Risks and Oversight of Government Sponsored Enterprises

Published by the Government Accountability Office on 1990-05-14.

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

                   United   States     General   Accounting      Office


For Release          Risks    and      Oversight       of     Government
on Delivery          Sponsored         Enterprises
Expected    at
2 p.m.    EDT
May 14, 1990

                     Statement         of
                     Richard     L.      Fogel
                     Assistant         Comptroller       General
                     General         Government      Programs

                     Before     the Subcommittee              on Oversight
                     Committee      on Ways and             Means
                     House    of Representatives

 GAO/T-GGD-90-41                                                             GAO Form 160 <12/W)
                            Risks    and Oversight    of
                      Government     sponsored   Enterprises

                              Summary of Statement By
                                  Richard L. Fogel
                        Assistant     Comptroller  General
                         General Government Programs

In response to a request        from the Honorable       J.J. Pickle,
Chairman,      House Subcommittee    on Oversight,      Committee on Ways and
Means, GAO presented       its preliminary     findings     on the purpose and
general     activities   of Government Sponsored Enterprises           (GSE), the
risks    they face as well as those the government            faces from a GSE
failure,     and the need for appropriate        oversight    and capital
standards      for GSEs.
GAO did not become aware of anything          in its preliminary       review
to suggest that any GSE is in danger of immediate             failure.
Nevertheless,     prudence dictates    that the government        not wait for
a crisis    before protecting    its interests.
The government protects             its interests       in some GSEs through
federal    oversight,       including     monitoring        of their    risks,
reasonable       capital    standards,     and enforcement          of safe and sound
practices.        This, however,        is not the case for Fannie Mae,
Freddie Mac and Sallie            Mae.    Furthermore,         the close ties between
the government and these GSEs weaken the discipline                          that
creditors      normally     provide     to private      firms.       The lack of
appropriate       federal     or private     discipline        for these three GSEs
make the federal          government vulnerable           to losses from any
serious     future     GSE problems that may arise.
GAO believes     that a better         system of oversight,         some reasonable
risk-based     capital    rules,     and appropriate      enforcement
authorities     are needed for Fannie Mae, Freddie Mac and Sallie
Mae. In general,        this system needs to assure that the federal
government obtains        timely     information     on the risks      undertaken     by
certain     GSES as well as proper oversight,             including
congressional      oversight.        This oversight     should be designed to
keep emerging problems           from imposing     losses on taxpayers         and
develop appropriate         responses quickly        so that major unanticipated
losses can be contained.             We have not yet formed an opinion             on
the precise way this can best be accomplished.                      We plan to
continue     our analysis      and make recommendations           in this regard in
our final     1991 report.
Mr. Chairman              and Members of the                      Subcommittee:

We are pleased               to be here                today      to discuss         our preliminary
findings          on government-sponsored                          enterprises             (GSE).         We share
your      concern         about      the         safety        and soundness           of GSEs.             They are
very      large     financial           organizations,                   established           by Congress,                that
undertake          a variety          of risks              to accomplish            certain          public        policy
purposes.           Their         operations              have become critical                    to the        finance
of housing,            agricultural,                   and student          lending.           The securities
GSEs issue          are perceived                  by investors             to have safety                 comparable
to U.S.       Treasury            securities.                  Given     their      public        policy        links        to
the     government,           a GSE experiencing                        serious       financial            difficulties
could      pose tough             and possibly                 expensive         decisions          for     the
Congress,          like      those         it     faced        during      the     Farm Credit             and thrift
crises.           No one wants                  to see those            experiences           repeated.

Our preliminary               work         on GSEs has involved                     learning          about        their
operations,            the    risks             they      face,    and how they             measure         and
control       risks.          We     have also              examined        how they          might        transmit
the risks          they      take      to the government.                        My testimony              today      will
describe          the purpose              and general             activities          of GSEs, the                risks
they      bear,     and how they                  are regulated.                  I will      then        discuss         our
concerns          about      the     need for              appropriate            oversight          and capital
standards          for     GSEs.

GSEs were created               by Congress            to correct            certain          flaws     in our
financial         system       that      made it       difficult            for     creditworthy
borrowers         to    finance         homes,      agricultural             businesses,              or college

One major         credit       problem       that      GSEs were designed                     to solve         was the
uneven availability                   of credit        throughout            the      country.          When banks
depended         primarily          on local        deposits         for     their       lending,
creditworthy            borrowers         living       in areas            of rapid          economic         growth
had trouble            borrowing         money when the              local         deposit       base was
insufficient            to meet the          lending        demands.               The national             credit
markets        that     GSEs created           have helped             to solve          this        problem.

Another        problem       that       GSEs were designed                  to solve          was the
difficulty            in attracting          large-scale             investment              funds     to
agricultural,              housing,       or student           lending.              Large-scale
investors         tended       to prefer           investments             in large          denominations
that     could        be easily         converted       into        cash.          However,       mortgage,
agriculture,            and student          loans       tended           to be small           and could            not
easily       be traded.             Furthermore,          the       risks         involved       in    such
lending        activities           were hard        to assess             because       lending         practices
varied       throughout           the    country,       the        loan     payments          could      be
unpredictable,               and the      collection           procedures             could      be difficult.

GSEs overcame             these        problems        by offering             securities                   attractive           to
large-scale           investors           and,      in turn,        making           these           investor          funds
available          to local          lenders        who want        to make mortgage,
agricultural,             or student             loans.

GSEs can be grouped                    in a variety            of ways.              One way of grouping
them is by their                 market         sector--that           is,     agriculture,                   housing,           or
higher       education           lending.           These market              distinctions                   are
important          because         the general            economic           climate         of       the market
sector       in which        GSEs lend             typically        affects            their          financial
health.         Another          grouping          is by their          operating               style--portfolio
lenders         (which      hold       loans),        guarantors,             or those               that      use both
techniques.              Portfolio          lenders        borrow       money at one rate                          and lend
it     at another.           They can be vulnerable                          both      to      loan         defaults       and
changes       in interest              rates.         By contrast,             guarantors                   enhance      the
credit      quality         of     financial          products         for     a fee.                They are less
vulnerable          to changes            in interest           rates         than      portfolio                lenders
but      equally      vulnerable            to loan        defaults.                Table        1 lists           the   GSEs
that      we studied,            the    year(s)        each was created,                       its     market          sector,
and its       style       of operations.

                                                          Table      1:
                                          GSEs INCLUDED IN THIS STUDY

                                                           Year              Market            Style of
GSE Name                                                   Created           Sector            Operation
Farm Credit      Banks                                     1916/             Agriculture       Portfolio        lender

Banks for     Cooperatives                                 1933              Agriculture        Portfolio       lender
Federal    Home Loan Banks                                 1932              Housing            Portfolio       lender
Federal National    Mortgage                               1938/             Housing            Portfolio   lender
  Association    (Fannie Mae)                              1968                                  and guarantor
Federal Home Loan Mortgage                                 1970              Housing            Portfolio   lender
  Corporation (Freddie  Mac)                                                                     and guarantor
Student Loan Marketing                                     1972              Education          Portfolio       lender
   Association (Sallie                 Mae)
College    Construction     Loan                           1986              Education          Guarantor
   Insurance    Association
     (Connie Lee)
Federal Agricultural     Mortgage                          1988              Agricultural       Guarantor
  Corporation    (Farmer Mac)                                                Real Estate

      GSE Risk Exposure                  and Control

      The Financial             Institutions           Reform,       Recovery         and Enforcement        Act
      required         that     we study        four      types     of risks       to which     GSEs are

      --    Interest          rate     risk    is   the    possibility          of losses      from   changes
            in interest              rates.     GSEs that          operate      as portfolio       lenders
     have a greater               potential         exposure         to interest         rate     risk     than
     GSEs that          operate       strictly         as guarantors.

-- Credit        risk         is the possibility                of losses        from borrowers
     failing          to repay their             loans       or other        parties,      like     mortgage
     insurers,          failing       to honor claims.

-- Business            risk     is the possibility                 of losses        from factors
     largely          beyond the GSEs' control,                      such as crop failures                 from
     droughts          or new legal           requirements            that     may alter          the way a
     GSE does business.

-- Management and operations                          risk       is the possibility               of losses
     resulting          from poor decisions                     or indecisiveness           on the part           of
     a GSE's managers.

GSEs deal with                these risks           in the normal course of business                        and
use their        existing          capital          to cover any losses                 they may incur.
If   the losses exceed available                          capital,       the GSE could             fail,
thereby        posing a problem               for     the government.

Our preliminary                work suggests             that      no GSE is currently               in danger
of immediate failure.                    I will          briefly      describe          each GSE's
current        risk     exposure        and its          related      control       mechanisms:
--   From a consolidated                    perspective,               the Farm Credit                  system         of
     Farm Credit              Banks,       Banks for            Cooperatives,               and their           related
     associations              were able           to report           profits         in 1988 and 1989
     after        3 years        of losses           caused        by a serious              agricultural
     recession          and resulting                loan       defaults,           high     exposure           to
     interest          rate      risk,      and management                  weaknesses.                Most     of these
     profits         have resulted                from      reversing          loss        reserves           taken       in
     prior        years.         The Agricultural                  Credit         Act of 1987 provided
     System         institutions             up to $4 billion                  in     federal          assistance
     which        has alleviated              any immediate                 concerns         about        System

     viability.               However,        System           institutions            report          that       loan
     repayment          is questionable                  for      about       14 percent          of their             $49
     billion         in loans            outstanding            at the        end of        1989.         In addition,
     the Farm Credit                Administration                 has identified                weaknesses               in
     the management                of institutions                 that       hold     over      60 percent               of
     the System's               assets.           Furthermore,              the      System's          health         depends
     heavily         on the        general         state        of agriculture.                  Farm         Credit
     institutions              have       recently          developed          systems          that      should
     enable         them to better                control         their       interest          rate      risk.           In
     addition,          new risk-based                capital          requirements              are being
     phased-in          that       are     somewhat            analogous          to those         being
     implemented              in the       banking          and thrift            industries.

--   The Federal              Home Loan Banks have historically                                  presented               little
     risk      of    failure.             Their      conservative              lending          policies           provide

     a substantial                 cushion              for      losses.            Future          profitability,
     however,           will       be dampened because                             part      of the          Federal           Home
     Loan Banks'                earnings              will       be used to help                    pay the          costs       of
     thrift       failures               and to fund                   new affordable                housing          programs.

--   Fannie       Mae faced               financial                   troubles        serious          enough to result
     in losses            for      4 years              in the          early       1980s.           Legislation                was
     enacted        in         1982 that              lengthened             Fannie          Mae's         tax     loss
     carryback,                qualifying               it      for     refunds           that      a Fannie          Mae
     official           estimated               to be $25 million.                           Fannie          Mae was able              to
     recover        from          its     problems               and posted               record       profits            in 1989.
     Its      financial            difficulties                       resulted        primarily              from     interest
     rate       changes.                Fannie          Mae reports                that      its      exposure            to
     interest           rate       risk         has been greatly                      lessened             although            not
     eliminated.                  Its     losses              from       credit       risk         have also          declined
     from unusually                     high     levels               experienced            in the          mid-1980s.
     Fannie       Mae is rebuilding                             its      capital          base and has recently
     announced            the planned                   addition            of     $2 billion              in capital.                It
     plans       to hold           capital              sufficient                to withstand,               on a national
     basis,       its          default          experience                from mortgages                   originated            in
     Texas in 1981 and 1982.

--   Freddie        Mac has consistently                                 reported          profitable              operations.
     Freddie        Mac generally                       avoids           interest          rate       risk       by limiting
     its      portfolio            lending,                  preferring            instead          to create             mortgage-
     backed        securities                  that          pass      interest           rate      risk         on to the

     security        investor.              Freddie          Mac's        credit          losses          from its
     guarantees          have been generally                        lower        than         industry            averages.
     Freddie        Mac's      policy         is to hold               capital           sufficient               to absorb,
     for      a period       of at least              7 years,            the         effects         of housing
     defaults        comparable             to those           experienced                during          the Great
     Depression.             Currently,              Freddie           Mac says it               holds           sufficient
     capital        to withstand              such losses               for      10.5 years.

--   Sallie        Mae's      financial             performance             has been consistently
     profitable.              Because         student           loans         are guaranteed                     by state
     agencies        and the          federal         government,                it      has experienced
     minimal        credit         losses.           Its      policy          is to minimize                     losses        from
     changes        in interest              rates         by borrowing                funds       with          interest
     rate      payments        that       adjust           parallel         with         the      interest            it    earns
     on its        student         loans.           Sallie         Mae has decreased                       its      capital
     holdings        since         1984 from           about          5 percent           of      assets          to about           3
     percent        in     1989.

--   Connie        Lee expects            little           or no losses                 from      credit           risk       and is
     not exposed             to interest             rate       risk      in its              current       business            of
     bond reinsurance.                    Connie           Lee's       capital           is     set     by management
     to conform            to private              market       standards               for     the highest                quality
     bond insurers.

     Farmer        Mac has prepared                  credit           standards               and methods             of
     operations            but has not yet                   guaranteed               any securities.

Government's Oversight
Approaches Vary

The day-to-day              management              and control         of risk-taking              is largely
controlled         by GSE managers                   and owners.           For some GSEs, the
government         protects           its      interest        by monitoring           GSE risk-taking,
setting        minimum       capital           levels,        and exercising           enforcement
authorities             to prevent           GSEs from         continuing          practices          thought        to
be unsafe.              But for       other         GSEs, the         government       does very          little
to   learn      about       unnecessary              risks     and guard         against       them.          Let me
briefly        describe       how the government                      oversees      GSE risk-taking                and

--   The Farm Credit                System and Farmer                  Mac are overseen               by an
     independent            federal          regulator,         the     Farm Credit           Administration.
     The Farm Credit                Administration              has established               risk-based
     capital       rules,          modeled          after     those     applicable          to commercial
     banks,       for     Farm Credit               Banks and Banks for               Cooperatives.                It
     also      examines           Bank operations              annually,         and has a full               range
     of enforcement                authorities              to stop     System       institutions             from
     engaging           in highly           risky      practices.

--   The Federal            Housing          Finance         Board     regulates        the    Federal         Home
     Loan Banks.             It     was created              in August      1989 w.ith            authority        to
     monitor       the      risk-taking              of Banks and enforce                  safe     practices.
     To date,       however,           no board             members had been appointed                    and the

     Secretary          of the          Department           of Housing          and urban            Development
     (HUD) serves              with      the    full       power      of the       Board       of Directors.
     Currently,          it     is unclear              how effective            the      Federal          Housing
     Finance       Board will             be as an independent                     regulator           for        safety
     and soundness.

--   Fannie       Mae is        subject         to oversight             by HUD.            In August             of
     1989,     HUD also           received             authority        to oversee           Freddie          Mac when
     the    Federal           Home Loan Bank Board                     (Freddie          Mac's       former          Board
     of Directors)              was abolished.                     HUD does not have                 the     full          range
     of explicit              enforcement           authorities              typically           available                to
     bank regulators                  and has never                used the audit             authority              it        has
     to oversee          Fannie          Mae.          Furthermore,            HUD officials               told           us,
     and we agree,              that      it     is unclear           whether           HUD has authority                       to
     establish          risk-based             capital        standards           for     Fannie       Mae and
     Freddie       Mac.         They do,          however,           have the           authority          to require
     less     capital          than      the     statutory           debt-to-capital                 formula

     The statutory              debt-to-capital                    standards       currently            applied                to
     Fannie       Mae and Freddie                 Mac are not based on the                           risks          they
     undertake.                As Table          1 noted,           Fannie      Mae and Freddie                     Mac

     operate       both        as portfolio               lenders       and as guarantors.                          The
     debt-to-capital                  standard          requires        that      capital           be held            for
     borrowings           they        make as portfolio                 lenders.            The standard                     does
     not     require          capital          to be held           on their       guarantees              of $500

     billion       in mortgage-backed                  securities.             Furthermore,              although
     their      portfolio          lending      operations             expose them to interest
     rate      risk,      the standard          does not require                   capital      for      such

     He are also concerned                    with     the fact         that       the statutory              capital
     standard          is broadly          defined      to include            owner equity,              loss
     reserves,          and subordinated               debt      equally.           From the
     government's            perspective,             owner equity             represents         the best
     protection           to the government               against           unexpected         losses         because

     owners have incentives                    to protect           their       personal         investment
     from losses.               By contrast,           loss      reserves          account       for     expected
     defaults          and subordinated               debt     involves         borrowings             from
     creditors           that     must     be repaid          to avoid default.                  In the final
     analysis,           Fannie     Mae      and Freddie           Mac can increase               their         risks
     without           a commensurate increase                   in equity          capital.

     HUD officials              say that       in the future                they plan to strengthen
     their      monitoring          and oversight              of Fannie           Mae   and Freddie              Mac.
     Nevertheless,              we are concerned               about        inherent         conflicts
     between HUD's housing                    policy      goals        and its        goals      as a
     financial           regulator.           Recent history                with    the thrift           crisis
     and the Farm Credit                   crisis      has illustrated                the disastrous
     effects       of having             regulators       both      promote the industry                      and be
     responsible            for    financial          oversight.

--   Sallie       Mae is             not     routinely          overseen          by any federal                agency
     nor is        it      subject           to federally              established            capital          rules.

--   Connie        Lee,        like         other       insurers,         is     subject        to     state
     regulation               that      oversees          its    risk-taking               and capital             levels.


The sheer          size        of     GSEs' financial                  obligations--over                  $800
billion       --their          public          policy       purposes,            and the        probability--in
view of        the       precedents             of Farm Credit                  and Fannie           Mae--that           the
federal        government               would       assist       a financially                troubled            GSE, make
it   appropriate               for      the     government             to oversee           their       risk-taking
activities              and establish               appropriate              capital         levels.

The situation                 that      we found           is   that      the      government           oversees          some
GSEs but         not others.                   The agricultural                  enterprises             and the
Federal        Home Loan Banks each have a regulator                                          with      certain
authorities              to    monitor           risk-taking            and set           capital        rules.          Connie
Lee's     activities,                 like      those        of other           private       insurers,            are
regulated          by state                authorities          and also           appear       to be disciplined
by private              creditors.              However,            Fannie       Mae's,       Freddie          Mac's,        and
Sallie        Mae's        risk-taking              and capital                levels      are not        closely
overseen         by the government.                          Furthermore,               GSE ties        with       the
government              have weakened               the discipline                 that      creditors            normally

provide       to completely          private          financial           firms    because these                ties
provide       investors      with a reasonable                   assurance         that        their     claims
will      be honored by the federal                    government            should       a GSE fail.

With inadequate            federal      oversight              and weakened private                    market
discipline,        GSE risk-taking              and capital               are largely           controlled             by
owners and managers.                 In financially                troubled        times after              capital
is depleted,        owners and managers may have incentives                                       to take
unusual risks         in a last-ditch                 effort       to recover.                General
creditors       may be willing           to lend GSEs the funds needed to take
these unusual risks             if    they expect               to be protected                from loss         by
federal       assistance.

The Farm Credit            and thrift          crises          vividly      demonstrate            the effects
of inadequate         federal        oversight           of the risk-taking                    and capital
of financial        institutions.               The government                did not have adequate
monitoring       capability          or any capital                rules      in place           to learn
about the Farm Credit                crisis       in time to prevent                    it     from becoming
serious.        For thrifts,          capital          regulations            were largely
unenforced,        and oversight              and supervision                were weak.            As a
result,       the crisis       reached         unprecedented               proportions.                After     each
financial       crisis,      legislation              reformed           and strengthened               the
supervisory        role     of the financial                   regulators,         making them more
independent        and giving         them responsibilities                       for        establishing
risk-based       capital       rules.          But the regulatory                  reforms         were
enacted too late            to avoid          large      taxpayer          losses.

While we did not               become     aware of anything                 in    our     preliminary
review      to     suggest      that     any GSE is in danger of immediate                                     failure,
prudence dictates               that     the government             not wait            for     a crisis
before      protecting          its     interests.           By strengthening                   oversight            and
establishing              risk-based      capital         rules     in the current                 favorable
environment,              the potential          for     future     financial            crises          can be

We think         a better       system of monitoring,                     some    reasonable               capital
rules,      and appropriate              enforcement          authorities               are needed for
Fannie      Mae,      Freddie         Mac, and Sallie             Mae.      In general,                 this      system

needs      to    assure       that     the federal         government            obtains          timely
information           on the risks          undertaken            by certain            GSEs as well                as
proper      oversight,          including         congressional             oversight.                  This
oversight          should      be     designed         to keep emerging problems                         from
imposing         losses       on taxpayers             and develop         appropriate             responses
quickly         so that       major unanticipated                 losses     can be contained.                            We
have not yet formed an opinion                           on the precise             way this             can best
be   accomplished.              We plan       to continue           our     analysis             and make
recommendations               in this      regard        in our final            1991         report.

That concludes               my prepared         statement.          My colleagues                 and I would
be pleased          to answer any questions.