.-“.- .-.-.-..._I... l_-” ..^ ... ..__._.....-...-.---..---.--_._--.-.-_-__ hll~rlst I!b!Nb GOVfiRNMENT- SPONSORED ENTERPRISES The Government’s Exposure to Risks s J I I 142017 I----~ ---- (;AOl’(;(;I)-!)O-!)7 c General Government Division B-239226 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 .lk 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 capital. 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 enterprises. 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 banks. 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 soundness. 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 difficulties. 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; and . 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 investors. 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 ExecutiveSummary 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 enterprises. 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 Cmtmts 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 InterestRate Risk Risk 31 42 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 75 83 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 90 95 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 Agriculture 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 Content8 Appendixes Appendix I: Comments From the Farm Credit System 126 Appendix II: Comments From the Farm Credit 132 Administration Appendix III: Comments From the Department of 134 Agriculture Appendix IV: Comments From the Federal Housing 144 Finance Board Appendix V: Comments From the Federal Home Loan 145 Banks 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 Education 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 Year) 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 Year) Page 13 GAO/GGD-90-97 Govemment’s RIska From GSES Contenta Table 3.3: Fannie Mae Capital (As of December 31 of Each 80 Year) 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 Year) 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 1989 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 Abbreviations 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 Introduction 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 funds. 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 Introduction 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 price. 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, respectively. ‘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 Introduction 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 Rural Housing 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 i-loT3,. crr3lls 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 issues. 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 introduction 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 Introduction (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 securities. .-. 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 Introduction Figure 1 .I: Operations ot FCS, FHLBa, and Sallie Mae Investors I--- I I I I Sell10 Mae Consolidated Consolidated Debt Securities Debt Debt Issued Issued Issued I 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 Lenders r-J-- J- r-J-- Banks Thrifts Credit Unions Educational Member Thrifts, Banks, & Others Farm Credit Associations Institutions Borrowers Student I Homeowner r-J-- I Farmer/ Rancher Agricultural Cooperative 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 Introduction 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 investments. 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 Introduction 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 Introduction Figure 1.2: Operations of Connie Lee and Farmer Mac Investors 1 I Farmer Mac . Guaranteed Security Issued -l.- A-- Connie Lee Provides Partial Bond Insurance College or Teaching A-- I Poolers 6”; I Loans ---.._ to ._ Farmer Mac Provides Security L Hospital Create-2 40~1 fritv Guarantee Coverage For a Fee i A-- Lenders Farm Credit Institutions, Banks, Insurance Companies Homeowners Page 24 GAO/GGD99-97 Government’s Risks From GSEs \ Chapter 1 Introduction 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 securities. 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 Introduction Figure 1.3: Operations of Fannie Mae and Freddie Mac Investors Porlfollo Lending GSE Freddie Mac 1 Thrifts Banks Lenders Mortgage Bankers Credit Unions Borrowers r--J-- Homeowners Apartment Owners Page 26 GAO/GGDSO-97 Government’s Risks From GSEs Chapter 1 Introduction 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 Introduction Figure 1.4: Growth of QSE Debt and t3uarantees 1000 Dollars in billions 900 .- *.-- .-- *c-- *c-- --- .- .-- 500 *I-- *.-- *.-- l - c- .- .- 400 .I--- .c-- e-0 200 0 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 Introduction examine the quality and timeliness of information available concerning GSEXtiVitkS. 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 guides; 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 Introduction 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 Page 31 GAO/GGiD-90-97 Government’s Risks From GSEs Chapter 2 Risk Identlflcation and Management 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 Page 32 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 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. Page 33 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 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. Page 34 GAO/GGD9087 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 Page 35 GAO/GGDQO-97 Government’s Risks From GSEs Chapter 2 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 Page 36 GAO/GGD-90-97 Government’s Risks Prom GSEE Chapter 2 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 risk. 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). Page 37 GAO/GGDQQ-97 Government’s Risks From GSES a?----- Chapter 2 Risk Identification and Management 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 liabilities. 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 Page 38 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 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 In---months 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. Page 39 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 Risk Identifiuttion and Management 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. Page 40 GAO/GGD-90-97 Government’s Risks From GSEs . 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 quarterly. 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). Page 41 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 Rbk Identlflcation and Management 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 Page 42 GAO/GGD-SO-97 Government’s Risks From GSEs 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 Page 43 GAO/GGB90-97 Government’s Risks From GSEs 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). Page 44 GAO/GGD99-97 Government’s Risks From GSEs 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 parties. 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. Page 46 GAO/GGD-99-97 Govemment’s Risks From GSEs Chapter 2 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. Page 46 GAO/ND-90-97 Government’s Risks From GSEs 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 1988 -- 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, Page 47 GAO/GGD90-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 factors. 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 Page 49 GAO/GGD-9087 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 1989. 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. Page 49 GAO/GGD90-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 quality. 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 Page 50 GAO/GGD90-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management . 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 -__ 2,818-- 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 1988 ..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 Chapter 2 Risk Identification and Management 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~____--...- millions .___ 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 mortgages. 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. Page 62 GAO/GGD90-97 Government’s Riiks From GSEs Chapter 2 Risk Identif’lcation and Management 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 Page 53 GAO/GGD-99-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 Page 64 GAO/GGDSO-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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. Page 65 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 GSEs GSESare limited to product lines that fall within their respective legislation. 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 Page 56 GAO/GGD-9087 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 Page 57 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 Page 68 GAO/GGD90-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 GSE. 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. Page 69 GAO/GGLb90-97 Government’s Risks From GSEs Chapter 2 RI& Identification and Management 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 performance. 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. Page 60 GAO/GGD-99-97 Government’s Risks F’rom Gf3Ea Chapter 2 Risk Identification and Management Figure 2.1: Farm Credit Syetem’s Net income, 1985-l 989 1000 Dollars in Millions 500 0 -500 -1009 -1600 -2900 -2600 1985 1996 1997 1966 1989 YfWU 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 1600 1600 1400 1200 1000 800 600 400 200 0 1 1995 h 1986 Years 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 Chapter 2 Risk Identification and Management Figure 2.3: Fannie Mae’e Net Income, 1985-1989 1000 Dollan In Mllllonm 900 wo 700 800 SW 400 300 290 190 0 -100 1965 1985 1957 1988 1989 VOWS Source: Fannie Mae’s 1989 Annual Report Figure 2.4: Freddie Mac’s Net Income, 1985-l 989 SW Dollan In Millions 450 400 360 300 250 200 159 100 so 0 1985 1986 1987 1988 1989 Yaars 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 160 100 SO 0 1955 1956 1997 1959 1999 Ywra Source: Sallie Mae’s 1989 Annual Report. Table 2.7: Return on Average Asset@ In basis pointsb Five-year simple 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 Y eBanks with assets greater than $10 billion. Source: GAO calculations based on GSEs’ annual reports. Page 63 GAO/GGDSO-97 Government’s Risks From GSEs Chapter 2 Rlek Identification and Management In percent Five-year simple 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, Y Page 64 GAO/GGD-90-9'7 Government’s Risks From GSEs Chapter 2 RI& Identifkation and Management 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 Page 65 GAO/GGD-90.97 Guvemment’e Risks From GSEs Chapter 2 Risk Identification and Management 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 Page 66 GAO/GGD-90-97 Government’s Risks Prom GSEs chapter 2 Risk Identification and Management 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 maintained. 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 Page 67 GAO/GGDSO-97 Government’s Risks From GSEs Chapter 2 Risk Identification and Management 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 controls. 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 systems. 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 Page 68 GAO/GGD-90-97 Government’s Risks From G!SJXs Chapter 2 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 Chapter 2 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. Page 71 GAO/GGD-90-97 Government’s Riske From GSEs Chapter 2 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, 1989. 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. Page 72 GAO/GGD-99-97 Government’s Risks From GSEs Chapter 2 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 Chapter 2 Risk Identification and Management 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. Page 74 GAO/GGD-90-97 Government’s Risks From GSEs 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 regulation. 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 Chapter 3 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 both. 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 institutions. ’ 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 1987 ~-- $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 CPA. ‘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 Reserves, 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 Reserves, 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- grade. 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 investment-grade. 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 Chapter3 LossReeervesnndCapitiBuffers 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 bankruptcy. 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 chapters 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~ n II 160 I' ' : I I 1 I 160 1 I 1 I 1 1 140 1 I ' I I I I I 120 .1 I 100 l :'l 80 I 1; I 'I ' w\ ' ,' 0 -20 lse0 1881 1982 1963 1984 1966 1086 1987 1888 1989 Y@W* - 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 Againrt- 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 Mae. 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. Overseen 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 provisions. 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 Mac.? 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). Page 93 GAO/G&D-90-97 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Monitoring Risks and Capital of Fannie Al[ae, Freddie Mac, and Sallie Mae * -- 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 _- _.--Commercial _....--------.- 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. Page 94 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Monitoring RSeksand Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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 Page 95 GAO/GGD-9087 Government’s Risks From GSEs Chapter 4 Federal Govemment Inadequately Monitoring Risks and Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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 Page 90 GAO/GGD-90-97 Government’s Risks From GSEs -..~ Chapter 4 Federal Government Inadequately Monhlng Rblu and Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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. Page 97 GAO/GGD-9087 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Monitoring Risks and Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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, Page 98 GAO/GGD90-97 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Motdtoring Rleks and Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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- Y tally available to bank regulators. Furthermore, HUD'S past monitoring Page 99 GAO/GGD-9097 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Mouitorhg RI&B and Capital of Fannie MM?, 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 mortgages. 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/ Page 100 GAO/GGD90-97 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Monhwlng Riska and Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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. Page 101 GAO/GGD90-97 Government’s Risks From GSEs Chapter4 Federal Government Inadequately Monitoring Rislrs and Capital of Faunie Mae, 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 payments. 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 Page102 GAO/GGD-90.97Government'sRbksFromGSEs Chapter 4 Federal Government Inadequately Monbring Ril~ks and Capital of Fannie Mae, Freddie Mac, and Sallie Mae 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 Page 103 GAO/GGD-90-07 Govemment'sRisksFromGSEe Chapter 4 Federal Government Inadequately Monitmlng RI&a andCapital of Fannie Mae, Freddie Mac, and Sallie Mae sound operations. FCA recently completed its first examination of Farmer Mac. 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. Page 104 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately 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. Page 106 GAO/GGD-DO-97 Government’s Risks From GSEs Chapter4 Federal Goverument Iuadequately Monitoring Risks and Capital of Fannie Mae, 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 banks; . 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. Page 106 GAO/GGD-9097 Government’s Risks From GSEs Chapter 4 Federal Goverument Inadequately Monitoring Risks and Capital of Fannie Mae, 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 following: 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, Page 107 GAO/GGDSO-97 Government’s Risks From GSEs Chapter 4 Federal Government Inadequately Monitoring Risks and Capital of Fannie Mae, 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, Page 108 GAO/GGD-90-97 Government’s Risks From GSEs Chapter 5 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 Agriculture 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 Page 109 GAO/GGD-99-97 Government’s Risks From GSES Chnpter I5 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 Page 110 GAO/GGD-9087 Govemment’s Risks From GSEs Chapter 6 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 Page 111 GAO/GGD-9087 Government’s Risks From GSEs Chapter 5 Agency Commentn and Our Evaluation 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 86. Page 112 GAO/GGD90-97 Government’s Risks From GSEs Chapter 5 Agency Commenta and Our Evaluation 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 V. 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. Page 113 GAO/GGD-90-97Government’s Risks From GSEe Chapter 5 Agency Comments and Our Evaluation 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 bailout. 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. Page 114 GAO/GGD+O-97 Goverument’s Risks From GSEs Chapter 5 Agency Comments and Our Evaluation 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. Page 115 GAO/GGDBO-97 Government’s Risks From GSEs Chapter 6 Agency Comments and Our Evaluation 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 Page 116 GAO/GGD-9087 Government’s Risks From GSEs Chapter 5 Agency Comments and Our Evaluation 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 Page 117 GAO/GGD99-97 Government’s Risks From GSEs Chapter 6 Agency Commenta and Our Evaluation 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 capital. Comments From the Department of Education and Sallie Mae 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 l 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 include: . 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 Page2 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 Page3 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 Page4 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 depleted. 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 Page5 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 institution. 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. Sincerely, Peter C. Myers Presidentand Chief Executive Officer Federal Farm Credit Banks The Farm Credit Council Funding Corporation Attachment 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 increase. 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 r------l 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 GSEs. L Page 132 GAO/GGD90-97 Government’s Risks From GSEs Appendix II Comments From the Farm Credit Administration 2 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. Sincerely, George D. Irwin, Deputy Director Office of Financial Analysis Enclosure 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. Enclosures Page 134 GAO/GGD-9@97 Government’s Risks From GSEs Appendix Ill Commenta From the Department of Agriculture GRNERALCOMMRNTS ON GAO DRAFTREPORTON GSEe &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 AppendixIII CommentaFromtheDepartment 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 AppendixIlI Comment8 From the Department ofAgriclllture 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. FC6.. 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 rignificant. 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 Association. : 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 GSE." 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 Y Page138 GAO/GGD-9097Goverruuent'sEisksFromGSEs AppendixHI 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 Act. 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 Government’sRisksFromGSEs AppendixIII CommentsFromtheDepartment ofAgriculture 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 reduced. 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 banks. Page140 GAO/GGD-90-97 Government’sRisksFromGSEs AppendixIII CommentsFromthe Department of Agriculture Concluebono_ 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 Financebard 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 Attachment 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 515124%4211 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. GENERALCOtNUTS 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 finance. Y Page 145 GAO/GGD-90-97 Government’s Risks From GSEs Appendix V Comments From the Federal Home Loan Banks r- 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 interests. 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 Y F@ZEKALHOME LOAN BANK OF DESMOINES 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 M‘DEKAL HOME LOAN BANK OF DESMO,N,?S 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 I4mnBanks CCDMAL HOME LOAN BANK OF DeSMOlNES 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 Chairman Bank Presidents’ Caucus Attachments 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 2 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 determined. 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 Y Page 162 GAO/GGD90-97 Government’s Riske From GSEs -- Appendix VI Comments From the Department of Housing and Urban Development 3 Treasury. It is appropriate to wait until all of these reports are released to consider specific regulatory standards. 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 7”31759..35mJ 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 FREDDIE MAC STRENGTHAND ITS ROUSINGMISSION 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 portfolio. 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 institutions. 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 strong. Page 155 GAO/GGD-90-97 Govemment'sRisksFromGSEs Appendix M CommenteFromFreddieMac Mr. Richard Fogel June 4, lQQ0 Page 3 REGULATING FREDDIE MAC 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. MINIMIJM LEVELS OF CAPITAL AND LIMITATIONS ON RISK TARING 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 interact. 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. MONITORINGFREDDIE WAC'S PERFORMAXE 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 performance. ENFORCEMENT AUTHORITY 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, etc. 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. PROBLEMSWITS DUAL REGULATION 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. Y Page 158 GAO/GGD-90-97 Government’s Risks From GSEs Appendix M CommenteFromFreddieMac 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 marketplace. 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. CONCLUSION 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. Sincerely, 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 -k&b 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 government. 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 obligations. 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. Sincerely, 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 attached. We appreciate the opportunity to comment on this draft report. Sincerely, j4*u-~wy.- - Leonard L. Haynes III Attachments Page 164 GAO/GGD-SO-97 Government’s Risks From GSEs Appendix X CommentsFrom Sallie Mae STUDENT LOAN MARKETING ASSOCIATION 1050 Thomas Jellerson Slreet. NW. Washlnglon. DC 200074871 202-298-2800 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 COLLEGE CONSTRUCTION LOAN INSURANCE ASSOCIATION One Weslln center 2445 M Slree~ NW Wash,nglon, DC 20037 2021728-3411 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 !ute200 1667 K Sireet, N.W. Washington.D.C.20006 (202)672-7700 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 report. 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, DC. Linda S. Lootens, Evaluator Resources, Community, and Economic 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
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)