oversight

Federal Agricultural Mortgage Corporation: GAO Actions to Meet Requirements in the Agricultural Credit Act of 1987

Published by the Government Accountability Office on 1990-01-05.

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

                       United States
                       General Accounting Office
                       Washington, D.C. 20548

                       Comptroller   General
                       of the United States

                       B-220607

                       January 6,199O

                       To the President of the Senate and the
                       Speaker of the House of Representatives

                       This report responds to provisions of the Agricultural Credit Act of
                       1987 (P.L. 100-233, Jan. 6, 1988) that required us‘to conduct certain
                       studies by January 6,1990, concerning a new secondary         market for
                                                                            ...I..L,I_*
                                                                                    “V..
                       agricultural real estate and rural housing loans created by the act. These
                       studies are to cover the implementation of the act; the effect of the new
                       market on producers, lenders, and capital markets; the feasibility and
                       appropriateness of such a market without the guarantee provided in the
                       act; and the feasibility of expanding the market to loans for farm-
                       related and rural small businesses. In addition, the act required us to
                       conduct periodic actuarial and financial reviews.


                       The Agricultural Credit Act of 1987, among other things, indicated that
Results in Brief       the Congress expected that the new secondary market would begin oper-
                       ations quickly and that its secondary market program would have been
                       in place and operating as a basis for the GAO work required by the act.
                       Because the new market-to be administered by the Federal Agricul-
                       tural Mortgage Corporation (known as Farmer Mac)-is not fully opera-
                       tional, we have not been able to complete the studies and other periodic
                       reviews required by the act. However, we have worked closely with var-
                       ious 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. Farmer
                       Mac officials have told us that the secondary market should be fully
                       operational in early 1990.

                       The following sections of this report provide information on (1) Farmer
                       Mac’s development and current status, (2) our past work relating to
                       agricultural real estate secondary market issues and Farmer Mac, (3) the
                       studies and reviews that the act requires us to do concerning Farmer
                       Mac, and (4) our planned work relating to the statutory requirements.


                       Farmer Mac was established as a federally-chartered instrumentality of
Development and        the United States generally to provide more lending capacity for farm
Status of Farmer Mac   real estate and rural housing and more long-term credit for farmers and


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                                                                           .,..”
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                     E22OlSO7




                    and Urban Affairs, and the Subcommittee on Conservation, Credit and
                    Rural Development, House Committee on Agriculture, during the com-
                    mittees’ oversight hearings. In late October 1989, Farmer Mac also
                    mailed to potential poolers the application to become a certified loan-
                    pooling facility.

                    According to Farmer Mac officials, Farmer Mac is developing a compre-
                    hensive Securities Guide that will cover in detail the program operating
                    procedures and the responsibilities of all secondary market participants.
                    Farmer Mac indicated that, subject to approval by its Board of Direc-
                    tors, the Securities Guide will be printed and distributed to all Farmer
                    Mac stockholders around the end of 1989. Although the act does not
                    require Farmer Mac to submit the Securities Guide for congressional
                    review, Farmer Mac officials said they plan to provide it to jurisdic-
                    tional congressional committees at the same time that it becomes an offi-
                    cial operating manual for the new market.


                    We have issued several reports and testified on several occasions on
Past GAO Work       agricultural real estate secondary market issues overall and Farmer Mac
Coricerning         in particular.1 One of our first products in this area, a July 1987 report2
Aghcultural Real    provides information on secondary markets, in general, and key issues
                    concerning the development of a secondary market for agricultural real
Esthte Secondary    estate loans that we believed merited further attention during the con-
Market Issues and   gressional debate on developing a secondary market for agricultural real
Farmer Mac          estate loans. Issues raised in that report focus on whether federal gov-
                    ernment involvement would be needed to establish the market, the role
                    the Farm Credit System (FCS) would play, the effects of such a market
                    on existing farm lenders, and what loans should be eligible to be sold in
                    the new market. Most of those issues are still the subject of debate
                    today, and some were incorporated in the Agricultural Credit Act of
                    1987 as studies mandated for us to perform. Appendix I provides fur-
                    ther information on those issues.

                    In a May 5, 1989, report” we provide information on underwriting stan-
                    dards for secondary markets, in general, and key issues that we believed

                    ‘Our previous related reports and testimonies are listed in “Related GAO Products” at the end of this
                    report.
                    2Farm Finance: Secondary Markets for Agricultural Real Estate Loans (GAO/RCED-87-149BR, July
                    17, 1987).




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                           potential financial exposure of the federal government, and (3) minimiz-
                           ing any potential impact on the borrowing of the federal government.
                           GSES are generally privately owned and operated corporations chartered
                           by the U.S. government generally to serve public policy purposes, such
                           as to facilitate credit flow to agriculture.


                           The Agricultural Credit Act of 1987 requires us to perform five separate
GA Studies Required        studies/reviews concerning Farmer Mac. Three are one-time studies that
by t”he Agricultural       the enabling legislation required to be completed within 2 years-Janu-
Credit Act of 1987         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 Mac” and
                           financial audits of Farmer Mac “on whatever basis the Comptroller Gen-
                           eral determines to be necessary.“6




                           “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; and beginning at the end of the second year
                           after a guarantee is issued, Farmer Mac may assessan 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.



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R-220507




affected by removing the Farmer Mac guarantee will be a less theoreti-
cal question than it is today. Furthermore, once sufficient experience is
gained through Farmer Mac’s full implementation of the secondary mar-
ket provisions mandated by the enabling legislation, we will be in a bet-
ter position to comment on the feasibility of expanding the market’s
program provisions to include loans to farm-related and rural small
businesses.

In addition to providing a necessary basis for us to conduct the studies
originally required by January 1990, the normal operations of Farmer
Mac will, as a -matter of course, provide the basis to conduct the recur-
ring actuarial and financial reviews also required by the act. We will be
able to begin our annual reviews of the actuarial soundness of the guar-
antee fees-which Farmer Mac can charge loan poolers to cover the risk
incurred by Farmer Mac in providing guarantees on the loan pools-
when Farmer Mac establishes those fees and when information is availa-
ble on the characteristics of loans in the pools.

Finally, a financial audit of Farmer Mac is feasible at any time after it
has conducted a financial transaction, such as the sale of stock to capi-
talize Farmer Mac, which was completed in December 1988. However, a
more comprehensive view can be gained of Farmer Mac once it becomes
fully operational. Under the authority vested in us in the Agricultural
Credit Act of 1987, we currently plan to audit Farmer Mac’s financial
statements in accordance with the requirements of the act.


We are sending copies of this report to the various congressional com-
mittees with jurisdiction over Farmer Mac; the Secretaries of Agricul-
ture and t,he 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.




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Contenta




Abbreviations

CEO             Chief Executive Officer
Fannie Mae      Federal National Mortgage Association
Farmer Mac      Federal Agricultural Mortgage Corporation
FCS             Farm Credit System
GAAP            generally accepted accounting principles
GAO             U.S. General Accounting Office
GSE             government-sponsored enterprise
WED             Resources, Community, and Economic Development
                   Division


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Appendix
 \       II

Key Issues Concerning the Development of
U~derwiting Standards for Farmer Mac

                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 federal government, we reported in May 1989 that the following
                issues relating to overall risk management merited consideration during
                the legislative review process for Farmer Mac underwriting standards.1

                What are the implications of the geographical diversity requirements in
                the act?
                What are the implications of the agricultural commodity diversity
                requirements of 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-
                ests2 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 Securities and Exchange Commission 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?




                 ‘This appendix was developed from information contained in section 4 of our report entitled Federal
                Agricultural Mortgage Corporation: Underwriting Standards Issues Facing the New Secondary Mar-
                ket (GAO/RCED -89 - lm     , May 5, 1989). A detailed discussion of the issues listed in this appendix
                isincluded in that report.
                ‘Subordinated participation interests are created when a pooler and/or lender retains a portion of a
                mortgage pool and the holders of the retained portion do not receive principal and interest payments
                (subordinated payments), on terms agreed to by the involved parties, until after all other investors
                have received their payments (senior payments).



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                         Appendix III
                         Key hwuer Concerning Farmer Mae-
                         Developed UnderwritIng Standards




                        terms could potentially result in loans in the pool that do not meet Con-
                        gress’ expectations. This standard requires that the property financed
                        meet the minimum acreage or minimum annual receipts requirements to
                        be established by Farmer Mac, but does not elaborate on the key terms
                        “minimum acreage” or “minimum annual receipts.” For purposes of
                        oversight, such a standard provides little assurance of what borrowers
                        Farmer Mac will ultimately include in the market.


                        While it is necessary to allow for flexibility in loan underwriting stan-
Exbeptions to the       dards to provide the capability to react to nonconforming but acceptable
Stdndards               situations, it is also important that the exception does not become the
                        rule because that could create a situation where the market is poten-
                        tially guided by a case-by-case subjective judgment that ultimately may
                        not provide the risk protection intended under broader pooling criteria.
                        The credit underwriting, loan diversification, and certified facility stan-
                        dards include broad language to allow for exceptions to and/or broader
                        interpretations of the standards. For example, credit underwriting
                        standard 9 provides that

                        “Farmer Mac may, on a pool-by-pool basis, accept loans that do not conform to one
                        or more of the preceding standards when: (a) those loans demonstrate compensating
                        strength on one or more of the standards to which they do conform; and (b) those
                        loans are made to producers of particular agricultural commodities or products in a
                        segment of agriculture in which such non-conformance and compensating strength
                        are typical of the financial condition of sound borrowers.”

                        Several financial sector officials and potential market participants indi-
                        cated that Farmer Mac could better ensure that the exception would not
                        become the rule by establishing some limitations on the absolute amount
                        of exceptions allowed in any given pool.


                        As is the case with terms and concepts, it is important that the financial
Consistency of          information in each loan application be reported in a consistent and
Financial Information   comparable manner to better ensure comparable and known risks in the
                        loan pool. Many potential market participants we talked to acknowl-
                        edged that the underwriting standards do not require financial informa-
                        tion in a manner that ensures such consistency. As a result, loans could
                        be included in pools that may not have comparable or even known risk
                        characteristics. For example:




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                        Appendix III
                        Key Iesues Concerning    Fazmer Mac-
                        Developed Underwriting     Standards




                      . Credit underwriting standard 5 requires that the real estate being
                        financed have a minimum 1 to 1 cash flow to debt service coverage
                        ratio, except for loans in which (a) the borrower’s principal residence is
                        on the property securing the loan and (b) the proforma debt coverage
                        ratio of the entity being financed has for the last 3 years been no less
                        than 1.6 to 1. We have been told that a large portion of agricultural real
                        estate loans being made to farmers today are for add-on purchases.
                        Some potential market participants have expressed concerns that it is
                        unreasonable to require such add-ons to meet the cash flow to debt ser-
                        vice coverage ratio of 1 to 1. They pointed out that in agriculture, as
                        well as in the rental housing markets, new purchases generally do not
                        economically cash-flow in the first few years. One way to accommodate
                        this phenomenon may be to require more stringent ratios and criteria for
                        the overall farm operation.
                      . Some lenders told us that the standards may allow loans to be based on
                        the value of an unusually high-priced residence on the property, and not
                        necessarily the ability of the property to carry debt based on its produc-
                        tion capability. To illustrate this point, one banker told us that a farmer
                        had off-farm income that supported the construction of a residence on
                        his farm at a cost that exceeded the value of an average house in the
                        area by about $100,000. The banker also told us that, when the farmer
                        defaulted and the farm was offered for sale, the buyers were willing to
                        pay only the average value of a home in the area; therefore the bank
                        lost about $100,000. Some lenders said that to avoid liquidity problems
                        that could result in losses upon default, Farmer Mac may want to con-
                        sider limiting the allowable dollar value of the house in determining the
                        ultimate loan amount for the entire property or allowing only a certain
                        percentage of off-farm income to be used to qualify as income support-
                        ing the loan application.




Operating Agreement     tally spells out the rights, responsibilities, and liabilities-including
                        recourse provisions-for      lenders and poolers. If such agreements are
                        not done properly and consistently, even small changes in language can
                        result in huge liability shifts. Most potential market participants that we
                        talked to acknowledged these risk implications. The Farmer Mac certi-
                        fied facility standards are very general in defining the framework for a
                        standard market operating agreement between lenders and loan poolers.
             *          In addition,




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                       Appendix III
                       Key Issues Concerulug     Farmer Mac-
                       Developed Underwrltlug      Standards




                      used to produce a wide range of agricultural commodities. These stan-
                      dards are important because they can determine the overall risk that
                      will exist in any given pool and may also affect the market’s structure.
                      The current diversification standards may allow poolers to potentially
                      bypass the geographic diversification requirement of the act by drawing
                      loans from the intersection of three contiguous regions, which could
                      reduce the diversity of individual pools due to similar agricultural com-
                      modities and climatic conditions in these areas. Farmer Mac could pre-
                      vent this by disallowing the formation of pools of loans that come from
                      such a limited geographic area. In the September 1989 oversight hear-
                      ings mentioned previously, Farmer Mac officials indicated in response to
                      questions from the Subcommittee on Policy Research and Insurance,
                      House Committee on Banking, Finance and Urban Affairs, that they
                      would not allow the diversification requirements of the act to be
                      bypassed.


                      Appraisal standards are a key part of the loan-making decision because
Appraisal Standards   they govern the valuation of property and cash flows that will be used
                      as a basis for the collateral and earning capacity to repay the loan in
                      case of default. Farmer Mac’s appraisal standards rely, in large part, on
                      Uniform Standards of Professional Appraisal Practice for such items as
                      appraisal definitions, education requirements, and appraisal reporting
                      developed by the Appraisal Foundation.” Farmer Mac standards also
                      have broad provisions for monitoring the implementation of the
                      standards.

                      While we did not specifically evaluate Farmer Mac appraisal standards,
                      we noted that they do not come under the appraisal provisions of the
                      recently passed Financial Institutions Reform, Recovery and Enforce-
                      ment 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 commercial banks, credit
                      unions, and savings and loan institutions. It appears that loans made by
                      insurance companies and FCSinstitutions-potential     major participants


                      “The Appraisal Foundation is a nonprofit entity established by IJS. and Canadian appraisal associa-
                      tions to help ensure that appraisers are qualified to offer their services to financial institutions and to
                      the real estate industry.



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  .
                   Appendix III
                   Key beuelr Concerning Farmer Mac-
                   Developed Underwriting  Standards




      1


                  In its September 1989 testimonies,6 Farmer Mac described the develop-
Faimer Mac        ment and operation of its secondary market, We are including in this
Stdndards         report the following information Farmer Mac provided us from the testi-
Development and   mony describing the standards’ development and planned
                  implementation.
ImjAementation
                   Farmer Mac officials stated that, before guaranteeing any pool of loans,
                   Farmer Mac will ascertain that the loans conform to its various stan-
                   dards and will evaluate the pool using a computerized “stress-test”
                  model to ascertain that the loss performance of the pool will be within
                   acceptable levels. According to Farmer Mac, the standards are intended
                  to (1) work interactively to eliminate loans that would be bad credit
                  risks, (2) function primarily as a first screen in determining the sound-
                  ness of pools under the program, and (3) produce loan pools with ulti-
                  mate losses, in “worst-case” economic scenarios, of 10 percent or less.
                  Each pool of loans that passes the standards will be further analyzed
                  using an industry-standard computerized risk analysis model to ensure
                  that potential losses in an economic stress situation will not exceed the
                  level of subordination or reserves supporting the pool. Further, in the
                  case of any pool that cannot pass this dynamic evaluation process,
                  Farmer Mac reserves the right to require that the pool (1) be restruc-
                  tured, (2) have more than 10 percent reserve or subordination, or (3) be
                  rejected for guarantee entirely.

                  Farmer Mac also indicated that the validity and reliability of the stan-
                  dards were tested with the stress-test model by using the standards as
                  the primary screening device in a series of special runs utilizing histori-
                  cal data from agricultural loans made during the 1965-1988 period.
                  Farmer Mac reported that the analysis made on that basis demonstrated
                  that loans conforming to its proposed standards, used as collateral for
                  the issuance of Farmer Mac-guaranteed senior securities in accordance
                  with the statute, should result in no guarantee payments by Farmer Mac
                  in excess of guarantee fees received on the pools.




                  “Statement of Henry D. Edelman, President and CEO, Federal Agricultural Mortgage Corporation,
          Y
                  before the Subcommittee on Policy Research and Insurance, House Committee on Banking, Finance
                  and Urban Affairs (Sept. 12, 1989), and the Subcommittee on Conservation, Credit and Rural Devel-
                  opment, House Committee on Agriculture (Sept. 27, 1989).



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        I   Appendix IV
            Major Contributors    to ThLs Report




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            B-220507                                                                                 Y




            ranchers at stable interest rates, including fixed rates. To achieve this,
            Farmer Mac is authorized to guarantee the timely payment of principal
            and interest on securities backed by agricultural real estate and rural
            housing mortgage loans-pooled by loan poolers that are to be certified
            by Farmer Mac-and sold to investors.

            In May 1988, the President appointed an interim Board of Directors of
            Farmer Mac that arranged for the sale of Farmer Mac’s common stock.
            The stock sale that was completed in December 1988 created stockhold-
            ers who elected 10 members to a l&member permanent Board of Direc-
            tors that included 6 presidential appointees. The Board first met with a
            quorum present on March 2, 1989, and on June 1, 1989, appointed a
            President and Chief Executive Officer.

            The act required Farmer Mac to develop the following standards and set
            forth certain requirements for submitting those standards for congres-
            sional review and determining when the standards would become
            effective.

        l Underwriting, security appraisal, and repayment standards were to be
          submitted to the Congress for review not later than 120 days after the
          appointment and election of the permanent Board of Directors. The
          standards were to take effect no later than 30 legislative or 90 calendar
          days after submission to the Congress.
        . Loan pool composition standards were to be submitted to the Congress
          for review, but the act contains no provision for when the standards
          were due. The standards were to take effect no later than 30 legislative
          or 90 calendar days after submission to the Congress.
        . Certification standards for agricultural mortgage marketing
                                                                _,.,_      facilities
                                                                   ._.I.-__I..
          were not required to be submitted for congressional review. They were
          to be issued within 120 days after the permanent Board first met with a
          quorum present.

            Farmer Mac submitted the required standards within the legislated time
            frames; and the last congressional review period officially ended on
            October 16, 1989,90 days after Farmer Mac submitted the last stan-
            dards-loan composition standards-to      the Congress for review.
            Although Farmer Mac was not required to submit the certification stan-
            dards for agricultural mortgage marketing facilities for review, it sub-
            mitted them along with the underwriting, security appraisal, and
    J       repayment standards to the Congress on June 30,1989. Farmer Mac tes-
            tified in September 1989 on these standards before the Subcommittee on
            Policy Research and Insurance, House Committee on Banking, Finance


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         merited further attention during congressional oversight as Farmer Mac
         developed its underwriting standards. Issues raised in that report pri-
         marily relate to the potential government risk and the ability of Farmer
         Mac to include various sizes and types of farms, ranches, financial
         intermediaries, and loans in this market. Appendix II provides further
         information on those issues.

         Our most recent work focuses on issues and concerns related to Farmer
         Mac’sspecific underwriting and other standards that it submitted to the
         Congress for review. We reviewed these standards at the request of the
         Subcommittee on Policy Research and Insurance, House Committee on
         Banking, Finance and Urban Affairs, and the Subcommittee on Agricul-
         tural Credit, Senate Committee on Agriculture, Nutrition, and Forestry.
         We testified before the Subcommittee on Policy Research and Insurance,
         House Committee on Banking, Finance and Urban Affairs; Subcommittee
         on Conservation, Credit and Rural Development, House Committee on
         Agriculture; and the Subcommittee on Oversight, House Committee on
         Ways and Means on our issues and concerns related to the specific
         Farmer Mac standards.* These focused on whether the loan criteria,
         market structure, and risk parameters in the Farmer Mac standards
         would satisfy the broad expectations that the Congress had when it
         passed the enabling legislation. Appendix III provides further informa-
         tion on issues and concerns we raised relating to Farmer Mac’s proposed
         standards. It also provides information, based on discussions with
         Farmer Mac officials, on the standards’ development and planned
         implementation.

         According to Farmer Mac officials, the Securities Guide will address
         many of these issues and concerns when it is finalized. We plan to
         review the Farmer Mac Securities Guide when it is completed to be in a
         position to continue to assist the various congressional committees in
         their oversight activities.

         In addition to the above work, we started work in September 1989 under
         the Financial Institutions Reform, Recovery and Enforcement Act of
         1989 (Sec. 1004, P.L. 101-73, Aug. 9, 1989). That act requires us to con-
         duct studies of risks undertaken by certain organizations referred to as
         government-sponsored enterprises (GsEs)-which include Farmer Mac-
         and the appropriate level of capital for such enterprises consistent with
         (1) the financial soundness and stability of the GSE, (2) minimizing any

                            rwritingStandards Developed by the Federal Agricultural Mortgage Corpo-
                            62, Sept. 12,19SS, and GAO/T-RI



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                        As mentioned previously, the Agricultural Credit Act of 1987, indicated
Planned GAO Work on     that the Congress expected that Farmer Mac would begin operations
Fpmer Mac Studies       quickly and that its secondary market program would have been in
R&quired by the         place and operating as a basis for the GiO work required by the act.
                        However, according to Farmer Mac officials, its secondary market oper-
A ’ ricultural Credit   ations will not be fully operational until at least early 1990. We have
A f t of 1987           testified at congressional oversight hearings concerning the implementa-
                        tion of Farmer Mac’s proposed underwriting and other standards. We
                        have also coordinated with key jurisdictional committees concerning our
                        general plans to initiate further work on the mandated studies as soon
                        as Farmer Mac’s secondary market operations become fully operational,
                        and the committees have concurred with our plans. We will continue to
                        coordinate with them in developing a plan of action for sequencing and
                        initiating the mandated Farmer Mac studies.

                        Because agricultural real estate loans are a new frontier for a national
                        secondary market, we believe that once Farmer Mac becomes fully oper-
                        ational, its program will yield new and invaluable insights into agricul-
                        tural financing that will facilitate our efforts to respond to the three
                        legislatively-mandated studies that the Congress envisioned could be
                        done by January 6, 1990. For example, we will be better able to report
                        on the effects of Farmer Mac operations on the market participants and
                        others once information is available on pools of loans, including bor-
                        rower characteristics, such as type, size, and location of farm opera-
                        tions; loan terms, such as interest rates, repayment periods, and loan
                        amounts; and lenders and poolers, such as type, size, location, and mar-
                        ket activity.

                        Further, the new secondary market’s operation will provide more credi-
                        ble insights into whether such a market could be feasible without a
                        Farmer Mac guarantee. In a renort entitled Farm Finance: Secondary
                        Markets for Agricultural Real Estate Loans (GAO/RCED-87-149BR,  July i7,
                        1987), we raised a related issue of whether federal government involve-
                        ment was needed to develop a large national-scope secondary market for
                        farm real estate loans. On the basis of our review of the development of
                        the housing secondary market-which       is the most developed secondary
                        mortgage loan market today and relies in large part on guarantees by
                        agencies similar to Farmer Mac -we indicated that government involve-
                        ment, such as that seen in the housing market, was probably necessary
                        to get an agricultural secondary market up and running. Once Farmer
                        Mac is operational and the financial markets gain experience with
                        Farmer Mac-generated securities, the issue of how the market would be



                        Page 6        GAO/RCED-90-90   GAO Requirements   Under Agricultural   Credit   Act of 1987
      This work was done under the direction of John W. Harman, Director,
      Food and Agriculture Issues, (202) 27645138. Other major contributors
      to this report are listed in appendix IV.




    lPCharlesV A. Bowsher
      Comptroller General
        of the United States




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                                                                                                       c




Contents


Letter                                                                                                         1
  /
Appendix I                                                                                                    12
Khy Issues Concerning
the Development of a
secondary Market for
Agricultural Real
Estate Loans
Appendix II
Key Issues Concerning
the Development of
Underwriting
Standards for Farmer
M&c
Appendix III                                                                                                 14

                                                                                                             15
Farmer Mac-             Consistency of Financial Information                                                 15
Developed               Financial Ratios                                                                     16
                        Standardized Market Operating Agreement                                              17
Underwriting            Regulatory Approaches                                                                18
Standards               Pool Diversification Standards                                                       18
                        Appraisal Standards                                                                  19
                        Standards for Rural Housing                                                          20
                        Farmer Mac Standards’ Development and Implementation                                 21

Appendix IV                                                                                                  22
Major Contributors to   Resources, Community, and Economic Development                                       22
                            Division, Washington, D.C.
This Report
Related GAO
          I
            Products                                                                                         24




                        Page 10      GAO/RCEDBOdO   GAO Requirements   Under Agricultural   Credit   Act of 1987
     ssuesConcerning the Development of a
$xondary Market for Agricultural Real
Estate Loans
                  On the basis of our examination of nine legislative proposals introduced
                  in the 100th Congress and our discussions with individuals and officials
                  from both the private sector and the government, we reported in July
                  1987 that the following issues merited additional consideration in the
                  debate concerning the development of a new national-scope secondary
                  market for agricultural real estate loans.’

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




      Y

                  ‘This appendix was developed from information contained in section 3 of our report entitled Farm
                  Finance: Secondary Markets for Agricultural Real Estate Loans (GAO/RCED-87-149BR, Ju~Y~
                  1987). A detailed discussion of the issues listed in this appendix is included in that report.



                  Page 12             GAO/RCED-90-90     GAO Requirements     Under Agricultural   Credit   Act of 1987
Aplpendix III

&y IssuesConcerningFamer Mac-Developed’
underwriting
 I           Standards                                                                                                      r

                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. Our
                observations below should help highlight the issues involved.2

                During congressional oversight hearings in September 1989 and in sub-
                sequent meetings with us, Farmer Mac officials commented on some of
                these issues and said they plan to issue a Securities Guide in December
                1989 that will address many of the issues we and others had raised. At
                these later meetings, Farmer Mac officials also provided us with infor-
                mation describing the standards’ development and planned implementa-
                tion This information is presented at the end of this appendix.

                As part of our responsibilities under the Agricultural Credit Act of
                1987-to study the implementation of Farmer Mac-and to be in a posi-
                tion to continue to assist the various congressional committees in their
                continuing oversight activities, we plan to review the Securities Guide
                when it is completed.


Key Terms and   loans be adequately defined to ensure that the loans in a pool have met
Concepts        certain basic criteria that (1) allow only loans of known and comparable
                risk into the pool and (2) ensure that Congress’ broad expectations are
                met. Some terms and concepts included in Farmer Mac’s standards are
                undefined.

                Throughout the standards Farmer Mac does not specify accounting
                practices to be used in calculating financial ratios and preparing finan-
                cial statements. Different accounting interpretations could result in
                loans with noncomparable risk. We will discuss broader implications of
                this later. Credit underwriting standard 6 illustrates how undefined

                ‘These standards are “Credit Underwriting, Loan Repayment and Security Appraisal Standards,”
                June 39, 1989; “Eligibility Standards for Certified Facilities,” June 30, 1989; and “Loan Diversifica-
                tion Standards,” July 18, 1989.
                2This appendix was developed from information contained in our testimony entitled Issues Surround-
                     nderwriting Standards Developed by the Federal Agricultural Mortgage Corporation (GAO/T-
                                     , 1989, and GAO/T-RCED-89-71, Sept. 27, 1989) and from conversations with




                Page 14              GAO/RCED-90-90      GAO Requirements      Under Agricultural    Credit   Act of 1987
                                                                                                               --
                       Appendix III
                       Key Issues Cbnceming     Farmer Mac-
                       Developed Underwriting     Standards




                   l  Standardized accounting terms and methods are not required. These
                      terms and methods are necessary to ensure consistency of financial
                      information used to make loan decisions that ultimately determine the
                      risks in the loan pools. Farmer Mac does not require borrowers’ financial
                      statements supporting loan applications to follow specific accounting
                      principles such as generally accepted accounting principles (GAAP). The
                      lack of reliance on GAAP or some set financial disclosure practice makes
                      it very difficult to compare financial information on all loans in a loan
                      pool. The Farm Financial Standards Task Force3 is currently completing
                      a national study of the use of accounting conventions in agricultural
                      finance. The task force found a lack of consistency in the use and under-
                     standing of accounting practices and terms used in agriculture and plans
                     to issue its report in early 1990, which it hopes will lead to more consis-
                     tency in the presentation of financial information.
                   . Projected financial statements are not specifically required. Projected
                     financial statements are important because they represent how the
                     farmer plans to carry out the farming operation during the projected
                     period. These statements are particularly important if the farmer plans
                     to change cropping or production systems on land he currently farms, or
                     buys new land and is farming it for the first time. As part of projected
                     financial statements, a cash-flow analysis is a valuable tool because it
                     provides lenders with a detailed repayment plan of how the farmer
                     plans to meet currently maturing debt obligations. Most lenders we
                     talked with told us that they currently prepare cash-flow analyses as an
                     integral part of their credit approval processes. They also told us that it
                     is imperative to have 3 years of tax returns together with the other
                     financial statements required by the standards to prepare reliable cash-
                     flow analyses. Farmer Mac does not require borrower tax returns to be
                     submitted with loan documentation. The “forward looking” approach,
                     which predicts future financial performance, is missing in the
                     standards.


                       It is important that Farmer Mac fully evaluate the potential effects of its
Financial Ratios       standards and accompanying financial ratios to determine if they will
                       have intended effects. Financial ratios are used together with other cri-
                       teria as determinants of the ability of a loan to qualify to be sold into
                       the Farmer Mac secondary market. Some examples of potential unin-
                       tended effects follow.

                       “The task force is sponsored by the American Bankers Association and composed of members from
                       many groups, including the academic community, commercial banks, insurance industry, FCS,
                       accounting profession, and regulatory agencies.



                       Page 16            GAO/RCED-90-90      GAO Requirements   Under Agricultural   Credit   Act of 1987
                           Appendix III
                           Key  Issues Concerning   Farmer Mac-
                           Developed Underwriting     Standards




                       . Recourse provisions of the subordinated participation interests4 have
                         not been addressed in the standards. This one element will be a pivotal
                         point that will determine if and when the government has to provide
                         funds to keep the market afloat in a recession scenario such as agricul-
                         ture experienced in the mid-1980s. Our report entitled Federal Agricul-
                         tural Mortgage Corporation: Underwriting Standards Issues Facing the
                         New Secondary Market (GAO/RCED-89-106BR), dated May 5, 1989, provides
                         further information on the subordinated participation interest issue.
                       l Several lenders and others we talked to raised concerns that, without a
                         market agreement specifically geared to making sure smaller lenders
                         with lower volume loans could participate in the market, small lenders
                         either may be excluded through competitive pressures or receive less
                         than desirable market agreements from individual poolers.


                           According to many sources we talked to, the potential market partici-
Rqgulatory                 pants could be regulated by several different regulators and this could
Approaches                 result in some participants’ being regulated more strictly than others.
                           This could result in inhibiting competition and actually excluding some
                           participants from the market. For example, there is some concern that
                           commercial bank regulators may require significantly more capital to be
                           held against Farmer Mac loans than insurance company regulators may
                           require. Both banks and insurance companies have acknowledged this
                           issue and agree that banks, under certain scenarios, could essentially be
                           excluded from the market or have to act as mortgage bankers by simply
                           originating mortgages and not retaining any part of the loan. While
                           Farmer Mac standards require that poolers have at least $2 million in
                           capital, they do not specify capital requirements in the sense of commer-
                           cial banking’s safety and soundness regulations. It is also probable that
                           appraisals will be regulated by several different regulators, posing a
                           similar concern. Farmer Mac needs to examine the potential implications
                           of differing regulatory approaches on all market participants and how
                           such approaches may affect Farmer Mac’s activities.


                           The Agricultural Credit Act of 1987 specified that each pool of loans
Pool Diversification       meet diversification requirements including that each pool be secured by
Standards                  agricultural real estate that is widely distributed geographically and is


                           “Subordinated participation interests are created when a pooler and/or lender retains a portion of a
                           mortgage pool and the holders of the retained portion do not receive principal and interest payments
                           (subordinated payments), on terms agreed to by the involved parties, until after all other investors
                           have received their psyments (senior payments).



                           Page 18              GAO/RCED-90-90     GAO Requirements     Under Agricultural   Credit   Act of 1987
                                                                                                                ,

                     Appendix III
                     Key Issues Concerning    Farmer Mac-
                     Developed Underwriting     Standards




                     in the new market-will           not come under the appraisal provisions of the
                     1989 act.

                     Because the Congress studied the appraisal issue and decided on federal
                     involvement in aspects of the appraisal industry that potentially cover
                     at least some loans sold into the Farmer Mac secondary market, we
                     believe additional consideration needs to be given to how the Congress
                     wants to assure itself that the collateral for all loans in the Farmer Mac
                     market is appraised adequately.


                     Credit underwriting standard 8 provides that Farmer Mac will adopt
Sthdards for Rural   credit underwriting standards similar to those of the Federal National
H&sing               Mortgage Association (Fannie Mae), adjusted to reflect the usual and
                     customary characteristics of rural housing. The standard establishes a
                     75-percent loan-to-value ratio that can be met in part with private mort-
                     gage insurance.

                     Farmer Mac has not identified specific Fannie Mae standards that will
                     be used, nor what adjustments will be made to reflect the usual and cus-
                     tomary characteristics of rural housing. We believe that Farmer Mac
                     standards should include more criteria on what the rural housing loans
                     will look like, so that the Congress has a better idea of the risk parame-
                     ters for that market and the adequacy of the 75-percent loan-to-value
                     ratio set in the standards.

                     In the September 1989 oversight hearings mentioned earlier, Farmer
                     Mac officials testified that in developing the standards for qualified
                     rural housing loans, Farmer Mac was taking advantage of Fannie Mae’s
                     experience by adopting most of Fannie Mae’s underwriting standards.
                     Farmer Mac’s testimony also listed nine Fannie Mae property exceptions
                     for rural housing mortgages that will be considered for inclusion by
                     Farmer Mac in rural housing pools.




                     Page 20            GAO/RCED-90-90      GAO Requirements   Under Agricultural   Credit   Act of 1987
 Ppe

Gzi     Contributors to This Report


  I
  I                  John P. Hunt, Jr., Assistant Director
Rbources,            Michael E. Gilbert, Assignment Manager
C&nmunity, and       J. Ken Goodmiller, Evaluator-in-Charge
                     Carolyn R. Kirkpatrick, Evaluator
Edonomic Division,
Development          M. JaneHunt, Rewfis Analyst

Wbhington, D.C.




                     Page 22       GAO/RCED-$bO-90 GAO Requirements   Under Agricultural   Credit   Act Of 1987
 -
 1 elated GAO Prod&s


-               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. 3030(GAO/RCED-88-66FqNov.5,    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 (G~O/Rc~~-87-172Fs, July 2, 1987).

                Issues Surrounding a Secondary Market for Agricultural                    Real Estate
                hUIS(GAO/T-RCED-87-29, June 3, 1987).




(029179)       Page 24           GAO/RCED-SO-90   GAO Requirements   Under Agricultural    Credit   Act of 1987
1


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