oversight

Federal Agricultural Mortgage Corporation: Secondary Market Development and Risk Implications

Published by the Government Accountability Office on 1990-05-04.

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

,I-”   p.’                      .


                    United   States   General   Accounting   Office
                    Report to Congressional Requesters
   GAO

   May 1990
                    FEDERAL AGRICULTURAL
                    MORTGAGE CORPORATION

                    Secondary Market Development
                    ayld Risk hnplieations




  GAO/RCED-90-118
GAO
                    United States
                    General Accounting  Office
                    Washington, D.C. 20548

                    Resources, Community,    and
                    Economic Development     Division

                    B-220507

                    May 4,199O

                    Congressional Requesters

                    As requested by your offices, we are providing you with a consolidation
                    of the information that we have reported to the Congress since June
                    1987 on the development and implementation of a new secondary mar-
                    ket for agricultural real estate and rural housing loans-the Federal
                    Agricultural Mortgage Corporation, known as Farmer Mac. (Requesters
                    are listed at the end of this letter.)


                    The Agricultural Credit Act of 1987 (P.L. 100-233, Jan. 6, 1988) created
Results in Brief    a secondary market for agricultural real estate and rural housing loans
                    to be administered by Farmer Mac. This report provides information on
                    certain aspects of secondary markets and identifies issues that we
                    believed merited further congressional consideration during the Con-
                    gress’ deliberations on developing and implementing Farmer Mac. The
                    issues focus generally on the potential financial risks to the government
                    of establishing such a market and specifically on whether the loan crite-
                    ria, market structure, and risk parameters in the Farmer Mac-estab-
                    lished standards would satisfy the broad expectations the Congress had
                    when it passed the enabling legislation.

                    More specifically, this report contains information previously reported
                    by us on (1) secondary markets, in general, including the purposes such
                    markets have served in the past, (2) underwriting, in general, and risk
                    management in other secondary markets, (3) major categories of under-
                    writing standards used in secondary markets, (4) key issues concerning
                    the development of a secondary market for agricultural real estate and
                    rural housing loans, and (5) key issues concerning Farmer Mac under-
                    writing standards.


                    A secondary market is one in which existing products-such       as automo-
Secondary Markets   bile and credit card loans-rather     than new products-such   as a new
                    issue of stock-are bought and sold. A secondary mortgage market is a
                    market for buying and selling mortgage loans or securities backed by
                    mortgage loans. The sale of such loans and securities returns funds to
                    the loan originator, creating liquidity and allowing the lender to make
                    additional loans to qualified borrowers or otherwise reuse the funds. A
                    secondary market also provides a mechanism for spreading financial
                    risk.


                    Page 1           GAO /RCED-90-118   Secondary   Market   Development   and Risk Implications
                        E-220507




                        Underwriting is the process of identifying potential risks associated
Underwriting and Risk   with financial instruments, such as insurance policies and mortgage-
Management in           backed securities, and either assessing the expected costs of covering
Secondary Markets       those risks or providing the essential information that would allow
                        others to assess the costs. Underwriting standards are used to limit the
                        type and amount of risks of loss permitted in a financial portfolio and to
                        establish methods to ensure against loss from those risks.

                        Generally, underwriting standards in secondary markets are used to
                        establish the qualifications that individual loans must meet if they are
                        to be eligible to be purchased and packaged into pools for resale. Stan-
                        dards for pools-such as maximum/minimum size of individual loans-
                        must therefore be flexible enough to evolve over time, accommodating
                        change in economic factors, risk-management techniques! and other fac-
                        tors that affect the secondary market. However, they must be constant
                        in their ability to ensure that only loans within acceptable risk parame-
                        ters are included in the pools.


                        We identified 10 major categories of underwriting standards used in
Categories of Current   today’s secondary markets. These standards are for (1) forming pools of
Underwriting            loans, (2) providing loan pool covenants, (3) providing assurances of
Standards               scheduled payments on securities, (4) registering securities and disclos-
                        ing related information, (5) ensuring that poolers are qualified and certi-
                        fied, (6) designing securities that are marketable, (7) determining what
                        loan and pool documentation is needed, (8) providing for individual loan
                        and pool administrative services, (9) providing for review of lender and
                        pooler performance, and (10) providing criteria for property appraisals.
                        Each category applies to secondary markets in general and can be used
                        to categorize underwriting standards designed for and by Farmer Mac.

                        In a July 1987 report,’ we raised five issues that we believed merited
Issues Concerning the   further consideration in t,he secondary market debate taking place at
Development of a        that time. Those issues are (1) whether federal government involvement
Secondary Market for    is needed to develop a large national-scope secondary market for farm
                        real estate loans, (2) what impact a large national-scope secondary mar-
Agricultural Real       ket for farm real estate loans would have on the Farm Credit System
Estate Loans            (FCS) and other lenders, (3) whether FCS should be given powers to oper-
                        ate as the secondary market for all lenders. (4) whether a new secon-
                        dary market entity could coexist with the FCS, and (5) what loans should
                        be eligible to be sold in the secondary market.

                        ‘Farm Fmmcr: Secondary Markets for .~gncultural Real Estate ham (GAO:KCED-85.IISBK,         .luly
                        17.1987)



                        Page 2              GAO.‘RCED-90-118   Secondary   Market   Development   and Risk Implications
                         B-220507




                         Most of the issues raised in our July 1987 report are still the subject of
                         debate today. Some were incorporated in the Agricultural Credit Act of
                         1987 as the basis for future GAO studies. Some of these studies are to
                         focus on (1) implementation of Farmer Mac and its effect on producers,
                         lenders, FCS, and the capital markets, (2) feasibility of an agricultural
                         real estate loan secondary market without a Farmer Mac guarantee, and
                         (3) feasibility of expanding Farmer Mac’s authority for the sale of secu-
                         rities based on a pool of loans made to farm-related and rural small busi-
                         nesses. The issue of what loans should be eligible for sale in the new
                         secondary market was the focus of congressional oversight hearings for
                         Farmer Mac in September 1989.


                         The requirements of the enabling legislation provided Farmer Mac with
Key Issues Concerning    a number of issues to resolve as it developed and now implements its
Farmer Mac               underwriting standards. The issues involve geographical and crop diver-
Underwriting             sity of loans to be included in pools, agricultural real estate appraisals,
                         risks associated with mandated reserves and risk-based fees for loan
Standards                pools, Securities and Exchange Commission (SEC) registration and disclo-
                         sure provisions as they apply to Farmer Mac, determination of loan-to-
                         value ratios, and rural housing provisions.

                         In September 1989, we testified before congressional committees on our
                         concerns related to specific standards that Farmer Mac had submitted to
                         the Congress for review.? Our concerns focused on whether the loan cri-
                         teria, market structure, and risk parameters in the Farmer Mac stan-
                         dards would satisfy the broad expectations that the Congress had when
                         it passed the enabling legislation.


                         During our studies of the development and implementation of a new sec-
Objectives, Scope, and   ondary market for agricultural real estate loans, we interviewed private
Methodology              and government individuals and officials concerned with secondary
                         markets in general and Farmer Mac in particular. We also reviewed the
                         underwriting standards of the national residential secondary markets
                         and researched manuals and other documentation from private entities,
                         where possible, to identify specific standards, procedures, and practices.

                         To consolidate our work into one report, as requested, we have essen-
                         tially reprinted-with  appropriate updates-sections    of previous

                         “Issues Surrounding Underwriting Standards Developed by the Federal Agricultural Mortgage Corpw
                         ration (GAO/T-RCED-89-62. Sept. 12. 1989, and GAO/T-RCED-89-71. Sept. 27.1989).



                         Page 3               GAO/RCED-90-118     Secondary   Market   Development   and Risk Implications
B-220507




reports and testimonies as stand-alone documents in this report. In
doing so, we organized the report from primer information first to more
detailed information later. Appendixes I-IX provide more details on the
information discussed above. Appendix X provides further information
on our objectives, scope, and methodology. Our previous reports and tes-
timonies are listed in “Related GAO Products” at the end of this report.


We are sending copies of this report to the various congressional com-
mittees with jurisdiction over Farmer Mac; the Secretaries of Agricul-
ture and the Treasury; the Chairman of the Board, Federal Agricultural
Mortgage Corporation; the President and Chief Executive Officer, Fed-
eral Agricultural Mortgage Corporation; the Director, Office of Manage-
ment and Budget; the Chairman, Securities and Exchange Commission;
and the Chairman of the Board, Farm Credit Administration. Copies will
also be made available to other interested parties who request them.

If we can be of further assistance, please contact me at (202) 275-5138
Major contributors to this report are listed in appendix XI.




john W. Harman
 Director, Food and Agriculture     Issues




Page 4           GAO/RCED-W-118   Secondary   Market   Development   and Risk Implications
B-220507




List of Requesters

The Honorable Richard H. Lehman
Chairman, Subcommittee on Consumer Affairs and Coinage
Committee on Banking, Finance and Urban Affairs
House of Representatives

The Honorable Ben Erdreich
Chairman, Subcommittee on Policy Research and Insurance
Committee on Banking, Finance and Urban Affairs
House of Representatives

The Honorable Doug Bereuter
Ranking Minority Member
Subcommittee on Policy Research and Insurance
Committee on Banking, Finance and Urban Affairs
House of Representatives




Page 5           GAO.‘RCED-SO-118   Secondary   Market   Development   and Risk Implications
Contents


Letter                                                                                                                1

Appendix I             Secondary Markets: A Primer                                                                    8

Appendix II            Underwriting Standards and Risks in Secondary Markets:                                        16
                           A Primer

Appendix III           Underwriting   Standards Used in Existing Secondary
                           Markets

Appendix IV            Key Issues Concerning the Development of a Secondary                                          49
                           Market for Agricultural Real Estate Loans

Appendix V             Key Issues Concerning the Development of Underwriting                                         55
                           Standards for Farmer Mac

Appendix VI            Profile of the Agricultural Credit Act of 1987 Provisions                                     72
                            Creating Farmer Mac

Appendix VII           Farmer Mac-Legislated Underwriting            Standards                                       83

Appendix VIII          GAO Work Concerning Farmer Mac Mandated by the                                                98
                          Agricultural Credit Act of 1987

Appendix IX            Key Issues Concerning Specific Farmer Mac-Developed                                      100
                           Underwriting Standards

Appendix X             Objectives, Scope, and Methodology                                                       101

Appendix XI            Major Contributors to This Report                                                        103

Related GAO Products                                                                                            104

Table                  Table V. 1: Cost of Registering Securities Wit.h the SEC                                  69




                       Page 6          GAOiRCED-90-118   Secondary    Market   Development   and Risk Implications
Abbreviations

CM0           collateralized mortgage obligation
Fannie Mae    Federal National Mortgage Association
Farmer Mac    Federal Agricultural Mortgage Corporation
FCA           Farm Credit Administration
FCS           Farm Credit System
FDIC          Federal Deposit Insurance Corporation
FHA           Federal Housing Administration
FmHA          Farmers Home Administration
Freddie Mac   Federal Home Loan Mortgage Corporation
GAAP          generally accepted accounting principles
GAO           General Accounting Office
Ginnie Mae    Government National Mortgage Association
REMIC         real estate mortgage investment conduit
SBA           Small Business Administration
SEC           Securities and Exchange Commission
VA            Veterans Administration


Page 7             GAO/RCEDSO-118   Secondary   Market   Development   and Risk Implications
Appendix I

Secondary Markets: A Primer


                  Key questions on secondary markets:’

              l What is a secondary market:’ The investment market is usually defined
                 in terms of primary and secondary markets. A primary market exists at
                the point that an original debt or ownership interest is created, e.g.,
                when a lender makes a loan directly to a borrower or a company sells a
                new issue of stock. In its simplest form, a secondary market transaction
                occurs when a loan is sold by the original lender or a stock is resold by
                an investor.
              l What is the home secondary mortgage market? The home secondary
                mortgage market is a market for the sale of individual home loans or for
                the sale of securities backed by home loans. This market is the most
                widely recognized and developed secondary mortgage market.
              l What factors assisted in the development of the home secondary mort-
                gage market? The key factors that contributed to the successful develop-
                ment of the home secondary mortgage market include (1) ability to issue
                securities based on loans, (2) homogeneity of loans/securities, and (3)
                improved marketability of securities through high-quality collateral,
                insurance, government backing, or other means.
              . What entities exist in the home secondary mortgage market? The home
                secondary mortgage market is composed of government and private
                organizations. Organizations most often associated with this market are
                the Government National Mortgage Association (Ginnie Mae), the Fed-
                eral National Mortgage Association (Fannie Mae), and the Federal Home
                Loan Mortgage Corporation (Freddie Mac). Large banks, mortgage bank-
                ers. and state and local governments are also active participants in this
                market.
              . How does the home secondary mortgage market operate’? In its simplest
                form, key steps occur in a secondary market transaction: a loan is made;
                the loan is sold or securities representing a pool of the loans are sold,
                often to securities dealers; and the securities are then sold to investors.
              l What types of financial instruments are used in the home secondary
                mortgage market‘? ITse of securities as opposed to single loan sales has
                been a major factor in the development of the secondary market for
                home mortgages. The financial instruments that promoted this develop-
                ment are generally referred to as mortgage-backed securities. Investors
                either-through     the purchase of securities-take    ownership in the
                loans backing the securities or-through      the purchase of bonds-essen-
                tially lend money to sellers and the ownership of the mortgage stays

                  ‘This appendix was developed from mformatwn contained in sectwn I of our report entitled Farm
                  Finance: Secondary Markets for Agrlcultllral Real Estate IA)ans (GAO, RCED-87-13UHK. .lul>r
                  1987).



                  Page 8               GAO’RCED-90-118     Secondary   Market   Development   and Risk Implications
                          Appendix I
                          Secondary Markets:   A Primer




                          with the sellers. These securities are issued with and without govern-
                          ment backing.
                      l   What functions do secondary markets perform? Historically, secondary
                          markets, especially the home mortgage secondary market, have been
                          credited with performing the following economic functions that promote
                          efficiency and equity in lending markets: (1) providing liquidity, (2)
                          moderating cyclical flow of funds, (3) assisting regional flows of capital,
                          and (4) reducing geographical spread in interest rates, and allowing
                          portfolio diversification.


                          The investment market is usually defined in terms of primary and sec-
What Is a Secondary       ondary markets. A primary market exists at the point that an original
Market?                   debt or ownership interest is created, for example, when a lender makes
                          a loan directly to a borrower or a company sells a new issue of stock. In
                          its simplest form, a secondary market transaction occurs when a loan is
                          sold by the original lender or a stock is resold by an investor. Thus,
                          essentially a secondary mortgage market involves the buying and selling
                          of existing rather than new products.

                          Many types of financial instruments-stocks,      corporate bonds, treasury
                          securities, and home mortgages-have their own well-developed secon-
                          dary markets. Perhaps one of the best-developed secondary markets is
                          the Kew York Stock Exchange, where every week several hundred mil-
                          lion shares of existing stock certificates are bought and sold by inves-
                          tors. Less-developed secondary markets exist for car loans, credit card
                          debt, and manufacturers’ notes receivable.

                          The success of obtaining large amounts of funds directly from individual
                          lenders or investors can be attributed largely to active secondary mar-
                          kets for those financial instruments, that is, markets that provide the
                          holders of those financial instruments the ability to sell them quickly,
                          creating liquidity. The financial community has been successful in pack-
                          aging, or pooling, many financial instruments for sale, such as loans of
                          relatively small denominations, and selling a financial instrument repre-
                          senting an interest in the underlying loans. For example, lenders have
                          packaged individual mortgage loans with similar characteristics, and
                          sold them as mortgage-backed securities.

                          The issuance of securities not backed by individual financial instru-
                          ments, such as loans, has also had significant success in attracting funds
                          to mortgage markets. For example, one of the home mortgage market
                          entities sells general obligation bonds and uses the proceeds to, among


                          Page 9               GAO ‘RCED-W-118   Secondary   Market   Development   and Risk Implications
                        Appendix I
                        Secondary Markets:   A Primer




                        other things, buy home mortgages. General obligation bonds are backed
                        by the full faith and credit of the issuing organization and are not
                        backed by loans or specific collateral.


                        The home secondary mortgage market is a market for the sale of securi-
What Is the Home        ties backed by home loans or for the sale of individual home loans. This
Secondary Mortgage      market is the most widely recognized and developed secondary mort-
Market?                 gage market. It is composed of government and private organizations
                        that make it possible for a large secondary market to exist for home
                        mortgages. In 1988, $281 billion in home mortgages was sold. A closer
                        look at the home secondary mortgage market will provide a better
                        understanding of secondary market development, the different secon-
                        dary market entities, market operations, and financial instruments used
                        in the secondary mortgage market.


                        Several factors played key roles in facilitating the development of the
What Factors Assisted   secondary market for home real estate loans. Probably most important
in the Development of   were the development of securities backed by mortgages, the homogene-
the Home Secondary      ity of the mortgages underlying the securities, and the improvement of
                        the securities’ marketability by risk reduction mechanisms known as
Mortgage Market?        credit enhancements. One such mechanism is a guarantee that investors
                        will receive certain returns on their investments, The government
                        played an important role in all of these secondary market developments.
                        It is unlikely that the home secondary mortgage market would have
                        become so well developed if these factors had not been adequately con-
                        sidered and appropriately incorporated.


Mortgage-Backed         As the housing finance industry developed, it increasingly obtained
Securities              funds for home mortgage loans through sales of securities. Tradition-
                        ally, lenders had made home mortgages by relying on customer deposits.
                        As the secondary market developed, lenders increasingly obtained funds
                        to support their home mortgage lending through government-sponsored
                        enterprises, charged with ensuring access to capital for the housing mar-
                        ket. These organizations, discussed later, sold general obligation bonds,
                        bought loans from lenders, and held the loans in their portfolios. As the
                        market developed further, the organizations issued securities backed by
                        pools of mortgage loans. These mortgage-backed securities are the pri-
                        mary source of lending funds for home mortgages today.




                        Page 10              G-40 ‘RCED-90-118 Secondary   Market   Development   and Risk Implications
                           Appendix I
                           Secondary Markets   A Primer




                           The increasing use of securities has enabled the lending community to
                           make more loans and has provided investors with an attractive invest-
                           ment. The ability to sell loans directly or indirectly to investors has pro-
                           vided lenders with an additional source of funding for long-term
                           mortgages, not provided through relatively short-term customer depos-
                           its The investors’ ability to place large investments with relative ease
                           and quickly convert them to cash has greatly increased the attractive-
                           ness of home mortgages as investments. Those factors reduce both the
                           lenders’ and investors’ transaction costs.


Homogeneity of Mortgages   Standardization of home mortgages greatly facilitated pooling of home
                           mortgages for securities and, therefore, development of the home mort-
                           gage secondary market. Development of the fixed-rate 30-year mort-
                           gage, home construction standards, and standard loan criteria sowed the
                           seeds of secondary market growth. Traditionally, the ability to create
                           loan pools with similar risks and terms has been desirable. Such stand-
                           ardization provides for ease of marketing and reduces administrative
                           costs.

Improved Securities        Investor confidence in the integrity of the financial instrument is crucial
Marketability              to its marketability. Several types of credit enhancement mechanisms
                           can be used to improve the marketability of an instrument including (1)
                           insuring or guaranteeing certain returns to investors in the event of
                           default by the borrowers, (2) requiring high levels of collateral, and (3)
                           providing recourse to the original lender in the event of borrower
                           default. These enhancement tools can be used singularly or in concert to
                           obtain the desired level of product marketability.

                           Federal government backing of mortgages was a major element in the
                           growth of the home mortgage secondary market by improving the mar-
                           ketability of securities. In the early stages of the market, Federal Hous-
                           ing Administration (FHA)-insured and Veterans Administration (VA)-
                           guaranteed loans were the backbone of the market. Federal government
                           guarantees of timely payment of principal and interest on certain securi-
                           ties, backed by FHA and v~ loans, dramatically enhanced the acceptance
                           of home mortgages by the investment community. With the increasing
                           use of securities, the percentage of home loans sold has grown dramati-
                           cally from about 30 percent of all home loans originated in 1978 to
                           about 68 percent in 1988. Later, use of conventional-mortgage-backed
                           securities gained acceptance as quasi-governmental organizations issued
                           securities with guarantees on principal and interest payments, coupled



                           Page 11              GAO/RCED90-116   Secondary   Market   Development   and Risk Implications
                         Appendix I
                         Secondary Markets:   A Primer




                         with private mortgage insurance requirements. Secondary market orga-
                         nizations also require certain levels of collateralizations, or loan-to-value
                         ratios, for loans they purchase.


                         Organizations most often associated with the home secondary mortgage
What Entities Exist in   market are Ginnie Mae, Fannie Mae, and Freddie Mac. Other organiza-
the Home Secondary       tions, such as large banks, mortgage bankers, and state and local govern-
Mortgage Market?         ments, are also active participants in the secondary home mortgage
                         market. All of these organizations differ somewhat in the role they play
                         in the secondary market for home loans, but all make it possible for the
                         existence of a large, active investment market for home loans.

                         Because Ginnie Mae, Fannie Mae, and Freddie Mac were chartered by
                         the federal government, the financial community perceives that their
                         securities are backed by the government.’ In reality, Ginnie Mae is a fed-
                         eral agency, and its debt is backed by the full faith and credit of the
                         federal government. However, Fannie Mae and Freddie Mac are private
                         organizations without explicit federal government guarantees.

                         These organizations do share a common characteristic of encouraging
                         investors to buy mortgages or securities representing a pool of mort-
                         gages, by assuming risks that would otherwise be borne by the original
                         lender or the investor. This is done by providing a guarantee to inves-
                         tors that the principal and interest on the securities, which is to be
                         derived from the underlying mortgage payments, will be paid to the
                         investor even in the case of borrower default.

                         In 1988, mortgage-backed securities issued by these organizations
                         totaled $151 billion or about 59 percent of all mortgaged-backed securi-
                         ties issued publicly. During the same year, private firms and state and
                         local governments accounted for about $72 billion, or about 28 percent,
                         and about $9 billion, or about 3 percent, respectively, of all publicly
                         issued mortgage-backed securities.




                         ‘This percewed government backing has not been tested for Fanme Mae and Freddie Mac



                         Page 12              GAO.J’RCED-90-l   18 Secondary   Market   Development   and Risk Implications
                     Appendix I
                     Secondary Markets   A Primer




                     Many different players can become involved in a secondary mortgage
How Does the Home    market transaction, but key activities occur in the process: a loan is
Secondary Mortgage   made; the loan is sold or securities representing a pool of the loans are
Market Operate?      sold, often to securities dealers; and the securities are then sold to inves-
                     tors. It is not unusual for one entity to perform several of these activi-
                     ties. For example, a mortgage banker may make the loan, pool it with
                     other loans, and sell the security representing the loans to investors.
                     Many other variations on this theme have developed.

                     Ginnie Mae, Fannie Mae, and Freddie Mac have established financial cri-
                     teria and standardized mortgage applications that are used by most par-
                     ticipants in the home secondary market. Fannie Mae and Freddie Mac
                     both purchase loans that meet their prescribed criteria, providing cash
                     to the lender to make new loans or for other purposes. The lender
                     receives income by (1) charging the borrowers a loan origination fee and
                     (2) receiving servicing fees for collecting the payments and forwarding
                     them to the purchaser or designated agent. However, most of Fannie
                     Mae’s and Freddie Mac’s activity is conducted through their “swap” pro-
                     grams through which they issue securities to holders of loans and take
                     the loans in exchange. The holders can then hold the securities or sell
                     them. Ginnie Mae does not buy loans; rather, it charges a fee to guaran-
                     tee loan pools, which are packaged by financial institutions to sell to
                     investors.

                     Once loans are purchased or guaranteed by a secondary market organi-
                     zation, they can be held in portfolio or packaged with other loans to
                     form a pool that becomes the collateral for a securities issue. This issue
                     is then sold to securities dealers, who, in turn, earn fees by selling the
                     securities to investors. The investors in such securities include commer-
                     cial banks; savings and loan associations; mutual savings banks; state
                     and local government agencies; pension funds; and private citizens,
                     either individually or through mutual funds.




                     Page 13              GAOiRCED-SO-118   Secondary   Market   Development   and Risk Implications
                        Appendix I
                        Secondary Markets:   A Primer




                        The innovative use of securities to better match the investors’ cash-flow
What Types of           and risk needs has been a major factor in the development of the secon-
Financial Instruments   dary market for home mortgages. The securities that promoted this
Are Used in the Home    development are generically referred to as mortgage-backed securities.
                        These securities are issued as both ownership and debt issues and are
Secondary Mortgage      named for their cash-flow characteristics. They are issued with and
Market?                 without government backing.

                        The most commonly known ownership issues are called “pass-through”
                        certificates, which represent ownership interests in the underlying pool
                        of mortgages. Once the security certificate has been sold to investors,
                        the ownership of the pool lies with the investors. Although the investors
                        own the mortgages, the loan originator collects all payments, both prin-
                        cipal and interest; and all payments, less a servicing fee, are “passed
                        through” to the investors-hence    the name “pass-throughs.”

                        The most commonly known debt securities are called mortgage-backed
                        bonds and “pay-through” bonds. A mortgage-backed bond is a debt obli-
                        gation of financial institution and is collateralized by mortgage loans.
                        The bonds’ payment characteristics are much like other bonds, having
                        stated maturities and interest paid at regular intervals. The pay-through
                        bond is also a debt of a financial institution and is collateralized by the
                        underlying mortgages. However, its cash-flow stream is like that of a
                        pass-through security, in that investors receive payments each month as
                        monthly payments are passed through to them. Several variations on
                        those types of mortgage securities have developed in recent years to
                        respond to specific investor requirements.


                        Historically, secondary markets, especially the home mortgage secon-
What Functions Do       dary market, have been credited with performing the following eco-
Secondary Markets       nomic functions.
Perform?

Provide Liquidity       A secondary market for a particular type of financial instrument
                        improves the ability to convert it into cash, or create liquidity, and
                        reduces transaction costs associated with selling the instrument. This
                        enhances the value of the instrument and attracts a broader range of
                        potential investors wishing to buy it.




                        Page 14              GAO/RCEDSO-118   Secondary   Market   Development   and Risk Implications
                            Appendix I
                            Secondary Markets:   A Primer




Moderate Cyclical Flow of   Traditionally, during periods of general capital shortages, the funds
Funds                       available for mortgages generally decreased; and real estate activity
                            slowed down. For example, funds available for home mortgages were
                            severely affected during the general capital shortages of 1969-70, 1974,
                            and 1979-80, as depositors withdrew their funds from deposit accounts
                            at savings and loan associations (thrifts) to seek higher returns on their
                            money. This deposit flight occurred because deposit accounts at the
                            thrifts had interest rate ceilings imposed on them by a provision of Fed-
                            eral Reserve Regulation Q.3As a result, when general interest rates went
                            up in the economy, depositors withdrew their funds to invest them in
                            the unregulated financial instruments. To some extent, the financial
                            institutions operating in the secondary market helped to alleviate the
                            severity of the shortage by purchasing mortgages from the thrifts and,
                            therefore, providing funds for additional lending. In recent years, since
                            general deregulation of interest rates, moderating cyclical flows of funds
                            has not been a major function performed by the home secondary mort-
                            gage market.


Assist Regional Flows of    Secondary markets stimulate the flow of funds from capital-surplus to
Capital                     capital-deficit areas. During the last decade, the home secondary mort-
                            gage market ensured that mortgage funds flowed to rapidly growing
                            areas needing capital, such as the South and West, from capital-surplus
                            areas of the Northeast.


Reduce Geographical         As capital becomes more mobile, a geographical moderation in interest
Spread in Interest Rates    rates results because capital will flow to areas of high interest rates,
                            thereby placing downward pressure on those rates. Because a strong
and Allow Portfolio         secondary market broadens the geographical base of investors, it can
Diversification             spread the risk of a single region, such as the Midwest, to a geographi-
                            cally broader range of investors, potentially lessening its effects.




                             ‘That provislon of regulation Q prescribed the maximum rates of interest that Federal Reserve Sys-
                            tem mem&r banks were allowed to pay on time and savings deposits. It WELS    rescmded on *January 29.
                            198”



                            Page 15               GAO.‘RCED-W-118      Secondary   Market   Development   and Risk Implications
Appendix II                                                                                                         -

Underwriting Standards and Risks in Secondary
Markets: A Primer

               Key questions on underwriting              standards and risks in secondary
               markets: I

               What are underwriting standards? Underwriting standards are guide-
               lines used to limit the type and amount of risks permitted in a financial
               portfolio and to establish methods of insuring against loss from those
               risks. The underwriting process identifies the potential risks associated
               with financial instruments, such as insurance policies and mortgage-
               backed securities, and provides the essential information that would
               allow determination of how much it will cost to cover these risks.
               How are risks borne in a secondary market? Existing secondary markets
               are structured to manage risks, and they offer securities designed to
               spread the risks to market participants in a method most acceptable to
               potential risk bearers. Risk bearers involved in these markets include
               lenders that originate loans, poolers who purchase loans from the lend-
               ers, guarantors and insurers of loan-backed securities, and investors in
               the securities.
               U’hat risk implications exist in current secondary market securities‘? The
               success of various secondary markets in attracting a wide range of
               investors was made possible by the markets’ ability to develop a variety
               of asset-backed securities attractive to investors. These securities have
               different risk implications for market participants, ranging from almost
               no risk to high risk.


               LJnderwriting standards are criteria, or guidelines, used to limit the type
What Are       and amount of risk of loss permitted in a financial portfolio and estab-
Underwriting   lish methods to insure against those risks. For example, if an automobile
Standards?     insurance company insures only drivers with accident-free driving
               records, the prices-or premiums-the      company charges to insure
               against expected losses should be lower than if the company insures
               motorists without accident-free driving records. The underwriting
               guidelines in this case would address the driving records of those who
               potentially could be insured.

               tinderwriting is the process of (1) identifying potential risks of loss
               associated with financial instruments, such as insurance policies, and
               (2) either assessing the expected costs of covering those risks or provid-
               ing the essential information that would allow others to make such a

               ‘This appendix was developed from mformation contained in sectlon 1 of our report entitled Federal
               Agricultural Mortgage C:orporation. ~‘nderwriting Standards Issues Facmg the New Secondary Mar-
               ket iGAOiRCED-8%106BR. May 5, 1989).



               Page 16               GAO,‘RCED-SC-118    Secondary   Market   Development   and Risk Implications
                      Appendix Jl
                      Underwriting Standards and Risks in
                      Secondary Markets A Primer




                      determination. 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. The under-
                      writing process is used when a business sells many types of financial
                      instruments, including insurance policies, stocks, bonds, and loans.

                      Banks use the underwriting process and underwriting standards to
                      make individual loans that they may hold in their portfolio or later sell
                      in a secondary market. These standards address factors, such as past
                      credit history, current and projected income, and expenses, that reflect
                      on the potential borrower’s willingness and ability to pay. This informa-
                      tion is used to make a lending decision. When a bank decides to make a
                      loan, it sets loan terms, including an interest rate, collateral values, and
                      other conditions consistent with the risks involved in the loan. An indi-
                      vidual with a good credit rating and sufficient collateral is likely to
                      receive more favorable terms-including       a lower interest rate-than    a
                      borrower with a delinquent payment history or limited financial
                      resources. Some risks, such as the credit risk and character of borrower,
                      can be controlled through use of underwriting standards; other risks,
                      such as the changing economic environment, cannot be controlled by
                      underwriting standards and are handled through pricing and use of
                      credit enhancements like insurance, reserves, or guarantees.


Underwriting in the   In secondary markets for residential and commercial mortgages, compe-
Secondary Mortgage    tent underwriting helps protect those who are taking the risks involved
                      in guaranteeing payments of mortgage-backed securities. In these mar-
Markets               kets, lenders can convert their long-term assets-which     in this situation
                      would be long-term mortgages-into      short-term assets by selling the
                      loans to secondary market organizations. These organizations buy loans
                      that meet their criteria, which usually ensure that the loans are readily
                      saleable. The secondary market organizations package the loans or pool
                      them together with other loans, using established underwriting stan-
                      dards, and in turn transfer or spread their risks by issuing securities
                      backed by the underlying loans to the investing public. As a result,
                      investors can invest their funds in securities that can be easily con-
                      verted into cash-having liquidity-and       are marketable, without incur-
                      ring the costs of evaluating the risk associated with individual loans. To
                      encourage investors to purchase such securities and to increase then
                      confidence in the securities, poolers can guarantee or insure timely prin-
                      cipal and interest payments, for a price, through the use of private
                      insurers. Governmental guarantors also, at times, bear the risks of loss
                      associated with the securities.


                      Page 17             GAO/RCEDS@118     Secondary   Market   Development   and Risk Implications
                             Appendix II
                             Underwriting Standards and Risks in
                             Secondary Markets: A Primer




                             Underwriting standards in current government-sponsored secondary
                             markets are found in legislation and in the organizations’ implementing
                             guidelines. Standards that are found in legislation may be stated in
                             broad or specific terms. Standards found in implementing guidelines
                             interpret, clarify, and expand upon legislated standards or are devel-
                             oped by the responsible organization to address areas where legislation
                             is silent and where there is a need for guidelines. Legislation that pro-
                             vides specific standards limits the flexibility an organization has in car-
                             rying out certain provisions of the legislation but gives the Congress
                             more control over the operation of the market.

                             Underwriting standards address both pools of loans that are used to
                             back securities and individual loans that make up the pools. Some stan-
                             dards affect both pools and individual loans; others affect one or the
                             other. For example, the size limitations of a pool would affect only the
                             pool while the size limitations of individual loans could affect both the
                             pool and the individual loan. In addition! standards applying to property
                             appraisals generally affect only individual loans.


                             Existing secondary markets for residential mortgages, commercial loans,
How Are Risks Borne          and certain agricultural loans are structured to manage risk by transfer-
in a Secondary               ring risks to certain market participants. Risk bearers involved in secon-
Market?                      dary mortgage market transactions include (1) originators of loans
                             (lenders), (2) poolers who purchase loans from the lenders and issue
                             securities, (3) insurers of loans that are ultimately included in a pool, (4)
                             guarantors of loan-backed securities issued by poolers, and (5) investors
                             in the securities. Risks fall into two broad categories-risks   related to
                             changes in the general economy: which affect all securities, and risks
                             that are unique or specific to individual securities.


Who Are the Risk Bearers ?   All of the risk bearers-loan originators, poolers, insurers guarantors,
                             and investors-differ     in the role they play in the secondary market for
                             residential loans; but all make it possible for the existence of a large,
                             active investment market for such loans. Most of the largest secondary
                             mortgage markets are sponsored by the federal government. Organiza-
                             tions most often associated with the secondary residential mortgage
                             market are Ginnie Mae. Fannie Mae. and Freddie Mac. All three ser1.e as
                             guarantors: Fannie Mae and Freddie Mac also serve as poolers and
                             investors in loans that have not been pooled. These organizations shart
                             a common characteristic of encouraging investors to buy mortgages oi
                             securities representing a pool of mortgages by assuming risks that


                             Page 18             GAOiRCED-90-118   Secondary   Market   Development   and Risk Implications
                      Appendix II
                      Underwriting Standards and Risks in
                      Secondary Markets: A Primer




                      would otherwise be borne by the original lender or the investor. This is
                      done by providing a guarantee to investors that the principal and inter-
                      est derived from the underlying mortgage payments will be paid in case
                      of borrower default. Other organizations, such as large banks, mortgage
                      bankers, and state and local governments, can serve alternately as all
                      types of risk bearers-loan originators, poolers, insurers, guarantors,
                      and investors-in   a secondary mortgage market.


What Are the Risks?   Potential risks in existing secondary markets include the general market
                      risks of interest rate changes and inflation and the cash-flow risks
                      inherent in defaults, prepayments, reinvestments, refinancing, and
                      liquidity-the    ability to quickly convert securities into cash. Some of
                      these risks are less manageable than others, but existing secondary mar-
                      kets have used risk management to shift risk from their portfolios to
                      other market participants. Market participants must use available infor-
                      mation to identify and analyze these risks through market mechanisms
                      and arrive at a price on securities that will compensate them for their
                      perceived risk. Generally referred to as risk pricing, this process is used
                      by participants to decide what types of securities would be better to
                      meet the risk and investment return preferences of investors. In addi-
                      tion to risk pricing, the cost of conducting the buying and selling trans-
                      actions must be included in determining security types.

                      To quantify and compare these risks and potential returns on alterna-
                      tive investments available in the market place, participants must have
                      access to adequate market information. Investors form expectations
                      about risks and returns on the basis of the information that is available
                      at the time investment decisions are made. Market information
                      addresses such factors as the history of loan defaults (when a borrower
                      fails to repay the loan), delinquencies (when a borrower fails to make
                      loan payments on time in accordance with established repayment sched-
                      ules but does not default), bankruptcies, interest rate changes, market
                      conditions! and early loan payments.

                      The greater the amount of relevant and reliable information available to
                      investors at the time they form their risk and return expectations, the
                      bet,ter the market is in discovering, pricing, and dealing with risks. For
                      example, forecasts of market performance can be wrong. especially
                      where little information exists, so the risk taker needs to analyze availa-
                      ble information for developing different scenarios and evaluating possi-
                      ble default rates, interest rate changes, and other factors. The risk taker
                      uses these scenarios to determine how to handle these risks, realizing


                      Page 19             GAO/RCEDSO-118    Secondary   Market   Development   and Risk Implications
                       Appendix II
                       Underwriting Standards and Risks in
                       Secondary Markets: A Primer




                       that risks are not the same across the nation even for the same market
                       or for similar markets and that methods for managing risks, such as
                       portfolio diversification, do not necessarily eliminate risks but strive to
                       make overall risks less volatile.

                       Certain risk factors affect the amount, timing, and uncertainty of cash
                       flows received by investors,but are difficult to measure. In agricultural
                       loans, for example, federal farm subsidy payments are subject to
                       change, thus altering cash flow and affecting returns on agricultural
                       investments. Further, federal farm credit programs that provide loan
                       guarantees and interest rate subsidies can change, affecting the amount
                       of the guarantees or subsidies and exposing investors to additional risks.
                       Weather conditions, such as the 1988 drought, can also have adverse
                       impacts on agriculture and change the cash-flow position of farmers in
                       various regions of the country.

                       For most existing secondary market securities backed by pools of loans,
                       information needed to evaluate risk for specific securities is available to
                       some degree. Risk can be divided into general market risk and cash-flow
                       risk. General market risk, of interest rate changes and inflation, affects
                       returns to investors, is related to the overall movements in the general
                       economy, and is usually more difficult to manage than cash-flow risk.
                       Cash-flow risk stems from repayments of loan principal by borrowers.
                       Cash-flow risk is specific or unique to a particular security issue and is
                       caused by actions of the lender, borrower, pooler, or others, altering the
                       cash flow to the investor.


General Market Risks   Major risks facing secondary market poolers and investors are changing
                       market interest rates, which increase or decrease the market price of
                       their securities, and inflation, which affects all securities by reducing
                       the purchasing power of the income returns and invested dollars. Mea-
                       suring these potential risks and the effects they could have on market
                       participants’ behavior is difficult because of the uncertainty in making,
                       analyzing, and interpreting forecasts of future interest rates and
                       inflation.

                       Interest rate risk can have a tremendous effect on the market value of
                       securities. For example, when market interest rates increase. the value
                       of lower-interest-rate securities held by investors, decreases. Because
                       potential investors have the option to buy the new higher-interest-rate
                       securities, all other things being equal. they would purchase the older



                       Page 20             GAO/RCED-90-118   Secondary   Market   Development   and Risk Implications
                  Appendix II
                  Underwriting Standards and Risks in
                  Secondary Markets: A Primer




                  securities from the current holders only if the market price of the securi-
                  ties were discounted to provide the same yield as the new securities. If,
                  for some reason, investors holding the lower-interest-rate securities
                  decided to sell in a higher-interest-rate environment, they would experi-
                  ence a loss on their investments.

                  Interest rate risks are sometimes managed by using a defense against
                  financial loss called “hedging.” Hedging makes it possible to reduce risks
                  of volatile rates to security holders by negotiating set prices for the
                  future regardless of whether the market rates increase, stay constant, or
                  decrease. Security holders, for instance, might enter into a contract to
                  sell their securities at a later date for a set price. Whether the interest
                  rate increases or decreases, they receive the same price at the time of
                  the sale. The security holders have hedged against fluctuating interest
                  rates and price declines.

                  Inflation risk is highly dependent on changes in the macroeconomic
                  environment and other financial factors. Inflation refers to a rising level
                  of prices as measured by a general price index. Inflation reduces the
                  purchasing power of the dollar, and as a result, lenders tend to demand
                  higher interest rates to compensate them for the reduction. For a partic-
                  ular security, risks of inflation, as well as changes in interest rates, can
                  be managed through the use of innovative financial instruments, such as
                  adjustable interest rate loans.


Cash-Flow Risks   Cash-flow risks for an investor or a pooler in a secondary mortgage mar-
                  ket involve the availability of funds for poolers to make payments to
                  investors when due and for poolers and investors to obtain funds by
                  liquidating the security when cash is needed. Availability depends pri-
                  marily on whether (1) borrowers default or become delinquent on pay-
                  ments or pay the loans off early, (2) poolers reinvest excess cash flow
                  wisely or are able to refinance when a shortfall occurs, and (3) the secu-
                  rities are liquid enough to be converted into cash. To help manage all
                  these risks, a pooler would issue securities whereby mortgage payments
                  are passed through to investors. However, investors might want differ-
                  ent, types of securities to avoid the same risks or may demand to be com-
                  pensated for these risks by requiring a higher interest rate.

                  Default risk occurs when, and if, issuers of secondary market asset-
                  backed securities fail to collect from loan originators enough mortgage
                  payments to pay investors the periodic interest payments or to repay
                  investors the principal amount at the time specified in the contract


                  Page 21             GAO/RCELWO-118    Secondary   Market   Development   and Risk Implications
Appendix U
Underwriting Standards and Risks in
Secondary Markets: A Primer




because borrowers default or become delinquent on the underlying
mortgages. For example, borrowers with adjustable interest rate mort-
gages may not be able to make payments when interest rates increase.
To protect the investors, some securities, such as bonds, contain provi-
sions that place strict obligations on the issuer who generally holds the
mortgages. Government-sponsored secondary market organizations have
additional provisions that preclude a loan originator who defaults
because of fraud from continued participation in the market.

In existing secondary markets, certain mechanisms-called      credit
enhancements-have       been developed for transferring risks to other par-
ties to help guard against the default risk being passed on to investors.
Issuers of securities can reduce or eliminate investors’ exposure to these
risks by using various methods of guaranteeing or insuring the timely
payment of principal and interest, such as government guarantees, pri-
vate insurance, or special reserves that can be drawn on to make such
payments. For example, as far as investors are concerned, default and
delinquency risk does not exist for U.S. Treasury securities. Securities of
U.S. government-sponsored organizations, e.g., Fannie Mae, Freddie Mac,
and Ginnie Mae, are generally considered to have virtually no default or
delinquency risk largely because of actual or implied government guar-
antees to pay security holders and because investors believe that the
government would act to prevent these organizations from defaulting.

Prepayment risk is manifested when borrowers make early principal
payments on mortgages or pay the entire principal amount before loan
maturity. For example, as interest rates decrease, a borrower with a
fixed interest rate is more likely to pay off the mortgage-thereby
removing it from the pool of loans-more quickly so it can be refinanced
at a lower rate. Conversely, when interest rates increase, a borrower
who has an adjustable-rate loan and expects that interest rates will con-
tinue to rise over an extended period may pay off the loan and obtain a
fixed-rate loan to lock in an interest rate. Under these scenarios, all prin-
cipal is repaid but future interest payments are forfeited. This creates
reinvestment decisions on how to obtain the best returns in a “down”
interest rate market. (See the discussion under “Reinvestment risk”
below.)

Prepayments expose investors in some types of secondary mortgage
market securities to the risk that they will receive less return on their
investment than anticipated. These prepayments mean that the princi-
pal amount of a loan is invested for a shorter period than investors
expected and, as a result, can expose investors to the possibility that


Page 22             GAO/RCED-90-118   Secondary   Market   Development   and Risk Implications
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Underwriting Standards and Risks in
Secondary Markets: A Primer




they may not be able to reinvest funds received as prepayments to
receive the same or greater return.

Investors can avoid prepayment risk by buying securities, such as
bonds, that do not permit prepayments and that promise to pay speci-
fied amounts of principal and interest periodically over the life of the
security. Where permissible, institutions may charge fees or higher
interest rates for loans that are prepaid or subject to prepayment condi-
tions to cover the added risks involved. For example, some commercial
real estate mortgages include terms that allow lenders to impose a pen-
alty charge on borrowers who pay off their loans during the first few
years of the mortgage. In addition, some lenders charge higher interest
rates on loans that allow prepayments, as a pricing mechanism to recog-
nize the risk involved in that kind of loan.

Reinvestment risk is caused by poolers having idle funds resulting from
a difference in amount and/or timing of (1) income received by the
pooler from mortgage payments and(2) amounts paid to investors. For
example, a pooler receives annual payments from borrowers and splits
these into quarterly payments to investors; the pooler invests all funds
received that are not paid to investors. Both poolers and investors in
loan-backed securities are subject to the risk of poolers having to invest
cash receipts (interest income and principal payments, including prepay-
ments) at lower than anticipated interest rates because of a general
decline in market rates. As a result, the actual return on the investment
could be less than the expected return. Investors can reduce potential
reinvestment risks by purchasing bonds that pay a fixed amount at
maturity.

Refinancing risk occurs when a pooler has a shortage of funds because
of a timing difference between cash inflows from loans and cash out-
flows to investors in securities backed by the loans. This timing differ-
ence may cause the pooler to borrow funds to avoid a shortfall in
making scheduled payments to investors. For example, defaults on
underlying loans for a bond issue may cause a shortfall in cash flows
going into the pool. It may take some time before foreclosure and recov-
ery can be accomplished. In the interim, the pooler may have to obtain
additional carryover financing-or    refinance-to   make up cash defi-
ciencies in meeting semiannual interest payments on the outstanding
securities until maturity. Investors do not experience refinancing risk in
secondary markets, and poolers can minimize risk by using security
design structures that pass payments directly to investors.



Page 23              GAO/RCED9@118    Secondary   Market   Development   and Risk Implications
                          Appendix II
                          Underwriting Standards and Risks in
                          Secondary Markets: A Primer




                          Liquidity risk in a secondary market relates to the ability to convert the
                          asset-backed securities into cash quickly. It is a risk investors take that
                          they will not be able to readily dispose of their investments through the
                          subsequent sale of the security at a price that will let them recoup their
                          original investment at any time they choose. In general, the more uncer-
                          tainty that exists, the thinner the market and the greater the liquidity
                          risk. For example, a U.S. government security has little or no liquidity
                          risk because such securities are widely traded, partly because of the
                          investors’ faith that the government will stand behind it? whereas the
                          stock of a small company traded on the open market may have substan-
                          tial liquidity risk. Liquidity risk can be lessened by purchasing low-risk
                          securities, such as Treasury securities, that are actively traded in a sec-
                          ondary market characterized by a large number of buyers and sellers.


                          The success of the various secondary markets in attracting a wide range
What Risk                 of investors was made possible in part by their ability to offer a variety
Implications Exist in     of asset-backed securities-including    pass-through securities, mortgage-
Current Secondary         backed bonds, mortgage pay-through bonds, collateralized mortgage
                          obligations (CMO), and real estate mortgage investment conduits
Market Securities?        (REMlc)-designed to provide the risk protection and returns sought by
                          investors. These securities, described more fully below, have different
                          risk implications for the market participants, ranging from almost no
                          risks to high risks. The residential mortgage secondary markets have led
                          the way in the area of security design. Other secondary markets offer
                          securities modeled after those originally introduced by Ginnie Mae, Fan-
                          nie Mae, and Freddie Mac. Investors in securities backed by mortgages
                          include commercial banks; savings and loan associations; mutual savings
                          banks; state and local government agencies; pension funds; and private
                          citizens, either individually or through mutual funds. These securities
                          allow investors to invest in mortgage assets without having to become
                          involved in the costly administrative details.


Pass-Through Securities   With a pass-through security, the borrowers’ mortgage payments of
                          interest and principal, minus fees for servicing and other charges, are
                          passed through to the holders who have ownership interests in the
                          security’s underlying mortgages.

                          Since the security holders own the mort,gages, they are subject to risks
                          of interest rate and inflation, default, prepayment, reinvestment, and
                          liquidity. However, the major risk associated with residential mortgage-
                          backed pass-through securities is prepayment caused when borrowers


                          Page 24             GAO/RCED-90-118   Second-   Market   Development   and Risk Implications
Appendix II
UnderwrIting Standards and Risks in
Secondary Markets: A Primer




refinance mortgages as market interest rates decline. This often can
result in a reduction in total return to the security holders. Frequently,
poolers bear the risk of default by guaranteeing or insuring, for a fee,
the timely payment of principal and interest to investors. The most com-
mon pass-through security has been the Ginnie Mae, which is issued by
private entities and backed by residential mortgages insured by FHA and
VA. Ginnie Mae offers, through the full faith and credit of the federal
government, guarantees for the timely payment of scheduled monthly
principal and interest to investors.

Mortgage pass-through securities are also issued directly by private
originators or poolers. These pass-throughs are not insured or guaran-
teed by any government agency but are supported only by the quality of
the underlying loans and any credit enhancement mechanism used to
transfer the risk of the pool to another party. Two types of credit
enhancements traditionally have been used to manage pass-through
risks, namely mortgage pool insurance, or guarantees provided by pri-
vate insurance companies, and letters of credit provided by commercial
banks.

In 1986, private sector entities began issuing a third type of credit
enhancement, senior/subordinated pass-through securities. In such secu-
rities, payments of principal and interest are passed through to inves-
tors on a prioritized basis: servicing and trustee fees are paid first;
senior security holders are paid second; a reserve fund is established
and maintained at a certain balance third; and finally, subordinated
security holders are paid from any remaining funds. The size of the sub-
ordinated class of securities is established according to how much pro-
tection against loss the investor or issuer desires. For example: the more
protection desired, the larger the subordinated class may be.

The senior pass-throughs are usually sold to investors after being rated
by a nationally recognized agency, such as Standard and Poor’s Corpora-
tion or Moody’s Investors Service. The rating on the senior security is
supported by the subordinated security in that payments are not made
to the subordinated security holders until after the senior security hold-
ers ha\Te received their regularly scheduled payments. These subordi-
nated securities may be designed to meet the needs of the participants
and may be sold to investors or retained by the issuer. In some cases, the
subordinated securities have been sold to investors at a substantially
higher yield compared to the senior class of securities because of the
higher risk associated with their expected cash flows. A July 1988 study
by Goldman, Sachs and Company indicates that, through June 1988,


Page 25             GAO/RCEDSQ118     Secondary   Market   Development   and Risk Implications
                          Appendix II
                          UnderwrIting Standards and Risks in
                          Secondary Markets: A Primer




                          about 60 percent of conventional pass-throughs had this type of credit
                          enhancement.


Mortgage-Backed Bonds     Mortgage-backed bonds are secured, or collateralized, by home mortgage
                          loans owned by the bond issuer who is usually a private-sector mortgage
                          originator, such as a savings and loan association, a savings bank, or a
                          mortgage banker. These securities have a maturity date and a stated
                          principal and rate of interest. They promise to pay investors interest
                          semiannually and to repay the principal amount at maturity.

                          Prepayment, reinvestment, and refinancing risks are borne by the issuer
                          of mortgage-backed bonds since the bond contract provides for the
                          issuer to make scheduled interest and principal payments without
                          regard to the timing or amount of payments the issuer receives from the
                          pooled mortgages. Default risk for mortgage-backed bonds is minimized
                          since such bonds are usually over-collateralized, meaning that the collat-
                          eral must continue to have a market value exceeding the face value of
                          the outstanding bonds.


Mortgage Pay-Through      Mortgage pay-through bonds are collateralized by home mortgage loans
Bonds                     owned by the bond issuer who is usually the mortgage originator, such
                          as a savings and loan association, a savings bank, or a mortgage banker.
                          These bonds are like pass-through securities in that they link the cash
                          flow from the collateral to the cash flow on the bonds. Payment fre-
                          quencies of the borrower on the mortgage and the issuer on the bonds
                          may differ; however, the issuer assumes the risk of making up any
                          shortfall. Principal payments on the bonds fluctuate depending on pre-
                          payments, defaults, and delinquent payments.

                          The issuer assumes any reinvestment risks due to prepayments. How-
                          ever, in the event of default. who assumes the risk depends on the liqui-
                          dation value of the collateral and the types of guarantees and insurance
                          provided in the contract between the issuer and the bond holder.


Collateralized Mortgage   CMOS  are bonds created from the cash flow of underlying pools of con-
Obligations               ventional mortgages. The principal and interest receipts from the mort-
                          gages have no direct relationship to payments to the bond holders. Each
                          pool of mortgages that backs the bonds is divided into a series of bonds,
                          commonly referred to as “tranches,” that have their own maturity dates
                          and fixed interest rates. Cash flow from the mortgages is used by the


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                       Appendix II
                       Underwriting Standards and Risks in
                       Secondary Markets: A Primer




                       issuer to make payments to holders of the various tranches. These pay-
                       ments are prioritized: first, interest payments are made to all tranches,
                       and then principal payments are made to the tranche that has the earli-
                       est maturity date, to the tranche with the next earliest maturity date,
                       and so on. After interest payments have been made, all available cash
                       goes to repay principal on the “fastest-pay” tranche. Following retire-
                       ment of the first tranche, the next tranche in the sequence becomes the
                       exclusive recipient of principal payments until this tranche is retired.
                       This sequential process continues until the last tranche of bonds is
                       retired. The most common type of CM0 has been a four-tranche CMO,
                       although CMOS have been structured with over a dozen tranches. The
                       average life of individual tranches may overlap or there may be gaps of
                       time between the tranches. The average maturity of a four-tranche CM0
                       might be as follows: first-tranche bonds, 1 to 3 years; second-tranche
                       bonds, 3 to 7 years; third-tranche bonds, 5 to 10 years; and fourth-
                       tranche bonds, 15 to 20 years.

                       The earlier tranches have short or intermediate final maturities and
                       attract investors seeking low exposure to interest rate risk. Since the
                       shorter tranches must be retired before the longer tranches receive prin-
                       cipal payments, the longer tranches have a limited amount of prepay-
                       ment and reinvestment risk although they are exposed to risks of
                       default, inflation, and liquidity. Investors who desire less prepayment
                       risk and less reinvestment risk prefer the longer tranche of a CM0 over a
                       pass-through security that has no prepayment risk protection.


Real Estate Mortgage   The Tax Reform Act of 1986 permitted a new tax-free entity called a
                       REMIC that can hold mortgages secured by any type of real estate and
Investment Conduits
                       issue multiple classes of mortgage-backed securities to investors. (Secu-
                       rities, issued by these entities, also have come to be known as REMICS.)
                       Among other things, the law grants flexibility to entities who issue
                       mortgage-backed securities and elect to be treated as a REMIC for tax
                       purposes by allowing them to use all the above mortgage-backed secur-
                       ity designs that are tailored to meet specific investor needs without
                       being taxed as a separate taxable entity.’

                       Generally, an entity qualifies as a REMIC if substantially all of its assets
                       consist of qualified mortgages. A REMIC offers advantages to issuers of
                       mortgage-backed securities: (1) a REMIC is treated as a partnership fol

                       ‘For a discussion of REMICs and their operations, see our report entitled Housing Finance. Agency
                       Issuance of Real kate Mortgage Investment Conduits (GAO/GGD-88-111. Sept. 2. 1988).



                       Page 27               GAOIRCED-90-I     18 Secondary   Market   Development   and Risk Implications
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Underwriting Standards and Risks in
Secondary Markets: A Primer




tax purposes, meaning that it is not subject to federal income tax pro-
vided it meets all the requirements of the law, and (2) REMICS can struc-
ture mortgage-backed securities to allow the pooler to consider the
issuance either as a pass-through or as a CMO. Since a REMIC is capable of
issuing multiple-classes of mortgage-backed securities that resemble
CMOS, risks of interest rate, inflation, default, prepayment, reinvestment,
and liquidity apply much the same as with CMOS, depending on the
length of maturities of the various classes.

In secondary mortgage markets, tax considerations are important
because decisions about the type of mortgage-backed securities sold to
investors is affected by the economic consequences of existing tax laws.
Securities issued by REMICS are one of the newest forms of mortgage-
backed securities in secondary mortgage markets, and the annual issu-
ance of these securities reached almost $98 billion in 1989. Government-
sponsored residential mortgage secondary markets-Fannie       Mae and
Freddie Mac-have issued most of the REMICS to date.




Page 28             GAOIRCED-90-118   Secondary   Market   Development   and Risk Implications
Appendix III

Underwriting Standards Used in Existing
Secondary Markets

                          Major categories of underwriting               standards used in existing secondary
                          markets:’

                          Loan pool composition determines the characteristics of pools and indi-
                          vidual loans eligible for pooling.
                          Pooling covenants provide legal rights and obligations of all parties
                          involved and ensure that certain matters are addressed similarly or uni-
                          formly from loan to loan within a pool.
                        . Credit enhancements provide assurances that, in the event borrowers do
                          not make loan payments as scheduled, security holders will receive
                          scheduled payments. These assurances take the form of government and
                          government-chartered organizations’ guarantees, government and third-
                          party private sector insurance, self-insurance by lenders and poolers in
                          the form of cash reserves and promises to pay from future income, gov-
                          ernment lines-of-credit, and overcollateralization.
                        . Securities registration and disclosure is designed to protect the investing
                          public by ensuring that full and fair disclosure of information is pro-
                          vided to prospective investors.
                        . Pooler eligibility ensures that poolers are qualified and certified by a
                          governmental or private entity before buying and pooling loans or sell-
                          ing securities to investors.
                          Security design determines the structure of and facilitates marketability
                          of securities backed by a pool of loans.
                          Documentation determines the form and content of documents support-
                          ing individual loans and packages of loans that form pools.
                          Servicing pertains to maintaining contact with borrowers, providing
                          accounting records and reports, collecting payments, and managing all
                          activities connected with the loans.
                          Monitoring provides for review of lender and pooler performance as
                          well as market operations.
                          Property appraisal provides criteria for determining or evaluating the
                          fair market value of the underlying loan collateral.


Underwriting              Generally, underwriting standards are used in forming pools of loans
                          and making individual loans with some of the standards overlapping
Standards and             and encompassing both pools and loans. Pooling standards dictate, in
Identified Categories     large part, what will be contained in individual loan standards since the
                          loan-making process must meet the requirements of the pool. Pooling

                           ‘This appendix was developed from informatlon contained in section 2 of our report entitled Federal
                          .4gricultural Mortgage Corporation: Ilnderwriting Standards Issues Facing the New Secondary Mar-
                          -ket (GAO/RCED-89-106BR. May 5. 1989).



                          Page 29                GAO/RCED-90-118     Scondary    Market   Development    and Risk Implications
Appendix III
Underwriting Standards   Used in Existing
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standards must be flexible enough to evolve over time, accommodating
change in economic factors, risk management techniques, and other fac-
tors that affect the secondary markets. However? they must be constant
in their ability to ensure that only loans that meet acceptable risk
parameters are included in a pool.

Underwriting standards for residential secondary mortgage markets
developed gradually over time and were shaped by authorizing legisla-
tion and by subsequent guidelines for implementing the legislation. In
some instances, the Congress required broad underwriting standards
and left it to the government-sponsored organizations or the lenders to
establish the more detailed standards in their implementing guidelines.
For example, the legislation creating Freddie Mac in 1970 required Fred-
die Mac to purchase and sell conventional residential mortgages meeting
general underwriting standards. Subsequent legislation created excep-
tions from these standards or added new standards. In implementing
these legislative standards and addressing areas where standards were
needed but legislation was silent, Freddie Mac developed more detailed
standards and modified them over time in response to changed economic
and risk factors. In addition, individual lenders who sell loans to Freddie
Mac have developed loan standards that amplify Freddie Mac’s and that
are also used in loan-making decisions.

Depending on the purpose of the market and risks that the organization
creating the secondary market is willing to accept, different strategies
may be followed in establishing standards. Legislation may (1) set
explicit standards when creating the market, (2) delegate responsibility
for setting the standards to the secondary market organization estab-
lished-if any-to carry out the market functions, or (3) allow lenders
or poolers to establish their own standards.

We identified 10 major categories of underwriting standards used by
existing residential mortgage and other secondary markets. These stan-
dards are based on characteristics of loans and securities that are
required of those markets. To obtain a better understanding of the
importance and implications of these standards to a secondary market,
we discussed each category with officials of existing residential secon-
dary markets-Ginnie     Mae, Fannie Mae. and Freddie Mac-and with
underwriters that are involved in secondary markets.

Outside of the residential markets, we found little documentation of
underwriting standards; however, we reviewed manuals and other docu-
mentation, where possible, to identify specific standards, procedures,


Page 30             GAOiRCED-90-118         Secondary   Market   Development   and Risk Implications
                        Appendix ID
                        Underwriting Standards   Used in Existing
                        Secondary Markets




                        and practices used. We reviewed private loan underwriting guidelines
                        for residential mortgages, banking manuals on real estate underwriting,
                        commercial loan guidelines, and loan policies and procedures of various
                        western and midwestern banks. We also reviewed draft agricultural real
                        estate standards developed by a task force composed of officials from
                        the FCS, the Independent Bankers Association of America, the American
                        Bankers Association. and the American Council of Life Insurance.


                        Loan pool composition standards, our first category, relate to the char-
Loan Pool Composition   acteristics of pools and individual loans that make up the pools for a
                        given secondary market. These standards set the parameters of loan
                        pools and usually define eligible borrowers, pool size, origin of loans,
                        and loan criteria.


Borrower Eligibility    Borrower eligibility requirements specify which borrowers may partici-
                        pate in the program and often play a part in determining the amount of
                        risk in a loan pool. Generally, these requirements are set to explicitly
                        limit risk or, in the case of government- sponsored markets, require the
                        markets to meet some public policy goal, such as affordable housing or
                        farm ownership, that often increases risk. Borrower eligibility require-
                        ments are imposed to ensure that (1) certain borrowers are not discrimi-
                        nated against, (2) other borrowers cannot be considered for a particular
                        market, and (3) only certain types of loans will be included in a particu-
                        lar market. For example, ITS. government-sponsored secondary markets
                        are made up of pools of loans from borrowers that, among other charac-
                        teristics, are generally individuals, not corporations, partnerships, or
                        trusts. The Small Business Administration (SBA) includes loans in its sec-
                        ondary market only if they are for small businesses organized to gener-
                        ate profits for their owners, are independently owned, and are not
                        dominant in their fields. Borrower eligibility is usually specified in legis-
                        lation with more explicit instructions provided in implementing
                        guidelines.


Pool Size               In government-sponsored secondary markets, legislation (1) prescribes
                        underwriting standards defining the total value of loans that can or
                        should be included in a pool or (2) instructs the organization to develop
                        such standards to include in their implementing guidelines.

                        Ginnie Mae, for example, requires a minimum pool value of $1 million
                        for pools consisting of single family mortgages to accommodate its


                        Page 31              GAO, RCED-90-118 Secondary   Market   Development   and Risk Implications
                  Appendix III
                  Underwriting Standards   Used in Existing
                  Secondary Markets




                  poolers who are usually smaller financial institutions. Fannie Mae and
                  Freddie Mac have two basic mortgage-backed security programs-swap
                  program and standard program-with         differing objectives and there-
                  fore differing pool size limitations. In addition, pool size is based on such
                  factors as Fannie Mae’s minimum pool size limitations of $500,000 for
                  all adjustable rate mortgages and $1 million for fixed-rate mortgages.
                  Size limitations have changed over time as markets have expanded and
                  the costs of homes have increased. Pool size for all markets is often
                  determined by investor appetites, economic factors, and administrative
                  cost implications.

                  None of the commercial or agricultural standards we reviewed and few
                  of the residential secondary markets require a minimum or maximum
                  number of loans in a pool.


Origin of Loans   Residential markets define who can originate loans by listing specific
                  organizations or types of organizations. For example, Freddie Mac buys
                  conventional mortgage loans from members of the Federal Home Loan
                  Bank system, the Federal Deposit Insurance Corporation, the National
                  Credit Union Administration, financial institutions whose deposits are
                  insured by an agency of a state or the United States, and authorized
                  public utilities. Fannie Mae’s customer base is substantially similar to
                  Freddie Mac’s; however, 2 percent of its business is FHA/W loans, 98 per-
                  cent is conventional mortgage loans. Ginnie Mae deals primarily with
                  loans insured by FHA and VA. Each of the loan-making organizations must
                  meet the purchasing organization’s standards but, in addition, may have
                  its own more specific standards that usually relate to the ability and
                  willingness of the borrower to repay the loan.

                  We found no underwriting standards that address geographical limita-
                  tions of loans within a pool. However, experts told us that securities
                  backed by pools of loans are generally rated for less risk if the loans are
                  spread over a wider geographical area from a variety of lenders and
                  that private markets require more geographical diversity than govern-
                  ment-backed markets. One way to spread risks in a secondary market is
                  to ensure that a pool has enough geographical diversity in it so that
                  problems in one particular region cannot cause the failure of the pool.
                  Pools made entirely of loans from areas experiencing financial difficul-
                  ties would be negatively affected; however, a pool that had only a few
                  of these loans would be affected much less because the risk would be
                  spread over a wider variety of more stable loans and economic condi-
                  tions. For example, residential housing markets in the Southwest have


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                Appendix III
                Underwriting Standards   Used in Existing
                Secondary Markets




                experienced economic recessions in recent years. This has led to higher
                default rates and cash-flow problems for poolers who did not signifi-
                cantly diversify their pools outside their regions.

                Legislation typically sets standards on who can originate loans for a
                particular market, and the administering organization-such    as Fannie
                Mae or Freddie Mac-issues clarifying guidelines when necessary.


Loan Criteria   Factors considered in determining whether a loan is eligible for a pool
                vary from individual loan characteristics to borrower characteristics.
                Standards are written so that these factors are sufficiently defined to
                allow poolers to determine whether a loan meets enough requirements
                to qualify for a pool. These standards provide the basis to price the risks
                inherent in the securities backed by these loan pools.

                Types of loan eligibility criteria described below include loan size and
                type; interest rates; loan maturity; borrower’s financial ratios, which set
                limits on risks; and credit check tests. These requirements are described
                in a minimum/maximum manner or in a specific quantity/quality        man-
                ner. Loan criteria are sometimes set in general terms in legislation and
                are more specific in implementing guidelines.

Loan Size       Underwriting standards usually set the dollar amount of a loan eligible
                to be included in a pool. Maximum-size standards are established to pre-
                vent one or a few loans from monopolizing a pool, thereby causing more
                risk if a loan prepays or defaults. Minimum-size loan standards are
                established to permit including in a pool small loans that may be more
                costly-in relation to dollar value-to process than large loans.

                Loan size limitations exist in most secondary markets and are usually
                contingent upon such factors as the number of residential units covered,
                the geographic location, and the ratio of the amount of the loan to the
                market value of the collateral-the    loan-to-value ratio. Depending on
                such factors, Fannie Mae’s and Freddie Mac’s maximum loan amounts
                currently range from $187,450 to $360,150 (effective as of Jan. 1,
                1990). They are based on a legislatively established formula. Ginnie
                Mae’s maximum for VA mortgages is $144.000, while its maximum for
                FH.4 loans for fiscal year 1990 is $124,875. Standards for other markets
                range from $120,000 to $600,000 depending on such factors as loan-to-
                value ratios and whether the loan rates are fixed or adjustable.




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                           Appendix III
                           Underwriting Standards   Used in Existing
                           Secondary Markets




AcmrlTypes                 Types of loans eligible to be included in a pool may take several forms.
                           A residential mortgage market may restrict loans to single family
                           houses, multifamily complexes, condominiums, or any combination of
                           these; commercial mortgage markets may include only one type of busi-
                           ness or any number of businesses; and agricultural mortgage markets
                           may include loans for purchasing real estate or loans for developing cer-
                           tain types of agricultural real estate, such as vineyards or orchards that
                           require years before income is realized from those crops. A residential
                           secondary market pool that includes condominiums may have a higher
                           risk than a pool of single family houses because, historically, single fam-
                           ily markets have performed better; and a pool of agricultural develop-
                           ment loans made to develop existing agricultural land may have a
                           higher risk than a pool of loans for purchasing agricultural real estate.

                           Existing secondary markets include a variety of loan types. Freddie Mac
                           and Fannie Mae purchase a variety of loan types including conventional
                           mortgages and F-HA/VA single family, Z-to-4 family, multifamily (more
                           than 4 families) mortgages, and second-home mortgages. Some markets,
                           such as Ginnie Mae and SBA, limit their loans to those guaranteed by the
                           U.S. government. Loans for the Farmers Home Administration’s (FmtIA)
                           secondary market include long-term real estate mortgage loans in rural
                           areas and farm ownership loans.

                           Loan-type standards are usually specifically set in legislation with
                           amplifying language in implementing guidelines.

Interest Rate Structures   Underwriting standards set, in general, the structure of interest rates,
                           such as fixed or adjustable rates and maximum/minimum interest rate
                           limits, for loans eligible to be included in a pool. Standards periodically
                           define risk factors and market conditions, which determine interest
                           rates. Generally pools do not demand all loans to have exactly the same
                           interest rate to qualify for a pool. For example, interest rates on mort-
                           gages pooled by Freddie Mac may vary from 0.5 to 2.5 percent above the
                           rate at which payments are passed through to investors--if the interest
                           on a mortgage-backed security is 10 percent, then the interest rat.e on
                           underlying mortgages must be between 10.5 and 12.5 percent. According
                           to Standard and Poor’s officials, the more narrow a range of rates in a
                           pool, the more efficient the pool.

                           Pools of fixed-rate loans are usually considered lower risk than pools of
                           adjustable-rate loans because with a fixed rate, a borrower can budget
                           payments more easily than with an adjustable rate where payments
                           may increase. However, in the past few years, some secondary markets


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                              Appendix III
                              Underwriting Standards   Used in Existing
                              Secondary Markets




                              have pooled and sold more adjustable-rate loans than previously. For
                              example, Freddie Mac began issuing adjustable-rate mortgage-backed
                              securities in 1986 and is developing new adjustable-rate products. About
                              5 to 8 percent of outstanding Freddie Mac securities are backed by
                              adjustable-rate mortgages, and Freddie Mac has been increasing its
                              purchases of these mortgages-about     16 percent of total purchases in
                              1988.

                              Interest rate structures are sometimes referred to in legislation, and spe-
                              cific standards usually are set in implementing guidelines.

Loan Maturity                 Loan maturity refers to both the maturity date, which is the date a loan
                              is due to be paid off, and the remaining term, which is the length of time
                              until the maturity date. Loans eligible to be included in a pool are almost
                              always required by pooling standards to meet loan maturity provisions.
                              Historically, secondary market poolers have preferred pooling loans of
                              similar maturities so the pool is more homogeneous to make securities
                              more saleable.

                              Maturity provisions allow various loan lengths for different pools. With
                              some exceptions, Freddie Mac and Fannie Mae provide that the original
                              term of a mortgage may not exceed 30 years while SBA requires that the
                              shortest remaining term to maturity of any loan in a pool must be at
                              least 70 percent of the longest remaining term to maturity of any loan in
                              a pool. In practice, loan pools have been composed of loans of about the
                              same length.

                              Secondary market entity implementing guidelines usually dictate matur-
                              ity provisions.

Financia.l Ratios and Tests   For loans to be eligible for inclusion in a secondary market, the loans
                              and the borrowers are usually required to meet certain qualifying finan-
                              cial ratios to set limits on the risks involved and to withstand credit his-
                              tory tests. Generally, underwriting standards may establish maximum
                              or minimum ratio percentages and require the application of these ratios
                              on a loan-to-loan basis. A loan pool usually consists of loans that have
                              financial ratios that fall within the limits established for the pool; how-
                              ever, ratios used in the various secondary markets and from pool to pool
                              may differ. Financial ratios focus on (1) borrower’s income and ability
                              to repay the loan, (2) amount of the loan compared to the value of the
                              collateral. (3) excess of borrower’s assets over liabilities, and (4) t,he
                              borrower’s willingness to pay.



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Appendix III
Underwriting Standards   Used in Existing
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Borrower’s ability to pay is dependent on cash flow and is usually the
“bottom line” in determining loan quality and risk. In general, ability to
pay is determined from a review of the borrower’s financial statements,
which, at times, may have to conform to generally accepted accounting
principles. Fannie Mae does not require financial statements when
underwriting the typical single family borrower; however, if the bor-
rower is self-employed, tax returns and financial information on the
business are required. Any one or a combination of several financial
ratios can be used to determine ability to pay.

The existing housing secondary markets use two overall ratios to qual-
ify conventional-loan home buyers: (1) total housing expense-to-income
ratio and (2) total debt payment-to-income ratio. For example, Fannie
Mae and Freddie Mac use a monthly housing expense-to-income ratio
with a standard of 28 percent. Housing expense includes principal and
interest payments, insurance, and taxes. Income includes all stable
income. Both also use a monthly debt payment-to-income ratio standard
of 36 percent. Debt payment includes the above housing expenses plus
other debt payments such as installment and revolving payments. Both
use these standards, but they may be exceeded providing compensating
factors exist.

In government-sponsored markets, legislation usually states that bor-
rowers must demonstrate an ability to repay a loan; standards relating
specifically to defining the borrower’s ability to pay are usually pro-
vided for in implementing guidelines.

Loan-to-value ratios are commonly used in almost all residential mort-
gage secondary markets to measure the borrower’s equity in the prop-
erty backing the mortgage. This ratio helps to determine loan quality
and is used as security for a loan. Higher loan-to-value ratios are more
likely to result in loss in the event of a foreclosure because the lender is
holding less security on the loan. Legislation for some secondary mar-
kets establishes maximum loan-to-value ratios; however, more stringent
ratios may be required by poolers or lenders. Pools usually consist of
loans with similar loan-to-value ratios; however. some pools consist of
loans with a range of ratios to achieve comparable risk parameters for
loans with different types of collateral.

Required loan-to-value ratios differ on the basis of the type of property
involved. interest rate used, borrower, and loan. For example, Fannie
Mae and Freddie Mac use loan-to-value ratio limitations from 80 to 9.5



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            Appendix III
            Undenwiting  Standards   Used in Existing
            Secondary Markets




            percent depending, for example, on whether the house is a 2-to-4 family
            or single family residence.

            L4ccording to bankers in the West and Midwest, agricultural real estate
            loan-to-value ratios should currently not exceed 65 percent because of
            the risks involved in agricultural real estate and the uncertainty of mar-
            ket value of the collateral backing loans. This ratio is down significantly
            from the 1970s when 80-90 percent ratios were common and were based
            on inflated real estate values.

            Although loan-to-value ratios may be mentioned in secondary market
            legislation, specific standards for such ratios are usually provided for in
            implementing guidelines.

            Net worth represents the difference between a borrower’s assets and lia-
            bilities. When the market value of the borrower’s assets are greater than
            liabilities, the net worth indicates that the borrower has general assets a
            creditor might have recourse to in case the collateral on the specific loan
            is not adequate to cover default losses. For example, even if the assets
            are sold for less than market value, a borrower’s net worth may be suffi-
            cient to cover the amount of liabilities owed to the creditors. Most com-
            mercial secondary markets have standards specifying the minimum
            amount of net worth as a percentage of a borrower’s total assets.

            Standards for net worth are usually provided for in implementing
            guidelines.

            Willingness to pay is a test that borrowers must pass to provide reason-
            able assurance that they will repay the loans. Such tests do not necessa-
            rily involve financial ratios but usually consist of checking the
            borrower’s credit payment history and reviewing public records to dis-
            close any previous judgments, foreclosures, tax liens, or bankruptcies.
            Verifying a borrower’s credit usually requires the lender or an indepen-
            dent credit reporting agency to obtain (1) information on the borrower’s
            employment. income, and credit history for at least the previous 2 years
            and (2) a list of all legal information-such  as suits! judgments, foreclo-
            sures, garnishments, and bankruptcies-for      the past several years.

            Credit check standards are usually provided in implementing guidelines.


            Several basic mortgage loan provisions address the legal rights and obli-
Covenants   gations of the involved parties. Known as covenants, these provisions-


            Page 37              GAO:RCED-90-118        Secondary   Market   Development   and Risk Implications
                  Appendix III
                  Underwriting Standards   Used in Existing
                  Secondary Markets




                  because they may affect loan prepayment patterns and credit risk-
                  must be considered when evaluating the pool payment characteristics.
                  Covenants generally deal with matters that require clarification to avoid
                  legal conflicts between the parties. Covenants are also established to
                  manage certain risk characteristics in loan portfolios for either borrow-
                  ers or lenders. Fannie Mae and Freddie Mac list covenants in two group-
                  ings-20 uniform covenants that are the same in all states and up to 9
                  nonuniform covenants that conform to the laws of various states where
                  the property is located. Matters-such    as provisions for loan assump-
                  tions, prepayments, borrower’s rights, lender’s rights, and pooler’s
                  rights-are    addressed in a consistent manner so that all parties are
                  aware of what the covenants provide for in these areas.

                  Covenants are provided for, at times, in legislation either specifically or
                  by inference; implementing guidelines usually provide more specifics on
                  how to define and manage them.


Loan Assumption   When property is sold and the buyer takes over payments on the
Provisions        existing mortgage, the loan is considered as assumed by the buyer. In
                  the residential housing secondary markets, loan assumptions are occa-
                  sionally permitted. For example, Fannie Mae and Freddie Mac do not
                  often allow assumption of fixed-rate mortgages but do allow adjustable-
                  rate mortgages to be assumed provided that the organization’s uniform
                  mortgage instruments and procedures are used by lenders. However,
                  when a conventional loan is assumable, the lender may charge an
                  assumption fee or, in some cases, increase the mortgage interest rate and
                  require the party assuming the mortgage to have a credit check. Ginnie
                  Mae pools only government-guaranteed mortgages, and those mortgages
                  are generally assumable.

                  Assumable loans facilitate the transfer of property, affect interest rates,
                  and increase the volume of activity, thus affecting secondary markets.
                  Loan assumptions tend to reduce prepayment risks by allowing the life
                  of the mortgage to be uninterrupted.


Prepayments       Loan prepayment occurs lvhen the borrower pays all or part of a loan
                  prior to the scheduled payoff date. Prepayment is a major risk of a sec-
                  ondary market investor because it results in a return of principal earlier
                  than the anticipated maturity date. thus reducing investors’ expect,ed
                  yields on that specific investment. It also creates reinvestment risks for
                  poolers or trustees who must hold and reinvest prepayments when they


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                    Underwriting Standards   Used in Existing
                    Secondary Markets




                    cannot pass them immediately through to security holders because, in
                    such cases, payments to the holders are set and are not tied to mortgage
                    receipts.

                    One method of reducing prepayments is to impose prepayment pena!-
                    ties. Although various states have restrictions against such penalties,
                    the federal government can, in some cases, override them where govern-
                    ment guarantees are involved. Illinois allows penalties on mortgages for
                    which the interest rate is below 8 percent, while Ginnie Mae and SBA do
                    not allow prepayment penalties. Freddie Mac does not allow penalties
                    for l-to-4 family units but does for multifamily (over 4 families) units.
                    Fannie Mae allows prepayment with no penalty in most cases. In gen-
                    eral, penalties are not allowed because they tend to limit the borrower’s
                    ability to refinance or repay loans.


Borrower’s Rights   Secondary market covenants address certain rights that protect the bor-
                    rower from actions on the part of lenders. In general, these rights reduce
                    the lender’s rights to collect on loans and, as a result, may increase the
                    lender’s operating cost, which may then be passed to other borrowers or
                    may decrease the lender’s and investor’s returns. These provisions
                    include the right of each borrower to have (1) no-recourse provisions
                    that limit the borrower’s loan liability only to the amount of the collat-
                    eral backing the loan, rather than to the borrower’s total assets, (2)
                    mandatory mediation to delay foreclosure or repossession, and (3) loans
                    restructured as an alternative to foreclosure.

                    Generally, legislation that creates borrower’s rights will dictate pooling
                    standards. For example, a provision was included in the 1988 Housing
                    and Community Development Act that mandated a lifetime cap on all
                    adjustable-rate mortgages. This law was then incorporated into the pool-
                    ing standards for all adjustable-rate mortgages pooled by Fannie Mae
                    and Freddie Mac


Lender’s Rights     Secondary market covenants also address rights of lenders to monitor
                    and review borrowers’ property and pertinent documentation. to require
                    escrow accounts, and to act when contract provisions are violated by
                    the borrower. Lender’s rights can play a large role in defining the
                    amount of risk a lender will take in making a loan.

                    To protect the integrity of a loan pool and encourage the saleability of
                    pool-backed securities, underwriting standards usually prescribe


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                     Underwriting Standards   Used in Existing
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                     recourse actions necessary for a loan to be included in a pool. Without
                     such a standard, a pool is considered a higher risk. However, these stan-
                     dards vary. For example, at the discretion of the seller of the loans,
                     Freddie Mac and Fannie Mae can buy mortgages (1) with recourse,
                     meaning that the seller bears a certain amount of risk and cost of bor-
                     rower default, or (2) without recourse, meaning that Freddie Mac and
                     Fannie Mae bear risks with certain limitations.


Pooler’s Rights      Secondary market covenants usually do not address the                          rights of poolers
                     as a separate provision; however, they may incorporate                         certain actions
                     that poolers may take to ensure pool quality and protect                        the financial
                     interests of investors. Pooler’s rights generally deal with                     the recourse a
                     pooler has on a lender for loans included in a pool.

                     For example, Freddie Mac and Fannie Mae are required to purchase a
                     certain quality of loans from sellers and are authorized to require, at
                     their option sellers to buy back and/or replace loans when the seller has
                     violated its contract. In addition, lenders servicing mortgages purchased
                     by or in which Fannie Mae or Freddie Mac has a participation interest
                     are required to warrant that they will diligently perform all duties nec-
                     essary or incident to the proper servicing of the mortgage. Fannie Mae
                     reserves the right to terminate the servicing contract whenever the
                     lender breaches or fails to fulfill its responsibilities.


                     Through use of various mechanisms, credit enhancement transfers risks
Credit Enhancement   of a loan or loan pool to other parties, thereby reducing the overall risk
                     to one party. It is an assumption of risk to ensure principal and/or inter-
                     est payments to holders of securities backed by pools of loans. Credit
                     enhancements often result in better ratings for securities, thereby mak-
                     ing the securities more saleable. Credit enhancements include risk-based
                     fees, insurance, cash reserves, subordinated participation interests,
                     guarantees, and overcollateralization. The mechanisms, formulas, and
                     allowances for implementing credit enhancement are usually specified
                     within broad parameters in legislation and in more detail in implement-
                     ing regulations.


Risk-Based Fees      In government-sponsored markets, either the loan originator or the
                     pooler pays a fee to the secondary market organization involved to help
                     cover expected losses for loans sold into the market. If the fee is not
                     adequate to cover potential losses, losses could result from borrower


                     Page 40             GAO/RCED-90-118         Secondary   Market   Development   and Risk Implications
            Appendix III
            Underwriting Standards   bed   in Existing
            Secondary Markets




            delinquencies, defaults, and foreclosures. The fee is usually based on a
            percentage of the total amount of principal in a loan portfolio. Generally
            a minimum percent is used to establish a reserve fund for credit
            enhancement; a maximum percent limiting the amount that can be col-
            lected from any pool is usually not used in current secondary markets.
            This fee is to be actuarially based to reflect the amount, probability, and
            timing of expected losses. A fee that is too low can place unnecessary
            burdens on the parties involved or on other credit enhancements that
            may be used in conjunction with such a fee. A fee that is too high can
            result in an excessive reserve fund and increase the cost of credit to
            borrowers.

            Risk-based fee amounts are usually derived from legislation that may
            specify amounts or provide authority for implementing guidelines to
            specify amounts.


Insurance   Mortgage insurance is another credit enhancement that can be used sin-
            gularly or in conjunction with other enhancements to transfer risks in
            case of defaults. Generally it is provided through private mortgage
            insurance companies, is paid by the borrower, and is required by inves-
            tors on certain nongovernment-insured loans and by Fannie Mae and
            Freddie Mac on certain nongovernment-insured or guaranteed loans to
            protect them from financial loss due to borrower default. For example,
            conventional single or 2-to-4 family mortgages purchased by Fannie Mae
            and Freddie Mac having a loan-to-value ratio greater than 80 percent
            are required to be covered by private mortgage insurance; coverage is
            required on the amount that is more than 75 percent of the value of the
            property securing the mortgage. However, there are two conditions
            under which they can buy loans with ratios above 80 percent without
            mortgage insurance: (1) the seller, who may be the original lender or
            another certified seller, retains at least a lo-percent participation in the
            loan and (2) the seller sells Freddie Mac or Fannie Mae a loan with full
            recourse to the seller, meaning that if the loan goes into default, the
            seller is required to buy it back.

            Other types of insurance are also generally required in a mortgage mar-
            ket to ensure that the property is adequately protected. Title insurance
            protects ownership rights and hazard insurance insures financial protec-
            tion to the owner against property damage and personal liabilities. In
            the case of agricultural real estate loans, crop insurance can be used to
            provide additional protection against loss of cash flow due to failed or
            poor crops.


            Page 41              GAO/RCEB90-118          Secondary   Market   Development   and Risk Implications
                             Appendix III
                             Underwriting Standards   Used in Existing
                             Secondary Markets




                             Insurance provisions are usually found in implementing guidelines.


Cash Reserves                Cash reserves are established by the pooler arranging to provide cash
                             through its own sources or through lenders participating in a pool. This
                             cash is usually invested in U.S. Treasury notes or the equivalent thereof.
                             Cash reserves provide a reliable credit enhancement against loss. Such
                             an enhancement is preferred by investors. However, poolers and lenders
                             do not necessarily prefer this type of credit enhancement because it
                             reduces their financial flexibility by tying up cash that cannot be rein-
                             vested except in lower-paying Treasury notes. Government-sponsored
                             residential mortgage markets do not require a cash reserve. Cash
                             reserves are currently used by private sector issuers of securities
                             backed by conventional, residential, and commercial mortgages. The size
                             of the cash reserve depends on several factors including size of pool,
                             availability of other credit enhancements, quality of loans, and expected
                             default rates.

                             Cash reserve amounts in secondary markets are usually set by the
                             pooler or other entity that may issue the securities.


Subordinated Participation   Subordinated participation interests are created when a pooler and/or
Interests                    lender retains a portion of a mortgage pool and the holders of the
                             retained portion do not receive principal and interest payments (subor-
                             dinated payments) until after all other investors have received their
                             payments (senior payments). Some subordinated participation interest
                             structures require that a certain percentage of current cash flows to
                             subordinate holders be escrowed into a fund-called      a liquidity
                             reserve-to ensure readily available funds for payments to senior secur-
                             ity holders. Subordinated payments and liquidity reserves act as credit
                             enhancements for senior security holders. In case of default or other
                             nonpayment of principal and interest, subordinated payments and
                             liquidity reserves are used to make up payment shortfalls to holders of
                             senior class securities. In some cases, these subordinated participation
                             interests are packaged and sold as separate high-risk/high-yield
                             securities.

                             One example of a subordinated participation is the FmHA rural housing
                             program. F~HA has issued securities backed by mortgages that consist of
                             class A and B bonds and residual bonds retained by FEW. Class A bonds
                             are enhanced by subordinated class B bonds and a contingency reserve



                             Page 42              GAO/RCED-SO-118        Secondary   Market   Development   and Risk Implications
                        Appendix III
                        Underwriting Standards     Used in Existing
                        Secondary Markets




                        fund. Payments of principal and interest for class B bonds are subordi-
                        nated by payments to the class A bond holders.

                        Subordinated participation interests are usually set by the pooler or
                        other entity that may issue the securities although a rating agency may
                        require a higher subordination percentage depending on the risk fac-
                        tor-the quality of the underlying loans and expected losses.


Guarantees              A guarantee is a promise of a third party to pay security holders when
                        the issuer of the security fails to do so. Guarantees for existing secon-
                        dary markets are provided by the government in the case of Ginnie Mae
                        and SBA, while Freddie Mac and Fannie Mae back their own guarantees.
                        These guarantees are the most preferred credit enhancements available
                        in the markets today because the government promises to stand behind
                        Ginnie Mae and SBA securities in case of default on underlying mortgages
                        and because investors perceive that the government also stands behind
                        Freddie Mac and Fannie Mae in case of defaults. In addition, guarantees
                        by the government and government-chartered organizations usually
                        result in a lower cost of funds to the respective secondary markets
                        because of their actual and perceived government backing.

                        The nature of government-sponsored organization guarantees differs.
                        For example, Ginnie Mae and SBA are explicitly backed by the full faith
                        and credit’ of the U.S. government for timely payment of both principal
                        and interest. On the other hand, Freddie Mac provides a guarantee of
                        timely payment of interest and eventual payment of principal for securi-
                        ties backed by pools of mortgages, and Fannie Mae provides a guarantee
                        of timely payment of both principal and interest. Both are required to
                        use their resources to stand behind their guarantees and have a federal
                        line of credit-at the Treasury’s discretion-when     their resources are
                        depleted. Legislation limits the amount of the line of credit.

                        Government-sponsored organization guarantees are established by
                        legislation.


Overcollateralization   Overcollateralization in secondary markets means that the lender or
                        investor may require an individual loan or security to be backed by col-
                        lateral that exceeds the market value of the loan or security to minimize

                        ‘By pledging Its “full faith and credit,” the [‘nited States acknowledges that, in the event the bor-
                        rower defaults. the I-S. government ~11 be legally hable and will make payment.



                        Page 43                GAO/RCEDW118           Secondary   Market   Development   and Risk Implications
                          Appendix ID
                          Underwriting Standards   Used in Existing
                          Secondary Markets




                          the risk of loss due to default. For example, mortgage-backed bonds
                          issued by some private entities may be collateralized by a pool of mort-
                          gage loans or mortgage-backed securities that, at times, range between
                          125 and 240 percent of the bond’s total face value. Overcollateralization
                          is attributable to several investor concerns about (1) repayment of prin-
                          cipal between dates when market value of the collateral is calculated,
                          (2) possible impairment of the value of the collateral due to changes in
                          the economy, and (3) receiving protection against defaults of the
                          mortgages.

                          Standards for overcollateralization               are usually set in implementing
                          guidelines.


                          Under federal securities laws, most private securities sold to the public
Securities Registration   are required to be registered with the Securities and Exchange Commis-
and Disclosure            sion (SEC), which is responsible for protecting the investing public by
                          ensuring that full and fair disclosure of information is provided to pro-
                          spective investors. Registration statements filed with the SEC contain
                          information required by the Securities Act of 1933, including financial
                          statements prepared in accordance with generally accepted accounting
                          principles. However, prior to creating Farmer Mac, the Congress
                          exempted government-sponsored organizations’ mortgage-backed securi-
                          ties from registration and disclosure provisions. Nevertheless, Freddie
                          Mac and Fannie Mae make available to prospective investors documents
                          that disclose information about loan pools, and issuers of Ginnie Mae
                          pass-through securities are required to prepare a prospectus for each
                          prospective purchaser. Freddie Mac disclosure includes such character-
                          istics as loan sizes, loan-to-value ratios, and type of loans. SBA is
                          required to have the seller disclose information, such as assumed pre-
                          payment date, maturity date, and selling price of the loan.

                          This standard is usually specified in legislation.


Pooler Eligibility        For an entity to become a pooler in existing secondary markets, it must
                          be certified by a sponsoring governmental or private agency. Criteria for
                          certification are contained, in large part, in law with certain aspects
                          specified in implementing guidelines by each market regulator before a
                          pooler can buy and pool loans or sell securities to investors. These
                          requirements may be applicable not only to poolers but also to lenders.




                          Page 44              GAO/RCED-90-118        Secondary   Market   Development   and Risk Implications
                  Appendix Ill
                  Underwriting Standards   Used in Existing
                  Secondary Markets




                  The requirements related to loan pool underwriting standards vary
                  because of differences in loan characteristics and risk factors of the
                  various markets. For example, a pooler for SBA must provide an applica-
                  tion to SBA and be approved before purchasing guaranteed portions of
                  loans and pooling them. Freddie Mac and Fannie Mae act as poolers and
                  therefore do not certify poolers; however, using set criteria, they
                  approve lenders to be eligible to sell them loans. Ginnie Mae, on the
                  other hand, does not act as a pooler but approves poolers to pool loans
                  and issue Ginnie Mae-guaranteed securities.


                  Security design in a secondary market refers to the characteristics of a
Security Design   security used to sell pools of loans to investors. Generally, security
                  design characteristics encompass the cash flows from the underlying
                  mortgages, investor preferences for certain cash-flow characteristics,
                  rate-of-return implications by restructuring cash flows to meet investor
                  needs, and in some cases tax consequences of certain security struc-
                  tures. Security design decisions are usually established in implementing
                  guidelines; however, security design characteristics often evolve as mar-
                  ket environments change.

                  One of the most recent innovations in security design is the REMIC. A
                  REMIC is a tax-free entity that can hold mortgages secured by real estate
                  and can issue multiple-class (i.e., a pool with “tranches” having their
                  own maturity dates and interest rates) mortgage-backed securities to
                  investors. Its primary benefit is that it can be used to manage irregular
                  cash flows from mortgages and pass them through to investors on the
                  basis of the investors’ investment objectives. For example, some REMICS
                  are structured so that the securities are paid on a quarterly basis to
                  investors, and therefore the monthly mortgage payments must be rein-
                  vested pending quarterly distribution. A REMIC also could contain mort-
                  gages with annual, quarterly, and monthly mortgage payment loans and
                  structure payments to investors on a quarterly basis only. REMICS were
                  created in the 1986 Tax Reform Act and became viable as a result of tax
                  changes that made escrowing irregular cash flows for later payment a
                  tax-neutral transaction, thereby increasing the yields of REMICS to inves-
                  tors while offering them a more “plain vanilla” (less complicated)
                  investment vehicle in terms of cash flows that appear to be more
                  routine.


                  As a category of underwriting standards, documentation requirements
Documentation     apply to individual loans and pools of loans in a secondary market. In


                  Page 45              GAOIRCED-90-118        Secondary   Market   Development   and Risk Implications
                Appendix III
                Underwriting Standards   Used in Existing
                Secondary Markets




                general these requirements are used for verifying the quality of loans
                and pools. Two different levels of documentation are usually included in
                this standard for secondary markets.

            l Documentation of packages of loans generally includes a listing of loans
              in the pool, each original mortgage note, documents transferring the
              mortgage to the pooler, and any other specific documentation from indi-
              vidual loan portfolios the pooler considers necessary.
            . Documentation of individual loans usually includes loan application,
              credit report, verification of employment and income, appraisal report,
              photographs of property, sworn statements or affidavits (if any), mort-
              gage insurance certificate, mortgage payment history, hazard and title
              insurance policies, and verification of water rights and other legal
              documentation.

                Documentation criteria may also include management controls to be
                used in data processing for individual loans and pools. Documentation
                criteria are similar for most national secondary markets. Documentation
                standards are usually developed in implementing guidelines.


                Generally lenders who sell loans to poolers continue to service those
Servicing       individual loans; however, servicing may also be performed by the
                pooler or its designee. Servicing includes maintaining borrower contact,
                collecting payments, and managing all activities connected with the
                loans, Fannie Mae and Freddie Mac require their lenders/servicers to
                warrant the diligent performance of all duties that are necessary or inci-
                dental to the servicing of the individual loans. Fannie Mae reserves the
                right to terminate the servicing contract whenever the lender breaches
                or fails to fulfill its responsibilities. To ensure that mortgage loans are
                properly serviced and to facilitate transfer of servicing from one lender
                to another when necessary, Fannie Mae has established a minimum ser-
                vicing fee. Quality servicing is essential to protecting the interests of the
                investors and those that provided credit enhancements. For example,
                servicers must have an efficient collection system to minimize delin-
                quencies and defaults to ensure timely payments to investors. Generally,
                a servicer’s contract may be terminated and transferred to a new ser-
                vicer if Fannie Mae determines that servicing is inadequate on the basis
                of its servicing standards.

                Most secondary markets have their own standards for servicing. For
                example, Freddie Mac requires the servicer to service mortgages in
                accordance with its Sellers’ and Servicers’ Guide. For SBA, the lender is


                Page 46              GAO/RCED-SO-118        Secondary   Market   Development   and Risk Implications
                      Appendix ill
                      Underwriting Standards   Used in Existing
                      Secondary Markets




                      responsible for servicing loans in the manner set forth in SBA’S Loan
                      Guaranty Agreement and other rules and regulations. Our report enti-
                      tled Federal Agricultural Mortgage Corporation: Underwriting Stan-
                      dards Issues Facing the New Secondary Market (GAO/RCED-89-106BR, May
                      5, 1989) provides further information on servicing provisions of existing
                      secondary markets.

                      Servicing standards are usually set forth in implementing guidelines.


                      Monitoring requirements include a continuous or periodic review of
Monitoring            lender and pooler performance as well as market operations and man-
                      agement controls-such      as data information systems. Lender perform-
                      ance is usually monitored by poolers; and pooler performance, market
                      operations, and management controls are monitored by the regulating
                      agency. Monitoring standards are usually set by implementing guide-
                      lines. They are critical because they ensure quality performance of the
                      lenders, poolers, and servicers and help maintain market stability.

                      Each party in a secondary market has some monitoring responsibilities.
                      For example, Freddie Mac may at any time conduct an audit of mort-
                      gages for the purpose of verifying the servicer’s compliance with the
                      terms and conditions of the purchase contract. The servicer, in turn,
                      must monitor individual mortgages. Likewise, Ginnie Mae or a desig-
                      nated agent can audit all records of any entity that has any dealings
                      with its guaranty. Fannie Mae has a program of monitoring activities of
                      lenders and document custodians. Lender monitoring includes a review
                      of lender eligibility, loan origination practices, loan-servicing practices,
                      and the handling and remittance of mortgage payments.


                      When evaluating individual mortgages in a pool, a pooler verifies the
Property Appraisals   appraised value of the property used as loan collateral. An appraisal is
                      an estimate of real property value, as of a specific date, supported by an
                      appraiser’s analysis of data. Appraisals generally involve valuing the
                      property on a cost or income basis and obtaining a site analysis, site
                      location map, survey site plan, neighborhood analysis, land value analy-
                      sis, and comparable site sales maps. Appraisals are necessary to help
                      quantify various risks associated with individual loans. Our report enti-
                      tled Federal Agricultural Mortgage Corporation: Underwriting Stan-
                      dards Issues Facing the New Secondary Market (GAOpCED-89-106BR, May
                      5, 1989) provides a detailed discussion of appraisal standards.



                      Page 47              GAO/RCED90-118         Secondary   Market   Development   and Risk Implications
Appendix III
Underwriting Standards   Used in Existing
Secondary Markets




Secondary markets have general appraisal requirements that incorpo-
rate various commonly approved approaches to appraisal. Ginnie Mae
and SBA requirements both contain standards similar to Fannie Mae’s
and Freddie Mac%. For example, both review appraisal reports to deter-
mine if estimated market value and related risks are supported. They
review appraisal and market value estimates for completeness, accu-
racy, and appraising logic. They do not approve specific appraisers but
can refuse appraisals done by specific appraisers. Their lenders approve
and select appraisers who must be qualified and experienced in apprais-
ing properties similar to the type being appraised.

Appraisal standards are generally set in implementing guidelines.




Page 48             GAO/RCED-90-118         Secondary   Market   Development   and Riik Implications
Appendix IV

Key Issues Concerning the Development of a
Secondary Market for Agricultural Real
Estate Loans
                            Questions for further consideration in the secondary market debate:’

                        l Is federal government involvement needed to develop a large national-
                          scope secondary market for farm real estate loans?
                        l What impact would a large national-scope secondary market for farm
                          real estate loans have on the Farm Credit System (ITS) and other
                          lenders?
                        l Should FCS be given powers to operate as the secondary market for ail
                          lenders?
                        l Could a new secondary market entity coexist with the FCS?
                        . What loans should be eligible to be sold in the secondary market?

                            On the basis of our examination of nine legislative proposals to establish
                            a secondary market for agricultural real estate loans introduced in the
                            100th Congress and our discussions with individuals and officials from
                            both the private sector and government, in July 1987 we raised several
                            issues that merited additional consideration in the secondary market
                            debate.” Our observations on the following questions should help high-
                            light the issues involved at the time of our July 1987 report.


                            Given the historical experience with farm real estate lending, it is
Is Federal Government       unlikely that a large national-scope secondary market for farm real
Involvement Needed          estate loans can be established without federal government involve-
to Develop a Large          ment. Historically, the federal government has encouraged FCS’ role in
                            providing farm real estate loans on reasonable terms because it had
National-Scope              determined that such credit was not adequately provided through other
Secondary Market for        lenders. FCS historically has been able to obtain a stable source of funds
Farrn Real Estate           from the capital markets to make long-term farm real estate loans. Wall
                            Street investment house representatives told us that a large secondary
Loans?                      market for farm real estate loans could not exist without some degree of
                            government involvement. Given the current financial stress in the farm
                            sector-combined      with the economic, weather, geographic, and political
                            environments normally facing the sector-potential      risks faced by
                            investors are great.




                            ‘This appendix was developed from information contained in section 3 of our report entitled Farm
                            Finance: Secondary Markets for Agricultural Real Estate Loans (GAO/RCED87-149BR, July 17,
                            1987).
                            “Our report entitled Farm Finance: Secondaw Markets for Agricultural Real Estate Loans (GAO/
                            RCED-87-149BR. July 17, 1987) contains legislative profiles on each of the nine proposals.



                            Page 49               GAO/RCEDSO-118      Secondary   Market   Development   and Risk Implications
                       Appendix IV
                       Key Issues Concerning the Development  of a
                       Secondary Market for Agricultural Real
                       Estate Loans




                       The private sector has not, of its own accord, developed a large national-
                       scope farm real estate secondary market. The legislative proposals all
                       provide some degree of government involvement to, at a minimum, get
                       such a market off the ground. The major consideration in this area is to
                       what extent federal backing is needed to stimulate or sustain secondary
                       market development. Will the federal government have to be involved in
                       the short or long term to ensure the long-term existence of such a secon-
                       dary market? Will the federal government have to provide some level of
                       credit enhancement, such as a guarantee or insurance, or would a fed-
                       eral charter be adequate?

                       Direct federal involvement in the secondary market for home mortgages
                       was critical to the development of that market and still plays a major
                       role today. In the early years federal insurance and guarantees of mort-
                       gages and mortgage-backed securities helped accelerate secondary mar-
                       ket development. Today, a significant amount of the home secondary
                       market activity is supported by a federally owned organization-Ginnie
                       Mae-and two other federally chartered organizations-Fannie         Mae
                       and Freddie Mac. The federal government does not guarantee or insure
                       Fannie Mae’s or Freddie Mac’s securities, but like the FCS, investors
                       assume the government stands behind their securities. The three organi-
                       zations accounted for about 69 percent of all mortgage-backed securities
                       issued in 1988. Fannie Mae and Freddie Mac accounted for about 47
                       percent.

                       Like the home mortgage market, a federally chartered organization (the
                       FCS)supports the majority of farm real estate lending today. If the home
                       mortgage secondary market offers any answers as to the need for gov-
                       ernment involvement to establish a large secondary market for agricul-
                       tural real estate loans, the answer is probably yes.


                       The Congress is currently concerned about the health of FCS because it
What Impact Would a    has lost billions of dollars in the last few years and is expected to need
Large National-Scope   federal assistance in the future. The Congress is also concerned about
Secondary Market for   the health of commercial banks that serve agriculture because they have
                       been failing at unusually high rates during the same period. We believe
Farm Real Estate       that a secondary market is not a short-term solution to the current
Loans Have on FCS      financial stress in the agricultural sector, but it does have major long-
and Other Lenders?     term implications.

                       Development of a national secondary market for agricultural real estate
                       loans could strengthen, weaken or leave unchanged the fates of FCS and


                       Page 50             GAO/RCED90-118     Secondary   Market   Development   and Riik Implications
Appendix IV
Key Issues Concerning the Development  of a
Secondary Market for Agricultural Real
Estate Loans




other lenders to agriculture. However, the current legislative proposals
do not provide enough information to allow a complete understanding of
how farmers, lenders, or the government would be potentially affected.

Because of its access to a stable source of credit through the capital mar-
kets that other lenders could not match, FCS has dominated farm mort-
gage lending. Commercial banks, generally, have obtained competitively
priced, short-term funds from customer deposits, which has aliowed
them to maint.ain a substantial market share for short-term agricultural
loans. However, because these funds are short-term deposits, large per-
centages of them cannot be prudently committed to long-term fixed-rate
loans. Commercial banks and other lenders see the ability to convert
long-term mortgage loans to short-term assets (through mortgage loan
sales) as positive.

If commercial banks could, without restriction, access the same source
of funds at the same cost as ES, they could potentially increase their
market share of total farm lending. Conversely, FCS could potentially
lose market share and, all other things being equal, lose a proportionate
amount of interest income.

However, the potential impact of a secondary market on FCS and other
lenders could be better understood if we knew what organization would
operate the market, what fees would be charged, what loan volume
might be expected, and what restrictions would be placed on participa-
tion. If total farm lending increased substantially and FCS operated a sec-
ondary market that all lenders could access without restriction and for
which it charged fees to lenders, including the FCS, to provide credit
enhancement, it might improve its financial position, even if it lost mar-
ket share as a primary lender.

On the other hand, if a secondary market for farm real estate loans were
to be controlled by any particular lender group, that group could use its
control to improve its fee income or market share at the expense of
other lenders. In addition. entry to the market could be restricted by
qualifying lender and loan criteria. For example, if only lenders with an
asset size of $40 million or more would be able to participate, most
“agricultural banks,” as defined by the Federal Reserve Board. would be
precluded from participating. As of September 30, 1989, the average
asset size of agricultural banks was about $31 million.

Some commercial agricultural lenders are already concerned about FCS’
market share because of the recent changes FCS made in response to the


Page 51             GAOIRCED-90-116    Secondary   Market   Development   and Risk Implications
                       AppendixN
                       Key Issues Concerning the Development  of a
                       Secondary Market for Agricultural Real
                       Estate bans




                       need to be more efficient and minimize operating losses, coupled with its
                       favored access to the capital markets. Prior to the early 198Os, FCS orga-
                       nizational structure was decentralized down to the local level, with sep-
                       arate locations and management for production credit and real estate
                       credit activities. The commercial banking sector’s concern about losing
                       market share flows from reorganizations of FCSat the local level that
                       have taken place since the early 1980s. For example, FCS production
                       lending and real estate lending facilities have consolidated in some areas
                       and colocated in others. The commercial banking sector sees the conve-
                       nience of “one-stop banking” at FCS, for both production and real estate
                       loans, as a catalyst that could eventually shift market share of short-
                       term loans from commercial banks to FCS.


                       Arguments for making FCS the secondary market for farm real estate
Should FCS E3eGiven    loans are that FCS already performs some secondary market functions,
Powers to Operate as   operates in all states, and needs an infusion of capital. It provides liquid-
the Secondary Market   ity and attracts a wide range of investors; insulates its borrowers
                       against the effects of cyclical flows of funds; enhances regional flows of
for All Lenders?       funds to farmers; and reduces regional differences in interest rates by
                       allowing money to flow to areas of higher interest rates, thereby exert-
                       ing downward pressure on those rates. FCS has been able to perform
                       these functions largely because investors perceive that the government
                       stands behind its securities. This perception has traditionally enabled it
                       to access the capital markets routinely for funds. In addition, its charter
                       has permitted it to operate as a national lending organization enabling it
                       to perform the cross-region functions normally attributed to secondary
                       markets.

                       On the other hand, arguments can be made against FCS being the secon-
                       dary market. With the changing face of agricultural lending, if the mar-
                       ket is not structured in such a way as to allow agricultural lenders,
                       other than FCS, equal access to the capital markets for farm real estate
                       lending, the agricultural credit delivery network as a whole may become
                       too vulnerable to financial stress. Commercial “agricultural banks” may
                       become less able to compete with FCS.

                       Furthermore, the implications for managing the government’s risk expo-
                       sure to the national agricultural credit portfolio may be unacceptable if
                       one lender-Fcs-increases       its market share of farm lending. A GAO
                       report entitled Financial Condition of American Agriculture (GAO;
                       RCED-86-09, Oct. 10, 1985) pointed out that farm lenders with loan portfo-
                       lios more concentrated in agricultural lending were more vulnerable to


                       Page 52             GAO/RCED-90-118   Secondary   Market   Development   and Risk Implications
                         Appendix N
                         Key Issues Concerning the Development  of a
                         Secondary Market for Agricultural Real
                         Estate Loans




                         financial stress in the sector. One solution to this problem may be to
                         develop short-range and long-range plans for agricultural lending that
                         would encourage as many lenders as possible to compete for farm lend-
                         ing, spreading the risk of lending to one sector, as much as possible,
                         throughout the lender and investor community. This strategy could pos-
                         sibly incorporate a plan for FCSto operate the secondary market,
                         thereby deriving more of its future income from secondary market
                         activities rather than from primary lending.


                         FCS’ favored status in the capital markets raises questions as to whether
Could a New              a new secondary market entity could also compete as well for funds.
Secondary Market         The issue most related to this question is whether the new entity could
Entity Coexist With      attract funds at an interest rate that would allow lenders to make loans
                         at competitive rates.
the FCS?
                         A related question is how well the investment community would accept
                         another agricultural lending entity, especially when the agricultural sec-
                         tor is still experiencing financial stress and FCS is losing billions of dol-
                         lars. Wall Street brokerage house representatives told us that if a new
                         secondary market were to be established, it would require at, least the
                         same level of government backing perceived by investors for FCS and
                         possibly more to initially establish the market.


                         Probably the most important issue to determining the potential impacts
What Loans Should Be     of a secondary market on farmers, lenders, and the government is
Eligible to Be Sold in   underwriting criteria that embody specific loan criteria. This single ele-
the Secondary            ment can determine such factors as market volume; expected loss expe-
                         rience; likely costs to risk bearers. such as investors and credit
Market?                  enhancers; and social benefits to the farm community. For example,
                         underwriting criteria that allowed virtually all farm loans to be sold in
                         the secondary market would result in a high expected loss experience
                         and high risk to investors and others who have provided credit
                         enhancements.

                         Another component of this eligibility question is whether land-based
                         agricultural loans can be adequately standardized to be included in a
                         national-scope secondary market. While it is possible to develop a stan-
                         dardized loan application that will go a long way to understanding risks
                         associated with the farm sector and individual farm operations, it will
                         likely be more difficult to develop large pools of loans with substantially
                         homogeneous characteristics. For example. Midwest grain farms have


                         Page 53             GAO/RCED-90-118    Secondary   Market   Development   and Risk Implications
Appendix N
Key Issues Concerning the Development  of a
Secondary Market for Agricultural Real
Estate Loans




much different cash-flow characteristics than West coast ranches with
tree crops and vineyards.




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Appendix V

Key Issues Concerning the Development of
Underwriting Standards for Farmer Mac

               Questions for further consideration in the secondary market underwrit-
               ing standards debate include the following:l

               What are the implications of the geographical diversity requirements in
               the act?
               What are the implications of the agricultural commodity diversity
               requirements in the act?
               Can state-of-the-art real estate appraisals provide enough assurance in
               verifying cash-flow potential and agricultural real estate values to
               enable prudent loan-making decisions?
               How would the use of lender or pooler subordinated participation inter-
               ests versus cash reserves affect the federal government’s financial risk
               on securities guaranteed by Farmer Mac?
               Will the prescribed risk-based fees be adequate for Farmer Mac?
               What implications do SEC registration and disclosure requirements have
               for Farmer Mac-guaranteed securities?
               What effect will the loan-to-value ratio in the act have on government
               risk?
               What effect will rural housing provisions have on Farmer Mac-guaran-
               teed securities and how will such loans be packaged?

               On the basis of our review of underwriting standards provisions for
               Farmer Mac in the Agricultural Credit Act of 1987, underwriting stan-
               dards and practices used in various existing secondary markets, and our
               discussions with individuals and officials from both the private sector
               and the government, in our May 1989 report we raised the following key
               issues relating to overall risk management that merited consideration
               during the legislative review process for Farmer Mac underwriting
               standards.




                ’ This appendix was developed from information contained in section 4 of our report entitled Federal
                Agricultural Mortgage Corporation: I’nderwriting Standards Issues Facing the New Secondary Mar-
               -ket (GAO/RCED-8%IOGBR, May 5.1989).



               Page 55                GAOIRCED-90-118      Secondary   Market   Development   and Risk Implications
                      Appendix V
                      Key Issues Concerning the Development  of
                      Underwriting  Standards for Farmer Mac




                      The act requires each loan pool to consist of loans that are secured by
What Are the          agricultural real estate that is widely distributed geographically. The act
Implications of the   does not define what is meant by “widely distributed geographically”;
Geographical          however, this concept could have a major effect on market operation
                      and performance.
Diversity
Requirements in the   Defining geographic diversity will require determining levels of risk
Act?                  Farmer Mac should accept in providing guarantees for pools of loans
                      from different areas of the country. For example, pools of loans concen-
                      trated in one area or region whose economy is not diversified are more
                      likely to fluctuate with that area’s economic conditions, thereby making
                      the pool more risky. Some areas of the United States have a higher
                      degree of risk than others because of such factors as less crop diversity,
                      more unpredictable weather conditions, poorer soil, fewer transporta-
                      tion networks, and the area’s reliance on export versus domestic mar-
                      kets. Secondary markets, in general, have the ability to reduce overall
                      risk by spreading risks of individual loans over a pool of loans. One way
                      to spread those risks is to include in the pool loans from various parts of
                      the United States so that the pool does not consist of loans only from the
                      same area/region. Areas, such as the West Coast-with       diverse agricul-
                      tural commodities and a high degree of domestic and export commodity
                      mix-could conceivably be packaged into pools that would have less
                      overall risk than a pool of loans from the Midwest-with      a reliance on
                      export markets that may rise as they did in the 1970s or slump as they
                      did in the early 1980s. Thus, packaging Midwest and West Coast loans
                      into one pool may improve the risk performance of a purely midwestern
                      pool of loans.

                       Defining what is meant by loans that are secured by agricultural real
                      estate that is widely distributed geographically may also require deter-
                      mining the size that financial institutions should be to be poolers of
                      Farmer Mac-guaranteed loans. A definition of “widely distributed” may
                      stipulate any of several pool constructions: a national portfolio consist-
                      ing of loans from all regions of the United States; a regional portfolio of
                      loans from one region (such as the Southwest, Midwest, or West Coast);
                      a portfolio from one or two states; or any combination of these or other
                      interpretations. The wider the area encompassed in this definition, the
                      more difficult it will be for smaller financial entities to be primary
                      poolers since they would need to have access to a regional or nationwide
                      network to purchase loans outside their areas. However, under this sce-
                      nario, smaller organizations could conceivably become subpoolers or
                      regional poolers that package loans to be sold to the major pooler and
                      included in large pools receiving a Farmer Mac guarantee.


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Key Issues Concerning the Development  of
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The demographic characteristics of stockholders that purchased Farmer
Mac stock indicate that the market structure may be able to accommo-
date a national diversification strategy and, at the same time, meet legis-
lative requirements that smaller institutions be included in the market
so that liquidity in the loan market can be achieved at these institutions.
Preliminary analysis indicates that both small and large institutions-
including those with assets of $25 million or less and those with over
$160 billion-operating     in all states have purchased Farmer Mac stock
and that they are predominantly from the Midwest. In addition, most of
those that have purchased enough stock to be poolers are generally
large enough to be regional or national poolers.

In December 1988, the Farmer Mac Interim Board completed its sale of
common stock for capitalization purposes and for purposes of determin-
ing which stockholders would qualify to be poolers and which ones
could be only loan originators. The stock was divided into two classes-
A and B-with the same par value per share. Class A stock was to be
held only by non+cs entities that are insurance companies, banks, or
other financial institutions. Class B stock was to be held only by FCS
institutions. All potential stockholders were required to purchase at
least 250 shares of stock to participate in the market. Potential class A
stock purchasers had to purchase designated amounts of stock based on
their asset size while potential class B stock purchasers had to purchase
only 250 shares regardless of size. Potential class A stockholders were
required to purchase stock based on the following schedule: 250 shares
for institutions with less than $50 million in assets; 500 shares for insti-
tutions with between $50 million and $100 million in assets; 1,250
shares for institutions with between $100 million to $500 million in
assets; and 5,000 shares for institutions with over $500 million in assets.
Additionally, both class A and class B stock purchasers who desired to
become poolers had to purchase at least 12,500 shares.

Preliminary analysis of class A stock purchase transactions indicates
that 1,614 institutions purchased stock. Information on class B stock
was not available for analysis. Of those that purchased class A stock, 22
purchased enough to qualify, contingent on meeting Farmer Mac certifi-
cation standards, as poolers-10 of which are commercial banking insti-
tutions, 3 are investment banks, 6 are insurance companies, 2 are trust
companies, and 1 is a commodity firm.

According to an analysis performed by the Independent Bankers Associ-
ation of America, of the 1,614 institutions that purchased class A stock,
1,496 are commercial banking institutions. Current analysis indicates


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                        Appendix V
                        Key Issues Concerning the Development of
                        Underwrltlng Standards for Farmer Mac




                        only that the other 118 were not commercial banks. About 74 percent, or
                        1,100 of the commercial banking institutions have assets of less than
                        $50 million-574    with assets of $25 million or less, 326 with assets from
                        $25 million to $37.5 million, and 203 with assets from $37.5 million to
                        $50 million. In addition, about 26 percent, or 393 banking institutions
                        with assets over $50 million bought shares: 284 with assets from $50
                        million to $100 million; 93 with assets from $100 million to $500 million;
                        and 16 with assets over $500 million. Involving the smaller banking
                        institutions in Farmer Mac appears to be consistent with the act’s
                        requirement of not discriminating against small lenders and its purpose
                        of providing greater liquidity so that agricultural borrowers might bene-
                        fit from the new market.

                        At the time the shares were offered, all 12 Farm Credit Banks and the
                        Central Bank for Cooperatives indicated that they would purchase class
                        B shares. As a result of the Agricultural Credit Act of 1987, the FCS is
                        undergoing reorganization including a mandatory merger of various
                        banks comprising the system. Although FCSofficials had made no deci-
                        sions on who would be poolers or originators, they told us that they are
                        currently developing an Fcs-wide certified pooler with all FCSinstitu-
                        tions as potential originators of loans.


                        The act states that a pool must consist of agricultural real estate loans
What Are the            representing a wide range of agricultural commodities. The term “wide
Implications of         range” is not defined in the act, yet such a definition could have a major
Agricultural            impact on the operation of the market. This issue is closely related to
Co-odity    Diversity   geographical diversity.

Requirements in the     Secondary markets can use loan diversity within a pool to help spread
Act?                    risks; however, most residential secondary markets have loan pools that
                        are homogeneous in terms of loan types, for example, l-to-4 family
                        homes. In the case of Farmer Mac, it may be possible to reduce risk of
                        default of any one pool when a pool includes loans covering a diversity
                        of commodities. If a pool consists of loans backed by agricultural real
                        estate used to produce a diversity of commodities (such as wheat,
                        grapes, cattle, corn, vegetables, and fruit), poor economic performance
                        by any one commodity would tend to have less effect on the overall
                        portfolio than a pool that consisted of only one commodity type and that
                        commodity was performing poorly.

                        Individual banks and holding companies located in a region that pro-
                        duces primarily one or two types of commodities may find it easier to


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                           Appendix V
                           Key Issues Concerning the Development of
                           Underwriting Standards for Farmer Mac




                           become poolers of agricultural real estate loans if a “wide range” of
                           commodity diversity is defined to mean commodity diversity within a
                           given region. However, that definition may translate to smaller rather
                           than a larger number of commodities and more potential risks fol
                           poolers. On the other hand, national poolers may have less risk-as
                           explained above-and regional poolers would probably be able to buy
                           loans outside their regions to become national poolers.


                           An agricultural real estate loan by nature is more difficult to appraise
Can State-Of-The-Art       because of its complexity. It tends to be more similar to a commercial
Real Estate Appraisals     real estate loan-rather    than a residential loan-relying   on income gen-
Provide Enough             erated through commodity production to repay the loan. In contrast, res-
                           idential real estate, even rental property, relies on the current resident’s
Assurance in               income that can come from diverse sources reflecting d wide variety of
Verifying Cash-Flow        professions.
Potential and              An appraisal of agricultural real estate depends, to a large extent. on
Agricultural Real          cash flow as a key factor in making a reliable estimate of both annual
Estate Values to           operating income and the fair market value of any commercial enter-
                           prise or farm. Income and fair market value estimates are used to deter-
Enable Prudent Loan-       mine the debt-carrying ability of the enterprise. thereby providing
Making Decisions?          information to evaluate against certain qualifying financial ratios. The
                           fair market value estimate, which represents the appraised value of the
                           enterprise, is also used in setting maximum loan size by multiplying fair
                           market value by the loan-to-value ratio.

                           State-of-the-art appraisals are based primarily on residential rather
                           than commercial business appraisal methods and techniques. Differ-
                           ences between housing and agricultural markets bring into question
                           whether these methods and techniques will provide a reliable verifica-
                           tion of agricultural real estate values and related cash-flow patterns for
                           loan-making and underwriting purposes. (Our report entitled Federal
                           Agricultural Mortgage Corporation: Underwriting Standards Issues Fac-
                           ing the New Secondary Market (GAO/HCED-89-lo6HH, May 5. 1989) provides
                           further information on appraisals.) Some important, distinctions between
                           agriculture and housing credit markets exist:

                         . Off-farm income can provide an additional income stream to evaluate in
                           making loans. However, loans for agricultural real estate are based on
                           the expected cash flow generated by commodities the borrolver can pro-
                           duce and sell, realizing that production and sales rely heavily on fac-
                           tors-such as changing federal farm subsidies, world market demand.


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    Key Issues Concerning the Development  of
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    weather conditions, and interest rates-that     are largely uncontrollable
    by the farmer.
l   A residence generally has a relatively stable collateral value that some
    business enterprises may lack.
l   Farm properties are much less homogeneous than residences, have
    higher unit prices, are harder to appraise, and may be more difficult to
    liquidate if the loan defaults.
l   In agriculture, the capacity of the operator, in terms of both financial
    and business/management skills, has an important determining effect on
    the value of the collateral.

    In recent years, various government reports have questioned the ability
    of the appraisal industry and financial institutions involved in loan
    making to ensure that appraisal practices provide a basis for adequate
    loan-making decisions. According to a 1988 report from the House Com-
    mittee on Government Operations, faulty and fraudulent appraisals
    have been associated with a number of failed banks and savings and
    loan institutions. According to the report, these abusive appraisals are
    recognized as a serious national problem whose harmful effects are
    widespread and costly. Additionally, a 1986 report from the House Com-
    mittee on Government Operations states that standardization in
    appraiser qualifications is lacking-only    33 percent of the nation’s real
    estate appraisers belong to any highly regarded professional trade asso-
    ciation; and these organizations have been unable to successfully disci-
    pline their members. Further, in testimony before the House Committee
    on Banking, Finance and Urban Affairs on January 13, 1989.2 GAO
    reported that, of the 26 failed savings and loan institutions reviewed, 88
    percent had violated federal regulations requiring them to obtain
    appraisals of loans. Some did not obtain appraisals or obtained apprais-
    als after the loan had been made.

    The Congress has recently passed the Financial Institutions Reform,
    Recovery, and Enforcement Act of 1989. The act requires appraisal
    standards at the federal level to ensure that loans or transactions
    requiring appraisals have appraisals performed in accordance with
    standards to be developed under the purview of the Federal Financial
    Institutions Examination Council-an organization that coordinates the
    activities of agencies that regulate depository institutions, such as com-
    mercial banks, credit unions. and savings and loan institutions. The goal
    of the act is to reduce appraisal fraud, abuse, and inconsistency and to

    ‘Failed Financial Institutions: Reasons. Costs. Remedies and l’nsolved Issues (GAO:T-.4FMD-89-l.
    Jan. 13.1989)



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                          Key Issues Concerning the Development of
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                          raise the standards of the real estate appraisal. However, it appears that
                          loans made by insurance companies and FCS institutions-potential
                          major participants in the new market-will     not come under the
                          appraisal provisions of the 1989 act. According to officials of the Ameri-
                          can Society of Farm Managers and Rural Appraisers, mortgages sold in
                          the new agricultural real estate secondary market should be included in
                          the appraisal guidelines in this proposed legislation. They said that
                          appraisers of agricultural real estate should be certified with additional
                          accreditation and education documenting their abilities as rural real
                          estate appraisers.

                          Given the billions of dollars of government-sponsored secondary mort-
                          gage market securities outstanding and the current savings and loan
                          problems-many       directly related to appraisals-the potential liability
                          to the government, as a result, is becoming an increasingly important
                          concern for secondary markets in general.” Because Farmer Mac’s legis-
                          lative history indicates that the Congress did not want the government
                          to assume major risks in this market, the “lessons learned” from the
                          savings and loan appraisal problems may help formulate appraisal pol-
                          icy for Farmer Mac.


How Would the Use of      The act provides that a pooler must establish either a cash reserve or
                          subordinated participation interests of at least 10 percent of the out-
Lender or Pooler          standing principal of a pool of loans. In the event of a pooler’s inability
Subordinated              to make principal and interest payments to investors, these funding
                          sources are to be used first to make such payments. The act does not
Participation Interests   provide a clear definition of subordinated participation interest. In addi-
Versus Cash Reserves      tion, it does not explain how poolers’ and lenders’ cash reserves are to
Affect the Federal        be structured.
Government’s              The Senate report on the bill, which became the Farmer Mac legislation,
Financial Risk on         states that the subordinated participation interest provision ensures
                          that FCS banks and associations in a weakened financial condition will
Securities Guaranteed     not be precluded from participating in this market because of an inabil-
by Farmer Mac?            ity to establish a cash reserve. The conference report accompanying the

                          “In September 1989. the Subcommittee on Oversight, House Committee on Ways and Means. held
                          hearings on the capital adequacy of go\ emment-sponsored enterprises, mcludmg Farmer Mac Out
                          testimonies, Government-Sponsored Enterprises (GAO/T-AFMD-89-16, Sept. 28. 1989) and Issues
                          Surrounding I’nderwriting Standards Developed by the Federal Agricultural Mortgage Corporatton
                          (GAO,‘T-RCED-89-71, Sept 27. 1989 1.were presented at those hearings In addition, our report. Fed-
                          eral Credit Insurance: Programs May Require Increased Federal .4ssistance in the Future (GAO.’
                          AFMD-90-l 1, No\. 16. 1989). also raises concerns about the growing potential government liabilit>
                          from government-sponsored enterprises (GSEs).



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                             Key Issues Concerning the Development of
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                             act states that it was the intent of the conferees to provide poolers with
                             flexibility in the design of subordinated participation interests.
                             Although the act specifies a cash reserve of at least 10 percent of the
                             outstanding principal of the pool is to be established, it does not specify
                             that it must be “maintained” at the same level.

                             The legislative history does not indicate whether the Congress intended
                             to accept more risk by using either a subordinated participation or a
                             cash reserve credit enhancement but does indicate that the Congress did
                             not want to assume major risk exposure from Farmer Mac. The amount
                             of potential government risk that is ultimately realized depends on how
                             the cash reserves and subordinated participation interests are
                             structured.


Current Usage of Cash        An entity that issues securities may establish and maintain                  a pure cash
Reserves                     reserve by depositing a predetermined amount of cash into                    a separate
                             account at the time securities are sold to investors. Interest               income
                             earned on the reserve may be added to the reserve balance                    or with-
                             drawn, depending on the terms of the contract.

                             Although existing government-sponsored residential mortgage markets
                             do not require cash reserves, private issuers of conventional mortgage-
                             backed securities, at times, establish cash reserves in conjunction with
                             other credit enhancements. In the event of payment delays, the issuer
                             draws down the reserve as necessary to provide payments to investors.
                             The initial size of such a reserve and the amount maintained-as     a per-
                             centage of the outstanding principal of the pool-vary     according to the
                             risk of the underlying loans and the rating of the security sought by the
                             issuer. The size of a cash reserve also depends on what other credit
                             enhancements have been set up for the security.


Current Usage of             The subordinated participation is a relatively new credit enhancement
Subordinated Participation   technique that has taken several forms initially and through evolution.
                             Essentially, a subordinated participation is that portion of a loan that a
Interests                    lender does not sell when selling loans in a secondary market transac-
                             tion. When the lender retains ownership in a portion of the loan, that
                             lender also has the right to receive principal and interest payments on
                             that portion of the loan. In the event of a cash-flow shortage caused b\
                             borrower nonpayment on the underlying loans, the lender agrees to
                             subordinate or forego the principal and interest payments that it would
                             receive during a payment period so those funds can be used to make


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                            Key Issues Concerning the Development  of
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                            payments to investors holding senior securities-those      that receive pay-
                            ments first-during    that same period. This security design reduces or
                            eliminates reliance on guarantors other than lenders and poolers. In
                            existing secondary markets, the subordinated portion is retained by the
                            lender or pooler or is sold to investors as a separate class of securities.
                            To make the subordinate security more attractive to investors, in prac-
                            tice, it has been supplemented by other forms of credit enhancements,
                            such as insurance or cash reserves dedicated to protect subordinate
                            security investors.

                            Some private poolers of conventional residential and commercial real
                            estate mortgages use a security design by which principal and interest
                            payments, when received, are paid first to senior security holders with
                            any excess cash being disbursed to subordinated security holders. One
                            characteristic of this type of security design is that unless specified
                            otherwise, only the current payment-whether         it is monthly. quarterly,
                            or annually-to    the subordinate holder can be used to pay cash-flow
                            shortages to senior security holders; no past or future payments t.o
                            subordinate holders can be used. Having no recourse beyond the current
                            payment period could limit risk to the lender and shift that risk to sec-
                            ondary market guarantors in periods where large cash-flow shortfalls
                            occur in a short time rather than over a period of time.

                            To guard against this risk and provide additional credit enhancement to
                            the investors, poolers and lenders holding subordinated participations
                            sometimes establish a small cash reserve-referred     to as a liquidity
                            reserve-for    disbursing cash to investors who hold senior securities.
                            The liquidity reserve has been established by lenders or poolers deposit-
                            ing a certain amount in the reserve when the loan is pooled or by
                            escrowing into the reserve a certain percentage-generally      less than 1
                            percent in housing markets-of     each month’s cash flow to the
                            subordinate security holder. The amount of the liquidity reserve, at
                            times, is determined by rating agencies who set formulas based on other
                            credit enhancements and the ratings desired for a given security.


Unclear What Effects the    The legislative history indicates that the government did not want to be
Use of Subordinated         exposed to major risk through Farmer Mac. One method of reducing gov-
                            ernment risk was to allow poolers to establish cash reserves or subordi-
Participation Interests     nated participation imerests to ensure payments to investors. b’hen
Versus Cash Reserves Will   borrowers make payments of principal and interest on loans backing up
Have on Government Risk     a pool! these payments are used to pay investors who hold the securities
                            backed by the pool. The cash reserves and subordinated participat,ions


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Key Issues Concerning the Development  of
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are provided for this market so that, in the event that borrowers do not
make payments as scheduled, funds are available from poolers and lend-
ers rather than from the government to pay investors to make up
shortfalls. However, even with a cash reserve or subordinated-participa-
tion-interest level of at least 10 percent-the  level required by the
implementing legislation-Farmer       Mac and the government may be
exposed to risk.

The act states that a pooler must take full recourse against reserves and
subordinated participations; but because the act does not specify the
mechanics of either, it is not clear exactly what full recourse entails. In
the case of a cash reserve, full recourse would probably apply to all cash
in the reserve. With a subordinated participation, full recourse would be
according to the specific terms set out in the subordinated participation
agreement. Since subordinated participation is not yet sufficiently
defined to determine what full recourse entails, the financial and risk
implications of full recourse to the subordinated participation cannot be
determined. Until it is determined how the subordinated participation or
cash reserve will be structured, the comparative risk implications to the
government when using either of these for Farmer Mac-guaranteed
securities cannot be determined. However, to the degree that limitations
are put on the ability of poolers to collect cash-flow shortages-result-
ing from nonpayment by borrowers-from          a subordinated participation
or cash reserve, Farmer Mac and potentially the government will be
expected to make up the difference.

The most critical concern in structuring a subordinated participation or
a cash reserve focuses on how likely it will be that cash-flow shortages
from borrower nonpayment will exceed cash reserves or the amount of
shortages that can be obtained from subordinated holders to pay to
investors. If it is likely that payment shortages will exceed the cash
reserves or the amount that may be obtained through recourse to the
subordinate security holders, then the question focuses on who will pro-
vide the guaranteed payments to investors. IJnless Farmer Mac is able to
make up that shortfall through other mechanisms, such as liquidity
reserves and risk-based fees, it may have to activate its $1.5 billion line
of credit from the Treasury. If that were to become inadequat,e, the gov-
ernment’s implied backing of the organization would be test,ed.




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                               Key Issues Concerning the Development of
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                               The ultimate potential loss to the government under this scenario would
                               be reduced by the amounts-minus      collection costs-that could eventu-
                               ally be collected from those nonpaying borrowers through normal collec-
                               tion procedures including extreme measures, such as foreclosures and
                               liquidation of borrower assets.


Options to Be Considered       Cash reserves maintained at a certain percent of the outstanding bal-
                               ance of a pool-at least 10 percent in Farmer Mac’s case-will provide
                               greater protection to the government than cash reserves that can be
                               drawn down; however, cash reserves that are maintained at a certain
                               level could be more costly to lenders and poolers. Subordinated partici-
                               pation interests provide varying levels of protection to the government
                               depending on the mechanics of the full recourse the government has to
                               subordinated participation interest holders. Costs to these holders can
                               also vary depending on the amount of recourse.

                               In the short run, cash reserves are likely to be more costly credit
                               enhancements for lenders and poolers than a subordinated participation
                               interest as used in practice today (see discussion above) because more
                               cash-at least 10 percent-must      be provided up front when using the
                               Farmer Mac-specified cash reserve. In the long run, the cost for lenders
                               and poolers would depend on the actual mechanics of the cash reserve
                               and subordinated participation. As indicated previously, subordinated
                               participation and cash reserves are not yet sufficiently defined and their
                               comparative risk implications to the government cannot be determined.
                               However, a cash reserve may be a less risky method for the government
                               in both the long and short run because it provides assurances that the
                               agreed-upon cash amount will be available at all times, versus relying on
                               future collections of cash-flow shortages from subordinated security
                               holders. The competing congressional concerns about (1) minimizing up-
                               front cash-flow needs by lenders or poolers and (2) containing govern-
                               ment risk exposure could be addressed through various cash reserve
                               and subordinated participation structures or other credit enhancements.
                               Many options are certainly available to address these concerns. Some
                               options present,ed below could be used singularly or in combination to
                               achieve the most desirable creciit enhancement package.

                           l   Subordinated participation interests could be adjusted above 10 percent
                               to better ensure that defaults over 10 percent will be covered by the
                               subordinated securities’current cash flows-the     higher the subordi-
                               nated participation interest, the more cash flow is available to cover
                               nonpayments.


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A combination of cash reserves and subordinated participation interests
could be used.
A liquidity reserve escrowed from current cash flows or initially depos-
ited by the pooler/lender could be established to provide some back-up
cash to pay current cash-flow shortages that are beyond the current
cash flow from the subordinated security.
A subordinated participation could be used to allow total and immediate
recourse to the pooler or lender in the amount of the cash reserve that
the lender and pooler could have elected to contribute to as an alterna-
tive to subordinated participation interests.
A subordinated participation could be used to allow recourse on each
payment period’s cash flow to the lender or pooler up to the amount of
the cash reserve they could have elected as an alternative to subordi-
nated participation interests.
Private mortgage insurance could be required on loans sold into the pool
or on the subordinated portion only.
Crop insurance on all or part of a loan could be required to help ensure
cash flow in the event of failed or poor crops.
Geographical and/or commodity diversity could be broad to try to mini-
mize risk in the portfolio.
Risk-based fees on individual pools could be raised.

These modifications could result in a profit-margin squeeze for partici-
pating lenders and poolers because of potential added costs. Depending
on the competitiveness of the market, this could also result in higher
costs of credit to the borrower.

Some Farmer Mac representatives we talked to indicated that strong cer-
tification standards for poolers may reduce the need for monetary credit
enhancements. They said that strict requirements for poolers to monitor
loan originators, especially appraisal practices, could reduce the poten-
tial risk in the market. In addition, the offering circular for Farmer Mac
stock states that the interim board recommended that the permanent
board establish a minimum capital requirement of $2 million for certi-
fied poolers, which Farmer Mac representatives said would help to
ensure the financial integrity of the market. These measures could help
ensure that risk parameters set out by Farmer Mac are met but still do
not resolve the questions concerning timing and amount of recourse to
subordinated participation interest holders for loan pool losses.




Page 66             GAO/RCED-W-118    Secondary   Market   Development   and Risk Implications
                      Appendix V
                      Key Issues Concerning the Development  of
                      Underwriting  Standards for Farmer Mac




Will the Prescribed   the amount of the initial principal of the pool plus up to 0.5 percent of
Risk-Based Fees Be    the outstanding balance of the pool each year to be used as Farmer
Adequate for Fanner   Mac’s risk-based fee. In the event of borrower’s nonpayment of loans
                      backing securities guaranteed by Farmer Mac and after all other cash
Mac?                  reserves or subordinated participation interests are exhausted, these
                      fees are used as a last resort to pay security holders before Farmer Mac
                      draws on its own resources or its line of credit to the Treasury to make
                      good on its guarantee. If Farmer Mac cannot maintain timely payment of
                      principal and interest on the loan pool, then it may need to draw on the
                      Treasury.

                      Since historical information on default rates for agricultural real estate
                      loans is limited, it is difficult at this time to determine whether a risk-
                      based fee of 0.5 percent initially and per year will be adequate. In resi-
                      dential markets where such data exist, a minimum, rather than a maxi-
                      mum rate is set. It is not normal practice to set a maximum rate for such
                      a fee in a secondary market because the fee then could cease to be based
                      on risk. Instead it could become more of a management decision reflect-
                      ing political or economical factors not necessarily risk-related. Setting
                      risk-based fees requires reliable historical information on default and
                      foreclosure rates that currently does not exist for agriculture.

                      The risk-based fee does not necessarily operate independently of other
                      credit enhancement mechanisms. For example, adjustments in the
                      amount of cash reserves or subordinated participation interests can be
                      made in conjunction with the risk-based fee rates to cover these
                      expected losses. Such an approach, however! requires the need for a
                      great deal of flexibility on Farmer Mac’s part.

                      An additional consideration is presented in the offering circular for
                      Farmer Mac stocks-that      the primary source of funding for Farmer Mac
                      operations will be the risk-based fee. Even though a portion of the fee is
                      to be set aside by Farmer Mac in a segregated account as a reserve
                      against losses from guarantee activities, there may be a constant draw-
                      down of this fee for daily operations of Farmer Mac. Neither the act nor
                      the offering circular defines what portion will be set aside.




                      Page 67              GAO/RC’ED-90-118   Secondary   Market   Development   and Risk Implications
                            Appendix V
                            Key Issues Concerning the Development. of
           ”                Underwriting  Standards for Farmer Mac




                            The act requires that securities offered to the public and backed by a
What Implications Do        Farmer Mac guarantee must be registered with the SEC. The Securities
SEC Registration and        Act of 1933 requires issuers to file with the SEC a registration statement
Disclosure                  and a prospectus before offering the securities to the public. The pur-
                            pose of registration is to ensure full and fair disclosure of information
Requirements Have           about the company, its management, and the intended use of the pro-
for Farmer                  ceeds from the issue. These disclosures are meant to help potential
                            investors make investment decisions on an informed basis, not to make
Mac-Guaranteed              investment recommendations to them about the registered securities.
Securities?                 The disclosures include (1) financial information, such as audited finan-
                            cial statements, (2) underwriting standards, and (3) nonfinancial infor-
                            mation, such as management capability, character of borrower, and
                            potential risk factors associated with the industry and the issuer’s
                            business.


Costs of Registering With   An issue that has been raised by potential poolers of and investors in
SEC                         Farmer Mac-guaranteed securities is whether the additional cost of reg-
                            istering these securities with SEC would adversely affect the volume of
                            loans originated and sold in the secondary market and increase the cost
                            of credit to borrowers. Some are concerned that these additional costs
                            could reduce poolers’ profits and/or increase costs to borrowers. SEC reg-
                            ulations require issuers to disclose estimated costs of issuing and distrib-
                            uting the registered securities. Issuers generally itemize these costs into
                            several categories including (1) SEC registration fees, (2) rating agency
                            fees, (3) printing and engraving fees, (4) legal fees, (5) accounting fees,
                            (6) trustee services fees, (7) state fees, and (8) miscellaneous fees.

                            Information was not available on these eight cost categories for other
                            government-sponsored secondary market organizations’ securities
                            because they are not required to register their securities with the SEC.
                            Therefore, we talked with SECofficials to determine how we might
                            obtain information on these costs. They suggested we review all initial
                            public offerings of mortgage-backed securities registered with the SEC in
                            1988, which had complete information on these categories. N7efound 21
                            such securities, none of which were directly guaranteed by the govern-
                            ment or a government-sponsored organization although they included
                            other kinds of credit enhancements. The amount of securities offered
                            ranged from $10 million to $1.4 billion, and the issuers’ estimated
                            costs-based on the eight categories-of issuing and distributing securi-
                            ties ranged from $250.000 to $4.915,000. A summary of these 8 cost
                            categories for the 21 registration statements we examined is shown in
                            table V. 1. The range in dollars represents the highest and lowest costs of


                            Page 68              GAO/RCED-90-118   Secondary   Market   Development   and Riik Implications
                                            Appendix V
                                            Key Issues Concerning the Development of
                                            Underwriting Standards for Farmer Mac




                                            each category for all the registration statements, and the range in per-
                                            cent of amount offered represents the highest and lowest percentages
                                            for each category for all the registration statements.

Table V.l: Cost of Registering Securities
With the SEC                                                                                                               Range as
                                                                                                                           percent of
                                                                                          Range in dollars               amount offered
                                            Cost categories                               Low            High             Low       High
                                            SEC rewtration fees                         $2,000         $290,000             ,025       0.025
                                            Rating agency fees                          14,000          500,000              005       0.450
                                            Printing and engraving fees                 15,000           550,000            ,010       1.000
                                            Legal fees                                  75,000         2,500,OOO            ,020       2.000
                                            Accounting fees                              5,000           350,000             003       0.350
                                            Trustee fees                                 7,000         1,003,000             004       0.250
                                            State fees                                   4,750            72,000            ,001       0.012
                                            Miscellaneous fees                           5.000           200.000            ,001       0.067

                                            The wide range in costs for these eight categories makes it difficult to
                                            use these data for drawing conclusions on the expected cost of SEC regis-
                                            tration of government-sponsored organization securities, such as those
                                            that would be guaranteed by Farmer Mac. However, we determined that
                                            (1) two cost categories--sEc: and rating agency fees-were incurred as a
                                            direct result of SECregistration and the absence of being considered a
                                            government-sponsored organization, (2) while SEC fees would likely be
                                            incurred by Farmer Mac, rating agency fees would be incurred only if
                                            Farmer Mac is rated, (3) costs from the other categories would likely be
                                            incurred to some extent by government-sponsored organizations-such
                                            as Fannie Mae and Freddie Mac-that disclose information on pools of
                                            loans backing securities along with other pertinent information, and (4)
                                            these other costs may be higher with SECregistration than without
                                            because SEC’s regulations call for the disclosure of more detailed infor-
                                            mation and would likely require more legal work.

                                            The amount of the SECregistration fee is calculated according to SEC’S
                                            regulation-currently    $0.025 per $100 of amount of securities offered
                                            The other cost categories vary according to a combination of factors,
                                            such as type of expenses involved, amount offered! and complexity of
                                            the security structure.




                                            Page 69             GAO/RCED90-11%    Secondary   Market   Development   and Risk Implications
                       Appendix V
                       Key Issues Concerning the Development of
                       Underwriting Standards for Farmer Mac




                       Because of these potential added costs, a profit-margin squeeze for par-
                       ticipating lenders and poolers could result. Depending on the competi-
                       tiveness of the market, this could also result in higher costs of credit to
                       the borrower.

                       The conference report that accompanies the act states that the conferees
                       were presented with conflicting information concerning spreads in inter-
                       est rates-that    would be caused by SECregistration-between      govern-
                       ment securities and AAA-rated corporate securities. As a result, the
                       conference report requires the Secretary of the Treasury, in consultation
                       with the SECand the Board of Governors of the Federal Reserve System,
                       to prepare a report for the Senate Committee on Agriculture, Nutrition,
                       and Forestry and the House Committee on Energy and Commerce within
                       180 days of the first sale of securities guaranteed by Farmer Mac. The
                       report is to include (1) an analysis of spreads in percentages, including
                       whether the spread between such securities and other securities issued
                       or guaranteed by government-sponsored organizations exceeds 0.25 per-
                       cent, and (2) an analysis of the impact of not treating Farmer Mac-guar-
                       anteed securities as government securities relative to other government
                       securities.


                       The act requires that no agricultural mortgage loan will have a loan-to-
What Effect Will the   value ratio greater than 80 percent to qualify for a Farmer Mac pool4
Loan-To-Value Ratio    Many western and midwestern bankers told us that they do not make
in the Act Have on     agricultural real estate loans with loan-to-value ratios of more than 65-
                       70 percent because of the uncertainty of the market value of the collat-
Government Risk?       eral backing the loans. The loan-to-value ratio can be an important fac-
                       tor in how likely it is that in case of a loan default, the pooler will
                       recover the outstanding loan amount. To the extent that this is not pos-
                       sible, Farmer Mac’s guarantee may be activated. If Farmer Mac is unable
                       to continue principal and interest payments to the investor from its
                       resources, then the Treasury line of credit may be needed.

                       To better manage the risk in loan pools, loans in the Farmer Mac pools
                       may have to meet varying loan-to-value ratios because of the legisla-
                       tively mandated requirement that loans in a pool must be diversified by
                       commodity. Loan-to-value ratios for these loans may vary depending on
                       the collateral backing the loan and the type of commodity produced. For
                       example, a midwestern company that, developed standards for making

                       ‘The Farmer Mac standards allow a loan-w-value ratm of 75 perwnt but allow for exceptions to be
                       made to provide for a higher pt” ‘.entage in certain situations.



                       Page 70               GAO/RCED-SO-118    Secondary   Market   Development   and Risk Implications
                        Appendix V
                        Key Issues Concerning the Development of
                        Underwriting Standards for Farmer Mac




                        agricultural production loans that it intended to sell recognized that
                        there are differing risks associated with the various commodities pro-
                        duced. Therefore, it varied its loan-to-value ratios from 50 percent for
                        poultry loans to 70 percent for seasonal crops, such as wheat and corn,
                        and to 75 percent for hog and cattle production loans. This raises ques-
                        tions on whether or not real estate loans-that     depend on various types
                        of commodity production for repayment and that are eligible to be sold
                        into the Farmer Mac secondary market-should         require various loan-to-
                        value ratios to ensure comparable and more manageable risks for loans
                        in the pool.


                        One of the stated purposes of the act is to enhance the ability of individ-
What Effect Will        uals in small rural communities-defined     as having a population of not
Rural Housing           more than 2,500-to obtain financing for moderate-priced homes. The
Provisions Have on      loans cannot exceed $100,000 as adjusted for inflation; the act does not
                        specify a formula for inflation adjustments. The act is silent on whether
Farmer Mac-             rural housing loans may be included in pools with agricultural real
Guaranteed Securities   estate or whether they must form pools consisting solely of such loans.
and How Will Such       However, the conference report that accompanies the act states that
                        pools composed solely of rural housing loans should include loans that
Loans Be Packaged?      are widely distributed geographically and vary widely in the amount of
                        principal. The conference report also states that, to qualify for a pool,
                        rural housing loans will require specific underwriting standards based
                        on FCS loans to rural residents and on other residential secondary mar-
                        kets. It is unclear whether these standards will be incorporated into the
                        overall Farmer Mac standards or applied and monitored separately from
                        the agricultural real estate portion of the market.

                        Including rural housing loans with agricultural real estate loans in
                        Farmer Mac pools could complicate the pool formation and risk-pricing
                        since pools could include loans backed by both agricultural real estate
                        and residences. Potential poolers told us that they are concerned that,
                        with residences, pools could be less homogeneous, thus restricting the
                        spreading of risk and the efficiency of the market and increasing costs
                        of administering and operating the pool. Trade-offs will necessarily
                        have to be made between pooling efficiency for rural housing alone and
                        for agricultural real estate and rural housing together.




                        Page 71             GAO/RCF.D!Nbllg   Secondary   Market   Development   and Risk Implications
Appendix VI

Profile of the Agrkulturd Credit Act of 1987
provisions Creating Farmer Mac

                         January 6, 1988
Date Signed by the
President’

Date to Be Established   Jmuaw671g88

                         One purpose of title VII of the Agricultural Credit Act of 1987 is to
Purpose                  establish Farmer Mac as a federally chartered instrumentality of the
                         United States, within the FCS.The corporation will (1) certify agricul-
                         tural mortgage marketing facilities, (2) provide for a secondary market-
                         ing arrangement for agricultural real estate mortgages that meet the
                         corporation’s underwriting standards in order to increase the availabil-
                         ity of long-term agricultural credit at a stable interest rate; provide
                         greater liquidity and lending capacity to lenders for agricultural real
                         estate; and provide for new lending to facilitate capital market invest-
                         ments in long-term agricultural funding, including funds at fixed inter-
                         est rates, and (3) enhance the ability of individuals in small rural
                         communities to obtain financing for moderate-priced homes.



Organizational
Structure/Market
Operation

Corporation and Market   The primary functions of the corporation are to (1) provide guarantees
Structure                for the timely payment of principal and interest to holders of securities
                         backed by pools of agricultural real estate loans that would be issued
                         either by private entities or by FCSinstitutions or their affiliates, created
                         for that purpose, to make those securities more marketable, (2) certify
                         private entities and KS institutions as eligible to receive guarantees
                         from the corporation on pools of agricultural real estate loans, and (3)
                         develop uniform underwriting, security appraisal, and repayment stan-
                         dards for qualified loans, in consultation with originators.


                         ‘This appendix was developed from information contained in appendix I of our report entitled Fed-
                         eral Agricultural Mortgage Corporation: I Jnderwriting Standards Issues Facing the New Secondary
                         Market (GAO/RCED-89-106BR, May 5, 1989).



                         Page 72               GAO/RCEDWllS        Secondm     Market   Development   and Risk Implications
Appendix VI
Profile of the Agricultural Credit Act of 1987
Prwisione   Creating Farmer Mac




Within 90 days of enactment (or by April 6,1988), the President was
required to appoint an interim board of directors. The interim board’s
primary duty was to arrange for an initial offering of the corporation’s
voting common stock to raise $20 million and to initiate actions to make
the corporation operable until a permanent board is formed. The interim
board would have nine members with one designated by the President
as chairperson. Three of the nine members would be representatives of
banks, other financial institutions, and insurance companies; three
would be representatives of FCSinstitutions; two would be representa-
tives of farmers or ranchers; and one would be a representative of the
general public. The representatives of the farmers or ranchers and of
the general public could not have served as directors or officers of any
financial institution. Not more than five members could be from the
same political party.

After $20 million of initially offered voting common stock was pur-
chased and fully paid, the corporation was to arrange for the election
and appointment of a 15-member permanent board of directors. Five
members were to be appointed by the President, with the advice and
consent of the Senate; five members elected by holders of common stock
that were insurance companies, banks, or other financial institutions;
and five members elected by holders of common stock that were FCS
institutions. The five presidential appointees were to be representatives
of the general public and must not be, nor have been, officers or direc-
tors of any financial institution; no more than three may be of the same
political party; and at least two must have experience in farming or
ranching. The President is required to appoint members to the perma-
nent board not later than the date that at least $20 million of common
stock has been subscribed and paid for or 270 days after enactment. The
President is to designate one of his appointees as chairperson of the
board and the presidentially appointed directors will serve at the plea-
sure of the President. The other directors will be elected for terms end-
ing on the date of the next annual stockholders’ meeting; if not
reelected, a director may serve until his successor takes office.

The duties of the board are to (1) determine the general policies that
shall govern the operations of the corporation, (2) select, appoint, and
determine the compensation of qualified persons to fill such offices as
may be provided for in the bylaws of the corporation, and (3) assign to
such persons such executive functions, powers, and duties as may be
prescribed by the bylaws of the corporation or by the board. The mem-
bers elected or appointed to the board shall be executive officers of the



Page 73              GAO/INXDM-118       Secondary   Market   Development   and Risk Implications
                            Appendix M
                            Profile of the Agricultural Credit Act of 1987
                            Provisions Creating Farmer Mac




                            corporation and shall discharge the executive functions, powers, and
                            duties of the corporation.

                            Two classes of voting common stock were to be created and offered,
                            with the same par value per share, one (class A) only to non-Fcs institu-
                            tions (banks, other financial institutions, and insurance companies) and
                            the other (class B) only to FCSinstitutions that are entitled to vote. Once
                            the permanent board had met, stock in either class could be issued only
                            to agricultural mortgage loan originators and agricultural mortgage mar-
                            keting facilities certified by the board to pool loans in the secondary
                            market. No stockholder, other than a holder of class B stock, may own,
                            directly or indirectly, more than 33 percent of the outstanding shares of
                            such class of the voting common stock. Unless the board imposed
                            restrictions, each class of stock would be transferable among institutions
                            of the kind eligible to buy that class of stock. (In July 1988, the Federal
                            Reserve System Board of Governors ruled that state banks are allowed
                            to purchase stock in Farmer Mac, and in May 1988 the Comptroller of
                            the Currency ruled that national banks are allowed to purchase stock in
                            Farmer Mac.) Nonvoting common and preferred stock, freely transfera-
                            ble, could also be issued.

                            Stockholders could be paid dividends. However, the dividends could not
                            be declared or paid on the corporation’s common stock while any corpo-
                            ration debt was outstanding to the Treasury and unless the board deter-
                            mined that adequate provision had been made for a reserve against
                            losses. This reserve is to be funded by fees for credit enhancement col-
                            lected from the issuers of the pool securities. Holders of nonvoting pre-
                            ferred stock are entitled to dividends before holders of common stock.


Mortgage Marketing          Not later than 120 days after the first meeting, with a quorum present,
Facilities’ Certification   of the permanent board, the corporation is required to issue standards
                            for certification of agricultural mortgage marketing facilities, which
                            purchase agricultural real estate loans from loan originators, create
                            securities or obligations backed by the loans, and market the securities
                            or obligations. The standards would not be permitted to discriminate
                            between or against FCSand non-Fcs applicants desiring to become certi-
                            fied agricultural mortgage marketing facilities. Any FCS institution
                            (other than the corporation), acting singly or in combination with other
                            FCS institutions, could create affiliates that could apply for certification.




                            Page 74              GAO/BCEDSO-118      Secondary   Market   Development   and Risk Implications
                     Appendix Vl
                     Profile of the Agricultural Credit Act of 1987
                     Provisions Creating Farmer Mac




                     A certified agricultural mortgage marketing facility must meet the fol-
                     lowing minimum requirements: (1) be an institution of the FCSor a cor-
                     poration, association, or trust under federal or state law, (2) meet or
                     exceed capital standards established by the board, (3) have as one of its
                     purposes the sale or resale of securities representing interests in or obli-
                     gations backed by pools of qualified agricultural mortgage loans that
                     had been provided guarantees by the corporation, (4) demonstrate man-
                     agerial ability that was acceptable to the corporation with respect to
                     agricultural mortgage loan underwriting, servicing, and marketing, (5)
                     adopt appropriate agricultural mortgage loan underwriting, appraisal,
                     and servicing standards that met or exceeded uniform standards estab-
                     lished by the board, (6) permit the corporation to examine its books,
                     records, and loan files pertaining to the pooling and credit enhancement
                     operations, and (7) adopt appropriate minimum standards and proce-
                     dures relating to loan administration and disclosure to borrowers con-
                     cerning the terms and rights applicable to loans for which a guarantee is
                     provided, in conformity with uniform standards established by the
                     corporation.

                     Not later than 60 days after receiving an application, the corporation
                     must certify a facility that meets these and whatever other standards
                     the corporation has established. Certification is for a period of not more
                     than 5 years and may be revoked, after notice and an opportunity for
                     hearing, for failure to continue to meet certification standards. Revoca-
                     tion does not affect the pool guarantee already extended to the facility.

                     FCSinstitutions are permitted to enter into agreements with any certified
                     facility (including those established as affiliates of FCSinstitutions) to
                     sell the institutions’ loans exclusively to or through the facility.


Credit Enhancement   Upon application by certified agricultural mortgage marketing facilities,
                     the corporation is authorized to provide credit enhancement-a guaran-
                     tee of timely payment of principal and interest-on     the facilities’ securi-
                     ties or obligations representing interests in pools of qualified
                     agricultural mortgage loans held by the facilities. At the time the corpo-
                     ration issues commitments to provide credit enhancement, the corpora-
                     tion imposes a fee on the certified agricultural mortgage marketing
                     facility, on the basis of the amount of risk incurred by the corporation.
                     The corporation’s provision of credit enhancement is subject to stan-
                     dards developed by the permanent board of directors. With respect to
                     any issue of guaranteed securities, in the event of default and pursuant
                     otherwise to the terms of the contract, the mortgages that constitute


                     Page 75               GAO/RCED-SO-118     Secondary   Market   Development   and Risk Implications
Appendix VI
Proftie of the Agricultural Credit Act of 1987
Provisions Creating Farmer Mac




such a pool become the absolute property of the corporation, subject
only to any unsatisfied rights of holders of securities backed by the
pool.

At a minimum, the standards for issuance of credit enhancement must
include the following diversification requirements: (1) loans in the pool
must be secured by agricultural real estate that would be widely distrib-
uted geographically, (2) provisions must be made for wide variation in
principal amounts of loans in the pool in such a way as to encourage
inclusion of loans for small farms and family farmers, (3) a loan pool
must be diversified to include loans backed by real estate used to pro-
duce a wide range of agricultural commodities, (4) the amount of any
single loan may not exceed 3.5 percent of the total principal amount of
the pool, (5) inclusion in a pool of 2 or more loans to related borrowers
would be prohibited, and (6) each pool must consist of not less than 50
loans. These standards and other underwriting standards do not go into
effect until 30 legislative days or 90 calendar days-whichever      is
longer-after    they have been submitted to the Congress.

The following responsibilities of and limitations on certified facilities
apply to the corporation’s credit enhancement: (1) the originator of any
loan in the pool is permitted to retain the right to service that loan, (2)
the facility will ensure opportunities for minority-owned or -controlled
investment banking firms, underwriters, and bond counsels to partici-
pate to a significant degree in any public offerings of securities, (3) the
 facility may not refuse to purchase qualified agricultural mortgage loans
originating in states with borrower’s rights laws, (4) the facility will act
in accordance with the standards of a prudent institutional lender to
resolve defaults on loans in the pool, (5) the proceeds of any collateral,
judgments, settlements, or guarantees received by the facility with
 respect to any loan in the pool are applied, less cost of collection, first to
 reimburse the Secretary of the Treasury for any funds that the corpora-
tion had borrowed from the Treasury for credit enhancement payments
 on the pool and second to reimburse the corporation for any such pay-
 ments made by it, (6) the loans are sold to the facility without recourse
to the originators, except to the extent the originators chose either to
participate in a cash contribution reserve established in connection with
 such loans or to accept a subordinated participation interest in such
 loans, and (7) the facilities, with optional participation by the origina-
tors, must establish a cash contribution reserve or subordinated partici-
 pation interest of at least 10 percent of the principal amount of each
 loan included in each such pool to be applied against losses due to loan
default.


Page 76               GAO/RCED9@118       Secondary   Market   Development   and Risk Implications
Appendix VI
Profile of the Agricultural Credit Act of 1987
Provisions Creating Farmer Mac




A cash contribution reserve is to be established and held by the facility,
but the act does not specify whether the established amount-in dollars
or percentage of outstanding principal-is     to be maintained. All cash
reserves would be in the form of U.S. Treasury securities or other secu-
rities issued, guaranteed, or insured by an agency or instrumentality of
the U.S. government. Contributions to the reserve, but not earnings on
the contributions, must be maintained as a segregated account. The
facility and any loan originators that exercised their option to contrib-
ute to the reserve must be paid at least semiannually any earnings on
the reserve in proportion to their contributions. However, the distribu-
tion of earnings may not be permitted to cause the reserve to fall below
10 percent of the total principal amount of loans in the pool. When
drawing on the reserve to meet losses due to a loan default, the losses
are charged first to any contribution to the reserve by the originator of
the defaulted loan before charging the contributions, if any, of other
originators.

A loan originator becomes liable for a subordinated participation inter-
est by agreeing to retain ownership of a portion of a loan that it sold to a
facility for inclusion in a pool and agreeing further not to receive its
share of principal or interest on any of those loans until full and timely
payments of principal and interest have been made to all other holders
of securities representing interests in the pool. Subordinated participa-
tion interests established by facilities, including optional participation
by loan originators, may not be less than 10 percent of the principal
amount of each loan in such pool.

Before credit enhancement commitment is activated, the certified agri-
cultural mortgage marketing facilities must take full recourse against
the cash contribution reserve or subordinated participation interest.
Once these are exhausted, the portion of risk-based fees paid by facili-
ties for credit enhancement and set aside by the corporation as a reserve
against losses would be available to pay principal and interest to holders
of securities. When a guarantee is issued by the corporation, the corpo-
ration will assess the pooler a fee of not more than 0.5 percent of the
initial amount of the pool and an annual fee of not more than 0.5 per-
cent of the principal amounts of loans in the pool.

If the facilities’ cash contribution reserve or the subordinated participa-
tion interests are insufficient to make required payments and the corpo-
ration’s risk-based fee fund is exhausted, the corporation would certify
to the Secretary of the Treasury that these sources had been exhausted
and that supplementary funds were required for credit enhancement.


Page 77               GAO/RCED-90118     Secondary   Market   Development   and Risk Implications
                        Appendix VI
                        Profile of the Agricultural Credit Act of 1987
                        Provisions Creating Farmer Mac




                        The corporation would then be authorized to issue, and the Secretary of
                        the Treasury to purchase, obligations in an amount sufficient to meet
                        the corporation’s credit enhancement liabilities. The Secretary could not
                        hold more than $1.5 billion of obligations issued by the corporation at
                        any one time. The Secretary would set the interest rate on the obliga-
                        tions, taking into consideration the average interest rate on outstanding
                        U.S. obligations, and would require that the corporation repurchase its
                        obligations within a reasonable time.

                        The permanent board is to adopt standards regarding characteristics of
                        loans in a pool, registration requirements-if     any-and transfer
                        requirements. During the first year after the date of enactment, the cor-
                        poration was not to provide guarantees for securities representing inter-
                        ests in, or obligations backed by, loans (1) in an aggregate principal
                        amount in excess of 2 percent of the total agricultural real estate debt
                        outstanding at the close of the prior calendar year less all FMIA agricul-
                        tural real estate debt, (2) in an additional principal amount in excess of
                        4 percent, the second year, (3) in an additional principal amount in
                        excess of 8 percent, the third year, and (4) without regard to the princi-
                        pal amount thereafter. Restructuring and borrower’s rights provisions
                        for pooled loans state that loan-servicing standards shall be patterned
                        after similar standards adopted by other federally sponsored secondary
                        markets, and borrowers have the option of not having their loans
                        pooled.


                        In addition to the initial $20 million of common stock sold, the corpora-
Funding of the Market   tion is authorized to require each agricultural mortgage loan originator
                        and each certified agricultural mortgage marketing facility to make
                        nonrefundable capital contributions, in exchange for stock, that are rea-
                        sonable and necessary to meet the administrative expenses of the corpo-
                        ration. The corporation could issue additional common stock but only to
                        agricultural mortgage loan originators or certified agricultural mortgage
                        marketing facilities. The corporation is authorized to issue nonvoting
                        common and preferred stock, which, in general, is freely transferable.

                        The corporation is to set aside in a segregated account as much of the
                        risk-based fee that it would charge agricultural mortgage marketing
                        facilities for guaranteeing loan pools as it deemed necessary for a
                        reserve against losses. The offering circular for Farmer Mac common
                        stock states that Farmer Mac’s operations will be financed primarily
                        through risk-based fees. Farmer Mac could also charge fees to cover
                        administrative costs.


                        Page 78              GAO/RCEDSO-118      Secondary   Market   Development   and Risk Implications
                           Profile of the Agricultural Credit Act of 1987
                           Provisions Creating Farmer Mac




                           An initial capitalization of $20 million would be provided from the
Cost to Establish          purchase of voting common stock by banks, other financial institutions,
                           insurance companies, and FCSinstitutions.


                           The law does not estimate or limit operating cost.
Cost to Operate

                           The law defines an agricultural mortgage loan originator to be any FCS
Eligibility Criteria for   institution, bank, insurance company, business and industrial develop-
Participating Lenders      ment company, savings and loan association, agricultural cooperative,
                           commercial finance company, trust company, credit union, association
                           of agricultural producers, or other entit:,. that originates and services
                           agricultural mortgage loans. The corporation may not discriminate
                           against small agricultural mortgage loan originators.


                           Not later than 120 days after the Board first meets with a quorum pre-
Lending Criteria/          sent, the Corporation, in consultation with originators, shall establish
Underwriting               uniform underwriting, security appraisal, and repayment standards for
Standards                  qualified loans. The standards could not go into effect until 30 legisla-
                           tive days or 90 calendar days (whichever is longer) after they had been
                           submitted to the Congress.

                           The law defines agricultural real estate to mean (1) a parcel or parcels
                           of land used for the production of one or more agricultural commodities
                           or products and consisting of a minimum acreage or producing minimum
                           annual receipts as determined by the corporation or (2) a principal resi-
                           dence that is a single-family, moderate-price residential dwelling located
                           in a rural area, excluding any community having a population in excess
                           of 2,500 inhabitants, and any dwelling with a purchase price exceeding
                           $100,000 (as adjusted for inflation). A qualified agricultural mortgage
                           loan would be an obligation (1) secured by a fee simple or leasehold
                           mortgage with status as a first lien on agricultural real estate located in
                           the United States not subject to any legal or equitable claims, (2) of a
                           citizen or national of the United States or an alien lawfully admitted for
                           permanent residence in the United States, or a private corporation or
                           partnership whose members, stockholders, or partners hold a majority
                           interest in the corporation or partnership and are individuals described
                           above, (3) of a person, corporation, or partnership that has training or
                           farming experience that, under criteria established by the corporation,
                           is sufficient to ensure a reasonable likelihood that the loan will be


                           Page 79              GAO/RCEDSO-118      Secondary   Market   Development   and Risk Implications
                       Appendix VI
                       Profile of the Agricultural Credit Act of 1987
                       Provisions Creating Farmer Mac




                       repaid, (4) approved by a certified agricultural mortgage marketing
                       facility as meeting the uniform underwriting and other standards estab-
                       lished by the corporation in consultation with agricultural mortgage
                       loan originators, and (5) meeting the underwriting and other standards
                       established by the corporation.

                       At a minimum, the standards would require the following conditions be
                       met: (1) the loan may not exceed $2.5 million (adjusted for inflation)
                       unless secured by not more than 1,000 acres of agricultural real estate,
                       (2) a loan-to-value ratio of 80 percent or less is required, (3) in establish-
                       ing the value of agricultural real estate, the purpose for which the real
                       estate is taxed would be considered, (4) adequate standards are devel-
                       oped to protect the integrity of the appraisal process, (5) a borrower
                       must demonstrate sufficient cash flow to adequately service the loan,
                       (6) sufficient documentation is required, (7) adequate standards have
                       been developed to ensure that the borrower is or will be actively
                       engaged in agricultural production and require the borrower to certify
                       to the originator that the borrower intends to continue agricultural pro-
                       duction on the site involved, and (8) speculation in agricultural real
                       estate for nonagricultural purposes is minimized. The law also requires
                       that the standards established by the corporation would not be used to
                       discriminate against small agricultural mortgage loan originators or
                       small agricultural mortgage loans of at least $50,000.


                       The law does not estimate what the expected volume of activity will be
Volume of Activity     for Farmer Mac; however, limitations on volume are provided. During
                       the first year after the date of enactment, the corporation is not to pro-
                       vide guarantees for securities representing interests in, or obligations
                       backed by, loans (1) in an aggregate principal amount in excess of 2 per-
                       cent of the total agricultural real estate debt outstanding at the close of
                       the prior calendar year less all FIIIHAagricultural real estate debt, (2) in
                       an additional principal amount in excess of 4 percent, the second year,
                       (3) in an additional principal amount in excess of 8 percent, the third
                       year, and (4) without regard to the principal amount thereafter.
                       Although the act does not state whether these percentages are cumula-
                       tive or are totals for each year, the Senate report on the bill leading to
                       the law states that they are to be applied cumulatively.


Regulatory Oversight   The corporation is an institution of FCS and subject to the regulatory
                       authority of FCA as to the safe and sound performance of the powers,
Body and Cost          functions, and duties vested in the corporation. (See Sections 2241-2259


                       Page 80              GAOIRCED-90-118     Secondary   Market   Development   and Risk Implications
Appendix Vl
profile of the Agricultural      Credit Act of 1987
Provisions   Creating   Farmer    Mac




of Title 12, U.S. Code.) In exercising its supervisory authority, FCAis to
consider the purposes of the corporation, the practices appropriate to
secondary markets in agricultural loans, and the reduced levels of risk
in appropriately structured secondary market transactions.

The corporation is required to publish both an annual report containing
 financial statements prepared in accordance with generally accepted
 accounting principles and audited by an independent public accountant
 and any other information prescribed by the FCA.The corporation is sub-
ject to the following audits by GAO: (1) an annual audit of the actuarial
soundness and reasonableness of fees charged by the corporation, (2) a
financial audit of the corporation on whatever basis the Comptroller
General determines to be necessary, and (3) three other specific reviews
due to the Congress within 2 years of enactment date, including reviews
of (a) the implementation of Farmer Mac and the effect of the corpora-
tion’s operations on producers, the FCS, other lenders, and the capital
markets, (b) the feasibility and appropriateness of promoting a secon-
dary market for securities backed by agricultural real estate loans that
have not been guaranteed by Farmer Mac, and (c) the feasibility of
expanding authority for the sale of securities based on a pool of loans to
farm-related and rural small businesses.

The securities representing an interest in a pool of qualified agricultural
mortgage loans for which credit enhancement had been provided by the
corporation would be subject to the registration and other requirements
of the Securities Act of 1933, the Securities Exchange Act of 1934, and
the Investment Company Act of 1940.

Any security or obligation that has been guaranteed by the corporation
would be exempt from any law of any state (with respect to, or requir-
ing registration or qualification of, securities or real estate to the same
extent as an obligation issued by, or guaranteed as to principal and
interest by, the United States or any agency or instrumentality of the
United States) except any state that, during an &year period beginning
on the effective date of this title, may enact a law that specifically
refers to this exemption and expressly provides that such exemption not
apply.

The cost of regulation is not discussed in the law. The Farm Credit
Administration (FC4) would assess the corporation for the cost of all of
its regulatory activities.




Page 81                 GAO/RCEDSO-118        Secondary   Market   Development   and Risk Implications
                     Appendix VI
                     Profile of the Agricultural Credit Act of 1987
                     Provisions Creating Farmer Mac




                     Securities representing an interest in pools of qualified agricultural
Targeted Investors   loans, for which the corporation had provided credit enhancement,
                     would be designated as authorized investments under federal or state
                     law for any person, trust, corporation, partnership, association, business
                     trust, or business entity to the same extent as U.S.-issued or -guaranteed
                     securities. Also for purposes of state laws that limit investments by pri-
                     vate entities in obligations issued by the United States, these pool securi-
                     ties would be treated as such obligations. However, states have 8 years
                     from the date of enactment to enact laws that could operate prospec-
                     tively either to prohibit or limit investments in the securities issued
                     under this law.


                     Securities are to carry a statement that they are not guaranteed by or
Risk Bearers         are not an obligation of the United States, the FCA, or any other instru-
                     mentality of the United States except the corporation. In addition, no
                     other FCS institution is liable for the corporation’s credit enhancements.
                     Once the facilities’ subordinated participation interests or cash contribu-
                     tion reserves, the corporation’s risk-based fee reserve, and any proceeds
                     from the potential issue of $1.5 billion in debt obligations to the Trea-
                     sury were exhausted, it appears that, barring any congressional or other
                     mitigating actions, the investors that bought the corporation’s loan-
                     backed securities bear the remaining credit risk.


                     The law does not contain a termination provision.
Market Duration




                     Page 82              GAO/RCED-90-118     Secondary   Market   Development   and Riik Implications
Appendix VII

Farmer Mac-Legislated Underwriting Standards


                   Key provisions of major categories of underwriting standards for
                   Farmer Mac contained in the Agricultural Credit Act of 1987:’

               .   Loan pool composition includes some specific and general guidance on
                   certain aspects of pool size, loan origination, borrower eligibility, and
                   loan criteria, such as loan size, loan types, interest rate structures, loan-
                   to-value ratios, and the borrower’s ability to pay.
               .   Pooling covenants include borrower’s rights, lender’s rights, and pooler’s
                   rights.
               .   Credit enhancement includes provisions for an initial and annual risk-
                   based fee, pooler- and/or lender-funded cash reserves or subordinated
                   participation interests equal to at least 10 percent of the outstanding
                   principal of loans in a pool, and a Farmer Mac guarantee of timely pay-
                   ment of principal and interest on securities backed by the pool.
               .   Securities registration and disclosure statements must be filed in accor-
                   dance with SEXrequirements.
               .   Pooler eligibility includes Farmer Mac’s establishing minimum eligibility
                   standards for entities that want to be certified as poolers. Certification
                   includes being an institution of the FCS or a private entity recognized by
                   law, meeting capital and managerial standards, and adopting standards
                   and procedures established by Farmer Mac.
               .   Security design must be such that it represents interests in or obligations
                   backed by any pool of qualified loans held by a pooler. Each security
                   with a Farmer Mac guarantee must clearly indicate that the security
                   does not have the full faith and credit of the United States.
               .   Documentation standards are required to be sufficient for qualified
                   loans.
               .   Servicing standards for loans shall be patterned after similar standards
                   adopted by other federally sponsored secondary market poolers.
               .   Monitoring includes the mandatory activities of the FCAin overseeing
                   the conduct of Farmer Mac’s and GAO'S annual reviews of the actuarial
                   soundness and reasonableness of fees established by Farmer Mac.
               .   Property appraisal standards are to be adequate to protect the integrity
                   of the appraisal process with respect to any loans.


                   The Agricultural Credit Act of 1987 (P.L. lOO-233), signed on January 6,
Farmer Mac         1988, established the Federal Agricultural Mortgage Corporation
Background         (Farmer Mac) as a federally chartered instrumentality of the United

                   ‘This appendix was developed from section 3 of our report entitled Federal Agricultural Mortgage
                   Corporation: Underwriting Standards Issues Facing the New Secondary Market (GAO/RCED-89.
                   106BR.May 5.1989).



                   Page 83               GAO/RCED-90118      Secondary   Market   Development   and Risk Implications
Appendix M
Farmer Mac-Legislated
Underwriting Standards




States and an institution of the FCS.The purpose of Farmer Mac is to
encourage capital market participation in agricultural real estate lend-
ing. This increased participation is intended to provide (1) lenders more
lending capacity by allowing them to sell their farm real estate and rural
housing loans through a secondary loan market and (2) farmers and
ranchers more long-term credit at stable interest rates, including fixed
rates.

Unlike Freddie Mac and Fannie Mae, Farmer Mac is not authorized by
law to purchase or pool loans. Farmer Mac is authorized to guarantee
the timely payment of principal and interest on securities backed by
agricultural real estate and rural housing mortgages pooled by certified
poolers. In the event Farmer Mac exhausts its required reserves and
other credit enhancements to provide such principal and interest pay-
ments, the enabling legislation provides that, under certain conditions,
Farmer Mac may borrow up to $1.5 billion from the U.S. Treasury.
According to some secondary market experts, because of Farmer Mac’s
ability to borrow from the government, these securities will probably be
actively traded at lower risk premiums, yet above rates on Treasury
securities. However, they stated that a growing market built on per-
ceived government backing could perpetuate the acceptance of risks
greater than those covered in credit enhancements, potentially testing
the government’s willingness to allow a government-chartered organiza-
tion to fail.

Farmer Mac is also authorized to provide certain regulatory functions,
such as developing standards for underwriting and for certifying
poolers who will purchase and pool loans. The underwriting standards
ultimately implemented by Farmer Mac will be the primary determinant
of risks that will be borne by the secondary market participants. These
standards will necessarily differ to some degree from those of the resi-
dential secondary markets because of the nature of agricultural real
estate loans.

Some basic distinctions exist between housing and agricultural credit
markets that are likely to cause the operation of the secondary market
for agricultural mortgages to differ from that of other markets. For
example, (1) farms, unlike residences, are business enterprises that gen-
erally lack the collateral value stability of residences, (2) farm proper-
ties are much less homogeneous than residences and therefore are
harder to appraise and more difficult to liquidate in the event of loan
foreclosure, and (3) the financial and business skills of farm operators
can affect the value of the collateral since their income comes largely


Page 84              GAO/RCED9@118   Secondary   Market   Development   and Risk Implications
                        Appendix VII
                        Farmer Mac-Legislated
                        Underwriting Standards




                        from the mortgaged property rather than from independent employment
                        or investment income. Repayment of agricultural loans may depend on
                        income from the property that acts as collateral for the loan, rather than
                        on the borrower earning wages or a salary. In addition, appraisals for
                        agricultural real estate loans may include many more undefined factors,
                        such as land values, that may depend on irrigation, type of crop, and the
                        borrower’s farming expertise.

                        Farmer Mac’s permanent board of directors is required to establish uni-
                        form underwriting, security appraisal, and repayment standards within
                        120 days after the 15-member permanent board’s first meeting with a
                        quorum present. (The board was established and first met with a quo-
                        rum present on March 2, 1989, when the stockholders elected 10 mem-
                        bers. The President had previously appointed the other five members.
                        According to Farmer Mac representatives, the standards must be estab-
                        lished by June 30,1989.) The standards will not take effect before the
                        later of 30 legislative or 90 calendar days beginning on the date the
                        standards are submitted to the Congress.

                        Our review of housing, commercial, and other agricultural secondary
                        market underwriting standards, as discussed in appendix III, indicates
                        10 key categories of underwriting standards, which also cover security
                        appraisal and repayment standards. We have distilled from the act and
                        included in this appendix the key aspects of each category of those stan-
                        dards for Farmer Mac. This appendix should therefore provide an
                        understanding of the baseline as specified in Farmer Mac legislation
                        from which more detailed standards will be developed either through
                        additional legislative action or Farmer Mac regulations and guidelines.
                        Where appropriate, we have indicated sections of the Agricultural
                        Credit Act of 1987 that contain the specific standard; we have also
                        noted where the act is silent on the 10 key categories. In appendix VI we
                        also include a profile of Farmer Mac that follows the same format used
                        in our earlier reports on secondary markets for agricultural real estate
                        loans.


                        To reduce risks incurred by Farmer Mac in providing guarantees,
Loan Pool Composition   Farmer Mac’s permanent board of directors is required to establish stan-
                        dards governing the composition of each pool of qualified loans. The
                        enabling legislation, however, provides some specific and general gui-
                        dance on certain aspects of loan pool composition requirements includ-
                        ing borrower eligibility, pool size. loan origin, and loan criteria.



                        Page 85                  GAO/RCEDSO-118   Secondary   Market   Development   and Risk Implications
                       Appendix VII
                       Farmer Mac-Legislated
                       Underwriting Standards




Borrower Eligibility   Borrower eligibility standards developed by Farmer Mac must ensure
                       that the borrower is or will be actively engaged in agricultural produc-
                       tion and require that the borrower certify to the lender that the bor-
                       rower intends to continue agricultural production on the site involved.
                       Loans guaranteed by Farmer Mac are to be an obligation of (1) a citizen
                       or national of the United States or an alien lawfully admitted for perma-
                       nent residence in the United States or (2) a private corporation or part-
                       nership whose members, stockholders, or partners hold a majority
                       interest in the corporation or partnership and are citizens or aliens as
                       described above and (3) a person, corporation, or partnership that has
                       training or farming experience that, under criteria established by
                       Farmer Mac, is sufficient to ensure a reasonable likelihood that the loan
                       will be repaid according to its terms. (Sec. 8.0 and 8.8)


Pool Size              At a minimum, each pool must consist of not less than 50 loans. (Sec.
                       8.6.)


Origin of Loans        Loan originators, or those entities permitted by law to make loans that
                       can be sold into the market, are FCSinstitutions, banks, insurance com-
                       panies, business and industrial development companies, savings and
                       loan associations, associations of agricultural producers, agricultural
                       cooperatives, commercial finance companies, trust companies, credit
                       unions, or other entities that originate and service agricultural mortgage
                       loans. (Sec. 8.0.)

                       Each pool of loans must be secured by agricultural real estate that is
                       widely distributed geographically and is used to produce a wide range of
                       agricultural commodities. The act does not define the terms “widely dis-
                       tributed” or “wide range.” (Sec. 8.6.)


Loan Criteria          The act provides criteria for loans to be eligible for pooling in this mar-
                       ket including loan size and type, borrower’s ability to pay, and loan-to-
                       value ratios. Criteria for interest rate structures and loan maturity are
                       not specifically given in the law. Borrower’s net worth and willingness
                       to pay are also not addressed.

Loan Size              In general, an individual loan may not qualify for Farmer Mac if the
                       principal amount exceeds $2,500,000, adjusted for inflation. However,
                       this limit does not apply if a loan is secured by agricultural real estate
                       that comprises not more than 1,000 acres. The act also prohibits in a


                       Page 86             GAO/RCED-90-118   Secondary   Market   Development   and Risk Implications
                               Appendix VU
                               Farmer Mac-Jxgislated
                               Underwriting Standards




                               pool (1) inclusion of any loan whose principal amount exceeds 3.5 per-
                               cent of the aggregate amount of principal of all loans in the pool, (2)
                               inclusion of two or more loans to related borrowers, and (3) discrimina-
                               tion against small lenders or small agricultural mortgage loans that are
                               at least $50,000. The law requires Farmer Mac to encourage including
                               loans for small farms and family farmers in pools. (Sec. 8.6 and 8.8.)

  Loan Types                   The types of loans eligible to be included in a pool are those that (1) are
                               backed by first mortgages on agricultural real estate located in the
                               United States and are not subject to any legal or equitable claims from a
                               preceding mortgage and (2) cover agricultural real estate that is or will
                               be actively engaged in agricultural production. (Sec. 8.0 and 8.8.)

! Interest Rate Structures     The act does not set a minimum/maximum interest rate for individual
                               loans eligible to be pooled. One of the purposes of the act, however, is to
                               provide a new source of long-term fixed interest rate financing to assist
                               farmers and ranchers in purchasing agricultural real estate. Adjustable
                               interest rate loans and rate spreads are not mentioned in the act but
                               would appear to be allowed. (Sec. 8.8.)

j Loan Maturity                Maximum and minimum term to maturity of qualified loans is not speci-
                               fied in the act except that the market should provide long-term agricul-
                               tural funding. The act states that Farmer Mac shall confine corporate
                               operations, as far as is practicable, to mortgage loans that the board
                               deems to meet the purchase standards imposed by private institutional
                               mortgage investors. If such private markets, for example, restrict quali-
                               fied loans to those with conventional fixed-rate 30-year mortgages,
                               Farmer Mac could establish guidelines to confine its pools to such loans
                               so far as practicable.

  Financial Ratios and Tests   Eligible loans must meet certain conditions for the borrower’s ability to
                               pay and for loan-to-value ratios, but not for net worth or willingness to
                               pay.

                               Borrower’s ability-to-pay ratios are not specifically provided in the act;
                               however, the act’s standards for qualified loans require that each bor-
                               rower must demonstrate sufficient cash flow to adequately service the
                               mortgage. The act mandates that in establishing further standards for
                               qualified loans, Farmer Mac require, as much as is practicable, quality
                               agricultural mortgages that meet the purchase standards imposed by
                               private institutional mortgage investors. The act defines a qualified loan
                               as an obligation of a person, corporation, or partnership that has suffi-
                               cient training or farming experience that, under criteria established by


                               Page 87              GAO/RCED-90-118   Secondary   Market   Development   and Risk Implications
                    Appendix VII
                    Farmer Mac-Legislated
                    Underwriting Standards




                    Farmer Mac, will ensure a reasonable likelihood that the loan will be
                    repaid according to its terms. (Sec. 8.8 and 8.0.)

                    Loan-to-value ratios of not more than 80 percent are required by the act
                    for qualified agricultural mortgage loans. (Sec. 8.8.)

                    Net worth is not explicitly contained in the act.

                    Willingness to pay on the part of the borrower is not defined in the act.
                    No provisions on evaluating a borrower’s willingness to pay are given.


                    Those covenants that are not addressed in the act include loan assump-
Covenants           tions and prepayments; however, borrower’s rights, lender’s rights, and
                    pooler’s rights are addressed.


Loan Assumption     The act contains no covenants for loan assumptions.
Provisions

Prepayments         The act contains no covenants for prepayments.


Borrower’s Rights   The act mandates that a pooler may not refuse to purchase qualified
                    loans originating in states that have established borrower’s rights laws
                    either by statute or under the constitution of such states. However, the
                    pooler may require discounts or charge fees reasonably related to costs
                    and expenses arising from such statutes or constitutional provisions. In
                    addition, at the time of an application for a loan, lenders that are FCS
                    institutions are required to give written notice to each borrower, inform-
                    ing the borrower, among other things, that he/she has the right not to
                    have the loan pooled. Within 3 days from the time of commitment, a
                    borrower has the right to refuse to allow the loan to be pooled. (Sec. 8.6
                    and 8.9.)

                    The act also provides that state usury laws that limit the rate or amount
                    of interest, discount points, finance charges, or other charges that may
                    be charged, taken, received, or reserved by agricultural lenders or certi-
                    fied poolers shall not apply to any agricultural loan in Farmer Mac. (Sec.
                    8.12.)



                    Page 88             GAO/RCFZDSO-118   Secondary   Market   Development   and Risk Implications
                     Appendix VII
                     Farmer MacLegislated
                     Underwriting Standards




Lender’s Rights      Lenders are to sell loans to poolers without recourse to the lender with
                     the exception of any cash reserves or subordinated participation inter-
                     ests the lender establishes for the loans. For pools to which they have
                     contributed loans, lenders may contribute a share of a minimum cash
                     reserve and may agree to retain a subordinated participation interest in
                     such loans. Lenders are to receive at least semiannually any earnings on
                     their contributions to the reserve. The lender has the right to retain ser-
                     vicing of its loans included in a pool. (Sec. 8.6 and 8.7.)


Pooler’s Rights      A pooler is to be certified within 60 days after Farmer Mac receives its
                     application if it meets Farmer Mac’s eligibility standards. Farmer Mac
                     will determine how long its certification will be effective-a maximum
                     of 5 years. The act is silent on recertification of a pooler. Farmer Mac
                     may, after giving notice and an opportunity for a hearing, revoke its
                     certification if the pooler fails to continue to meet the standards. Revo-
                     cation of a pooler’s certification is to have no effect on guarantees
                     already issued by Farmer Mac. A pooler may demand payment under
                     the Farmer Mac guarantee only after full recourse has been taken
                     against reserves and subordinated participation interests. Although the
                     pooler may not refuse to purchase qualified loans from states with bor-
                     rower’s rights laws, the pooler may require discounts or charge fees rea-
                     sonably related to costs and expenses arising from such statutes or
                     constitutional provisions. A pooler is required to establish a reserve or
                     subordinated participation interest of at least 10 percent of the out-
                     standing principal of the pool. In doing so, a pooler may contribute the
                     minimum reserve required for a pool or retain a subordinated participa-
                     tion interest in each loan; ask lenders to contribute the minimum reserve
                     or retain a subordinated participation interest; or, with the lenders, con-
                     tribute a share of the minimum reserve or retain a share of the subordi-
                     nated participation interest. The pooler has the right to demand each
                     lender in the pool to absorb losses on loans originated up to the total
                     amount the lender has contributed to the reserve before the losses are
                     absorbed by the contributions of other lenders participating in the pool.
                     (Sec. 8.5,8.6, and 8.7.)


Credit Enhancement   The enabling legislation provides several mechanisms to absorb risk.
                     This act requires that Farmer Mac establish risk-based fees, poolers
                     establish either cash reserves or subordinated participation interests,
                     and Farmer Mac provide a guarantee fee for each pool of loans. There
                     are no provisions for mortgage insurance or overcollateralization.



                     Page 69             GAO/RCEDW118   Secondary   Market   Development   and Risk implications
                  Appendix VII
                  Farmer Mac-Legislated
                  Underwriting Standards




Risk-Based Fees   At the time it issues a guarantee, Farmer Mac is to assess the pooler an
                  initial risk-based fee of not more than 0.5 percent of the initial principal
                  of each pool of qualified loans. Beginning at the end of the second year
                  after a guarantee is issued, Farmer Mac may assess the pooler an annual
                  fee of not more than 0.5 percent of the principal amount of the loans
                  then constituting the pool. Farmer Mac shall establish such fees on the
                  basis of the amount of risk of loss it incurs by providing the guarantees
                  on which the fee is assessed. Fees shall be established on an actuarially
                  sound basis, and GAO shall review them annually. Some portion of the
                  fees assessed will be set aside in a segregated account as a reserve
                  against losses. (The act does not define what that portion will be.)
                  Farmer Mac may not issue obligations to the Secretary of the Treasury
                  until this reserve is exhausted, and no dividends on Farmer Mac stock
                  can be paid until such a reserve is established. This reserve cannot be
                  used to make payments for any pool until the cash reserve or subordi-
                  nated participation interest discussed below, whichever has been set
                  aside for that pool, is exhausted. (Sec. 8.4,8.6, and 8.10.)


Insurance         The act has no provisions for mortgage insurance for Farmer Mac loans
                  or pools.


Cash Reserves     The act provides that a certified pooler can meet requirements for finan-
                  cial reserves for a pool of loans by establishing a cash reserve. Farmer
                  Mac can provide a guarantee to pay principal and interest to investors if
                  a cash reserve in an amount equal to at least 10 percent of the outstand-
                  ing principal amount of the loans constituting the pool has been estab-
                  lished by the pooler. The cash reserve is to be maintained by the pooler;
                  however, the act does not specify whether the cash reserve must be
                  “maintained” at the established amount or at the same percent of the
                  outstanding principal of the pool. Whenever a pooler does not receive
                  payments of principal and interest or cannot pay investors for any other
                  reasons, the cash reserve is to be used to pay investors before any other
                  source of funds is used. No other reserve or guarantee can be activated
                  until this reserve is exhausted. Farmer Mac is to require poolers to take
                  full recourse against the reserve before demanding any Farmer Mac-
                  guarantee assistance. (Sec. 8.6 and 8.7.)

                  For each pool of loans in which a cash reserve is used, a pooler is
                  responsible for establishing the reserve, but the pooler and the partici-
                  pating originators may each contribute a share of the reserve. The cash
                  reserves required shall be held in the form of U.S. Treasury securit,ies or


                  Page 90              GAO/RCED90-118   Secondary   Market   Development   and Risk Implications
                             Appendix M
                             Farmer Mac-Legislated
                             Underwriting Standards




                             other securities issued, guaranteed, or insured by an agency or instru-
                             mentality of the United States. Cash reserves are to be maintained in a
                             segregated account consisting of contributions, but not earnings accru-
                             ing on contributions, to ensure the repayment of principal and payment
                             of interest on securities representing an interest in, or obligations
                             backed by, the pool of qualified loans. (Sec. 8.7.)

                             Additional requirements relating to reserves include (1) poolers shall
                             distribute to lenders, at least semiannually, any earnings on the contri-
                             butions of the lenders to the reserve, (2) no withdrawals to distribute
                             earnings may be made that would decrease reserve levels below the
                             reserve requirement, (3) poolers that maintain a reserve to which any
                             lender has contributed shall maintain separate loan loss accounting for
                             each loan for which a contribution was made by the lender, and (4) each
                             lender in the pool shall absorb any losses on loans originated by that
                             lender up to the total amount the lender has contributed to the reserve
                             before losses are absorbed by the contributions of other lenders in the
                             pool. Apparently contributions by the pooler are to be used in conjunc-
                             tion with the lenders’ in case of losses; however, the law does not spec-
                             ify the manner in which this is to be done. (Sec. 8.7.)

                             The offering circular for Farmer Mac’s common stock sale states that
                             the interim board recommended to the permanent board that each
                             pooler should be required to establish variable minimum levels (not less
                             than 10 percent) for cash reserves as determined by Farmer Mac on a
                             pool-to-pool basis in accordance with Farmer Mac’s guidelines.


Subordinated Participation   In general, instead of establishing a cash reserve, a pooler may meet the
Interests                    requirements of providing a reserve by retaining a subordinated partici-
                             pation interest in each loan in each pool in an amount not less than 10
                             percent of the principal amount of each loan. If a subordinated partici-
                             pation interest is used, Farmer Mac can provide a guarantee to pay prin-
                             cipal and interest to investors only when such retained interest, in an
                             amount equal to at least 10 percent of the outstanding principal amount
                             of the loans constituting the pool, has been established. The subordi-
                             nated participation interest is to be maintained by the pooler. Whenever
                             a pooler does not receive payments of principal and interest or cannot
                             pay investors for any other reasons, the subordinated participation is to
                             be used to pay investors before any other source of funds is used. No
                             other reserve or guarantee can be activated until this subordinated par-
                             ticipation is exhausted. Farmer Mac is to require poolers to take full
                             recourse against the subordinated participation before demanding any


                             Page 91              GAO/RCEDWI   18 Secondary   Market   Development   and Risk Implications
                 Appendix W
                 Farmer Mac-Legislated
                 Underwriting Standards




                 Farmer Mac-guarantee assistance. However, the act does not define
                 whether full recourse refers to the total amount of the subordinated
                 participation or to the principal and interest payments due to holders of
                 the subordinated participation. (Sec. 8.6 and 8.7.)

                 For each pool of loans, a certified pooler and the participating lender of
                 loans sold to a pooler may each contribute a share of the minimum
                 reserve. The lender may agree to retain a subordinated interest in any
                 loan, and the amount retained shall be credited to the pooler for pur-
                 poses of determining whether the requirements for a reserve have been
                 met. Farmer Mac shall prescribe what will be the rights of holders of
                 subordinated participation interests to receive distributions from a pool.
                 This will be done in such a manner to enhance the likelihood that other
                 holders of nonsubordinated interests in a pool will receive regular
                 receipt of the full amount of scheduled principal and interest payments
                 on the loans comprising the pool.

                 Although the act does not define subordinated participation interests, it
                 authorizes the board to establish policies and procedures with respect to

             l the establishment of reserves and the retention of subordinated partici-
               pation interests and
             . the manner in which reserves or interests shall be available to make
               payments of principal and interest on securities for which Farmer Mac
               has provided guarantees. (Sec. 8.6 and 8.7.)

                 The conference report that accompanies the Agricultural Credit Act of
                  1987 further states that poolers are to be provided with flexibility in the
                 design of subordinated participation interests rather than restrict them
                 to a particular design. The offering circular for Farmer Mac’s common
                 stock sale states that the interim board recommended to the permanent
                 board that each pooler should be required to establish variable minimum
                 levels (not less than 10 percent) for subordinated participation interests
                 as determined by Farmer Mac on a pool-by-pool basis in accordance with
                 Farmer Mac’s guidelines.


Guarantees       The act provides for Farmer Mac to guarantee the timely payment of
                 principal and interest in the event that a pooler is unable to make such
                 payment. Farmer Mac shall make payments of principal or interest
                 when due in cash; and Farmer Mac, rather than the pooler, shall be the
                 recipient of all rights satisfied by these payments. Such guarantee
                 applies to securities representing interests solely in, or obligations fully


                 Page 92             GAO/RCED+O-118   Secondary   Market   L’)evelopment   and Risk hnplications
                              Appendix VII
                              Farmer Mac-Legislated
                              Underwriting Standards




                              backed by, pools of qualified loans. A guarantee can be made only if a
                              reserve or retained subordinated participation interest of at least 10
                              percent of the outstanding principal of the loans in the pool has been
                              established. The guarantee can be exercised only after full recourse has
                              been taken against such reserves or retained participation interests.
                              (Sec. 8.0 and 8.6.)

                              According to the conference report that accompanies the act, the act
                              intends that Farmer Mac have flexibility to refuse guarantees where
                              underwriting standards are not met or for other reasons where, in its
                              judgment, an unreasonable risk exists.


Overcollateralization         The act contains no provisions for overcollateralization.


                              Farmer Mac securities must be registered with the SEC. The Agricultural
Securities Registration       Credit Act of 1987 provides for applying certain laws regulating such
and Disclosure                securities:

                          l For purposes of the Securities Act of 1933, no security guaranteed by
                            Farmer Mac shall be deemed as issued or guaranteed by a person who is
                            controlled or supervised by, or is acting as an instrumentality of? the
                            government of the United States.
                          . Farmer Mac-guaranteed securities shall not be deemed to be a “govern-
                            ment security” for purposes of the Securities Exchange Act of 1934 or
                            the Investment Company Act of 1940.

                              The act also provides that Farmer Mac-guaranteed securities will not be
                              backed by the full faith and credit of the United States. Each security
                              shall clearly indicate that it is an obligation of, and its guarantee of prin-
                              cipal and interest is by, Farmer Mac, not the FC4, the United States, or
                              other agency or instrumentality of the United States.

                              Farmer Mac securities are to be exempt from any state law with respect
                              to registration or qualification of securities unless a state specifically
                              passes, by January 6, 1996, a law overriding this provision. The exemp-
                              tion is to apply to the same extent as any obligation issued by, or guar-
                              anteed as to principal and interest by, the United States or any U.S.
                              agency or instrumentality. State usury laws are superseded for all loans
                              included in this market. (Sec. 8.12.)




                              Page 93              GAO/RCEDWllS   Secondary   Market   Development   and Risk Lmplications
                     Appendix M
                     Farmer Mac-Legislated
                     Underwriting Standards




                     The act establishes minimum eligibility standards for entities that want
Pooler Eligibility   to be certified as poolers. Under these minimum standards, a pooler
                     must (1) be an institution of the FCSor a corporation, association, or
                     trust organized under the laws of the United States or any state, (2)
                     meet or exceed capital standards established by the board, (3) have as
                     one of its purposes the sale or resale of securities representing interests
                     in, or obligations backed by, pools of qualified loans that have been pro-
                     vided guarantees by Farmer Mac, (4) demonstrate managerial ability
                     with respect to agricultural mortgage loan underwriting, servicing, and
                     marketing that is acceptable to Farmer Mac, (5) adopt appropriate agri-
                     cultural mortgage loan underwriting, appraisal, and servicing standards
                     and procedures that meet or exceed those established by the board, (6)
                     agree to allow Farmer Mac officials and employees to have access to all
                     books, accounts, financial records, reports, files, and all other papers or
                     property of any type that are necessary to facilitate an examination of
                     the operation of the pooler in connection with securities and the pools of
                     qualified loans that back securities guaranteed by Farmer Mac, and (7)
                     adopt appropriate minimum standards and procedures relating to loan
                     administration and disclosure to borrowers concerning the terms and
                     rights applicable to loans for which guarantees are provided, in con-
                     formance with standards established by Farmer Mac. Certification of
                     poolers is effective for a period determined by Farmer Mac of not more
                     than 5 years.

                     Other responsibilities of the pooler as a condition of obtaining a guaran-
                     tee from Farmer Mac are that the pooler

                     act in accordance with the standards of a prudent institutional lender to
                     resolve loan defaults,
                     use the receipts from any collateral, judgments, settlements, or guaran-
                     tees received by the pooler with respect to any loan in the pool to, first,
                     pay costs of collection, second, repay the Treasury any funds Farmer
                     Mac has borrowed to make good on guarantees on securities, and third,
                     reimburse Farmer Mac for any guarantee payments from its funds,
                     permit the lender of the loan to retain the right to service the loan,
                     buy loans without recourse to the lender except for the lender’s interest
                     in a reserve or subordinated participation,
                     comply with Farmer Mac’s pooling standards,
                     ensure that minority-owned or -controlled investment banking firms,
                     underwriters, and bond counsels throughout the United States have an
                     opportunity to participate to a significant degree in any public offering
                     of securities, and



                     Page 94              GAO/RCED90-118   Secondary   Market   Development   and Risk Implications
                    Appendix VII
                    Farmer Mac-Legislated
                    Underwriting Standards




                  . not refuse to purchase qualified loans originating in states that have
                    established borrower’s rights laws either by statute or under the consti-
                    tution of the states, except that the pooler may require discounts or
                    charge fees reasonably related to costs and expenses arising from state
                    statutes or constitutional provisions. (Sec. 8.5 and 8.6.)

                    In addition, the offering circular for Farmer Mac common stock states
                    that the interim board has recommended that the permanent board
                    establish a minimum capital requirement of $2 million for certified
                    poolers .


                    The act does not specify security designs to be used for Farmer Mac
Security Design     securities. Securities guaranteed by Farmer Mac apparently may be
                    designed in many ways to represent interests in or obligations backed by
                    any pool of qualified loans-as defined in the act-held by a pooler. As
                    stated in the registration and disclosure category, each Farmer Mac-
                    guaranteed security is to clearly indicate that the security is not backed
                    by the full faith and credit of the United States. (Sec. 8.12.)


Documentation       The board’s underwriting standards must contain sufficient documenta-
                    tion standards for qualified loans. There are no specific requirements
                    for how documentation is to be accomplished or what management con-
                    trols will be used for data processing. (Sec. 8.8.)


Servicing           The lender of any loan in a pool shall be permitted to retain the right to
                    service the loan. Loan-servicing standards established by Farmer Mac
                    shall be patterned after similar standards adopted by other federally
                    sponsored secondary market facilities. All poolers must adopt loan-ser-
                    vicing standards that meet or exceed Farmer Mac’s standards; however,
                    the act does not require Farmer Mac to submit servicing standards to the
                    Congress for review. (Sec. 8.5, 8.6, and 8.9.)


Monitoring          The act provides that poolers will make available to Farmer Mac all
                    books, accounts, financial records, reports, files, and other papers or
                    property that belong to or will be used by Farmer Mac in reviewing
                    pools and securities guaranteed by Farmer Mac. Other than this state-
                    ment, monitoring of poolers and lenders is not specifically addressed in
                    the act nor is monitoring of management controls, such as data informa-
                    tion systems.


                    Page 95             GAO,/RCED9@118   Secondary   Market   Development   and Risk Implications
                      Appendix VII
                      Farmer Mac-Legislated
                      Underwriting Standards




                      The FCA has regulatory authority with respect to examining Farmer
                      Mac’s condition and providing general supervision of safe and sound
                      performance of the powers, functions, and duties vested in Farmer Mac.
                      The FIX is authorized to use its enforcement powers in carrying out its
                      duties. In exercising its authority, the IXA shall consider the purposes
                      for which Farmer Mac was created, the practices appropriate to the con-
                      duct of secondary markets in agricultural loans, and the reduced levels
                      of risk associated with appropriately structured secondary market
                      transactions. The financial transactions of Farmer Mac will be examined
                      by FCA examiners in accordance with the principles and procedures
                      applicable to commercial corporate transactions under rules and regula-
                      tions prescribed by FCA. These examinations shall occur not less than
                      once per year. In addition, Farmer Mac is to prepare annual financial
                      statements, in accordance with generally accepted accounting principles.
                      These financial statements will be audited by an independent public
                      accountant.

                      GAO is to perform an annual review of the actuarial soundness and rea-
                      sonableness of the fees established by Farmer Mac. GAO is also to con-
                      duct a financial audit of Farmer Mac on whatever basis GAO determines
                      necessary and, not later than 2 years after the date of enactment, three
                      special studies of (1) the implementation of the act by Farmer Mac and
                      the effect of the corporation’s operations on producers, the FCS, other
                      lenders, and the capital markets, (2) the feasibility and appropriateness
                      of promoting a secondary market for securities backed by agricultural
                      real estate loans that have not been guaranteed by Farmer Mac, and (3)
                      the feasibility of expanding authority for the sale of securities based on
                      a pool of loans to farm-related and rural small businesses. (Sec. 8.10,
                      8.11, 703, and 704.) Our report entitled Federal Agricultural Mortgage
                      Corporation: GAO Actions to Meet Requirements in the Agricultural
                      Credit Act of 1987 (GAO/RCED-90-90, Jan. 5, 1990) provides the status of
                      our actions and plans to complete the mandated work.


                      Farmer Mac, in consultation with lenders, is to establish uniform secur-
Property Appraisals   ity appraisal standards for qualified loans. Loan quality is to meet, sub-
                      stantially and generally, the purchase standards imposed by private
                      institutional mortgage investors. Underwriting standards are to be ade-
                      quate to protect the integrity of the appraisal process with respect to
                      any agricultural mortgage loans. (Sec. 8.8.)




                      Page 96              GAO/RCED-90-118   Secondary   Market   Development   and Risk Implications
Appendix VU
Farmer Mac-Legislated
Underwriting Standards




Certified poolers are to adopt appropriate agricultural mortgage loan
appraisal standards and procedures that meet or exceed the standards
established by Farmer Mac. (Sec. 8.5.)




Page 97             GAO/RCED-SO-118   Secondary   Market   Development   and Risk Implications
Appendix VIII

GAO Work Concerning Farmer. Mac Mandated
by the Agricultural Credit Act of 1987.

                The Agricultural Credit Act of 1987 requires us to perform five separate
                studies/reviews concerning Farmer Mac. Three are one-time studies that
                the enabling legislation required to be completed within 2 years-Janu-
                ary 6, 1990-after enactment.’ The other two are recurring actuarial
                and financial reviews. The one-time studies are to address the

                implementation of the act’s provisions by Farmer Mac and the effect of
                Farmer Mac’s operations on producers, the FCS, other lenders, and the
                capital markets,
                feasibility and appropriateness of establishing a secondary market for
                securities backed by agricultural real estate loans that do not have a
                Farmer Mac guarantee, and
                feasibility of expanding the authority granted by the act to authorize
                the sale of securities based on or backed by loans made to farm-related
                and rural small businesses-farm-related     businesses are those that
                make 90 percent or more of their annual dollar volume of sales to agri-
                cultural producers.

                The recurring reviews are to be

                annual reviews of the actuarial soundness and reasonableness of fees
                established by Farmer Mac2 and
                financial audits of Farmer Mac “on whatever basis the Comptroller Gen-
                eral determines to be necessary.“”

                Because the new market-to     be administered by Farmer Mac-is not
                fully operational, we have not been able to complete the studies and
                other periodic reviews required by the act. However, we have worked
                closely with various congressional committees and testified before them
                concerning Farmer Mac’s proposed underwriting and other standards
                designed to guide the new market’s operation. We are staying abreast of
                Farmer Mac activities, are continuing planning efforts, and will initiate
                the major bodies of mandated work as pertinent data become available.


                ‘This appendix was developed from information contained in our report entitled Federal Agricultural
                                   n: GAO Actions to Meet Requirements in the Agricultural Credit Act of 1987
                                    Jan. 5, IWO).

                ‘These fees are to be established by Farmer Mac and can be no more than one-half of 1 percent of the
                initial principal amount of each pool of qualifying loans. Beginning at the end of the second year after
                a guarantee is issued, Farmer Mac may assess an annual fee of not more than one-half of 1 percent of
                the principal amount of the loans then constituting the pool.

                ‘The conference report that accompanies the act states that such financial audits shall be performed
                at least once every 3 years.



                Page 98                GAO/RCED-90118       Secondary    Market   Development   and Risk Implications
Appendix VIII
GAO Work Concerning Farmer Mac Mandated
by the Agricultural Credit Act of 1987




Farmer Mac officials have told us that the secondary market should be
fully operational in 1990.




Page 99            GAO/RCELN@118    !3econdary   Market   Development   and Risk Implications
Key Issues Concerning SpecikFarmer Mac-
Developed Underwriting Standards

                 On the basis of our examination of the Farmer Mac provisions of the
                 Agricultural Credit Act of 1987 and the Farmer Mac-developed stan-
                 dards’ and discussions with individuals and officials from both the pri-
                 vate sector and the federal government, we testified in September 1989
                 that several issues merited further consideration by the Congress during
                 the legislative review period to ensure that the loan criteria, market
                 structure, and risk parameters satisfy Congress’ broad expectations. On
                 December 28, 1989, Farmer Mac issued a Securities Guide to the Con-
                 gress, which Farmer Mac officials indicated addresses many of the
                 issues we and others had raised during the hearings. The following are
                 areas of concerns that we raised in our September 1989 testimony?

             .   Key terms and concepts.
             .   Exceptions to the standards.
             .   Consistency of financial information.
             .   Financial ratios.
             .   Standardized market operating agreement.
             .   Regulatory approaches.
             .   Pool diversification standards.
             .   Appraisal standards.
             .   Standards for rural housing.
             .   Farmer Mac standards’ development and implementation.




                 ‘These standards are “Credit Underwriting, Loan Repayment and Security Appraisal Standards,”
                 June 30, 1989; “Eligibility Standards for Certified Facilities,” June 30. 1989: and “Loan Diversifica-
                 tion Standards,” July 18. 1989.

                 ‘This appendix was developed from information contained in our testimony entitled Issues Surround-
                     Underwriting Standards Developed by the Federal Agricultural Mortgage Corporation (GAO/T-
                     ED-89-‘/1, Sept. 27. 1989, and GAO/T-RCED-89-62. Sept. 12, 1989)Jn addition, our report enti-
                 tled Federal Agricultural Mortgage Corporation: GAO Actions to Meet Requirements in the Agricul-
                 tural Credit Act of 1987 (GAO/Rm-90-90,      Jan. 5.1990) contains further information based on
                 discussions with Farmer Mac officials concerning the rationale for standards development and
                 planned implementation.



                 Page 100               GAO/RCED+O-118        Secondary   Market   Development    and Risk Implications
Aubendix X

Objectives, Scope,and Methodology


               As requested by the Chairman, Subcommittee on Consumer Affairs and
               Coinage, and the Chairman and the Ranking Minority Member of the
               Subcommittee on Policy Research and Insurance, House Committee on
               Banking, Finance and Urban Affairs, we have consolidated into this
               report information that we reported to the Congress during recent years
               on the development and implementation of a new secondary market for
               agricultural real estate and rural housing loans.

               As agreed with the congressional requesters, this report provides infor-
               mation on (1) secondary markets, in general, including the purposes
               such markets have served in the past, (2) underwriting, in general, and
               risk management in other secondary markets, (3) major categories of
               underwriting standards used in other secondary markets, (4) key issues
               concerning the development of a secondary market for agricultural real
               estate loans, and (5) key issues concerning Farmer Mac underwriting
               standards.

               To consolidate our work into one report, as requested, we have essen-
               tially reprinted-with    appropriate updates-sections  of previous
               reports and testimonies as stand-alone documents in this report. In
               doing so, we organized the report from primer information first to more
               detailed sections later.

               During our studies of the development and implementation of a new sec-
               ondary market for agricultural real estate loans, we interviewed private
               and government individuals and officials concerned with secondary
               markets in general and Farmer Mac in particular. We also reviewed the
               underwriting standards of the national residential secondary markets
               and researched manuals and other documentation from private entities,
               where possible, to identify specific standards, procedures, and practices.
               To validate the 10 categories of underwriting standards, we discussed
               them with national residential secondary market officials and members
               of the financial community participating in secondary market activities.
               In developing information for examining costs to register Farmer Mac
               securities, we obtained from SEC files readily available information for
               securities that were registered in 1988. We obtained from FCS, Farmer
               Mac, and the Independent Bankers Association of America information
               on numbers of lenders and poolers who have purchased enough Farmer
               Mac stock to participate in the market. We obtained statistics on real
               estate mortgage investment conduits (REMIC) from Inside Mortgage Capi-
               tal Markets.




               Page 101        GAOIRCED-90118   Secondary   Market   hvelopment   and Risk Implications
    Appendix X
    Objectives, Scope, and Methodology




    We interviewed agricultural economists, bankers, and representatives of
    investment houses and investment rating agencies familiar with secon-
    dary market and farm credit issues. We also interviewed officials of the
    American Institute of Certified Public Accountants, the Department of
    Agriculture, the Board of Governors of the Federal Reserve System, the
    Farm Credit Administration, the Federal National Mortgage Association,
    the Federal Home Loan Mortgage Corporation, the Government National
    Mortgage Association, FCS, the Department of the Treasury, the Small
    Business Administration, the Veterans Administration, the Federal
    Housing Administration, the SEC,Farmer Mac, the American Bankers
    Association, the Independent Bankers Association of America, the
    American Council of Life Insurance, the American Society of Farm Man-
    agers and Rural Appraisers, the National Association of Review
    Appraisers and Mortgage Underwriters, the Federal Financial Institu-
    tions Examination Council, the Office of the Comptroller of the Cur-
    rency, and the Federal Deposit Insurance Corporation. We also
    interviewed farmers, farm groups, ranchers, and bankers in the West
    and Midwest and reviewed research literature, legislation, and publica-
    tions concerning underwriting in general.

    Overall, the information presented in this report was developed through
    our individual studies and reviews conducted during periods ranging
    from July 1986 through January 1990. Specific sections of this report
    were developed from information contained in the following reports and
    testimonies that were issued from July 17, 1987, to January 5, 1990.

l Federal Agricultural Mortgage Corporation: GAO Actions to Meet
  Requirements in the Agricultural Credit Act of 1987                  Jan.
                                                                       (GAO/RCED-9080,


  5, 1990).
l Issues Surrounding Underwriting Standards Developed by the Federal
  Agricultural Mortgage Corporation (GAO/T-RCED-89-71, Sept. 27, 1989, and
  GAO/T-RCED-89-62, Sept. 12, 1989).
. Federal Agricultural Mortgage Corporation: Underwriting Standards
  Issues Facing the New Secondary Market (GAO/RCED-8%106BR, May 5,
  1989).
l Farm Finance: Secondary Markets for Agricultural Real Estate Loans
  (GAO/RCED-87-149BR, July 17, 1987).

    We obtained informal comments from Farmer Mac representatives on
    reports and testimonies listed above that were issued since the Farmer
    Mac interim board of directors was established in May 1988 and incor-
    porated their comments where appropriate in those products.



    Page 102             GAO/RCEDW-118   Secondary   Market   Development       and Risk Implications
ADoendix XI

Major Contributors to This Report


                          John P. Hunt, Jr., Assistant Director
Resources,                Michael E. Gilbert, Assignment Manager
Community, and            Mary L. Dietrich, Evaluator-in-Charge
Economic                  J. Ken Goodmiller, Advisor
Development   Division,   M JaneHunt,Rwofis Analyst
Washington, D.C.




                          Page 103       GAO/RCEDSO-118   Secondary   Market   Development   and Risk Implications
Related GAO Products


              Federal Agricultural Mortgage Corporation: GAO Actions to Meet
              Requirements in the Agricultural Credit Act of 1987 (GAO/RCED-90-90,
              Jan. 5, 1990).

              Federal Credit and Insurance: Programs May Require Increased Federal
              Assistance in the Future (GAo/AF%lD9o-ii,Nov. 16, 1989).

              Issues Surrounding Underwriting Standards Developed by the Federal
              Agricultural Mortgage Corporation (GAO/T-RCED-89-71, Sept. 27, 1989, and
              GAO/T-RCED-89-62,Sept. 12, 1989).

              Federal Agricultural Mortgage Corporation: Underwriting Standards
              Issues Facing the New Secondary Market (GAO/RCED-89-106BR, May 5,
              1989).

              Farm Finance: Provisions for Secondary Markets for Farm Real Estate
              L0ansinH.R. ~~~~(GAo/RcED-~~-~~Fs,Nov.~,   1987).

              Farm Finance: Secondary Markets for Agricultural                Real Estate Loans
              (GAO/RCED-87-149BR, July 17, 1987).

              Farm Finance: Legislative Proposals for Secondary Markets for Farm
              Real Estate Loans (GAO/RCED-~~-~~~F~,July 2, 1987).

              Issues Surrounding a Secondary Market for Agricultural                 Real Estate
              LOanS(GAO/T-RCED-87-29, June3, 1987).




(150400)      Page 104         GAO/RCEDSO-118   !Secondary   Market   Development   and Risk Implications
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