oversight

Risks and Oversight of Government Sponsored Enterprises

Published by the Government Accountability Office on 1990-05-15.

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

                   United States General Accounting OfRce
                   Testimony




                     Risks   and   Oversizht       of    Government
For Release
                     Sponsored     Enterprises
on Delivery
Expected    at
10 a.m. EDT
May 15, 1990




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


                     Before    the
                     Committee      on Banking,         Housing   and
                     Urban Affairs
                     United    States   Senate




 GAO/T-GGD-90-42
                                    /
                                    _'                                  f&o Form160<12/87)
                            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     Donald W. Riegle,
Jr.,     Chairman, Senate Committee on Banking,        Housing and Urban
Affairs,      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 Committee:


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--WHO THEY ARE, THE RISKS THEY
BEAR, AND HOW THEY ARE OVERSEEN


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
educations.


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.

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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.




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                                                           Table      1:
                                            GSEs INCLUDED IN THIS STUDY


                                                            Year              'Market             Style   of
GSE   Name                                                  Created            Sector             Operation
Farm Credit       Banks                                     1916/             Agriculture         Portfolio       lender
                                                            1988

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
       Mechanisms


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


       --    Interest          rate      risk   is   the    possibility          of     losses   from   changes
             in interest              rates.     GSEs that          operate      as portfolio        lenders
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     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 GSB's
current        risk      exposure         and its          related          control          mechanisms:




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--   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

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     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

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     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
capital.


     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 with             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
     specifies.


     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

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     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
     risks.


     We 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.



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--   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 GOVERNMENTNEEDS TO IMPROVE ITS
APPROACH FOR OVERSEEING CERTAIN GSEs



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

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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 Cred t and thrift                          crises          vividly       demonstrate                  the     effects
of inadequate            federal         oversight            of     the risk-taking                   and capital
of financial              nstitutions.                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.

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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
reduced.


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.




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