oversight

Housing Enterprises: Investment Authority, Policies, and Practices

Published by the Government Accountability Office on 1997-06-27.

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

GAO
      Unjted States
      General Accounting Office
      Washington, D.C. 20548

      General    Government   Division




      B-277287

      June 27, 1997
        _.._
      The Honorable James A. Leach
      Chairman, Committee on Banking
       and Financial Services
      House of Representatives

      Subject:    Housing Enterrxises:      Jnvestment Author&v. Policies. md Practices

      Dear Mr. Chairman:

      In response to your request of April 10, 1997, we are conduct&g a review of non-
      mortgage investment practices at the Federal Home Loan Mortgage Corporation
      (Freddie Mac). Recently, you asked us to conduct a more limited review for
      comparative purposes at the Federal National Mortgage Association (Fannie Mae).

      Specifically, you requested that we review Freddie Mac’s and Fannie Mae’s (the
      enterprises) (1) legal authority for making non-mortgage investments and oversight
      of that authority by the enterprises’ regulators, (2) non-mortgage investment policies
      and practices, and (3) use of non-mortgage investments for arbitrage purposes.

      You recently asked for an interim report on the results of our review to date. This
      letter responds to that request. At a future date, we expect to issue a more
      comprehensive final report.

      RESULTS IN BRIEF

      Information provided by the enterprises and their regulators, and our review of the
      enterprises’ charters, indicate that the enterprises have broad investment authority.
      me Department of Housing and Urban Development (HUD) and the Office of
      Federal Housing Enterprise Oversight (OFHEO) have regulatory and enforcement
      authorities that could be used to limit the enterprises non-mortgage investments, at
      least in certain circumstances, but the extent of such authorities is not clearly
      stated in statute.

      HUD has general regulatory authority over each enterprise and is charged with
      making such rules and regulations as shall be necessary and proper to ensure that

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the purposes of the respective charter acts are accomplished. HUD officials told us
that HUD’s regulatory activities have focused on establishing numeric goals for
enterprise mortgage purchases serving low and moderate income and underserved
borrowers and on fair lending. HUD historically has not focused attention on non-
mortgage investment policies and practices at the enterprises but has recently
requested information from Freddie Mac on its non-mortgage investments. With
respect to limitations on enterprise investment activities, HUD officials said that they
are considerjng a range of possible standards that could be app.ropriate and within the
scope of HUD’s statutory authority. On one end of the range being considered is a
narrower standard based on an enterprise activity being reasonably related to the
 enterprise’s mission and on the other end a broader standard based on an activity not
 conflicting with the enterprise’s mission.

OFHEO has exclusive authority, without review or approval of HUD, over matters of
enterprise safety and soundness and certain other matters. OFHEO thus could limit
an enterprise’s non-mortgage investments if the investments were not conducted in a
safe and sound manner. With respect to the enterprises’ non-mortgage investment
policies and practices, OFHEO has concluded that these investments have not
constituted a safety and soundness concern.

The enterprises each have investment policies that specify permissible credit ratings,
maturities, and concentration limits, and describe the relationship of investments to
earnings and to achievement of the enterprise’s housing finance mission.2 Non-
mortgage investments constituted about 15 percent of on-balance sheet assets at
Fannie Mae and 9 percent at Freddie Mac as of December 31, 1996. The enterprises’
non-mortgage investments, as reported, included cash and cash equivalents, asset-
backed securities, private corporate securities, and state and municipal bonds.
According to enterprise officials, most holdings had maturities under 2 years, and all
were investment grade securities.3


‘We do not report specific details of these investment policies because of the
proprietary nature of such enterprise information.

2Credit rating agencies such as Standard and Poor’s give securities ratings related to
the credit risk associated with the investment. Concentration limits place a cap on the
maximum share of assets that can be accounted for by investments in a single
company’s securities.

3Credit rating agencies such as Standard and Poor’s rate bond issuers with ratings
ranging from AAA for the highest credit rating to CC for highly speculative.
Investment grade securities are those that have a credit rating of BBB or above.
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Enterprise officials indicated that non-mortgage investments are held for two principal
reasons: (1) cash management purposes and (2) as an investment-vehicle to employ
capital for future demand to fund residential mortgages. In March 1997, Freddie Mac
created a non-mortgage investment fund to invest in securities with maturities
exceeding 5 years to be funded by matched maturity non-callable debt.4 Although
Fannie Mae’s investment policies differ from Freddie Mac’s, its publicly disclosed
securities holdings indicated non-mortgage investment holdings with maturities
exceeding 5~yea.r~. Based on our work to date, neither enterprise’ appears to have
actively traded its non-mortgage investments.

Regarding the use of non-mortgage investments for arbitrage purposes, we are defining
the term “arbitrage” to mean using the funding advantage from government
sponsorship to raise funds for making non-mortgage investments. To date, we have
not examined in detail specific non-mortgage investments nor the debt issuance to
fund such investments at either enterprise. Thus, based on the work we have done to
date, the degree to which enterprise non-mortgage investments represent arbitrage
with enhanced earnings as the primary result, or merely another tool to accomplish
the enterprises’ special purposes, is not clear.

INVESTMENT AUTHORYIY RESIDES IN EACH ENTERPRISE
BUT IS SUBJECT TO HUD AND OFHEO OVERSIGHT

Each enterprise has broad investment powers in its charter. The Freddie Mac charter
act provides that the funds of the corporation, “may be invested in such investments
as the Board of Directors may prescribe.“5 The Fannie Mae charter act empowers the
corporation, among other things, “to enter into and perform contracts, leases . . . or
other transactions, on such terms as it may deem appropriate; to lease, purchase, or
acquire any property, real personal or mixed . . . and to sell, for cash or credit, lease
or otherwise dispose of the same, at such time and in such manner as and to the
extent that it may deem necessary and appropriate; and to do all things as are
necessary or incidental to the proper management of its affairs and the proper
conduct of its business.“’




‘Bonds characterized as non-callable debt are bonds that are issued for a fixed-term
until maturil$; the issuer does not have the option to “call” the bond (i.e., buy the bond
back from the investor) prior to its date of maturity.

512 U.S.C. 9 1452(d).

Q2 U.S.C. 6 1723(a).
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One general rule of law is that a corporation’s powers can be no broader than the
purposes for which the corporation is organized. This rule is particularly relevant
where, as in the case of the enterprises, the corporation is organized for special, as
opposed to general, purposes. Thus, even though the enterprises have broad
investment powers, the exercise of those powers must be related in some degree to
the accomplishment of the special purposes for which the enterprises were created.
Under general corporate law, this relationship has been described as the logical
relation of-the activity to the corporate purpose expressed in the charter.

HUD and OFHEO each have regulatory responsibilities for the enterprises. Under the
Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the 1992
Act),7 OFHEO is charged with the duty to ensure that the enterprises are adequately
capitalized and operate safely and in accordance with the act. OFHEO has regulatory
and enforcement authority, without the review or approval of HUD, with respect to
matters generally related to enterprise safety and soundness and to a few specific
matters, including certain capital distributions and executive compensation at the
enterprises.’ Therefore, OFREO is responsible for supervising an enterprise
investment that affects the enterprise’s safety and soundness without consultation with
HUD. Actions taken by OFHEO with respect to other matters not specified in the act
as exclusive to OFHEO are subject to the review and approval of the Secretary of
HUD.

Except for the specific powers granted OFHEO, HUD has general regulatory power
over each enterprise and is charged with making such rules and regulations as shall be
necessary and proper to ensure that those provisions of the 1992 Act that generally
concern new mortgage programs and housing goals and the purposes of the respective
charter acts are accomplished.’ In conjunction with administering this provision, HUD
is evaluating the scope of its authority with respect to the mission-relatedness of
enterprise investments. With respect to regulatory limitations on enterprise
investment activities, HUD officials said they are considering a range of possible
standards that could be appropriate and within the scope of HUD’s statutory authority.
On the one end of the range being considered is a narrower standard based on an
enterprise activity being reasonably related to the enterprise’s mission and on the
other end a broader standard based on an activity not conflicting with the enterprise’s
mission. Because both enterprises were created by Congress to accomplish the


7P. L. No. 102-550, Title XIII, codified at 12 U.S.C. Q 4501.

812 U.S.C. 9 4513(b).

Q12 U.S.C. 8 4541.
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purposes set forth in their charter acts, their investment powers appear to be limited
to some degree by those purposes.

In previous reports, we have indicated that the rationale Congress has followed in
establishing government-sponsored enterprises (GSE) has centered on the objective of
focusing GSE activity on specific sectors of the economy in which there was thought
to be some failure of the market.” Restraining the ability of the GSEs to use the
benefits received from government sponsorship to engage in non&-&sion activities
engaged in by other entities that do not have such benefits would be consistent with
this rationale. Limiting the reach of the GSEs’ activities, however, could limit their
ability to undertake activities in other areas that may complement activities directly
related to mission. For example, because the enterprises must specialize in the
secondary mortgage market, they are limited in the extent to which they can diversify
business risks by investing outside the housing market. While potential tradeoffs of
this nature could create difficulties for GSE mission regulators, they would not
necessarily create tradeoffs for OFHEO in carrying out its safety and soundness
oversight.

OFHEO has concluded that each enterprise’s non-mortgage investment policies and
practices, including those reflected in Freddie Mac’s new investment policy instituted
in March 1997, have not constituted a safety and soundness concern. Its conclusion
was largely based on how each enterprise matched the maturities (and related
characteristics) of its debt obligations used to finance its non-mortgage investments
with those investments, and the high credit standards and generally short maturities of
the non-mortgage investments.

OFHEO recently reviewed Fannie Mae’s mortgage protection plan (MPP), a proposed
program that contains a non-mortgage investment in cash value life insurance. Under
this proposed program, Fannie Mae would purchase a cash value life insurance policy
on a first-time homebuyer after the borrower’s residential mortgage was purchased by
Fannie Mae. The policy would provide Fannie Mae and the home buyer protection
from default and foreclosure due to the borrower’s death as well as limited protection
from default and foreclosure due to disability and job loss. As the mortgage is paid
off, Fannie Mae would share in any payment in excess of the amount of the
outstanding mortgage made upon the recipients’ death. Due in part to potential tax
benefits, and in part to Fannie Mae’s relatively low cost of capital, Fannie Mae expects




“For example, see Enternrise Resource Bank Act (GAO/GGD-96-140R, June 27, 1996),
p. 9.
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that the aggregate payoff from these policies will be profitable.” OFHEO concluded
that MPP would not create a “risk of significant deterioration of the financial
condition” of Fannie Mae.12

HUD’s mission regulation actions since the passage of the 1992 Act have focused on
developing numeric goals governing enterprise purchase of mortgages serving very-
low, low, and moderate income households and other underserved borrowers;
promulgating rules containing numeric goals; and enforcing the numeric standards.
HUD officials told us that the activities of HUD’s Office of Government Sponsored
Enterprise Oversight have continued to focus on the numeric goals and fair lending
issues.

BUD officials told us that they had not focused attention on non-mortgage investment
practices at the enterprises prior to the mid-April publicity surrounding Freddie Mac’s
investment in Phillip Morris bonds referred to in your request letter. At that time,
HUD requested information from Freddie Mac on its non-mortgage investments and
subsequently received a reply on April 28. HUD is currently considering how to
proceed. To date, HUD has not sought information on Fannie Mae’s non-mortgage
investment policies and practices. As to Fannie Mae’s MPP, HUD initially received
information from Fannie Mae on April 25, 1997. The Secretary of BUD then
determined that MPP constituted a new program and requested further information
from Fannie Mae on May 14, 1997. By statute, new programs are subject to HUD’s
 approvaL13 HUD approved MPP on June 23, 1997.


“In this sense, Fannie Mae’s investment is similar to other investments in cash value
life insurance. The Department of the Treasury (Treasury), Office of Tax Policy, is
investigating the tax consequences of this proposed plan. The issues Treasury is
examining relate to those addressed by section 264 of the Internal Revenue Code that
limits the deductions available to taxpayers in connection with certain life insurance
policies that cover the lives of employees or other interested persons. During the
week of June 9, 1997, legislation was introduced by the Chairman, House Committee
on Ways and Means, that could have the impact of making tax treatment of MPP less
favorable.

12Letter from Mark Kinsey to the Secretary of HUD (June 23, 1997). This
determination by the Director of OFHEO is required by the 1992 Act prior to HUD’s
approval of a new mortgage program.

 13This approval is required by 12 U.S.C. 0 4542. A “new program” is defined as “any
 program for the purchasing, servicing, selling, lending on the security of or otherwise
 dealing in conventional mortgages” that either significantly differs from a program
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THE ENTERPRISES STATE THAT THEY HOLD NON-MORTGAGE INVESTMENTS
PRIMARILY TO IMPROVE CASH MANAGEMENT AND MEET FUTURE FUNDING
DEMANDS

Both enterprises have investment policies that specify permissible credit ratings,
maturities, and concentration limits, and describe the relationship of investments to
earnings and achievement of the enterprise’s housing finance mission. Non-mortgage
investmentsconstituted   about 15 percent of on-balance sheet assets at Fannie Mae
and 9 percent at Freddie Mac as of year-end 1996. Table 1 shows selected statistics
on mortgage assets and stockholders’ equity (i.e., capital) to provide further
perspectives. For example, non-mortgage investments equated to about 2.6 percent of
Freddie Mac’s and about 6.3 percent of Fannie Mae’s total mortgage servicing
portfolio. Non-mortgage investments were more than double Freddie Mac’s capital
and more than four times Fannie Mae’s capital.

As shown in table 1, over half of Freddie Mac’s non-mortgage investments and over 40
percent of Fannie Mae’s were short-term investments in cash, cash equivalents, term
federal funds, and eurodollar deposits. Freddie Mac’s and Fannie Mae’s 1996 annual
reports also showed overall non-mortgage investments by contractual maturity. About
78 percent of Freddie Mac’s non-mortgage investments had maturities under 1 year,
and about 93 percent had maturities under 5 years; the corresponding figures for
Fannie Mae were 68 and 75 percent.14 According to enterprise officials, all of their
non-mortgage investments were investment grade securities. Based on our work to
date, neither enterprise appears to have actively traded its non-mortgage investments.




approved or engaged in before October 28, 1992, or represents an expansion of
previously approved program limits. 12 U.S.C. 0 4502(13). Fannie Mae disagrees with
HUD’s characterization of MPP as a new mortgage program.

14Fannie Mae does not report its financial statistics in as much detail as Freddie Mac
does. Therefore, the statistics are not directly comparable. For example, we
understand that for Fannie Mae the “other” category includes corporate debt, auction
rate preferred stock, and state and municipal bonds. In addition, the Freddie Mac and
Fannie Mae ‘data on maturities are not directly comparable. For example, Fannie
Mae’s annual report does not indicate the maturities of asset-backed securities. The
percentages we report include asset-backed securities in total non-mortgage
investments. Since we cannot determine the value of asset-backed securities that have
short-term maturities,. the percentages we report may understate the short-term
maturity shares for Fannie Mae.
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Table 1: Selected Financial Data for the Housing Enternrises as of December 31. 1996

Millions of dollars
                                                   Freddie Mac                 Fannie Mae
 Total assets                                               $173,866                  $351,041
  Stockholders’ equity                                         6,731                     12,773
              _..._
  Mortgage servicing portfolio                               610,820                   834,039
  Non-mortgage investments

         -- Cash and cash equivalents                          9,141                        850
         -- Term-federal funds and                             1,330                     21,734
            eurodollar deposits
         -- Asset-backed securities                            2,086                     12,792

         -- State/municipal bonds                              2,009                        6,lQ;
         -- Corporate
            Commercialdebt
                         paper                                   81:                                a

            Other rate preferred stock
         -- Auction                                              243
                                                                 392                     11,23:
         -- Accrued interest receivable                           64                                a

     Total non-mortgage investments                          $16,084                    $52,807

Note: The mortgage servicing portfolio includes mortgages purchased and held as on-
balance sheet assets in retained portfolio plus mortgages purchased and pooled as off-
balance sheet assets to back mortgage-backed securities. Repurchase agreements
were excluded from non-mortgage investments based on our understanding that such
agreements are mortgage related. Freddie Mac mortgage related securities held for
trading were also excluded.

Ylhese individual data elements are not reported; we understand that they are included
in the “other” category.

Source: 1996 annual reports of Freddie Mac and Fannie Mae.

Freddie Mac officials told us that the primary purposes for holding non-mortgage
investments:with maturities of under 5 years is for cash management and to meet
future anticipated demands for funding residential mortgages. About 7 percent of
Freddie Mac’s non-mortgage investments had maturities exceeding 5 years. These
investments with longer maturities included many asset-backed securities that tend to
be paid off, and thereby terminate, prior to their stated maturity dates.


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In March 1997, Freddie Mac created a non-mortgage investment fund to hold securities
with maturities exceeding 5 years to be funded by matched maturity non-callable
debt.15 Freddie Mac officials told us that the primary purpose of this new fund, which
is authorized to contain up to $10 billion, is to meet future unanticipated demands for
funding residential mortgages. Freddie Mac officials told us that its other non-
mortgage investment funds, which generally have maturities under 5 years, would
decline. In addition, they also made the following five points about the longer
maturity investments in the newly created fund:

-   Freddie Mac would not likely sell these longer maturity non-mortgage securities,
    because the fund is meant to provide a source for funding those mortgages whose
    demand is unanticipated;

-   if unanticipated demands for funding mortgages did occur, the capital cushion
    necessary to support mortgage purchases would already be employed in the non-
    mortgage assets, and thus, would be available to support other investments;
    therefore, they observed, selling such non-mortgage assets, in such an event, could
    be done quickly in contrast to the time required to raise additional capital,

-   longer maturity non-mortgage investments do not exhibit the prepayment risks
    associated with mortgages;

-   match funding these investments would allow Freddie Mac to access the non-
    callable bond market without generating interest rate risk, and

-   the investment portfolio would help stabilize income when necessary to counteract
    adverse earnings’ impact from other forces.

Fannie Mae officials told us that the primary purposes for holding non-mortgage
investments are for cash management; to provide a source of liquidity for managing
the cash flows intrinsic to a business of its size; and to provide an additional capital
cushion, in addition to that held to meet the internally generated risk-based capital
standards. They told us that such a capital cushion enables them to respond to capital
markets and fund residential mortgages. Fannie Mae officials told us that non-
mortgage investments with maturities exceeding 5 years are a relatively small portion
of its total business. They told us that most of these securities are asset-backed
securities tith variable interest rates and that the variable rate characteristic reduces
the interest rate risk associated with fixed-rate long-term bonds. Fannie Mae officials


15Before March 1997, Freddie Mac investment policies allowed purchase of securities
with maturities of over 5 years
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told us, however, that bonds with the characteristics of the Phillip Morris bonds
purchased by Freddie Mac could not have been purchased by Fannie Mae under its
investment guidelines, because the purchase would not have met Fannie Mae
requirements for maturity, credit quality, and concentration limitations.

NON-MORTGAGE INVESTMENTS DIFFER IN THE DEGREE TO WHICH THEY
GENERATE ARBITRAGE PROFITS AND RELATE TO MISSION

Financial analysts generally define arbitrage as profiting from differences in price
when the same security is traded on two or more markets. However, arbitrage can
also arise if securities have different yields by virtue of differences in government
provided benefits between those securities. We are using this latter definition of
arbitrage in considering enterprise non-mortgage investments.‘6 In a previous report,
we concluded that the largest enterprise benefit from government sponsorship flows
from the market perception of an implied guarantee on enterprise obligations, because
this perception generates a funding advantage-a reduction in yields on enterprise
debt.17 In that report, we indicated that the funding advantage could be in the range
of 30 to 106 basis points.

To date, we have not examined in detail specific non-mortgage investments nor the
debt issuance to fund such investments at either enterprise. We note, however, that,
under our definition of arbitrage, Freddie Mac has made at least one investment that
would have generated arbitrage profits.” This investment was in Phillip Morris bonds.



160ur definition of arbitrage is similar to the definition of an arbitrage bond defined in
a section of the U.S. tax code. 26 U.S.C. 9 148. In this section of the tax code, the
definition is in reference to state and local governments whose funding costs are
lowered by virtue of federal income tax exemption for interest on state and local
bonds. ln section 148, an arbitrage bond “means any bond issued as part of an issue
any portion of the proceeds of which are reasonably expected (at the time of the
issuance of the bond) to be used directly or indirectly-(l) to acquire higher yielding
investments, or (2) to replace funds which were used directly or indirectly to acquire
higher yielding investments.”

 ‘7Ho~sing Enterprises: Potential Imnacts of Severing Government Snonsorshin
 (GAO/GGD-96-120, May 1996).

 18Jfenterprise non-mortgage investments had different credit risks and maturities than
 the enterprise debt issued to finance such investments, we would have adjusted for
 those differences.
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The Phillip Morris bonds, which had an A rating, were purchased by Freddie Mac and
were funded by Freddie Mac bonds with the same maturity.‘g The yield difference
was slightly over 60 basis points.2o Freddie Mac officials told us that investments in
its non-mortgage investment fund holding securities with maturities exceeding 5 years
is authorized to contain up to $10 billion.21 Freddie Mac officials told us that Freddie
Mac’s long-term non-mortgage investments are generally funded with matched maturity
non-callable debt. Applying, as an example, the interest rate differential of slightly
more than 66 .basis points between the matched Freddie Mac and Philhp Morris debt
issues, a $10 billion fund could generate as much as $60 million annually in profits-
about 4.8 percent of Freddie Mac’s 1996 net income.22

Based on our work to date, the various non-mortgage investments appear to fall along
a continuum representing the degree to which they clearly relate to the enterprises’
mission. On one end are investments with characteristics like the Phillip Morris bonds
which generate arbitrage profits but whose relationship to mission is not readily clear;
on the other end are short-term non-mortgage investments, such as term federal funds,
whose relationship to mission in enhancing liquidity is clear, although they might also




lgRecently, the Standard and Poor’s (S&P) credit rating agency rated each enterprise
for its government risk rating, which is based on the probability that the federal
government would be called upon in the event of an enterprise default on its
obligations. Each enterprise received an AA minus rating. S&P indicated that the
rating for each enterprise still accounted for some benefits, namely liquidity of
enterprise obligations, due to government sponsorship. If the enterprises were
privatized, S&P said that each would likely have to raise additional equity capital to
maintain an AA minus rating.

“A basis point is one one-hundredth   of a percentage point.

21Freddie Mac officials told us that current holdings in the fund have a value of $400
million and that Freddie Mac’s forecasted level for year-end 1997 is $2 billion.

22The funding advantage is similar to that estimated between enterprise non-callable
debt and non-callable debt issued by A rated corporations (the benchmark security) in
a study commissioned by HUD. See Brent W. Ambrose and Arthur Warga (Ambrose
and Warga), “Implications of Privatization: The Costs to Fannie Mae and Freddie
Mac,” in HUD, Studies on Privatizing Fannie Mae and Freddie Mac (May 1996), pp.
180-182. Ambrose and Warga estimates of the funding advantage, based on a AA
benchmark security, are lower and were in a range around a value of about 40 basis
points.
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generate arbitrage profits. Other enterprise non-mortgage investments fall somewhere
in between these extremes.23

Although longer maturity, non-mortgage investments may generate arbitrage proEts,
enterprise officials are of the opinion that they also contribute to fulfilling mission.
Both enterprises told us that longer maturity, non-mortgage investments are a vehicle
to employ capital that represents a cushion above the capital held for current
mortgage purchases. In this regard, Freddie Mac’s Chairman stated the following:
“Freddie Mac’s investment in longer-term non-mortgage securities provide a potential
source of readily available funds in the event of a market disruption. Under these
circumstances, Freddie Mac could maintain our commitment to provide mortgage
funds by liquidating our longer-term investments and purchasing long-term
mortgages.“24

Based on the work we have done to date, the degree to which enterprise non-
mortgage investments represent arbitrage with enhanced earnings as the primary
result, or merely another tool to accomplish the enterprises’ special purposes, is not
clear.

ENTERPRISE, HUD, AND OFHEO COMMENTS AND OUR EVALUATION

On June 20, 1997, we obtained oral comments on a draft of this letter from senior
officials at Freddie Mac and Fannie Mae and senior officials responsible for enterprise
oversight at HUD and OFHEO. Specifically, we met with Freddie Mac’s Vice President
for Industry Relations and Corporate Treasurer; Fannie Mae’s Deputy General Counsel,
Corporate Treasurer, and Vice President for Regulatory Activities; HUD’s Director of
Government Sponsored Enterprise Oversight and Associate General Counsel for
Finance and Regulatory Enforcement; and OFHEO’s Acting Director, General Counsel,
Chief Economist, and Acting Director of Examinations.




23The major characteristics of bonds in the category of the Phillip Morris bonds are
maturities over 5 years, investment grade, and higher yield than maturity matched
enterprise bonds. The continuum we have identified is inclusive of both enterprises’
non-mortgage investments.

24Letter from Leland C. Brendsel to the Honorable Nicholas P. Retsinas (April 28,
1997).
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Enterorise Comments and Our Evaluation

The Freddie Mac officials objected to our definition of arbitrage. They said that
according to our definition, any financial institutions that match funds [based on
maturity] would perform arbitrage while financial institutions that do not match funds
would not be considered to perform arbitrage. We made changes to our draft to
clarify that by arbitrage we mean using the funding advantage from government
sponsorship... to raise funds for non-mortgage investments.

The Freddie Mac officials also said that our representation of non-mortgage
investments as representing points ‘on a continuum is not correct. They said that the
long-term non-mortgage investments are all liquid investments that serve mission
purposes. Based on the work we have done to date, there appear to us to be
differences among non-mortgage investments in the extent to which they appear to be
clearly related to the enterprises’ mission. Our discussion of a continuum in this
interim report is provided as a preliminary analytic framework for describing those
apparent differences. As we examine a wider range of non-mortgage investments in
particular detail as our work progresses, it remains to be seen if such a continuum
will continue to be a useful analytic framework or whether some other framework (or
no clear pattern) will emerge.

The Freddie Mac officials commented on our discussion of non-mortgage investments
as a share of (1) on-balance sheet assets, (2) mortgage servicing portfolio, and (3)
capital as reported in table 1. They stated that the only relevant base was mortgage
servicing portfolio, because non-mortgage investments serve to support all mortgage
purchases. We have not to date reached a conclusion about how best to describe the
relative share of the enterprises’ financial activity represented by non-mortgage
investments, but rather offer examples of the share as a percentage of different bases
for illustrative purposes. We will further consider this issue, and take Freddie Mac’s
views into account, as our work progresses.

Both the Freddie Mac and Fannie Mae officials made the following comments. First,
the officials said that enhancing earnings is not a primary purpose of non-mortgage
investments. They stated that the primary purposes of non-mortgage investments are
to achieve the statutory purposes, not to increase profits. We no longer attribute to
the enterprise officials the statement that enhanced earnings are a principal reason for
non-mortgage investments. Second, the Freddie Mae and Fannie Mae officials took
exception to our indicated range of the enterprises’ funding advantage on debt of 30 to




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106 basis points, which is contained in a previous report.25 The Freddie Mac officials
incorporated, by reference, their comments on the funding advantage from our
previous report. Our previous report addressed the enterprises’ comments. In this
interim report, we use the yield spread of slightly over 60 basis points from Freddie
Mac’s investment in Phillip Morris bonds as an example of what the funding advantage
could be on long-term non-mortgage investments.

Fannie Mae..officials made additional comments. They told us that they emphasize the
mortgage investment component of MPP, especially as MPP relates to credit risk
management of Fannie Mae’s mortgage portfolio. Based on this emphasis, they
characterize MPP more as a mortgage investment than a non-mortgage investment.
We refer to MPP as a proposal with a non-mortgage investment component in cash
value life insurance because this component is directly related to the topic of this
letter. We added details, however, to help clarify MPP’s link to Fannie Mae’s mortgage
activities and credit risk management.

The Fannie Mae officials disagreed with our analysis of HUD’s regulatory authority
under the 1992 Act. One Fannie Mae official stated that despite HUD’s general
regulatory power, which includes authority to ensure that the purposes of the charter
acts are accomplished, he believes that HUD does not have authority to set standards
governing Fannie Mae’s investment activities. He stated that this limitation on HUD
has existed since the enterprise became a privately-owned corporation under the
Housing and Urban Development Act of 1968.26 We disagree with the Fannie Mae
official’s conclusion regarding HUD’s legal authority. The language of section 1321 of
the 1992 Act appears to us to be clear. It provides that HUD has general regulatory
authority over the enterprises and is charged with ensuring that the purposes of their
charter acts are accomplished. We believe that this authority includes the power, at a
minimum, to determine whether an enterprise activity conflicts with the statutory
mission and to respond appropriately.

The Freddie Mac and Fannie Mae officials made a number of comments of a clarifying
nature, which have been incorporated where appropriate.




25Housing Entermises: Potential ImDacts of Severing Government SDonsorshiD
(GAO/GGD-96-120, May 1996), pp. 42-44. Also see pages 49-53 for a related discussion
in the section, “Enterprise Comments and Our Evaluation.”

 %b.   L. No. 90448.
                                       GAO/GGD-97-137R   Housing   Enterprises:   Investment   Practices
 14
B-277287

HUD and OFHEO Comments and Our Evaluation

The HUD officials said that they are considering a range of possible standards that
could be appropriate and within the scope of HUD’s statutory authority. They also
provided some clarifying comments. The OFHEO officials provided explanations and
their perspectives that helped us clarify our discussion of (1) regulatory oversight of
government-sponsored enterprises, (2) the enterprises’ non-mortgage investment
policies and practices, and (3) publicly available enterprise financial data.

We incorporated   comments by HUD and OFHEO officials in our discussion where
appropriate.

SCOPE AND METHODOLOGY

We interviewed officials at the enterprises, HUD, and OFHEO; reviewed the
enterprises charters and relevant statutes; reviewed literature on the role of the
enterprises in the residential mortgage market; and obtained and reviewed publicly
available and proprietary information on Freddie Mac’s investment policies, practices,
and justification.  To date, we have reviewed publicly available information on Fannie
Mae’s non-mortgage investments but not its proprietary information on investment
policies, practices, and justification. We received verbal comments on this report on
June 20, 1997, from senior officials at Freddie Mac, Fannie Mae, HUD, and OFHEO.

We do not report specific details of the enterprises’ investment policies because of the
proprietary nature of such enterprise information. We conducted our work for this
interim report in Washington, D.C., between April and June 1997 at Freddie Mac, and
beginning in June 1997 at Fannie Mae, in accordance with generally accepted
government auditing standards.



We are sending copies of this letter to HUD; OFHEO, the enterprises; the Ranking
Minority Member of your Committee; the Chairman and Ranking Minority Member of
your Subcommittee on Capital Markets, Securities and Government Sponsored
Enterprises; and the Chairman and Ranking Minority Member of the Senate Committee
on Banking, Housing and Urban Affairs. We will also make copies available to others
on request.’




                                       GAO/GGD-97-137R   Housing   Enterprises:   Investment   Practices
15
B-277287

Please contact me at (202) 512-8678 or Bill Shear at (202) 512-4325
                                                                 -. if you or your staff
have any questions.

Sincerely yours,


      b&e
        -2.               bhiJ@y
Jean Gleason Stromberg
Director, Financial Institutions
   and Markets Issues




 (233525)
                                        GAO/GGD-97-137R   Housing   Enterprises:   Investment   Practices
 16
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