oversight

Federal Housing Enterprises: OFHEO Faces Challenges In Implementing a Comprehensive Oversight Program

Published by the Government Accountability Office on 1997-10-22.

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

               United States General Accounting Office

GAO            Report to Congressional Committees




October 1997
               FEDERAL HOUSING
               ENTERPRISES
               OFHEO Faces
               Challenges In
               Implementing a
               Comprehensive
               Oversight Program




GAO/GGD-98-6
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division

      B-275470

      October 22, 1997

      Congressional Committees

      This report addresses requirements that we assess the operations of the Office of Federal
      Housing Enterprise Oversight (OFHEO) contained in Sec. 430 of the Department of Veterans
      Affairs/Department of Housing and Urban Development Appropriations Act of 1997 (P.L.
      104-204). The report assesses OFHEO’s capacity to fulfill its mission of helping to ensure the
      safety and soundness of the Federal National Mortgage Association and the Federal Home Loan
      Mortgage Corporation.

      As such, the report provides information on OFHEO’s development of risk-based capital
      standards, implementation of an examination program, establishment of mission support
      functions, and participation in a U.S. initiative to assist Mexico in developing a secondary
      mortgage loan market. We also provide recommendations to the acting director of OFHEO on
      strengthening reporting to Congress on the development of the risk-based capital standards and
      ensuring adequate resources for the examinations program.

      We are sending copies of the report to other appropriate congressional committees, the Acting
      Director of OFHEO, the Chairman of the Board of Governors of the Federal Reserve System, the
      Comptroller of the Currency, the Federal National Mortgage Association, the Federal Home
      Loan Mortgage Corporation, and other interested parties. We will also make copies available to
      others upon request.

      Major contributors to this report are listed in appendix V. If you have any questions about this
      report, please call me on (202) 512-8678.




      Thomas J. McCool
      Director, Financial Institutions
        and Markets Issues
B-275470

List of Congressional Committees

The Honorable Christopher Bond
Chairman
The Honorable Barbara A. Mikulski
Ranking Minority Member
Subcommittee on Veterans Affairs,
  HUD, and Independent Agencies
Committee on Appropriations
United States Senate

The Honorable Alfonse M. D’Amato
Chairman
The Honorable Paul S. Sarbanes
Ranking Minority Member
Committee on Banking,
  Housing, and Urban Affairs
United States Senate

The Honorable Robert F. Bennett
Chairman
The Honorable Barbara Boxer
Ranking Minority Member
Subcommittee on Financial Services
  and Technology
Committee on Banking,
  Housing, and Urban Affairs
United States Senate

The Honorable Richard H. Baker
Chairman
The Honorable Paul E. Kanjorski
Ranking Minority Member
Subcommittee on Capital Markets, Securities,
  and Government Sponsored Enterprises
Committee on Banking and Financial Services
House of Representatives




                    Page 2                     GAO/GGD-98-6 Federal Housing Enterprises
B-275470

The Honorable Jerry Lewis
Chairman
The Honorable Louis Stokes
Ranking Minority Member
Subcommittee on Veterans Affairs,
  HUD, and Independent Agencies
Committee on Appropriations
House of Representatives




                    Page 3          GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary


             There is a widespread perception in the financial markets that, during a
Purpose      financial emergency, the U.S. government would rescue either or both of
             the two largest federal housing enterprises, the Federal National Mortgage
             Association (Fannie Mae) and the Federal Home Loan Mortgage
             Corporation (Freddie Mac), which had combined financial obligations of
             $1.5 trillion at year-end 1996. To lower the probability that such a costly
             government intervention would ever be considered necessary, it is
             important that the Office of Federal Housing Enterprise Oversight (OFHEO)
             fulfill its mission of helping to ensure the safety and soundness of Fannie
             Mae and Freddie Mac (the enterprises) pursuant to the Federal Housing
             Enterprises Financial Safety and Soundness Act of 1992 (the act). OFHEO’s
             primary means for fulfilling its mission are establishing capital standards
             for the enterprises and conducting on-site examinations to assess their
             management practices and financial condition.

             The Department of Veterans Affairs (VA)/Department of Housing and
             Urban Development (HUD) Appropriations Act of 1997 required GAO to
             assess OFHEO’s fulfillment of its safety and soundness mission. Based on
             discussions with congressional staff, GAO established the following two
             major objectives to respond to the mandate: (1) identify the reasons why
             OFHEO has not issued final risk-based capital standards for the enterprises
             even though there was a December 1, 1994, deadline for doing so and
             (2) assess OFHEO’s implementation of its safety and soundness examination
             responsibilities.


             Congress established and chartered the enterprises as
Background   government-sponsored, privately owned and operated corporations to
             enhance the availability of mortgage credit across the nation during both
             good and bad economic times. The enterprises are to accomplish this
             mission by purchasing mortgages from lenders (banks, thrifts, and
             mortgage bankers) who can then use the proceeds to make additional
             mortgage loans to home buyers. The enterprises issue debt to finance
             some of the mortgage assets that they retain in their portfolios. A majority
             of the mortgages, however, are pooled to create mortgage-backed
             securities (MBS) that may be sold to investors or repurchased by the
             enterprises and held in their portfolios. The enterprises charge fees for
             guaranteeing the timely payment of principal and interest on MBS held by
             investors. At year-end 1996, the enterprises had combined debt obligations
             of $487 billion and combined MBS obligations to investors of $1.021 trillion
             (a total of about $1.5 trillion).




             Page 4                                  GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary




The federal government’s creation of and continued relationship with
Fannie Mae and Freddie Mac have created the perception in the financial
markets that it would not allow the enterprises to default on their debt and
MBS obligations, even though there is no requirement that it do so. As a
result, Fannie Mae and Freddie Mac can borrow money in the capital
markets at lower interest rates than comparably creditworthy private
corporations that do not enjoy federal sponsorship, and at least a portion
of the financial benefits that accrue to the enterprises have been passed
along to homeowners in the form of lower mortgage interest rates.
However, the potential also exists that the government would choose to
intervene to rescue the enterprises in a financial emergency. In fact, during
the 1980s, the government did provide limited regulatory and financial
relief to Fannie Mae when it experienced significant financial difficulties,
and, in 1987, Congress authorized $4 billion to bail out the Farm Credit
System, another government-sponsored enterprise.

Recognizing the potentially large costs that Fannie Mae and Freddie Mac
pose to taxpayers, Congress passed the act, which established OFHEO as an
independent regulator within HUD whose mission is to help ensure the
enterprises’ safety and soundness. Under the act, OFHEO’s director, who is
presidentially appointed and must be confirmed by the Senate, has wide
independent authority to ensure that OFHEO fulfills its safety and
soundness mission. For example, the director has the authority to take
enforcement actions against the enterprises without the review and
approval of the HUD Secretary. OFHEO had a budget of about $15.5 million in
fiscal year 1997 and a professional staff of about 85 individuals consisting
of full-time staff, temporary staff, contract employees, and detailees from
bank regulatory agencies. OFHEO’s budget is subject to the congressional
appropriations process, but its expenditures are financed, to the extent
provided in appropriations acts,1 by annual assessments on Fannie Mae
and Freddie Mac rather than with taxpayer funds.

As required by the act, OFHEO is to carry out its oversight function in part
by establishing minimum capital standards. The act also mandated that
OFHEO develop a stress test that serves as the basis for the risk-based
capital standards. Under the act, the purpose of a stress test is to lower
taxpayer risks by simulating in a computer model situations where the
enterprises are exposed to adverse credit and interest rate scenarios and
requiring them to hold sufficient capital to withstand these scenarios for a
10-year period plus an additional 30 percent to cover management and
operations risk. The act establishes the broad outlines of a stress test, but

1
 OFHEO’s budget authority is included in the annual VA/HUD Appropriations Act.



Page 5                                             GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary




OFHEO  is required to complete several projects to further specify the
adverse credit and interest rate scenarios and their impacts on the
enterprises. Under the act, the stress test and risk-based capital standards
were to have been completed by December 1, 1994. The act also requires
OFHEO to conduct annual, on-site safety and soundness examinations of the
enterprises to assess their operations and financial condition. In OFHEO’s
opinion, this requirement can be and has been met without conducting
full-scope2 enterprise examinations on an annual basis.

Since the mid-1980s, Fannie Mae and Freddie Mac have been consistently
profitable, and, in 1997, the Standard & Poor’s credit rating firm gave both
enterprises relatively high “AA-” government risk credit ratings.3 However,
OFHEO officials have pointed out that current profitability does not
guarantee future profitability. Since Congress passed the act, which
established OFHEO in 1992, enterprise assets, which consist primarily of
mortgages and MBS that the enterprises retain in their portfolios, have
more than doubled. Although potentially more profitable than issuing MBS
to investors, larger retained holdings of mortgages and MBS expose the
enterprises to potentially greater losses resulting from fluctuations in
interest rates.

To identify the reasons why OFHEO has not issued risk-based capital
standards, GAO interviewed OFHEO and enterprise officials, as well as
former HUD officials who worked on enterprise safety and soundness
issues at HUD prior to OFHEO’s creation. GAO also reviewed a variety of
OFHEO documents, such as internal memorandums and written
explanations of the stress test development process provided at GAO’s
request. GAO did not assess the adequacy or appropriateness of OFHEO’s
approach to developing the stress test. Since OFHEO has not completed its
development of risk-based capital standards, GAO could not evaluate the
usefulness of specific steps OFHEO has taken to reach a final rule
promulgating a risk-based capital standard. GAO assessed OFHEO’s
implementation of its examination responsibilities by determining the
organization’s adherence to an examination schedule and plan that was
established in September 1994.




2
 Full-scope examinations are generally understood to mean thorough assessments of all of the
management practices and business strategies of a financial institution that could affect its safety and
soundness.
3
 Standard & Poor’s assessed the risks that the enterprises’ financial activities pose to the U.S.
government. The firm rates companies on a scale ranging from “AAA” for the lowest credit risks to
“CC” for the greatest credit risks.



Page 6                                                 GAO/GGD-98-6 Federal Housing Enterprises
                   Executive Summary




                   To fulfill its statutory safety and soundness mission, OFHEO is to establish
Results in Brief   risk-based capital standards that are sufficient to withstand the rigors of a
                   complex stress test and implement a comprehensive and timely
                   examination program. To date, OFHEO has not fully completed either of
                   these tasks.

                   OFHEO  has not established the risk-based capital standards because it must
                   first develop the stress test. Development of a stress test has been
                   protracted primarily due to (1) the complexity of the development process
                   as specified in the act and (2) OFHEO’s initial decision in 1994 to develop its
                   own sophisticated stress test rather than adopting and modifying stress
                   tests that were already under development. OFHEO officials told GAO that
                   they chose not to adopt existing stress tests because, in their judgment,
                   those tests did not provide an adequate basis for understanding the risks
                   facing the enterprises or the capital necessary to offset those risks. OFHEO
                   officials also said that the organization faced significant and
                   time-consuming challenges in acquiring expertise, obtaining accurate
                   financial information from the enterprises, initiating the federal
                   rulemaking process, and completing several financial modeling and
                   computer programming projects.

                   OFHEO  has already missed its December 1994 statutory deadline for
                   completing a stress test and establishing risk-based capital standards by
                   almost 3 years. Tasks remaining include making key policy decisions
                   about the stress test and continuing to translate its components into
                   proposed and final rules. OFHEO now estimates that it will not complete
                   this part of the statutory mandate until 1999. Because the risk-based
                   capital standards are among OFHEO’s primary tools for helping to ensure
                   the enterprises’ safety and soundness, GAO believes that it is essential that
                   OFHEO complete the tasks remaining to develop those standards as
                   expeditiously as possible.

                   OFHEO  has not fully implemented a timely and comprehensive enterprise
                   safety and soundness examination program. OFHEO established an
                   examination plan in September 1994 that provided for a 2-year cycle for
                   the assessment of six “core” risks, such as interest rate and credit, facing
                   the enterprises. As of May 1997, OFHEO had completed or initiated
                   examinations covering five of these six “core” risks. However, OFHEO’s
                   current 3- to 4-year cycle for assessing the six core risks is considerably
                   longer than the 2-year cycle established in the plan. In addition, OFHEO has
                   scaled back the planned coverage of its most recently completed core risk
                   examination.



                   Page 7                                   GAO/GGD-98-6 Federal Housing Enterprises
                         Executive Summary




                         GAO’s analysis found that, among other factors, limited resources allocated
                         to the examination office were largely responsible for OFHEO’s inability to
                         comply with the 1994 plan. According to OFHEO officials, the organization
                         plans to reassess its examination strategy and make changes necessary by
                         early 1998 to ensure that its examination staff cover all six core risk areas
                         within a 1-year period. GAO believes that, without a reassessment and
                         potentially a reallocation of resources, OFHEO may not be able to
                         implement an annual examination cycle by early 1998 that fully covers all
                         risk areas, since the organization has been unable to implement a 2-year
                         cycle with the current assignment of staff to the examination function.
                         Thus, GAO believes that, in the reassessment of its examination strategy,
                         OFHEO could usefully include consideration of different examination cycles
                         and related coverage that could be accomplished with alternative resource
                         levels.



Principal Findings

OFHEO’s Development of   In OFHEO’s planning process and its published documents, the organization
a Stress Test and        has consistently underestimated the time necessary to complete major
Risk-Based Capital       components of the stress test and risk-based capital standards. For
                         example, in 1995 OFHEO estimated that the final rule would be issued in
Standards Has Been       May 1997, but OFHEO now expects that the process will not be completed
Protracted               until 1999. GAO’s review identified several reasons why OFHEO did not
                         comply with the statutory deadline. GAO also found that OFHEO faces
                         continuing challenges and may not meet its current estimate.

                         OFHEO’s  statutory mandate to develop a stress test and risk-based capital
                         standards presented complex and time-consuming challenges to the
                         organization. For example, according to OFHEO, the final stress test must
                         be flexible and capable of assessing the effects of different credit and
                         interest rate scenarios on differing components of the enterprises’
                         mortgage portfolios, such as single family and multifamily mortgages, as
                         well as new financial products. By contrast, the risk-based capital
                         standards developed by federal banking regulators permit institutions to
                         hold the same level of capital against corporate loans that represent high
                         credit risks as against corporate loans that represent low credit risks.

                         During OFHEO’s start-up phase in 1993 and 1994, there were strategies
                         available that OFHEO could have pursued that might have resulted in the




                         Page 8                                  GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary




faster completion of a stress test and risk-based capital standards. As the
foundation of the stress test, OFHEO could have adopted and modified a
stress test under development by HUD in 1992, or the financial models that
the enterprises had established to assess the potential impacts of
alternative credit and interest rate scenarios. However, OFHEO officials
determined that pursuing these strategies would have left the organization
with an inadequate basis for assessing the risks facing the enterprises. For
example, OFHEO officials determined that the available HUD stress test only
allowed for very broad estimates of the potential impacts that different
interest rate and credit scenarios would have on the enterprises’ financial
condition. Consequently, OFHEO concluded that it could develop capital
standards that would be more closely related to enterprise risks by
developing its own sophisticated stress test and associated financial
modeling capability. GAO notes that the implementation of this strategy is
requiring a substantial development period and resource costs.

Between 1994 and 1997, OFHEO experienced other sources of delay in
completing the stress test and risk-based capital standards. For example,
OFHEO had not completed hiring half of its full-time research staff until
1996. OFHEO officials also told GAO that the development of the stress test
has been delayed by OFHEO’s need to (1) obtain accurate enterprise
financial data on a timely basis; (2) initiate the federal rulemaking process,
which involved a substantial commitment of staff time; and (3) complete a
variety of economic and financial modeling and computer programming
projects that involved greater managerial and technical challenges than
OFHEO initially anticipated. OFHEO officials told GAO that most of these
financial modeling and computer programming projects had been
completed by April 1997, although some final testing was required.

Given OFHEO’s history of underestimating the time necessary to complete
the stress test and risk-based capital standards and given the challenges
that remain, GAO is concerned that OFHEO may not meet its current estimate
of issuing a final rule by 1999. To comply with its plan, OFHEO has to initiate
an interagency review of the proposed rule by the Office of Management
and Budget (OMB) and other agencies, and has to make key policy
decisions necessary to complete the stress test. OFHEO must also continue
to translate the complex financial modeling components of the stress test
and risk-based capital standards into proposed and final rules. GAO
believes it is essential that OFHEO complete the tasks remaining to develop
the stress test and establish the risk-based capital standards as
expeditiously as possible because they are among OFHEO’s primary tools
for helping to ensure the enterprises’ safety and soundness.



Page 9                                   GAO/GGD-98-6 Federal Housing Enterprises
                      Executive Summary




OFHEO Has Not Fully   In September 1994, OFHEO established a “risk-focused” examination
Implemented Its       schedule and plan that senior OFHEO officials said they believed was
September 1994        necessary for helping to ensure the safety and soundness of Fannie Mae
                      and Freddie Mac. The plan, as subsequently modified, identified six core
Examination Plan      risks facing the enterprises, such as credit and interest rate risks, and
                      established a 2-year cycle for OFHEO examiners to assess each of these six
                      risks. In addition, the plan identified specific areas that OFHEO examiners
                      were to assess during each scheduled examination. OFHEO’s risk-focused
                      examination strategy is generally consistent in concept but not in timing
                      with risk-focused examination strategies that the Office of the Comptroller
                      of the Currency (OCC) and the Federal Reserve System have established to
                      assess the safety and soundness of large commercial banks. For example,
                      OCC and Federal Reserve System examiners are to assess the major
                      risks—such as credit and interest rate—facing large commercial banks
                      but, as required by law, they are to do so on an annual basis.4

                      Between September 1994 and May 1997, OFHEO made important progress in
                      implementing the plan, such as completing or initiating examinations at
                      both enterprises that addressed five of the six core risks. However, GAO
                      found that OFHEO was not able to implement other important components
                      of the 1994 plan. For example, OFHEO’s current 3- to 4-year examination
                      cycle for covering the six core risk areas is considerably longer than the
                      2-year cycle established in the 1994 plan. Moreover, OFHEO also scaled back
                      the planned coverage of its core business risk examination. OFHEO
                      completed this risk examination in May 1997 but covered only one of the
                      four areas identified in the 1994 plan. OFHEO’s relatively long examination
                      cycle and limited examination coverage raise questions about the
                      organization’s ability to fully monitor the enterprises’ financial activities
                      and risks. In particular, with its current examination schedule, OFHEO may
                      not be able to do another on-site examination of the enterprises’ interest
                      rate risks until 1999 or 2000, even though such risks may have increased
                      because of increased holdings of debt-financed mortgage assets, since the
                      previous interest risk examination was completed in 1996.

                      In May 1995, GAO reported that limited staff resources had impeded OFHEO’s
                      initial efforts to implement the 1994 plan.5 This situation persisted
                      between 1995 and 1997. As of June 1997, OFHEO’s examination office had 17


                      4
                       The Federal Deposit Insurance Corporation Improvement Act of 1991 (Pub. L. No. 102-242, as
                      amended) requires bank regulators to do full-scope examinations of large banks (total assets of
                      $250 million or more) on an annual basis.
                      5
                       Government-Sponsored Enterprises: Development of the Federal Housing Enterprise Regulator
                      (GAO/GGD-95-123, May 30, 1995).



                      Page 10                                               GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary




authorized positions of which 12 were reserved for line examiners and
specialists directly responsible for conducting examinations; the other 5
positions consisted of the office director and deputy director, executive
secretary, and 2 financial analysts. In its two most recently completed core
risk examinations, OFHEO assigned 9 and 8 of its line examiner and
specialist positions, respectively, to each examination for 1 year to
complete them. This significant staff commitment limits OFHEO’s ability to
complete examinations covering three core risks per year, the minimum
necessary to cover all six risks in the 2-year period stipulated in the 1994
plan. In addition, as of March 31, 1997, OFHEO’s examination office had five
vacancies, including the director position, which had further limited its
capacity to implement the 1994 plan. By August 1997, an OFHEO official
reported that the organization had filled three of the examination office
positions, including the director position, and the two others were in the
process of being advertised.

OFHEO  officials said that another important factor that has contributed to
OFHEO’s inability to fully implement the 1994 examination plan was the
time that OFHEO examination staff needed to develop an understanding of
the enterprises’ operations and risk management. Prior to 1993 when
OFHEO began operations, the enterprises had not been subjected to an
examination oversight program. OFHEO officials said that the first round of
examinations has taken longer than initially anticipated in 1994 because of
the time necessary to obtain basic information about the enterprises’
operations and risk management practices.

OFHEO  officials told GAO that the organization plans to reassess its
examination program and make changes as necessary to ensure that the
enterprises’ safety and soundness are adequately monitored. They also
said that the planned reassessment is to include a review of the adequacy
of OFHEO’s examination staff resources to ensure that it has a sufficient
number of line examiners and specialists to cover all core risk areas
within a 1-year period. OFHEO’s acting director said that OFHEO may have
some flexibility to increase its examination staff resources by shifting staff
from its research activities as the stress test and risk-based capital
standards are completed.

GAO believes that, without a reassessment of resources, OFHEO may not be
able to implement an annual examination cycle by early 1998, since it has
not implemented a 2-year cycle with its existing allocation of resources to
the examination function. In fact, as of June 1997, OFHEO had not yet
initiated important components of the 1994 plan, such as the remaining



Page 11                                  GAO/GGD-98-6 Federal Housing Enterprises
                       Executive Summary




                       core risk examination, which could take considerable time to complete.
                       Thus, GAO believes that by including in the reassessment an analysis of the
                       staff resources necessary to adequately carry out alternative examination
                       cycles, such as 1 or 2 years, OFHEO could help ensure a fuller consideration
                       of the trade-offs associated with examination coverage provided versus
                       costs involved and thereby engage in a more informed decisionmaking
                       process.


                       Because it is essential that OFHEO complete its efforts to develop and issue
Recommendations        risk-based capital standards as soon as possible, it is important that
                       congressional oversight be provided to help ensure that OFHEO’s current
                       plan to do so is accomplished in a timely manner. To that end, GAO
                       recommends that OFHEO’s director periodically report to Congress on
                       OFHEO’s progress toward complying with the current estimate of
                       completing a stress test and risk-based capital standards by 1999. GAO also
                       recommends that OFHEO’s director (1) assess the examination staff
                       resources necessary to adequately cover all risk areas on 1- and 2-year
                       examination cycles, (2) identify the most appropriate examination cycle
                       after considering the trade-offs between examination coverage and
                       resource requirements that would be involved, and (3) develop a strategy
                       for obtaining the necessary examination office resources, which may
                       involve reallocating existing resources over time.


                       OFHEO’s acting director provided written comments on a draft of this
Agency Comments        report, which are summarized in chapters 2 and 3 and reprinted in
and GAO’S Evaluation   appendix IV. OFHEO also provided technical comments that were
                       incorporated in the report where appropriate.

                       OFHEO  generally agreed with the report’s findings and recommendations.
                       With respect to the reasons for the protracted development of the stress
                       test and risk-based capital standards, OFHEO cited the complexity of the
                       process as specified in the act and OFHEO’s decision to develop its own
                       stress test rather than redesigning existing stress tests. OFHEO also said
                       that GAO’s report should not be interpreted to suggest that using an
                       existing stress test would have produced an acceptable result. With regard
                       to OFHEO’s examination program, OFHEO said that the office plans to
                       transition to an annual cycle by year-end 1997. In addition, the acting
                       director stated that OFHEO will review the adequacy of its examination staff
                       resources to ensure that a comprehensive program can be implemented.




                       Page 12                                 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary




GAO did not take a position on the adequacy or appropriateness of OFHEO’s
approach to developing the stress test. To do so would have required that
GAO demonstrate whether the other alternatives could have been modified
sufficiently to meet the requirements of the act in a shorter period of time.
Rather, GAO pointed out that there were potential trade-offs associated
with the time that would have been required to adopt and modify existing
stress tests compared to the comprehensive development approach that
OFHEO chose. While OFHEO has agreed to review the adequacy of its
examination resources, GAO believes it is essential that OFHEO promptly
specify the resources necessary to carry out an appropriate examination
cycle and develop a plan to obtain these resources as may be necessary.




Page 13                                 GAO/GGD-98-6 Federal Housing Enterprises
Contents



Executive Summary                                                                                  4


Chapter 1                                                                                         18
                        Background                                                                18
Introduction            Congress Established OFHEO to Help Ensure the Safety and                  22
                          Soundness of the Enterprises
                        Overview of the Enterprises’ Financial Performance and Business           28
                          Strategies
                        Objectives, Scope, and Methodology                                        33

Chapter 2                                                                                         36
                        OFHEO Has Consistently Underestimated the Time Necessary to               37
OFHEO’s                   Complete Stress Test Development
Development of a        The Complexity of the Development Process Has Contributed to              38
                          Delays
Stress Test and         OFHEO’s Decision to Develop a Sophisticated Stress Test Has               40
Risk-Based Capital        Been a Key Factor in the Ongoing Development Process
Standards Has Been      OFHEO’s Need to Hire Expertise and Obtain Accurate Financial              43
                          Data Proved Time-Consuming
Protracted              OFHEO Faces Continuing Challenges in Implementing the Final               47
                          Risk-Based Capital Rule by 1999
                        Conclusions                                                               49
                        Recommendations                                                           50
                        Agency Comments and Our Evaluation                                        50

Chapter 3                                                                                         52
                        OFHEO Established a Detailed Enterprise Examination Schedule              53
OFHEO Has Not Fully       and Plan in 1994
Implemented a           OFHEO Has Not Been Able to Fully Implement the 1994                       56
                          Examination Plan
Comprehensive           Limited Examination Staff Resources Impeded OFHEO’s Ability               59
Enterprise Safety and     to Implement the 1994 Examination Schedule and Plan
Soundness               OFHEO Plans to Reassess Its Examination Strategy and Staff                65
                          Resources
Examination Program     Conclusions                                                               65
                        Recommendations                                                           66
                        Agency Comments and Our Evaluation                                        67




                        Page 14                              GAO/GGD-98-6 Federal Housing Enterprises
                      Contents




Chapter 4                                                                                        68
                      OFHEO Has Implemented Its Financial, Human Resources, and                  68
OFHEO’s                 Contract Management Functions
Implementation of     OFHEO’s Participation in Mexico Initiative Did Not Involve                 72
                        Research or Examination Staffs
Key Mission Support   OFHEO’s Financial and Staff Resources, 1993-1997                           73
Functions             OFHEO’s Relationship With HUD                                              74

Appendixes            Appendix I: Financial Modeling and Computer Programming                    76
                        Projects OFHEO Has Initiated to Complete Development of the
                        Stress Test and Risk-Based Capital Standards
                      Appendix II: OFHEO Officials Have Participated in a U.S.                   78
                        Government Initiative Assisting Mexico in Developing a
                        Secondary Mortgage Loan Market
                      Appendix III: OFHEO’s Staffing Levels, Fiscal Years 1993 to 1997           80
                      Appendix IV: Comments From the Office of Federal Housing                   83
                        Enterprise Oversight
                      Appendix V: Major Contributors to This Report                              87


Tables                Table 1.1: Total Enterprise Debt and Net MBS Outstanding as of             21
                        December 31, 1996
                      Table 1.2: OFHEO’s Full-Time, Temporary, Contractor, and Bank              25
                        Regulator Detailee Staff as of March 31, 1997
                      Table 1.3: OFHEO’s Obligations, Fiscal Years 1996 Through 1998             26
                      Table 1.4: Fannie Mae Year-end Profitability Data, 1990 to 1996            29
                      Table 1.5: Freddie Mac Year-end Profitability Data, 1990 to 1996           29
                      Table 1.6: Fannie Mae and Freddie Mac Total Asset Growth                   31
                        Rates, 1992 to 1996
                      Table 1.7: Growth of Enterprises’ Retained Mortgage Assets as              31
                        Percentage of Mortgages in Total Portfolio, 1992 to 1996
                      Table 2:1: OFHEO’s Planned Completion Dates for Developing                 37
                        the Stress Test and Issuing the Final Risk-Based Capital
                        Standards
                      Table 3.1: OFHEO’s Examination Plan for Monitoring the Six                 54
                        Core Risks on a 2-Year Cycle
                      Table 3.2: OFHEO’s Completed, Ongoing, and Planned                         57
                        Examinations as of May 1997
                      Table 3.3: OFHEO Line Examination Positions Assigned to                    62
                        Completed Enterprise Core Risk Examinations




                      Page 15                               GAO/GGD-98-6 Federal Housing Enterprises
          Contents




          Table 4.1: OFHEO’s Pay Band Levels and Positions in Each Band              70
            in 1996
          Table 4.2: OFHEO Contracts By Value, 1994 to 1997                          72
          Table 4.3: OFHEO’s Obligations, Fiscal Years 1993 Through 1997             73
          Table 4.4: OFHEO’s Full-time, Contractor, and Bank Regulatory              74
            Detailee Staff, at End of Fiscal Years 1993-1997
          Table II.1 OFHEO’s International Travel Related to the Mexico              79
            Initiative, Fiscal Years 1995 and 1996
          Table III.1: OFHEO’s Full-time, Contractor, and Bank Regulatory            80
            Detailee Staff, Fiscal Year-end 1993
          Table III.2: OFHEO’s Full-time, Contractor, and Bank Regulatory            80
            Detailee Staff, Fiscal Year-end 1994
          Table III.3: OFHEO’s Full-time, Contractor, and Bank Regulatory            81
            Detailee Staff, Fiscal Year-end 1995
          Table III.4: OFHEO’s Full-time, Contractor, and Bank Regulatory            81
            Detailee Staff, Fiscal Year-end 1996
          Table III.5: OFHEO’s Full-time, Contractor, and Bank Regulator             82
            Detailee Staff as of March 31, 1997

Figures   Figure 1.1: OFHEO’s Organizational Structure                               23
          Figure 3.1: Line and Nonline Full-Time Permanent Positions in              61
            OFHEO’s Office of Examination and Oversight




          Page 16                               GAO/GGD-98-6 Federal Housing Enterprises
Contents




Abbreviations

ANPR       Advanced Notice of Proposed Rulemaking
APA        Administrative Procedure Act
FHEO       Office of Fair Housing and Equal Opportunity (HUD)
FMS        Financial Management System (Department of Veterans
                Affairs)
HAAS       HUD Administrative Accounting System
HUD        Department of Housing and Urban Development
HUDCAPS    HUD Central Accounting and Program System
LTV        loan-to-value ratio
MBS        Mortgage-Backed Security
NPR        Notice of Proposed Rulemaking
OCC        Office of the Comptroller of the Currency
OEO        Office of Examination and Oversight (OFHEO)
OFA        Office of Finance and Administration (OFHEO)
OFHEO      Office of Federal Housing Enterprise Oversight
OGC        Office of General Counsel (OFHEO)
OMB        Office of Management and Budget
OPA        Office of Policy Analysis (OFHEO)
ORACS      Office of Research and Capital Standards (OFHEO)
PASA       Participating Agency Service Agreement
PEMS       Performance Evaluation Management System (OFHEO)
SEDESOL    Mexico’s Secretariat for Social Development
USAID      United States Agency for International Development
VA         Department of Veterans Affairs


Page 17                           GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1

Introduction


               Congress has a long-standing concern that the safety and soundness of the
               two largest government-sponsored enterprises,1 the Federal National
               Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
               Corporation (Freddie Mac), be maintained so that they can meet their
               intended purposes and that their financial activities do not pose risks to
               taxpayers. Consequently, Congress passed the Federal Housing
               Enterprises Financial Safety and Soundness Act of 1992 (the act),2 which
               established the Office of Federal Housing Enterprise Oversight (OFHEO)
               within the Department of Housing and Urban Development (HUD) as an
               independent financial safety and soundness regulator of Fannie Mae and
               Freddie Mac (the enterprises). For reasons relating to the federal charters
               and structures of the enterprises—which had combined financial
               obligations of $1.5 trillion at year-end 1996—investors and rating agencies
               perceive the enterprises’ securities as implicitly guaranteed by the federal
               government, despite there being no such statutory obligation. We have
               been mandated by the Department of Veterans Affairs (VA)/HUD
               Appropriations Act of 19973 to assess OFHEO’s fulfillment of its safety and
               soundness mission. Based on discussions with congressional staff, our
               major objectives were to (1) identify why OFHEO has not finalized
               risk-based capital standards for the enterprises even though there was a
               December 1, 1994, deadline for doing so and (2) assess OFHEO’s
               implementation of its enterprises’ safety and soundness examination
               responsibility. We are also providing information on OFHEO’s
               implementation of key mission support functions and participation in a
               U.S. government initiative to assist Mexico in developing a secondary
               mortgage loan market.


               The enterprises help ensure that mortgage funds are available to home
Background     buyers by buying mortgages from mortgage originators, such as
               commercial banks, thrifts, and mortgage bankers. In turn, the originators
               use the funds supplied by the enterprises to make additional mortgage
               loans thereby helping ensure a continuous supply of mortgage credit
               nationwide during both good and bad economic periods.




               1
                Government-sponsored enterprises are federally chartered, privately owned corporations designed to
               provide a continuing source of credit nationwide to specific economic sectors. In addition to Fannie
               Mae and Freddie Mac, the Federal Home Loan Banks also promote housing lending.
               2
                Housing and Community Development Act of 1992, Pub. L. No. 102-550, Title XIII, 12 U.S.C. 4501, et.
               seq.
               3
                Pub. L. No. 104-204 § 430, 110 Stat. 2874, 2930 (September 26, 1996).



               Page 18                                                GAO/GGD-98-6 Federal Housing Enterprises
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Introduction




The enterprises hold some of the mortgages they purchase in portfolio as
direct investments on their books and issue debt and equity securities to
finance these holdings. However, a majority of mortgages that the
enterprises buy from mortgage originators are “securitized”—that is, the
enterprises package them into mortgage pools to support
mortgage-backed securities (MBS). These mortgage pools receive interest
and principal payments from the mortgages in the pools and pass them on
to the investors who purchased MBS. The enterprises guarantee the timely
payment of principal and interest on MBS held by investors, administer the
payments, and charge “guarantee fees” for providing these services. The
enterprises may also repurchase MBS and hold the securities in their
mortgage portfolios.

The enterprises are government-sponsored in that they operate under
federal charters that convey certain benefits, impose certain restrictions,
and permit the enterprises to earn a profit while serving public policy
purposes, such as providing liquidity4 to mortgage markets. In 1992,
Congress expanded the enterprises’ public purpose by requiring annual
goals for the purchase of mortgages on housing serving very-low, low-, and
moderate-income and other households that are underserved by the
residential mortgage market.5 These goals are to be set, monitored, and
enforced by HUD. The charters restrict the enterprises to buying mortgages
that do not exceed a set dollar amount, known as the conforming loan
limit.6

A major factor that enhances the enterprises’ profitability is the financial
markets’ perception that there exists an implied federal guarantee of their
debt and MBS obligations. Investors perceive that this implied guarantee
decreases the risk of default on the enterprises’ financial obligations.
Consequently, this perception reduces the enterprises’ borrowing costs
because investors are willing to accept lower expected returns on
enterprise debt than they would for similar private firms without
government ties. Likewise, interest rates on MBS are lowered by this




4
 A market is more liquid if investors can buy and sell large amounts of holdings without affecting the
prices of the traded securities.
5
Federal Housing Enterprises Safety and Soundness Act of 1992, Pub. L. No. 102-550, §§ 1331-1334, 12
U.S.C. §§ 4561-4564.
6
The conforming loan limit depends on how many housing units are financed by a single residential
mortgage loan. Currently, the conforming loan limit on a single-unit residence is $214,600.



Page 19                                                GAO/GGD-98-6 Federal Housing Enterprises
                           Chapter 1
                           Introduction




                           perception.7 Their lower funding costs allow the enterprises to increase
                           their purchases and give them a cost advantage over their potential
                           competitors. This perception of a federal guarantee remains, even though
                           laws chartering the enterprises contain explicit language stating that there
                           is no such guarantee.

                           The market perception of the implied federal guarantee is based on,
                           among other things, federal ties to the enterprises, including
                           government-sponsored status, each enterprise’s $2.25 billion conditional
                           line of credit with the Department of the Treasury, and their exemptions
                           from state and local income taxes and securities registration fees imposed
                           by the Securities and Exchange Commission. In 1996, we estimated that
                           the financial benefits that accrue to the enterprises from their federal
                           sponsorship ranged from about $2.2 billion to $8.3 billion on a pretax basis
                           and from about $1.6 billion to $5.9 billion on an aftertax basis in 1995.8 We
                           also reported that approximately 80 percent to 95 percent of these
                           estimated benefits were derived from the lower funding costs that the
                           enterprises accrue as a result of the perception of a federal guarantee.


Enterprise Activities      It is widely accepted that the enterprises’ activities have generated
Benefit Homeowners but     benefits to mortgage borrowers, such as lower mortgage interest rates. For
Pose Potential Financial   example, in our 1996 report, we estimated that the activities of the
                           enterprises resulted in a savings on single-family fixed-rate home
Risks to Taxpayers         mortgages below the conforming loan limit of about 15 to 35 basis points.9
                           Thus, a borrower with a $100,000 thirty-year, fixed-rate mortgage saves
                           about $10 to $25 a month on mortgage payments as a result of the
                           enterprises’ activities.10 For the approximately $2 trillion in outstanding

                           7
                            Investors will accept lower expected returns on enterprise MBS, just as for enterprise debt, because
                           of the perception of an implied federal guarantee. This, in turn, lowers the cost of funding mortgages
                           through issuance of MBS.
                           8
                            See Housing Enterprises: Potential Impacts of Severing Government Sponsorship (GAO/GGD-96-120,
                           May 13, 1996). Some analysts contend that these benefits pass entirely through to mortgage borrowers
                           in the form of lower mortgage rates, while others contend that some of the value of the benefits could
                           be retained by the enterprises in the form of higher profits or higher expenditures, such as for
                           compensation. See FNMA and FHLMC: Benefits Derived From Federal Ties (GAO/GGD-96-98R,
                           Mar. 25, 1996).
                           9
                            A basis point equals 1/100 of a percentage point. See Housing Enterprises: Potential Impacts of
                           Severing Government Sponsorship (GAO/GGD-96-120, May 13, 1996).
                           10
                             These estimates are based on an analysis of the increases in mortgage rates that would likely occur if
                           the federal government fully severed its ties with the enterprises, and the perception of a federal
                           guarantee were removed. Assuming that federal ties remain, we estimated that the rate on
                           single-family fixed-rate housing mortgages below the conforming loan limit are lowered by 15 to 35
                           basis points. See Housing Enterprises: Potential Impacts of Severing Government Sponsorship
                           (GAO/GGD-96-120, May 13, 1996).



                           Page 20                                               GAO/GGD-98-6 Federal Housing Enterprises
                                       Chapter 1
                                       Introduction




                                       conventional conforming fixed-rate mortgages in 1995, we estimated that
                                       the aggregate annual savings in mortgage payments were in the range of
                                       $3 billion to $7 billion. Other benefits of the enterprises are that they have
                                       reduced regional disparities in interest rates and mortgage availability, and
                                       spurred the development of new technologies that facilitate the home
                                       financing process.

                                       However, the potential also exists that, in the event of a financial
                                       emergency, the federal government would choose to intervene and assist
                                       either Fannie Mae or Freddie Mac or both in meeting their debt and MBS
                                       obligations, which stood at a combined $1.5 trillion at year-end 1996 (see
                                       table 1.1),11 potentially exposing the taxpayers to losses. In fact, during the
                                       early 1980s when short-term interest rates rose dramatically, Fannie Mae
                                       experienced substantial financial difficulties because the enterprise had
                                       funded its mortgage portfolio with short-term debt. As rates increased,
                                       Fannie Mae had to issue new short-term debt at higher rates to replace
                                       existing short-term debt that came due. Because interest earned on the old
                                       mortgages in portfolio was less than interest expenses on new debt,
                                       Fannie Mae experienced total losses of about $277 million between 1981
                                       and 1984. (The type of risk Fannie Mae faced in the early 1980s is referred
                                       to as interest rate risk.) In response, the federal government provided
                                       limited tax relief and regulatory forbearance in the form of relaxed capital
                                       requirements. Similarly, in 1987, Congress authorized $4 billion to support
                                       the Farm Credit System—another government-sponsored
                                       enterprise—when it experienced financial difficulties.

Table 1.1: Total Enterprise Debt and
Net MBS Outstanding as of              Dollars in billions
December 31, 1996                                                                         Debt                 Net MBS
                                       Enterprise                                  outstanding             outstandinga                  Total
                                       Fannie Mae                                           $331                     $548                 $879
                                       Freddie Mac                                            156                     473                  630
                                       Total                                                $487                   $1,021               $1,509
                                       a
                                        Excludes MBS that the enterprises have repurchased and hold in their portfolios.

                                       Sources: Fannie Mae and Freddie Mac.




                                       11
                                         Even in the event of a major financial disaster and the insolvency of both enterprises, it is unlikely
                                       that the government would lose $1.5 trillion in providing support to the enterprises. This is because the
                                       government, as the conservator of the enterprises, would foreclose on the residences securing the
                                       mortgages, and the government could liquidate these properties to help offset its initial expenditures.



                                       Page 21                                                GAO/GGD-98-6 Federal Housing Enterprises
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                        Introduction




                        Recognizing the potentially large financial costs that Fannie Mae and
Congress Established    Freddie Mac posed to taxpayers, in 1992, Congress passed the act, which
OFHEO to Help           established OFHEO as an independent regulator within HUD whose mission
Ensure the Safety and   is to help ensure the enterprises’ safety and soundness. One of OFHEO’s
                        most important means of helping to ensure the enterprises’ financial
Soundness of the        soundness is to establish capital requirements that are related to potential
Enterprises             risks that the enterprises face. Further, the act gave OFHEO broad authority
                        to examine the activities of the enterprises, such as the requirement that
                        OFHEO conduct annual on-site examinations of the enterprises to assess
                        their financial condition. During fiscal year 1997, OFHEO had a budget of
                        about $15.5 million and a total staff—full-time staff, temporary staff,
                        contract employees, and detailees from bank regulatory agencies—of 85
                        individuals as of March 31, 1997,12 to carry out its safety and soundness
                        responsibilities and to perform administrative support functions.

                        The act established OFHEO as an independent office within HUD with
                        respect to safety and soundness matters, and reserved for the Secretary of
                        HUD the responsibility to oversee the enterprises’ efforts to meet the
                        housing goals as well as general regulatory power over the enterprises.
                        However, the act also clarified that the duty to ensure that Fannie Mae and
                        Freddie Mac are adequately capitalized and operate in a safe and sound
                        manner belongs to OFHEO exclusively. OFHEO was intended to operate
                        separately from HUD as a safety and soundness regulator and to be staffed
                        with experts in financial analysis or financial institution oversight.

                        OFHEO  is under the management of a presidentially appointed and
                        Senate-confirmed director. The act provided the director with numerous
                        exclusive authorities (i.e., without the review and approval of the
                        Secretary of HUD), such as powers to examine the operations of the
                        enterprises, determine capital adequacy, and take enforcement actions.
                        The act also gave the director exclusive authority to manage OFHEO, which
                        includes preparing annual budgets and hiring personnel. Thus, the director
                        leads and directs OFHEO’s activities by setting internal and external
                        policies, managing overall operations, and serving as the chief
                        spokesperson for the organization. OFHEO’s first director was appointed on
                        June 1, 1993, and resigned on February 13, 1997, to become the
                        Administrator of the Small Business Administration. As of June 1997,
                        OFHEO was headed by the acting director, while the President and Congress
                        considered potential candidates for the organization’s new director.



                        12
                         OFHEO’s staffing levels tend to fluctuate throughout the year as full-time staff resign or are hired and
                        contractors and detailees either complete or begin their assignments.



                        Page 22                                                GAO/GGD-98-6 Federal Housing Enterprises
                                            Chapter 1
                                            Introduction




                                            OFHEO is organized into six offices, which report to the director and deputy
                                            director. Figure 1.1 illustrates OFHEO’s organizational structure.



Figure 1.1: OFHEO’s Organizational Structure


                                                           Director




                                                        Deputy Director




                                                                         Office of Congressional
                                Office of General                           and Public Affairs
                                     Counsel
                                                                       Director for    Director for
                                                                      Congressional      Public
                                General Counsel
                                                                         Affairs         Affairs




    Office of Finance           Office of Examination                     Office of Policy                   Office of Research,
           and                            and                                 Analysis                           Analysis and
     Administration                   Oversight                                                              Capital Standards
       Director                      Director                            Chief Economist                         Director




                                        •   The Office of the General Counsel (OGC) has responsibility for preparing
                                            regulations required by the act and advising the director on legal issues,
                                            including financial institutions regulatory issues, applicable corporate law
                                            principles, and general legal matters.
                                        •   The Office of Congressional and Public Affairs is responsible for handling
                                            public and press inquiries, briefing Members of Congress and staff on
                                            matters relating to OFHEO, monitoring legislative development, and
                                            bringing congressional concerns to the attention of the director.




                                            Page 23                                                   GAO/GGD-98-6 Federal Housing Enterprises
    Chapter 1
    Introduction




•   The Office of Finance and Administration (OFA) is responsible for ensuring
    that OFHEO has the infrastructure to function independently. This office is
    to provide human resources management, budget formulation and
    execution, financial and strategic planning, contracting and purchasing,
    office automation, travel, records and document security, and related
    administrative support services. OFA is also responsible for developing
    annual budgets and serving as the liaison with the Office of Management
    and Budget (OMB).
•   The Office of Examination and Oversight (OEO) is responsible for
    designing and conducting annual on-site examinations of Fannie Mae and
    Freddie Mac, as required by law, and performing additional examinations
    as determined by the director.
•   The Office of Policy Analysis (OPA) is responsible for providing and
    coordinating economic and policy advice to the director on all issues
    related to regulation and supervision of the enterprises. This office is also
    to direct and conduct research and assess the impact of issues and trends
    in the housing and mortgage markets on OFHEO’s regulatory
    responsibilities.
•   The Office of Research, Analysis and Capital Standards (ORACS) is
    responsible for developing and implementing a financial “stress test,”
    which uses interest rate and credit risk scenarios prescribed in the act to
    determine the enterprises’ risk-based capital requirements. The office is
    also responsible for conducting research and financial analysis on issues
    related to the enterprises’ activities, such as simulating Treasury yields
    and associated interest rate movements.

    Compared to other federal financial regulators, such as the Federal
    Reserve System and the Office of the Comptroller of the Currency (OCC),
    which have thousands of employees, OFHEO is a small organization. Table
    1.2 shows the distribution of OFHEO’s authorized and onboard permanent
    employees as of March 31, 1997, among the six offices discussed above. As
    table 1.2 indicates, OFHEO had an authorized staffing level of 72 full-time
    permanent positions but had only 58 full-time permanent staff on board as
    of March 31, 1997. OFHEO supplements its permanent full-time staff with
    full-time and part-time temporary employees, contractors, and detailees
    from other financial regulatory agencies that perform key functions on a
    reimbursable basis. For example, OFHEO has used contract staff and bank
    regulatory detailees to assist in developing capital standards and in
    performing on-site safety and soundness examinations. As of March 31,
    1997, OFHEO had 6 full-time temporary staff, 1 part-time temporary staff, 19
    contractor staff, and 1 bank regulatory detailee on board. Thus, OFHEO had




    Page 24                                 GAO/GGD-98-6 Federal Housing Enterprises
                                            Chapter 1
                                            Introduction




                                            a total onboard staff of 85 individuals (58 full-time permanent, 7
                                            temporary, 19 contract, and 1 detailee).


Table 1.2: OFHEO’s Full-Time, Temporary, Contractor, and Bank Regulator Detailee Staff as of March 31, 1997
                                                           Full-time
                                                         permanent         Full-time         Full-time
Unit                                                      positions permanent staff temporary staff       Contract                Detail
Director                                                                 7                 5
Research, Analysis, and Capital Standards                              17                  14                 4a          14
Examination and Oversight                                              17                  12                              3          1
General Counsel                                                          9                 8                  1
Finance and Administration                                             11                  11                 1            2
Policy Analysis                                                          6                 4                  1
Congressional and Public Affairs                                         5                 4
Total                                                                  72                  58                 7           19          1
                                            a
                                            One of the four staff members was part-time.

                                            Source: OFHEO.



                                            Table 1.3 shows actual, estimated, and requested OFHEO obligations for
                                            fiscal years 1996 through 1998. Most OFHEO expenses cover personnel and
                                            contractor services. For fiscal year 1997, OFHEO estimated in its fiscal year
                                            1998 budget request to Congress that it will spend about $9.1 million
                                            (about 59 percent of its $15.5 million total) on personnel services (i.e.,
                                            expenses related to personnel compensation and benefits, but exclusive of
                                            contractors). According to OFHEO, it sets its salaries and benefits, as
                                            required by the act, by maintaining comparability with federal banking
                                            regulatory agencies. The second largest category of expenses (“other
                                            services”) generally covers OFHEO’s contractor services. In fiscal year 1997,
                                            OFHEO expects to spend nearly $3.8 million (about 25 percent of total
                                            obligations) on specialized technical services associated with developing
                                            and maintaining its research capability and computer models, examination
                                            services, and specialized legal services. All other expenses constitute a
                                            smaller percentage of OFHEO’s total obligations. These expenses cover such
                                            fundamental items as computer acquisition, travel, and rent, some of
                                            which fluctuate with changing numbers of staff and contractors on
                                            location.




                                            Page 25                                             GAO/GGD-98-6 Federal Housing Enterprises
                                         Chapter 1
                                         Introduction




Table 1.3: OFHEO’s Obligations, Fiscal
Years 1996 Through 1998                  Dollars in thousands
                                                                                 Actual           Estimated            Requested         1997-1998
                                         Obligation category                      1996                 1997                 1998           change
                                         Personnel services                      $7,234                $9,119                $9,572             $453
                                         Other services                            4,800                 3,793                3,664             –129
                                         All other                                 2,758                 2,588                3,076              488
                                         Total                                  $14,792               $15,500              $16,312             $ 812
                                         Source: OFHEO’s fiscal year 1998 budget request to Congress.



                                         Although OFHEO’s financial plans and forecasts are to be included in the
                                         budget of the United States and are subject to the appropriations process,13
                                         the organization is not funded with tax dollars. Rather, the act requires the
                                         enterprises to pay annual assessments to cover OFHEO’s costs. Each
                                         enterprise is required to pay an amount in proportion to the ratio of its
                                         individual assets to the total combined assets of both enterprises. The
                                         assessment is to be paid semiannually into a Department of Treasury fund,
                                         known as the Federal Housing Enterprises Oversight Fund.


OFHEO Carries Out Its                    Under the act, OFHEO is to establish two sets of capital standards to help
Oversight Mission by                     ensure the safety and soundness of the enterprises and minimize taxpayer
Developing Capital                       risks. The first standard, which is called the “minimum capital” standard,
                                         requires a minimum amount of capital that an enterprise must hold.
Standards and Conducting                 Minimum capital is computed on the basis of capital ratios specified in the
Examinations                             act that are applied to certain on-balance-sheet and off-balance-sheet
                                         obligations of the enterprises. The ratios are (1) 2.50 percent of aggregate
                                         on-balance-sheet assets; (2) 0.45 percent of the unpaid principal balance of
                                         outstanding MBS and substantially equivalent instruments; and
                                         (3) 0.45 percent of other off-balance-sheet obligations (with some
                                         exclusions), except as the OFHEO Director adjusts the ratio to reflect
                                         differences between the credit risk of such obligations and MBS. OFHEO has
                                         classified Fannie Mae and Freddie Mac as “adequately capitalized” under
                                         the minimum standard in each quarter beginning in the quarter that ended
                                         on June 30, 1993.14



                                         13
                                           OFHEO’s budget authority is included in the annual VA/HUD Appropriations Act.
                                         14
                                           OFHEO issued the final rule implementing the minimum capital standard on July 8, 1996, and the
                                         final rule was first used to classify the enterprises as adequately capitalized in the third quarter of 1996.
                                         Prior to the issuance of the final rule, OFHEO classified the enterprises as adequately capitalized
                                         under interim standards.



                                         Page 26                                                  GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1
Introduction




The act also requires OFHEO to establish a stress test to serve as the basis
for the development of risk-based capital standards. The stress test is
intended to lower taxpayer risks by simulating in a computer model
situations where the enterprises are exposed to adverse credit and interest
rate shocks, and requiring the enterprises to hold sufficient capital to
withstand these shocks. The capital amount must be adequate to last
during a 10-year period (the stress period), within specific parameters
relating to credit risk,15 interest rate risk,16 new business, and other
activities. The act defines an enterprise’s required risk-based capital level
as equal to the amount calculated by applying the stress test, along with an
additional 30 percent of that amount to allow for management and
operations risk.17 Further, the act required the director to issue final
regulations establishing the stress test within 18 months of the Director’s
appointment (i.e., by December 1, 1994). However, as we discussed in our
May 1995 report on OFHEO’s operations,18 OFHEO did not meet this deadline.
As of April 1997, OFHEO’s acting director said that OFHEO expects to issue a
proposed rule implementing the stress test and risk-based capital
standards by September 1998, with a final rule to be issued in 1999. We
discuss OFHEO’s development of the stress test and risk-based capital
standards in chapter 2 of this report.

In the absence of risk-based capital standards, OFHEO’s primary means of
monitoring the safety and soundness of the enterprises is its examination
program. The act gave OFHEO broad authority to examine the enterprises
and requires annual on-site examinations. At such examinations, OFHEO
full-time staff, with the assistance of temporary contractors and detailees
from bank regulatory agencies, are to assess the financial condition of the
enterprises and recommend improvements as necessary. OFHEO also has
the authority to take enforcement actions against the enterprises, such as
cease and desist orders, to stop unsafe and unsound practices. Further,
OFHEO has the authority to place an enterprise into a conservatorship when
certain circumstances exist and the enterprise is unable to meet its



15
  In general, credit risk is the risk of loss arising from borrowers failing to repay their loans and/or
other parties failing to meet their obligations to administer or guarantee loans. Credit risk is inherent
in the daily operations of all financial firms, including the enterprises.
16
 In general, interest rate risk is the exposure to possible losses and changes in value arising from
changes in interest rates.
17
 In general, management risk and operations risk are the exposure to financial loss from inadequate
systems, management failure, faulty controls, or human error.
18
 Government Sponsored Enterprises: Development of the Federal Housing Enterprise Financial
Regulator (GAO/GGD-95-123, May 30, 1995).



Page 27                                                 GAO/GGD-98-6 Federal Housing Enterprises
                              Chapter 1
                              Introduction




                              financial obligations or is critically undercapitalized. We discuss OFHEO’s
                              examination program and the adequacy of its resources in chapter 3.


                              Since the mid-1980s, Fannie Mae and Freddie Mac have been consistently
Overview of the               profitable. In 1997, the enterprises received relatively high ratings for
Enterprises’ Financial        financial performance and management from the Standard & Poor’s credit
Performance and               rating company. Nevertheless, the enterprises have adopted business
                              strategies in recent years that OFHEO officials believe could potentially
Business Strategies           weaken their future financial performance. For example, since OFHEO’s
                              creation in 1992, the enterprises have substantially increased their
                              holdings of mortgage assets in lieu of issuing MBS to investors. According
                              to OFHEO’s former director, increased holdings of mortgage assets
                              potentially expose the enterprises to greater interest rate risks. OFHEO has
                              also reported that there is some evidence that the enterprises have taken
                              on increased credit risk since 1992. The enterprises have also developed
                              sophisticated strategies since the early 1980s that were intended to better
                              manage the interest and credit risks that they face.


Enterprises Have              Tables 1.4 and 1.5 show selected year-end profitability data for Fannie Mae
Consistently Done Well        and Freddie Mac for the years 1990 through 1996. As the tables indicate,
Financially in Recent Years   during those years, the enterprises consistently earned profits for their
                              stockholders; this occurred despite significant downturns in regional
                              mortgage markets, such as those in New England and California during the
                              early 1990s. In 1996, Fannie Mae had a net income of $2.7 billion, while
                              Freddie Mac had a net income of about $1.2 billion. The financial data also
                              indicate that since 1990 the enterprises have consistently achieved a return
                              on average common equity, a common measure of profitability, exceeding
                              20 percent. By contrast, the return on average common equity for the
                              commercial banking industry between 1990 and 1996 was about
                              12.5 percent.




                              Page 28                                 GAO/GGD-98-6 Federal Housing Enterprises
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                                   Introduction




Table 1.4: Fannie Mae Year-End
Profitability Data, 1990 to 1996   Dollars in billions
                                                                                                                    Return on average
                                   Year                                                          Net income           common equity
                                   1990                                                                  $1.17                        33.7%
                                   1991                                                                   1.36                        27.7
                                   1992                                                                   1.62                        26.5
                                   1993                                                                   1.87                        25.3
                                   1994                                                                   2.13                        24.3
                                   1995                                                                   2.14                        20.9
                                   1996                                                                   2.73                        24.1
                                   Sources: Fannie Mae and OFHEO.



Table 1.5: Freddie Mac Year-End
Profitability Data, 1990 to 1996   Dollars in billions
                                                                                                                    Return on average
                                   Year                                                          Net income           common equity
                                   1990                                                                  $ .41                        20.5%
                                   1991                                                                    .56                        23.6
                                   1992                                                                    .62                        21.2
                                   1993                                                                    .79                        22.2
                                   1994                                                                    .98                        23.2
                                   1995                                                                   1.09                        21.9
                                   1996                                                                   1.24                        22.1
                                   Sources: Freddie Mac and OFHEO.



                                   On February 3, 1997, the Standard & Poor’s rating firm gave both Fannie
                                   Mae and Freddie Mac a relatively high “point-in-time”19
                                   risk-to-the-government credit rating of “AA-.”20 OFHEO commissioned
                                   Standard & Poor’s to evaluate the enterprises’ financial condition and
                                   issue the ratings pursuant to its authority under the act. In the Standard &
                                   Poor’s report accompanying the rating, the firm generally cited the
                                   enterprises for their consistent profitability, demonstrated ability to

                                   19
                                     Under a “point-in-time” credit rating, Standard & Poor’s rates the financial condition of a company on
                                   a single day; in the case of the enterprises, the ratings were for February 3, 1997. Standard & Poor’s
                                   issued a point-in-time credit rating because OFHEO did not ask the firm to rate the enterprises on an
                                   ongoing basis.
                                   20
                                     Standard & Poor’s uses long-term issuer credit ratings ranging from “AAA” for the highest credit
                                   rating to “CC” for highly speculative. According to OFHEO, the risk-to-the-government rating evaluates
                                   the risk that Fannie Mae or Freddie Mac will become financially troubled and require government
                                   assistance. According to Standard & Poor’s, the AA- rating is probably higher than the ratings that the
                                   enterprises would receive in the absence of government sponsorship.



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                            Chapter 1
                            Introduction




                            withstand regional downturns in mortgage markets during the early 1990s,
                            historically conservative credit and interest rate risk strategies, and the
                            quality of their management. In addition, Standard & Poor’s stated that the
                            enterprises’ domination of the secondary conforming mortgage market
                            and the benefits of their ties to the federal government, such as relatively
                            low borrowing costs, also justified the “AA-” rating. However, Standard &
                            Poor’s did find that both enterprises could face capital adequacy shortages
                            if a severe, nationwide downturn occurred in the mortgage markets or
                            interest rates rose precipitously.


Enterprise Growth Has       Although Fannie Mae and Freddie Mac have been consistently profitable,
Been Rapid, Which Has       the enterprises have adopted strategies that could potentially increase
Implications for Interest   their interest rate and credit risks. Since 1992, when Congress passed the
                            act that established OFHEO, the enterprises’ combined assets have more
and Credit Risks            than doubled in size, although Freddie Mac’s growth has been relatively
                            faster (see table 1.6 ). During 1996, Fannie Mae’s total assets21 grew at
                            about an 11 percent annual rate, and Freddie Mac’s assets grew at about a
                            27 percent annual rate. In 1995, Fannie Mae’s total assets grew at about a
                            16 percent annual rate, and Freddie Mac’s assets grew at about a
                            29 percent annual rate. Table 1.7 indicates that the enterprises’ retained
                            mortgage portfolios, which include whole mortgages and MBS that the
                            enterprises have repurchased, have been growing as a percentage of their
                            total mortgage portfolios (retained mortgages plus outstanding MBS held by
                            investors), although this growth has also been relatively faster at Freddie
                            Mac. For example, Freddie Mac’s retained mortgage assets as a percentage
                            of its total mortgage portfolio increased from about 8 percent at year-end
                            1992 to about 23 percent at year-end 1996. Fannie Mae’s retained mortgage
                            assets increased from about 27 percent of its total mortgage portfolio at
                            year-end 1992 to about 34 percent at year-end 1996. In previous reports on
                            bank and thrift failures, we found that rapid asset growth in the double
                            digit range, unless carefully managed, can result in a deterioration in
                            management controls and ultimately poor financial performance.22




                            21
                              The enterprises’ total assets generally consist of retained mortgages, investments, cash and cash
                            equivalents, accrued interest receivable, receivables from currency swaps, acquired property and
                            foreclosure claims, and other assets. MBS guarantees are off-balance-sheet items and therefore not
                            part of total assets.
                            22
                              See, for example, Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26, Mar. 4, 1991).



                            Page 30                                               GAO/GGD-98-6 Federal Housing Enterprises
                                        Chapter 1
                                        Introduction




Table 1.6: Fannie Mae and Freddie Mac
Total Asset Growth Rates, 1992 to       Dollars in billions
1996                                    Growth rate                             1992         1993         1994             1995    1996
                                        Fannie Mae
                                        Total assets                            $181         $217         $273             $317    $351
                                        Annual growth                            N/A            20%          26%             16%     11%
                                        Freddie Mac
                                        Total assets                             $60           $84        $106             $137    $174
                                        Annual growth                            N/A            40%          26%             29%     27%
                                        Fannie Mae and Freddie
                                        Mac
                                        Total assets                            $241         $301         $379             $454    $525
                                        Annual growth                            N/A            25%          26%             20%     16%
                                        N/A = Not applicable.

                                        Sources: Fannie Mae, Freddie Mac, and OFHEO.



Table 1.7: Growth of Enterprises’
Retained Mortgage Assets as             Dollars in billions
Percentage of Mortgages in Total                                                1992         1993         1994             1995    1996
Portfolio, 1992 to 1996
                                        Fannie Mae
                                        Retained mortgage assets                $156         $190         $221             $253    $287
                                                  a
                                        Net MBS                                 $424         $471         $486             $513    $548
                                        Retained as percentage of
                                        total portfolio                            27%          29%          31%             33%     34%
                                        Freddie Mac
                                        Retained mortgage assets                 $34           $56          $73            $108    $138
                                        Net MBSa                                $408         $439         $461             $459    $473
                                        Retained as percentage of
                                        total portfolio                             8%          11%          14%             19%     23%
                                        a
                                        Excludes MBS that the enterprises have repurchased and hold in their portfolios.

                                        Sources: Fannie Mae, Freddie Mac, and OFHEO.



                                        According to OFHEO’s 1996 annual report, the enterprises’ increasing
                                        reliance on retained mortgage assets, which are financed by debt and
                                        equity, potentially exposes them to greater interest rate risk. The
                                        enterprises have incentives to finance mortgages (or repurchase
                                        previously issued MBS) with debt because the difference between mortgage
                                        yields and borrowing costs generally exceeds MBS guarantee fees.
                                        However, the increased proportion of retained mortgage assets could



                                        Page 31                                            GAO/GGD-98-6 Federal Housing Enterprises
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Introduction




expose Fannie Mae and Freddie Mac to greater interest rate risks because
they assume the risks for changes in the market value of the retained
mortgage assets due to fluctuations in interest rates. By contrast, when the
enterprises issue MBS to investors, the investors who purchase the
securities assume responsibility for losses due to interest rate fluctuations.
In testimony before the House Subcommittee on Capital Markets,
Securities, and Government-Sponsored Enterprises on April 17, 1996,
OFHEO’s former director expressed concern that the combined retained
mortgage assets of the enterprises exceeded $360 billion at year-end 1995,
which, at that time, was more than twice the combined portfolio that the
enterprises had when OFHEO was created in 1992. Nevertheless, at year-end
1996, the enterprises’ combined retained mortgage assets had grown
another $63 billion to $424 billion, or about 17 percent, since year-end
1995.

OFHEO’s 1996 annual report also suggested that the enterprises may be
facing somewhat increased credit risks in the future. The report attributed
the potentially increasing credit risks to the fact that fewer homeowners
chose to refinance their existing mortgages in 1994 and 1995 because
mortgage interest rates were higher than they had been in 1992 and 1993.
According to the annual report, refinanced mortgages tend to be less risky
than mortgages that have not been refinanced because they have lower
loan-to-value (LTV) ratios,23 and those who choose to refinance generally
have equity in their homes. The enterprises have also embarked on
business strategies that have resulted in a larger share of mortgage
purchases with higher LTV ratios. Between year-end 1992 and year-end
1995, the percentage of Fannie Mae mortgage purchases with LTV ratios
exceeding 90 percent rose from 6 percent of all purchases to 19 percent of
all purchases. Freddie Mac’s percentage of mortgage purchases with LTV
ratios exceeding 90 percent increased from 3 percent of all purchases to 14
percent of all purchases. At Fannie Mae, credit losses, provision for loss
expenses plus foreclosed property expenses, increased from $335 million
in 1995 to $409 million in 1996 (about a 22-percent increase) while Freddie
Mac’s credit losses increased from $541 million in 1995 to $608 million in
1996 (a 12-percent increase).




23
  In general, loans with lower LTV ratios represent smaller borrower risks to mortgage loan originators
and the enterprises than loans with higher LTV ratios. The LTV ratio is determined by dividing the
balance of the mortgage loan outstanding by the estimated value of the residential property. Thus, the
LTV ratio on an outstanding mortgage balance of $60,000 on a single-family residence with an
estimated value of $100,000 would be 60 percent. The enterprises generally require private mortgage
insurance or other credit enhancements on mortgage loans with LTV ratios exceeding 80 percent.



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Enterprises Have            The enterprises have developed strategies to lower the interest rate risks
Implemented Strategies to   that they face from increased mortgage asset holdings. For example, both
Mitigate Risks              enterprises issue callable bonds that can be paid off early if interest rates
                            fall. By calling the bonds and issuing new debt as interest rates fall, the
                            enterprises curtail interest expenses. Conversely, if rates increase, the
                            enterprises continue to pay below-market rates on their existing bonds.
                            The enterprises have also developed other methods, including using
                            certain derivative products, to control the volatility of their interest
                            expenses as the economy varies.24

                            The enterprises also use strategies to minimize potential credit risks. For
                            example, for mortgage purchases with LTV ratios exceeding 80 percent, the
                            enterprises usually require mortgage insurance from highly rated
                            providers or other kinds of credit protection. The enterprises also have
                            nationwide, geographically diversified mortgage portfolios that afford
                            protection against regional downturns in housing markets, as has been
                            demonstrated in the past. In addition, according to OFHEO’s 1996 annual
                            report, the enterprises have further protected themselves against credit
                            risk by shifting an increasing percentage of the primary risk of default to
                            mortgage originators, such as commercial banks. Lenders bear primary
                            default risk if they pledge collateral or agree to repurchase mortgages that
                            default. The OFHEO report states that the percentage of Freddie Mac
                            purchased mortgage loans where the lender bears primary default risks
                            rose from 12 percent of purchases in 1994 to 22 percent in 1995.


                            The VA/HUD Appropriations Act of 1997 required us to do a comprehensive
Objectives, Scope,          audit of OFHEO’s overall operations concerning staff organization,
and Methodology             expertise, capacity, and contracting authority to ensure that OFHEO’s
                            resources are adequate and being used appropriately to ensure that the
                            enterprises are adequately capitalized and being safely operated. Based on
                            discussions with congressional staff, we established the following three
                            objectives to assess OFHEO’s overall operations and its capacity to fulfill its
                            safety and soundness mission: (1) identify the reasons that OFHEO did not
                            complete the stress test and risk-based capital standards by December 1,
                            1994, (2) assess OFHEO’s implementation of its examination
                            responsibilities, and (3) review the status of OFHEO’s implementation of key
                            mission support functions and determine whether OFHEO’s participation in
                            a U.S. government initiative to assist Mexico in developing a secondary


                            24
                              Derivatives are financial products whose value is determined by an underlying reference rate, index,
                            or asset. The underlying include stocks, bonds, commodities, interest rates, foreign currency exchange
                            rates, and indexes that reflect the collective value of various financial products.



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Introduction




mortgage market has had a material impact on OFHEO’s ability to fulfill its
mission.25

To identify the reasons for OFHEO’s delays in developing the stress test and
risk-based capital standards, we interviewed senior officials in OFHEO’s
Office of Research and Capital Standards (ORACS), as well as former HUD
officials who worked on enterprise safety and soundness issues prior to
OFHEO’s establishment in 1992. We also reviewed key OFHEO documents,
such as internal memorandums, written explanations of the development
of the stress test that OFHEO provided at our request, and staff vacancy and
attrition data in ORACS. We also met with senior Fannie Mae and Freddie
Mac officials to obtain their views on OFHEO’s development of the stress
test and capital standards. The scope of our work did not involve assessing
the adequacy or the appropriateness of OFHEO’s approach to developing the
stress test. Since OFHEO has not yet completed the development of
risk-based capital standards, we could not evaluate the usefulness of
specific steps OFHEO has taken to reach a final rule promulgating a
risk-based capital standard.

With respect to assessing OFHEO’s implementation of its safety and
soundness responsibilities, we interviewed senior examination officials
and their counterparts at the enterprises. We also reviewed the following
documents: (1) OFHEO’s September 1994 examination schedule and plan,
(2) OFHEO’s draft examination handbook, (3) statistics on the number of
staff assigned to each exam as well at the time needed to complete each
exam, and (4) attrition and vacancy data for OFHEO examiners. We
assessed OFHEO’s compliance with the 1994 plan and compared OFHEO’s
plan with plans that the Office of the Comptroller of the Currency (OCC)
and the Federal Reserve System have established for examining large
commercial banks. The scope of our work did not involve making an
independent assessment of the accuracy of OFHEO’s examination findings,
conclusions, and/or recommendations.

We reviewed the status of OFHEO’s implementation of key mission support
functions by interviewing officials in the Office of Finance and
Administration. We also reviewed relevant documentation such as
administrative policies and procedures, contracts, and cost data.




25
  In floor debate regarding the VA/HUD Appropriations Act of 1997, two Senators expressed concern
that foreign travel by OFHEO officials had diverted the organization from completing the risk-based
capital standards within established deadlines. OFHEO’s participation in the Mexico initiative during
1995 and 1996 represented its largest foreign travel expense.



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We assessed the impact of OFHEO’s participation in the Mexico initiative by
reviewing cost and travel data and identifying staff members who made
foreign trips. We also asked senior OFHEO officials to estimate the amount
of time that they have devoted to developing presentations for the
initiative and going on foreign travel. We did not independently verify the
cost and travel data or OFHEO officials’ estimates of the time that they
devoted to the Mexico initiative.

We did our work between December 1996 and April 1997 in accordance
with generally accepted government auditing standards.

We provided copies of a draft of this report to OFHEO for review and
comment. The Acting Director provided written comments on the draft
report’s analysis and recommendations, which are summarized in chapters
2 and 3 and reprinted in appendix IV. OFHEO also provided technical
comments on the draft report, which have been incorporated where
appropriate.




Page 35                                GAO/GGD-98-6 Federal Housing Enterprises
Chapter 2

OFHEO’s Development of a Stress Test and
Risk-Based Capital Standards Has Been
Protracted
              The act required OFHEO to develop a stress test and risk-based capital
              standards as essential components of the organization’s mission to help
              ensure the safety and soundness of Fannie Mae and Freddie Mac.
              Although OFHEO faced a deadline of December 1, 1994, to issue a final rule
              implementing the stress test and capital standards, OFHEO officials estimate
              that the final rule will not be issued until 1999.

              Our review found that the delay in the ongoing development process had
              been caused primarily by (1) the complex challenges of developing the
              stress test as required by the act and (2) OFHEO officials’ decision in 1994
              that the organization develop its own sophisticated stress test rather than
              adopting and modifying stress tests that were already under development.
              OFHEO concluded that it could develop capital standards that would be
              more closely related to enterprise risks by developing its own
              sophisticated stress test and associated financial modeling capability.
              However, we note that it has also involved a substantial development
              period and resource costs. Related factors that have contributed to the
              delay in OFHEO’s ongoing development of the stress test have included the
              time necessary to hire expert staff, obtain accurate financial data, and
              initiate the federal rulemaking process. These tasks have taken more time
              than OFHEO initially anticipated in 1994.

              To meet its anticipated issuance of the final rule by 1999, OFHEO faces
              other important challenges. In particular, senior OFHEO officials must
              coordinate the issuance of the stress test with executive branch agencies,
              such as OMB, HUD, and the Department of the Treasury, and make key
              policy decisions about various components of the stress test. In addition,
              OFHEO’s attorneys and others must continue to translate the economic and
              financial modeling components of the proposed stress test and capital
              standards into proposed and final rules that comply with applicable
              federal statutes. Given the importance of the risk-based capital standards,
              we believe it is essential that OFHEO complete the tasks remaining to
              develop those standards as expeditiously as possible.




              Page 36                                 GAO/GGD-98-6 Federal Housing Enterprises
                                      Chapter 2
                                      OFHEO’s Development of a Stress Test and
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                                      Protracted




                                      OFHEO’s  development of a stress test and risk-based capital standards is an
OFHEO Has                             essential component for helping to ensure the safety and soundness of
Consistently                          Fannie Mae and Freddie Mac. Essentially, the purpose of the stress test
Underestimated the                    that OFHEO is required to develop under the act is to lower potential
                                      taxpayer risks by requiring the enterprises to hold sufficient capital to
Time Necessary to                     withstand a severe interest rate shock coupled with adverse credit
Complete Stress Test                  conditions over a 10-year period, plus an additional 30 percent to protect
                                      against management and operations risk. Under the act, OFHEO was to have
Development                           completed the final rule implementing the stress test and risk-based
                                      capital standards by December 1, 1994, but, as discussed earlier and
                                      shown in table 2.1, OFHEO did not comply with this mandate.

Table 2:1: OFHEO’s Planned
Completion Dates for Developing the                             Estimated completion of major components of the stress
Stress Test and Issuing the Final     OFHEO plan                test and capital standards
Risk-Based Capital Standards          May 1994                  Complete stress test by December 1995 and publish final rule
                                                                by March 1996.
                                      July 1995 plan            Complete stress test by January 1996 and publish final rule by
                                                                May 1997.
                                      September 1996 plan       Complete stress test by March 1997. OFHEO 1996 annual
                                                                report stated that the completed stress test would be put
                                                                forward for public comment in 1997.
                                      April 1997 plan           Propose completed stress test by September 1998 and issue
                                                                final rule in 1999.
                                      Sources: OFHEO’s acting director and OFHEO’s 1996 annual report.



                                      In OFHEO’s planning process and its published documents, the organization
                                      has consistently underestimated the time necessary to complete major
                                      components of the stress test and resulting risk-based capital standards.
                                      For example, in its May 1994 plan for the development of the stress test,
                                      OFHEO estimated that the final rule would be issued in March 1996.
                                      Moreover, OFHEO’s revised July 1995 and September 1996 plans also
                                      underestimated the time necessary to complete the stress test and
                                      risk-based capital standards. In OFHEO’s 1996 annual report, the former
                                      director stated that in 1997 the organization would have developed, tested,
                                      and put forward for public comment an operational stress test. However,
                                      in April 1997, OFHEO’s acting director said that the organization does not
                                      expect to submit an operational stress test for public comment until 1998,
                                      with the final rule expected to be issued in 1999.

                                      The remainder of this chapter provides a general discussion of the reasons
                                      why OFHEO did not comply with the statutory deadline and points out




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                            OFHEO’s Development of a Stress Test and
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                            Protracted




                            several continuing challenges that the organization faces in complying
                            with its current estimate for issuing a final rule.


                            The complex requirements of the stress test as specified in the act have
The Complexity of the       contributed to the time being taken by OFHEO to complete the process.
Development Process         OFHEO is legislatively required to develop a stress test to establish

Has Contributed to          risk-based capital standards. In addition, the act establishes the broad
                            outlines of the stress test, but requires OFHEO to complete several
Delays                      important projects before the final rule can be issued.


OFHEO’s Mandate to          OFHEO’s  development of a stress test and risk-based capital standards for
Develop Capital Standards   the enterprises presented highly complex challenges. According to OFHEO,
Presented Complex           the stress test should be flexible and allow OFHEO to adjust the enterprises’
                            capital requirements on a periodic basis as the financial risks that they
Challenges                  face change. For example, under the completed stress test, an enterprise
                            would be required to hold additional capital if OFHEO determined that the
                            enterprise had made changes in its asset and liability structure that would
                            result in greater losses under alternative credit and interest rate shock
                            scenarios. Similarly, OFHEO, via the stress test, could require Fannie Mae or
                            Freddie Mac to hold additional capital against new activities that may
                            represent greater risks than their more traditional activities.

                            By contrast, the risk-based capital standards that have been developed by
                            OCC, the Federal Reserve System, and the Federal Deposit Insurance
                            Corporation for federally regulated banks categorize assets into broad
                            groups, which may not account for changes in the institutions’ business
                            practices that could affect their risk profiles. For example, banks are
                            permitted to hold the same level of capital for loans made to corporations
                            with high credit ratings as they are required to hold for corporations with
                            speculative credit ratings. In addition, federal bank regulators have not
                            established and implemented uniform risk-based capital standards to
                            address interest rate risks.26 Instead, regulators assess the interest rate
                            risks facing banks during scheduled examinations and make case-by-case
                            decisions as to whether the banks hold adequate capital to protect against
                            these risks.



                            26
                              Section 305 of the Federal Deposit Insurance Corporation Improvement Act of 1991 required bank
                            and thrift regulators to revise risk-based capital standards in order to take adequate account of interest
                            rate risk and other risk factors, such as concentrations of credit and nontraditional products risks. 12
                            U.S.C. 1828 note.



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                           Chapter 2
                           OFHEO’s Development of a Stress Test and
                           Risk-Based Capital Standards Has Been
                           Protracted




OFHEO Must Complete        The act establishes the broad outlines of a stress test involving the impact
Several Complex Tasks to   of adverse credit and interest scenarios on the enterprises’ financial
Develop the Stress Test    condition. According to OFHEO’s 1995 and 1996 annual reports, OFHEO must
                           further specify the adverse credit and interest rate scenarios for the stress
and Risk-Based Capital     test by carrying out the following complex tasks:
Standards
                           Develop a credit stress benchmark: Under conditions specified in the act,27
                           OFHEO is required to identify the region and time period associated with the
                           highest mortgage default and loss severity rates in the United States, and
                           then simulate the effect of these stressful conditions on the enterprises’
                           nationwide total mortgage portfolios.

                           Identify an appropriate house price index: Changes in home prices, and
                           the corresponding changes in loan-to-value ratios (LTV), affect mortgage
                           defaults and loss severity. The act requires that OFHEO reflect these factors
                           by establishing the current LTV ratios of enterprise mortgages outstanding
                           at the start of the stress test. For this purpose, the act specifies the use of
                           an appropriate house price index, such as the Department of Commerce’s
                           Constant Quality Home Price Index or an index of similar quality used by
                           the federal government.

                           Develop a methodology to assess the performance of various mortgage
                           types, such as single and multifamily mortgages, under differing credit and
                           interest rate risk scenarios: The act requires that the stress test reflect
                           differing risk characteristics of various mortgage types. For example, the
                           differences in risk for single-family home mortgages, which primarily serve
                           as residences and capital investments, and multifamily building mortgages,
                           which primarily serve as income-producing businesses. Multifamily loans
                           are less homogeneous and tend to be subject to more diverse risks than
                           single-family mortgages.

                           Determine the risks of enterprise commitments: In developing the stress
                           test, OFHEO is required to assume that the enterprises fulfill all outstanding
                           commitments to purchase mortgages or to issue securities. OFHEO must
                           determine how to translate the contractual commitment into portfolio


                           27
                             “With respect to mortgages owned or guaranteed by the enterprise and other obligations of the
                           enterprise, losses occur throughout the United States at a rate of default and severity (based on any
                           measurements of default reasonably related to prevailing practice for the industry in determining
                           capital adequacy) reasonably related to the rate and severity that occurred in contiguous areas of the
                           United States containing an aggregate of not less than 5 percent of the total population of the United
                           States that, for a period of not less than 2 years, experienced the highest rates of default and mortgage
                           losses, in comparison with such rates of default and severity of mortgage losses in other such areas for
                           any period of such duration.”



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                        Protracted




                        assets and associated funding, and into MBS, so that their credit and
                        interest rate risk can be factored into the stress test.

                        Develop an interest rate model to better understand interest rate risks
                        facing the enterprises: The act requires that the specified stressful credit
                        conditions be combined with one of two interest rate scenarios that result
                        in the highest capital requirement.28 In one scenario, the 10-year constant
                        Treasury yield rises during the first year of the stress period and remains
                        at the new level for the remainder of the stress period.29 In the other
                        scenario, the 10-year yield decreases during the first year of the stress
                        period and remains at that level for the remainder of the stress period.30
                        Other market interest rates must be simulated relative to the 10-year note
                        yield in a manner reasonably related to historical experience. OFHEO must
                        develop appropriate interest rate models to simulate the specified interest
                        rate changes on the enterprises’ financial condition.


                        When OFHEO began operations in June 1993, there were potential strategies
OFHEO’s Decision to     that it could have pursued that might have resulted in the faster
Develop a               completion of a stress test and risk-based capital standards. For example,
Sophisticated Stress    OFHEO could have adopted an enterprise stress test that had been under
                        development by HUD after making several significant adjustments to bring
Test Has Been a Key     it into compliance with the act. Or, Fannie Mae officials told us that OFHEO
Factor in the Ongoing   could have adopted an approach that the enterprise had developed to
                        assess the impacts of various credit and interest rate shocks on its
Development Process     financial condition. Instead, OFHEO officials decided to create a new and
                        comprehensive stress test that they believed would provide a better basis
                        for establishing risk-based capital standards than modifying existing stress
                        tests. OFHEO officials concluded that their strategy will result in capital
                        standards that better reflect enterprise risk. However, we note that
                        implementation of the strategy has resulted in the protracted period of


                        28
                         Rising interest rates increase interest expenses as debt turns over and decrease the value of existing
                        assets that are paying a below market rate. When interest rates decline, homeowners tend to prepay
                        mortgages more quickly, resulting in a decrease of the net average interest rates received by the
                        enterprises on mortgages held in their portfolios.
                        29
                         Under the act, the 10-year constant maturity Treasury yield increases to the greater of (1) 600 basis
                        points above the average yield during the preceding 9 months or (2) 160 percent of the average yield
                        during the preceding 3 years, but in no case to a yield greater than 175 percent of the average yield
                        during the preceding 9 months.
                        30
                          The 10-year constant maturity Treasury yield decreases to the lesser of (1) 600 basis points below the
                        average yield during the preceding 9 months or (2) 60 percent of the average yield during the preceding
                        3 years, but in no case to a yield less than 50 percent of the average yield during the preceding 9
                        months.



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                              OFHEO’s Development of a Stress Test and
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                              Protracted




                              time and the substantial resources that are being devoted to completing
                              the process.


OFHEO Had Alternative         One possible strategy that OFHEO could have chosen was to make
Strategies to Choose From     significant adaptations to a stress test for the enterprises that HUD had
in Developing a Stress Test   developed by 1992. HUD used the results of its stress test in its annual
                              reports to Congress where it assessed the financial condition of the
                              enterprises if subjected to mortgage credit conditions that existed during
                              the Great Depression.31 HUD’s stress test, which was similar to that used by
                              credit rating agencies, such as Moody’s Investors Service, began with the
                              development of economic relationships among key variables such as
                              interest rates, house prices, and unemployment in the national economy.
                              According to the former HUD officials who developed the stress test, they
                              wanted a test that would be able to simulate the consequences of a variety
                              of economic scenarios, such as rising unemployment rates and subsequent
                              mortgage default rates, on the enterprises’ financial condition.

                              However, these former HUD officials also said that the stress test would
                              have required extensive development to meet the requirements of the act.
                              The former officials said that the HUD stress test assigned enterprise
                              balance sheet items into broad asset and liability categories, or “buckets,”32
                              and would still have required the disaggregation of enterprise assets and
                              liabilities based on risk characteristics. The former officials added that in
                              1992, HUD lacked the staff and computer resources necessary to make such
                              detailed assessments. They also said that the HUD stress test did not meet
                              the act’s requirement that OFHEO specify credit risk relationships for the
                              enterprises based on historic mortgage default rates in specific areas of
                              the country (the credit stress benchmark).33 The former HUD officials said
                              that developing such a geographic credit stress benchmark would have

                              31
                               U.S. Department of HUD, 1991 Report to Congress on the Federal Home Loan Mortgage Corporation
                              (December 1992) and 1991 Report to Congress on the Federal National Mortgage Association
                              (December 1992).
                              32
                                In such a “bucket analysis,” financial analysts normally create simplified, called synthetic, assets and
                              liabilities that are meant to mimic the general characteristics of the overall assets or liabilities
                              contained in the bucket. The approach lacks specificity but requires less time input by analysts and
                              fewer computer resources.
                              33
                                According to HUD’s reports, the HUD stress test is perhaps more stringent than the one called for in
                              the act; consequently, the HUD stress test may require higher capital levels at each enterprise at any
                              one point in time than the capital levels ultimately established by OFHEO. We identified one source for
                              this discrepancy: the HUD test postulated a Depression scenario. The credit risk specified in the act
                              depends on default and loss severity data that lend themselves to statistical analysis. According to
                              OFHEO, the enterprises’ historical loan data are generally only statistically reliable since the first
                              quarter of 1980. Credit conditions since 1980 have been more favorable than those that occurred
                              during the Depression.



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                            required substantial additional work. Nevertheless, the former officials
                            said that they believed the adaptations necessary to bring the HUD stress
                            test into compliance with the act could have been completed faster than
                            the time it is taking OFHEO to develop its stress test.

                            Alternatively, Fannie Mae officials told us that OFHEO could have adopted
                            an approach to developing the stress test similar to the approaches that
                            Fannie Mae follows to assess the impacts of various credit and interest
                            rate scenarios. The officials said that Fannie Mae’s approach—which they
                            referred to as “top down”—combines assets and liabilities with similar
                            performance characteristics into aggregated categories and tests their
                            performance under specified interest and credit risk scenarios.34 Using
                            such an approach, a Fannie Mae official said that OFHEO could possibly
                            have met the 18-month deadline. In addition, Fannie Mae officials said that
                            any stress test and risk-based capital standards that OFHEO ultimately
                            develops must be consistent with the enterprises’ capacity to implement
                            them and the enterprises’ business practices.

                            OFHEO could also have chosen other options requiring different levels of
                            aggregation of enterprise assets and liabilities.35 For such options, the
                            trade-off between resource requirements and specificity in estimating
                            enterprise risks would be similar to the two options previously discussed.


OFHEO Decided to            According to an internal OFHEO memorandum dated February 22, 1994,
Develop Its Own             senior OFHEO officials determined that the alternative strategies discussed
Sophisticated Stress Test   above were not sufficient to serve as the basis for the statutory stress test.
                            For example, OFHEO officials determined that, among other limitations, the
                            HUD stress test was insufficient because it would have limited OFHEO’s
                            ability to evaluate the impacts of various economic scenarios and business
                            strategies on the enterprises’ financial condition. In our discussions with
                            OFHEO officials, they said that the HUD stress test had other significant
                            limitations that made it unusable. For example, ORACS’ director said that
                            the HUD stress test lacked the capacity to assess the consequences of



                            34
                              Our ability to demonstrate a comparison between Fannie Mae’s approach and OFHEO’s approach is
                            limited because we cannot disclose information that Fannie Mae considers to be proprietary or
                            components from OFHEO’s stress test development that are not in the public domain.
                            35
                             For example, 30-year fixed-rate mortgages can be aggregated according to coupon rates on the
                            mortgage loans (i.e., the interest rates paid by borrowers). Aggregation simplifies the analysis at the
                            possible loss of specificity in estimating risks. For example, homeowners with mortgage rates below
                            prevailing mortgage rates on newly originated mortgage loans tend to default less frequently than
                            homeowners paying higher interest rates.



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                       Protracted




                       adverse interest rate and credit scenarios on the enterprises’ derivative
                       instruments.

                       In 1994, OFHEO officials also determined that they could not use the
                       enterprises’ existing financial models for assessing the impact of various
                       credit and interest rate scenarios and developing the stress test for several
                       reasons. For example, OFHEO officials determined that, although the
                       enterprises’ financial models may have been sufficient to meet their
                       business needs, the models were not adequate for meeting the
                       requirements of the statutory stress test. OFHEO officials also decided that
                       the financial models used by the enterprises differed substantially and,
                       therefore, OFHEO needed to develop a common model to ensure regulatory
                       consistency. In addition, OFHEO officials wanted the organization to
                       develop an independent capacity to assess the risks facing the enterprises
                       and to make regulatory decisions as it was deemed necessary.

                       Consequently, OFHEO officials told us that in 1994 they decided to develop a
                       comprehensive and sophisticated stress test to comply with the act’s
                       requirements and establish the organization’s regulatory independence. To
                       develop such a stress test, OFHEO officials said that they needed to collect
                       and test extensive data on the historical performance of enterprise loans
                       as well as their current books of business on a disaggregated basis. OFHEO
                       officials also determined that the organization needed to develop
                       sophisticated models and computer programs to assess how alternative
                       economic scenarios would affect the enterprises’ financial condition and
                       capital positions. OFHEO officials said that they believed that the final stress
                       test will result in risk-based capital standards that better reflect the risks
                       facing the enterprises.


                       Our review identified several other factors that have contributed to
OFHEO’s Need to Hire   OFHEO’s ongoing development of the stress test and risk-based capital
Expertise and Obtain   standards. First, once senior OFHEO officials had made the decision to
Accurate Financial     develop a sophisticated stress test, the organization had to hire expert
                       staff and purchase a powerful computer network system capable of
Data Proved            running financial models. Second, OFHEO officials said the enterprises did
Time-Consuming         not always provide accurate financial data on a timely basis. Third, OFHEO
                       officials initiated the federal rulemaking process, which involved
                       significant staff time and resources. Finally, between 1994 and 1997, OFHEO
                       had to initiate and complete several economic modeling, financial
                       modeling, and computer programming projects, which proved more
                       challenging than the organization had initially anticipated.



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                         OFHEO’s Development of a Stress Test and
                         Risk-Based Capital Standards Has Been
                         Protracted




OFHEO Had to Obtain      The need to hire expertise and acquire a sophisticated computer network
Needed Expertise and a   are factors that contributed to the time needed for the ongoing
Computer Network         development of the stress test and risk-based capital standards. According
                         to the ORACS director, OFHEO viewed hiring and developing a capable staff
                         of permanent employees and contractors as another means for the
                         organization to establish itself as a viable, independent regulatory agency.
                         ORACS has focused its hiring efforts on individuals who had substantial
                         expertise in housing economics, the capital and mortgage markets,
                         computer programming, or computer systems. We reviewed OFHEO
                         personnel records and determined that the ORACS staff have extensive
                         experience in housing economics, financial analysis, residential mortgage
                         markets, and computer systems. In addition, senior ORACS officials have
                         postgraduate degrees and experience in relevant settings, such as
                         securities firms or other federal financial regulatory agencies.

                         However, OFHEO also provided hiring data that indicate that it took ORACS a
                         substantial period of time to recruit the individuals deemed necessary to
                         develop and implement the stress test and risk-based capital standards.
                         For example, the data indicated that 7 of the 14 full-time staff in ORACS in
                         May 1997 were hired in 1995 and 1996. In addition, OFHEO’s acting director
                         said that between October 1996 and April 1997, OFHEO lost several key staff
                         members from ORACS and its Office of Policy Analysis, including a senior
                         policy analyst, a senior economist, and a systems administrator, which
                         further contributed to the challenges of completing the stress test and
                         capital standards within established deadlines. Moreover, it has taken
                         considerable time for OFHEO to hire key contract staff to develop essential
                         components of the stress test. For example, OFHEO did not contract with
                         Price Waterhouse to develop financial reporting software and a
                         consolidated data format for both enterprises until August 1995.

                         OFHEO  also needed to acquire a sophisticated computer network on which
                         the financial models are to be run. In 1994, based on an analysis of
                         available computer hardware and software, OFHEO officials decided to
                         purchase a powerful computer network. According to OFHEO’s acting
                         director, the computer network did not become fully operational until late
                         1994. Without the computer network, OFHEO’s growing ORACS staff could
                         not make significant progress on many of the complex economic
                         modeling, financial modeling, and computer software projects necessary
                         to develop the stress test and risk-based capital standards.




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                             Protracted




OFHEO Encountered            OFHEO  officials said another factor that has contributed to the ongoing
Some Difficulties            development of the stress test was that OFHEO and the enterprises had to
Obtaining Accurate           establish a workable system for delivering large amounts of financial data.
                             OFHEO required large amounts of historical and current financial data from
Financial Data on a Timely   the enterprises so that it could, among other tasks, determine the
Basis                        benchmark loss experience and develop models of mortgage performance;
                             such work was necessary before the impact of the various credit and
                             interest rate scenarios on the enterprises financial condition could be
                             determined. OFHEO first requested that the enterprises provide
                             comprehensive financial data on loan performance in May 1994 and the
                             enterprises responded over the next 18 months. Although ORACS’ director
                             stated that the enterprises generally made good faith efforts to supply the
                             requested data, various problems and delays were encountered. For
                             example, he said that the enterprises did not always provide all necessary
                             data in their initial submissions, which resulted in repeated follow-up
                             requests. Also, he said that OFHEO technical staff sometimes encountered
                             problems and delays contacting their counterparts at the enterprises
                             without first being routed through regulatory compliance officials.

                             OFHEO   officials also stated that they encountered some difficulties
                             obtaining accurate financial data from Freddie Mac on a timely basis and
                             that this has delayed the development of the stress test. OFHEO initiated a
                             targeted examination of “data integrity” issues at Freddie Mac in
                             August 1996 which, when completed in November 1996, stated that
                             Freddie Mac had not established adequate controls to ensure the accuracy
                             of information submitted to OFHEO. According to OFHEO, Freddie Mac has
                             agreed to correct these problems. However, a Freddie Mac official told us
                             that data integrity issues did not result in delayed completion of the stress
                             test.36

                             Fannie Mae officials we contacted said that OFHEO’s initial requests for
                             information imposed certain regulatory burdens on the enterprise. In
                             keeping with their view that OFHEO could have relied on a “top-down”
                             approach to developing the stress test, Fannie Mae officials said they did
                             not fully understand why OFHEO required such a substantial amount of data
                             about individual mortgage loans. They said that requesting such detailed
                             mortgage loan data is not necessary and slows the development of the
                             stress test. OFHEO officials said they needed individualized loan data to


                             36
                               The Freddie Mac official said that error-free data are not essential in the early stages of designing a
                             financial model and that testing of data can be accomplished through the use of smaller data sets. In
                             addition, the official said that Freddie Mac has provided OFHEO with substantial support in its
                             development of the risk-based capital standards and associated financial models.



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                            better model the enterprises’ financial condition and better understand the
                            potential impacts of various credit and interest rate scenarios.

                            Freddie Mac officials we interviewed had a different perspective toward
                            OFHEO’s development of the stress test and the potential for regulatory
                            burden. Freddie Mac officials told us that they do not know what stress
                            test OFHEO will ultimately develop. They said that OFHEO should take the
                            time necessary to “do the job right,” and attributed this view to the
                            position that both enterprises are currently well capitalized and therefore
                            the risk of delay is low. Freddie Mac officials also said that they
                            understood OFHEO’s position that developing an in-house understanding of
                            enterprise risks was important. Freddie Mac officials, however, expressed
                            the concern that OFHEO could end up developing a stress test that relied
                            too heavily on disaggregated information. The officials said that their
                            potential concerns with a highly refined stress test and capital standards
                            were that they could create (1) a regulatory burden; and (2) unintended
                            consequences by ignoring beneficial linkages, such as those associated
                            with hedging activities, among financial assets and liabilities.


OFHEO Officials Initiated   OFHEO  officials also cited the protracted federal rulemaking process as a
Rulemaking Process          factor that has contributed to the ongoing development of the stress test
                            and risk-based capital standards. The officials said that complying with the
                            federal rulemaking requirements placed important demands on the time of
                            OFHEO’s staff. For example, ORACS’ director said that the office staff
                            responsible for the development of the stress test worked with OFHEO
                            attorneys in drafting rulemaking proposals, which are summarized below.
                            ORACS’ director and other officials said that OFHEO’s staff must frequently
                            assume such time-consuming responsibilities to compensate for the
                            organization’s relatively small size as compared to other federal financial
                            regulators.

                            On February 8, 1995, OFHEO issued an Advance Notice of Proposed
                            Rulemaking (ANPR), which solicited public comment for a period of 120
                            days on a variety of technical and policy issues and a range of alternative
                            approaches to modeling the enterprises’ credit and interest rate risks. ANPR
                            covered such subjects as defining the credit stress benchmark, assessing
                            the default and loss characteristics of a wide range of mortgage types, and
                            the effects of high inflation rates on mortgage losses. When the period for
                            public comment closed in June 1995, OFHEO had received a total of 15
                            comments from a variety of interested parties, including the enterprises
                            and two mortgage banking firms, which OFHEO officials said they have



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                          considered in the development of the stress test. On June 10, 1996, OFHEO
                          published a Notice of Proposed Rulemaking (NPR), which described two
                          key elements of the stress test—the benchmark loss experience and the
                          house price index. These issues are discussed below and in appendix I.
                          During 1997, OFHEO staff are working on a second NPR that will cover issues
                          not addressed in the first NPR, such as interest rates and mortgage
                          performance.


OFHEO Managed Multiple    OFHEO  also initiated and completed several complex and time-consuming
Projects to Develop the   projects between 1994 and 1997 to develop the stress test and risk-based
Stress Test and Capital   capital standards. The projects that OFHEO initiated included
                          (1) establishing the credit stress benchmark, (2) developing a consistent
Standards                 format for data provided by Fannie Mae and Freddie Mac, (3) identifying
                          an appropriate house price index, and (4) developing econometric models
                          and computer programs to simulate enterprise financial performance.
                          Most of these projects had been completed by June 1997 (see app. I).
                          According to OFHEO’s acting director, OFHEO faced significantly greater
                          technical and managerial challenges than initially anticipated, developing
                          an integrated financial model to simulate the behavior of the enterprises’
                          assets, liabilities, and off-balance-sheet obligations under adverse credit
                          and interest rate conditions. This financial model is to serve as the
                          foundation of the final stress test.37 According to ORACS’ director, however,
                          OFHEO had largely completed the integrated financial model by April 1997,
                          although some final testing and documentation projects were to have been
                          completed during the summer of 1997.


                          OFHEO  faces continuing challenges in meeting its proposed deadline of
OFHEO Faces               issuing the final rule implementing the stress test and risk-based capital
Continuing Challenges     standards by 1999. In particular, OFHEO officials must coordinate the
in Implementing the       interagency review process and make key policy decisions about the stress
                          test. Further, OFHEO must translate the components of the stress test and
Final Risk-Based          capital standards into proposed and final rules in compliance with federal
Capital Rule by 1999      statutes.




                          37
                           OFHEO refers to the model as the Financial Simulation Model. OFHEO’s work on the model includes
                          assessing the impact of fluctuations in interest rates on mortgage performance, determining the impact
                          of rising house prices on the enterprises’ financial condition, estimating mortgage prepayment and
                          default and loss severity rates, and simulating the cash flows of enterprise assets, liabilities, and
                          off-balance-sheet obligations and translating these cash flows into pro forma accounting statements.



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                           Protracted




OFHEO Must Coordinate      OFHEO’s acting director said that OFHEO plans to share the basic
Interagency Review         components of the stress test and related financial models on an informal
Process                    basis with OMB, HUD, and Treasury in the summer of 1997. He said that
                           given the complexity of the stress test and its related financial models, it
                           will be important to provide information about them at the earliest
                           possible stage. The acting director said the informal interagency review
                           process can go forward before the stress test is finalized because the goal
                           will be to explain the technical components of the stress test and related
                           financial models to OMB and Treasury technical staff and to receive their
                           comments and analysis.


OFHEO Needs to Make        OFHEO’s   acting director told us that the organization needs to make key
Key Policy Decisions       policy decisions about various components of the stress test by early 1998.
                           OFHEO’s chief economist said that OFHEO’s technical staff had the
About the Stress Test
                           responsibility to lay out options on various complicated issues that are
                           necessary to complete the stress test, such as assumptions about future
                           interest rates, the shape of the yield curve, the enterprises’ future debt
                           issuances, and the relationship between home prices and interest rates,
                           but it is up to OFHEO management to choose the appropriate option. Once
                           these decisions have been made, then OFHEO will have a better idea as to
                           how the stress test will affect the enterprises’ financial condition and
                           risk-based capital levels.


OFHEO Must Translate the   OFHEO’s general counsel told us that once ORACS completes development of
Components of the Stress   the stress test, OFHEO’s staff will face the task of translating the stress test
Test Into Proposed and     into proposed and final rules. The general counsel stated that OFHEO wants
                           to avoid having the final rule successfully challenged in court under the
Final Rules While          Administrative Procedure Act (APA). OFHEO’s general counsel said that
Protecting Proprietary     another concern that will confront the organization in drawing up the
Enterprise Data            proposed and final rules will be the need to give adequate notice to the
                           public to provide for comment on the development of the stress test as
                           required by APA without compromising proprietary enterprise data.

                           Enterprise officials we contacted said they are very concerned that OFHEO
                           not disclose proprietary information during the rulemaking process. In
                           fact, Fannie Mae officials told us that OFHEO has already publicly disclosed
                           some proprietary information in research papers. Although the Fannie
                           Mae officials said that OFHEO researchers attempted to disguise the
                           proprietary data through high-level aggregation, the officials said that this
                           high-level approach was not effective because OFHEO only supervises two



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              OFHEO’s Development of a Stress Test and
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              Protracted




              companies. OFHEO’s acting director stated that the research papers did not
              disclose proprietary enterprise data. He also said that OFHEO has
              established a rigorous policy for preventing the release of such proprietary
              data; for example, OFHEO researchers are to submit all proposed papers to
              senior officials who determine if the papers disclose confidential
              information.38


              The stress test and risk-based capital standards that OFHEO is legislatively
Conclusions   required to develop are essential means by which the organization is to
              fulfill its mission of helping to ensure the safety and soundness of Fannie
              Mae and Freddie Mac. The stress test is to simulate the effects that various
              adverse credit and interest rate shocks would have on the enterprises, and
              the risk-based capital standard is to be designed to ensure that the
              enterprises hold adequate capital to withstand such stress for a period of
              10 years. OFHEO has already missed the December 1, 1994, deadline for
              completing the process by almost 3 years and estimates that it will be 1999
              at the earliest before this statutorily mandated task is completed.

              Although developing the stress test under the act presented complex
              challenges, OFHEO’s decision in 1994 to develop its own sophisticated
              stress test rather than adopting and modifying stress tests that were
              already under development resulted in a substantial commitment of time
              and resources. Related factors contributing to the delay in implementing
              this decision included OFHEO (1) failing to hire its full complement of
              research staff until 1996 or get its computer network operational until late
              1994, (2) experiencing delays in obtaining accurate enterprise financial
              data, (3) devoting considerable staff time and resources to the federal
              rulemaking process, and (4) encountering greater managerial and
              technical challenges than initially anticipated in developing an integrated
              financial model that serves as the basis of the stress test. An OFHEO official
              said that this financial model had largely been completed by April 1997,
              although final testing needed to be completed during the summer of 1997.

              We recognize the complexity of the challenges that OFHEO has faced.
              However, we note that OFHEO has consistently underestimated the time
              needed to complete its tasks. Given OFHEO’s history of failing to meet its
              own publicly announced completion targets and considering the
              challenges that remain, we are concerned that OFHEO may not meet its
              current estimate of issuing a final rule by 1999. For example, to meet the

              38
               Fannie Mae and OFHEO officials have a basic disagreement as to what constitutes disclosure of
              proprietary information. On this subject, Freddie Mac officials also indicated a disagreement with
              OFHEO.



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                     Protracted




                     schedule in the current plan, OFHEO must coordinate the interagency
                     review process and make key policy decisions, such as forecasts about
                     future interest rates. In addition, OFHEO must translate the complex
                     components of the stress test and capital standards into proposed and
                     final rules as required by APA while protecting against the unauthorized
                     disclosure of proprietary enterprise data.

                     We believe it is essential that OFHEO take all feasible steps to comply with
                     its plan and complete the stress test and risk-based capital standards as
                     soon as possible because they are critical to helping maintain the safety
                     and soundness of Fannie Mae and Freddie Mac. Although the enterprises
                     have been consistently profitable in recent years, their rapid growth and
                     potentially increasing interest rate risks pose potential costs to taxpayers
                     that exceeded $1.5 trillion at year-end 1996. Without a stress test and
                     risk-based capital standards in place, OFHEO’s capacity to lower such
                     taxpayer risks is limited.


                     Given the history of OFHEO’s failure to meet its own publicly announced
Recommendations      plan to complete the stress test and risk-based capital standards, strong
                     congressional oversight appears necessary to ensure that OFHEO issues its
                     final rule in a timely manner. Accordingly, we recommend that OFHEO’s
                     director report to Congress periodically on the organization’s progress
                     towards compliance with its current plan. We also recommend that the
                     director include in such reports information on the status of OFHEO’s
                     progress towards important milestones, such as its (1) projected
                     completion of final testing on the financial model that comprises the stress
                     test, (2) progress toward completing the interagency review process,
                     (3) estimated completion of key policy decisions regarding the stress test
                     by early 1998, and (4) progress in translating the components of the stress
                     test into proposed and final rules. Finally, we recommend that the director
                     inform Congress of any problems that may arise in completing the stress
                     test and risk-based capital rules by 1999 and of actions that the
                     organization plans to take to correct such problems.


                     In written comments, OFHEO’s acting director agreed with the report’s
Agency Comments      analysis of why the development of the stress test and risk-based capital
and Our Evaluation   standards has been protracted and stated that OFHEO is implementing our
                     recommendation that Congress be informed of progress in completing the
                     final rule. He emphasized that the complexity of the development process
                     as specified in the act and OFHEO’s decision to develop its own



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sophisticated stress test have been the primary factors in delaying the
completion of the final rule. The acting director also said that the report
should not be interpreted to suggest that using the HUD stress test or using
the enterprises’ financial models would have produced an acceptable
result. As examples, he said that the HUD stress test did not include the
credit stress benchmark, and a simplified stress test would not adequately
address the enterprises’ increased interest rate risks resulting from their
larger retained mortgage portfolios. He said that the enterprises’ mortgage
portfolios are becoming increasingly complex and involve large volumes
of derivative instruments. Among other reasons, the acting director said
that relying on the enterprises’ financial models would not have been
appropriate because it potentially would have jeopardized OFHEO’s
independence as a regulatory agency.

We did not take a position in the report on the adequacy or
appropriateness of OFHEO’s approach to developing the stress test and
risk-based capital standards. To do so would have required that we
demonstrate whether the other alternatives could have been modified
sufficiently to meet the requirements of the act in a shorter period of time.
Given that the time is long past when such a demonstration would have
affected OFHEO’s approach, we chose not to pursue such an assessment.
Rather, we pointed out that there were potential trade-offs associated with
the time that would have been necessary to adopt and modify the HUD
stress test, or another aggregated type of stress test, and the
comprehensive development approach that OFHEO has chosen.




Page 51                                    GAO/GGD-98-6 Federal Housing Enterprises
Chapter 3

OFHEO Has Not Fully Implemented a
Comprehensive Enterprise Safety and
Soundness Examination Program
              OFHEO’s  examination program is its primary means of helping to ensure the
              safety and soundness of Fannie Mae and Freddie Mac in the absence of
              risk-based capital standards. Since 1994, OFHEO has made important
              progress in fulfilling its essential examination oversight function, such as
              by establishing a “risk-focused” examination strategy, defining six “core
              risks” facing the enterprises, and by completing or initiating on-site
              examinations to monitor five of these risks. However, OFHEO has also
              scaled back the implementation of a detailed examination schedule and
              plan that was developed in September 1994. In particular, OFHEO’s current
              3- to 4-year cycle for examining the six core risks facing the enterprises is
              considerably longer than the 2-year cycle established in its 1994
              examination plan, and OFHEO’s most recently completed core risk
              examination covered fewer areas than planned. Without a more timely and
              comprehensive examination program, OFHEO faces limitations in its ability
              to monitor the risks facing the enterprises, such as their potentially greater
              interest rate risks resulting from increasing holdings of debt-financed
              mortgage assets.

              The evidence we obtained indicated that, among other factors, limited
              resources applied to the examination function were largely responsible for
              OFHEO’s inability to fully implement the 1994 examination plan. Our
              analysis found that to complete each core risk examination, OFHEO was
              required to commit a significant majority of its 12 line examiner and
              specialist positions to the examination for a period of 1 year as well as
              noncore risk—or targeted risk—examinations that were required. As a
              result, OFHEO may lack the line examiner and specialist staff resources
              necessary to complete examinations covering three core risks per year,
              the minimum necessary to cover all six core risks in a 2-year cycle. In
              addition, staff attrition in 1996 and early 1997 left the examination office
              with 5 vacancies out of 17 authorized full-time positions—a vacancy rate
              of 30 percent—as of March 31, 1997, which further limited OFHEO’s ability
              to implement the 1994 plan. By August 1997, an OFHEO official reported
              that the organization had filled three of the positions and two others were
              being advertised.

              OFHEO   officials said that they recognize the need to shorten the 3- to 4-year
              examination cycle to adequately assess the enterprises’ financial condition
              and management practices. During 1997, OFHEO plans to reassess its
              examination strategy and make changes to shorten the examination cycle
              for all six core risks to 1 year. In the reassessment of its examination
              strategy, OFHEO could usefully include consideration of different




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                             Soundness Examination Program




                             examination cycles and related coverage that could be accomplished with
                             alternative resource levels.


                             In September 1994, OFHEO established a detailed examination strategy,
OFHEO Established a          schedule, and plan to help ensure the safety and soundness of Fannie Mae
Detailed Enterprise          and Freddie Mac. The plan identified six “core risks,” such as interest rate
Examination Schedule         risk, facing the enterprises, and established a 2-year cycle for OFHEO
                             examination staff to assess these risks. OFHEO’s examination plan is
and Plan in 1994             generally consistent in substance but not in timing with risk-focused
                             examination plans that OCC and the Federal Reserve System have
                             established to annually assess the safety and soundness of large
                             commercial banks. Although we recognize that large banks may engage in
                             a wider variety of potentially risky activities than the enterprises, we
                             believe a generally consistent examination approach by OFHEO and the
                             bank regulators is important because the potential exists that a large bank
                             or enterprise failure could cause substantial taxpayer losses.39


OFHEO’s Examination          The act requires OFHEO to conduct annual, on-site safety and soundness
Program Called for           examinations of the enterprises to assess their operations and financial
Assessing Enterprise Risks   condition. According to an OFHEO attorney, this requirement can be and
                             has been met without conducting full-scope enterprise examinations on an
on a 2-Year Cycle            annual basis. Full-scope examinations are generally understood to mean
                             thorough assessments of all of the management practices and business
                             strategies of a federally regulated financial institution that could affect its
                             safety and soundness.

                             During 1994, senior OFHEO officials established a “risk-focused”
                             examination schedule and plan to assess the risks facing Fannie Mae and
                             Freddie Mac on a 2-year cycle. Under the plan OFHEO adopted in
                             September 1994 and has subsequently modified,40 OFHEO identified six core
                             risks, which OFHEO officials believed represent the greatest risks to the
                             enterprises. These six core risks are corporate governance, interest rate,
                             credit, operations, business, and information technology. Although there
                             are six core risks, OFHEO’s plan stipulated that examiners could cover these

                             39
                               The Federal Deposit Insurance Corporation administers the Bank Insurance Fund, which uses
                             premiums paid by banks to protect the depositors of failed banks. The potential exists that during a
                             financial emergency, a large bank failure or series of large bank failures could drain the Bank
                             Insurance Fund, thereby requiring a taxpayer bailout. As discussed in the report, the potential exists
                             that the government would choose to rescue the enterprises if they could not meet their debt and MBS
                             obligations.
                             40
                               For example, OFHEO did not identify information technology risks as a core risk until 1995.



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                                         risks in five exams by consolidating the credit risk and interest rate risk
                                         components into a single risk management examination (see table 3.1).
                                         The risk management examination was also intended to cover five other
                                         risk areas, such as asset growth and composition, which OFHEO does not
                                         consider to be core risks. Under the plan, the four other core risk
                                         examinations designated specific areas that OFHEO examiners were to
                                         cover. For example, the business line examination was to assess the
                                         adequacy of the enterprises’ risk management of the following businesses:
                                         single-family mortgage guarantee, multifamily mortgage guarantee,
                                         portfolio, and financial services.

Table 3.1: OFHEO’s Examination Plan
for Monitoring the Six Core Risks on a   Exam type                          Summary of examination objectives
2-Year Cycle                             Corporate governance risk          Assess enterprise board of directors oversight,
                                                                            organization structure, internal controls, and information
                                                                            flows.
                                         Risk management                    Assess interest rate risk, credit risk, and five other risk
                                                                            areas.
                                         Business risk                      Assess risks in four enterprise business areas, including
                                                                            single-family mortgages, multifamily mortgages, portfolio,
                                                                            and financial services.
                                         Operations risk                    Assess operational practices in four areas, such as
                                                                            securitization.
                                         Information technology risks       Assess the enterprises’ use of computer technology and
                                                                            associated risks.a
                                         a
                                          OFHEO did not identify information technology risk as a core risk until 1995. However, the
                                         September 1994 plan did identify information technology risk as an area that required a targeted
                                         examination.

                                         Source: OFHEO.



                                         OFHEO’s  1994 examination plan also identified other risks that examiners
                                         were to assess within a 2-year period. These exams were considered to be
                                         more targeted than the exams established to assess the six core risks. In
                                         particular, OFHEO examiners were to assess the books and records of both
                                         enterprises to determine the accuracy and reliability of their financial
                                         reporting. These books and records examinations were to encompass the
                                         financial reporting underlying the enterprises’ public financial statements
                                         and the internal reporting supporting management processes. The plan
                                         also called on OFHEO examiners to assess the enterprises’ use of
                                         sophisticated derivative instruments. In addition, the plan called for OFHEO
                                         to develop the capacity to monitor the enterprises’ financial condition on
                                         an off-site basis, such as by collecting periodic financial information from




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                             the enterprises that show trends in asset growth, financial performance,
                             and funding.

                             OFHEO  uses a “top-down” approach to examinations to assess the six core
                             risks as well as targeted risks. The examination of a particular risk is to
                             begin with a “Level I” review in which examiners evaluate board of
                             directors oversight and planning and review internal and external audits.
                             The examiner is to proceed to a Level II review if deficiencies in the
                             management of risk are found. This level of review usually would involve
                             additional testing of controls. If a Level II exam does not resolve all areas
                             of concern, a Level III review—a detailed review of the control
                             environment, including extensive transaction testing—is to be conducted.


OFHEO Examination Plan       The risk-focused examination plan and 2-year cycle OFHEO established in
Is Generally Consistent in   1994 is generally consistent in concept but not in timing with risk-focused
Substance but Not in         examination plans that OCC and the Federal Reserve have recently
                             established to examine large commercial banks. By law, bank regulators
Timing With Plans            are required to conduct full-scope examinations of the financial condition
Developed by Bank            and safety and soundness of large banks at least once a year.41 OCC has
Regulators                   chosen to implement the full-scope requirement by developing a
                             risk-focused examination system that identifies nine major risks, such as
                             interest rate and credit risks, facing national banks; some of these risks are
                             similar to the core risks OFHEO has identified as facing the enterprises.
                             According to OCC, its staff are to assess each of the risks facing particular
                             national banks on an off-site basis prior to initiating an examination. These
                             off-site assessments are to be accomplished by reviewing previous
                             examination reports and available financial data among other documents.
                             OCC staff are then to focus the majority of their time and resources on the
                             greatest risks facing particular banks during the on-site examination
                             process. The Federal Reserve System has established a risk-focused
                             annual examination program, which is similar to that of OCC, for large
                             banks under its supervisory responsibility.

                             We recognize that large commercial banks engage in a variety of
                             potentially risky activities, such as trading securities and lending for many
                             purposes, on a worldwide basis, while the enterprises’ activities are
                             generally confined to a single line of business, mortgage purchases, in the
                             United States. Consequently, it could be argued that large banks should be
                             subjected to a more rigorous level of supervision and examination than the

                             41
                              See Federal Deposit Insurance Corporation Act of 1991, Pub. L. No. 242, § 111(a), as amended, 12
                             U.S.C. § 1820d. Under this act, bank and thrift regulators are required to do annual, full-scope
                             examinations of banks or thrifts with total assets of $250 million or more.



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                           enterprises. However, as pointed out in our previous reports, we believe
                           that the enterprises should generally be subjected to a similar level of
                           supervision as banks, although some modifications to adjust for their
                           differing risk characteristics may be necessary.42 For example, banks and
                           the enterprises share some risk characteristics, such as interest rate,
                           credit, business, and management risks, and the failure of either an
                           enterprise or a large commercial bank could potentially impose losses on
                           taxpayers.


                           Our review found that, despite making important progress, OFHEO has not
OFHEO Has Not Been         been able to fully implement the enterprise examination schedule and plan
Able to Fully              that was established in September 1994. Although OFHEO has completed or
Implement the 1994         initiated examinations covering five of the six core risks, at its current rate
                           it will take OFHEO 3 to 4 years to examine all six core risk areas, which is
Examination Plan           considerably longer than the 2-year cycle established in the 1994 plan.
                           Moreover, OFHEO scaled back the planned coverage of the most recently
                           completed core risk examination. OFHEO’s relatively long examination
                           cycle and limited examination coverage raise questions about its capacity
                           to fully assess the enterprises’ management, financial practices, and risks
                           on a timely basis.


OFHEO Has Made             Between August 1994 and May 1997, OFHEO made important progress in
Progress in Implementing   implementing the 1994 examination schedule and plan. As of May 1997,
                           OFHEO had completed or initiated examinations covering five of the six
the 1994 Plan
                           core risk areas, and OFHEO plans to initiate the remaining core examination
                           covering operations risk in 1997 (see table 3.2). OFHEO also completed
                           three targeted examinations covering the enterprises’ use of nonmortgage
                           derivative contracts, the enterprises’ compliance with a flood insurance
                           statute,43 and data integrity issues at Freddie Mac.



                           42
                             We have observed that bank regulation is a useful starting point for determining the regulatory
                           structure that should apply to government-sponsored enterprises, such as Fannie Mae and Freddie
                           Mac. As examples, we have stated that government-sponsored enterprises should be subject to capital
                           standards and periodic on-site examinations. See Government-Sponsored Enterprises: A Framework
                           for Limiting the Government’s Exposure to Risks (GAO/GGD-91-90, May 22, 1991) and
                           Government-Sponsored Enterprises: The Government’s Exposure to Risks (GAO/GGD-90-97, Aug. 15,
                           1990).
                           43
                             The National Flood Insurance Reform Act of 1994 requires the enterprises to implement procedures
                           that are reasonably designed to ensure that adequate flood control insurance is in place over the term
                           of the mortgage loans the enterprises purchase after September 28, 1995. Pub. L. No. 103-325 § 522, 42
                           U.S.C. § 4012a(b)(3). According to an OFHEO official, OFHEO ensures that the enterprises comply
                           with these requirements on a biennial basis.



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Table 3.2: OFHEO’s Completed,
Ongoing, and Planned Examinations   Exam type                                     Start datea               End datea
as of May 1997                      Core risks
                                    Corporate governance                          August 1994               June 1995
                                    Risk management (credit and interest          May 1995                  June 1996
                                    rate risks)
                                    Business                                      June 1996                 May 1997
                                    Information technology                        March 1997                Planned September
                                                                                                            1997
                                    Operations                                    Planned 1997              Planned 1997 or 1998
                                    Targeted
                                    Nonmortgage derivatives                       May 1994                  November 1994
                                    Flood insurance                               January 1996              May 1996
                                    Freddie Mac data integrity                    August 1996               November 1996
                                    a
                                     Includes both Fannie Mae and Freddie Mac exams. The end date is for the enterprise exam that
                                    OFHEO completed last. All of the Fannie Mae and Freddie Mac exams were completed within
                                    several weeks of one another.

                                    Source: OFHEO.



                                    OFHEO’s  examination office has also established an off-site capacity to
                                    monitor the enterprises’ financial condition and safety and soundness as
                                    specified in the 1994 plan. The Office of Examination and Oversight (OEO)
                                    staff collects financial information from the enterprises and produces
                                    internal reports that discuss relevant supervisory issues. OEO’s acting
                                    director said that the examination staff works closely with ORACS staff to
                                    develop a better understanding of the enterprises’ financial activities. He
                                    also said that OFHEO plans to more fully integrate off-site monitoring into
                                    the examination process. For example, OFHEO plans to produce internal
                                    reports focusing on each of the six core risks. These reports would be
                                    reviewed by examiners prior to initiating a risk-based examination,
                                    potentially creating examination efficiencies.


OFHEO Has Not                       Despite making progress, OFHEO has not implemented other important
Implemented Other                   components of the 1994 examination plan. As shown in table 3.2, OFHEO
Important Components of             completed examinations covering four—corporate governance, credit,
                                    interest rate, and business—of the six core risk areas between 1995 and
the 1994 Examination Plan           1997, plans to complete the information technology examination in 1997,
                                    and plans to initiate the operations risk examination in 1997, which may
                                    not be completed until 1998. Therefore, OFHEO’s first cycle for covering all




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                            six core risk areas will take 3 to 4 years (1994 to 1997 or 1994 to 1998)44
                            rather than the 2-year cycle established in the 1994 plan.

                            OFHEO   also scaled back the planned coverage of its most recently
                            completed core risk examination. The core business risk examination that
                            OFHEO completed in May 1997 covered risk management in one of the four
                            business areas specified in the 1994 plan—the single-family guarantee
                            component. OFHEO’s inability to cover the other three business areas (in
                            particular, the multifamily mortgage guarantee business) has limited the
                            organization’s capacity to fully monitor the enterprises’ safety and
                            soundness. OFHEO’s 1997 annual report states that the enterprises’
                            purchases and new guarantees on multifamily mortgages tripled from
                            $3 billion at year-end 1992 to $9 billion at year-end 1996. According to the
                            annual report, multifamily mortgage loans are relatively risky. For
                            example, although the delinquency rates on the enterprises’ multifamily
                            mortgages have improved significantly since 1992, they are still higher
                            than the delinquency rates on the enterprises’ single-family mortgages.45

                            In addition, OFHEO was not able to implement the objective in the 1994
                            examination schedule and plan that it assess the books and records of the
                            enterprises to assess the accuracy of their financial reporting. We pointed
                            out in chapter 2 that OFHEO did initiate a “data integrity” examination at
                            Freddie Mac in 1996 that identified significant problems in the controls
                            over data submitted to OFHEO for development of the stress test and
                            risk-based capital standards. Thus, such examinations appear to be
                            important for ensuring accurate enterprise financial data. OFHEO has not
                            yet initiated a data integrity or books and records targeted examination at
                            Fannie Mae, although it plans to do so as part of the information
                            technology examination, according to OFHEO officials.


OFHEO’s Capacity to Fully   OFHEO’s inability to fully implement the 1994 examination schedule and
Assess Enterprise           plan limits its capacity to fully assess the enterprises’ management
Risk-Taking Is Limited      practices, financial condition, and risks. For example, although Fannie
                            Mae and Freddie Mac have been consistently profitable in recent years, we
                            pointed out in chapter 1 that the enterprises have adopted business
                            strategies that could potentially weaken their future financial

                            44
                              OFHEO initiated the corporate governance risk exam in August 1994.
                            45
                              Single-family mortgage loan delinquency rates at both enterprises equaled .58 percent of outstanding
                            single-family mortgages in 1996. During 1996, Fannie Mae’s delinquency rate on multifamily mortgages
                            was .68 percent, which was well below the delinquency rate of 2.65 percent in 1992. Freddie Mac’s
                            delinquency rate on multifamily mortgages was 1.96 percent in 1996, having fallen from 4.45 percent in
                            1992.



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                        performance, such as by growing at rapid rates and potentially incurring
                        greater interest rate risks through increased holdings of debt-financed
                        mortgage assets. Under its current 3- to 4-year examination cycle,
                        however, OFHEO may not be able to do an on-site examination to assess the
                        enterprises’ interest rate risks until 1999 or 2000, since the previous risk
                        management examination was completed in 1996.


                        The evidence indicates that limited examination staff resources were
Limited Examination     largely responsible for the fact that OFHEO has not been able to fully
Staff Resources         implement the 1994 examination plan. In particular, OFHEO has too few
Impeded OFHEO’s         examiners and specialists to fully cover the six core risks within a 2-year
                        period. Although OFHEO supplements its examination staff with temporary
Ability to Implement    contractors and detailees, their use has not been sufficient to ensure
the 1994 Examination    compliance with the plan. OFHEO officials said that another contributing
                        factor was the time that its examiners needed to develop an understanding
Schedule and Plan       of the enterprises’ operations and risk management.


OFHEO’s Limited         In testimony before the House Banking, Finance, and Urban Affairs
Examination Staff       Committee, Subcommittee on Housing and Community Development on
Resources Have Been a   October 29, 1993, OFHEO’s former director stated that the organization was
                        relatively understaffed as compared to other federal financial regulators.
Long-Standing Concern   For example, the former director said that OFHEO was relatively
                        understaffed as compared to the Federal Housing Finance Board, the
                        Office of Thrift Supervision, and OCC, and that OFHEO staff were responsible
                        for assessing more assets per employee than other regulators. OFHEO’s
                        former director told us in December 1996 that the small size of the
                        examination office remained an area of concern. In our 1995 report on
                        OFHEO’s development as an independent regulator, we also stated that
                        limited staff resources had impeded OFHEO’s ability to implement its
                        examination program; for example, OFHEO had just seven staff members in
                        its examination office at year-end 1994.46 In addition, OFHEO officials we
                        contacted said that limited staff resources impeded their ability to
                        implement the 1994 plan.

                        Another factor that OFHEO officials cited for the organization’s inability to
                        fully comply with the 1994 plan was that the examination staff needed to
                        take the time necessary to develop an understanding of the enterprises’
                        operations and risk management practices. OFHEO’s acting director said
                        that prior to 1993 when OFHEO began operations, Fannie Mae and Freddie

                        46
                          GAO/GGD-95-123.



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                               Mac had never been subjected to a safety and soundness examination
                               program. Consequently, he said that OFHEO’s first cycle of examinations
                               has proved more time-consuming than OFHEO officials initially anticipated
                               in 1994. He also said that subsequent examination cycles would proceed
                               faster because of the experience gained during the first cycle.


Each Core Risk                 We analyzed OEO’s allocation of examination staff resources and found
Examination That OFHEO         that it appears to lack an adequate number of positions to cover the six
Has Initiated Tied Up a        core risks within a 2-year period. During fiscal year 1997, OEO had 17
                               authorized full-time permanent positions (see fig. 3.1). As the figure
Significant Majority of Line   indicates, 12 of the 17 positions were assigned to line examiners and
Examination Staff for          specialists, those individuals who are assigned full-time to conduct the
About 1 Year                   labor-intensive tasks associated with core risk and targeted examinations
                               (such as conducting and writing up interviews with enterprise officials,
                               reviewing policies, collecting and analyzing financial data, reviewing the
                               enterprises’ asset and liability management practices, writing examination
                               drafts, and documenting findings).

                               Although OEO’s director and deputy director also play a vital role in the
                               examination process, such as by reviewing examination reports and
                               communicating findings to senior enterprise officials, they have other
                               responsibilities that claim their time as well. As examples, the director and
                               deputy director are to establish policies and plans for the office, prepare
                               annual budgets, and conduct internal and external meetings, among other
                               responsibilities. The two financial analyst positions are primarily
                               responsible for conducting OFHEO’s off-site financial monitoring program.
                               The remaining position is for the executive secretary, who is responsible
                               for maintaining the correspondence of the office and other administrative
                               support functions.




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Figure 3.1: Line and Nonline Full-Time Permanent Positions in OFHEO’s Office of Examination and Oversight


                                                    Director




                                                Deputy Director                                          Executive Secretary




                                                                                   Examination Manager


   Senior Accounting
       Specialist
                                                                                                         Senior Enterprise
                                                                                                            Examiner
   Senior Information
   Systems Specialist

                                                          Senior Capital Markets                         Senior Enterprise
                                                                Specialist                                  Examiner
   Financial Analyst


                                                            Senior Enterprise                            Senior Enterprise
                                                               Examiner                                     Examiner
   Financial Analyst



                                                           Senior Secondary                              Senior Enterprise
                                                           Mortgage Specialist                              Examiner




                                                          Senior Secondary                               Senior Enterprise
                                                          Mortgage Specialist                               Examiner




      Line examiner or specialist position
      Nonline examiner or specialist position




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                                    In the two most recent core risk examinations,47 OFHEO needed to commit
                                    a significant majority of its line examination staff to each exam for a
                                    period of about 1 year to complete them (see table 3.3). Specifically, OFHEO
                                    assigned nine of its line examiners and specialists full-time to the business
                                    risk examination and eight examiners full-time48 to the risk management
                                    examination. In addition, OFHEO assigned a financial analyst to work on the
                                    risk management examination even though this individual’s primary
                                    responsibility is to produce off-site financial reports. Further, OFHEO’s staff
                                    of line examiners and specialists is required to do targeted examinations,
                                    such as of the enterprises’ compliance with flood insurance requirements.
                                    With such a large majority of its line examination and specialist staff
                                    assigned to one core risk management examination for a whole year and
                                    with various targeted examination requirements, it appears that OFHEO
                                    lacks adequate examination resources to cover three core risks per year,
                                    the minimum necessary to cover all six core risk areas on a 2-year cycle as
                                    stipulated in the 1994 plan.

Table 3.3: OFHEO Line Examination
Positions Assigned to Completed                                                              Total line examiner
Enterprise Core Risk Examinations                               Line examiners and                and specialist Exam start and
                                    Examination type           specialists assigned                     positions end dates
                                    Business                                                                        June 1996 to
                                                                                       9                         12 May 1997
                                    Risk management                                                                 May 1995 to
                                                                                       8a                        12 June 1996
                                    a
                                     Includes an examiner who resigned from OFHEO approximately 75 percent of the way through
                                    the examination. Also, excludes a financial analyst who was assigned to the examination.

                                    Source: OFHEO.




Examination Office Has              During 1996 and 1997, OFHEO’s examination office experienced significant
Had Attrition                       attrition of permanent full-time staff, which has further limited its ability to
                                    implement the 1994 plan. During 1996, three full-time permanent
                                    staff—two examiners and a capital markets specialist —resigned, and, in
                                    January 1997, OEO’s director passed away. As of March 31, 1997, OEO had
                                    five full-time permanent position openings, which represented a vacancy
                                    rate of 30 percent. Of the five vacancies in the examination office, one was


                                    47
                                      We did not include OFHEO corporate government risk examination in this analysis because it was
                                    initiated in 1994 when the examination office only had a total of seven staff, including the director,
                                    deputy director, and executive secretary.
                                    48
                                     One OFHEO examiner resigned approximately 75 percent of the way through the risk management
                                    examination.



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                            for the director, three were for line examiner or specialist positions, and
                            one was for a financial analyst.

                            According to OEO’s acting director, the office places a high priority on
                            filling these vacancies in 1997 through a competitive civil service
                            announcement because the vacancies further limit OEO’s capacity to do
                            examinations on a timely basis. As of August 1997, an OFHEO official said
                            that the organization had filled the OEO director position, a financial
                            analyst position, and a specialist position. In addition, the official said that
                            OFHEO was in the process of announcing the other two specialist positions.


                            OFHEO   officials told us that the organization prefers to recruit senior-level
                            examiners who have substantial experience in overseeing the operations
                            of financial companies. OFHEO officials said they adopted this strategy for
                            the following reasons: (1) experienced examiners can more quickly
                            understand the operations of the enterprises, (2) OFHEO grants
                            considerable latitude to its examiners so they must have credibility with
                            senior enterprise officials, (3) senior examiners allow OFHEO to minimize
                            its staffing levels, and (4) it is too expensive to establish an examiner
                            development program that would focus on recruiting more junior-level
                            examiners. However, OFHEO officials also said that it can be difficult to
                            attract and retain senior examiners because they are also in demand by
                            large financial corporations and other financial institution regulators that
                            may be able to offer higher salaries and career opportunities than OFHEO.

                            We reviewed the backgrounds of OFHEO’s full-time examination staff and
                            found that they have substantial backgrounds in examining financial
                            institutions and financial analysis. For example, the acting director had
                            served a total of 15 years with the Office of Thrift Supervision and OCC.
                            Other staff had also worked for financial regulators and had postgraduate
                            degrees in finance, business, accounting, and/or professional certifications
                            from relevant accrediting organizations.


OFHEO’s Use of              OEO’s acting director said that OFHEO plans to continue supplementing its
Contractors May Have        examination staff with contract employees and detailees from other
Been Affected by Cost and   financial regulators. In the past, contract employees and detailees have
                            performed most functions of OFHEO examiners, such as conducting
Other Factors               examinations and documenting their findings. However, OEO officials said
                            that OFHEO examiners make all final examination conclusions and
                            recommendations that are based on the work of the contract employees
                            and detailees. In April 1997, OFHEO’s contract with a private firm for



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examination and related support services expired. The firm provided five
examiners who worked on the risk management examination and three
examiners who worked on the business risk examination. This contract
was replaced by another contract that was signed in March 1997 to
provide support for OFHEO’s ongoing information technology risk
examination. OFHEO plans to use its full-time staff, including new hires, to
staff the operations risk examination that is also scheduled to begin in
1997.

Despite relying on contractors to supplement its full-time examination
staff, OFHEO has not been able to fully implement the 1994 plan. One factor
that may have limited OFHEO’s use of contractors is cost. For example,
OEO’s acting director estimated that hiring a contractor full-time for 1 year
costs approximately $175,000 to $200,000 per year.49 By contrast, he
estimated that OFHEO’s compensation and travel costs for a full-time
examiner are about $125,000. He also estimated that OFHEO’s compensation
and travel costs for a detailee from a bank regulatory agency vary from
about $100,000 to $150,000, depending upon whether the detailee normally
works in a regional office and OFHEO must pay temporary housing costs in
the Washington, D.C., area.

Another factor that appears to have limited OFHEO’s use of contractors is
an ongoing dispute between Fannie Mae and OFHEO over the potential
disclosure of proprietary information; OEO’s acting director said that OFHEO
temporarily stopped using contractors during the course of the risk
management exam as a result of this dispute. Fannie Mae officials told us
that they believe OFHEO lacks the statutory authority to use contractors as
full-fledged examiners. Instead, Fannie Mae officials said they believe that
OFHEO only has the authority to use contractors for temporary technical
assistance. Fannie Mae officials said that contractors could disclose
proprietary information gained during the examination process to the
enterprise’s direct competitors. In response, OFHEO’s general counsel told
us that the organization has statutory authority to use contractors during
the examination process. The general counsel also said that OFHEO has
implemented adequate procedures to protect proprietary enterprise
information. Among other procedures, OFHEO generally requires
contractors to (1) sign oaths to the effect that they will not disclose
proprietary information obtained from the enterprises and (2) turn over to
OFHEO officials materials obtained from the enterprises during the
examination process.


49
  OFHEO limits its contractor costs by hiring on a part-time basis.



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                       Soundness Examination Program




                       OEO’s  acting director stated to us that OFHEO plans to shorten the time that
OFHEO Plans to         it takes to complete the core risk examinations. He said that OFHEO plans
Reassess Its           to initiate an assessment of its examination program during 1997 and to
Examination Strategy   make procedural changes as necessary to enhance enterprise oversight by
                       early 1998. The acting director stated that OFHEO plans to assess the
and Staff Resources    appropriate mix of full-time staff, contractors, and detailees as well as
                       potential examination strategies that would shorten the current
                       examination cycle for assessing the core risks from 3 to 4 years to 1 year
                       rather than the 2-year cycle in the 1994 plan. The acting director stated
                       that shortening the examination cycle to 1 year is a reasonable goal
                       because OFHEO plans to fill its five vacant positions during 1997, which
                       would facilitate a faster examination cycle. Moreover, the acting director
                       said that the experience OFHEO has gained during the first round of
                       examinations should also shorten subsequent examination cycles. OFHEO
                       has hired OCC’s former Chief National Bank Examiner as a consultant to
                       advise the organization on assessing its examination strategy.

                       OEO’s acting director said that, as part of its reassessment, OFHEO plans to
                       determine the appropriate number of examiners and specialists necessary
                       to shorten the examination cycle to 1 year. According to OFHEO’s acting
                       director, OFHEO may shift resources from ORACS to OEO after the stress test
                       and risk-based capital standards are completed. Consequently, OFHEO may
                       have some flexibility over time to increase the resources in its
                       examination office without necessarily increasing its overall staffing levels
                       or budget.


                       OFHEO’s  examination program, along with the development of minimum
Conclusions            and risk-based capital standards, is an essential component for helping to
                       ensure the safety and soundness of Fannie Mae and Freddie Mac. Since
                       OFHEO began operations in 1993, the organization has made important
                       progress in developing a viable examination program. This progress
                       included developing a risk-focused approach to examinations, identifying
                       six core risks facing the enterprises, and completing or initiating
                       examinations to cover five of those six risks. In addition, OFHEO has
                       completed special exams of the enterprises’ nonmortgage derivatives
                       activities, compliance with flood insurance requirements, and data
                       integrity issues at Freddie Mac.

                       OFHEO  has also assembled an examination staff that has substantial
                       experience in monitoring financial institutions. However, limited staffing
                       levels and staff attrition—among other factors, such as the need for OFHEO



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                  Comprehensive Enterprise Safety and
                  Soundness Examination Program




                  to develop an understanding of the enterprises’ operations and risk
                  management—have compelled OFHEO to scale back the implementation of
                  a detailed examination schedule and plan that it established in 1994. As a
                  result, OFHEO has a 3- to 4-year cycle for examining the enterprises, which
                  is considerably longer than the 2-year cycle in the plan. OFHEO also reduced
                  the planned coverage of its business risk examination. In our view, OFHEO’s
                  inability to fully implement a comprehensive examination program limits
                  the organization’s ability to adequately monitor the enterprises’
                  management practices and financial condition.

                  According to OFHEO officials, the organization plans to reassess its
                  examination strategy and to make changes as necessary to shorten the
                  examination cycle from 3 to 4 years to 1 year. We are concerned that,
                  without a reassessment of resources, OFHEO may not be able to implement
                  an annual enterprise examination program that adequately covers all risk
                  areas by early 1998. Thus far, OFHEO has not been able to implement a
                  2-year examination cycle that fully covers all identified risk areas with
                  examination office resources currently assigned. In fact, as of June 1997,
                  OFHEO had not completed the first cycle of examinations and important
                  tasks remained. Thus, OFHEO’s plan to implement, even after it fills existing
                  OEO vacancies, an annual examination strategy by early 1998 represents a
                  substantial additional challenge to an examination staff that already has a
                  significant workload.

                  Therefore, we believe that including in OFHEO’s assessment an analysis of
                  the staff resources necessary to adequately carry out alternative
                  examination cycles, such as 1 or 2 years, could help ensure a fuller
                  consideration of the trade-offs associated with examination coverage
                  provided versus costs involved and thereby result in a more informed
                  decisionmaking process.


                  We recommend that OFHEO’s and OEO’s director promptly (1) conduct an
Recommendations   analysis to determine the examination office staff positions and financial
                  resources that would be needed to cover all core and targeted risk areas
                  within 1- or 2-year examination cycles; (2) identify the most appropriate
                  examination cycle after considering the trade-offs between examination
                  coverage and resource requirements that would be involved; and
                  (3) develop a strategy for obtaining the necessary examination office
                  resources, which may involve reallocating OFHEO’s existing full-time and
                  contracting positions over time.




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                     In written comments, the acting director of OFHEO agreed with our findings
Agency Comments      and recommendations regarding the examination program. The acting
and Our Evaluation   director attributed OFHEO’s relatively long 3- to 4-year examination cycle to
                     the fact that the enterprises had not been subjected to a safety and
                     soundness examination program prior to OFHEO’s creation. He also stated
                     that upon completion of the first round of examinations at year-end 1997,
                     OFHEO will have completed the “discovery” process that is essential to
                     understanding the quantity and quality of risk at the enterprises. The
                     acting director further stated that OFHEO will transition to a “continuous
                     examination process” at year-end 1997 that will allow for an annual
                     examination cycle. Moreover, the acting director said that OFHEO’s
                     previous examination work would allow it to prioritize future examination
                     activities while dramatically increasing the efficiency of the examination
                     process.

                     The acting director agreed with the report’s finding that adequate
                     resources must be committed to the examination program. He also said
                     that OFHEO should be able to attract and retain qualified examiners in the
                     future as a result of its increasing visibility in the regulatory community
                     and efforts to ensure pay comparability. Further, the acting director stated
                     that OFHEO will continue to review the adequacy of its examination staff
                     resources and supplement its permanent examination staff with expertise
                     from within OFHEO, bank regulatory detailees, and contractors.

                     While OFHEO has agreed to review the adequacy of its examination staff
                     resources, we believe it is essential that OFHEO promptly specify the
                     resources necessary to carry out an appropriate examination cycle and
                     develop a plan to obtain the permanent staff, detailees, and contractors
                     that may be required.




                     Page 67                                 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 4

OFHEO’s Implementation of Key Mission
Support Functions

                          In response to our statutory mandate to assess OFHEO’s overall operations,
                          we reviewed OFHEO’s implementation of key functions that support the
                          organization’s safety and soundness mission-related activities. These
                          mission-related support functions are OFHEO’s financial, human resources,
                          and contract management systems. Despite some initial implementation
                          challenges, OFHEO officials we contacted said that these mission-support
                          functions are now operating satisfactorily.

                          We also assessed whether OFHEO’s participation in a U.S. government
                          initiative to assist Mexico in developing a secondary mortgage loan market
                          has diverted OFHEO from fulfilling its safety and soundness mission.
                          Although OFHEO officials made 10 trips to Mexico in 1995 and 1996 to
                          support the initiative, the trips did not involve staffs directly responsible
                          for developing the stress test or conducting examinations. In addition,
                          most of OFHEO’s foreign travel and related costs were paid by the United
                          States Agency for International Development (USAID).

                          In this chapter, we also provide trend information on OFHEO’s budget and
                          staff resources and discuss OFHEO’s relationship with HUD to provide
                          further perspectives on how OFHEO has deployed its resources during its
                          first 4 years of operations.


                          Since our first report on OFHEO’s operations,50 the organization has
OFHEO Has                 implemented its financial management, human resource, and contracting
Implemented Its           mission support functions. According to OFHEO officials, the organization
Financial, Human          experienced some problems in making the support functions fully
                          operational. In particular, OFHEO experienced repeated problems with
Resources, and            HUD’s operations of its financial management systems, which OFHEO
Contract Management       officials said compelled them to convert to a different financial
                          management system offered by VA. Nevertheless, OFHEO officials said that
Functions                 they are now generally satisfied with the operational performance of these
                          support functions.


OFHEO Switched to a New   When OFHEO began its operations in June 1993, it relied on HUD’s financial
Financial Management      management system, which was called the HUD Administrative Accounting
System in 1996 After      System (HAAS). Under HAAS, OFHEO staff reviewed invoices and sent
                          approved invoices to HUD for payment processing. However, we reported
Repeated Problems With    in 1995 that HAAS did not meet OFHEO’s needs because, among other
HUD’s Systems             reasons, OFHEO staff had limited access to the system and experienced

                          50
                            GAO/GGD-95-123.



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                        substantial delays in how HUD recorded OFHEO obligations and expenses.
                        Also, HUD staff confused OFHEO with another HUD agency, the Office of Fair
                        Housing and Equal Opportunity (FHEO), which resulted in errors in OFHEO’s
                        financial reports. In October 1995, HUD converted OFHEO to its new
                        accounting system, the HUD Central Accounting and Program System
                        (HUDCAPS).

                        Although HUDCAPS offered improvements over HAAS, OFHEO officials said
                        that they remained dissatisfied with system access and performance and
                        the level of support provided by HUD. For example, OFHEO officials said that
                        HUD staff continued to inaccurately record transactions and did not
                        provide OFHEO with the support necessary to correct errors. In addition,
                        OFHEO officials said that there were prolonged periods when HUDCAPS was
                        unavailable, and OFHEO staff were unable to record transactions. These
                        deficiencies with HAAS and HUDCAPS caused OFHEO officials to initiate a
                        search for a new financial management system.

                        In 1996, OFHEO entered into a “cross-servicing” arrangement51 with VA, a
                        franchiser under the Government Management Reform Act,52 to operate
                        OFHEO’s financial management system beginning in fiscal year 1997. During
                        the first half of fiscal year 1997, OFHEO officials concentrated on the
                        conversion of the organization’s financial accounting activities from
                        HUDCAPS to the VA Financial Management System (FMS).


                        OFHEO officials said that the VA FMS has met their initial performance
                        expectations, but the conversion process was more difficult than initially
                        planned due to the amount of reconciliation needed to the financial data
                        contained in the HUD records. OFHEO officials said that they plan to have the
                        organization’s fiscal year 1997 financial statements audited by an
                        independent accounting firm.


OFHEO Has Implemented   Under the act, OFHEO has exclusive authority over hiring and compensation
Its Human Resource      levels for its personnel. The act further specifies that OFHEO personnel may
Management Systems      be paid without regard to certain provisions of federal law53 relating to

                        51
                          A “cross-servicing” agreement is an interagency agreement where one agency agrees to provide
                        specific services to another agency. As a small independent office, OFHEO is able to secure
                        administrative services from larger organizations having the capability to provide services on a cost
                        reimbursement basis.
                        52
                         Pub. L. No. 103-356, § 403 (1994), 31 U.S.C. § 501 note. This act establishes pilot programs at six
                        agencies designated by OMB to provide administrative support services to other agencies.
                        53
                         The act provides that OFHEO personnel may be paid without regard to provisions of Title 5, United
                        States Code, relating to classification and General Schedule pay rates. See 12 U.S.C. § 4515(a).



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                                     classification and general pay rates. In concert with the act, OFHEO has
                                     developed an independent classification and qualification system and pay
                                     structure. Occupations are to be based in part on the type of work done
                                     relative to OFHEO’s mission, the nature and subject matter of the work, and
                                     the fundamental qualifications required. The act also provides that OFHEO’s
                                     compensation levels should be comparable with those of OCC, the Federal
                                     Reserve System, the Federal Deposit Insurance Corporation, and the
                                     Office of Thrift Supervision. According to OFHEO, pay band levels are based
                                     on comparisons with similar occupations in those other federal financial
                                     regulatory agencies. OFHEO’s broad pay band structure is comprised of
                                     seven band levels, plus the executive-level director position, which is set
                                     by law. OFHEO’s staff members’ pay band levels also depend upon the
                                     complexity of the work, scope of responsibility, and supervisory
                                     responsibility. Table 4.1 shows the levels and number of positions
                                     assigned to those levels.

Table 4.1: OFHEO’s Pay Band Levels
and Positions in Each Band in 1996                                                                         Positions
                                     Level                                                Pay range          in level
                                       I                                            $15,876 - 26,460               0
                                       II                                            21,168 - 42,337               8
                                       III                                           31,753 - 58,213               8
                                       IV                                            42,337 - 79,381               5
                                       V                                            52,921 - 105,842              22
                                       VI                                           79,381 - 137,594              20
                                       VII                                          89,966 - 142,886               8
                                     Director                                               133,600                1
                                     Total                                                                        72
                                     Source: OFHEO.



                                     OFHEO  officials also said that the organization’s performance management
                                     system, the Performance Evaluation Management System (PEMS), was fully
                                     implemented by March 31, 1995, and that OFHEO began its first rating cycle
                                     in April 1995. Changes in base pay occur once a year, at the end of the
                                     PEMS performance review cycle, and are to be based solely on merit. An
                                     OFHEO official said that the organization is currently evaluating PEMS to
                                     ensure that it remains an effective tool for assessing the performance of
                                     the staff.




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                       According to an OFHEO official, on September 30, 1996, OFHEO’s Schedule A
                       authority54 to hire employees expired and by January 1997, the
                       organization had converted to the federal civil service competitive hiring
                       system and procedures. OFHEO officials expressed generally negative views
                       on the impact that the conversion from Schedule A hiring authority to civil
                       service hiring authority will have on the organization. The director of
                       ORACS said that the civil service procedures could impede OFHEO’s capacity
                       to hire necessary expert staff. OFHEO’s Director of the Office of Finance
                       and Administration said that it is too soon to evaluate the impact of the
                       conversion. However, she did say that the competitive service
                       requirements are much more time-consuming and cumbersome than the
                       Schedule A procedures.


OFHEO’s Contracting    During its start-up phase, OFHEO used HUD for procuring contracting
Authority Considered   services but experienced various difficulties. In our first report on OFHEO’s
Adequate for Mission   operations,55 we stated that HUD was not staffed to provide the expedited
                       procurement processing that OFHEO’s start-up mode of operations required.
Support                In June 1994, OFHEO hired its own procurement contracting officer and
                       exercised its contracting authority as provided in the act. According to an
                       OFHEO official, HUD’s general counsel has written a legal opinion stating
                       that OFHEO is subject to both the Competition in Contracting Act and the
                       Federal Acquisition Regulation. OFHEO officials we contacted said that the
                       organization has all of the contracting authority necessary to provide
                       mission support. Table 4.2 lists all of the contracts OFHEO entered into
                       between 1994 and the second quarter of fiscal year 1997. With the
                       exception of one contract terminated because of nonperformance, OFHEO
                       officials said they are generally satisfied with their contractors’
                       performance.




                       54
                         Schedule A hiring authority is one of the federal government’s excepted appointing authorities used
                       for hiring employees under special circumstances. This temporary authority, granted by the Office of
                       Personnel Management, permits agencies to fill positions without following the extensive
                       requirements of the competitive service. Schedule A hiring authority may be used if, for example, a
                       crash program or a new organization must be staffed so quickly that there is not time for following
                       established competitive service procedures.
                       55
                         GAO/GGD-95-123.



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Table 4.2: OFHEO Contracts by Value, 1994 to 1997
                                                                                                                                        Contract
Contractor                               Task description                                   Award date        End date                   amount
General Analytics Corporation            ADP-related work                                   07/06/94          09/30/97               $6,235,000
Haynes & Associates, Inc.                Examination-related work                           06/02/95          04/12/97                 1,911,000
Price Waterhouse                         Design & development work for the                  08/31/95          09/30/00
                                         financial simulation model                                                                    1,450,000
Computer Temporaries, Inc.               Various temporary services                         04/04/94          09/30/97                 1,057,000
Manufacturing Technology, Inc.           ORACS computer network                             05/26/94          09/01/94                   518,000
Strategic Compensation Association       Executive compensation study                       09/27/96          09/30/00                   289,000
Home Associates, Inc.                    Construction of OFHEO space                        03/31/97          03/31/97                   234,000
Ernst & Young LLP                        Information system & technical                     03/21/97          12/31/01
                                         examination support                                                                             212,000
Standard & Poor’s Rating Services        Credit rating of enterprises                       09/30/96          03/31/97                   200,000
INTEX Solutions, Inc.                    Simulate cashflow performance of                   09/30/96          09/30/01
                                         financial products                                                                              173,000
Risk Management Technologies             Design and development of financial                08/08/95          03/07/96
                                         database                                                                                        101,000
                                         Source: OFHEO.




                                         We assessed whether OFHEO’s participation in a U.S. government initiative
OFHEO’s                                  to assist Mexico in developing a secondary market for mortgage loans has
Participation in                         had a substantial impact on delaying the development of the stress test
Mexico Initiative Did                    and risk-based capital standards. A total of 8 OFHEO officials—the former
                                         director, 4 senior officials, and 3 staff members—made a total of 10 foreign
Not Involve Research                     trips related to the Mexico initiative in 1995 and 1996.56 Other participants
or Examination Staffs                    in the initiative included officials from OCC, the enterprises, and private
                                         sector institutions that specialize in housing finance. Under an agreement
                                         with USAID, USAID provided about $159,000 to OFHEO in 1996 to provide
                                         technical assistance to Mexico and for travel-related purposes. See
                                         appendix II for a more detailed discussion of OFHEO’s participation in the
                                         Mexico initiative and related costs.

                                         Based on a review of OFHEO’s travel records and discussions with senior
                                         staff, we do not believe that OFHEO’s participation in the Mexico initiative
                                         was a significant factor in delaying the development of the stress tests and
                                         capital standards or OFHEO’s inability to fully implement its examination
                                         program. For example, staff from OFHEO’s two principal mission-related

                                         56
                                          Except for the former director, OFHEO officials did not all participate in each of the 10 foreign trips.
                                         See appendix II of this report, table II.1.



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                                         Support Functions




                                         offices, ORACS and OEO, did not participate in the initiative or foreign trips.
                                         Other than the former director, the four senior staff who did participate in
                                         the initiative, the current acting director, the chief economist, the director
                                         of congressional affairs, and the director of public affairs estimated that
                                         they spent less than 5 percent of their time in 1996 on the Mexico
                                         initiative.57 For example, the chief economist estimated that he spent only
                                         about 2 weeks in 1996 traveling to Mexico and preparing for presentations.
                                         OFHEO officials said that the organization benefits from participating in
                                         outside activities, such as the Mexico initiative, because they increase staff
                                         development and allow the agency to gain exposure to and credibility with
                                         participants in the mortgage finance markets. The other three OFHEO
                                         officials who went on some of the foreign trips were staff members in
                                         OFHEO’s Office of the Director.



                                         Since OFHEO began its operations in June 1993, its obligations increased
OFHEO’s Financial                        from about $2.1 million at fiscal year-end 1993 to about $14.8 million at
and Staff Resources,                     fiscal year-end 1995 (see table 4.3). This growth reflects the staff and
1993-1997                                contractors hired that OFHEO considered necessary to carry out its mission,
                                         such as developing capital standards and conducting examinations. During
                                         fiscal year 1996, OFHEO’s obligations remained flat at $14.8 million and then
                                         increased by an estimated 5 percent in fiscal year 1997. Table 4.4 shows
                                         the growth of OFHEO full-time, contractor, and detailee staff for fiscal years
                                         1993 through 1997. Appendix III provides additional information about
                                         OFHEO’s staffing resources.


Table 4.3: OFHEO’s Obligations, Fiscal
Years 1993 Through 1997                  Dollars in thousands
                                                                                Actual       Actual       Actual     Actual      Estimated
                                         Obligation category                     1993         1994         1995       1996            1997
                                         Personnel servicesa                        $163     $2,690       $5,783     $7,234           $9,119
                                         Other servicesb                            1,956     2,473        5,858      4,800               3,793
                                                     c
                                         All other                                     7      1,323        3,139      2,758               2,588
                                         Total                                  $2,126       $6,486    $14,780      $14,792         $15,500
                                         Growth (%)                                  N/A        205%        128%        N/A                  5%
                                         N/A = Not applicable.
                                         a
                                          Obligations for the salaries and benefits of OFHEO personnel.
                                         b
                                             Obligations for contractor services.
                                         c
                                          Obligations for rent, travel, computer acquisition, etc.

                                         Source: OFHEO.
                                         57
                                           OFHEO did not provide an estimate of the time that the former director devoted to the Mexico
                                         initiative.



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Table 4.4: OFHEO’s Full-Time,
Contractor, and Bank Regulatory          Staff                                      1993       1994       1995         1996        1997a
Detailee Staff, at End of Fiscal Years   Full-time permanent                            7        37          63          66           58
1993-1997
                                         Full-time temporary                            1          4          4          10             7b
                                         Contract                                    N/A        N/A          24          20           19
                                         Detailee                                    N/A        N/A           2            5            1
                                         Total                                          8        41          93         101           85
                                         N/A = Not applicable.
                                         a
                                          As of March 31, 1997.
                                         b
                                             Includes one part-time temporary staff member.

                                         Source: OFHEO.




                                         OFHEO’s  relationship with HUD has provided mixed benefits. For example,
OFHEO’s Relationship                     OFHEO’s acting director said that OFHEO’s association with HUD allows OFHEO
With HUD                                 staff to keep apprised of developing housing and housing-finance issues. In
                                         addition, the acting director said that he believes that HUD has benefited
                                         from its relationship with OFHEO. For example, he said that OFHEO’s review
                                         and comments on HUD’s proposed regulations implementing its oversight
                                         of the enterprises’ compliance with the act’s housing-related goals resulted
                                         in improvements. However, OFHEO officials also said that HUD has not
                                         always been able to provide adequate support, such as in the case of its
                                         financial management systems.

                                         In a previously issued report,58 we commented on the current regulatory
                                         structure for the government-sponsored housing enterprises. One of the
                                         issues discussed was whether the regulation should be done in a
                                         stand-alone organization or an office within an executive branch agency.




                                         58
                                          See Government-Sponsored Enterprises: Advantages and Disadvantages of Creating a Single Housing
                                         GSE Regulator (GAO/GGD-97-139, July 9, 1997). This report commented on the potential benefits of
                                         merging OFHEO with the Federal Housing Finance Board.



                                         Page 74                                              GAO/GGD-98-6 Federal Housing Enterprises
Page 75   GAO/GGD-98-6 Federal Housing Enterprises
Appendix I

Financial Modeling and Computer
Programming Projects OFHEO Has Initiated
to Complete Development of the Stress Test
and Risk-Based Capital Standards
              Between 1994 and 1997, OFHEO initiated several financial modeling and
              computer programming projects to complete the development of the
              stress test and risk-based capital standards. Most of these projects had
              been completed by April 1997. The following summarizes several of the
              more important projects:

              OFHEO  developed the benchmark loss experience by November 1995: To
              develop the benchmark loss experience, OFHEO reviewed nationwide data
              provided by the enterprises that showed the loss histories on 5.6 million
              mortgage loans dating back to 1979. Based on this analysis, OFHEO has
              proposed that the benchmark loss experience be based on mortgage loans
              originated in Arkansas, Louisiana, Mississippi, and Oklahoma during 1983
              and 1984.

              OFHEO  translated the enterprises’ financial data into a common format.
              This project was completed by January 1996: According to OFHEO, the
              stress test and capital standards must treat the assets, liabilities, and
              off-balance-sheet obligations of both enterprises equally and consistently.
              OFHEO determined that the most efficient way of doing this was to translate
              both enterprise balance sheets into comparable standardized terms and
              units and run them through a single financial model. OFHEO has also
              reported that the most challenging aspect of this process was translating
              Fannie Mae and Freddie Mac’s huge data files into a consistent format to
              support stress test research. The process was further complicated by the
              differences in the ways that the enterprises record and report financial
              information. According to OFHEO, a contractor, Price Waterhouse, is
              continuing to transform the data so that it can be accessed more efficiently
              by OFHEO staff.

              OFHEO  decided to create a house price index rather than relying on an
              existing index. This project was completed in March 1996: To respond to
              the act’s stress test requirement that it assess the impact changing house
              prices would have on the enterprises’ mortgage portfolios, OFHEO
              determined that it needed to develop a new house price index rather than
              rely on the one available from the Department of Commerce. OFHEO’s
              house price index combines similar indexes that had been published
              jointly by Fannie Mae and Freddie Mac. OFHEO made some technical
              changes to publish an index that OFHEO officials said better met the
              organization’s regulatory requirements. OFHEO’s index, first published in
              March 1996, provides historical house price information on mortgage
              loans purchased by the enterprises since 1975. According to OFHEO, the
              organization’s house price index is superior to the Department of



              Page 76                                GAO/GGD-98-6 Federal Housing Enterprises
Appendix I
Financial Modeling and Computer
Programming Projects OFHEO Has Initiated
to Complete Development of the Stress Test
and Risk-Based Capital Standards




Commerce index for the purpose of determining the current values of
single-family properties securing enterprise loans.59

OFHEO  developed econometric models and computer programs to simulate
the financial performance of the enterprises. This work was completed by
June 1997. OFHEO developed software to simulate the cash flows of all
enterprise financial instruments and contracts, based on interest rate and
mortgage performance models. OFHEO also developed econometric models
to estimate mortgage default rates and loss severities and developed
computer programs to simulate operating decisions and translate cash
flow simulations into pro forma financial statements.




59
  OFHEO’s index is produced using data on single-family detached properties financed by conforming
conventional mortgages purchased by the enterprises. Thus, mortgages on properties that exceed the
conforming loan limit are excluded. The Department of Commerce index includes such
nonconforming loans, which was a reason OFHEO determined that the index was not appropriate for
the stress test.



Page 77                                             GAO/GGD-98-6 Federal Housing Enterprises
Appendix II

OFHEO Officials Have Participated in a U.S.
Government Initiative Assisting Mexico in
Developing a Secondary Mortgage Loan
Market
               The proposal for OFHEO’s collaborative efforts to facilitate a secondary
               mortgage market in Mexico resulted from the May 1995 U.S.-Mexico
               Binational Commission meeting during which the former HUD Secretary
               and Mexico’s Secretariat of Social Development (SEDESOL) Minister
               proposed a conference to be held in Mexico City in July 1995, to explore
               relevant policy issues. On September 11, 1995, OFHEO officials met with a
               subgroup of participants from the Mexico City conference, including the
               World Bank, USAID, Freddie Mac, and U.S. private sector institutions, to
               discuss ways to facilitate the development of a Mexican secondary
               mortgage loan market.

               Funding for most of OFHEO’s initiative was provided by USAID in the form of
               a Participating Agency Service Agreement (PASA), which went into effect
               on September 30, 1995. Under this agreement, USAID funds were used to
               pay for direct expenses (travel, conferences, studies, etc.) related to
               providing technical assistance to Mexico’s SEDESOL in the development of
               products, methodologies, and strategies to eliminate barriers to the
               successful development and implementation of a securitized secondary
               mortgage market in Mexico. Total PASA funds with USAID were $159,000 in
               fiscal year 1996, the first fiscal year of the agreement.

               During fiscal year 1996, OFHEO used PASA USAID funds to provide technical
               assistance to Mexico. This assistance included sponsoring seminars and
               papers on mortgage markets and related issues. For example, in
               April 1996, OFHEO sponsored a seminar and incurred nontravel-related
               expenses of $6,850 for such services as interpretation, transcription
               (English and Spanish), video and recording coverage, printing, copying,
               postage, office materials, telephone and fax charges, and a $6,400
               consulting fee for a summary of the proceedings and interviews with
               senior Mexican bankers in preparation for a project analyzing mortgage
               data. Other uses of PASA funds by OFHEO included shooting footage for a
               video on the development of a secondary mortgage market in Mexico and
               assembling a glossary, in Spanish, of housing finance and secondary
               mortgage market terms.

               During fiscal years 1995 and 1996, 8 OFHEO officials—the former director, 4
               senior officials, and 3 staff members—made 10 foreign trips related to the
               Mexico initiative (see table II.1). Travel expenses for these foreign trips
               totaled about $49,999 with USAID paying $27,018 in fiscal year 1996 and
               OFHEO expending a total of $22,981 of its own funds in fiscal years 1995 and
               1996. The four senior OFHEO officials—the acting director, chief economist,
               director of congressional affairs, and director of public affairs—who



               Page 78                                 GAO/GGD-98-6 Federal Housing Enterprises
                                           Appendix II
                                           OFHEO Officials Have Participated in a U.S.
                                           Government Initiative Assisting Mexico in
                                           Developing a Secondary Mortgage Loan
                                           Market




                                           participated in the foreign trips relating to the Mexico initiative estimated
                                           that they spent 5 percent or less of their time on Mexico-related work in
                                           fiscal year 1996. OFHEO did not provide any estimates on the amount of
                                           time that the former director spent on the Mexico initiative. Due to the
                                           relatively small amount of time committed to the Mexico initiative, OFHEO’s
                                           acting director said he does not believe that the organization’s
                                           participation had a material impact on the development of risk-based
                                           capital standards. In addition, he said that staff from OFHEO’s ORACS and
                                           OEO did not participate in the initiative. OFHEO’s support staff were used to
                                           create and distribute written materials and to administer the PASA
                                           agreement with USAID. The three other OFHEO employees who participated
                                           in some of the foreign trips are staff members in OFHEO’s Office of the
                                           Director.

Table II.1 OFHEO’s International Travel
Related to the Mexico Initiative, Fiscal                                   OFHEO
Years 1995 and 1996                        Travel date                   employees Itinerary               Funds            Cost
                                           FY 1995
                                           June 1995                               4 DC-Mexico-DC          OFHEO          $5,507
                                           July 1995                               5 DC-Mexico-DC          OFHEO           8,074
                                           FY 1996
                                           November 1995                           2 DC-Mexico-DC          USAID           3,401
                                           February 1996                           3 DC-Mexico-DC          USAID           3,063
                                           April 1996                              6 DC-Mexico-DC          USAID          10,353
                                           May 1996                                5 DC-Mexico-DC          OFHEO           5,988
                                           May 1996                                1 NY-Mexico-DC          OFHEO             617
                                           June 1996                               1 DC-Turkey-DC          OFHEO           2,795
                                           August 1996                             4 DC-Mexico-DC          USAID           5,384
                                           September 1996                          4 DC-Costa Rica-DC      USAID           4,817
                                           Total                                                                         $49,999
                                           Source: OFHEO.



                                           OFHEO’s acting director cited several benefits to OFHEO from its
                                           participation in initiatives undertaken with PASA funds. He said the primary
                                           benefit for OFHEO was that it allowed the organization to establish contacts
                                           with personnel in the mortgage industry and develop its stature as an
                                           independent regulator. In addition, he said that OFHEO was able to share
                                           information on its role and activities with interested parties.




                                           Page 79                                       GAO/GGD-98-6 Federal Housing Enterprises
Appendix III

OFHEO’s Staffing Levels, Fiscal Years 1993
to 1997

Table III.1: OFHEO’s Full-Time,
Contractor, and Bank Regulatory
Detailee Staff, Fiscal Year-End 1993                             Full-time Full-time      Full-time
                                                               permanent permanent      temporary
                                       Unit                     positions       staff          staff   Contract      Detail
                                       Director                                    3
                                       Research, Analysis,
                                       and Capital Standards                       1              1
                                       Examination and
                                       Oversight
                                       General Counsel
                                       Finance and
                                       Administration                              2
                                       Policy Analysis
                                       Congressional and
                                       Public Affairs                              1
                                       Total                                       7              1
                                       Source: OFHEO.



Table III.2: OFHEO’s Full-Time,
Contractor, and Bank Regulatory                                  Full-time Full-time      Full-time
Detailee Staff, Fiscal Year-End 1994                           permanent permanent      temporary
                                       Unit                     positions       staff          staff   Contract      Detail
                                       Director                                    6
                                       Research, Analysis,
                                       and Capital Standards                       8              2
                                       Examination and
                                       Oversight                                   7
                                       General Counsel                             3              2
                                       Finance and
                                       Administration                              6
                                       Policy Analysis                             3
                                       Congressional and
                                       Public Affairs                              4
                                       Total                          45          37              4
                                       Source: OFHEO.




                                       Page 80                                     GAO/GGD-98-6 Federal Housing Enterprises
                                       Appendix III
                                       OFHEO’s Staffing Levels, Fiscal Years 1993
                                       to 1997




Table III.3: OFHEO’s Full-Time,
Contractor, and Bank Regulatory                                  Full-time Full-time       Full-time
Detailee Staff, Fiscal Year-End 1995                           permanent permanent       temporary
                                       Unit                     positions       staff           staff   Contract      Detail
                                       Director                          7          7              1          1
                                       Research, Analysis,
                                       and Capital Standards            14          14             2         12
                                       Examination and
                                       Oversight                        14          13                        7           1
                                       General Counsel                   8          8              1                      1
                                       Finance and
                                       Administration                   11          10                        4
                                       Policy Analysis                   6          6
                                       Congressional and
                                       Public Affairs                    5          5
                                       Total                            65          63             4         24           2
                                       Source: OFHEO.



Table III.4: OFHEO’s Full-Time,
Contractor, and Bank Regulatory                                  Full-time Full-time       Full-time
Detailee Staff, Fiscal Year-End 1996                           permanent permanent       temporary
                                       Unit                     positions       staff           staff   Contract      Detail
                                       Director                          8          7              1
                                       Research, Analysis,
                                       and Capital Standards            17          15             5         11
                                       Examination and
                                       Oversight                        17          14             1          7           4
                                       General Counsel                   8          9              1                      1
                                       Finance and
                                       Administration                   11          11             1          2
                                       Policy Analysis                   6          5              1
                                       Congressional and
                                       Public Affairs                    5          5
                                       Total                            72          66            10         20           5
                                       Source: OFHEO.




                                       Page 81                                      GAO/GGD-98-6 Federal Housing Enterprises
                                      Appendix III
                                      OFHEO’s Staffing Levels, Fiscal Years 1993
                                      to 1997




Table III.5: OFHEO’s Full-Time,
Contractor, and Bank Regulator                                    Full-time Full-time       Full-time
Detailee Staff as of March 31, 1997                             permanent permanent       temporary
                                      Unit                       positions       staff           staff   Contract      Detail
                                      Director                             7         5
                                      Research, Analysis,
                                      and Capital Standards               17         14             4a        14
                                      Examination and
                                      Oversight                           17         12                        3           1
                                      General Counsel                      9         8              1
                                      Finance and
                                      Administration                      11         11             1          2
                                      Policy Analysis                      6         4              1
                                      Congressional and
                                      Public Affairs                       5         4
                                      Total                               72         58             7         19           1
                                      a
                                      One of the four staff members was part-time.

                                      Source: OFHEO.




                                      Page 82                                        GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV

Comments From the Office of Federal
Housing Enterprise Oversight




              Page 83        GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV
Comments From the Office of Federal
Housing Enterprise Oversight




Page 84                               GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV
Comments From the Office of Federal
Housing Enterprise Oversight




Page 85                               GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV
Comments From the Office of Federal
Housing Enterprise Oversight




Page 86                               GAO/GGD-98-6 Federal Housing Enterprises
Appendix V

Major Contributors to This Report


                        William B. Shear, Assistant Director
General Government      Wesley M. Phillips, Evaluator-in-Charge
Division, Washington,   Thomas J. Givens, III, Senior Evaluator
D.C.
                        Paul G. Thompson, Attorney
Office of the General
Counsel, Washington,
D.C.




(233512)                Page 87                               GAO/GGD-98-6 Federal Housing Enterprises
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