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 Page 1 GAO/RCED-90-90 GAO Requirements Under Agrkultural Credit Act of 1987 .,..” . I 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). Page 3 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 I ’ I R-220607 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. Page 6 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 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. Page 7 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 FM20697 Page 9 GAO/RCED-99-99 GAO Requirements Under Agricultural Credit Act of 1987 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 Page 11 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 \ 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). Page 13 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 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: Page 16 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 - -.I..- 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, Page 17 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 - 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. Page 19 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 . 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). Page 21 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 I . I I Appendix IV Major Contributors to ThLs Report Page 23 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 I 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 Page 2 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 ~~ * -’ I R-220607 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 Page 4 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 I 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 Y Page 8 GAO/RCED-90-90 GAO Requirements Under Agricultural Credit Act of 1987 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 /jif!: J !;’ :
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)