Risks and Oversight of Government-Sponsored Enterprises

Published by the Government Accountability Office on 1990-07-27.

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
9:30 a.m. EDT
July   27, 1990

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

                    Before    the Subcommittee        on Housing     and
                    Community    Development
                    Committee    on Banking,       Finance      and Urban   Affairs
                    House of Representatives

                     :-,+-?   hi-(   I
                                Risks   and Oversight      of
                          Government-Sponsored       Enterprises

                                   Summary of StatementBy
                                      Richard    L. Fogel
                            Assistant      Comptroller    General
                             General      Government   Programs

In response      to a request      from the Honorable          Henry B. Gonzalez,
Chairman,     House Subcommittee          on Housing     and Community
Development,       Committee    on Banking,     Finance      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        but did
not conduct      an independent       test    of the financial      vulnerabilities
of government-sponsored          enterprises.         Nevertheless,      caution
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       oversiqht,       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
agriculture,                    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,                   agriculture,                    or    student


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              Agriculture             Guarantor
  Corporation        (Farmer  Mac)                                                        Rural     Housing

          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,        which         did         not      include          an independent                       test

of    the       financial              vulnerabilities                        of      GSEs,         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

--   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,             the     information                  we reviewed                   suggested

     that       certain           System          institutions                   continue              to     have         serious
     financial             difficulties                     and,      in     total,         System             institutions
     report        that          about         14 percent              of      their        $49 billion                    in     loans

     outstanding                 at     the      end of            1989 were            high-risk                 loans.           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            most         of     Sallie            Mae's                 student               loans         are

     guaranteed                 by     state          and non-profit                         aqencies                    and        reinsured               by
     the      Department                   of    Education,                  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

--   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                  level           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 with             authority                   to

     monitor           the         risk-taking                    of    Banks       and enforce                   safe      practices.
     To date,           however,                  no board             members           had       been        confirmed               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


     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.

--     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.

       Unlike            other           enterprises,                    Connie         Lee has          no federal              ties     that

       may promote                    unsafe             risk-taking               and        expose      the        federal

       government                   to      losses.


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
mon toring               capability                 or     capital             rules        in   place            to     learn           about
the      Farm Credit               crisis             in    time          to    prevent            it         from      becoming

ser      ous .        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,

changes              in     management                   strategies,               economic              downturns,                 or     other

adverse              events           could         precipitate                   future          GSE losses.                     The speed

with       which            a firm        can            go from           an apparently                     sound          position             to        one
that       is        financially                   imperiled               was seen              in    the        thrift          industry,

the       Farm Credit                  System,                 and Fannie            Mae in            the        1980s.            Thus,
caution              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.