oversight

GSEs: Recent Trends and Policy Issues

Published by the Government Accountability Office on 1997-07-16.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before Subcommittee on Capital Markets, Securities and
                          Government Sponsored Enterprises, House Committee on
                          Banking and Financial Services, and Subcommittee on
                          Government Management, Information and Technology,
                          House Committee on Government Reform and Oversight
For Release on Delivery
Expected at
2:00 p.m. EDT
                          GSEs
on Wednesday
July 16, 1997

                          Recent Trends and Policy
                          Statement of James L. Bothwell
                          Chief Economist




GAO/T-OCE/GGD-97-76
Mr. Chairmen and Members of the Committees:

We are pleased to be here today to discuss the large and growing role of
government-sponsored enterprises (GSEs) in the nation’s credit markets.
As you are aware, Congress originally created GSEs to enhance the credit
available to homebuyers, farmers, students and colleges. Congress
established GSEs as federally chartered, but privately owned and operated
corporations, limited their activities to certain economic sectors deemed
worthy of public support, and gave them certain advantages to help
accomplish their public purposes.1 Today, the outstanding volume of
federally assisted GSE credit is large and rapidly increasing. As shown in
Figure 1, Appendix I, the volume of GSE credit more than doubled between
1990 and 1996, from $874 billion to almost $1.8 trillion, and is now almost
double the outstanding amount of credit made available through all federal
direct loan and federal loan guarantee programs combined. As shown in
Figure 2, Appendix I, GSE credit has also steadily increased as a percentage
of the total net credit outstanding in our economy,2 from less than
2 percent in 1970 to over 12 percent in 1996. By contrast, the share of total
net credit accounted for by federal direct and guaranteed loans has
declined substantially over this period from almost 13 percent in 1970 to
less than 7 percent in 1996.

As shown in Figure 3, Appendix I, 95 percent of total outstanding GSE
credit in 1996 was housing related, with the remaining 5 percent going for
agricultural and educational purposes. In recent years, housing has also
been the only sector where GSE credit has been growing as a percentage of
the total available credit outstanding. In particular, as shown in Figure 4,
Appendix I, the two largest housing GSEs, Fannie Mae and Freddie Mac,
have increased their share of total residential mortgage debt from
23 percent in 1990 to over 37 percent in 1996.3 By contrast, as shown in
Figure 5, Appendix I, the share of farm credit supplied by the Farm Credit
System, the largest agricultural GSE, actually declined between 1985 and
1995. And Congress passed legislation

1
Appendix II provides more details on the creation and operations of each of the major GSEs.
Appendix III provides a list of related GAO products.
2
 Total net credit outstanding in the economy includes debt owed by all domestic sectors except
financial intermediaries, which are omitted to avoid double counting.
3
 Specifically, of the $3.0 trillion in outstanding mortgage debt at the end of fiscal year 1990,
12.5 percent was in Fannie Mae’s portfolio or its guaranteed mortgage pools, while 10.7 percent was in
Freddie Mac’s portfolio or mortgage pools. By the end of fiscal year 1996, Fannie Mae’s share of the
$4.1 trillion in outstanding mortgage debt had increased to 22.5 percent, while Freddie Mac’s share had
risen somewhat less, but still by a substantial amount, to 14.6 percent. During this period, the share of
total outstanding mortgage credit supplied by the Federal Home Loan Bank System actually declined
from 3.9 percent to 3.7 percent.



Page 1                                                                        GAO/T-OCE/GGD-97-76
in 1996 that allowed the two education GSEs — Sallie Mae and Connie
Lee — to end their government sponsorship and become fully private
corporations.

While the legal powers, organizational structures, and operating styles of
GSEs differ, they have several common characteristics. For example, each
GSE was chartered by Congress to help achieve a particular public purpose,
each is privately owned and operated, and each operates under certain
restrictions and obligations which would not apply to a completely private
corporation. Each GSE was also given certain explicit advantages —such as
exemptions from state and local corporate income taxes, lines of credit
with the Treasury Department, or exemptions from SEC registration
requirements and fees — to help achieve its public purpose. The most
important benefit that GSEs receive from their government sponsored
status, however, is an implicit one stemming from investors’ perceptions
that the federal government would not allow a GSE to default on its
obligations. Although GSE obligations are not obligations of the United
States Government, the lower perceived risk of holding GSE obligations
allows GSEs to borrow at rates lower than comparably creditworthy private
corporations that do not enjoy federal sponsorship. In our recent
statement on the potential impacts of privatizing Fannie Mae and Freddie
Mac, we estimated that this funding advantage saved the two GSEs from
about $2 billion to $8 billion in 1995.4

Because of their federal sponsorship, GSEs also involve significant risks
and potential costs to taxpayers, including the risk that taxpayers could be
potentially liable for a GSE’s obligations if it were to get into financial
difficulty. In 1987, Congress did in fact authorize $4 billion in financial
assistance to the Farm Credit System when it experienced financial stress.5
 Limited financial and regulatory relief was also provided to Fannie Mae
when it suffered losses of $277 million between 1981 and 1984.6

The special nature of GSEs, and the potential taxpayer exposure to large,
rapidly increasing GSE financial obligations, raises several important policy
issues, including the adequacy of GSE regulation, the potential for
expansion of GSE activities, and potential ways to limit GSE exposures. Over
the past few years, we have performed several major evaluations of the
4
 Housing Enterprises: Potential Impacts of Severing Government Sponsorship, GAO/T-GGD-96-134,
June 12, 1996.
5
Farm Credit System: Repayment of Federal Assistance and Competitive Position, GAO/GGD-94-39,
March 10, 1994.
6
Housing Enterprises: Potential Impacts of Severing Government Sponsorship, GAO/GGD-96-120,
May 13, 1996.



Page 2                                                                  GAO/T-OCE/GGD-97-76
    effectiveness of the various GSE regulators.7 Based on our reviews, we
    developed the following five criteria for an effective GSE regulator:

•   objectivity and arm’s length status from the GSE,
•   prominence in government,
•   consistency in regulation of similar markets,
•   separation of primary and secondary market regulation, and
•   economy and efficiency.

    Although Congress has enacted some recent legislative changes to
    strengthen and improve regulatory oversight of GSEs, our work has shown
    that none of the three housing GSE regulators — the Office of Federal
    Housing Enterprise Oversight (OFHEO), the Department of Housing and
    Urban Development (HUD), nor the Federal Housing Finance Board
    (FHFB)— meets all five of our criteria. In 1993 we recommended that OFHEO
    and the FHFB be merged to better meet these criteria and our ongoing work
    continues to support merging the housing GSE regulators and making one
    agency responsible for both GSE safety and soundness and mission
    compliance.

    Based on our work, we have also developed several criteria that
    policymakers could use to evaluate proposals to expand the types of
    products or services that existing GSEs currently offer.8 Under these
    criteria, any new GSE product or service should:

•   add value and be consistent with the GSE’s public mission,
•   be properly priced to reflect risk,
•   be within the GSE’s area of expertise, and
•   avoid competing with products and services offered by fully private
    companies or member institutions.

    Because GSEs have been given the advantages of federal sponsorship to
    achieve particular public purposes, we believe that any proposals to

    7
     Government-Sponsored Enterprises: A Framework for Limiting the Government’s Exposure to Risks,
    GAO/GGD-91-90, May 22, 1991; Government-Sponsored Enterprises: The Government’s Exposure to
    Risks, GAO/GGD-90-97, Aug. 15, 1990; FHLBank System: Reforms Needed to Promote Its Safety,
    Soundness, and Effectiveness, GAO/T-GGD-95-244, Sept. 27, 1995; Government-Sponsored Enterprises:
    Development of the Federal Housing Enterprise Financial Regulator, GAO/GGD-95-123, May 30, 1995;
    Farm Credit System: Farm Credit Administration Effectively Addresses Identified Problems,
    GAO/GGD-94-14, Jan. 7, 1994; Federal Home Loan Bank System: Reforms Needed to Promote Its
    Safety, Soundness, and Effectiveness, GAO/GGD-94-38, Dec. 8, 1993; Improved Regulatory Structure
    and Minimum Capital Standards are Needed for Government-Sponsored Enterprises,
    GAO/T-GGD-91-41, June 11, 1991.
    8
     See, in particular, Federal Home Loan Bank System: Reforms Needed to Promote Its Safety,
    Soundness, and Effectiveness, GAO/GGD-94-38, Dec. 8, 1993.



    Page 3                                                                    GAO/T-OCE/GGD-97-76
significantly expand their existing activities should be required to meet
these, or similarly rigorous, criteria before they are approved.

Finally, we have also done work addressing ways that Congress might
limit the taxpayers’ potential exposure to GSE obligations. One obvious
way to do this is to end their federal sponsorship. As I mentioned at the
beginning of my statement, Congress passed legislation last year that
would make two of the GSEs — Sallie Mae and Connie Lee — fully private
entities. In 1996, we, along with the Treasury Department, HUD, and the
Congressional Budget Office, produced reports that analyzed the potential
impacts of privatizing the two largest GSEs — Fannie Mae and Freddie
Mac.9 While taking such action could eliminate taxpayers’ risk exposure to
these GSEs, it would also have major impacts on housing finance markets,
including a likely increase in mortgage interest rates for certain borrowers.
Our report also discussed some more limited policy options that would
reduce the level of taxpayers’ risk exposure to these two GSEs, such as
imposing “user fees” or greater restrictions on their housing finance
activities. As with privatization, however, each of the options that we
presented had benefits, risks, and trade-offs that would need to be
considered and weighed carefully.

Mr. Chairmen, this concludes my prepared statement, and we would be
happy to respond to any questions that you or other members of the
committees may have.




9
 Housing Enterprises: Potential Impacts of Severing Government Sponsorship, GAO/GGD-96-120,
May 13, 1996; Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac, Congressional
Budget Office, May 1996; Government Sponsorship of the Federal National Mortgage Association and
the Federal Home Loan Mortgage Corporation, United States Department of the Treasury, July 11,
1996; Studies on Privatizing Fannie Mae and Freddie Mac, May 1996, and Privatization of Fannie Mae
and Freddie Mac: Desirability and Feasibility, July 1996, United States Department of Housing and
Urban Development.



Page 4                                                                    GAO/T-OCE/GGD-97-76
Page 5   GAO/T-OCE/GGD-97-76
Appendix I




                                                         Figure 1
                         Rapid Growth in GSE Credit

                         Federal Loans & Guarantees & GSE Credit: 1990-1996
                                                    In Billions of Dollars
                                     Billions of $
                                            2,000


                                            1,500


                                            1,000


                                             500


                                                0
                                  Fiscal Year       90    91    92     93    94    95    96

                             GSE Credit             874   988 1,129 1,282 1,533 1,548 1,771

                             Guaranteed Loans       611   701    680   666   668   693   775

                             Direct Loans           162   160    156   151   155   160   165




             Source: U.S. Budget with GAO adjustment for Sallie Mae’s holdings of guaranteed loans.




             Page 6                                                                      GAO/T-OCE/GGD-97-76
Appendix I




                                       Figure 2

               GSE Credit Affects Rising
               Share of Total U.S. Credit

             Federal Loans & Guarantees & GSE Credit: 1970-1996
                          As a Percent of Total Credit Outstanding
                              Percent
                                  20
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                                   0
                    Fiscal Year              70          75         80          85          90         96
                                   AAAAAA
                                   AAAAA
               Direct Loans        AAAAA
                                   AAAA     3.7 3.4 4.3 3.8 1.5                                         1.1

               Guaranteed Loans             9.2 8.8 7.8 6.1 5.9                                         5.6
                                   AAAAAA
                                   AAAA
                                   AAAAAA
               GSE Credit          AAAAA
                                   AAAA     1.8 2.3 3.9 5.5 8.0 12.1




Source: U.S. Budget & Federal Reserve Board




Page 7                                                                                                      GAO/T-OCE/GGD-97-76
Appendix I




                                  Figure 3
                   Housing Gets Largest
                   Share of GSE Credit
                         GSE Credit by Sector FY 96




                 Housing
                      95.0%                                                    Education
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                                                                                Agriculture




                                Total: $1.8 trillion




Source: U.S. Budget, FY 1998




Page 8                                                                              GAO/T-OCE/GGD-97-76
Appendix I




                                                      Figure 4

             GSE Share of Mortgage Credit
                      is Rising
                                     Mortgage Lending Shares: FY 1990 & FY 1996
                            Fannie        12.5%                                  Fannie    22.5%
                            Mae                                                  Mae
   Freddie          10.7%
   Mac
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                                                                       3.7%
                                                                   FHLBS




                       Other    55.5%                                                       Other       44.4%


                                     FY 1990                                                 FY 1996
                                 Total: $3.0                                              Total: $4.1
                                 trillion                                                 trillion




Source: U.S. Budget & Federal Reserve Bulletin




Page 9                                                                                               GAO/T-OCE/GGD-97-76
Appendix I




                                       Figure 5
                GSE Share of Farm Credit is
                       Declining
                               Farm Credit Shares: 1985 & 1995


                                                                           Banks 39.0%
          FCS
      29.0%                         Banks
                                       23.0%




                                               FCS
                                               24.0%

 USDA Loans
     12.0%

                                                       USDA Loans             Other 30.0%
                               Other 36.0%
                                                             7.0%


                       1985                                         1995




Source: U.S. Budget, FY 1998




Page 10                                                              GAO/T-OCE/GGD-97-76
Appendix II




Housing GSEs   The two major housing GSEs—Fannie Mae and Freddie Mac—were both
               created to improve the operations and efficiency of the housing credit
               markets. Although they were created in different circumstances and have
               operated differently, their charters and methods of operations have
               become much more similar.

               Fannie Mae was first created in 1938 as a government-held association to
               buy FHA, and later VA and conventional, loans from originators, primarily
               mortgage banks, with funds raised by selling bonds. The initial goals of the
               program were to support the development of a national mortgage market
               and to improve liquidity through the creation of a resale market for
               mortgage loans. In the 1950s, Congress began the process of shifting
               Fannie Mae to private ownership. This was to be accomplished by
               requiring each mortgage seller to purchase a certain amount of common
               stock based on the amount of loans it sold to Fannie Mae, which would
               allow the gradual retirement of preferred stock owned by the Treasury
               Department.

               The Housing and Urban Development Act of 1968 completed the
               transformation of Fannie Mae into a government-sponsored enterprise.
               The act separated Fannie Mae into two separate components. One
               component, Ginnie Mae, remained in HUD to provide support to FHA, VA,
               and special assistance programs. The other part was the
               government-sponsored, privately owned, for-profit Federal National
               Mortgage Association, which was to be concerned exclusively with
               attracting funding into residential mortgages. To accomplish this purpose,
               Fannie Mae used funds raised by selling bonds to purchase mortgage loans
               from originators and held them in its own portfolio.

               Congress chartered Freddie Mac in 1970 in reaction to the loss of deposits
               in the savings and loan industry that was curtailing that industry’s ability
               to fund and originate home mortgages. Its creation ensured that the
               savings and loan industry had access to funds to continue to fund
               mortgages. In comparison to Fannie Mae, Freddie Mac did not hold
               mortgages in its portfolio, but created mortgage-backed securities (MBS)
               and sold them to investors. However, Freddie Mac guaranteed timely
               interest and principal payments on these securities.

               In the early 1980s, Fannie Mae and Freddie Mac experienced different
               financial results as short-term interest rates increased. Because Fannie
               Mae was funding the mortgages in its portfolio with short-term debt, sharp
               short term rate increases meant that the interest earned on the old



               Page 11                                                  GAO/T-OCE/GGD-97-76
Appendix II




mortgages in its portfolio was less than interest expenses on the newly
issued debt. As a result, Fannie Mae experienced total losses of about
$277 million between 1981 and 1984. In response to Fannie Mae’s financial
problems, the federal government provided limited tax relief and
regulatory forbearance in the form of relaxed capital requirements.
Freddie Mac’s different method of operations meant that investors, and
not Freddie Mac, bore the risks of changing interest rates. To avoid future
losses from interest rate changes, Fannie Mae partially adopted Freddie
Mac’s strategy of issuing MBS and shifting the interest rate risk to investors.

The activities of Fannie Mae and Freddie Mac have largely converged. The
effect of the Housing and Community Development Act of 1992, along with
the GSE-related provisions in the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 (FIRREA), was to make the charters of Fannie
Mae and Freddie Mac substantially the same. Both GSEs attempt to smooth
the availability of mortgage funds across time and regions and promote
liquidity in the secondary mortgage market. In addition to their traditional
goal of improving the functioning of capital markets, the charters of both
enterprises now include distributional goals. Both Fannie Mae and Freddie
Mac have the additional purpose of providing access to mortgage finance
for low-income families and underserved areas. A primary difference
between the two GSEs continues to be Fannie Mae’s relatively greater use
of debt-financing to hold mortgages in its own portfolio, although Freddie
Mac has increased its portfolio investment share in recent years.

The Federal Home Loan Bank System is the third housing-related GSE. It
was established in 1932 to extend mortgage credit by making loans, called
advances, to its member institutions, who in turn lend to homebuyers for
mortgages. The System consists of 12 federally chartered, privately owned
FHLBanks that raises funds by issuing consolidated debt securities in the
capital market. The advances are secured by home mortgage loans or such
other collateral as U.S. Treasury securities. These advances help member
institutions, originally limited to thrifts, by enhancing liquidity and
providing access to national capital markets.

With the evolution of national mortgage markets and the contraction of
the thrift industry, the original justifications for the Federal Home Loan
Bank System to support housing credit and the thrift industry have
diminished. Rather than phase down its activities, Congress allowed the
Federal Home Loan Bank System to expand its membership pool to
include commercial banks, which now comprise 65 percent of the
members.



Page 12                                                    GAO/T-OCE/GGD-97-76
                    Appendix II




Agricultural GSEs   The largest of the two agriculture GSEs, the Farm Credit System (FCS),
                    raises money through bond sales and makes loans directly to farmers. FCS
                    lends this money to the farming sector through a network of
                    member-owned cooperatives with the purpose of ensuring a stable supply
                    of credit to agriculture. Established in 1916, FCS became insolvent in the
                    mid-1980s when inadequate interest-rate risk management and falling land
                    prices depressed the value of collateral behind FCS credit and created large
                    losses for the institution. This necessitated a federal bailout through the
                    FCS Financial Assistance Corporation (FAC), which injected funds into FCS
                    by issuing $1.261 billion in bonds.

                    Unlike direct loans and FCS loans, the other agricultural GSE—Farmer
                    Mac—operates by promoting a secondary market for agricultural loans.
                    Farmer Mac was created in 1987 by the same legislation that provided for
                    the FCS bailout. Its purpose was to create and oversee a secondary market
                    for, and to guarantee securities based on, farm real estate loans. However,
                    unlike the GSEs in the housing sector, Farmer Mac was not able to
                    establish a growing niche in farm credit markets by guaranteeing farm
                    securities. As a result of the decline in Farmer Mac’s capital base, the
                    Farm Credit System Reform Act of 1996 expanded its powers. The 1996
                    Act transformed Farmer Mac from just a guarantor of securities formed
                    from loan pools into a direct purchaser of mortgages in order to form
                    pools to securitize. The expanded powers make it more attractive for
                    banks to participate in Farmer Mac and permit Farmer Mac to act as a
                    pooler. While the new powers are intended to boost Farmer Mac’s
                    revenues, it is too early to tell how this will affect Farmer Mac’s role in
                    agricultural credit. However, as a direct purchaser of loans with no
                    required subordination, this increased role does have the potential to
                    expose Farmer Mac to greater credit risk than on guaranteed pools, which
                    require loan originators or other entities outside the pool to hold a
                    10-percent subordinated interest in pooled loans.


Education GSEs      The federal government created two GSEs to increase the availability of
                    credit in the educational sector. The largest one, Sallie Mae, was created in
                    1972 as a for-profit, shareholder-owned corporation. Sallie Mae purchases
                    insured student loans from eligible lenders and makes secured loans to
                    lenders. It now holds about one-third of all outstanding guaranteed student
                    loans. In 1996 Congress passed legislation establishing a process for
                    restructuring Sallie Mae and ultimately terminating its federal government
                    sponsorship.




                    Page 13                                                  GAO/T-OCE/GGD-97-76
Appendix II




The second education GSE, Connie Lee, was created in 1986 to insure and
reinsure the financing of postsecondary education facilities. Connie Lee’s
financial condition has been strong, particularly since 1991, when it
obtained the “triple-A” credit rating necessary to engage in the financial
guaranty business as a direct writer of insurance. Legislation passed in
1996 privatized Connie Lee by repealing the corporation’s enabling
legislation and requiring the federal government to sell, and Connie Lee to
purchase, the corporation’s federally owned stock during fiscal year 1997.




Page 14                                                 GAO/T-OCE/GGD-97-76
Appendix II




Page 15       GAO/T-OCE/GGD-97-76
Appendix III

Related GAO Products


               Housing Enterprises: Investment, Authority, Polices, and Practices,
               GAO/GGD-97-137R, June 27, 1997.


               Housing Enterprises: Potential Impacts of Severing Government
               Sponsorship, GAO/T-GGD-96-134, June 12, 1996.

               Housing Enterprises: Potential Impacts of Severing Government
               Sponsorship, GAO/GGD-96-120, May 13, 1996.

               GAO views on the “Federal Home Loan Bank System Modernization Act of
               1995”, Letter from James L. Bothwell, Director, Financial Institutions and
               Markets Issues, GAO, to the Honorable James A. Leach, Chairman,
               Committee on Banking and Financial Services, U.S. House of
               Representatives, Oct. 11, 1995.

               FHLBank System: Reforms Needed to Promote Its Safety, Soundness, and
               Effectiveness, GAO/T-GGD-95-244, Sept. 27, 1995.

               Housing Finance: Improving the Federal Home Loan Bank System’s
               Affordable Housing Program, GAO/RCED-95-82, June 9, 1995.

               Government-Sponsored Enterprises: Development of the Federal Housing
               Enterprise Financial Regulator, GAO/GGD-95-123, May 30, 1995.

               Farm Credit System: Repayment of Federal Assistance and Competitive
               Position, GAO/GGD-94-39, March 10, 1994.

               Farm Credit System: Farm Credit Administration Effectively Addresses
               Identified Problems, GAO/GGD-94-14, Jan. 7, 1994.

               Federal Home Loan Bank System: Reforms Needed to Promote Its Safety,
               Soundness, and Effectiveness, GAO/GGD-94-38, Dec. 8, 1993.

               Improved Regulatory Structure and Minimum Capital Standards are
               Needed for Government-Sponsored Enterprises, GAO/T-GGD-91-41, June 11,
               1991.

               Government-Sponsored Enterprises: A Framework for Limiting the
               Government’s Exposure to Risks, GAO/GGD-91-90, May 22, 1991.

               Government-Sponsored Enterprises: The Government’s Exposure to
               Risks, GAO/GGD-90-97, Aug. 15, 1990.



(972628)       Page 16                                                 GAO/T-OCE/GGD-97-76
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