oversight

Farmer Mac: Revised Charter Enhances Secondary Market Activity, but Growth Depends on Various Factors

Published by the Government Accountability Office on 1999-05-21.

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

                United States General Accounting Office

GAO             Report to the Chairman, Subcommittee
                on Capital Markets, Securities and
                Government-Sponsored Enterprises,
                Committee on Banking and Financial
                Services, House of Representatives
May 1999
                Farmer Mac
                Revised Charter
                Enhances Secondary
                Market Activity, but
                Growth Depends on
                Various Factors




GAO/GGD-99-85
GAO                United States
                   General Accounting Office
                   Washington, D.C. 20548

                   General Government Division



                   B-280648

                   May 21, 1999

                   The Honorable Richard H. Baker
                   Chairman, Subcommittee on Capital Markets,
                    Securities and Government-Sponsored Enterprises
                   Committee on Banking and Financial Services
                   House of Representatives

                   Dear Mr. Chairman:

                   The Federal Agricultural Mortgage Corporation (Farmer Mac) is a
                   government-sponsored enterprise (GSE) that was established in 1988 with
                   a statutory mission to create a secondary market in agricultural mortgages,
                   thus improving the availability of agricultural mortgage credit. By 1996, it
                   was evident that Farmer Mac was having difficulties fulfilling its statutory
                   mission. To relieve structural impediments that had limited Farmer Mac’s
                   ability to function efficiently, Congress passed the Farm Credit System
                   Reform Act of 1996 (the 1996 Act), which significantly revised Farmer
                   Mac’s statutory authorities.

                   You asked us to review the progress that Farmer Mac has made in
                   achieving its statutory mission and examine its future viability. Our
                   objectives were to (1) examine actions taken by Farmer Mac to promote
                   the development of a secondary market, including the introduction of new
                   programs and products; the standardization of loan processes, including
                   loan documents and underwriting standards; and the use of risk
                   management techniques to facilitate safe and sound secondary market
                   activities, and (2) analyze Farmer Mac’s future viability and discuss the
                   potential benefits and costs of a government-sponsored secondary market
                   for agricultural mortgages.

                   In an attempt to make the secondary market in agricultural mortgages an
Results in Brief   attractive alternative for lenders, Farmer Mac has (1) used its enhanced
                   charter authorities to develop new programs and products and streamlined
                   the process for buying loans; (2) standardized certain aspects of the loan
                   processes, such as underwriting; and (3) developed risk management
                   techniques to facilitate safe and sound secondary market activities. While
                   these efforts have increased secondary market activity, Farmer Mac’s
                   share of the overall agricultural mortgage market remains small, about 1.2
                   percent.

                   Since its 1996 restructuring, Farmer Mac has introduced programs to
                   directly purchase agricultural mortgages from lenders and to exchange


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agricultural mortgage-backed securities (AMBS) for mortgage loans held
by lenders. Farmer Mac also has recently introduced a program (called
AgVantage) through which it, in effect, provides to agricultural lenders
loans that are based on agricultural mortgage collateral. Farmer Mac has
standardized some aspects of secondary market transactions by requiring
participating lenders to attest that their loans meet Farmer Mac
underwriting standards. However, Farmer Mac has not developed
standardized loan documents because it believes the cost would be
prohibitive given the state-by-state variability of laws governing
agricultural mortgages. Farmer Mac has also modified its loan
underwriting standards by, for example, requiring larger down payments to
address its increased exposure to credit risk allowed under the 1996 Act.
Farmer Mac purchased futures and options to help manage the interest-
rate risk of those loans it held in its portfolio, and its risk management
techniques appeared to be generally consistent with industry risk
management principles.

On the basis of our analysis, it appears that Farmer Mac could continue to
be viable if (1) its recent rate of expansion is maintained, (2) it continues
to experience rates of return that are comparable to current levels, and (3)
economic conditions in the national and agricultural economies remain
stable. For our analysis, we defined viability as the ability of Farmer Mac
to generate sufficient profit from its core business operations in the
secondary market in agricultural mortgages to provide a reasonable return
to its investors.

There are trends (such as those previously cited) and events that could
improve or worsen Farmer Mac’s financial condition. If Farmer Mac
develops new programs and products that are attractive to lenders or if
Farm Credit System (FCS) institutions or other lenders increase
participation in Farmer Mac programs, Farmer Mac’s financial condition
could improve. However, events such as a less favorable interest-rate
environment or declines in the credit quality of agricultural mortgages
could reduce Farmer Mac’s future profitability.

Even if Farmer Mac is viable under its current operating structure, the
more fundamental public policy issue is whether the public benefits it
generates are greater than the potential public costs it imposes. One
important determinant of the net benefits generated by Farmer Mac is the
extent to which its activities compete with or complement those of other
GSEs. Because there is potential for mission overlap among Farmer Mac,
FCS, and the Federal Home Loan Bank (FHLBank) System, new or
expanded activities by one of these entities can affect the benefits



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             generated by the other two. In judging Farmer Mac’s overall level of public
             benefit, Congress may want to consider how Farmer Mac interacts with
             these other GSEs.

             The Agricultural Credit Act of 1987 (the 1987 Act) authorized Farmer Mac
Background   to promote the development of a secondary market for agricultural real
             estate and rural housing loans. As a GSE, Farmer Mac is a federally
             chartered, privately owned and operated corporation that operates as a
             special purpose corporation. Farmer Mac is also an independent entity
                                                1
             within FCS, which is another GSE. When Congress passed the 1987 Act,
             some observers stated that a Farmer Mac-sponsored nationwide secondary
             market would develop quickly and be widely used. Others stated that
             Farmer Mac would serve more as a safety valve for the agricultural sector
             if FCS encountered difficulties.

             A secondary market is a financial market for buying and selling loans,
             either individually or in the form of securities backed by cash flows from
             groups or “pools” of loans. By authorizing Farmer Mac to promote the
             development of an agricultural secondary market, Congress intended to
             (1) increase the availability of long-term financing to creditworthy farmers
                                                                                    2
             and ranchers at stable interest rates and (2) provide greater liquidity in
             agricultural financing. Ideally, such a market would provide agricultural
             lenders with access to national capital markets, which, by returning cash
             to such lenders in exchange for the mortgages, would generate additional
             funds for them to lend and enhance their ability to manage credit and
             interest-rate risks.

             Under Farmer Mac’s originating statute, the 1987 Act, it was only to certify
             certain agricultural lenders and other financial institutions to act as third-
             party “poolers”that is, financial institutions that would buy qualified
             loans from other lenders or “originators,” assemble or “pool” the loans, and
             issue and sell securities that are backed by these pools to investors.
             Farmer Mac guarantees the timely payment of principal and interest to
             investors who purchase these mortgage-backed securities. The original
             statute did not permit Farmer Mac to buy and hold agricultural loans. The
             1987 Act also required either originators/poolers to maintain a cash reserve
             to cover at least the first 10 percent of losses arising from defaults on the
             pools of loans backing Farmer Mac-guaranteed securities or holders of
             subordinated participation interests (SPI) to absorb these losses before
             1
                 In this report, we treat Farmer Mac and FCS as two distinct GSEs.
             2
             A market is more liquid if investors can buy and sell large amounts of holdings without affecting the
             prices of the traded securities.




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                                                               3
Farmer Mac’s guarantee could be exercised. The purpose of the reserve
requirement was to minimize risks to Farmer Mac and the federal
government by requiring originators, poolers, and investors to hold most of
                       4
the loan’s credit risk.

Risk-based capital requirements for banks and FCS institutions required
them to hold capital against the full amount of the sold loan, not just the 10
percent retained by the lender. Regulators of primary market lenders (e.g.,
banks and FCS institutions) viewed the retained SPI as the source of
substantially all of the loan’s credit risk and, therefore, obtaining Farmer
Mac’s guarantee did not reduce the amount of capital the lender was
required to hold. As a result, the incentive for banks and FCS
institutionsmajor agricultural mortgage lendersto sell loans into
Farmer Mac-guaranteed loan pools was reduced. Further, the 1987 Act
required certain diversification standards to be met—that is, each pool was
to be made up of loans secured by properties from different geographic
locations that produce different agricultural commodities.

The necessity to operate through third-party poolers and establish the
mandatory cash reserve or SPI increased the complexity and expense of
secondary market transactions to both Farmer Mac and lenders. Under its
original operating structure, Farmer Mac was unable to achieve a profit,
and its prospects for survival were dim.

Eight years after its creation, Farmer Mac faced possible financial failure
                                                                             5
and was ineffective in creating a successful agricultural secondary market.
Farmer Mac requested and Congress granted new statutory authorities in
the 1996 Act to improve Farmer Mac’s ability to fulfill its statutory mission.
Among other things, the revised charter allowed Farmer Mac to (1)
purchase agricultural mortgage loans directly from lenders and serve as a
pooler, (2) eliminate the mandatory 10-percent minimum cash reserve and
SPI required with each loan pool and also eliminate the loan diversification

 3
   SPIs represent the right to receive a portion of the principal and interest payments on a loan or pool
of loans, but only after investors in the Farmer Mac-guaranteed securities backed by these pools had
received all payments due to them. Originators could have retained SPIs in the loans they sold to
Farmer Mac or they could have sold SPIs to a pooler.
4
The required 10-percent loss reserve generally exceeded historical worst-case scenarios by a wide
margin.
5
 According to our prior work, some factors that contributed to the slow development of the
agricultural secondary market included: strong liquidity of agricultural lenders, stringent regulatory
capital requirements for banks and FCS institutions originating agricultural mortgages, and weak loan
demandespecially for long-term, fixed rate loans. See Federal Agricultural Mortgage Corporation:
Secondary Market Development Slow and Future Uncertain (GAO/RCED-91-181, Sept. 10, 1991).




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standards, (3) have its securities accorded full “agency status” in the
                  6
financial markets, and (4) relax and delay the implementation of
regulatory capital standards for Farmer Mac. The first three revisions
made Farmer Mac’s operating structure essentially the same as Freddie
Mac’s and Fannie Mae’sthe GSE facilitators of the secondary markets for
residential mortgage loans.

Primary market lenders, secondary market entities, and investors in
securities backed by cash flows from loan pools face credit, interest-rate,
prepayment, management, and business risks. Farmer Mac faces credit
riskthat is, the possibility of financial loss resulting from default by
borrowers on farming assets that have lost value and/or other parties’
failing to meet their obligations. This risk occurs when Farmer Mac holds
mortgages in portfolio and when it guarantees principal and interest
                                                                            7
payments to investors in AMBS it issues. Farmer Mac’s interest-rate risk
can result from the possibility of an increase in interest rates in the
national economy that is not matched by an increase in interest rates paid
by borrowers to Farmer Mac for loans that are held in portfolio by Farmer
Mac. Farmer Mac’s prepayment risk can result from the possibility of a
decline in interest rates, which can cause borrowers to prepay their
            8
mortgages. Farmer Mac faces management risk from the possibility of
financial loss resulting from a management mistake that can threaten the
company’s viability. Finally, Farmer Mac faces business risk from the
possibility of financial loss due to conditions within the agricultural sector
that affect loan performance.

The risk characteristics of agricultural mortgage loans are different from
                                                                 9
those of conventional single-family residential mortgage loans.
Agricultural mortgages are commercial loans that fund a wide variety of
agricultural activities (e.g., poultry farms or orange groves), while single-
family mortgages fund a fairly homogeneous asset. As a result, in the event
of loan foreclosure, farm properties can be harder to appraise and more

6
 Agency status results from regulatory exemptions and trading preferences of GSEs’ securities. The
1996 Act requires (rather than allows) Federal Reserve Banks to act as Farmer Mac’s depositories and
fiscal agents.
7
 Interest-rate risk is the possibility that a fixed-rate debt instrument will decline in value as a result of a
rise in interest rates.
8
Prepayment risk is the potential loss of anticipated future income that results from borrowers’ paying
off their loans earlier than expected.
9
The common definition of a single-family residential mortgage is a loan for purchase or refinance of a
housing unit in a one- to four-unit structure. A conventional mortgage loan is one without federal
mortgage insurance.




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difficult to liquidate than a single-family residence. In addition, the
financial and business skills of farm operators can affect the value of their
collateral since their income comes largely from the mortgaged property,
rather than from independent employment or investment income. As a
result, assessing the risks of cash flows from agricultural loan pools can be
more difficult than such an assessment for single-family residential
mortgages. To some extent, agricultural mortgage loans are more like
multifamily loans than single-family loans because multifamily loans are
commercial loans in which income is derived largely from rental of the
mortgaged property.

Farmer Mac strives to fulfill its statutory mission mainly by purchasing
agricultural mortgages from lenders. Lenders who participate in the
primary market for such agricultural mortgages include federally insured
depository institutions, insurance companies, and FCS institutions. Once
purchased by Farmer Mac, the mortgages can be held directly in portfolio
or pooled to back newly issued AMBS. Farmer Mac, in turn, can hold some
AMBS in portfolio and sell some AMBS to investors in national financial
          10
markets. About $1.1 billion in total AMBS were outstanding as of year-end
1998; slightly more than half of the value was held by investors other than
Farmer Mac. Farmer Mac guarantees timely payment of principal and
interest to investors in its AMBS.

Farmer Mac conducts its operations through two broadly defined
programs. The Farmer Mac I Program consists of agricultural and rural
housing mortgage loans that do not contain federally provided primary
mortgage insurance. The Farmer Mac II Program consists of agricultural
mortgage loans containing primary mortgage insurance provided by the
U.S. Department of Agriculture (USDA). Farmer Mac was authorized in the
Food, Agriculture, Conservation, and Trade Act of 1990 (the 1990 Act) to
facilitate the creation of a secondary market for USDA-guaranteed
agricultural loans. Under Farmer Mac II, Farmer Mac can purchaseor
have others purchasethe guaranteed portions of USDA loans, assemble
them into pools, and hold them in portfolio or sell them as securities to
investors. At year-end 1998, Farmer Mac held $306.8 million of Farmer Mac
II AMBS in portfolio and other investors held $30.1 million.




10
 Farmer Mac also purchases rural residential mortgage loans and either holds them in portfolio or
pools them to back newly issued AMBS.




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              We focused our attention on the secondary market in agricultural
Scope and     mortgages under the Farmer Mac I Program because it is the primary
Methodology   program through which Farmer Mac conducts its secondary market
              activity. However, we included Farmer Mac II Program activity in our
              analysis of Farmer Mac’s future viability. To address our objectives overall,
              we reviewed relevant literature, congressional testimony, Securities and
              Exchange Commission public filings, and relevant Internet World Wide
              Web sites. We also held numerous discussions with Farmer Mac
              executives and interviewed representatives of the American Bankers
              Association, Independent Bankers Association of America, and the Farm
              Credit Council.

              To gain a better understanding of the agricultural mortgage market and its
              prospects for future growth, we met with financial and agricultural
              economists from USDA’s Economic Research Service. Additionally, to
              obtain a regulatory perspective on Farmer Mac activities, we met with
              officials from the Farm Credit Administration (FCA), the Director of FCA’s
              Office of Secondary Market Oversight, and the Department of the
              Treasury’s Director of GSE Policy. In our analysis of the agricultural
              mortgage market, we did not undertake detailed analyses of competing
              FCS or FHLBank System products. We also did not analyze the USDA loan
              guarantee programs.

              To determine Farmer Mac’s risk management practices and exposure to
              each type of risk, we (1) obtained Farmer Mac’s written and oral responses
              to questions on interest-rate, prepayment, credit, business, and
              management risks; (2) reviewed corporate policies and standards,
              including Farmer Mac’s Seller/Servicer Guide (Farmer Mac guide), which
              specifies lender requirements for participation in Farmer Mac programs;
              (3) obtained data on Farmer Mac’s current financial condition and
              operating results, such as delinquency rates and profit margins; (4)
              reviewed methodologies for determining capital adequacy, pricing,
              sensitivity to interest-rate changes, sensitivity to economic stress, and
              management information systems; and (5) examined copies of external
              auditors’ reports and management letters. We also reviewed FCA’s March
              1998 regulatory examination report and discussed the report with FCA
              officials.

              To help determine the potential market benefits from a government-
              sponsored secondary market for agricultural loans, we conducted a mail
                                                                         11
              survey of approved Farmer Mac sellers and nonparticipants. Using two
              11
                 An approved seller is a financial institution that has completed a seller application (supported by
              financial information, proof of sufficient insurance, and evidence of Farmer Mac stock ownership) and




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mail questionnaires, we conducted the survey in late 1998 and early 1999
and telephoned selected nonrespondents in 1999. We obtained information
on the background of the financial institutions, questioned their
knowledge of and participation in Farmer Mac programs, and sought their
views on Farmer Mac and the secondary agricultural mortgage market.
Survey participants were chosen from lists provided by Farmer Mac. The
263 institutionscommercial banks, thrifts, mortgage bankers, trust
companies, and FCS institutionson Farmer Mac’s approved sellers list
(as of Oct. 1998) and the 331 financial institutions of various sizes with
over $100 million in assets on Farmer Mac’s nonparticipants list (as of Oct.
                                           12
1998) were sent the respective surveys. To the list of 331 nonparticipants,
we added 3 large insurance companies that are agricultural mortgage
lenders that were not on Farmer Mac’s list. Our survey results are not
generalizable to the universe of agricultural lenders, but the results are
generalizable to the unique groups identified by Farmer Mac and us. We
did not examine the impact of Farmer Mac on agricultural mortgage
interest rates or the availability of agricultural mortgage credit. See
appendixes I and II for a more detailed description of our survey
methodology and survey results, respectively.

We constructed financial scenarios using various assumptions to help
illustrate Farmer Mac’s ability to sustain mission viability as described in
appendix III. We defined mission viability as the ability of Farmer Mac to
generate a profit from its core business of operating a secondary market in
agricultural mortgages and to provide a reasonable rate of return to its
equity investors. Our purpose was to construct scenarios to illustrate
conditions that could affect Farmer Mac’s future viability. These scenarios
do not represent forecasts of the future. We were limited by our reliance
on publicly available data in presenting our scenarios.

We reviewed the legislative history and statutory authorities governing
Farmer Mac. We also reviewed legal opinions written by and on behalf of
Farmer Mac, FCA, and the Farm Credit Council. The legal opinions
addressed whether Farmer Mac has the authority to undertake the
AgVantage Program, which is discussed in more detail in the next section
of this report. The opinions also focused on the statutory language of the
Farm Credit Act of 1971 (the 1971 Act), as amended, defining the

had it approved by Farmer Mac. A nonparticipant is a financial institution that has not been approved
by Farmer Mac to participate in Farmer Mac’s programs.
12
   By using a Farmer Mac-provided nonparticipants’ list of commercial banks meeting certain Farmer
Mac-determined thresholds, we eliminated from our survey many agricultural banks having $100
million or less in assets.




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                       authorities of Farmer Mac as well as the legislative history of the 1971 Act
                       and Farmer Mac’s mission. We also discussed the legal opinions with
                       officials from these three entities.

                       To provide a perspective on secondary market servicing guidelines and
                       procedures, in addition to reviewing the Farmer Mac guide, we reviewed
                       two Fannie Mae guides for servicing single-family and multifamily
                       residential mortgages.

                       We did not independently verify the information supplied by Farmer Mac
                       or others.

                       We conducted our work in Washington, D.C., between July 1998 and April
                       1999 in accordance with generally accepted government auditing
                       standards. We obtained written comments on a draft of this report from
                       the President and Chief Executive Officer of Farmer Mac. His written
                       comments are discussed at the end of this letter and are reprinted in
                       appendix IV.

                       Farmer Mac has developed new programs and products in an attempt to
Farmer Mac’s Actions   provide an alternative source of funding for agricultural lenders. Farmer
Taken to Promote       Mac also has used its new charter authorities to streamline the process for
Secondary Market       buying loans, including some standardization, and developed a program to
                       market its products to agricultural lenders. The market’s reception of
Growth                 Farmer Mac’s products thus far has been limited, and Farmer Mac’s loan
                       purchase volumes have remained small in relation to the primary market.
                       For example, the share of agricultural mortgages sold to Farmer Mac has
                       shown some growth since the 1996 restructuring, but its market share
                       represented about 1.2 percent of the agricultural mortgage debt
                       outstanding as of the third-quarter of 1998. In addition to its loan purchase
                       programs, Farmer Mac, in 1998, initiated its AgVantage Program in which
                       Farmer Mac in effect provides loans to agricultural lenders with the
                       lenders’ using agricultural mortgages as collateral. Activity under this
                       program has been of relatively small volume to date.

                       In an attempt to facilitate an efficient secondary market, Farmer Mac has
                       streamlined the process for buying loans and standardized some aspects of
                       a secondary market transaction, including underwriting guidelines, but it
                       believes that standardized loan documents, such as those used in the
                                                                                              13
                       secondary market for residential mortgages, would be cost prohibitive.

                       13
                        Standardization refers to the application of established and industrywide loan documentation
                       procedures in connection with loan originations.




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                     To mitigate its exposure to risks, Farmer Mac uses risk management
                     techniques to help it conduct secondary market activities in a safe and
                     sound manner.

New Programs and     In its effort to stimulate greater secondary market activity, since 1996
                     Farmer Mac has developed several new programs and loan products that
Products Have Been   were designed to increase participation by traditional (e.g., rural banks) as
Introduced           well as nontraditional (e.g., mortgage banks) agricultural mortgage
                     lenders. Through workshops and various marketing initiatives, Farmer
                     Mac has increased the number and types of sellers approved to sell loans
                     to Farmer Mac, established new programs, and expanded its product line.
                     Farmer Mac expected these initiatives to enhance market reception to
                     Farmer Mac, thereby increasing the volume of agricultural mortgages sold
                     in the secondary market.

                     Secondary market activity is likely to be greater when the secondary
                     market creates products that help lenders and investors manage various
                     risks at low cost. For example, interest-rate risk associated with long-term,
                     fixed-rate loans can often be managed at lower cost by secondary market
                     investors (e.g., AMBS investors, including Farmer Mac) with access to
                     long-term bond financing relative to primary market financial institutions
                     that rely on deposit bases. Secondary market entities, such as Farmer Mac,
                     can also use their nationwide operations to obtain geographic
                     diversification of their loan purchases to help manage credit risk. While
                     standards for underwriting, appraisal, and loan servicing are used to help
                     manage credit risk, secondary market entities have relatively less ability
                     than lenders to rely on borrower relationships to assess credit risk. Thus,
                     from the pool of loans meeting their underwriting standards, secondary
                     market entities increase their risk of purchasing loans with high credit risk
                     from less creditworthy borrowers.

                     By establishing a training program, Farmer Mac sought to educate and
                     attract lenders by increasing their interest in and improving their
                     understanding of Farmer Mac and the secondary market for agricultural
                     mortgages. In 1997, over 800 lenders attended the more than 20
                     seller/servicer workshops that Farmer Mac conducted across the nation to
                     inform lenders of Farmer Mac’s new authorities and programs and of the
                     benefits of participating in the agricultural secondary market. Marketing
                     initiatives have resulted in Farmer Mac’s approving several nationally
                     known, large commercial banks and mortgage banks as approved sellers
                     from which it could buy loans, which has increased the potential for lender
                     diversity. The initiatives also expanded the number of outlets through
                     which Farmer Mac products can be marketed to customers. Lenders



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approved to submit loans for possible sale to the Farmer Mac I Program
                                14
totaled 286 as of December 1998. At its peak under the old charter,
Farmer Mac had nine approved sellers (at that time known as poolers).

The mechanism that Farmer Mac established to purchase mortgages
directly from lenders for cash and provide loans to agricultural lenders
(i.e., the AgVantage Program) is called its Cash Window Program. This
program grew out of the 1996 legislation that granted Farmer Mac greater
flexibility in its business dealings with agricultural lenders. The 1996 Act
authorized Farmer Mac to purchase loans directly from originating
lenders. Before this act, lenders could only participate in the secondary
market by selling agricultural real estate loans to qualified Farmer Mac
poolers. Additionally, the Cash Window Program was designed to (1)
provide lenders with new product terms and competitive interest rates for
agricultural real estate loans and (2) provide a responsive process for
better servicing the credit needs of lenders’ borrowers. The Cash Window
Program began in July 1996 and by December 1998, $732 million in loans
were sold to Farmer Mac.

In late 1997, Farmer Mac introduced its Part-Time Farm Program, which
covered farms with substantial off-farm income. This program offers a
fixed-rate, 30-year home mortgage product for farms on at least five acres
of land or farms generating at least $5,000 in gross farm sales from
agricultural crops or livestock. The value of the home must represent at
least 30 percent of the total appraised value of the property. Farmer Mac
sought to facilitate the use of this program by making the origination and
servicing requirements simple and using familiar documents and
procedures. For example, standard conforming residential secondary
                                                     15
market origination forms are used in this program.

In February 1998, as an expansion of the Cash Window Program, Farmer
Mac established the AgVantage Program, which allows Farmer Mac to fund
eligible lenders by providing cash advances. The primary difference
between the AgVantage Program and existing Farmer Mac programs is
that, in this program, the lender does not sell its loans to Farmer Mac but
instead issues a bond backed by eligible loans and other collateral. To

14
   Farmer Mac had 265 approved sellers as of October 1998, which was our cutoff date for including
institutions in our survey. Forty-six percent (91 of 196) of those approved sellers responding to our
survey reported actually completing transactions with Farmer Mac for the period January 1997 through
September 1998. Of those institutions selling, pledging, or swapping loans, the average dollar amount
transacted by an institution during that period was $6.1 million.
15
 Conforming mortgages are residential mortgages that meet Fannie Mae and Freddie Mac underwriting
standards and are within the current 1999 conforming limit of $240,000.




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facilitate access to this program, Farmer Mac has provided standard
documentation, including a standard form for the bond. Farmer Mac
                                       16
guarantees the bond and purchases it. This transaction allows the lender
to keep the loans and associated credit risk, while increasing its debt and
liquidity positions. Farmer Mac is to receive low-risk income from the
bond and guarantee fees. This program was designed to meet the demand
for long-term loans by being attractive to lenders with excess collateral,
but inadequate liquidity.

Since the program’s February 1998 inception through December 1998, 16
AgVantage bond transactions had been consummated with 10 AgVantage
issuers, resulting in Farmer Mac guarantees for $143.6 million of
AgVantage bonds. Due to the short-term nature of the obligations that had
been issued, only $10.8 million of the $143.6 million remained outstanding
at year-end 1998.

In addition to the Cash Window, Part-Time Farm, and AgVantage
Programs, Farmer Mac can purchase loans through a Swap Program
(introduced in early 1997). A swap is a transaction in which lenders
exchange one or more eligible loans for Farmer Mac-guaranteed securities,
                  17
rather than cash. Unlike Cash Window transactions, which generally
involve loans with Farmer Mac-specified terms, Farmer Mac is to negotiate
these swap transactions with the lender and is to acquire loans with
payment, maturity, and interest-rate characteristics that Farmer Mac
would not purchase through its Cash Window Program. In January 1999,
Farmer Mac reported that it had committed to enter into a $408 million
long-term, standby purchase commitment that operates similarly to a swap
                          18
in agricultural mortgages. As of January 1999, Farmer Mac had

16
   Farmer Mac purchases general bond obligations issued by qualified lenders that are collateralized by
Farmer Mac I- or Farmer Mac II-qualified farm mortgages, rather than purchasing the loans outright
from lenders and then selling AMBS to investors. In April 1998, FCA concluded that the AgVantage
Program was within Farmer Mac’s statutory authority. In reaching her conclusion, FCA’s General
Counsel found that the AgVantage bonds are securities guaranteed by Farmer Mac, issued by certified
facilities, and represent obligations backed by pools of qualified loans.
17
   Many qualified loans should be eligible for swap transactions on the basis of their conformity to
Farmer Mac’s “existing loan” criteria, which require that the loans be outstanding for at least 5 years
and have low (60 percent or less) loan-to-value ratios and other indications of performance. Qualified
loans outstanding for less than 5 years are eligible for swap transactions only on the basis of their
conformity to Farmer Mac’s more stringent credit ratios as of the date of their origination and are to be
subject to other performance analyses.
18
 According to a Farmer Mac press release, the recipient of the standby commitment segregates the
loans on its books and pays Farmer Mac an annual fee approximating its usual guarantee fee on the
outstanding balance of the loans, in return for Farmer Mac’s assumption of the credit risk on those
loans. This structure permits the lender to retain the loans while reducing its credit risk and
concentration exposures and, consequently, its capital requirements.




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consummated four Farmer Mac I swap transactions totaling approximately
$493 million (includes the previously mentioned $408 million transaction).

In 1997 and early 1998, complementary to its existing product lines,
Farmer Mac developed new loan products that included a refined 1-year
adjustable rate mortgage (ARM) and a new 3-year ARM with flexible
borrower prepayment terms. These two loan products can be converted to
a long-term, fixed-rate loan after a certain time period has elapsed. Farmer
Mac also developed a 10-year, fixed-rate mortgage. See table 1 for a list of
Farmer Mac’s programs and their descriptions and features, in addition to
the various loan products offered.




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Table 1: Farmer Mac programs and products
Program                 Program description                                  Product feature
              a
Farmer Mac I
 Cash Window Program    Sellers receive cash by selling 100 percent          Terms and rates are described below under the Full-Time
                        of qualifying first mortgage agricultural real       Farm, Part-Time Farm, and AgVantage Programs.
                        estate loans directly to Farmer Mac.
   Full-Time Farm       Designed for borrowers who live on                   Types of agricultural loans offered include:
    Program             agricultural properties and derive a                 • 15-year fixed rate, 15-year maturity with 15- or 25-year
                        significant portion of their income from farm          amortization and partial open prepayment (annual,
                        employment.                                            semiannual, or monthly payments);
                                                                             • 10-year fixed rate and 10-year maturity fully amortizing
                                                                               (semiannual or monthly payments);
                                                                             • 5-year reset loan with a 5-, 10-, or 15-year term; 5-, 10-,
                                                                               15-, or 25-year amortization and open prepayment without
                                                                               penalty (annual, semiannual, or monthly payments);
                                                                             • 1- and 3-year ARMs, 15-year maturity, 15- or 25-year
                                                                               amortization, and open prepayment (semiannual
                                                                               payments); and
                                                                             • facility loans, 10- or 15-year fixed rate maturity, and fully
                                                                               amortized.
   Part-Time Farm          Designed for borrowers who live on                Farmer Mac offers a 30-year fixed rate residential mortgage,
    Program                agricultural properties with a valuable           which is a fully amortizing loan with monthly principal and
                           residence and derive a significant portion        interest payments and no prepayment limitations.
                           of their income from off-farm employment.
   AgVantage Program       Allows sellers to retain qualified mortgages      AgVantage bonds may range in maturity from short-term to
                           in portfolio and sell securities backed by        15 years and have low fixed or variable rates of interest.
                           those mortgages to Farmer Mac.
 Swap Program              Agricultural lenders receive mortgage-            Security terms, rates, etc., are negotiated with the seller on
                           backed securities in return for qualifying        the basis of the characteristics of the loan.
                           agricultural real estate mortgages.
              b
Farmer Mac II
 Cash Window Program       Lenders receive cash by selling 100 percent       • 7-year fixed rate and 15-year fixed rate based on full
                           of the guaranteed portion of USDA loans             amortization;
                           directly to Farmer Mac.                           • 5- or 10-year fixed rate based on full amortization with 5- or
                                                                               10-year rate reset periods—which are tied to the Farmer
                                                                               Mac 5- or 10-year Reset Cost of Funds Index Net Yield;
                                                                               and
                                                                             • floating rate is tied to Farmer Mac 3-month Cost of Funds
                                                                               Index’s “Net Yield” with calendar quarter rate adjustments
                                                                               or The Wall Street Journal’s Prime Rate.
 Swap Program              Lenders receive Farmer Mac-guaranteed             Security terms, rates, etc., are negotiated with the seller on
                           securities in return for the guaranteed           the basis of the characteristics of the loan.
                           portion of USDA loans.
                                             a
                                              Farmer Mac I operates as a secondary mortgage market for high-quality agricultural real estate and
                                             rural home mortgages. Participation is limited to financially healthy farmers as established in the
                                             Agricultural Credit Act of 1987.
                                             b
                                             In the 1990 Act, Farmer Mac was authorized to serve as the pooler for secondary sales of agricultural
                                             and rural development loans that are guaranteed by USDA. This program benefits borrowers who are
                                             unable to get commercial credit at affordable rates because of financial problems.
                                             Sources: Farmer Mac and FCA.




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Increased authority granted to Farmer Mac by the 1996 Act, which allowed
its operating structure to parallel that of Fannie Mae and Freddie Mac, has
provided it with flexibility to develop programs. However, this expanded
operational authority does not mean that program success will be
guaranteed or that expected outcomes will be achieved. Although Farmer
Mac has expanded its seller base and provided lenders with streamlined
procedures, including some standardization, to access the secondary
market, Farmer Mac acknowledges that it cannot be certain whether the
new products it offers will generate a sufficient volume of loans that would
allow Farmer Mac to continuously function as a profitable corporation.

One key factor that could hinder lenders’ use of Farmer Mac programs
would be their lack of knowledge about these programs. Our survey
results showed that familiarity with Farmer Mac programs varied widely,
with the majority of the nonparticipating respondents being unfamiliar
with the programs52 percent and 62 percent were unfamiliar with
Farmer Macs I and II Cash Window Programs, respectively. With other
programs, familiarity was even lower70 percent of the respondents were
unfamiliar with the AgVantage Program, and over 87 percent were
unfamiliar with the Swap Programs under Farmer Macs I and II. Even
among approved sellers, familiarity with some Farmer Mac programs was
low. For example, 31 percent of the respondents were unfamiliar with the
AgVantage Program; 75 percent and 78 percent were unfamiliar with the
Swap Programs under Farmer Macs I and II, respectively.

The AgVantage Program’s volume has been relatively small to date, but
nevertheless, Farmer Mac officials consider the program to be beneficial
because it encourages lenders to do business with Farmer Mac and it is
considered to be competitive with advances offered by the FHLBank
       19
System. Furthermore, Farmer Mac officials believe that the AgVantage
Program is more advantageous to lenders than FHLBank System advances
considering that AgVantage loans can be sold to Farmer Mac at a later time
without the need for any additional paperwork requirements.

On the basis of our survey, 23 percent of the approved sellers surveyed
said they are “likely” or “very likely” to participate in the AgVantage
Program in the next 3 years; among nonparticipants, this proportion was
12 percent. The extent to which these lender inclinations result in
increased secondary market activity for Farmer Mac has yet to be
determined.

19
 FHLBanks make loans, called advances, on the security of mortgages and other collateral, to lenders
who are owner-members of the FHLBank System.




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Farmer Mac Has                Standardization, such as the development of standardized loan documents,
                              can help streamline the process for buying loans. Thus, standardization
Standardized Some Loan        has the potential to help lower transaction costs and increase the
Processes                     efficiency of the secondary market. Farmer Mac had standardized some
                              aspects of the secondary market transaction by requiring its agricultural
                                                                                          20
                              mortgage lenders to make representations and warranties that the loans
                              they are selling meet Farmer Mac underwriting standards. Farmer Mac
                              officials told us that standardized loan documents have not been
                              developed because of the prohibitive cost associated with standardization
                              given that state laws governing agricultural mortgage loans and
                              agricultural lending practices vary from state-to-state. Farmer Mac had
                              established lender requirements in its Farmer Mac guide that provides
                              various levels of standardization for different lender practices.

Loan Documentation Was        Although its statute is silent on loan document standardization, Farmer
Standardized to Some Extent   Mac has, to some extent, taken steps to standardize loan documentation
                              for the agricultural secondary market. Standardization of loan origination
                              documents is common in the secondary market for residential mortgages.
                              In the secondary market for residential mortgages, Fannie Mae and
                              Freddie Mac have increased efficiency through greater standardization of
                                                                   21
                              mortgage products and processes. Standardized documents can reduce
                              the cost and effort necessary to evaluate the quality of asset pools because
                              inspection or review of each lending arrangement can be replaced with
                              verification that adherence to the predetermined industrywide standards
                              for loan origination has been maintained.

                              Farmer Mac officials stated that early in Farmer Mac’s existence, it sought
                              to standardize loan documents but was not able to achieve a level of
                              standardization approaching that achieved by Fannie Mae and Freddie
                              Mac. These Farmer Mac officials attributed this inability to differences in
                              agricultural real estate state laws that differ greatly from state-to-state.
                              Residential real estate state laws are more uniform. These officials also
                              stated that, with the diversity of agricultural lender practices and the
                              heterogeneous characteristics of agricultural loans, developing nationwide
                              documents would be difficult and costly.



                              20
                                 A representation is any statement, or any attempt to give an impression about a state of facts, that
                              was done to convince another person to make a contract. A warranty is a statement, either written or
                              implied, that assertions made in completion of a contract are true.
                              21
                               See Housing Enterprises: Potential Impacts of Severing Government Sponsorship (GAO/GGD-96-120,
                              May 13, 1996), pp. 4 and 54.




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Farmer Mac generally allows agricultural lenders the option of using
Farmer Mac forms, their own forms, or an off-the-shelf commercial loan
package. According to Farmer Mac’s Chief Executive Officer and General
Counsel, the vendor of the off-the-shelf package is to guarantee Farmer
Mac that each loan package meets the legal requirements of all states
where the loans were originated. These officials also stated that Farmer
Mac forms do not meet the legal requirements of all states. Farmer Mac
provides loan origination forms on a disk for use by lenders, but it only
requires that participants use the loan summary and environmental survey
forms. As long as other forms used by the lenders present information in
substantially the same format as Farmer Mac forms, the use of Farmer
Mac’s forms is not required. These Farmer Mac officials noted that small
lenders, rather than large lenders, are more apt to use the off-the-shelf
commercial product because small lenders often lack in-house legal
departments.

The Chief Executive Officer and General Counsel of Farmer Mac stated
that regardless of whether the loan documents used are the lender’s own
or those of the commercial vendor, the documents must include legally
enforceable standard Farmer Mac representations, warranties, and
provisions to ensure that the loans conform to Farmer Mac’s loan
underwriting and appraisal standards. These officials also stated that since
the initial use of representations and warranties in 1991, they have
encountered no problems enforcing the terms of the loan agreements. The
Farmer Mac guide states that Farmer Mac is to verify, via examination of
loan files, that the documents submitted by lenders conform to Farmer
Mac’s underwriting standards and other loan origination requirements.
Also, as stated in the Farmer Mac guide, Farmer Mac’s verification of loan
files does not relieve lenders of their obligations under the representations
and warranties provided to Farmer Mac.

For its part-time farm loansessentially, residential mortgage
loansFarmer Mac uses the standard, conforming residential mortgage
loan application and documentation forms used in the residential mortgage
secondary market. Also, to improve the consistency of information
included in the closing/settlement statements for all loans sold to Farmer
Mac, lenders are required to use the standard Department of Housing and
Urban Development closing/settlement statement, which is commonly
known as the HUD-1. This document provides an itemized listing of the
funds that are payable at closing, such as loan fees and real estate
commissions.




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                                   When submitting a loan for sale to Farmer Mac, sellers are to follow the
                                   following general steps:

                                 • Meet with the customer and prepare a preliminary approval loan package.
                                 • Submit the package to Farmer Mac for preliminary approval.
                                 • Following approval and lock in of interest rate, complete the appraisal and
                                   title work.
                                 • Close and fund the loan.
                                 • Deliver executed legal documents to Farmer Mac for final approval.
                                 • After being notified of final approval, submit a Notice of Purchase Request
                                   at least 2 days before the desired purchase date. (Farmer Mac wires
                                   purchase funds on the basis of the seller’s instructions.)

                                   If the loan documents are properly completed and submitted in
                                   accordance with Farmer Mac guidelines, the entire loan process from
                                   submission to completion is expected to take about 8 business days.

                                   Farmer Mac officials expressed no concerns with their current approach
                                   of using lender or commercial off-the-shelf loan documents. They felt that
                                   the legal protections afforded by the inclusion of the Farmer Mac standard
                                   representations, warranties, and provisions were more important than the
                                   standardization of the forms. They also noted that the use of lender
                                   documents better supported the Swap Program since forms do not have to
                                   be redone. Also, the officials said that the current costs to Farmer Mac of
                                   achieving further standardization of loan documents exceed the benefits.

Farmer Mac Had Developed           The Farmer Mac guide specifies requirements for lender participation in
Standardized Lender Guidelines     Farmer Mac programs. The Farmer Mac guide requires participating
                                   lenders to follow certain standardized practices. For example, Farmer
                                   Mac requires inclusion of standardized representations and warranties
                                   (e.g., the seller is authorized to do business and loan information
                                   submitted to Farmer Mac is true and correct). In addition, the Farmer Mac
                                   guide specifies requirements for underwriting, collection of mortgage
                                   payments, administration of escrow accounts, and initiation of foreclosure
                                   proceedings. The guide includes nine underwriting standards, including
                                   those pertaining to obtaining a credit report and financial statements, the
                                   borrowers’ debt-to-asset ratio, and the loan-to-value (LTV) ratio for the
                                   financed agricultural property. The Farmer Mac guide provides some
                                   underwriting flexibility to recognize differences and variances in financial
                                   reporting of agricultural borrowers. It also provides flexibility for special
                                   loan-servicing practices associated with specific agricultural activities,
                                   such as livestock operations and properties with irrigation systems. The




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Farmer Mac guide includes sections on loan-making, -selling, and
-servicing as well as seller requirements for participation in Farmer Mac
programs. Individual chapters of the guide include credit and appraisal
standards for various programs and guidelines for managing loan
delinquencies.

To provide perspective to the Farmer Mac guide, we compared it with the
two previously mentioned Fannie Mae guides for servicing residential
                                                                22
mortgagesthe single-family guide and the multifamily guide. The Fannie
Mae guides differ from the Farmer Mac guide due to differences in the
types of industry served and loan programs. For example, single-family
residential mortgages generally are not commercial loans (i.e., most
finance owner-occupied housing), while multifamily residential and
agricultural mortgages are commercial mortgages. Fannie Mae’s
multifamily guide includes separate sections for its delegated underwriting
program and negotiated transactions. Under its delegated underwriting
program, Fannie Mae delegates its authority to underwrite and determine
the creditworthiness of a loan to the originating lender and agrees to
purchase the loan without prior review. In return for this autonomy, the
lender is to assume a percentage of the risk of default on the loan. In
contrast, Farmer Mac generally takes on the full credit risk of backing
AMBS. This practice conforms most closely to Fannie Mae’s negotiated
transactions program. In this program, Fannie Mae, similar to Farmer
Mac, provides some underwriting flexibility to recognize differences
among multifamily properties in specifying lender obligations in
transaction documents.

The Fannie Mae and Farmer Mac guides share some similarities in the
topics that they cover. For example, Fannie Mae’s single-family guide and
the Farmer Mac guide, have sections on lender relationships, mortgage and
property insurance, special mortgage programs, delinquent mortgages, and
mortgage foreclosures. However, the Fannie Mae guides address each
servicer requirement and guideline in greater specificity than the Farmer
Mac guide does. Farmer Mac officials told us that they continuously work
on further developing Farmer Mac’s guide as the corporation grows.




22
 We also reviewed Fannie Mae’s Forms Guide, which contains required Fannie Mae standardized
forms to be used by lenders.




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Farmer Mac Uses Risk       Farmer Mac is expected to fulfill its public policy purpose and earn a profit
                           by taking prudent risks. Like any other private financial firm, Farmer Mac
Management Techniques to   faces risks from changes in market interest rates; loan defaults and other
Help Ensure Safe and       credit problems; external business factors, such as natural disasters or
Sound Operations           industry competition; and poor management decisions that may adversely
                           affect its profitability. Farmer Mac uses risk management procedures in its
                           operations to help ensure that its secondary market operations are
                           conducted in a safe and sound manner. Farmer Mac has mechanisms in
                           place to measure, monitor, and take actions to control, its exposure to
                           these risks.

                           On the basis of (1) unverified information provided by senior officers of
                           Farmer Mac and its federal regulator and (2) reports and analyses done by
                           third parties, such as external auditors and consultants, it appears that
                           Farmer Mac generally manages its operations in ways that are consistent
                           with industry risk management principles. For example, Farmer Mac
                           strives to limit interest-rate risk by issuing AMBS in the capital markets
                           and attempts to control losses from other risks, such as credit risk,
                           through the monitoring of seller/servicer financial condition and servicing
                           performance.

                           Principles of risk management that have been developed by various
                           financial industry and regulatory bodies stress the importance of board of
                           directors and management involvement in managing the risks undertaken
                                                     23
                           by financial institutions. Under these principles, an organization’s risk
                           management strategy is to be based on a framework of responsibilities and
                           functions, driven by the board of directors down to operating levels, which
                           are to cover all aspects of risk. The basis for this principle is the belief that
                           unless the board of directors is fully integrated into the risk management
                           approach, the organization’s managers and employees will not be fully
                           committed to risk management. To emphasize the importance of risk
                           management, these principles state that a risk management group made up
                           of senior managers is to be created. Farmer Mac’s risk management
                           function is overseen by the Asset Liability Committee, which is made up of
                           senior managers, and its Board of Directors’ Finance Committee.




                           23
                            Principles of risk management have been developed by various industry and regulatory bodies,
                           including the Bank for International Settlements, the International Organization of Securities
                           Commissions, the Derivatives Policy Group, U.S. bank regulators, and a group assembled by Coopers &
                           Lybrand. All of these risk management principles are broadly similar. The principles listed in this
                           report are termed generally accepted risk principles and were developed by Coopers & Lybrand.




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                                                            24
Interest-Rate Risk   Like other portfolio lenders, Farmer Mac is exposed to interest-rate risk
                     (the possibility of an increase in interest rates in the national economy that
                     is not matched by an increase in interest rates paid by borrowers whose
                     loans are held in portfolio by Farmer Mac). Farmer Mac employs several
                     techniques to control interest-rate risk. Farmer Mac measures its exposure
                     to interest-rate risk. Farmer Mac’s management and Board of Directors
                     are to ensure compliance with its interest-rate risk policy limits. Farmer
                     Mac also purchases financial instruments to help manage part of its
                     exposure to interest-rate risk. Constant monitoring and adjustment of the
                     control techniques are necessary to avoid increases in Farmer Mac’s
                     exposure to interest-rate risk, which changes over time as the economy
                     and its portfolio change.

                     Farmer Mac is exposed to interest-rate risk on its portfolio of guaranteed
                     securities and other investments and on loans purchased through the Cash
                     Window Program.

                     Measurement of interest-rate risk. The following two techniques are
                     employed by Farmer Mac to measure interest-rate risk: duration gaps and
                     market value of equity sensitivity.

                     Duration gaps measure the average economic life of a whole portfolio,
                     rather than the time to final payment for each asset or liability. The
                     difference between a firm’s asset and liability durations is called its
                     duration gap.

                     The duration gap measures the overall interest-rate risk exposure of
                     Farmer Mac. The larger the gap in absolute value, the greater Farmer
                     Mac’s exposure to interest-rate risk. For example, if Farmer Mac’s average
                     economic life of its assets is 1.5 years greater than the average economic
                     life of its liabilities, then it has a duration gap of 1.5 years. Should interest
                     rates rise, Farmer Mac’s net interest income would fall because interest
                     expenses would rise sooner than interest income. Farmer Mac tries to
                     manage interest-rate risk by managing its portfolio to keep the duration
                     gap within a certain parameter.

                     Another technique that Farmer Mac uses in measuring interest-rate risk is
                     to estimate the sensitivity of its market value net worth to various changes
                     in interest rates. Market value net worth provides a measure of Farmer
                     Mac’s ability to absorb losses. Financial firms report their income

                     24
                      A portfolio lender purchases loans to hold in portfolio or makes loans, or does both of these activities,
                     and in the process can earn net interest income.




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statements and balance sheets according to generally accepted accounting
                     25
principles (GAAP). GAAP relies primarily on the historical (book) value
of the financial assets and liabilities, rather than on their current market
value. The market value of such assets and liabilities is affected by current
interest rates, but the market value also can change if the likelihood of
prepayment or repayment changes. The market value of assets minus the
market value of liabilities provides the market value of net worth.

For example, Farmer Mac carries a 10-year, 8-percent loan at the amount
of unpaid principal over the life of the loan. If interest rates decrease, the
market value of the loan increases because the loan earns a higher yield
than the yield on a new loan. Likewise, the market value declines if interest
rates rise because the yield would be greater on a new loan. One method of
monitoring a firm’s exposure to interest-rate risk is to regularly determine
the market value of the firm’s assets and liabilities (marking-to-market)
and project how market value would change for assumed changes in
interest rates.

Management of interest-rate risk. Once its interest-rate risk exposure is
measured, Farmer Mac managers can change Farmer Mac’s exposure by
various actions that lengthen or shorten the expected maturity of assets
and liabilities so that payment streams on assets and liabilities behave
similarly. The managers may issue liabilities with variable maturity terms
or call featurescallable debt allows Farmer Mac to repay its bonds after
a specified time frame, which is a useful option if interest rates were to
declineor levy prepayment penalties on borrowers who prepay their
mortgages when interest rates fall. This is known as prepayment risk.
Prepayment penalties allow Farmer Mac to offer competitive interest rates
to farmers and ranchers and entice investors to accept lower rates of
return on their investment in Farmer Mac-guaranteed securities. However,
as indicated by agricultural lenders’ responses to our survey, prepayment
penalties reduce the competitive attractiveness of Farmer Mac products as
compared with agricultural loan products offered by FCS and other
agricultural lenders without prepayment penalties.

Management of interest-rate risk is important at Farmer Mac because of its
investment portfolio and pipeline operations (loans submitted to Farmer
Mac for approval and loans approved but not yet committed for
purchase—i.e., locked in interest rate). Farmer Mac controls interest-rate
risk associated with portfolio lending by striving to closely match the

25
 GAAP is a set of accounting rules and conventions defining acceptable practices in preparing financial
statements. GAAP’s aim is to provide conformity in financial statements reporting.




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              interest-rate sensitivity of its assets and liabilities and by requiring a yield
                                       26
              maintenance provision for loans that are paid off earlier than their
              scheduled payoff date. In addition, interest-rate risk can be avoided by
              issuing and selling AMBS and shifting the interest-rate risk to investors. In
              its role as financial guarantor of AMBS, Farmer Mac does not directly
              undertake interest-rate risk. Also, through the use of sophisticated hedging
              techniques, such as futures contracts, Farmer Mac attempts to align the
              duration of its assets and liabilities, thereby minimizing interest-rate risk.

              Farmer Mac monitors interest-rate risk exposure through duration gaps
              and market value equity sensitivity reports that identify interest-rate
              mismatches. These two reports are provided to Farmer Mac’s Board of
              Directors on a regular basis.

Credit Risk   Credit risk is the possibility of financial loss resulting from default by
              borrowers on farming assets that have lost value and/or other parties’
              failing to meet their obligations. Credit risk is inherent in the daily
              operations of all financial firms, including Farmer Mac. Like other financial
              firms, Farmer Mac’s underwriting standards represent a major tool in
              limiting credit risk. Farmer Mac uses several techniques to measure and
              manage its credit risk exposure.

              Measures of credit risk. Farmer Mac uses the two following basic
              measures of credit risk: (1) the volume of loans or bonds that are not
              performing according to the contractual agreement and (2) the dollar
              losses to Farmer Mac resulting from such nonperforming loans or bonds.

              Typically, when a borrower fails to make a scheduled payment, the loan is
              termed delinquent. Delinquency rates are an early indicator of credit
              problems. After a period of continuing delinquency, the loan servicer or
                                                                                 27
              Farmer Mac may act to recover the loan principal by foreclosing on the
              property and filing a claim with any party that insured or guaranteed the
              loan. At the time of foreclosure, the loan is said to have defaulted.
              Generally, only a small fraction of delinquent loans default. Farmer Mac
              said it monitors delinquency rates on a monthly basis, and its delinquency
              rates over the last 2 years have generally been less than 1 percent.



              26
               A yield maintenance provision is an agreement designed to discourage prepayment and to
              compensate lenders for reinvestment costs during periods of falling interest rates.
              27
               Foreclosure is a legal proceeding initiated by a creditor to take possession of collateral securing a
              defaulted loan.




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The financial losses from defaults include any principal of the loan or bond
                                                                         28
not repaid, interest not paid, and expenses to foreclose or restructure,
adjusted by recoveries from collateral sales and insurance. Defaults and
loss rates can be predicted by Farmer Mac when it has historical default
and loss data for similar types of loans in various economic circumstances.
With new types of products, defaults and losses are difficult to predict
accurately, and product performance must be monitored carefully to
control credit risk. Farmer Mac only has a limited history of loan
performance data, so it uses the historical loan loss data of a FCS
institution to construct hypothetical loan pools to estimate losses on loan
pools. The result is to be used to determine the level of guarantee fees that
Farmer Mac needs for a pool of loans to generate sufficient income to
provide an adequate return and maintain a minimum level of capital.

Methods to manage credit risk. Farmer Mac manages credit risk by trying
to control the number of defaults and minimize the losses that result from
defaults. Farmer Mac controls defaults through credit underwriting,
appraisal standards, and geographic and commodity diversification
standards that provide a quality control over the credit risks it takes and
help it to prevent defaults. To minimize losses from any defaults that do
occur, Farmer Mac uses techniques called credit enhancements (e.g.,
USDA guarantees or collateral requirement) that should allow Farmer Mac
to recover portions of its potential losses from collateral or from third
parties, such as lenders, loan insurers, or loan guarantors.

Underwriting standards. Farmer Mac has underwriting standards to
determine which mortgages it will buy, that it could then hold as
investments or place into mortgage pools. Underwriting is the process of
identifying the potential risks of loss associated with financial activities to
determine loan eligibility, and underwriting also aids in the pricing of such
risks. Underwriting is an integral part of business and financial
transactions that occur daily throughout the private and public sectors of
the economy and involve the transfer and pricing of risk. Underwriting
standards provide guidelines that are used to (1) limit the type and amount
of risk of loss permitted in a financial portfolio and (2) establish methods
to control such risks. Farmer Mac’s underwriting standards are discussed
in appendix V.




28
   A loan restructuring occurs when a lender grants a concession to a borrower in financial difficulty.
For example, the lender negotiates a workout agreement with the borrower to modify the original
credit terms, rather than initiate foreclosure proceedings against the delinquent borrower.




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Before Farmer Mac purchases a loan or bond or guarantees a security,
certain underwriting standards are to be met. Underwriting standards
cover numerous borrower and property characteristics that help Farmer
Mac evaluate the likelihood of defaults and the severity of related losses.
For example, as stated in the Farmer Mac guide, Farmer Mac has
underwriting standards that indicate (1) whether a borrower has sufficient
income to make the scheduled payments and a credit history suggesting
that the borrower has met past obligations in an acceptable manner and
(2) the maximum LTV ratio, which measures the borrower’s equity (down
payment) in the property. Experience has shown that borrowers with low
amounts of equity in the property, and thus high LTV ratios, are more likely
to default than borrowers with high amounts of equity. Farmer Mac has
also established appraisal standards to estimate the value of the property
serving as collateral for the mortgage and geographic and commodity
diversification standards to mitigate Farmer Mac’s exposure to a particular
agricultural region or commodity product.

Because Farmer Mac does not make loans directly, standards are also to
be used to qualify other parties to participate in its credit activities. For
example, Farmer Mac has established standards for lenders, Central
                                          29
Servicers, and Contract Underwriters. Such standards include measures
of financial strength, past performance indicators, and management
quality. Lenders, Central Servicers, and Contract Underwriters expose
Farmer Mac to risks of default to the extent that they fail to follow
standards adequately when making the loan or fail to collect payments
diligently. Farmer Mac has also established audit and quality control
procedures to monitor the performance of lenders, Central Servicers, and
Contract Underwriters. Farmer Mac also sets standards for firms with
which they share financial risk. For example, when Farmer Mac enters a
transaction to exchange cash flows as a means to limit its interest-rate
risk, there is credit risk that the other party may fail to meet its obligation
(i.e., counterparty risk). To mitigate such risk, Farmer Mac sets minimum
standards of financial strength for such parties.

Farmer Mac said it contracts out certain functions to take advantage of the
experience and efficiency of outside resources. Two key functions that are
contracted out are Farmer Mac’s loan-servicing function and credit loan-
underwriting function. As discussed below, Farmer Mac is to mitigate the
risks of contracting by performing annual on-site inspections of the third-
parties’ operations for compliance with the terms of their agreements.

29
 Central Servicers and Contract Underwritiers are firms that Farmer Mac has contracted with to
provide loan-servicing and loan underwriting services, respectively.




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Farmer Mac divides the loan servicing into two functions, the Central
Servicer and the Field Servicer. The Central Servicer has entered into a
contract with Farmer Mac to provide general servicing for certain Farmer
Mac I loans and is responsible for directing the Field Servicer in the
performance of such servicer’s duties. The duties of the Field Servicer
include things such as maintaining borrower relationships, servicing the
loans, annually inspecting the mortgaged property to detect any adverse
trend in the property’s condition and preparing a report related to such
inspection, and monitoring for current hazard insurance policy and tax and
assessment payments. The Field Servicer is also to assist the Central
Servicer in resolving delinquent loans. The Central Servicer is also
responsible for establishing, maintaining, and monitoring delinquent loans.
Farmer Mac annually performs an on-site review of the Central Servicer to
make certain that it is in compliance with the terms of the contract
agreement. In addition, the Central Servicer is required to have its
independent public accountants review its servicing operations for
compliance with Farmer Mac requirements.

Contract Underwriters are entities that have entered into contracts with
Farmer Mac to perform the function of underwriting loans in accordance
with Farmer Mac’s underwriting and appraisal standards. Contract
Underwriters are required to review appraisals to ensure compliance with
the requirements set forth in the Farmer Mac guide. Farmer Mac annually
performs on-site due diligence of the Contract Underwriter and checks for
compliance with Farmer Mac requirements.

Farmer Mac made modifications to address increased credit risk since
passage of the 1996 Act. Before changes in Farmer Mac’s operating
structure authorized by the 1996 Act, Farmer Mac was responsible for a
loan’s credit loss in excess of 10 percent of outstanding loan principal. The
10-percent cash reserve or SPI required for every loan pool formed and
securitized covered the first 10 percent in losses.

As a result of its new legislative authority granted in 1996, to purchase
agricultural mortgage loans directly from lenders and to issue and
guarantee 100 percent of the securities backed by such loans without a
lender cash reserve or SPI requirement, Farmer Mac is subject to a first
              30
loss position. To mitigate its increased credit risk position, Farmer Mac
took the following steps


30
 The first loss position refers to the first 10 percent of losses arising from defaults on the pools of
loans backing Farmer Mac-guaranteed securities.




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• Farmer Mac lowered its loan underwriting standard LTV ratio for a
  qualified loan from 75 percent to 70 percent for loans up to $2.3 million.
  This change requires borrowers to increase their down payment or risk
  sharing in the loan, thereby decreasing the chance that borrowers will
  default on their loans because of their larger equity stake. The LTV ratio is
  important in determining the probability of default and the magnitude of
  loss.

• Farmer Mac increased the annual pool fee rate it normally charges lenders
                                                                 31
  for providing loan pool guarantees from 25 to 50 basis points —the
  maximum allowed by statute—of the initial principal loan amount. A
  portion of this fee is required by law to be set aside by Farmer Mac in a
  segregated account as a reserve against losses arising from its guarantee
  activities. Among other things, full recourse must be taken against such
  reserve before Farmer Mac may be authorized to draw upon its $1.5 billion
  line of credit with the Department of Treasury to satisfy its guarantee
  obligations.

• Farmer Mac established new loan loss reserves for Farmer Mac I loans
  securitized after 1996 (i.e., AMBS). Loan loss reserves represent the
  estimated amount necessary to cover anticipated credit losses in the loan
  portfolio. Farmer Mac I loans securitized before1996 had to be supported
  by the 10-percent cash reserve or SPI requirement.

  To mitigate the credit risk from new products, Farmer Mac requires the
  following:

• AgVantage bonds, which are general obligations of the issuer, are to be
  over-collateralized continuously by eligible collateral in an amount ranging
  from 120 percent to 150 percent of the bonds’ outstanding principal
  amount, depending on the financial status of the borrower. Eligible
  collateral includes qualified loans, cash, U.S. treasury securities, or
  securities guaranteed by an agency or instrumentality of the federal
  government.

• The eligibility for part-time farm loans, which are generally residential
  loans, is to be determined on the basis of lenders’ compliance with the
  underwriting standards that are used for conforming residential
  mortgages. Part-time farm loans are underwritten to conforming
  residential ratiosa 28-percent inside ratio (monthly housing expense to
  gross monthly income) and a 36-percent outside ratio (total monthly debt
  31
       A basis point is one one-hundredth of a percentage point.




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                  expense to gross monthly income). Income may come from farming or
                  nonfarming sources.
                                                                                        32
                  Farmer Mac currently uses a credit-scoring model to monitor the credit
                  quality of loans in pools to determine the financial performance of
                  approved sellers and to determine if loan loss reserves are adequate. In
                  addition, Farmer Mac stated that it uses credit scoring in connection with
                  its credit approval process, but not as a determinative factor for credit
                  approval.

Business Risk     We defined business risk as the possibility of financial loss due to
                  conditions within the agricultural sector that affect loan performance. For
                  example, Farmer Mac has business risk associated with being limited to
                  operating in the agricultural and rural housing lines of business. Business
                  risk cannot be easily measured, and many business risk factors are
                  difficult to anticipate and control.

                  Farmer Mac is limited in its ability to manage its business risk exposure by
                  legislation that requires it to serve a specific public mission. Farmer Mac’s
                  charter requires that its activities be concentrated in the buying and selling
                  of agricultural and rural housing loans across the nation and in good and
                  bad economic conditions. This requirement prohibits Farmer Mac from
                  seeking alternative business opportunities to supplement, diversify, or
                  replace current business when economic conditions or the promise of
                  higher returns would lead a private firm into other lines of business.
                  However, Farmer Mac can shift assets into new products and investments
                  within its given line of business.

                  Even though diversification standards were eliminated by the 1996 Act,
                  Farmer Mac requires its loan pools to be diversified both geographically
                  and, with respect to agricultural commodities (products), to help it to
                  avoid large exposure to regional economic shocks. Farmer Mac has
                  established a standard for the maximum percentage that a region or
                  commodity product can make up of the portfolio, which Farmer Mac said
                  it periodically monitors for compliance.

Management Risk   Management and operations risk (subsequently referred to as management
                  risk) is the possibility of financial loss resulting from a management
                  mistake that can threaten the company’s viability. In many respects,
                  management risk encompasses all of the risks faced by Farmer Mac,

                  32
                   A credit-scoring model uses statistical analysis to identify and weigh (or score) the characteristics of
                  borrowers who have been most likely to make loan payments.




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                       including interest-rate, credit, prepayment, and business risks. For
                       example, since Farmer Mac’s management establishes loan standards and
                       financing policies, its decisions determine Farmer Mac’s exposure to credit
                       and interest-rate risk. Generally, the managers can expose Farmer Mac to
                       losses through incompetence, inadequate planning, poor internal controls,
                       risky business strategies, fraud, and negligence. Management risk is not
                       easily quantified, but its control is crucial to the firm’s successful
                       operation.

                       Farmer Mac generally controls its exposure to management risk through
                       personnel administration, strategic and operational planning, its
                       policymaking process, internal controls systems, management information
                       systems, and board of directors and management oversight of firm
                       operations.

                       The dollar value of Farmer Mac’s loan purchases and the size of the
Indicators of Farmer   secondary market have both increased since passage of the 1996 Act. Both
Mac’s Mission          trends represent positive indicators of progress in fostering secondary
Achievement and        market developments. Even with this expansion, Farmer Mac-guaranteed
                       securities and individual mortgage holdings accounted for about 1.2
Future Viability       percent of the agricultural mortgage debt outstanding as of the third-
                       quarter of 1998. This compares to the approximately 16 percent of
                       multifamily residential mortgage loans accounted for by the housing
                       enterprises (Fannie Mae and Freddie Mac) as of year-end 1997.

                       Our analysis shows that Farmer Mac is currently viable in its agricultural
                       mortgage mission activities. However, Farmer Mac’s future viability
                       depends on its growth potential in the secondary market for agricultural
                       mortgages and the prospects for realizing that potential are unclear. There
                       are trends and events that could improve or worsen Farmer Mac’s financial
                       condition. If Farmer Mac develops new products that are attractive to
                       lenders or if FCS institutions or other lenders increase participation in
                       Farmer Mac programs, Farmer Mac’s financial condition could improve.
                       However, events such as a less favorable interest-rate environment or
                       declines in the credit quality of agricultural mortgage could reduce Farmer
                       Mac’s future profitability. Even if Farmer Mac continued to be
                       economically viable under its current operating structure, it is difficult to
                       determine whether the public benefits created justifies continued
                       government sponsorship. These public benefits could affect and be
                       affected by the activities of two other GSEsFCS and the FHLBank
                       System. These benefits and costs are difficult to quantify.




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Indicators of Farmer Mac’s          Since the 1996 restructuring, two key measures show that Farmer Mac has
                                    made some progress in fulfilling its statutory mission by fostering
Mission Fulfillment                 secondary market development. Specifically, the dollar amounts of Farmer
                                    Mac’s loan purchases and issued securities have both increased since
                                    passage of the 1996 legislation.

                                    To foster development of a secondary market, Farmer Mac must be able to
                                    sustain growth in the purchase of loans over time. Loan purchase data
                                    provided by Farmer Mac are shown in table 2. Loan purchases have
                                    continued to grow in both of the Farmer Macs I and II Programs. Of
                                    particular importance is (1) the sustained growth in the Farmer Mac I
                                    Program and (2) data showing that the upward trend in this program has
                                    been greater than the growth of the Farmer Mac II Program. Total loan
                                    purchase dollar volumes have increased since the 1996 Act.

Table 2: Annual Loan Purchases by
Farmer Mac at Year-end 1995-98      Dollars in millions
                                    Program                  1995            1996            1997             1998
                                    Farmer Mac I            $113.5          $162.3          $230.5            424.3
                                    Farmer Mac II             56.3            92.5            95.0            119.8
                                    Total                   $169.8          $254.8          $325.5           $544.1
                                    Source: Farmer Mac.

                                    The dollar value of Farmer Mac-guaranteed securities and loans held for
                                    securitization are also key indicators of secondary market development.
                                    After loans are purchased by Farmer Mac, they are grouped into packages,
                                    or pooled, and issued as Farmer Mac-guaranteed securities (i.e., AMBS).
                                    Farmer Mac either sells the securities to others or holds them in portfolio.
                                    Decisions to hold securities in portfolio or offer them for sale depend upon
                                    prevailing market conditions and are influenced by factors such as the
                                    market liquidity of the securities, the ability of investors to estimate risks
                                    of holding the securities, and general market knowledge about and
                                    acceptance of the securities. As shown in table 3, the amount of Farmer
                                    Mac-guaranteed securities outstanding has more than doubled since year-
                                    end 1995. Additionally, the amount held in portfolio has been fairly stable
                                    while the amount held by others has grown, which indicates a growing
                                    acceptance of AMBS, leading to a broader secondary market.




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Table 3: Farmer Mac’s Secondary
Market at Year-end 1995-98        Dollars in millions
                                                                                                         Percentage
                                                                                                            change
                                  Category                 1995        1996        1997          1998       1995-98
                                  Farmer Mac I            $278.6      $217.1      $192.9        $228.5      (18.0)%
                                  held by
                                  Farmer Mac
                                  Farmer Mac II            138.5       199.4       249.5         306.8         121.5
                                  held by
                                  Farmer Mac
                                   Subtotal               $417.1      $416.5      $442.4        $535.3          28.3
                                  Farmer Mac I             $94.7      $214.4      $385.8        $567.5         499.3
                                  held by others
                                  Farmer Mac II                 4.8     11.6         23.3         30.1         527.1
                                  held by others
                                   Subtotal                $ 99.5     $226.0      $409.1       $597.6          500.6
                                  Total                   $516.6      $642.5      $851.3      $1,132.9         119.3
                                  securities
                                  outstanding
                                  Loans held for                0.0     13.0         47.2        168.1             --
                                  securitization
                                  Total                   $516.6      $655.5      $898.5      $1,301.0       151.8%
                                  secondary
                                  market
                                  Source: Farmer Mac.



Secondary Market                  Even though Farmer Mac’s operating results have been positive since its
                                  1996 statutory changes, its secondary market penetration rate (i.e.,
Penetration Rate Remains          percentage share of the agricultural mortgage market) remains small and
Small                             is low compared to the penetration rate of the housing enterprises in the
                                  residential secondary markets. Interest income from nonmortgage
                                  investments is a significant source of income at Farmer Mac.
                                                           33
                                  In 1991, we reported that Farmer Mac’s authorizing legislation indicated
                                  that Congress expected Farmer Mac would be able to develop a large,
                                  nationwide secondary market quickly, and that it would be widely used.
                                  We also reported that the secondary market development to that point had
                                  been slow, and that the future was uncertain.

                                  While Farmer Mac’s penetration of the agricultural mortgage market has
                                  been growing, it remains relatively small. As shown in table 4, at year-end
                                  1995 there were about $517 million Farmer Macs I and II securities
                                  outstanding. Agricultural mortgage debt outstanding at that time was
                                  about $84.8 billion; Farmer Mac’s market penetration was about 0.6
                                  percent of this total market. Farmer Mac estimated that about half of the

                                  33
                                       GAO/RCED-91-181.




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                                         agricultural mortgage loans outstanding at that time met its underwriting
                                         standards. Thus, Farmer Mac’s penetration would have been about 1.2
                                         percent of the agricultural mortgages meeting Farmer Mac underwriting
                                         standards. As of the third-quarter of 1998, Farmer Mac’s market
                                         penetration rate was about 1.2 percent of the agricultural mortgage loans
                                         outstanding and about 2.4 percent of those estimated by Farmer Mac as
                                         meeting its underwriting standards.

Table 4: Farmer Mac’s Share of
Agricultural Mortgage Debt Outstanding   Dollars in millions
at Year-end 1995-98                      Category                         1995                 1996                1997                1998
                                         Farmer Mac                      $516.7               $655.5              $898.6            $1,301.0
                                         secondary
                                         market
                                                                                                                                                a
                                         Agricultural                  84,800.0             87,300.0            90,200.0            94,295.0
                                         mortgage debt
                                         Farmer Mac                       0.61%               0.75%                 1.0%                 1.2%
                                         market share
                                         (percent)
                                         a
                                         Preliminary 1998 third-quarter Federal Reserve Bulletin data. Year-end data were not available as of
                                         April 1, 1999.
                                         Sources: Economic Report of the President (Feb. 1999) and Farmer Mac.


Farmer Mac’s Market                      Of the approximately $94 billion in total agricultural mortgage debt
Penetration Is Low Compared to           outstanding as of the third-quarter of 1998, about 31 percent was
the Housing Enterprises                  accounted for by FCS holdings, 29 percent by commercial banks, and 39
                                         percent by other lenders, such as life insurance companies. The remaining
                                         approximately 1 percent was accounted for by Farmer Mac AMBS.

                                         Farmer Mac’s market penetration is low when compared to that of the
                                         housing enterprises. To provide perspective, we compared Farmer Mac’s
                                         penetration to the housing enterprises’ penetration of the conventional
                                         single-family (one- to four-unit) and conventional multifamily residential
                                         mortgage markets. As shown in figure 1, mortgage pools of the housing
                                         enterprises accounted for about 43 percent of conventional single-family
                                         and 16 percent of conventional multifamily residential mortgages
                                                                           34
                                         outstanding as of year-end 1997. As of year-end 1980, about one decade
                                         after the housing enterprises were chartered as GSEs, the single-family
                                         market penetration rate was about 9 percent. The enterprises did not enter
                                         the conventional multifamily market until 1983. The multifamily
                                         penetration rate may provide a better comparison with Farmer Mac’s


                                         34
                                            The housing enterprises compete for purchases of primarily conventional residential mortgages. To
                                         the degree that they purchase federally insured mortgages, the reported shares of the housing
                                         enterprises are overstated.




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penetration rate, because multifamily mortgages, just as agricultural
mortgages, are supported by income flows from commercial properties.

During its first decade of operations, Farmer Mac had the disadvantage of
a more limited charter in relation to the housing enterprises. However,
compared to the housing enterprises in their early years, Farmer Mac also
had the advantage in that securitization of a wide variety of financial assets
had already been achieved. We recognize differences such as these in
making our comparisons. We are not suggesting that Farmer Mac should
mirror the market penetration levels achieved by the housing enterprises
in their first decade of operations. Nor are we suggesting that Farmer Mac
should be expected to reach the market penetration levels reached by the
housing enterprises in the long-term. For example, the possibly greater
heterogeneity of borrowing farm operators and of farm properties serving
as collateral for agricultural mortgages, even in comparison to multifamily
residential mortgages, could lead to a different long-term outcome.




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Figure 1: Secondary Market Penetration
of Single-family, Multifamily, and
Agricultural Mortgages




                                         a
                                          Fannie Mae and Freddie Mac holdings of multifamily mortgages in 1980 were comprised of federally
                                         insured mortgages.
                                         b
                                         Farmer Mac was established in 1988 and did not issue guaranteed securities until 1991.
                                         Sources: Federal Reserve Bulletin, Economic Report of the President (Feb. 1999) and Farmer Mac.


                                         According to Farmer Mac’s 1996 annual report, Farmer Mac had achieved
                                         limited penetration into the agricultural mortgage credit market because of
                                         the (1) historical preference of lenders, particularly FCS institutions, to
                                         retain the loans in their own portfolios; (2) excess liquidity of many
                                         agricultural lenders; (3) disinclination of lenders to offer intermediate-
                                         adjustable term or long-term, fixed-rate loans as a result of higher
                                         profitability on short-term loans; and (4) lack of borrower demand for
                                         intermediate and long-term loans due to lower interest rates associated
                                         with short-term loans. Many of the factors are largely beyond the control
                                         of Farmer Mac.

                                         Opinions from our survey support the first two reasons cited for limited
                                         penetration into the agricultural mortgage market. For example, 66 percent
                                         of nonparticipant lenders said that choosing to hold loans in portfolio was
                                         a reason that contributed a “very great” or “great” extent to their decision
                                         not to sell loans to Farmer Mac. The reason of having adequate funding to



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                               meet agricultural mortgage loan demands was also noted by 64 percent of
                               the nonparticipant lenders. Other reasons were considered to be
                               significantly lower in importance, according to our survey.

                               One particular change to Farmer Mac’s program, cited as encouraging
                               participation by both approved sellers and nonparticipating lenders, was
                               the elimination of or phasing out of the prepayment penalty. Among the
                               approved sellers we surveyed, 80 percent said that eliminating the penalty,
                               and 54 percent said phasing out the penalty, would encourage them to sell
                               more loans to a “very great” or “great” extent. Among nonparticipating
                               lenders, these figures were 47 percent and 35 percent, respectively for
                               encouragement to participate in Farmer Mac programs. For both groups of
                               respondents, eliminating or phasing out the penalty led the list of proposed
                               changes that would encourage lenders to sell agricultural mortgage loans
                               to Farmer Mac. However, phasing out or eliminating the penalty would
                               increase prepayment risks faced by investors and, therefore, could lead
                               them to demand higher interest rates charged borrowers for loans sold to
                               Farmer Mac. In our survey, we did not ask lenders how much they thought
                               borrowers would be willing to pay for eliminating or phasing out the
                               prepayment penalty.

Income From Nonmortgage        In addition to its rate of market penetration, another indicator of Farmer
Investments Is a Significant   Mac’s mission fulfillment would be a declining percentage of its
Source of Farmer Mac Income    nonmortgage investments compared to its agricultural mortgage-servicing
                                          35
                               portfolio. This would show that Farmer Mac was depending more on
                               agricultural mortgages for viability and less on nonmortgage investments.
                                                     36
                               In a previous report, we identified profits from nonmortgage investments
                               (i.e., investments other than those in agricultural mortgages) as a primary
                               source of income at Farmer Mac. These investments were part of Farmer
                               Mac’s debt issuance strategy. According to Farmer Mac officials, this
                               strategy has the stated purpose of increasing Farmer Mac’s presence in the
                               capital markets and improving the pricing of its AMBS, thereby enhancing
                               the attractiveness of the loan products offered through its programs for the
                               benefit of agricultural lenders and borrowers. Farmer Mac officials told us
                               that the strategy’s contribution to mission achievement should develop
                               over a reasonable period of time. In doing our previous work, we voiced a
                               concern that Farmer Mac’s temporary approach could become a

                               35
                                  Farmer Mac’s agricultural mortgage-servicing portfolio includes agricultural mortgages backing
                               Farmer Mac AMBS (i.e., those held in Farmer Mac’s portfolio and by other investors) plus mortgages
                               held for securitization.
                               36
                                Government-Sponsored Enterprises: Federal Oversight Needed for Nonmortgage Investments
                               (GAO/GGD-98-48, Mar. 11, 1998).




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                                permanent strategy to enhance profits even if it does not enhance Farmer
                                Mac’s ability to purchase agricultural mortgages.

                                Farmer Mac held about $1.2 billion in nonmortgage investments as of
                                December 31, 1998. These investments were about 60 percent of Farmer
                                Mac’s balance sheet assets and slightly more than the approximately $1.1
                                billion in Farmer Mac’s agricultural mortgage-servicing portfolio. Interest
                                income from nonmortgage investments is a significant source of income at
                                Farmer Mac.

Analysis of Farmer Mac’s        Although it is difficult to measure the overall benefits and costs associated
                                with government sponsorship of Farmer Mac, a necessary condition for its
Future Viability                overall benefits to exceed its cost is that Farmer Mac’s direct economic
                                benefits be positive. That is, Farmer Mac would have to be profitable or
                                economically viable in carrying out its mission. If Farmer Mac cannot be
                                profitable in its mission-related activities with the implicit subsidy it
                                receives from government sponsorship, it is not likely that it is providing
                                enough public benefit with its existing charter to justify the potential cost
                                the implicit financial subsidy may be imposing on the federal government.

                                We constructed financial scenarios using various assumptions to help
                                illustrate the relationship between Farmer Mac’s secondary market
                                penetration and its long-term ability to sustain mission viability. We
                                considered the possibility of unfavorable economic conditions leading to
                                no growth as well as favorable economic conditions leading to substantial
                                growth in Farmer Mac's secondary market penetration.

Economic Scenarios Suggest      To take into account the uncertainties regarding Farmer Mac’s future
That Farmer Mac Could Be        growth, we constructed two economic scenarios to help illustrate Farmer
Viable if Prevailing Economic   Mac’s ability to sustain mission viability. We define mission viability as the
Conditions Continue             ability of Farmer Mac to generate a profit from its core business of
                                operating a secondary market in agricultural mortgages and to provide a
                                reasonable return to its investors. Farmer Mac is owned by its
                                                                               37
                                shareholders and its stock is publicly traded. In our analysis, viability is a
                                long-term concept in which the time horizon is defined at a future point in
                                time when Farmer Mac could eventually become characterized as a
                                mature, rather than a newly created, growing institution. Just as growth is
                                uncertain, the number of years necessary for Farmer Mac to eventually
                                become a mature institution is uncertain. Farmer Mac has yet to pay
                                dividends to its shareholders, but returns to shareholders have been

                                37
                                 Farmer Mac stock without ownership restrictions is traded on The Nasdaq Stock Market under the
                                name “FedAgri” and the symbol “FAMCK.”




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generated by increases in Farmer Mac’s stock price. For long-term
viability, our scenarios require cash flows that eventually compensate
shareholders for the opportunity costs of their financial capital
                                   38
investments and associated risks. This requires shareholders to receive a
rate of return that is competitive with other investments. In our scenarios,
we assume that the average required return on equity equals FCS’ average
return of 11.25 percent as of June 1998.

The first scenario holds the outstanding amount of Farmer Mac AMBS
constant near its current level of about $1.5 billion, and the second
scenario doubles Farmer Mac AMBS to $3 billion. The first scenario was
constructed to illustrate whether Farmer Mac could be viable in the event
that its mortgage-servicing portfolio did not substantially grow. The
second scenario was constructed to illustrate Farmer Mac’s viability if
AMBS experienced a substantial increase, that is, if AMBS backed by
agricultural mortgages doubled. The calculations are presented in
             39
appendix III. The scenarios do not represent forecasts of the future. In
presenting these scenarios, we rely on publicly available data and make a
number of simplifying assumptions.

Our results were sensitive to alternative assumptions and to our reliance
on annual 1998 Farmer Mac financial performance data. For example, the
shares of Farmer Mac business were accounted for by pre-1996 Act
guarantee activity; post-1996 Act guarantee and purchase activity; and
Farmer Mac II activity was affected by choosing annual 1998, rather than
the fourth-quarter of 1998, financial performance data. Specifically, the
post-1996 Act Farmer Mac I activity involves relatively higher guarantee
fees and greater credit risk than the other activities. Although the fourth-
quarter 1998 statistics may provide a more accurate basis than annual
statistics for estimating future trends in some variables, such as guarantee
fees, the fourth-quarter statistics may reflect temporary rather than
                                                                          40
sustainable levels of some other variables, such as loan loss provisions.


38
   Shareholders could be compensated either in the form of dividend payments or increases in stock
price resulting from Farmer Mac’s retention of earnings. Either form of compensation is dependent on
Farmer Mac profits in the long term.
39
   The $1.5 billion of AMBS in the first scenario include a $408 million long-term standby purchase
commitment entered into in January 1999. Farmer Mac reported in a press release that the long-term
commitment operates as a swap in agricultural mortgages.
40
   If we had chosen fourth-quarter 1998 data, adjustments in loan loss provision statistics would have
been required to make them more consistent with values that would correspond to likely expansion in
new Farmer Mac I activity. Our reliance on publicly disclosed information would have limited our
ability to make such adjustments.




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For future nonmortgage investment holdings, we distinguished between
(1) investment securities and (2) cash and cash equivalents. As of
December 31, 1998, Farmer Mac’s nonmortgage investment holdings were
about $1.2 billion dollars, with $644 million accounted for by investment
securities. On the basis of Farmer Mac’s view that the debt issuance
strategy’s contribution to mission achievement should develop over a
reasonable period of time, we arbitrarily reduced holdings of investment
securities by half, or $322 million. Even with this reduction in investment
securities, Farmer Mac investment securities would account for larger
shares of balance sheet assets and mortgage-servicing portfolios than such
investments for the housing enterprises. Cash and cash equivalents, which
are short-term investments that can help Farmer Mac facilitate liquidity in
the agricultural mortgage market, were kept constant at current levels.

To calculate revenues for each scenario, we assumed that the split
between AMBS held in portfolio and sold to investors would equal the
percentage splits as of December 31, 1998. We also used the year-end 1998
levels to specify average AMBS guarantee fees, average gain on AMBS
issuance, and average interest-rate spread between retained portfolio
holdings (i.e., mortgage and nonmortgage investments combined) and debt
costs. To determine expenses and opportunity costs for each scenario, we
calculated Farmer Mac capital requirements on the basis of the current
statutory minimum capital standards. We specified required return on
equity on the basis of the annual 1998 return of 11.25 percent on equity for
FCS. We assumed the average provision for loan losses to equal the year-
end 1998 average. Some expenses were treated as variable (depending on
size); we calculated these expenses using average operating costs. Other
expenses that we assumed to be subject to economics of scale were held
constant. We recognize that by assuming fixed operating costs, we may
have understated Farmer Mac’s costs, particularly in scenario 2, which
anticipates a substantial expansion in Farmer Mac’s agricultural mortgage
purchases. Our scenarios also did not incorporate Farmer Mac corporate
income tax liabilities that would have the effect of reducing after-tax
corporate income.

Results from the first scenario showed that Farmer Mac would have
estimated revenues of $16.6 million and expenses of $15.6 million, or an
economic profit of about $1 million. In the second scenario, Farmer Mac
would have estimated revenues of $26.7 million and expenses of $20.4
million, or an economic profit of about $6.3 million. If we had developed
scenarios with larger specified increases in Farmer Mac AMBS, estimated
economic profits would have been greater than $6.3 million. However, our




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                               assumption of fixed operating costs would become more unrealistic in
                               such a specified scenario.

                               Farmer Mac’s nonmortgage investments affected the level of profitability
                               in both scenarios. If we removed Farmer Mac’s investment securities from
                               our scenarios, annual revenues would be reduced by about $2 million and
                               required return on equity would be reduced by about $1 million for both
                               scenarios. With these reductions, economic profit would become about
                               zero (i.e., a breakeven level) in our first scenario and about positive $5.3
                                                                                     41
                               million in our second scenario. In our 1998 report, we questioned the
                               need for a mature GSE to hold long-term nonmortgage investments to
                               fulfill its statutory mission. The Department of the Treasury agreed with
                               our assessment when it commented on our 1998 report.

A Number of Factors Could      Farmer Mac’s potential for growth will be affected by its ability to provide
Have Major Impacts on Farmer   benefits to commercial banks, FCS institutions, and other agricultural
Mac’s Viability                mortgage lenders. In addition, a number of other factors could have a
                               major impact on Farmer Mac’s viability. These factors include the
                               following: (1) changing economic conditions in the national and
                               agricultural economies, (2) potential changes affecting participation by
                               FCS institutions in Farmer Mac programs, and (3) risk-based capital
                               standards to be promulgated by FCA.

                               An important element in Farmer Mac’s growth potential is that it continues
                               to take actions intended to provide benefits to agricultural lenders. Our
                               survey suggests that continued growth is possible. Seventy-three percent
                               of the approved sellers who participated in our survey said that they are
                               likely to increase sales to Farmer Mac in the next 3 years. In addition,
                               about one-fourth of the nonparticipants responding to our lender survey
                               said that they expect to begin participating in Farmer Mac programs in the
                               next 3 years. To the extent these lenders’ inclinations are carried out, they
                               could enhance agricultural secondary market activity.

                               Economic conditions in the national and agricultural economies can affect
                               the size of the overall agricultural mortgage debt market. Farmer Mac’s
                               rate of growth will be affected to some extent by the size of this overall
                               market. While the residential mortgage market has grown, agricultural
                               mortgage debt has declined. The 1997 constant dollar value of agricultural
                               mortgage debt outstanding was slightly more than half of its 1980 value. If
                               the decline in the constant dollar value of agricultural mortgage debt
                               continues, it could directly affect Farmer Mac’s growth potential.
                               41
                                    GAO/GGD-98-48.




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Economic conditions in the agricultural and aggregate national economy
can affect participants in the primary and secondary mortgage markets in
other ways. For example, over the last 5 years, the economic environment
faced by financial institutions has generally been favorable and interest
rates have generally declined to relatively low levels. The agricultural
economy has also been fairly strong. However, recent adverse trends in
agricultural economic conditions, such as low commodity prices, reduced
export demand, and weather-related problems in certain areas of the
United States, have provided stress to the agricultural economy that could
lessen the credit quality of agricultural mortgages. Over the past 2 years,
delinquency rates on Farmer Mac I AMBS have generally been under 1
percent (except for the first quarter of 1998 when it was 1.15 percent).
During the fourth quarter of 1998, FCS experienced an increase in loan
losses and its provision for loan losses expanded dramatically. Farmer
Mac’s ability to serve as a safety valve for the agricultural sector if FCS
encountered difficulties has yet to be tested. However, one financial
industry group we interviewed suggested that within the next few years,
we may have a test for whether Farmer Mac could help in a situation
similar to the one presented in the 1980s in which agricultural real estate
prices plummeted, the credit quality of agricultural mortgages declined,
and FCS essentially stopped making loans.

Before Farmer Mac’s recent, long-term, standby purchase commitment
transaction, FCS institutions had not been active participants in Farmer
Mac programs. An expansion of FCS’ participation in Farmer Mac
programs as a means to manage credit and interest-rate risks could help
Farmer Mac’s business expand.

Farmer Mac’s January 1999 transaction of $408 million with a FCS
institution illustrates the use of a Farmer Mac program to manage credit
risk, because Farmer Mac is providing a guarantee to the FCS institution in
the event of borrower defaults. In providing this service, Farmer Mac has
the ability to diversify its credit risk by purchasing agricultural mortgages
throughout the nation. However, in terms of evaluating credit risk, Farmer
Mac is currently at a disadvantage compared to primary market lenders
who have personal relationships with borrowers and knowledge of their
local economies to evaluate credit risk. In the future, credit scoring, which
has recently been introduced to evaluate credit risk associated with
commercial lending, could help Farmer Mac evaluate credit risk.

Farmer Mac also has the ability to help lenders manage interest-rate risk.
Increased demand by agricultural borrowers for long-term, fixed-rate
agricultural mortgages could help facilitate growth in Farmer Mac’s



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business as FCS lenders seek to manage the potentially higher level of
interest-rate risk. Conditions for such expansion differ somewhat from
those for participation by commercial banks. Specifically, FCS institutions
have access to national capital markets. Therefore, they can be better able
to manage interest-rate risk without secondary market sales than lenders
                                  42
who rely on their deposit bases.

Increased AMBS issuance itself could facilitate the role of two other
factors that could in turn promote greater expansion. First, increased
AMBS issuance can create the possibility that investors may obtain
expanded historical information on AMBS cash flow performance, improve
investors’ ability to evaluate risks from secondary market activity, lower
yields they demand, and thus promote a further increase in secondary
market sales. Second, increased AMBS issuance could help Farmer Mac
realize economies of scale—a condition where average costs decline as
output (i.e., in this case, loan purchase and other secondary market
activity) increases. Farmer Mac is a relatively small corporation operating
in a secondary market activity often characterized as exhibiting economies
of scale. Therefore, the direct impact of expansions in Farmer Mac
purchases could indirectly cause further expansion in the presence of
economies of scale.

In the future, the relative importance of FCS institutions and commercial
banks in making agricultural mortgage loans could have an effect on
Farmer Mac’s expansion. Commercial banks compete with FCS
institutions in the primary mortgage market. However, because they are
GSEs, FCS institutions (1) are less likely to rely on Farmer Mac to help
them manage interest-rate risk than would commercial banks and (2) have
been less likely to participate in Farmer Mac programs than commercial
banks. If commercial banks continue to be more likely to sell their
agricultural mortgages to Farmer Mac than FCS institutions, Farmer Mac’s
expansion could be better served by an expansion in the share of
agricultural mortgages originated by commercial banks. FCA has
announced changes in its regulatory policies and practices that are
intended to increase competition among FCS institutions. If this increased
competition increases efficiency, improvements in the ability of FCS
institutions to compete with commercial banks could result. If this, in
turn, would lead to an increase in FCS’ share of the primary market for
agricultural mortgages, Farmer Mac’s growth potential could be
constrained.

42
 GSEs can issue callable and noncallable debt with a wide range of maturities to manage their interest-
rate risk.




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                            The purpose of establishing a risk-based capital standard for Farmer Mac
                            is to help ensure that its capital is aligned with the risks of its financial
                            activities, including potential risks to taxpayers. Congress has recognized
                            the role of risk-based capital standards in mitigating the risk to taxpayers
                            from GSE financial activities. FCA has a congressional mandate to
                            establish risk-based capital standards for Farmer Mac no sooner than
                            February 1999. FCA must develop a stress test that exposes Farmer Mac to
                            statutorily specified interest-rate and credit stresses. For example, the
                            credit stress must be based on the worst credit conditions experienced by
                            a region of the country accounting for at least 5 percent of the nation’s
                            population. FCA issued an advance notice of proposed rulemaking in 1998
                            seeking comments on its possible use of loan credit performance data for
                            the Farm Credit Bank of Texas in developing the capital standard. FCA
                            plans to issue a notice of proposed rulemaking in 1999 seeking comments
                            on its proposed risk-based capital standards for Farmer Mac.

                            As of December 31, 1998, Farmer Mac held regulatory capital of $80.7
                            million, $30.5 million in excess of its regulatory minimum capital
                            requirement of $50.2 million. Farmer Mac has stated that it does not expect
                            the risk-based capital standards will require it to raise additional capital.
                            However, in the long-term, the risk-based requirements could become
                            more difficult to meet and, under such circumstances, Farmer Mac may
                            need to make adjustments to its book of business or raise more capital to
                            meet the standard. In such a situation, shareholders would likely require
                            compensation for any additional equity investments. In turn, Farmer Mac’s
                            funding costs could rise, and, therefore, its growth could be reduced. This
                            possibility, in which Farmer Mac may be called upon to raise capital to
                            mitigate risk to taxpayers from Farmer Mac’s financial activities, illustrates
                            that Farmer Mac’s viability under current capital standards is not
                            necessarily the proper basis for judging the benefits and costs of
                            government sponsorship.

Value Created From          Government sponsorship of a financial institution can generate a number
                            of public benefits and costs, which are difficult to quantify. The benefits
Government Sponsorship of   Farmer Mac can generate in the agricultural mortgage market depend on
Farmer Mac Depends on       whether its new loan programs and products help agricultural lenders
Activities of Other GSEs    manage risks in ways that improve loan terms offered to borrowers. Its
                            potential costs depend on the likelihood that taxpayers may be called upon
                            if Farmer Mac is unable to meet its obligations. The net benefits and costs
                            also depend on how Farmer Mac’s activities interact with those of the two
                            other GSEsFCS and the FHLBank System.




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Government sponsorship of a financial institution can generate a number
of benefits. To the degree that lower funding costs and other benefits are
passed on to borrowers in the affected financial sector, public benefits are
generated. The special purpose charters can also provide GSEs with
motivation to make investments that enhance efficiency in the affected
financial sector. For example, GSEs that create secondary markets have
incentives to make investments that facilitate standardization. In a 1996
       43
report, we found that government sponsorship of the housing enterprises
was associated with lower interest rates on single-family residential
mortgages, and that the enterprises increased efficiency through greater
standardization of mortgage products and processes. Government
sponsorship of Farmer Mac has the potential, if it remains viable and
continues to grow, to generate benefits through loan programs and
products that help agricultural lenders manage risks.

Government sponsorship also generates potential public costs. One
potential cost is that taxpayers could be called upon if a GSE is unable to
meet its financial obligations. Such a situation occurred in the late 1980s
when FCS encountered financial difficulties. Opportunity costs can also be
generated when the implied backing of certain financial institutions diverts
funding from other financial institutions that may be able to serve the
sector more efficiently. For example, the possibility is present that
government sponsorship of Farmer Mac could reduce the incentives of
other financial institutions to develop secondary market products of value
to agricultural lenders. In addition, opportunity costs can also be
generated when implied backing of financial institutions serving a specific
sector diverts funding from other sectors.

As previously discussed, one limitation on Farmer Mac’s growth could be
its inability to reach a size sufficient to generate economies of scale. One
approach to improving its growth potential could be to expand Farmer
Mac’s charter beyond agricultural mortgages, for example, to other rural
and agricultural loans. While such an expansion could increase the scope
of potential benefits generated by Farmer Mac, it could also increase
potential costs and could affect both FCS and the FHLBank System.

The financial performance and benefits provided by FCS and the FHLBank
System affects Farmer Mac and are affected by Farmer Mac’s charter
authorities and activities. For example, Farmer Mac’s current programs
and products provide an alternative-funding source for agricultural
mortgage lenders, such as commercial banks that compete with FCS
43
     GAO/GGD-96-120.




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              institutions in the primary mortgage market. The AgVantage Program
              competes with FHLBank advances to rural lending institutions. In July
              1998, the FHLBank System’s regulator (the Federal Housing Finance
              Board) authorized mortgages on farm properties on which a residence is
              located and constitutes an integral part of the property, as collateral for
              advances received by FHLBank member institutions with total assets of
              $500 million or less. Given that there is currently a degree of overlap
              between Farmer Mac’s activities and the activities of other GSEs, any
              expansion of Farmer Mac’s charter would probably have effects on these
              other entities that would need to be taken into consideration.

              Removing Farmer Mac’s charter would eliminate potential benefits and
              costs resulting from its activities as a GSE. Elimination of Farmer Mac’s
              charter could affect the public benefits and costs associated with FCS and
              FHLBank System activities.

              Likewise, expansions in FCS lending to a wider variety of companies
              participating in the agricultural economy could create benefits. However,
              such expansion could increase the potential costs from government
              sponsorship of FCS, reduce agricultural loans made by depository
              institutions, and reduce agricultural mortgage loans sold to Farmer Mac.
              Expansion in the FHLBank System, such as the recent expansion to
              include certain agricultural mortgages as eligible collateral for obtaining
              FHLBank advances, may also limit Farmer Mac’s growth potential.

              In summary, charter revisions, regulatory changes, or other actions
              affecting the activities of each GSE in relation to agricultural and rural
              finance could in turn affect the financial performance and benefits
              generated by the other GSEs.

              The share of loans in a primary market that are sold by lenders in a
Conclusions   secondary market depends on the benefits generated by the secondary
              market. Farmer Mac has used its post-1996 charter authorities to
              streamline the process for buying loans and to develop new programs and
              products that have provided an alternative funding source for some
              agricultural lenders. Farmer Mac has also standardized some aspects of
              the secondary market transaction by requiring participating agricultural
              mortgage lenders to make representations and warranties that their loans
              meet Farmer Mac underwriting standards, but Farmer Mac has not
              standardized loan documents because state laws governing agricultural
              mortgage loans and agricultural lending practices vary. In addition, Farmer
              Mac employs risk management techniques to measure and manage its
              various risks and to help ensure that Farmer Mac conducts its secondary



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                   market operations in a safe and sound manner. We noted that elements of
                   Farmer Mac’s risk management techniques appeared to be generally
                   consistent with industry risk management principles. Since its 1996
                   restructuring, Farmer Mac has made some progress in developing a
                   secondary market in agricultural mortgages, but it currently has a
                   relatively small market presence.

                   Farmer Mac is a niche player as a secondary market entity in the
                   agricultural mortgage market. It appears that Farmer Mac can be viable if
                   it continues to expand, it experiences returns that are comparable to
                   current levels, and economic conditions in the overall and agricultural
                   economies of the nation remain stable. Even if Farmer Mac continued to
                   be economically viable under its current operating structure, it is difficult
                   to determine whether the public benefits created justify continued
                   government sponsorship. The future benefits from government
                   sponsorship of Farmer Mac are potentially limited by possible expansions
                   of competing FHLBank funding alternatives and increased competitive
                   pressures from FCS institutions. Therefore, the potential public benefits
                   created from government sponsorship of Farmer Mac could be affected by
                   legislative, regulatory, and other developments affecting the FHLBank
                   System and FCS as well as Farmer Mac.

                   Farmer Mac, FCS, and FHLBanks now offer programs that compete
Matter for         directly and indirectly with one another. Therefore, the public benefits
Congressional      and costs of these three GSEs are interrelated. Congressional committees
Consideration      with jurisdiction may want to consider interactions among the activities
                   and the charters of these three GSEs as part of their ongoing oversight.

                   We received comments on a draft of this report from Farmer Mac. These
Farmer Mac         written comments are provided in appendix IV.
Comments and Our
Evaluation         Farmer Mac said, in general, it did not disagree with our statements on the
                   background, history, and progress of Farmer Mac’s development.
                   However, Farmer Mac disagreed with our (1) conclusion that it is difficult
                   to determine whether the public benefits created justifies continued
                   government sponsorship of Farmer Mac, (2) comparison of Farmer Mac’s
                   secondary market penetration to the housing enterprises, and (3)
                   characterization that Farmer Mac continues to rely on nonmortgage
                   investments as a primary source of income.




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Net Public Benefits      Farmer Mac stated, “The Report’s ultimate conclusion, that it is difficult to
                         determine whether the public benefits provided by Farmer Mac justify
Resulting From           continued government sponsorship, is inconsistent with the GAO’s
Government Sponsorship   findings and analyses regarding Farmer Mac’s economic viability and
                         program development.” Farmer Mac agreed with the positive findings
                         about Farmer Mac’s development and its economic viability and said that
                         our ultimate conclusion conflicted with these findings. Farmer Mac also
                         took issue with our conclusion that the activities of FCS and the FHLBank
                         System affect the net public benefits provided by Farmer Mac. In addition,
                         Farmer Mac stated that we should have but did not take into account its
                         contribution to a more efficient agricultural credit market and the
                         availability of a competitive supply of mortgage credit for agricultural
                         borrowers.

                         In this report, a number of factors contribute to our conclusion that it is
                         difficult to determine whether the public benefits created justifies
                         continued government sponsorship of Farmer Mac. First, although our
                         analysis shows that Farmer Mac is currently viable in its agricultural
                         mortgage mission activities, its growth potential in the secondary market
                         for agricultural mortgage and the prospects for realizing that potential are
                         unclear. Since its restructuring resulting from the 1996 Act, Farmer Mac
                         has experienced a favorable interest-rate environment that has contributed
                         to profitability for financial institutions in general. Perhaps of greater
                         importance, its agricultural mortgage-servicing portfolio has not been
                         subject to major credit stress, such as a prolonged increase in default
                         rates. Therefore, its ability to manage interest-rate and credit risks under
                         stressful conditions has not been tested since the 1996 Act.

                         In addition, while Farmer Mac competes in various ways with FCS
                         institutions and the FHLBank System, interaction between Farmer Mac
                         and FCS institutions is subject to countervailing forces. On the one hand,
                         as we explain in this report, FCS institutions have access to GSE-issued
                         debt, and, therefore, FCS institutions may not have the same incentives as
                         banks to sell mortgages to Farmer Mac to manage interest-rate risk. If
                         banks remain more likely than FCS institutions to use Farmer Mac’s
                         products, the possibility of an expanded presence in agricultural lending
                         (i.e., directly or indirectly) by FCS or the FHLBank System, as explained in
                         this report, could lessen potential benefits to be generated by Farmer Mac.
                         On the other hand, Farmer Mac has completed transactions with FCS
                         institutions, but its limited experience to date is not sufficient to establish
                         the likelihood of any future trend for its business with FCS. In addition, a
                         more expansive definition of eligible mortgages on farm properties as
                         collateral for FHLBank advances has increased the potential for



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competition between Farmer Mac’s AgVantage Program with FHLBank
advances. Since 64 percent of Farmer Mac approved sellers responding to
our survey indicated that they were also members of the FHLBank System,
the potential for overlap between GSE programs is significant. Because
there is overlap in the three GSEs’ activities, it is not clear how much value
is added by a given GSE’s existence that would not be generated by the
others in its absence.

Most importantly, viability is not necessarily the only proper measure of
the benefits and costs of government sponsorship. At some places in its
comments, Farmer Mac appears to imply that viability is sufficient to
indicate that its public benefits are greater than its public costs, although
the viability measure does suggest that broader benefits might result from
increased lender competition and wider availability of credit. There are a
number of public costs and benefits that are not included in the viability
measure. For example, due to potential liabilities and opportunity costs
associated with government sponsorship, it is possible that the public cost
generated by Farmer Mac activities may exceed its private cost. One
potential public cost is that taxpayers could be called upon if a GSE is
unable to meet its financial obligations. Opportunity costs can also be
generated when the implied backing of certain financial institutions diverts
funding from other financial institutions that may be able to serve the
sector more efficiently. These potential costs resulting from government
sponsorship of Farmer Mac cannot be statistically estimated.

Farmer Mac also stated that a broader standard than economic results,
focusing on the secondary market’s contribution to increased lender
competition and wider availability of agricultural mortgage credit, would
                                                                    44
be a more appropriate measure of public benefits than viability. To the
extent that Farmer Mac develops unique programs and processes that
improve the efficiency of agricultural mortgage markets, public benefits
from such functions can exceed economic returns to Farmer Mac (i.e.,
spillover public benefits can be created). However, in activities where the
GSEs provide similar or overlapping functions, market shifts among the
GSEs are less likely to generate such spillover benefits. In the absence of
statistical measures of lender competition and agricultural mortgage
availability, these potential benefits also cannot be statistically estimated.
In light of the measurement difficulties of the potential costs and potential

44
 Farmer Mac’s comment letter also cited efforts that have attracted other nontraditional lenders into
the agricultural mortgage market, particularly commercial mortgage lenders and agricultural supply
and equipment companies. We discussed Farmer Mac outreach to nontraditional lenders, such as
mortgage bankers, in this report. Also of note, we did not receive survey results from any respondent
identifying itself as an agricultural supply and equipment company.




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                              benefits and the difficulty in predicting Farmer Mac’s growth potential, we
                              reached the conclusion that it is difficult to determine whether the net
                              public benefits resulting from government sponsorship of Farmer Mac
                              justify continued government sponsorship.

Comparison of Farmer          Farmer Mac said that our draft report misleadingly compared Farmer
                              Mac’s market penetration to that of the housing enterprises during
Mac’s Market Penetration to   different time frames. Farmer Mac noted that the comparison in the draft
That of the Housing           report did not account for differences in operating charters, stage of
Enterprises                   development when the respective GSEs were created, and available
                              resources to foster secondary market development. For these reasons,
                              Farmer Mac stated that our report “contains no valid foundation for the
                              finding that Farmer Mac’s market penetration at its early stage of
                              development is low compared to the housing enterprises and all references
                              to that effect should be deleted from the report.” In contrast to our
                              conclusion, Farmer Mac stated, “…we believe the correct finding is that
                              Farmer Mac’s 2% market penetration during its first three years of
                              operations compares very favorably to the housing GSEs’ progress in the
                              multifamily market, which is the more appropriate market for comparison
                              with agricultural mortgages.”

                              A major point of the section in the report containing these comparisons is
                              that Farmer Mac’s penetration of the agricultural mortgage market is
                              relatively small. As Farmer Mac stated in its 1998 annual report, its $1.3
                              billion of secondary market activity at December 31, 1998, represented
                              only 1.5 percent of all outstanding agricultural mortgages.

                              In comparing Farmer Mac’s penetration to that of the housing enterprises
                              over the first decade of their operations as GSEs, we recognize differences
                              in operating charters, stage of development when the respective GSEs
                              were created, and available resources to foster secondary market
                              development. However, we believe that these market penetration
                              comparisons, especially with multifamily residential mortgages, provide
                                                                                         45
                              useful perspective in analyzing Farmer Mac’s development. In making
                              these comparisons, we were not suggesting that Farmer Mac should mirror
                              the market penetration levels achieved by the housing enterprises in their
                              first decade of operations. Nor were we suggesting that Farmer Mac
                              should be expected to reach the market penetration levels reached by the
                              housing enterprises in the long-term. For example, the possibly greater
                              heterogeneity of borrowing farm operators and of farm properties serving

                              45
                               As discussed in this report, multifamily mortgages, just as agricultural mortgages, are supported by
                              income flows from commercial properties.




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as collateral for agricultural mortgages, even in comparison to multifamily
residential mortgages, could lead to a different long-term outcome. We
have revised the report to clarify our purpose in making these market
penetration comparisons.

Farmer Mac was established as a GSE in 1988, and the 1996 Act made
Farmer Mac’s operating structure essentially the same as Freddie Mac’s
and Fannie Mae’s. Fannie Mae and Freddie Mac became GSEs in 1968 and
1970, respectively. Prior to 1968, Fannie Mae was a government
corporation. Freddie Mac was one of the first financial institutions in the
nation to develop the ability to buy loans, form loan pools, and issue
securities backed by loan pools. Fannie Mae began to issue securities
backed by loan pools in the 1980s. As stated in this report, the housing
enterprises did not enter the conventional multifamily market until 1983.

In relation to differences in operating charters, Farmer Mac’s original
charter was more limited than the housing enterprises’ charters in that it
created the necessity to operate through third-party poolers and establish
a mandatory reserve or subordinated interest in its guarantee function.
The housing enterprises did not have these constraints. However, Farmer
Mac also had advantages during its first decade of operations compared to
the housing enterprises during their first decade of aspirations as GSEs.
Farmer Mac had the benefit of learning from the experiences of the
housing enterprises, because it began operations in 1988, after the housing
enterprises had developed the securitization concept for residential
mortgages. In the 1990s, Farmer Mac also had the benefit of observing and
learning from the dramatic expansion in securitization of residential
mortgages and other financial assets.

While, Fannie Mae had been a government corporation before it was
established as a GSE, this advantage was limited, because it became a GSE
and continued as one for over a decade before it securitized residential
mortgages. Regarding available resources to foster secondary market
development, the housing enterprises initially focused their available
resources on establishment of a secondary market in single-family rather
than multifamily residential mortgage loans. In contrast to the housing
enterprises lack of focus on multifamily mortgages, Farmer Mac,
consistent with its statutory authority, has focused its available resources
on establishment of a secondary market in agricultural mortgages.




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Nonmortgage Investment   Farmer Mac said that our draft report incorrectly stated that interest
                         income from nonmortgage investments continues to be a primary source
Income                   of income at Farmer Mac. Farmer Mac said that net interest income from
                         investments, including that from interest on cash and cash equivalents,
                         was about one quarter of Farmer Mac’s total revenues in 1998. Farmer
                         Mac also stated that its nonmortgage investments are part of its debt
                         issuance strategy as part of a broad business strategy to achieve increased
                         market presence for Farmer Mac securities. Farmer Mac stated that the
                         draft report should be revised to reflect more accurately the purposes for
                         its debt issuance strategy and note that nonmortgage interest income
                         should be characterized as a minor source rather than a primary source of
                         income.

                         We relied on a number of statistical indicators for our analysis of interest
                         income from nonmortgage investments. None of these indicators provided
                         a precise measure of the percentage of Farmer Mac’s net income
                         accounted for by nonmortgage investments, because data are not publicly
                         available on the allocation of Farmer Mac’s interest and operating
                                                                                              46
                         expenses among its various financial activities. In our 1998 report, we
                         indicated that as of June 30, 1997, Farmer Mac’s nonmortgage investments
                         of $931 million represented about 66 percent of Farmer Mac’s assets. In its
                         comment letter on our 1998 report, Farmer Mac stated that Farmer Mac’s
                         income from nonprogram investments represented about 38 percent of
                                           47
                         total net income. As of December 31, 1998, Farmer Mac held $1.18 billion
                         in nonmortgage investments (including cash and cash equivalents) that
                         accounted for about 61 percent of total assets. As indicated in our report,
                         Farmer Mac AMBS held by other investors has grown dramatically, which
                         would logically lessen the relative importance of nonmortgage investment
                         income compared to earlier periods. Because of the difficulty in precisely
                         determining the importance of interest income from nonmortgage
                         investments, we now characterize it as a significant rather than a primary
                         source of income at Farmer Mac.

                         Farmer Mac has stated that the purpose of its investment policy is to
                         increase its presence in the capital markets. In its comments, Farmer Mac
                         stated that the number of investors purchasing Farmer Mac’s debt and
                         mortgage-backed securities has increased significantly as the market
                         acceptance and liquidity of the securities has improved. As we stated in

                         46
                              GAO/GGD-98-48.
                         47
                            We understand that Farmer Mac’s definition of nonprogram investments is equivalent to our
                         definition of nonmortgage investments. We did not verify Farmer Mac’s calculation nor determine
                         Farmer Mac’s method for allocating interest and operating expenses.




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our 1998 report, these developments could be beneficial to achieving
Farmer Mac’s mission if they lead to benefits to Farmer Mac that are then
passed on to borrowers in the form of more favorable loan terms.

As arranged with your office, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 20 days after its
issue date. At that time, we will send copies of this report to
Representative Paul E. Kanjorski, Ranking Minority Member, of your
Subcommittee; Senators Richard G. Lugar, Chairman, and Tom Harkin,
Ranking Minority Member, of the Senate Committee on Agriculture,
Nutrition and Forestry; Representatives Larry Combest, Chairman, and
Charles W. Stenholm, Ranking Minority Member, of the House Committee
on Agriculture; Senators Phil Gramm, Chairman, and Paul S. Sarbanes,
Ranking Minority Member, of the Senate Committee on Banking, Housing
and Urban Affairs; Representatives Jim Leach, Chairman, and John J.
LaFalce, Ranking Minority Member, of the House Committee on Banking
and Financial Services; Henry Edelman, President and Chief Executive
Officer of Farmer Mac; and Marsha Pyle Martin, Chairman and Chief
Executive Officer of FCA. We will also make copies available to others on
request.

Major contributors to this report are listed in appendix VI. Please contact
me or William Shear, Assistant Director, at (202) 512-8678 if you or your
staff have any questions.

Sincerely yours,




Thomas J. McCool
Director, Financial Institutions
 and Markets Issues




Page 51                            GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Contents



Letter                                                                                              1


Appendix I                                                                                         54
                        Survey Population and Sample                                               54
Methodology for         Questionnaire Design                                                       54
Survey of Farmer Mac    Survey Administration                                                      55
                        Disposition of Survey Sample                                               55
Approved Sellers and    Survey Error and Data Quality                                              56
Nonparticipants
Appendix II                                                                                        58

GAO Survey Results of
Farmer Mac Approved
Sellers and
Nonparticipants
Appendix III                                                                                       81

GAO Analysis of
Farmer Mac's Future
Viability
Appendix IV                                                                                        85
                        GAO Comments                                                               97
Comments From the
Federal Agricultural
Mortgage Corporation
Appendix V                                                                                         99
                        Newly Originated Loan Standards                                            99
Farmer Mac's            Seasoned Loan Standards                                                   101
Underwriting            Facility Loan Standards                                                   102
                        Part-time Farm Loan Standards                                             102
Standards




                        Page 52                           GAO/GGD-99-85 Enhancing AgMortgage Liquidity
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Appendix VI                                                                                          104

Major Contributors to
This Report
Tables                  Table 1: Farmer Mac programs and products                                     14
                        Table 2: Annual Loan Purchases by Farmer Mac at Year-                         30
                          end 1995-98
                        Table 3: Farmer Mac’s Secondary Market at Year-end                            31
                          1995-98
                        Table 4: Farmer Mac’s Share of Agricultural Mortgage                          32
                          Debt Outstanding at Year-end 1995-98
                        Table I.1: Disposition of Samples                                             56
                        Table III.1: Scenario 1: No Secondary Market Growth But                       82
                          Investment Securities Reduced by 50 Percent
                        Table III.2: Scenario 2: Farmer Mac Doubles Its Share of                      84
                          the Agricultural Mortgage Market


Figures                 Figure 1: Secondary Market Penetration of Single-family,                      34
                          Multifamily, and Agricultural Mortgages




                        Abbreviations

                        AMBS          agricultural mortgage-backed securities
                        ARM           adjustable rate mortgage
                        FCA           Farm Credit Administration
                        FCS           Farm Credit System
                        GAAP          generally accepted accounting principles
                        GSE           government-sponsored enterprise
                        LTV           loan-to-value (ratio)
                        SPI           subordinated participation interests
                        USDA          United States Department of Agriculture
                        OSMO          Office of Secondary Market Oversight
                        FHLBank       Federal Home Loan Bank




                        Page 53                              GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Appendix I

Methodology for Survey of Farmer Mac
Approved Sellers and Nonparticipants

                        To help determine the potential market benefits from a government
                        sponsored secondary market for agricultural loans, we surveyed all 263
                        financial institutions that were currently approved to sell loans to Farmer
                        Mac (as of Oct. 1998) and a sample of 334 commercial banks and insurance
                        companies (as of Oct. 1998) that were not currently approved sellers but
                        had been targeted by Farmer Mac as program candidates.

                        We asked officials at these financial institutions for their views on Farmer
                        Mac programs and the secondary market for agricultural loans, their use of
                        Farmer Mac services, and their behavior in the agricultural lending market.
                        We conducted this mail questionnaire survey beginning in November 1998
                        and received 200 usable responses from approved sellers and 189
                        responses from nonparticipants by mid-February 1999.

                        Our ideal target populations were current participants in Farmer Mac
Survey Population and   programs and comparable institutions not currently approved to
Sample                  participate in any Farmer Mac programs.

                        The actual study populations we were able to survey were limited to those
                                                                                             1
                        defined by available Farmer Mac records. We obtained a list of 263
                        financial institutions that had been approved to originate or pool
                        agricultural loans and then sell them to Farmer Mac. Farmer Mac also
                        provided us with a list of 331 nonparticipating (not approved to sell loans
                        to Farmer Mac) commercial banks that met the marketing criteria
                        developed by Farmer Mac. These banks had been designated by Farmer
                        Mac as banks with significant potential for becoming Farmer Mac
                        approved sellers. To this list of nonparticipants, we added three large
                        insurance companies that were active in agricultural mortgage lending, but
                        were not Farmer Mac members.

                        We chose to survey all 263 approved sellers and 334 nonparticipating
                        institutions. No stratification or random probability sampling was used to
                        select elements from the study populations.

                        We created two self-administered mail questionnaires, one for approved
Questionnaire Design    sellers and another for nonparticipants. See appendix II for reproductions
                        of the questionnaires and the results of the survey. To develop the
                        questionnaires, we consulted officials from Farmer Mac and experts in the
                        field of agricultural finance and asked them to review the draft

                        1
                         In addition to the 263 approved sellers on our original sample frame, during the course of the survey
                        we discovered 2 institutions on the nonparticipant sample that had become approved sellers, bringing
                        the total to 265.




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                        Appendix I
                        Methodology for Survey of Farmer Mac Approved Sellers and Nonparticipants




                        questionnaires. We also conducted six pretest interviews by telephone
                        with a variety of institutions selected from both survey populations. The
                        information gathered from these sources was used to improve the
                        structure of the questionnaires and the wording of individual questions and
                        response choices on the questionnaires.

                        We mailed questionnaires to our samples on November 12, 1998. For the
Survey Administration   approved seller survey, we addressed the questionnaires to the individuals
                        identified as contacts in Farmer Mac’s records. For the nonparticipant
                        survey, questionnaires were addressed to the President or Chief Executive
                        Officer of the institution. Respondents were instructed to mail or fax their
                        completed questionnaires. On December 3, 1998, we mailed replacement
                        questionnaires to those who had not yet responded. On December 23, we
                        sent an additional follow-up mailing to the remaining nonrespondents.

                        In early February 1999, we selected 6 approved sellers from the 57 who
                        had not yet responded, and 11 nonparticipants out of 105 who had not yet
                        responded and telephoned them to determine their reason for nonresponse
                        and to prompt them to return questionnaires.

                        During our fieldwork, we discovered that 37 institutions on the
                        nonparticipants’ sample frame were already represented on the approved
                        seller sample and were in fact approved sellers. These duplicate cases
                        were removed from further consideration as nonparticipant sample
                        elements.

                        When our fieldwork was concluded in mid-February 1999, we had received
Disposition of Survey   200 usable approved seller questionnaires and 167 usable nonparticipant
Sample                  questionnaires. In addition, some of the nonparticipating institutions that
                        did not return questionnaires told us that they did no agricultural lending,
                        or reported that their answers were included in a questionnaire returned
                        by another surveyed institution in the same bank holding company, which
                        we counted as substantive responses. A total of 189 responses from
                        nonparticipants were received.

                        The final response rate was 77 percent for the approved seller survey and
                        66 percent for the nonparticipant survey. See table I.1 for a more complete
                        description of the dispositions of our survey samples.




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                                    Appendix I
                                    Methodology for Survey of Farmer Mac Approved Sellers and Nonparticipants




Table I.1: Disposition of Samples
                                                                                          Approved
                                    Disposition                                             sellers      Nonparticipants
                                    Total initial samples                                      263                   334
                                    Additional eligibles discovered during                        2                    0
                                    fieldwork
                                    Sampled elements outside study population
                                    (ineligible)
                                       Out of business                                             5                 10
                                       Duplicate element or became seller                          0                 37
                                    Sampled elements in the study population
                                    (eligible)—nonrespondents
                                       Undeliverable questionnaire                                 1                  2
                                       Refusal                                                     3                  6
                                       All other nonresponses                                     56                 90
                                    Sampled elements in the study population
                                    (eligible)—respondents
                                       No agricultural lending                                    0                   20
                                       Responses rolled up on one questionnaire                   0                    2
                                       Usable response                                          200                 167
                                    Response rate (respondents/total                          76.9%               65.8%
                                    eligible)
                                    Source: GAO.


                                    Although we did not use any random probability sampling techniques to
Survey Error and Data               select our sample, and therefore our survey results are not subject to
Quality                             sampling error (imprecision in survey estimates caused by the natural
                                    variation that can occur among different possible samples of the same
                                    size), the practical difficulties of conducting any survey may introduce
                                    other types of errors. As discussed in the remaining text in this appendix,
                                    we took steps to minimize the extent of such errors.

                                    Surveys may be subject to coverage error. Coverage error occurs when the
                                    sampling frame does not fully represent the target population of interest.
                                    For our seller survey, Farmer Mac gave us a list of approved sellers as of
                                    October 1998, but we did not verify this list nor did we necessarily capture
                                    all sellers approved after that date but before our survey ended. Because
                                    the nonparticipant sample was uniquely defined as those institutions that
                                    Farmer Mac was targeting as possible candidates for membership, it would
                                    not be subject to coverage error as commonly defined.

                                    Measurement errors are defined as differences between the reported and
                                    true value of a characteristic under study. Such errors can arise from
                                    differences in how questions are interpreted by respondents, deficiencies
                                    in the sources of information available to respondents, the misreporting by
                                    respondents, or poorly designed questions. We received expert review of
                                    our survey questionnaire from a nationally recognized survey firm retained



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Appendix I
Methodology for Survey of Farmer Mac Approved Sellers and Nonparticipants




by Farmer Mac. We also conducted pretests with sampled respondents to
minimize such measurement errors.

Nonresponse error arises when surveys are unsuccessful in obtaining any
information from eligible elements or fail to get valid answers to individual
questions on returned questionnaires. To the extent that those not
providing information would have provided significantly different
information from those that did respond, bias from nonresponse can also
result. Because the seriousness of this type of error is often proportional to
the level of missing data, response rates are commonly used as indirect
measures of nonresponse error. We took steps to maximize response rates,
such as multiple mailings and telephone calls to convert nonrespondents.
In addition, during telephone follow up with 17 nonrespondents, we asked
them why they had not yet responded, and none of the answers indicated
that they held beliefs that could be associated with extreme questionnaire
answers that would differ substantially from those who did respond.

Finally, surveys may be subject to processing error in data entry,
processing, and analysis. We verified the accuracy of a small sample of
keypunched records by comparing them to their corresponding
questionnaires, and we corrected errors found. Less than 1 percent of the
data elements we checked had random keypunch errors that would not
have been corrected during data processing. In addition, we performed
diagnostics to check the reliability of results during the processing and
tabulation of survey data. Analysis programs were also independently
verified. We did not, however, verify the substantive answers given by
survey respondents.




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GAO Survey Results of Farmer Mac Approved
Sellers and Nonparticipants




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Appendix III

GAO Analysis of Farmer Mac’s Future
Viability

                 SCENARIO 1

                 Would Farmer Mac have been viable in 1998 (profitable including a
                 reasonable return to shareholders) at its current agricultural mortgage
                 market level but with a 50-percent reduction in its investment security
                 portfolio?

                 Assumptions:

               • The agricultural mortgage debt market remains the same size.
               • The secondary market for agricultural mortgage securities outstanding
                 remain constant at the December 31, 1998, levels. This includes $552
                 million held in Farmer Mac’s portfolio (on balance sheet) and $598 million
                 held by others (off balance sheet). However, we have included the $408
                 million swap transaction announced in January 1999 and made
                 adjustments to guarantee fee income and loan loss provisions for this
                 transaction. Thus, the size of the secondary market for scenario I is $1.558
                 billion.
               • The net yield for on balance sheet interest earning assets is 63 basis points
                 for calendar year 1998. (Net interest income = $10.569 million for calendar
                 year 1998. The average balance for interest earning assets = $1,682 million;
                 average net yield on interest earning assets = $10.569 million /$1,682
                 million or 63 basis points.)
               • Investment securities are reduced by 50 percent from the December 31,
                 1998, total of $644 million to $322 million. Cash and cash equivalents and
                 loans held for securitization remain at the December 31, 1998, totals of
                 $541 million and $168 million, respectively.
               • Guarantee fees remain constant at the calendar year 1998 total of $3.727
                 million.
               • Gain on the sale of Farmer Mac agricultural mortgage-backed securities
                 (AMBS) securities remain constant at the calendar year 1998 total of
                 $1.400 million.
               • Miscellaneous income remains constant at the calendar year 1998 total of
                 $0.142 million.
               • Other expenses/loan loss reserves remain constant at the calendar year
                 1998 total of $9.323 million, except for an extra provision for the swap
                 transaction.
               • Average required return on equity is assumed to equal the Farm Credit
                 System’s average return of 11.25 percent at June 1998.
               • No capital above the minimum capital standards is retained.




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                                            Appendix III
                                            GAO Analysis of Farmer Mac’s Future Viability




Table III.1: Scenario 1: No Secondary Market Growth But Investment Securities Reduced by 50 Percent
                                                                                                                          Income
Annual Revenues                                                                                                           Dollars in Millions
           Net Interest Income Calculation
           Balance Sheet Interest Earning
           Assets at December 31, 1998 Amount (in millions) Net Spread (basis points)
            Farmer Mac Securities                        $552
            Loans held for securitization                 168
            Investment Securities                         322
            Cash/Cash equivalents                         541
           Total Interest Earning Assets               $1,583    times 63 basis points                           equals                    $9.973

            Guarantee fees:                                                                                                                 3.727
            Gain on sale of AMBS:                                                                                                           1.400
            Estimated guarantee fee from Jan 1999 swap:a                                                                                    1.346
            Miscellaneous income:                                                                                                           0.142

Total Annual Revenues                                                                                                                    $16.588

Annual Expenses (excludes interest expense netted out above)
           Provision for loan losses:                                                                                                      $1.614
           Extra provision for swap loss reservesb                                                                                          0.579
           Total other expenses (excluding provision for loan losses):                                                                      7.709
           Return on equity:
                  Minimum capital:
                         On balance sheet: $1,583.0 million x 2.75%       = $43.533 million
                         Off balance sheet:    598.0 million x 0.75%      =   4.485 million
                         Swap adjustment:     408.0 million x 0.75%       =   3.060 million
                                                                    Total   $51.078 million x 11.25%                                        5.746

Total Annual Expenses                                                                                                                    $15.648


Economic Profit                                                                                                                            $0.940
                                            a
                                            Calculation: Average guarantee fee = total guarantee fees/AMBS outstanding = $3.727
                                            million/$1,133 million = .00328 = 33 basis points. Swap amount = $408 million x 33 basis points =
                                            $1.346 million.
                                            b
                                             Calculation: Provision for losses/guarantee income = $1.614 million/$3.727 million = 43 percent.
                                            Extra provision = estimated guarantee fees x 43% = $1.346 million x 43% = $0.579 million.
                                            Source: GAO.




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  GAO Analysis of Farmer Mac’s Future Viability




  SCENARIO 2

  What would Farmer Mac’s situation be if it were able to double its
  December 31, 1998, market share from $1.558 billion (amount in scenario
  I) to $3.116 billion in outstanding Farmer Mac securities?

  Assumptions:

• The agricultural mortgage debt market remains the same size.
• The $3.116 billion in outstanding Farmer Mac securities consist of $1.104
  billion on balance sheet and $2.012 billion off balance sheet. This is the
  same distribution between on and off balance sheets as used in scenario 1
                                                                             1
  but doubles the amounts of agricultural mortgage securities outstanding.
• All other assets are fixed at the same levels as in scenario 1.
• The net yield for on balance sheet interest earning assets is 63 basis points
  as in scenario 1.
• Revenues from guarantee fees, gains on AMBS issuance, and
  miscellaneous sources are doubled to reflect the doubling of the
  outstanding securities.
• Other expenses are considered fixed except for loan losses. Loan loss
  expense is doubled to reflect the doubling of the outstanding securities.
• Average return on equity is computed at 11.25 percent as in scenario 1.




  1
   On balance sheet calculation: $552 million x 2 = $1.104 billion on balance sheet. Off balance sheet
  calculation = ($598 million off balance sheet + $408 million swap) x 2 = $2.012 billion.




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                                             GAO Analysis of Farmer Mac’s Future Viability




Table III.2: Scenario 2: Farmer Mac Doubles Its Share of the Agricultural Mortgage Market
                                                                                                             Income
Annual Revenues                                                                                              Dollars in Millions
           Net Interest Income Calculation
           Balance Sheet Interest Earning
           Assets                          Amount (in millions) Net Spread (basis points)
            Farmer Mac Securities                          $1,104
            Loans held for securitization                     168
            Investment Securities                             322
            Cash/Cash equivalents                             541
           Total Interest Earning Assets                   $2,135 times 63 basis points       equals                        $13.451

            Guarantee fees: $3.727 million annually x 2                                                                        7.454
            $1.346 million for swap x 2                                                                                        2.692
            Gain on sale of AMBS: $1.400 million annually x 2                                                                  2.800
            Miscellaneous income: $0.142 million annually x 2                                                                  0.284

Total Annual Revenues                                                                                                       $26.681

Annual Expenses (excludes interest expense netted out above)
           Provision for loan losses: $1.614 million annually x 2                                                             $3.228
           Extra provision for swap x 2                                                                                        1.158
           Total other expenses (excluding provision for loan losses): $7.709 million annually                                 7.709
           Return on equity:
                  Minimum capital:
                         On balance sheet: $2,135.0 million x 2.75%      = $58.713 million
                         Off balance sheet: 2,012.0 million x 0.75%      = 15.090 million
                                                                   Total    $73.803 million x 11.25%                           8.303

Total Annual Expenses                                                                                                       $20.398


Economic Profit                                                                                                               $6.283
                                             Source: GAO.




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Appendix IV

Comments From the Federal Agricultural
Mortgage Corporation

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




Now on p. 1.




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Now on pp. 44 and 45.




Now on p. 45.
Now on p. 29.




Now on p. 36.




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Now on p. 29.
Now on p. 2.



Now on p. 37.



See comment 1.




See comment 2.




See comment 2.




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 Now on p. 36.




See comment 3.



Now on p. 39.




See comment 2.




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Now on p. 10.




Now on p. 32.

Now on p. 8.




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Now on p. 32.


Now on p. 34.




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See comment 1.




Now on p. 41.




Now on pp. 40 and 41.




Now on p. 35.

Now on pp. 35 and 36.




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Now on pp. 16-28.
See comment 4.
Now on p. 20.



Now on p. 10.

See comment 5.




Now on p. 18.
See comment 6.



Now on p. 23.
See comment 7.




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Now on p. 24.




Now on p. 25.
See comment 8.




Now on pp. 27 and 28.
See comment 9.




Now on p. 39.
See comment 10.




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               Comments From the Federal Agricultural Mortgage Corporation




               The following are GAO’s comments on the Farmer Mac letter dated May
               10, 1999.

               1. We discussed Farmer Mac’s accomplishments and growth throughout
GAO Comments   this report.

               2. Farmer Mac suggested that instead of total assets, we use earning
               assets, a slightly smaller number, in constructing our scenarios on its
               future viability. Additionally, it was suggested that we use 63 basis points
               to calculate net interest income since it was the 1998 yield on the average
               balance of earning assets. These suggested changes have been
               incorporated into the scenario calculations. Farmer Mac also disagreed
               with the approach used in the economic scenarios in which we include
               return on equity as an opportunity cost. Farmer Mac referred to our
               approach as a novel concept not supported by generally accepted
               accounting principles. We measured long-term viability using an economic
               rather than an accounting definition of profit. This approach requires
               equity investors to receive a rate of return to compensate them for the
               opportunity cost of equity investment. The approach is based on accepted
               principles used in economics and finance.

               3. In its comments, Farmer Mac stated that under both of our scenarios,
               Farmer Mac meets our viability test. Further, Farmer Mac said its track
               record is that of a growing and innovative company, and it reiterated the
               positive findings of our survey results. Among those who participated, 73
               percent of the approved sellers said they are likely to increase sales to
               Farmer Mac in the next 3 years; and about one-fourth of nonparticipants
               expect to begin participating in Farmer Mac programs in the next 3 years.
               To put these findings in perspective, we have clarified our report to show
               that these findings represent inclinations of lenders’ future actions, which
               could enhance agricultural secondary market activity, but only to the
               extent that they are carried out.

               4. Farmer Mac stated that a significant portion of the draft report is
               written with the use of the phrase “is to” as if to suggest that the matters
               under discussion are to be, but have not yet been, implemented. We use “is
               to” in cases where we have not verified the actions. In cases where we
               reviewed documents verifying that action had been taken, the text of the
               report has been changed to reflect that the respective action was taken.

               5. Farmer Mac took issue with a statement that secondary market entities
               have relatively less ability than lenders to rely on borrower relationships to
               assess credit risk. The comment cited standards Farmer Mac has in place



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for underwriting, appraisal, and field servicers. We added qualifying
language that is based on Farmer Mac’s comment.

6. Farmer Mac asked that we clarify its position concerning the
standardization of loan documents. The President and Chief Executive
Officer of Farmer Mac stated that it is not Farmer Mac’s position that
further standardization lacks merit, but that the costs to Farmer Mac of
achieving further standardization of loan documents exceed the benefits of
doing so at this time. We have incorporated this position into the report.

7. Farmer Mac stated that it monitors delinquency rates on a monthly
rather than a quarterly basis. The report now reflects this change.
Additionally, in commenting on our report, Farmer Mac referred to our
statement that “Farmer Mac does not have a history of loan performance
data, so it uses the historical loan loss data of a FCS institution” for loss
estimation purposes, and noted that it does maintain an extensive loan
information database on all loans it purchases. We added qualifying
language to our report to address this comment.

8. Farmer Mac took issue with our statement that it contracts out certain
functions where it lacks in-house expertise. In its response, Farmer Mac
stated that it was a business decision to contract out certain functions to
take advantage of the experience and efficiency of outside resources. The
report has been revised accordingly.

9. In its comment letter, Farmer Mac noted that the draft report
incorrectly stated that Farmer Mac does not incorporate credit scoring
into its loan approval process. We revised the text to note that Farmer
Mac does use credit scoring in connection with the credit approval
process, but not as a determinative factor for credit approval.

10. Farmer Mac took issue with our statement that if the decline in the
constant dollar value of agricultural mortgage debt continues, it could
directly affect Farmer Mac’s growth potential. Farmer Mac stated the
opinion that it would have significant opportunity even if decline in
agricultural debt occurred. Farmer Mac’s rate of growth could be affected
to some extent by the size of the overall market. On the basis of this
premise, we have not changed this language.




Page 98                                GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Appendix V

Farmer Mac's Underwriting Standards


                          Underwriting standards are to be used by Farmer Mac to determine which
                          mortgages it will buy, which it could then choose to hold as investments or
                          place into mortgage pools. Generally, eligible loans must meet each of the
                          standards. The standards are meant to limit the risk that the mortgages will
                          create losses for the pools or Farmer Mac by ensuring that the buyer has
                          the ability to pay; the buyer is creditworthy and is likely to meet scheduled
                          payments; and, in the event of default, the value of the agricultural real
                          estate limits any losses. Farmer Mac requires lenders to provide
                                                                                                  1
                          representations and warranties to help ensure that the qualified loans
                          conform to these standards and other requirements of Farmer Mac.

                          Farmer Mac’s underwriting standards have elements (e.g., factors such as
                          past credit history and current and projected income and expenses that
                          reflect the potential borrower’s willingness and ability to repay the loan)
                          that are similar to the standards in the housing secondary markets.

                          The underwriting standards are based on credit ratios, other quantitative
                          measures, and qualitative terms. Farmer Mac’s underwriting standards, by
                          law, may not discriminate against small agricultural lenders or small loans
                          of at least $50,000.

                          Farmer Mac has nine underwriting standards for newly originated loans,
Newly Originated Loan     each of which is summarized below. A newly originated loan is one that
Standards                 has been originated for less than a year.

                        • Standard 1: Creditworthiness of the Borrowers. Standard one confirms the
                          5Cs (character, capital, capacity, collateral, and conditions) of credit that
                          are to be involved in each loan and requires loan originators to obtain
                          complete and current credit reports for each borrower. The credit report
                          must include historical experience, identification of all debts, and other
                          pertinent information. All sellers are required to verify all information
                          contained in the credit report.

                        • Standard 2: Balance Sheets and Income Statements. This standard requires
                          the loan applicant to provide fair market value balance sheets and income
                          statements for at least the last 3 years.

                        • Standard 3: Debt-to-Asset (or Leverage) Ratio. The entity being financed
                          should have a pro forma debt-to-asset ratio of 50 percent or less on a
                          market value basis. The debt-to-asset ratio is calculated by dividing pro

                          1
                          A qualified loan is a loan that is on U.S. farmland secured by a first lien that meets the credit
                          underwriting requirements of Farmer Mac.




                          Page 99                                           GAO/GGD-99-85 Enhancing AgMortgage Liquidity
  Appendix V
  Farmer Mac's Underwriting Standards




  forma liabilities by pro forma assets. A pro forma ratio shows the impact
  of the amount borrowed on assets and liabilities.

• Standard 4: Liquidity and Earnings. The entity being financed should be
  able to generate sufficient liquidity and net earnings, after family living
  expenses and taxes, to meet all debt obligations as they come due over the
  term of the loan and provide a reasonable margin for capital replacement
  and contingencies. This standard is achieved by having a pro forma current
  ratio of not less than 1.0; and a pro forma total debt service ratio of not
  less than 1.25, after living expenses and taxes. The current ratio is
  calculated by dividing pro forma current assets by pro forma liabilities.
  Total debt service coverage ratio is calculated by dividing net operating
  income by annual debt service. Net income from farm and nonfarm
  sources may be included.

• Standard 5: Loan-to-Value (LTV) and Cash Flow/Debt Service Coverage
  Ratio. The LTV should not exceed 70 percent in the case of a typical
  Farmer Mac loan secured by agricultural real estate, 75 percent in the case
  of qualified facility loans, or 85 percent in the case of part-time farm loans,
  with private mortgage insurance coverage required for amounts above 70
  percent. A minimum debt service cash flow ratio of not less than 1.0 from
  the subject real estate securing the loan is required, except for loans in
  which the borrower’s principal residence is on the property securing the
  loan. The pro forma total-debt service coverage ratio of the entity to be
  financed must not have been less than 1.50 for the last 3 years. The LTV
  ratio is important in determining the probability of default and the
  magnitude of loss.

• Standard 6: Minimum Acreage and Annual Receipts Requirement.
  Agricultural real estate must consist of at least five acres or be used to
  produce annual receipts of at least $5,000 to be eligible to secure a
  qualified loan.

• Standard 7: Loan Conditions. The loan (1) must be at a fixed payment level
  and either fully amortize the principal over a term not to exceed 30 years
  or amortize the principal according to a schedule not to exceed 30 years
  and (2) mature no earlier than the time at which the remaining principal
  balance (i.e., balloon payment) of the loan equals 50 percent of the original
  appraised value of the property securing the loan. The amortization is
  expected to match the useful life of the mortgaged asset and payments
  should match the earnings cycle of the farm operations. For facilities, the
  amortization schedule should not extend beyond the useful agricultural
  economic life of the facility.



  Page 100                              GAO/GGD-99-85 Enhancing AgMortgage Liquidity
                  Appendix V
                  Farmer Mac's Underwriting Standards




                • Standard 8: Rural Housing Loans Standards. Farmer Mac has adopted the
                  credit underwriting standards applicable to Fannie Mae, adjusted to reflect
                  the usual and customary characteristics of rural housing. These standards
                  include, among other things, allowing loans secured by properties that are
                  subject to unusual easements, having larger sites than those for normal
                  residential properties in the area, and having property that is located in
                  areas that are less than 25 percent developed.

                • Standard 9: Nonconforming Loans. On a loan-by-loan determination,
                  Farmer Mac may decide to accept loans that do not conform to one or
                  more of the underwriting standards or conditions, with the exception of
                  standard 5. Farmer Mac may accept those loans that have factors (i.e.,
                  compensating strengths) that outweigh their inability to meet all of the
                  standards. Examples of compensating strength include substantial
                  borrower net worth or a larger borrower down payment. The granting of
                  standard 9 exceptions is not intended to provide a basis for waiving or
                  lessening in any way Farmer Mac’s focus on buying only high-quality loans.
                  According to a Farmer Mac official, nonconforming loans currently
                  comprise about 10 percent of the loans approved for sale to Farmer Mac.


                  In addition to the previously listed underwriting requirements, the 1999
                  maximum loan size to a single borrower is limited to $3.5 million for loans
                  secured by more than 1,000 acres and $6 million for loans secured by 1,000
                  acres or less. The maximum size of an individual loan is indexed to the rate
                  of inflation and is changed annually by Farmer Mac.

                  Farmer Mac views the history of loan repayment as an indicator of the
Seasoned Loan     operation’s profitability and the borrower’s willingness to repay the loan
Standards         on time. As a result, Farmer Mac has developed loan criteria for seasoned
                  loans. A seasoned loan is a loan that was originated at least 1 year before
                  purchase and has completed at least one full installment of principal and
                  interest payments.

                  The degree of re-underwriting required is dependent on the age of the loan
                  and its updated LTV. If a loan is less than 5 years old, with an updated LTV
                  of less than 60 percent and on which the borrower has paid on time since
                  origination, the loan is eligible for sale to Farmer Mac if it met Farmer Mac
                  standards at the time of origination. If a loan is over 5 years old with a
                  current LTV equal to or less than 60 percent, and the borrower has paid on
                  time for each of the last 3 years, no underwriting analysis is required and
                  the loan is eligible for sale to Farmer Mac. Seasoned loans with an updated
                  LTV of greater than 60 percent must be re-underwritten to meet all of



                  Page 101                              GAO/GGD-99-85 Enhancing AgMortgage Liquidity
                      Appendix V
                      Farmer Mac's Underwriting Standards




                      Farmer Mac’s standards. Farmer Mac reserves the right to verify the credit
                      quality and performance characteristics of seasoned loans.

                      Facility loans are loans made to specialized facilities such as dairies,
Facility Loan         feedlots, packing facilities, storage units, grow-out facilities (poultry and
Standards             hog), and processing buildings. To qualify as a specialized agricultural
                      facility, the currently appraised value of the buildings must exceed 60
                      percent of the total appraised value of the property.

                      All facility loans must comply with the previously listed credit standards
                      for newly originated loans. In addition, they must meet certain
                      requirements depending on the type of facility loan and on whether the
                      borrower has a contractual relationship with product users. For example,
                      the maximum LTV for hog and poultry facilities is 75 percent, whereas the
                      maximum LTV for agribusiness facilities is 65 percent. Another example is
                      where a poultry facility has a production contract or other credit
                      enhancement with a financially strong product user, then the Farmer Mac
                      underwriting thresholds are a maximum LTV ratio of 75 percent, a
                      maximum debt-to-asset ratio of 65 percent, and a minimum total debt
                      service coverage ratio of 1.25 to 1. Under a scenario without a credit
                      enhancement, the thresholds would be a maximum LTV ratio of 65
                      percent, a maximum debt-to-asset ratio of 50 percent, and a minimum total
                      debt service coverage ratio of 1.35 to 1. The difference in the underwriting
                      requirements reflects the presumed ability that the loan can be repaid from
                      a financial source not tied to the mortgaged property.

                      For part-time farm loans (a loan designed for borrowers who live on
Part-time Farm Loan   agricultural properties but derive a significant portion of their income from
Standards             nonfarm employment) the requirements concerning acreage and annual
                      agricultural income are the same as for the full-time program. The property
                      must contain a single-family detached residence that should constitute at
                      least 30 percent of the total appraised value of the property.

                      Because part-time farmers and part-time farms have much in common with
                      conventional residential lending, this type of loan is underwritten
                      according to conforming residential housing loans standards (i.e., 28
                      percent of monthly housing expense to gross monthly income and 36
                      percent of total monthly debt expense to gross monthly income). The
                      maximum LTV for a part-time farm loan is 85 percent; private mortgage
                      insurance is required on any part-time farm loan with an LTV greater than
                      70 percent. The maximum loan size is limited to $2.3 million, but there is
                      no minimum loan size and no maximum acreage. Compensating factors,
                      such as substantial borrower net worth or the borrower’s making a large



                      Page 102                              GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Appendix V
Farmer Mac's Underwriting Standards




down payment, allow Farmer Mac to approve loans that vary from the
standards.




Page 103                              GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Appendix VI

Major Contributors to This Report


                        Richard J. Hillman, Associate Director
General Government      William B. Shear, Assistant Director
Division, Washington,   Joe E. Hunter, Evaluator-in-Charge
D.C.                    Marion L. Pitts, Senior Evaluator
                        James R. Black, Senior Evaluator
                        Carl M. Ramirez, Senior Social Science Analyst
                        Anne K. Rhodes-Kline, Senior Social Science Analyst
                        Michelle A. Sager, Social Science Analyst
                        Jerry T. Sandau, Computer Specialist

                        Rachel DeMarcus, Assistant General Counsel
Office of the General
Counsel, Washington,
D.C.




                        Page 104                         GAO/GGD-99-85 Enhancing AgMortgage Liquidity
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