistent     with the
very principle6     we u6e to determine Freddie Mac'6 capital                adequacy and
we believe they are effectively           in place today.


         tal           Shoa       Be -red        Through    Strv              and &a&&

We agree that a GSE's minimum           level of required capital            6hould be tied
to the level of risk          of  the GSE. In this regard, we analyse Freddie
Mac using three different           stress tests which predict             how Freddie Mac
would fare in the event of a 6evere                        economic di6aEtOr.       The most
impOrta&     te6t fOCU606      on credit    ri6k (the Great DOprO66iOn ECOnariO),
and the two      Other6 focu6 on rising           interest     rate6 (a credit crunch and
a permanent inflation        increase).      All      of the60 techniques have implied
minimum Capital        standards.       Under these stress            teEt6,    Freddie Mac
6urvives a major economic disaster            for     over ten years, and continues to
be well-capitalized       for even a 600 ba6i6 point intereEt-rate               change.
Freddie Mac'6 stress test6 also provide an important        and reliable      way
of monitoring       risk taking. They prevent  Freddie Mac from     taking on
risk6     that Will reduce the perfOrmawX     on the 6treES tOEt6 below a
level     comparable to firm8 that issue investment    grade debt.       Stress
te6ts also take into account all of Freddie Mac's risk6 and how they
In addition      to subjecting    Freddie Mac to these 6tres6 te6t6,            we have
recently    reported    our balance 6hOet on a market            Value   basis.    This
approach     differs     from the traditional        hilltorical       CO6t financial
Etatements because our a66Ot6 and liabilities              are valued under CUrrent
market   conditions.       GAO state6    that one of the limitation6         of market
value accounting      is that it meamres        only the liquidation        value of a
firm and not the going concern value.             Thi6 liquidation       value is the
be6t estimate Of the ultimate         CO6t t0 the gOVertUIU3nt.

Market      value    accounting   ia a very u6eful   tool   for any financial
institution       becau6e it provide6    an a66e6sment of    the institution's
as6ets and liabilities          at their  fair market value,    and thus their

         Page 166                                     GAO/GGDW97        Government’s Risks From GSEs
     Appendix VII
     Comments From Freddie Mac

Mr. Richard Fogel
June 4. 1990
Page 4

ability  to absorb risk.   We take   a further     etep and subject this market
value balance sheet to interest      rate shocks to determine the impact of
interest   rate swings.  This provides us with information         concerning our
net worth in the event of significant       intereat   rate changes.
To further      limit    our risks,  our       charter is a strong       backstop,     in that
it   tightly      limits    our activity         to the purchase          of high      quality
residential     mortgages.

           Mac's Rim         are ailv       Monitor&
The credit  risk on a nationally              diversified       portfolio of mortgages is
low, well understood.      and not            subject     to   quick changes.  Monitoring
this risk is straightforward.
Interest  rate risk can change more quickly      and can dissipate     market
value capital     suddenly, but it ia also well understood and easy to
measure.    Freddie Mac, however, largely  avoids interest     rate risk by
financing  its mortgages purchase6 with pass-through  Securities.
In d6VelOping our regulatory              relationship      with HUD, we are preparing
quarterly         reports,      including        results      of     our     stress      tests,
mark-to-market        capital     and other data that provide key indicator6                   of
risks.        Because our risk6 are measurable and are relatively                      easy to
monitor,       this   reporting      approach will       provide    IRJD with an accurate
assessment of Freddie Mac on a timely basis.                     This fulfills       the third
component of the bank supervisory                     model, effective         monitoring      of


MIp Can Be An Effedve             Raaator      With It6 Current      Tool6
The final     element   of the bank regulatory        model is enforcement
authority.   We believe   that BUD has significant    authority  over Freddie
Mac through its general       regulatory authority.    What is needed is a
structure  in which to u6e its authority     to limit   risk taking,  monitor
performance and enforce rules, as GAO recommends.
The report asserts that BUD does not have a full range of enforcement
powers typically  available    to bank regulators.      These statements       are
based OIL the lack of explicit     provision6  in FIRREA on such matter6 as
cease and desist    orders,     supervisory   agreements.    conservatorships,

     Page 167                                              GAO/GGD-90-97 Government'sRisksFromGSEs
          Appendix M
          Comments Prom Freddie Mac

    Mr. Richard Fogel
    June 4, 1990
    Page 5

    We   believe   that HUD has available         to it a wide range of enforcement
    powers even in the absence of explicit                 statutory      language     providing
    such powers.        The 'general    regulatory      power' that FIBREA grants BUD
    over Freddie       Mac necessarily     includes       certain      implied      or inherent
    powers to take reasonable,          appropriate       actions to enforce directives
    issued by the Secretary       in the exercise        of that power.           For   instance,
    if the Secretary       were to conclude that Freddie Mac was engaged in an
    unsafe or unsound practice,         we do not doubt that the Secretary                   could
    apply to a U.S. District         Court for a temporary restraining                order and,
    ultimately,     a permanent injunction         requiring        us to cease and desist
    from   the practice    in question.

    The report proposes that Freddie Mac should have two regulators       -- one
    for program fulfillment  and one for financial     safety and soundness --
    because BUD could have "inherent     conflicts    between its    short-term
    policy  goals and its goals as a financial     regulator.**  This proposal
    does not withstand close analysis.
    First.     every government         agency that      might regulate      Freddie   Mac's
    financial      condition    would suffer     from other conflicts      of interest    at
    least     as severe as HUD's.            As a result,    dual regulation      would not
    eliminate     the conflict     of interests     that it is intended to address.       In
    the past,       various    administrative     agencies have resisted        and opposed
    actions     and innovations        necessary    to Freddie Mac's accumulation         of
    additional      capital  and the successful conduct of its business.
    For     example,     if Treasury     were to regulate         Freddie      Mac indirectly
    through the Office          of the Comptroller       of the Currency,          it could be
    expected      to choose the interests            of national      banks over those of
    Freddie      Mac.      The Office        of Thrift    Supervision       would favor       the
    interests       of thrifts.        Other possible        regulators       mentioned     have
    conflicts      of interest       equally     severe.   The Federal Housing Finance
    Board is primarily         concerned with the welfare of the Federal Home Loan
    Banks,     which have aometimes been at odds with Freddie Mac. The Federal
    Deposit Insurance Corporation             competes with Freddie Mac as a creditor
    of insolvent        savings and loan associations.             All kinds of financial
    institutions       are   Freddie Mac customers,       and their      interests    were not
    necessarily      the ssme as ours.
    Second, dual regulation     would be an inefficient       form     of regulation     for
    the GSEs. If RUD and the safety and soundness regulator                disagree,     the
    likely  result    is that the matter   will    ultimately      be escalated      to an
    arbiter   who may lack understanding        of housing         issues.       Obtaining
    approval of important     actions from two regulatory        entities    would take a
    great deal of time.     Meanwhile, key business decisions           would go unmade,
    and opportunities    would be lost.


          Page 158                                        GAO/GGD-90-97 Government’s Risks From GSEs
      Appendix M

Mr. Richard Pogel
June 4, 1990
Page 6

Regulatory       paralysis    presents     its     own risks,       and could ultimately
contribute      to the financial       instability      of GSEs by depriving           GSEs of
the ability       to make quick,      innovative      decisions.         The only efficient
system     is to have a single regulator             which is responsible          for   making
decisions       on the difficult          policy      questions      presented      by GSEs.
Multiple     layers of bureaucratic          supervision      will    likely   serve only to
reduce efficiency,         with little         promise of      yielding      more    effective
supervision      or better decisions.
The GSEs         were created       to be market driven          and market-sensitive
entities.       The regulatory     objective     should be two-fold:   to ensure that
GSEs are       not taking      improper       or unreasonable   risks;  and to avoid
regulating      them so heavily      that they are unable to fulfill      their public
missions,      or lose their      flexibility      to compete in and respond to the

For  the foregoing reasons and the fact that HUD's mission is to oversee
and  promote   housing in the United States, we recommend that HUD remain
the single    regulator  of Freddie Mac.    One avenue to consider  is to
place the safety end soundness responsibilities      in a division of HUD
that is separate from the program regulator.

Freddie Mac is pleased that the first      GAO study has found no evidence
that it poses any risk to the Federal government.      We believe     that the
next report should consider a wider range of public policy implications
of its     recommendations    concerning appropriate  capital     levels   and
regulatory    structure for the GSEs.
As  reflected  in our letter,     we believe that the bank supervision  model
recommendations outlined      in the GAO study are effectively  in place for
Freddie Mac at the present time.
Again, we appreciate  the opportunity  to comment on this report.                      I look
forward to next year and the completion of the full study.

Leland C. Brendsel
Chairman and Chief       Executive    Officer

      Page169                                           GAO/GGD-90-97 Government’s RisksFromGSEs
Appendix   VIII

CommentsFrom Fannie Mae

                        3900 Wiuonrin Avenue, NW       David 0. Maxwell
                        Warhington. DC 20016.2899      Chairmen of the Board and
                        202 162 6770                   Chief Executive Officer

                                                                                      9 FannieMae
                  June 4, 1990                                                     *-b

                  The Honorable Charles A. Bowsher
                  comptroller  General of the United States
                  United States General Accounting Office
                  441 G Street, W.W.
                  Washington, D.C. 20548
                  Dear Mr. Bowsher:
                  We welcome the opportunity                to comment upon the draft       of the
                  initial     report prepared by the General Accounting Office to assess
                  for Congress the government's               exposure to risk posed by eight
                  government-sponsored            enterprises     (filGSEsl*). Pursuant    to the
                  Financial      Institutions      Reform, Recovery, and Enforcement Act of
                  1989, the GAO was directed to study the risk-taking              and capital of
                  these enterprises.          We believe that the GAOhas been successful in
                  ident\tyysiz     the risks to whiFCahnnyennieMae i;i:;bject,          as well as
                  the                elements      of              Mae's         management and
                  capitalization        strategy.
                  We agree with the GAO that Congressional       interest in GSEs is
                  warranted in light of their size, the public policy purposes that
                  they serve, as well as the potential for assistance by the Federal
                  A8 a publicly          sponsored private    corporation,  Fannie Mae has
                  reliably     provided mortgage products and services that increase the
                  availability      and affordability   of housing for low-, moderate-, and
                  middle-income Americans for over half a century.            The GAO draft
                  report recognizes well the need to assess GSEs on the basis of
                  their execution of their public policy purposes as well as their
                  risks.     Accordingly,    Fannie Mae's growth over time should not be
                  viewed merely in terms of size, but also should be assessed in
                  light of the benefits provided to homeowners.
                  Our portfolio    and MBS finance about one out of every seven
                  mortgages in the United States.   During 1989 and through the first
                  quarter of 1990, our net new business volume of $113.6 billion
                  helped more than one million    American families   purchase homes.
                  The benefits  that Fannie Mae provides to American homeowners have

                        Fannie Mae    The USA‘s Housing Partner

                         Page160                                              GAO/GGD-SO-97
                                                                                        Government’s   RisksFromGSEs
       Appendix VIII
       Comments From Fannie Mae

The Honorable Charles A. Bowshar
June 4, 1990
Page 2
never cost taxpayers a penny since Fannie Mae became private.                       In
fact,  over the last three years we paid some $908 million                          in
federal income taxes.
The GAO correctly      identifies   several    indicia      of Fannie Mae's
status    as a GSE. Congress designed Fannie Mae's continuing
government ties to ensure that we could carry out our special
purpose of assuring a ready supply of affordable             mortgage credit
in all parts of the United States.       A8 the GAO draft observes, the
rating agencies and in many cases, creditors,            view GSEs in terms
of their     government relationship,       recognizing       that they are
enterprises    sponsored by the government to fulfill             statutorily
definad public missions and given certain            government ties that
permit the borrowing of large amounts of money at reduced cost.
These cost savings result in lower interest           rates to lenders and
consumers on eligible    mortgages.
Fannie Mae understands the GAO'5 close scrutiny                       of our financial
performance during          the early 1980s. As the GAO correctly                notes,
during the early 19808, Fannie Mae was caught in the outdated
strategy      of borrowing         short and lending         long at a time of
unprecedented         interest    rate heights        and volatility.        While our
financial      difficulties      in the early 1980s were noteworthy,              it is
significant       that Fannie Mae's management directed a full recovery
without     requesting        or receiving       financial    assistance      from the
government.           Indeed,      since     Fannie      Mae became a private
corporation,         Fannie Mae has never requested the Treasury to
exercise      ite discretionary          authority      to purchase Fannie Waers
Fannie Mae’s recovery         from the financial   difficulties      in the early
part of the last decade was the result                  of several management
strategies,      including     development of a new line of business, our
HBS; developing new mortgage and debt instruments to better match
assets and liabilities            and manage interest          rate risk;   using
advanced technology to adapt to the new business environment: and
taking     steps to improva underwriting          and reduce credit         risk.
Throughout      this     period,    BUD, as Fannie Mae's regulator,            was
regularly     given voluminous and revealing            information     of Fannie
Mae’s     current      status    and business    plans       for a turnaround.
Regularly,     for moet of that time, senior officers              of Fannie Mae
discussed at length with senior officials              of BUD the information
provided and its meaning.
The GAO recognizes on page 15 of the draft report that Fannie
Maea     exposure    to     both    interest        rate   risk     and serious
delinquencies    has declined.     As the GAO notes on page 64, we have
improved our ability      to withstand       fluctuations     in interest  rates
by more closely matching durations of assets and liabilities.                  In
1989, debt having callable       features constituted          around 30 percent
of all term debt issued.           As the percentage of callable             debt
increases,    tha optimal      duration      gap will     approach zero.       As
evidenced by the record of profits         and increase in equity through-
out the latter      half of the last decade, today Fannie Mae is

       Page 161                                  GAO/GGD9097 Government’s Risks     FromGSEs
            Appemdix VJII
            Comments   From   FannieMae

    The Honorable Charles A. Bowsher
    June 4, 1990
    Page 3
    financially    strong and profitable. Management has every incentive
    to ensure that Fannie Mae stays that way because the first      layer
    of risk     in our business is borne by holders of our 240 million
    shares of common stock, listed on the New York Stock Exchange and
    other exchanges.
    Fannie Mae agrees with the GAO's conclusion           on page 129 of the
    draft that "the government has a special interest             in achieving
    public    policy     purposes11 pursued by the GSEs. Fannie Mae's
    statutory    mission directs that Fannie Mae's activity        focus on the
    public policy purpose of assuring a ready supply of affordable
    mortgage credit.       We believe Congress had "an idea that worked" in
    designing Fannie Mae as a shareholder-owned         company to carry out
    this purpose.        We disagree that GSE statue creates incentives      for
    management to take excessive risks.          The price of Fannie Mae's
    stock and its cost of debt rise and fall              with the company's
    financial    health.     Fannie Mae's managers are obviously interested
    in the long-term health and survival        of the institution      and, as
    stockholders      themselves,    have every incentive     to promote its
    financial    well-being.
    Fannie Mae has put in place a system of sophisticated                     risk
    management tools,       which,    combined with    our publicly        stated
    intention   to increase capital by retaining      substantial    amounts of
    earnings and increasing       loss reserves,   is designed to provide a
    level of capital ample for the risks we take.         We intend to add $2
    billion   to $2.5 billion      to Fannie Mae's capital    during 1990 and
    1991. This doe8 not include the $500 million         that could be added
    to capital    through conversion       of equity   warrants    expiring      on
    February 1991.
    We have concluded that the appropriate     methodology for examining
    Fannie Mae’s     capital  is to measure our ability     to withstand
    certain   wstres5 tests."    In developing  these stress tests,     we
    worked with Paul Volcker and others at the firm of James D.
    Wolfensohn in New York.
    The stress test Fannie Mae uses for our credit            risk business
    applies     default   rates derived from Fannie Mae’s     experience  on
    Texas loans originated      during 1981 and 1982 to our entire book of
    business in every year and in every state.            Because the Texas
    economy   was highly dependent on a single industry,     and there was a
    substantial     over-supply  of homes, losses similar   to Texas's on a
    nationwide basis are highly unlikely.        We use this credit stress
    test to determine the amount of capital required to remain solvent
    under such an extreme stress.
    In addition   to this credit stress test, we use two interest       rate
    stress tests to measure our ability       to remain solvent in wworst
    case" financial    environments.   The first   replicates the interest
    rate experience of 1970 through 1982, when the United States had
    the highest average, and most extreme swings, in interest      rates in
    the last 100 years.      The second simulates a parallel   upward shift
Y   in the yield curve of 600 basis points over a twelve month period

            Page162                                GAO/GGD90-97
                                                              Government’s   RisksFromGSEs
       Appendix VIII
       Comments From   FannieMae

The Honorable Charles A. Bowsher
June 4, 1990
Page 4
starting       from November 1989 levels and holds interest         rates at
that level for four years.         The U.S. economy has never experienced
such a sustained period of high interest            rates.     Given Fannie
Mae's current balance sheets and net interest          margin,  our current
asset/liability       matching position    would permit the company to
maintain a positive       nat interest margin even under such an extreme
interest      rate environment.
Based upon these credit and interest           rate risk stress tests, we
will attain by the end of 1991 and maintain at a minimum there-
after the following     capital ratios:      non-recourse credit risk at a
ratio of 135:1, recourse and collateralized           credit risk at 250:1,
interest   rate risk on our on-balance sheet mortgages at 50:1, and
credit and interest     rate risk of our other on-balance sheet assets
at 5O:l.     These capital    ratios are designed to meet difficulties
in the housing      markets and movements in interest            rates of a
character significantly      worse than any experienced over the nation
as a whole in the post-World          War II period.      These ratios also
result   in an amount of capital        that is ,ample to protect against
other types of risk, including management and operations risks and
an economic or financial           environment    even more adverse than
envisioned in our stress tests.
Given Fannie Mae's purpose,           size,  and relationship  to the
government,      we concur    that  thorough   and ongoing regulatory
scrutiny     is appropriate.    The government has both the right and
responsibility      to understand    what we do and our financial
condition.      We welcome close scrutiny.
Under the applicable         regulations,      as I have said, we provide
substantial     information     to HUD on a regular basis.          Also, as a
private     corporation     whose stock is traded on the major stock
exchanges, Fannie Mae publicly              discloses    large quantities      of
information      quarterly    and more frequently          as events warrant.
Fannie Mae receives intense scrutiny by investors and analysts and
in recent years has been the subject                  of several    studies    by
government agencies.         Finally,     we are intensively     and virtually
continuously      audited by a large and reputable public accounting
firm, KPMGPeat Marwick.
We look forward to working with GAO staff on the 1991 study.  We
believe the process will make an important contribution   to the
definition of the issues and the assessment of options.

cc:   Richard    L. Fogel

      Page 163                                GAO/GGD-90-97 Government’s Risks From GSES
Appendix   IX

CommentsFrom the Department of Elducatio~

                                          UNITED STATES DEPARTMENT                          OF EDUCATION
                                OFFlCJZ    OF THE    ASSISTANT    SECRETARY      FOR     POW-SECONDARY        EDUCATlON

                                                                     JUs I 3 rggO

                Mr. Richard        L. Fogel
                Assistant       Comptrol    ler     General
                United     States     General       Accounting                  Office
                General     Government        Division
                Washington,       DC 20548

                Dear    Mr.     Fogel:

                Thank    you for      the opportunity          to               review     GAO’s          draft       report,
                “Government-Sponsored            Enterprises:                        Government’s                 Exposure       to
                Risks,”     GAO/GGD-90-Xx,        Dated       May               23,    1990.

                The Department       is in general        agreement         wiih     the single           GAO
                recommendation.          However,      we are     looking       forward        to receiving                                 tile
                more specific      recommendations          which       the   draft       report     indicates
                will     be in the   final     report.      Additional          technical        COtm3IltS                            are

                We appreciate              the      opportunity         to      comment           on   this       draft     report.


                                                                             j4*u-~wy.-                       -

                                                                             Leonard         L.    Haynes         III


                       Page 164                                                          GAO/GGD-SO-97 Government’s Risks From GSEs
Appendix   X

CommentsFrom Sallie Mae

               1050 Thomas Jellerson Slreet. NW.
               Washlnglon. DC 200074871

               EDWARD A FOX
               Plssldenl and
               ChWl Exseulws onlcer
                                                     June 8, 1990

                Mr. Richard L. Fogel
                Assistant Comptroller General
                Government Accounting Office
                GAO Building Room 3858C
                441 G street, N.W.
                Washington, DC 20548
                Dear Mr. Fogel:
                       Thank you for the opportunity   to review and comment on
                the draft of your report on Government                          :
                mnt           Exnosure to Risb . We have read the study and
                compliment you and your staff for the thorough, comprehensive and
                professional    nature of your work. Since we have conveyed
                technical    comments by telephone, I will limit myself here to a few
                general observations.
                        First,   we trust you are aware that the many statements
                contained in the report concerning the probability           of federal
                assistance in the event of a GSE failure        in and of themselves tend
                to reinforce     the study's conclusion that there is a perception
                among investors that the federal government will act as a credit
                backstop for all GSEs. We feel that there is an element of
                unfairness     in the government's willingness     to reinforce   this view
                without making the guarantee explicit       while at the same time using
                it as justification      for increased regulation.
                          Second, we are forced to take issue with the proposition
                that    the unquantifiable   benefits of "agency status" somehow
                warrant     the application  of increased federal regulation.     We
                diaagree that Sallie Mae benefits in an economically significant
                way from its agency status.        We believe the "AAA*' nature of our
                balance sheet and the effectiveness        of our corporate management by
                themselves largely support our credit stature in the capital
                markets.      Moreover, it is arguable that the lost business
                opportunities     which result from the limitations     imposed on the
                scope of our business activities       more than offset any marginal
                borrowing cost savings that might be present under certain market
                conditions     on account of our "agency status."

                              Page165                       GAO/GGD9997Government’s Risks   From   GSEs
       Appendix X
       Commenta From SaUie Mae

Mr. Richard L. Fogel,          GAO
Page Two
June 8, 1990

         Third,     we question    the treatment       of GSEs as analogous to
banks for purposes of federal             regulation     and oversight.        The
government's        interests    in the safety and soundness of the banking
sector,     including      the protection     of federal    deposit     insurance
funds and consumer confidence             in the monetary system, would seem
to be far more pervasive           and direct      than the interests       at stake in
protecting       investors     in GSEs.
          Finally,      we urge that you carefully           consider    the wisdom of
developing         separate risk-based      capital     rules for each of the
different       types of GSEs or allowing           a federal     regulator      to create
such rules in the absence of agreement on objective                        standards.
After     17 years of exemplary risk management, the imposition                       of an
outside      regulator     to monitor and evaluate          the adequacy of Sallie
Mae's capital         does not appear justified.            With full      disclosure     of
the financial         risks undertaken      by GSEs, we believe          investors     are
able to make better-informed            judgments on investment             risk in the
context      of current      market conditions       than regulators        would under
static     guidelines.
        We thank you for taking note of our views on this difficult
and complex subject.     The process of working together   has been an
educational    one for us and we look forward to assisting   you with
the second part of your report.
                                              Very truly      yours,

                                              Edward A. Fox
                                              President  and
                                              Chief Executive          Officer

       Page 166                                      GAO/GGD-90-97 Government’s Risks From GSEs
Appendix   XI

Canments From ConnieLee

                I st&l~~“cd   by Ad “I Congrew

                One Weslln center
                2445 M Slree~ NW
                Wash,nglon,  DC 20037

                Olwer R Sockwell
                Prescdent and

                                                                                June 11, 1990

                 Mr. Craig A. Simmons, Director
                 Financial Institutions and
                      Market Issues
                 U.S. General Accounting Office
                 441 G Street, N.W.
                 Room 5251
                 Washington, D.C. 20548
                 Dear Mr. Simmons:
                      We have reviewed the draft report “Government Sponsored Enterprises: Government’s
                 Exposure to Risks” particularly the material contained therein concerning the College
                 Construction Loan Insurance Association (“Connie Lee”). We agree with the representations of
                 Connie Lee contained therein and offer our continued cooperation in the future.

                                  Page 167                                           GAO/GGIhBO-97 Government’s Risks From GSEs
Appendix        XII                                                                                                   ,

CommentsFrom Farmer Mac

                      Farmer Mac
                      Federal AgriculturalMortgageCorporation
                      1667 K Sireet, N.W.

                                                                                June 6. 1990

                       Richard L. Fogcl
                       Assistant Comptroller General
                       General Acuouqting Office
                       Washington, D.C. 20548
                       Dear Mr. Fogcl:
                               I would like to open this letter by expressing our appreciation to GAO for providing
                       Farmer Mac the opportunity to review and comment on the revised draft of GAO’s report
                       on the study of GSEs. Although we did review the report generally we focussed our
                       comments on the portions of it that specifically related to the Farmer Mac program. I
                       would like to say that WCgenerally found the discussion about Farmer Mac to be fair and
                       accurate. We are pleased with your thoroughness and the objectivity that is reflected in the
                              In the paragraphs that follow, we have made a few minor suggestions about the
                       Farmer Mac discussion that we believe will clarify certain aspects of the report and ask
                       that you consider including our comments in the final version of the report. To facilitate
                       your completion of the report our comments have been keyed to specific page numbers and
                       paragraphs in the report.
Now on p. 20.                  Page 32 -- Change the last sentence in the paragraph at the top of the page to read:
                       “However. Farmer Mac officials said that the authorizing statute for that program does not
                       require SEC registration of any debt securities that it might issue.” We believe that the
                       statute is clear on this matter and does not require SEC registration of this type of
                       instrument. We would be pleased to provide a legal interpretation if you so desire.
Now on p. 24.                   Pa&+ 39 -- The figure describing rhc operation of Farmer Mac omits reference to the
                       fact that the securities issued by poolers and guaranteed by Farmer Mac must, by statute,
                       be backed by a minimum ten percent cash reserve or subordinated class of securities. This
                       structure for the Farmer Mac program is a very important element limiting the ultimate
                       risk that Farmer Mac will take in connection with the guarantee it places on the mortgage-
                       backed securities. We believe that this aspect of the program should be specifically
                       identified in the figure.
Now on p. 25                  Page 41 -- The first full sentence at the top of this page should be revised to read:
                       “Farmer Mac will certify qualified financial institutions to act as poolers under the
                       program. Certified poolcrs will buy mortgage loans from eligible originators, form loan
                       pools and issue and sell Farmer Mac securities backed by the pools.” As written. the report
                       does not mention that poolcrs will purchase loans and form loan pools to back the securities
                       being issued under the program. Our suggested change clarifies this point.


                               Page 168                                     GAO/GGD90-97 Government’s Risks From GSES
                           Appendix XII
                           Comments Prom Farmer Mac


Nowonp.103               Page 180 -- The first sentence in the paragraph discussing Farmer Mac states that
                 Farmer Mac does not have any regulatory capital requirements. WC agree that there are no
                 “regulatory capital requirements” on Farmer Mac at this time, but believe that the
                 statement as prerented does not complctcly describe the situation with regard to the
                 implicit equity requirements on Farmer Mac resulting from the required
                 senior/subordinated or reserve structure,
                         More specifically, the statute authorizing Farmer Mac requires that every pool be
                 backed by a cash reserve or subordinated class of securities. This statutory provision
                 creates an equity requirement with respect to each pool that is comparable to a 9 to I debt
                 to equity (capital) requirement on Farmer Mac itself. That is, every pool will always be
                 backed by a minimum of 10 percent equity. We believe that this statutory requirement
                 should be factored in to the discussion of the existence of regulatory capital requirements
                 in Farmer Mac’s case. In our opinion, the statutory structure thereby creates a minimum of
                 IO percent equity for Farmer Mac at all times. This exceeds the capital requirements
                 financial regulators, rating agencies and securities analysts USCfor banks, finance
                 companies and other financial institutions. We would hope that the GAO report could be
                 cognizant of this requirement.
                         Once again, I would like to thank you for providing us this opportunity to comment
                 on the GAO report. WCare pleased with the. working relationship that has been developed
                 with your staff and look forward to working with GAO on the second phase of this report.
                 If there is further information that we can provide to you regarding my statements in this
                 letter or if you have any questions about the Farmer Mac program generally, please do not
                 hesitate to contact me by telephone.

                                                                  Thomas R. Clark
                                                                  Vice President - Corporate Relations


                           Page 169                                      GAO/GGD-90-97 Government’s Risks From G!3Es
 ppendix XIII

k&r             Contributors to This Report

                         Richard L. Fogel, Assistant Comptroller General
General Government       Craig A. Simmons, Director, Financial Institutions and Markets Issues
Division, Washington,    Suzanne J. McCrory, Project Director
DC.                      Larry D. Harrell, Project Manager
                         William A. DeSarno, Senior Evaluator
                         Edward J. DeMarco, Senior Economist
                         Christine J. Kuduk, Economist
                         Rodney S. Shaffer, Evaluator
                         Mark D. Ulanowicz, Evaluator

                         Gregory L. Fletcher, Senior Accountant
Accounting and
Financial Management
Division, Washington,

                         Linda S. Lootens, Evaluator
Community, and
Development Division,
Washington, D.C.

                         Page 170                           GAO/GGD-90-97 Government’s Risks From GSEs
Page 171   GAO/GGDSO-97 Government’s Risks From GSEs
RelatedGAO Products

              Farm Credit: Basis for Decision Not to Assist Jackson Federal Land
              Bank (GAO/GGD-90-16, Dec. 13, 1989).

              Home Ownership: Mortgage Servicing Transfers Are Increasing and
                                                      Nov. 1, 1989).
              Causing Borrower Concern (GAO/RCED-90-62,

              Farm Finance: Financial Condition of American Agriculture as of
              December 31, 1988 (GAOjRCED-go-49BR,Nov.15, 1989).

              Federal Credit and Insurance: Programs May Require Increased Federal
              Assistance in the Future (GAOjAFMD-90-11,Nov. 16, 1989).

              Thrift Industry: The Role of Federal Home Loan Bank Advances (GAO/
              GGD-89-123,Sept. 21, 1989).

              Federal Agricultural Mortgage Corporation: Underwriting Standards
              Issues Facing the Secondary Market (GAO/RCED-89-106BR, May 5, 1989).

              Financial Audit: Federal Home Loan Banks’ 1987 Financial Statements
              (GAOIAFMD-89-28,Dec. 39, 1988).

              Housing Finance: Agency Issuance of Real Estate Mortgage Investment
              Conduits (GAO/O-88-111, Sept. 2, 1988).

              Thrift Industry: Federal Home Loan Bank Board Advances Program
              (GAO~GD-88-46BR,Mar. 9, 1988).

              Farm Credit: Actions Needed on Major Management Issues (GAO/
              GGD-87-61,Apr. 1, 1987).

              The Federal National Mortgage Corporation in a Changing Economic
              Environment (GAO/RCED-85-102,Apr. 15, 1985).

              Guidelines for Rescuing Large Failing Firms and Municipalities (GAO/
              GGD-84-34,Mar. 29, 1984).

              Page 172                           GAO/GGD90-97 Government’s Risks From GSEs