Controlling the Risks of 

Government=Sponsored Enterprises 

As Regutred by the 

Omnibus Budget ReconciIiallon Act of 19SM 

CONTROLLING THE RISKS OF 

GOVERNMENT-SPONSORED ENTERPRISES 

The Congress of the United States 

Congressional Budget Office 

For sale by the Superintendent of Documents. U.S. Government Printing Omce 

Washington. DC 20402 
NOTES 

Unless otherwise indicated, all years referred to in this report 

are calendar years. 

Details in the text and tables of this report may not add to 

totals because of rounding. 
PREFACE 

This report satisfies the requirements of section 13501(c) of the Omnibus 

Budget Reconciliation Act of 1990 (Public Law 101-508). That statute directs 

the Congressional Budget Office (CBO) to prepare a study on governmentsponsored enterprises (GSEs). The law specifies that the study include "an 

analysis of the financial risks each GSE assumes, how Congress may improve 

its understanding of those risks, the supervision and regulation of GSEs' risk 

management, the financial exposure of the Federal Government posed by 

GSEs, and the effects of GSE activities on Treasury borrowing," as well as 

"an analysis of alternative models for oversight of GSEs and of the costs and 

benefits of each alternative model to the Government and to the markets and 

beneficiaries served by GSEs." In keeping with CBO's mandate to provide 

nonpartisan analysis, the report includes no recommendations. 

Robin Seiler of the Budget Process Unit coordinated the report and.wrote 

Chapters I, 11, and IV, under the supervision of Marvin Phaup, James L. 

Blum, and Robert Hartman. Chapter 111 was written by David D. Trechter, 

formerly of CBO's Natural Resources and Commerce Division. Douglas 

Hamilton of the Fiscal Analysis Division prepared Chapter V. Marvin Phaup 

and Susan Borghard of the Budget Process Unit wrote Chapter VI. Joyce 

Manchester of the Fiscal Analysis Division made a major contribution to 

Chapter I. Research assistance was provided by Susan Borghard, Dan 

Covitz, Nicholas Dugan, Susan Postle, Thomas Steinbach, and Patricia 

Wahl. 

The authors are greatly indebted to numerous officials of the Farm 

Credit System, the Federal Agricultural Mortgage Corporation, the Federal 

National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Bank System, the Student Loan Marketing 

Association, the Farm Credit Administration, the Department of Housing 

and Urban Development, and the Federal Housing Finance Board for the information they provided, their many insights, and their thoughtful comments on drafts of the report. Useful comments were also provided by omcials of the General Accounting Office, the Ofice of Management and Budget, the Department of the Treasury, Standard and Poor's Corporation, and 

Fitch Investors Service. 

Kristen Allen, James R. Barth, Jack M. Guttentag, Paul M. Horvitz, 

Edward J. Kane, John A. Maxim, Jr., Roy T. Meyers, Jonathan A. Scott, 

James D. Shilling, Thomas H. Stanton, Mark W. Stephenson, and Lawrence 
iv GOVERNMENT-SPONSORED ENTERPRISES April 1991 

J. White served as external reviewers of portions of the report and provided 

valuable comments. Within CBO, Philip F. Bartholomew, Michael Crider, 

Alfred B. Fitt, Peter H. Fontaine, Kim Kowalewski, Wilhelmina Leigh, 

Andrew Morton, Larry Mote, Jay Noell, Frederick Ribe, and Bruce 

Vavrichek made useful suggestions. 

The manuscript was edited by Paul L. Houts, Sherry Snyder, and 

Francis S. Pierce, with the assistance of Nancy H. Brooks. Sherry Snyder 

also coordinated and supervised the production of the full report. Kathryn 

Quattrone prepared the report for publication. 

Robert D. Reischauer 

Director 

April 1991 
CONTENTS 

SUMMARY ...................................... xvii 

PUBLIC PURPOSES AND RISKS OF GSEs ......... 1 

GSEs in the Financial System ........................ 3 

Public Purposes and Operations of GSEs ......... 3 

Benefits and Restrictions Under Federal Law .... 6 

Implications of the Implicit Federal Guarantee ... 9 

Growth of GSE Activities ..................... 11 

Alternatives to GSEs ......................... 13 

Effect of GSE Activities on Treasury 

Interest Costs ............................. 17 

Risks of GSEs ...................................... 19 

Credit Risk .................................. 20 

Interest Rate Risk ............................ 24 

Management. Operations. and Business Risks ... 29 

How GSE Capital Affects the Government ...... 30 

Risk of Changes in Federal Policy .............. 30 

Possible Changes in Federal Policy ................... 31 

Plan of the Report .................................. 32 

FEDERAL SUPERVISION AND 

REGULATION OF GSEs ........................... 35 

Elements of Supervision of Safety 

and Soundness .................................. 36 

Institutional Capacity ........................ 37 

Statutory Mandate ........................... 38 

Statutory Authority .......................... 38 

Adapting Federal Supervision to the Unique 

Characteristics of GSEs .......................... 40 

Relying on Federal Oversight 

and Early Warning ........................ 41 
vi GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Streamlining Supervision of 

Low-Risk GSEs ........................... 42 

Selecting and Limiting the Use 

of Enforcement Powers ..................... 45 

Dealing with an Insolvent GSE ................ 46 

Privatization as an Alternative to 

Enhanced Supervision ........................... 47 

Using Private Assessments of GSE Risks to 

Minimize the Possibility of Supervisory Failure .... 48 

Requiring Reproducible Federal 

Reports on GSE Risk Exposure 

and Capital Adequacy ..................... 48 

Using Credit Ratings to Assess the 

Government's Exposure to GSE Risks ....... 50 

Requiring the GSEs to Issue Risky 

Subordinated Debt ........................ 55 

Evaluating the Options ....................... 58 

Program Regulation of GSEs ........................ 59 

Creating a New Agency to Supervise 

and Regulate All GSEs ........................... 60 

Issues in Setting Federal Capital 

Requirements for GSEs .......................... 62 

Establishing Statutory Minimum 

Capital Standards ......................... 63 

Limiting Supervisory Discretion in 

Setting Risk-Based Requirements ........... 64 

Including Management and Operations Risks 

in a Risk-Based Capital Standard ........... 66 

Establishing Comparable Capital Standards 

for the Housing GSEs ...................... 67 

Economic Effects of Federal Capital 

Requirements ............................. 68 

In FARM CREDIT SYSTEM .......................... 69 

The Farm Credit System in the Agricultural 

Finance System ................................. 70 

Public Purposes and Activities of the FCS ....... 70 
CONTENTS v ii 

Historical Development and Performance ....... 70 

Causes of the System's Decline in the 1980s ..... 75 

Legislative Responses to the System's 

Financial Problems ........................ 78 

Recent Performance and Outlook .............. 84 

Credit Risk ........................................ 88 

Management and Control of Credit Risk ........ 89 

Indicators of Loan Performance ................ 90 

Managing Credit Risk at Farmer Mac .......... 92 

Interest Rate Risk .................................. 93 

Management and Control of Interest 

RateRisk ................................. 93 

Responding to Prepayment Risk ............... 94 

Measures of Interest Rate Risk ................ 95 

Farmer Mac's Exposure to Interest 

RateRisk ................................. 96 

Capitalization of the Farm Credit System ............. 96 

Structure and Levels of Capital ................ 97 

 he FCS ~nsurance Fund ...................... 99 

A Scenario Analysis of the System's 

Capital Adequacy ........................ 100 

Federal Supervision of the FCS ..................... 105 

Options for Change ................................ 108 . 

Eliminate Joint and Several Liability ......... 109 

Eliminate or Consolidate District Banks ....... 112 

Insurance Fund Issues ....................... 114 

Adequacy of the FCA's Authority to 

Regulate Farmer Mac ..................... 116 

Reforms Proposed in the Administration's 

Fiscal Year 1992 Budget .................. 117 

Moving the FCA into a New Agency 

Responsible for Supervising All GSEs ...... 118 
viii GOVERNMENT-SPONSORED ENTERPRISES April 1981 

IV FEDERAL NATIONAL MORTGAGE 

ASSOCIATION AND FEDERAL HOME 

LOAN MORTGAGE CORPORATION .............. 121 

Fannie Mae and Freddie Mac in the 

Housing Finance System ........................ 122 

Public Purposes and Activities ................ 122 

Historical Development and Performance ...... 128 

Ending Market Share and 

Economic Effects ......................... 136 

CreditRisk ....................................... 140 

Management and Control of Credit Risk ....... 141 

Indicators of Credit Risk and Loan 

Performance ............................. 145 

Pricing Mortgage Purchases and MBS 

Guarantees .............................. 152 

Interest Rate Risk ................................. 152 

Management and Control of Interest 

RateRisk ................................ 152 

Measuring the GSEs' Exposure to 

Interest Rate Risk ........................ 155 

Capitalization .................................... 164 

Components and Trends of Capital ............ 165 

Statutory Leverage Ratio .................... 167 

Fannie Mae's Internal Capital Standard ....... 168 

Freddie Mac's Internal Capital Standard ...... 170 

OMB's Assessment of the Capital Adequacy 

of Fannie Mae and Freddie Mac ............ 172 

HUD's Supervision and Regulation of 

Fannie Mae and Freddie Mac .................... 173 

Statutory Mandate and Authority to 

Supervise Safety and Soundness ........... 174 

Institutional Capacity to Supervise 

Fannie Mae and Freddie Mac .............. 176 

Role as a Program Regulator ................. 176 

Options for Change in the Current 

Regulatory Structure ........................... 180 

Strengthen HUD's Institutional Capacity ...... 180 
CONTENTS ix 

Strengthen HUD's Statutory Mandate and 

Authority to Supervise Safety 

and Soundness . . . . . . . . . . . . . . . . . . . . . . . . . . . Allow HUD to Streamline the 

Supervisory Process . . . . . . . . . . . . . . . . . . . . . . Establish an Independent Supervisory 

Agency Within HUD . . . . . . . . . . . . . . . . . . . . . Move Supervision of Fannie Mae and 

Freddie Mac to a New Supervisor 

of All GSEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer Supervision of the GSEs to the 

Federal Housing Finance Board . . . . . . . . . . . Issues in Setting Federal Risk-Based Capital 

Requirements for Fannie Mae 

and Freddie Mac . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Including an Interest Rate Risk Component 

in a Risk-Based Capital Standard . . . . . . . . . . Providing Statutory Direction About 

Setting a Risk-Based Capital 

Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Possible Economic Effects of Requiring 

the GSEs to Maintain More Capital . . . . . . . . 

THE FEDERAL HOME LOAN BANK SYSTEM . . . 

Current Activities of the FHLB System . . . . . . . . . . . . . . Advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 

Risk Management Services . . . . . . . . . . . . . . . . . . . Banking Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financing the Resolution of the Thrift Crisis . . . Community Investment and Affordable 

Housing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management and Control of Interest 

Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indicators of Interest Rate Risk . . . . . . . . . . . . . . . BusinessRisk ...................................... 
x GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Decline in the Demand for Advances 

by the Thrift Industry ..................... Problems of Attracting New Members ......... Effect of Lower Dividend Yields on the 

Costs of Resolving the S&L Crisis .......... Capitalization of the FHLB System ................. Current Levels of Capital in the FHLB 

System .................................. Capital Standards of the FHLB System ........ Effects of the Capital Standards on 

Competition in Housing Finance 

Federal Regulation and Supervision ................. Statutory Authority of the Regulator .......... Start-up Problems of the Regulator ........... Policy Options for the Federal Home 

Loan Bank System ............................. Is the FHLB System Still Needed? ............ Eliminating the Problems Created 

by FIRREA .............................. Creating a Level Playing Field for 

the Housing GSEs ........................ 

VI STUDENT LOAN MARKETING ASSOCIATION ... 241 

Sallie Mae and Postsecondary Education 

Finance ....................................... 242 

Students as Credit Risks ..................... 242 

Current Structure of the Student 

Loan System ............................. 243 

Organizational Structure and Ownership ...... 245 

Financing and Operating Services ............ 245 

Sallie Mae's Funding Sources ................. 248 

Secondary Market Structure and 

Competition ............................. 249 

Credit Risk ....................................... 249 

Risk from Guarantee Agencies ................ 250 

Risk from Warehousing Loans ................ 250 
CONTENTS xi 

Risk from Exchange Agreements ............. 252 

Interest Rate Risk ................................. 252 

Earnings History .................................. 254 

Program Risk ................... ; ................. 256 

Capitalization .................................... 257 

Current Federal Oversight of Sallie Mae ............. 259 

Options for Limiting Future Federal 

Exposure to Risk ............................... 259 

Privatize Sallie Mae ......................... 261 

Increase Treasury Department Oversight 

and Early Warning ....................... 262 

Require Private Risk Assessment ............. 263 

Subject Sallie Mae to a Centralized 

Supervisor of All GSEs .................... 264 

APPENDIXES 

Assumptions Used in the Scenario Analysis of the 

Capital Adequacy of the Farm Credit System ......... 269 

Internal Capital Standards and Capital 

Adequacy of Fannie Mae and Freddie Mac ........... 273 
xii GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLES 

1. Characteristics of Government-Sponsored 

Enterprises ......................................... 5 

2. Legal Benefits Enjoyed by GovernmentSponsored Enterprises ............................... 8 

3. Government-Sponsored Enterprise Securities 

and Guarantees Outstanding at End of Year .......... 12 

4. Average 10-Year Cumulative Default Rates 

for Corporate Bonds Rated by Moody's 

Investors Service, by Rating Category ................ 65 

5. Consolidated Balance Sheets and Income Statements 

for the Banks and Associations of the Farm Credit 

System, by District, Year-End 1990 .................. 82 

6. CAMEL Ratings for Institutions in the Farm 

Credit System ..................................... 86 

7. Indicators of Credit Quality in the Farm 

Credit System, by District Bank ..................... 91 

8. Sensitivity of the Estimated Mark-to-Market 

Net Worth of Farm Credit Banks and Districts 

to a Change of One Percentage Point in Interest 

Rates, Year-End 1990 .............................. 95 

9. A Scenario Analysis of the Capital Adequacy 

of the Farm Credit System, Assuming a 

Repetition of the 1980s ............................. 102 

10. Enforcement Actions and Budget of the Farm 

Credit Administration, 1986-1990 .................. 107 

11. Mortgage Purchases by Fannie Mae and 

Freddie Mac, 1981-1990 ............................ 125 
CONTENTS xiii 

Fannie Mae's Consolidated Balance Sheets 

and Income Statements, 1981-1990 .................. 130 

Freddie Mac's Consolidated Balance Sheets 

and Income Statements, 1981-1990 .................. 134 

Percentage of Outstanding Residential Mortgage 

Debt Financed by Different Financial Institutions, 

Year-End 1981-1990 ............................... 137 

Mortgages Financed by Fannie Mae and Freddie 

Mac Covered by Credit Enhancements, 

Year-End1990 .................................... 144 

Fannie Mae and Freddie Mac's Conventional SingleFamily Mortgage Purchases and MBS Issues, 

1985-1990, by Loan-to-Value (LTV) Ratio ............ 146 

Capital (Stockholders' Equity and Reserves) of 

Fannie Mae and Freddie Mac, Year-End 1990 ........ 165 

Fannie Mae's Compliance with Its Internal Capital 

Standard, Year-End 1989 and 1990 ................. 169 

Projected Years Freddie Mac Survives a Simulated 

Great Depression Scenario, Year-End 1987-1990 ..... 171 

Balance Sheet of the Federal Home Loan 

Bank System ..................................... 202 

Income Statement of the Federal Home 

Loan Bank System ................................ 204 

Estimated Change in the Mark-to-Market Net 

Worth of the Federal Home Loan Banks from 

an Increase of One Percentage Point in 

Interest Rates ..................................... 218 
xiv GOVERNMENT-SPONSORED ENTERPRISES April 1991 

23. Advances Made by Federal Home Loan Banks to 

Member Institutions as of December 31,1990 ........ 220 

24. Effect of Lower FHLB Dividend Yields on 

the S&L Industry ................................. 225 

25. Consolidated Sallie Mae Balance Sheets and 

Income Statements, 1981-1990 ..................... 247 

26. Sallie Mae Maturity Gap Analysis .................. 253 

FIGURES 

1. Lending by the Farm Credit System, 1945-1988 ....... 71 

2. Market Share of the Farm Credit System, 1945-1988 ... 75 

3. Return on Assets of the Major Components of 

the Farm Credit System, 1960-1983 .................. 76 

4. Quarterly Pretax Income of Fannie Mae and 

Freddie Mac as a Percentage of Assets and 

Mortgage-Backed Securities ........................ 133 

5. Percentage of Conventional Single-Family Mortgages 

Financed by Fannie Mae, Freddie Mac, and 

Mortgage Banks That Were Seriously Delinquent 

or in Foreclosure .................................. 149 

6. Percentage of Conventional Multifamily Mortgages 

Financed by Fannie Mae and Freddie Mac That 

Were Seriously Delinquent or in Foreclosure 

at Year-End, 1988-1990 ............................ 151 

7. Estimated Durations of Fannie Mae's Assets 

and Liabilities, 1980-1990 .......................... 153 
CONTENTS xv 

8. Sensitivity of Freddie Mac's Estimated Pretax 

Mark-to-Market Net Worth to Instantaneous 

Changes in Interest Rates .......................... 158 

9. Sensitivity of Fannie Mae's Estimated Pretax 

Mark-to-Market Net Worth to Instantaneous 

Changes in Interest Rates .......................... 160 

10. Net Interest Margin of Federal Home 

Loan Banks, 1974-1990 ............................ 215 

11. Aggregate Capital-to-Asset Ratio of the 

Federal Home Loan Banks ......................... 226 

12. Stock Requirements on FHLB Advances for Members 

of the Federal Home Loan Bank System ............. 229 

13. Pretax Income for Sallie Mae as a Percentage 

of Average Total Assets ............................ 254 

14. Book Value of Sallie Mae's Capital as a 

Percentage of Average Total Assets ................. 255 

BOXES 

1. What Is a Government-Sponsored Enterprise? .......... 2 

2. Using Stress Tests to Assess the Risk Exposure 

and Capital Adequacy of GSEs ....................... 22 

3. Historical and Market Value Accounting for GSEs ..... 26 

4. The Private Credit-Rating Process ................... 51 

5. Current Organizational Structure and Ownership 

of the Farm Credit System .......................... 72 
xvi GOVERNMENT-SPONSORED ENTERPRISES April 1991 

6. Comparison of the CBO and OMB Stress Tests 

of the Farm Credit System ......................... 104 

7. Changes in Policy to Limit Exposure 

to Credit Risk ..................................... 143 

8. The Conflict Between HUD's Pursuit of Programmatic 

Objectives and Efforts to Reduce Fannie Mae's 

Risk Exposure in the Late 1970s .................... 179 

9. Risk Classes for Determining Collateral 

Requirements ..................................... 212 

10. The Guaranteed Student Loan Program ............. 244 

11. Federal Reimbursement of Guarantee 

Agencies: The HEAF Case ......................... 251 
SUMMARY 

Government-sponsored enterprises (GSEs) are financial institutions 

chartered by the federal government to achieve the public purposes of 

facilitating the flow of funds to agriculture, housing, and higher education. Today, there are five enterprises: the Farm Credit System, the 

Federal National Mortgage Association (Fannie Mae), the Federal 

Home Loan Mortgage Corporation (Freddie Mac), the Federal Home 

Loan Bank (FHLB) System, and the Student Loan Marketing Association (Sallie Mae). These institutions achieve their public purposes by 

borrowing on the strength of an implicit federal guarantee. Investors 

in their obligations infer this guarantee from the GSEs' special benefits under federal law, the exemption of their obligations from the 

normal protections afforded to investors, Congressional support for the 

achievement of their public purposes, and the huge volume of their 

outstanding obligations, which totaled over $980 billion at the end of 

1990. 

Achieving public purposes by providing financial services exposes 

each GSE to risk. Any financial institution's overall exposure to risk is 

a function of its exposure to credit risk, interest rate risk, management 

and operations risks, and business risk. The distribution of the firm's 

overall risk between owners and creditors depends on how much of its 

assets is financed with equity. The government can allow a GSE's 

owners and management considerable discretion in determining the 

enterprise's exposure to each type of risk and the distribution of its 

overall risk. The implicit federal guarantee of GSE obligations transfers to the government a large portion of the risk that creditors normally bear. Federal risk bearing conveys an implicit subsidy and creates 

a permanent potential for federal losses. The government's exposure to 

a GSE will be quite low, however, if the enterprise is exposed to low 

levels of risk and is highly capitalized, and if the government has the 

ability to prevent large increases in risk and declines in capitalization. 

The federal government can use two tools to limit the risks taken 

by each GSE to the minimum level necessary to achieve its public purposes. First, the government can restrict by statute the types of loans a 
xviii GOVERNMENT-SPONSORED ENTERPRISES April 1991 

GSE can finance and require it to shed some of the credit risk of the assets and take a minimum amount of interest rate risk. Second, a federal agency can be empowered to supervise the activities of the enterprise to ensure that its operations are safe and sound, and to regulate 

its programs to assure that it achieves its public purposes. 

The government can also require the owners and creditors of a 

GSE to bear a significant portion of the enterprise's overall risk. An 

enterprise's capital--stockholders' equity plus any liabilities on which 

payments can and will be interrupted as a condition of federal assistance--can protect the government both prospectively and retrospectively. Prospectively, capital can give a GSE an incentive to consider a 

wide range of possible outcomes, thereby limiting its incentive to ignore the potential costs to the government of bearing excessive risks. 

Retrospectively, capital is the deductible on the government's implicit 

guarantee of the enterprise's obligations. 

This Congressional Budget Office (CBO) report analyzes how the 

five GSEs achieve their public purposes and assesses the financial exposure to the government arising from their activities. CBO has concluded that two of the GSEs--the FHLBs and Sallie Mae--currently 

pose a minimal risk of loss to the federal government. The two largest 

enterprises--Fannie Mae and Freddie Mac--are reasonably well capitalized relative to, and pose a low level of risk of loss to the government 

from, their exposure to credit risk and interest rate risk. The Farm 

Credit System's financial condition and overall risk have improved 

substantially since the government last provided assistance in 1987, 

but the system remains quite vulnerable and continues to expose the 

government to more risk than any other enterprise. CBO has not assessed the exposure to management and operations risks of any of the 

GSEs, however, and therefore cannot offer definitive conclusions about 

their overall exposure to risk or the adequacy of their capital. 

The report also examines federal supervision of the GSEs and 

regulation of their programs, as well as strategies and policies that 

would enable the government to control its exposure to risk more effectively. CBO has concluded that federal supervision currently cannot 

ensure that Fannie Mae, Freddie Mac, and Sallie Mae will not increase their exposure to risks or lower their capitalization in the fu- 
SUMMARY xix 

ture. Federal supervision of the FHLB system and the Farm Credit 

System generally is adequate to protect the government. CBO's analysis raises the questions, however, of whether the government should 

take steps to assure the future viability of the FHLBs and reduce the 

near-term vulnerability of the Farm Credit System. 

The report presents the conceptual framework that CBO has 

adopted to understand federal supervision and regulation of GSEs. 

The framework is used to analyze current supervision and regulation 

of each of the enterprises and to develop strategies and options for 

reform. 

FEDERAL SUPERVISION OF GSEs 

Governments supervise the safety and soundness of many types of financial institutions. Federal supervision of GSEs most closely resembles the supervision of depository institutions. In both cases the government is protecting itself as the ultimate guarantor of the liabilities 

of the financial institutions. In fact, the Farm Credit Administration, 

which supervises the several hundred institutions of the Farm Credit 

System, has statutory authority very similar to that of the federal 

bank and thrift regulators. The other four GSEs differ from depository institutions in many important ways, however, and federal supervision of them need not follow the regulation of depository institutions in every respect. 

CBO has identified several ways to adapt the bank and thrift 

model of supervision to GSEs. These approaches include tailoring the 

statutory authority of supervisory agencies to reflect the attributes of 

GSEs, obtaining private assessments of the government's exposure to 

risk, centralizing supervision and regulation of the enterprises, and 

imposing federal risk-based or minimum capital requirements on 

them. 
xx GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Adapting Supervisory Authority to the 

Unique Characteristics of Some GSEs 

One strategy would provide a supervisory agency or agencies with 

statutory authority that was tailored to the unique characteristics of 

Fannie Mae, Freddie Mac, Sallie Mae, and perhaps the FHLB system. 

For example, a supervisory agency could be required to monitor intensively the internal plans of the first three GSEs, which have publicly 

traded stock that subjects them to some market discipline, and to 

sound an early warning of planned increases in risk. The agency could 

also be allowed to request that the President remove the board of directors of an enterprise that was planning excessive increases in risk or 

had begun to experience significant losses. Alternatively, an agency 

could be required to streamline the regulatory reporting and disclosure and the federal examinations of a GSE if it found that the enterprise posed little risk to the government. A streamlined process would 

allow federal examinations to focus on evaluating management systems, the quality of financial models and stress tests, and the accuracy 

of the data used to run them. The Congress could also use statutory 

language or legislative history to limit the ability of the agency to misuse its enforcement powers and to enable the enterprise to anticipate to 

some extent how they would be used. Finally, a supervisory agency 

could be required to appoint a conservator to manage the affairs of an 

ailing GSE and to prepare a legislative plan to recapitalize or otherwise reduce the risk of the enterprise. 

Tailoring the statutory authority of the agency or agencies that 

supervised Fannie Mae, Freddie Mac, Sallie Mae, and perhaps the 

FHLBs in these ways would make federal monitoring less burdensome 

than supervision of banks and thrifts and would minimize the possibility of unnecessary interference in their operations. To varying degress, the adaptations would run some risk that the supervisory agencies would have difficulty detecting changes in the enterprises' risks 

and minimizing the government's exposure to those risks. 
SUMMARY xxi 

Obtaining Private Assessments of 

the Government's Exposure to Risk 

Another strategy for oversight would rely on private assessments of 

the government's exposure to the risks of each-GSE. Private risk assessments could reduce the possibility that a supervisory agency would 

allow an enterprise to take excessive risks, neglect to report losses or 

noncompliance with federal capital requirements, or take little or no 

action if the enterprise was in trouble. One or more of three possible 

approaches could be taken. First, a supervisory agency could be required to report regularly on its quantitative assessments of a GSE's 

exposure to credit risk and interest rate risk, and on the market values 

of its assets and liabilities, where available. The enterprise would be 

required to make available simultaneously the empirical data on 

which the supervisory agency had based its findings. Second, the government could hire private credit-rating agencies to rate the government's exposure to the risk of each GSE. Finally, if an enterprise was 

adequately capitalized, it could be required to issue subordinated debt 

that did not carry an implicit federal guarantee. Variations in the 

market value of that debt could indicate investors' perceptions of a 

GSE's risks. 

Each of these sources of information could provide some privatesector discipline of the federal supervisory process. There would be 

costs to obtaining the assessments, however. Also, it is doubtful that 

private parties could be as well informed as a properly motivated supervisory agency that regularly examined a GSE, learned its techniques for measuring and managing risk, and developed its own stress 

tests. Private assessments could still be valuable if there were significant concerns about whether the supervisory agency would stay well 

informed, would publicize problems quickly, and would act to protect 

the government from excessive risk or to minimize losses. 

Centralizing Supervision and Regulation of GSEs 

CBO has identified two options that would reform supervision of the 

safety and soundness of GSEs by consolidating responsibilities for several enterprises in a single federal agency. One option would be to cen- 
xxii GOVERNMENT-SPONSORED ENTERPRISES April 1991 

tralize all responsibility in a new federal agency with an independent 

board. This agency would have greater supervisory responsibility, 

would be accountable to a broader range of interests, and could be more 

visible than are the existing agencies that supervise GSEs. These factors probably would reduce the possibility that one or more of the enterprises could dominate the decisions of, or capture, the agency's 

board. Such an agency, however, might not simultaneously develop 

sufficient expertise in housing, higher education, and agriculture to 

supervise all the GSEs effectively. A lack of expertise could lead to 

adopting standardized monitoring and capital requirements that did 

not account for the differences among the enterprises. 

A less far-reaching change would move supervision and program 

regulation of Fannie Mae and Freddie Mac from the Department of 

Housing and Urban Development to the Federal Housing Finance 

Board (FHFB), which supervises the FHLB system. The board might 

be able to develop more extensive expertise in housing finance than a 

centralized supervisor of all GSEs, but it would have to take into account the significant differences in the ownership, activities, and tax 

status of the three enterprises. The Congress probably would want to 

distinguish carefully between the FHFB's statutory authority over the 

FHLBs and its authority over Fannie Mae and Freddie Mac. The board 

would also have to develop expertise in issues that are unique to the 

latter two enterprises. 

Issues in Setting Federal Capital Requirements for GSEs 

The government has imposed capital requirements that vary with risk 

only on the member institutions of the Farm Credit System. Welldesigned, risk-based standards could give the management of the other 

GSEs an incentive to limit the government's exposure to risk. In a 

streamlined supervisory process, risk-based requirements could incorporate the use of sophisticated financial models and stress tests to assess exposure to credit risk and interest rate risk. 

The Congress might also want to establish a statutory minimum 

capital requirement to protect the government against a GSE's exposure to management and operations risks, which cannot be measured 
SUMMARY xxiii 

with precision, and against errors in judgment in setting risk-based 

capital standards. Responsibility to establish a minimum standard 

could also be delegated to a supervisory agency to prevent a statutory 

requirement from becoming a ceiling on enterprise capital. 

Finally, Fannie Mae, Freddie Mac, Sallie Mae, or the FHLBs could 

be allowed to reach a "safe harbor" from federal capital requirements if 

two credit-rating agencies gave them an acceptably high rating. This 

option could create the possibility that a supervisory agency would be 

unable to act even if it discerned risks that the rating agencies had not 

uncovered. This concern could be addressed by requiring the agency to 

conduct federal examinations to assess exposure to management and 

operations risks and giving it authority to correct deficiencies, or by requiring very high ratings. 

FARM. CREDIT SYSTEM 

The Farm Credit System (FCS) has several attributes that make it 

unique among the GSEs. First, in contrast to the other enterprises, 

which only serve financial institutions, most of the institutions in the 

system make loans directly to individual borrowers. Second, the FCS 

is the only GSE that is supervised by an agency with powers equivalent to those of the bank regulatory agencies, is subject to minimum 

risk-based capital standards, and is financing a federal insurance fund. 

Finally, the FCS is much more dependent on the financial well-being of 

a single sector of the economy--agriculture-- than are the other GSEs. 

The FCS has recently been through a period of wrenching financial difficulties and, largely in response to legislation providing federal 

financial assistance, significant and continuing institutional change. 

CBO's analysis of the system suggests that the institutional changes 

made to date have greatly reduced the risk that the FCS poses to the 

federal government, but that portions of the system remain in weak 

financial condition. The weaker Farm Credit Banks could seriously 

threaten the financial integrity of the entire system if the farm economy were to suffer a serious downturn during the next few years. The 

likelihood of such a downturn is not high, in CBO's view. Neverthe- 
xxi v GOVERNMENT-SPONSORED ENTERPRISES Apdl 1991 

less, the FCS's financial condition will bear close scrutiny during the 

next three to five years. 

Activities and Recent Legislation 

The FCS is organized as a multitiered, federated cooperative with 

about 275 member institutions in 12 disti-icts. Like all cooperatives, 

each institution is owned and controlled by its member/borrowers. The 

government created the initial components of the system to make 

long-term loans for agricultural real estate. FCS lending later expanded to include production credit, lending to agriculturally oriented 

and rural cooperatives, and rural housing loans. 

The Agricultural Credit Act of 1987, which provided federal financial assistance to the FCS, also significantly changed the system's 

institutional structure. The statute provided for some consolidation of 

the FCS: the district banks that made short- and long-term loans were 

merged, similar merger authority was given to local associations that 

make short- and long-term loans, and the system was urged to explore 

the possibility of reducing the number of districts through mergers. 

The statutory authority of the Farm Credit Administration (FCA), 

which supervises the FCS, was strengthened and clarified. The legislation also established the Financial Assistance Corporation (FAC) to 

provide up to $4 billion in financial assistance to the system by late 

1992, to be financed with debt backed by an explicit federal guarantee. 

The Farm Credit System Insurance Corporation, which is a federal 

agency, was created to collect premiums from member institutions and 

build up a fund that would be available, beginning in 1993, to assure 

the timely repayment of borrowings by the system. Finally, the statute created the Federal Agricultural Mortgage Corporation (Farmer 

Mac) to increase agricultural lenders' access to capital markets by 

guaranteeing securities backed by loans for agricultural real estate 

and rural housing. Farmer Mac was also recently given authority to 

issue and guarantee securities backed by loans guaranteed by the 

Farmers Home Administration (FmHA). 
SUMMARY xxv 

Risks, Capitalization, and Federal Supervision 

Since the mid-1980s, the FCS has improved its management of credit 

risk by clarifying lending standards, although local associations retain 

some discretion in making loan decisions. Institutions in most districts 

are using differential loan pricing, so that loan rates reflect, at least 

partially, the relative credit risk of borrowers. The FCS has also improved its internal mechanisms for controlling its exposure to interest 

rate risk. The banks more closely monitor their portfolios to spot mismatches between the terms of loans and the bonds issued to finance 

them. Portions of the system are also using sophisticated financial 

techniques to manage their exposure. 

The fortunes of agriculture have improved since 1987, and with 

them the financial condition of the FCS. The system has been profitable in each of the last three years, has disposed of a large inventory of 

acquired property, and has stopped its loan portfolio from shrinking. 

Banks and associations in some districts continue to have significant 

financial problems, however. The next three to five years are of particular concern because two of the primary sources of protection for the 

government--the FCA's minimum risk-based capital standards and the 

insurance fund--are not yet fully in place. 

The FCS will eventually have several tiers of capital or capitallike funds on which to draw when another agricultural downturn occurs. The FCA requires each system institution to have permanent 

capital equal to at least 7 percent of risk-adjusted assets by the end of 

1993. After collateral pledged to back FCS obligations and earnings, 

this capital will be the first funds available to absorb losses. If internal 

resources are insufficient, system institutions will be able to seek additional assistance from the insurance fund, which has a target level of 

at least 2 percent of the FCS's insured liabilities. If neither source is 

sufficient, the district banks are jointly and severally liable for all system obligations. This means that financially healthy portions of the 

FCS would be called on to assure timely payment on borrowings by 

institutions in the system that could not meet their obligations. 

As a partial test of the ability of the FCA's minimum capital standards and the insurance fund to handle potential financial difficulties 
xxvi GOVERNMENT-SPONSORED ENTERPRISES April 1991 

in the FCS, CBO conducted a simple scenario analysis, which assumed 

a downturn in the farm economy beginning in 1991 that is somewhat 

less severe than the one that occurred in 1984 through 1987. The 

analysis indicated that seven districts within the system might be 

unable to maintain their minimum capital standards throughout the 

1991-1996 period. The shortfalls in three of the districts were large 

and persistent, and the insurance fund was not sufficiently large to 

offset the deficits. 

The institutional capacity, statutory mandate, and statutory authority of the Farm Credit Administration are quite similar to those of 

the bank and thrift regulatory agencies. Because the FCS consists of 

several hundred institutions--most of which lend directly to borrowers--and makes many different types of loans, the FCA conducts 

bank-type examinations. 

Policy Options 

CBO examined three broad policy options that could affect the risk 

that the FCS poses to the government: eliminating joint and several 

liability, eliminating or consolidating district banks, and authorizing 

the Insurance Corporation to change the target size and rate of growth 

of the system's insurance fund. Each option would address an important issue but might compromise the financial viability of the FCS. 

Assessing the relative costs and benefits of these options is difficult, because the recent institutional changes in the system limit the value of 

historical data. A fourth option concerns possible changes in the FCA's 

statutory authority over Farmer Mac. 

Eliminate Joint and Several Liability. All districts currently share the 

liability for the bonds issued by any FCS district. Increasingly, however, the lending that exposes the FCS to risk occurs at the local association level. Joint and several liability can give institutions in some 

districts an incentive to take excessive risk, since they reap the benefits of lending but share the responsibility for repayment of their obligations with institutions in other districts. 
SUMMARY xxvii 

Eliminating joint and several liability would address these concerns but could have other drawbacks. For example, FCS bondholders 

would be purchasing the bonds of institutions lacking the geographic 

diversity of the whole system. Investors might infer a reduced federal 

commitment to the system and an increased willingness of the government to allow portions of the FCS to default on their obligations. The 

liquidity of the debt could also decrease. All three factors could increase the borrowing costs of institutions in the system. 

Eliminate or Consolidate District Banks. District banks have provided 

oversight and coordination of the activities of local associations. With 

lending authority being increasingly placed at the local level and 

improvements in communications and transportation, some analysts 

feel that FCS district banks could be eliminated safely or reduced in 

number. The primary benefit would be to reduce the system's operating costs. Replacing the district banks with additional nationallevel institutions, however, could compromise the cooperative nature 

of the FCS. In addition, the practicality of reducing the number of 

banks is diminished by the lack of an acceptable means of dealing with 

their nonaccruing assets. 

Changes in the Insurance Fund. The board of the Farm Credit System 

Insurance Corporation could be given additional authority to modify 

the structure of the fund to help protect the government against loss in 

the period of heightened vulnerability that the system faces in the next 

few years. The Insurance Corporation's board could change the premium rates or the target fund level to respond to changes in the system's 

financial situation or conditions within agriculture. Such changes, 

however, might imperil the financial condition of the more vulnerable 

portions of the system. 

Increasing the FCA's Authority over Farmer Mac. The FCA could be 

given the same clear authority to define unsafe and unsound practices 

in advance, to set capital standards, or to appoint a conservator or receiver for Farmer Mac that it possesses with respect to the banks and 

associations of the FCS. Although the FCA could use such authority to 

restrict Farmer Mac's freedom, the corporation would probably continue to function. An alternative approach would be to require the 
xxviii GOVERNMENT-SPONSORED ENTERPRISES April 1991 

FCA to report promptly to the Congress on any practices of Farmer 

Mac that posed an unreasonable risk to the government. 

FEDERAL NATIONAL MORTGAGE ASSOCIATION AND 

FEDERAL HOME LOAN MORTGAGE CORPORATION 

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), the largest 

GSEs, support the housing sector by linking mortgage lenders to the 

capital markets. The enterprises are relatively well capitalized with 

respect to, and subject the government to a low level of risk of loss 

from, their exposure to credit risk and interest rate risk, and appear to 

be well managed and to operate efficiently. There are substantial 

questions, however, about whether the Department of Housing and 

Urban Development (HUD), which has general regulatory authority 

over the two GSEs, has either the institutional capacity to conduct adequate examinations and monitoring or the statutory authority to assure that the enterprises are adequately capitalized and operate safely. 

Activities, Risks, and Capitalization 

Fannie Mae and Freddie Mac purchase home mortgages from lenders. 

Both GSEs finance most of the mortgages they buy with mortgagebacked securities (MBSs), although Fannie Mae also finances a sizable 

portfolio of mortgages and other assets with debt. Although Fannie 

Mae suffered losses in the early 1980s because of high interest rates, 

the enterprise has been consistently and highly profitable in recent 

years. Freddie Mac has always been profitable. 

In the 1980s, Fannie Mae and Freddie Mac expanded their activities dramatically as thrift institutions had fewer incentives to hold 

mortgages in their portfolios. Today, these two GSEs enjoy a dominant 

position in the secondary market for the conventional mortgages they 

are eligible to purchase, particularly fixed-rate loans. Their significant market power arises from the implicit federal subsidies they receive, their nationwide operations, an ability to convert mortgages to 

MBSs with great efficiency, economies of scale, and federal capital re- 
SUMMARY xxu 

quirements for depository institutions that favor securitization of 

mortgages. The implicit subsidies Fannie Mae and Freddie Mac receive and the large outstanding volume of their MBSs increase the 

value of the securities. Competition between the GSEs and among the 

lenders they serve passes this benefit on to borrowers and has reduced 

the interest rates on fixed-rate mortgages that the enterprises can purchase by about 0.3 percentage points (30 basis points). 

Fannie Mae and Freddie Mac are exposed to comparable credit 

risk. The mortgages they finance are protected by borrowers' down 

payments, property appreciation, insurance, and agreements by lenders. Fannie Mae's financial difficulties in the early 1980s induced it to 

purchase some riskier mortgages in the hope of earning higher returns. These loans performed significantly worse than those financed 

by Freddie Mac in the same period. Since the major changes in Fannie 

Mae's underwriting guidelines in 1985, however, the two GSEs' guidelines for single-family mortgages have been virtually identical, and 

the single-family loans each has purchased have had quite similar 

risk-related characteristics and geographic distributions. The performance of the mortgages purchased by each enterprise since 1985 

has also been comparable. If Fannie Mae and Freddie Mac continue to 

compete vigorously, they are likely to continue to be exposed to similar 

credit risk. Competition induces them to maintain similar underwriting guidelines and prices in order to avoid a deterioration in the 

quality of the loans that lenders sell them. 

Fannie Mae was exposed to significant interest rate risk in the late 

1970s and early 1980s, but has reduced its exposure greatly in the last 

decade. Today, each GSE's exposure is a function of its strategy for 

financing the mortgages it buys. Fannie Mae finances loans with debt 

whenever it expects to earn enough on average to compensate for the 

risk that changes in interest rates will produce low returns. The GSE 

began issuing large amounts of debt that it can prepay, or call, in 1989, 

and plans to increase the percentage of its long-term debt that is callable. Callable debt raises its interest expense, but reduces its exposure 

to interest rate risk by stabilizing its net interest income. Freddie Mac 

has consistently taken very little interest rate risk by financing nearly 

all the mortgages it purchases with MBSs. 
xxx GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Perhaps the greatest risk to Fannie Mae and Freddie Mac is a 

nationwide recession or depression that would significantly increase 

the default losses on their mortgages and lower their income from MBS 

guarantee fees. The GSEs and the Office of Management and Budget 

have used stress tests that simulate the performance of mortgages in 

an economic downturn to assess the severity of their exposure to this 

risk. The results of the stress tests imply that the enterprises would be 

able to survive such conditions for an extended period. 

Other analyses suggest that large changes in ifiterest rates are unlikely to harm Fannie Mae and Freddie Mac significantly. Freddie 

Mac's financing strategy insulates it from alwost all risk of loss. Although Fannie Mae's portfolio makes it more exposed, its higher ratio 

of capital to assets and MBSs and the profitability of its portfolio provide some protection against its greater exposure to interest rate risk. 

Both enterprises are currently in compliance with the capital standards they impose on themselves. Moreover, each has the capacity to 

increase its capitalization significantly over the next five years by retaining earnings and without selling additional stock. If the GSEs 

achieve these potential increases and do not raise their overall risk, 

the federal government's risk exposure will decline. 

CBO's conclusions about the credit risk, interest rate risk, and 

capitalization of Fannie Mae and Freddie Mac are based on data provided by them. To be confident about the enterprises' risk exposure 

and capitalization, the government would have to conduct a thorough 

examination of their operations to verify the data they provided and to 

assess their exposure to management and operations risks. 

HUD's Supervision and Regulation of Fannie Mae and Freddie Mac 

The Department of Housing and Urban Development (HUD) has had 

general regulatory authority over Fannie Mae since 1968, and acquired the same authority over Freddie Mac in 1989. HUD has no 

clear statutory mandate to assure the safe and sound operation of the 

GSEs, however, and the extent of its statutory authority is disputed. 

This disagreement could be a source of conflict if the department at- 
SUMMARY xxxi 

tempted to set a capital standard for the GSEs that was more restrictive than the leverage ratio now imposed by their charters, or to enforce such a standard or take other action if either enterprise began to 

falter. Although HUD has created the Financial Institutions Regulatory Board to articulate supervisory issues and options for the Secretary and has allocated staff positions to support the board, the department does not have sufficient institutional capacity to conduct examinations of the GSEs or to monitor their activities effectively. 

The department can require Fannie Mae and Freddie Mac to devote a portion of their mortgage purchases to low- and moderateincome housing, if the loans provide the GSEs with a reasonable economic return. It is unlikely that the department could use this authority to jeopardize the safety and soundness of the GSEs. HUD's authority to disapprove new mortgage purchase programs is a source of 

conflict with the enterprises, however, since the department asserts a 

right to consider the effect of new activities on competition with other 

financial institutions and on consumers, whereas Fannie Mae and 

Freddie Mac do not believe that HUD has such authority. 

Options for Change in the Current Regulatory Structure 

The Department of Housing and Urban Development could be given 

the same institutional capacity to supervise Fannie Mae and Freddie 

Mac as the Federal Deposit Insurance Corporation and other federal 

agencies have to supervise federally insured depository institutions. 

Specifically, the department could be allowed to assess the two GSEs 

for the costs of supervising them--or, more narrowly, for the costs of examinations-and to determine the budget, number of personnel, and 

salaries of its new regulatory staff. Charging only for the cost of examinations would prevent HUD from using assessments to subsidize 

some of its other activities, but reliance on appropriated funds could 

limit the resources available for off-site monitoring and analysis of the 

enterprises. 

The department (or another supervisory agency) could also be 

given a clear statutory mandate to protect the government from excessive risk. Consistent with this mandate, the department could be 
xxxii GOVERNMENT-SPONSORED ENTERPRISES April 1991 

authorized to set risk-based capital requirements, enforce capital standards and other limits on risk taking, take action if either GSE was 

insolvent or close to insolvency, and streamline the supervisory process 

of the enterprises if it found their overall risk to be low. HUD could be 

given a significant amount of discretion in exercising such authorities. 

It could be required to use stress tests to evaluate the risks and capital 

adequacy of Fannie Mae and Freddie Mac, but given the flexibility to 

develop ones that it deemed appropriate; granted specific enforcement 

powers and allowed to use them to enforce capital requirements and to 

eliminate practices that it found to be unsafe and unsound; and allowed to appoint a conservator if either GSE was close to insolvency. 

These authorities would enable HUD to require the enterprises to corred management weaknesses or operating deficiencies that it had detected in examinations, or to address practices that it considered to be 

unsafe and unsound but that had not resulted in large losses. The department could also take swift action to prevent an undercapitalized or 

insolvent Fannie Mae or Freddie Mac from increasing the risk of its activities. 

Alternatively, HUD's discretion could be narrowly limited in 

statute. The stressful economic conditions and other rules that would 

form the basis for risk-based capital requirements for Fannie Mae and 

Freddie Mac could be specified in law to some degree. The department's enforcement actions could be limited to situations in which 

either enterprise was not in compliance with the standards. If HUD 

and either GSE could not agree on a recapitalization plan, the department could be required to seek legislation. This approach would assume that Fannie Mae and Freddie Mac are unlikely to suffer significant losses without HUD's detecting them, and that large losses would 

occur slowly enough to allow an adequate recapitalization plan to be 

implemented. It would reduce the possibility that the department 

could set capital requirements that were too high or would intervene in 

the operations of Fannie Mae or Freddie Mac even though they met 

federal capital requirements. 
SUMMARY miii 

Issues in Setting Capital Requirements 

for Fannie Mae and Freddie Mac 

Unlike the FHLBs and depository institutions that invest in mortgage 

loans, Fannie Mae and Freddie Mac are not subject to binding federal 

capital requirements. HUD or another supervisory agency could be 

allowed' to set a binding, risk-based capital requirement for the two 

GSEs. Establishing such a standard would raise issues about the 

treatment of interest rate risk and about the possible economic effects 

of requiring the enterprises to raise their capitalization more rapidly 

than they could without lowering returns or raising prices. A standard could take interest rate risk into account by varying each GSE's 

required amount of capital with its exposure to this risk. Requiring 

Fannie Mae to hold more capital to protect against its exposure could 

cause it to reduce the rate of growth of or to shrink its portfolio and 

could limit its ability to provide some services to the mortgage market. 

Continuing to allow Freddie Mac to increase its exposure to interest 

rate risk without raising its capitalization could lead the GSE to 

change its financing strategy, although this would require a change in 

its risk preferences. 

Requiring Fannie Mae and Freddie Mac to increase their capital 

more rapidly would reduce the government's exposure. It could also 

lead to small increases in mortgage rates (which would lower the market values of outstanding mortgages and MBSs), although the reductions in mortgage origination and servicing costs likely to occur in the 

next decade could offset any increases. Capital standards that reduced 

the implicit federal subsidy to the two GSEs might also help lenders to 

compete with them for loans that the enterprises buy. 

FEDERAL HOME LOAN BANK SYSTEM 

The principal purpose of the Federal Home Loan Bank (FHLB) System 

is to provide loans to depository institutions that finance lending for 

residential mortgages. The system exposes the government to a minimal amount of risk, but is at a critical juncture. Financial markets 

have evolved since the system was created in the 1930s, and fully private firms (in concert with federal agencies) can now provide the 
xxxiv GOVERNMENT-SPONSORED ENTERPRISES April 1991 

services once provided only by the FHLBs, although at a somewhat 

higher cost. Thus, the government must decide whether the system is 

still needed to provide these services. If the Congress opts to preserve 

the FHLB system, it may wish to take several steps to improve the 

system's viability and to help level the playing field in the nation's 

system of housing finance. 

Activities, Risk, and Capitalization 

The FHLB system provides a variety of services to its memberlowners, 

which are primarily thrifts but also include commercial banks, credit 

unions, and insurance companies that have more than 10 percent of 

their portfolios in home mortgages and related assets. The system's 

most important activity is providing loans (called advances) to its 

members for short-term liquidity and to finance housing. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 

(FIRREA) required the banks to make a one-time payment of $2.1 billion from their retained earnings, as well as a fixed annual payment of 

$300 million, to help cover the interest and principal payments on debt 

issued by the Resolution Funding Corporation (REFCORP) to finance a 

portion of the cost of resolving insolvent thrifts. FIRREA also directed 

the banks to devote minimum amounts each year to subsidize advances 

made to institutions that finance affordable housing for low- and moderate-income families. 

The FHLB system's exposure to credit risk is quite small, primarily because most of the system's assets are advances, which are collateralized with high-quality assets. In almost 60 years of operation, 

no member of the FHLB system has ever defaulted on an advance. The 

banks have also controlled their exposure to interest rate risk relatively successfully in the past, and current measures of interest rate 

risk show that changes in interest rates would have only small effects 

on their financial condition. 

The demand for FHLB advances has fallen recently and is expected to continue to decline, but this trend is unlikely to cause a significant increase in the system's exposure to risk. The FHLBs should 

be able to reduce their costs enough to match the decline in income 
SUMMARY xxxv 

caused by the shrinkage of their assets. Demand for advances is likely 

to continue to fall for two reasons. First and foremost, the traditional 

industry served by the system--the savings and loan industry--is 

shrinking, which implies that fewer advances will be needed in the future by that industry to meet liquidity and other needs. Second, certain provisions of FIRREA impede the recruitment of new members 

into the system and inadvertently have created some destabilizing dynamics. As new members decide not to join the system, gross income 

from advances falls with the shrinkage of the thrift industry. As it 

does, the fixed payments to REFCORP and for affordable housing take 

an ever larger fraction of the system's income, which causes dividend 

yields on FHLB stock to drop and justifies the original decisions of 

potential members not to join. 

The FHLB system is well capitalized, with the book value of capital averaging about 7 percent of assets at the end of 1990. Two types of 

federal capital standards require the system to maintain high levels of 

capitalization. First, members must hold stock in an FHLB as a condition of membership and to obtain advances. Second, federal regulations impose a minimum capital standard on the system as a whole, 

requiring aggregate capital levels to be at least 8+ percent of the system's outstanding consolidated obligations. 

The FHLB system is required to hold much higher levels of capital 

than Fannie Mae and Freddie Mac maintain. This implies that the 

latter two GSEs receive a larger implicit subsidy than the FHLBs. The 

difference is one reason why lenders that use FHLB advances are at a 

competitive disadvantage vis-a-vis Fannie Mae and Freddie Mac in financing conventional mortgages that those GSEs can purchase, particularly fixed-rate loans. 

Federal Supervision and Regulation of the FHLB System 

The Federal Housing Finance Board (FHFB) has ample statutory authority to prevent the system from suffering significant losses. The 

FHFB has been given broad powers, including the authority to determine the compensation of the members of the board of each FHLB, to 

suspend or remove board members or any bank employee, and to liqui- 
mvi GOVERNMENT-SPONSORED ENTERPRISES April 1991 

date or reorganize a bank if necessary. The FHFB has the final word 

on each bank's budget, quarterly dividend payments, and applications 

for new members. 

The FHFB is a relatively new agency. A definitive assessment of 

its performance, therefore, is not yet possible. The FHFB was created 

in 1989 to replace the Federal Home Loan Bank Board (FHLBB), 

which regulated the FHLB system (and the thrift industry) throughout 

most of its history. In its first full year of operation, the FHFB experienced some difficulties in accomplishing its goals, but none of these 

problems threatened the safety and soundness of the system. Many of 

the problems reflected the inevitable difficulties of developing a new 

agency, and the board has taken steps to address some of them. 

Policy Options 

Although the FHLB system exposes the government to little credit risk 

or interest rate risk, three policy issues can be raised about the system's hture. First, the system may no longer play an essential role in 

overcoming imperfections in.the nation's housing finance system. Consequently, the Congress may wish to consider phasing out the FHLBs. 

Eliminating the system would raise the cost of funds to thrifts somewhat and could adversely affect federal support for affordable housing 

if alternative programs were not funded. The effect on the thrifts' cost 

of funds would not be large, because the high capitalization of the system has limited its ability to provide significant implicit subsidies to 

its members. Reducing the system's capital standards could raise its 

ability to subsidize mortgage lenders (which would increase its role in 

the housing finance system), but at a cost of increasing the government's exposure to risk. 

Second, if the FHLB system is preserved, the Congress may wish 

to take steps to improve its viability. The most important step would 

be to require the system to devote a proportion of its income, rather 

than fixed amounts of money, to cover REFCORP's financing costs and 

subsidize affordable housing. This change would raise prospective 

dividends on FHLB stock and enhance the system's ability to attract 

new members. In addition, the Congress may wish to consider re- 
SUMMARY xxxvii 

ducing (or eliminating) the preferential treatment given to members of 

the FHLB system.with 70 percent or more of their assets in home mortgages. Such a change could increase the membership of commercial 

banks in the system. Most of these banks have less than 70 percent of 

their portfolios in home mortgages, but because of their size, may have 

substantial holdings of mortgages in dollar terms. 

Third, the government may wish to set comparable federal capital 

requirements for the FHLB system and the other two housing GSEs-- 

Fannie Mae and Freddie Mac. Making capital standards comparable 

for all three enterprises would allow each to provide equivalent implicit federal support to the lenders they serve and would be a step 

toward leveling the playing field in the housing finance system. The 

government could set comparable requirements by imposing a uniform 

statutory minimum standard, or by requiring them to have enough 

capital to pass the same credit and interest rate stress tests and to 

maintain comparable amounts of capital to cover their exposure to 

management and operations risks. 

STUDENT LOAN MARKETING ASSOCIATION 

The Student Loan Marketing Association (Sallie Mae), which provides 

financing and liquidity to the market for student loans, exposes the 

government to a negligible amount of risk at present. The principal 

policy issue with respect to Sallie Mae is what action--if any--the government should take to prevent the enterprise from increasing its exposure to risk in the future. 

Activities, Risks, and Capitalization 

Sallie Mae exists to encourage lenders to originate federally guaranteed student loans (GSLs). The GSE does so by agreeing to buy student loans and by providing funds that lenders can use to make and 

hold such loans. Sallie Mae also provides lenders with management 

and operational support. 
xxxviii GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Sallie Mae's exposure to credit risk is small because most of its 

assets are either fully guaranteed by the federal government or fully 

collateralized by federally guaranteed claims. The enterprise could 

experience losses if state agencies that guarantee student loans were 

not fully reimbursed by the government and became insolvent, if its 

loans to lenders were not fully collateralized, or if counterparties to its 

interest rate exchange agreements defaulted on their obligations, but 

its exposure to these sources of credit risk is insignificant. Sallie Mae 

minimizes its exposure to interest rate risk by financing its variablerate assets with variable-rate debt and, on occasion, through interest 

rate exchange contracts. 

These conclusions about the low level of Sallie Mae's exposure to 

credit risk and interest rate risk are consistent with the observed stability of the GSE's earnings. Neither recession, nor sharp swings in interest rates, nor declines in real estate or commodity prices have had 

much effect on its earnings. The enterprise's steady profitability is 

both evidence of absence of risk and a buffer against loss by the government from the enterprise's operations. 

Sallie Mae's capitalization also provides adequate protection for 

the government. A stress test conducted by the Office of Management 

and Budget indicates that the GSE would remain adequately capitalized and make money even if its performing assets and the .terms of 

the GSL program changed significantly. 

Federal Oversight of Sallie Mae 

There is no federal agency with a statutory mandate or authority to 

supervise the safe and sound operation of Sallie Mae. Periodic Congressional oversight is the most significant form of federal monitoring 

and control of the GSE. The Secretary of the Treasury has statutory 

authority to examine Sallie Mae's financial records and is required to 

report annually to the President and the Congress on the enterprise. 

Treasury has fulfilled this requirement by sending copies of Sallie 

Mae's annual report to the Congress. 
SUMMARY xxxix 

Options for Limiting: Future Federal Exposure to Risk 

The Congress could limit the government's future exposure to risk 

from Sallie Mae's operations by relying on enhanced Treasury oversight and early warning, requiring private risk assessments, subjecting the GSE to a new agency created to supervise all the enterprises, or by privatizing Sallie Mae. If a genuine separation can be 

achieved, privatization may be appealing.. 

One approach to privatizing Sallie Mae would be to make the implicit federal guarantee of its obligations explicit and to set a schedule 

for its withdrawal. Because the markets might perceive Sallie Mae as 

too big to fail, even without GSE status, it might also be necessary to 

divide the firm into several independent entities, which would have 

none of Sallie Mae's current ties to the government. The new entities 

would be subject to the antitrust laws. This approach would require an 

eficient division of the enterprise that minimized any losses of economies of scale. The government could retain a small, standby presence 

in the secondary market for student loans by purchasing the residual 

elements of Sallie Mae short of its complete dissolution, and operating 

it directly as a federally owned corporation. This approach could provide gains for the student loan market by increasing competition, for 

Sallie Mae stockholders by allowing entry into new lines of business, 

and for the government by eliminating its exposure to the enterprise's 

risks. It is not clear, however, that the gains of privatization in this 

manner would offset the legal and administrative costs involved. 

CHAPTER I 

PUBLIC PURPOSES AND RISKS OF GSEs 

Government-sponsored enterprises (GSEs) are federally chartered financial institutions that facilitate the flow of investment funds on 

favorable terms into agriculture, housing, and higher education. 

Today, there are five enterprises: the Farm Credit System, the Federal 

National Mortgage Association (Fannie Mae), the Federal Home Loan 

Mortgage Corporation (Freddie Mac), the Federal Home Loan Bank 

(FHLB) System, and the Student Loan Marketing Association (Sallie 

Mae). The legal powers, organizational structures, and operating 

styles of the GSEs vary, but they share four characteristics: they are 

privately owned, operate nationwide, have specialized lending powers, 

and benefit from an implicit federal guarantee that enhances their 

ability to borrow. These attributes set them apart from other federally 

chartered corporations (see Box 1). 

GSEs raise two public policy issues. First, providing financial services exposes them to risk--the possibility that returns will be lower 

than expected. If any enterprise suffered large losses that threatened 

its viability, the government would probably provide financial assistance so that the enterprise could continue to achieve its public purposes and the market for outstanding GSE obligations would not be 

disrupted. Consequently, the government bears some of the risk to 

which each enterprise.is exposed. This raises the question of whether 

the cost of bearing this risk is an acceptable price to pay for an enterprise to achieve its public purposes. Reports by the Department of 

the Treasury and the General Accounting OEce (GAO) have addressed 

a portion of this issue by examining the risks of each GSE.1 A related 

question is how the government can assure that the enterprises 

achieve their public purposes, while avoiding unnecessary risks and 

limiting the government's financial exposure. 

1. Department of the Treasury, Report of the Secretary of the Treasury on Government Sponsored 

Enterprises (May 1990); and General Accounting Offlice, Government-Sponsored Enterprises: The 

Government's Exposure to Risks (Auguat 1990). 
2 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

BOX 1 

What Is a Government-Sponsored Enterprise? 

The term government-sponsored enterprise (GSE) has no fixed meaning and can be 

defined broadly or narrowly to focus attention on different public policy issues. 

Broadly defined, a GSE is a corporation chartered by the federal government to 

achieve public purposes that has nongovernmental status, is excluded from the federal budget. and is exempt from most, if not all, laws and regulations applicable to 

federal agencies, officers, and employees. In addition to encompassing the institutions analyzed in this report, this definition includes nonprofit corporations that 

receive federal appropriations such as AMTRAK, the Legal Services Corporation, 

and the Corporation for Public Broadcasting. It also includes the Securities Investor 

Protection Corporation, a nonprofit firm created to pay claims of customers of failing 

brokerage houses, and profit-seeking, stockholder-owned corporations like the 

National Consumer Cooperative Bank, which was an independent federal agency 

until 1981. 

This broad definition of a GSE raises the issue of whether such quasi-governmental institutions are properly accountable and responsive to elected officials and 

the public. Indeed, many of the entities that meet the definition are indistinguishable from federal agencies, except that their enabling laws require federal budget documents to classify them as private firms. 

Narrowly defined, a WE is a privately owned, federally chartered financial institution that has nationwide operations and specialized lending powers and that 

benefits from an implicit federal guarantee that enhances its ability to borrow. This 

report examines the five enterprises--the Farm Credit System, Fannie Mae, Freddie 

Mac, the Federal Home Loan Banks, and Sallie Mae--that meet this definition. 

In addition to these five enterprises, the Office of Management and Budget classifies four other entities as GSEs: the Financing Corporation (FICO), the Resolution 

Funding Corporation (REFCORP), the Farm Credit System Financial Assistance 

Corporation (FAC), and the College Construction Loan Insurance Association 

(Connie Lee). The first three institutions do not meet either a narrow or a broad 

definition of a GSE. FICO, REFCORP, and FAC are federal corporations created and 

excluded from the budget to raise funds for resolving failing thrifts and Farm Credit 

System institutions. Connie Lee is partly owned by the Department of Education 

and does not enjoy an implicit federal guarantee of its obligations and, thus, is a GSE 

only in a broad sense. 

SOURCE: Congressional Budget Office adapted from Ronald C. Moe and Thomas H. 

Stanton,"Government-Sponsored Enterprises aa Federal Instrumentalities: Reconciling Private Management with Public Accountability," Public Administration 

Review (JulylAugust 1989), pp. 321-329; and Harold Seidman, "GovernmentSponsored Enterprisee," Public Budgeting and Finunce. vol. 9 (Autumn 1989). pp. 

76-80. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 3 

Second, recent developments in the financial system raise the 

question of whether the GSEs are still needed to achieve their public 

purposes, or whether other financial institutions can do so. Before the 

enterprises were established, financial institutions serving farmers, 

homebuyers, and students often lacked immediate access to the capital 

markets, and home mortgages and agricultural and student loans were 

not easily sold. As a consequence, credit for these borrowers was more 

costly and, in some instances, less available than it has been since tihe 

enterprises were created. If the GSEs are still needed, there are questions about the long-run competitiveness and viability of the FHLB 

system. 

This Congressional Budget Office (CBO) report analyzes the risks 

of the five GSEs and the financial exposure to the government arising 

from their activities. The report examines how the enterprises achieve 

their public purposes and how they and the government limit their 

exposure to risk. Policy options that would enable the government to 

control its risk exposure more effectively are discussed. This chapter 

provides an overview of the enterprises' public purposes, operations, 

and risks, and possible changes in federal policy. 

GSEs IN THE FINANCLAL SYSTEM 

Each GSE's charter act sets forth the institution's public purposes, 

provides special benefits under federal law that convey an implicit federal guarantee of its obligations, and authorizes and places restrictions 

on its activities. These ties to the government make GSEs very important institutions in the loan markets in which they operate, and facilitated a rapid growth in GSE activities in the 1980s. The implicit federal guarantee conveys subsidies to GSEs and can weaken privatemarket discipline of their risk taking. 

Public Purposes and Operations of GSEs 

The primary public purpose of all five GSEs is to provide selected borrowers access to credit for specific purposes. Each enterprise was established because wholly private financial institutions were believed 
4 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

to be incapable of providing an adequate supply of loanable funds at all 

times and to all regions of the nation. Achievement of this objective 

does not necessarily require subsidization of the lenders and borrowers 

served by GSEs, but in practice several of the enterprises do provide 

subsidies. 

The GSEs ensure borrowers' access to credit in two ways. They 

borrow large amounts of funds from other financial institutions-- 

depository institutions, pension funds, and insurance companies--and 

lend the money to borrowers or lenders, or purchase loans made by 

lenders. Some GSEs also issue or guarantee securities backed by pools 

of loans purchased from or assembled by lenders. Both forms of financial intermediation funnel money from lenders in regions that 

have surplus funds to lenders and borrowers in other regions where the 

demand for loans exceeds supply. 

Several of the GSEs have secondary public purposes. The member 

institutions of the Farm Credit System were created to enable farmers 

and agricultural producers and cooperatives to manage, control, and 

own a cooperative system of primarily local agricultural lenders. The 

Secretary of Housing and Urban Development (HUD) may require that 

Fannie Mae and Freddie Mac devote a reasonable portion of their 

mortgage purchases to the goal of providing adequate housing for lowand moderate-income families, provided the purchases generate a 

reasonable economic return. The FHLB system is required by law to 

make some long-term loans at subsidized interest rates to finance affordable housing for families with low and moderate incomes. Because 

the system is owned primarily by thrift institutions, it also is responsible for making payments to the government to cover some of the costs 

of repaying the debt issued by the Resolution Funding Corporation 

(REFCORP) to finance the cost of resolving insolvent federally insured 

thrifts. 

Most GSEs are portfolio lenders, that is, they own until maturity 

some or all of the loans that they purchase. The associations and banks 

that are part of the Farm Credit System lend directly to farmers and 

other agricultural producers, agricultural cooperatives, and rural utilities and homebuyers. Sallie Mae purchases and holds in portfolio federally guaranteed student loans (GSLs) and makes advances to educa- 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 5 

tional lenders. To support housing finance, the FHLBs make advances 

(loans collateralized, or backed, by home mortgages) to thrifts and 

some other financial institutions. Fannie Mae and Freddie Mac hold in 

portfolio a portion of the residential mortgage loans that they purchase. All of these GSEs finance their portfolios by issuing notes, 

bonds, and other liabilities, by selling stock, and by retaining some of 

their earnings. (See Table 1 for a summary of the types of assets financed by the GSEs, their organizational structure, and their operations.) 

TABLE 1. CHARACTERISTICS OF GOVERNMENT-SPONSORED 

ENTERPRISES 

Enterprise 

Assets Organizational 

Financed Structure Operations 

Farm Credit System 

Farm Credit Banks Agricultural operating, 11 regional banke, 262 Portfolio lenders 

and afiliated production, supply, and , associations; all are associations real estate loans borrower-owned 

cooperatives 

Banks for Loans and leases to 3 national borrower- Portfolio lenders 

Cooperatives agricultural cooperatives, owned cooperatives 

rural utilities, and 

othera 

Federal Agricultural Agricultural real eetate Unitary firm Guarantor 

Mortgage Corporation and rural housing loans, 

(Farmer Mac) and loans guaranteed by 

the Farmera Home 

Administration 

Federal National Reeidential mortgage Unitary firm 

Mortgage Association loans 

(Fannie Mae) 

Federal Home Loan Residential mortgage Unitary firm 

Mortgage Corporation loans 

(Freddie Mac) 

Federal Home Loan Advances secured by 12 district banhe 

Bank Syetem residential mortgages or federal agency 

securities 

Student Loan Federally guaranteed Unitary firm 

Marketing Asnociation student loans and 

(Sallie Mae) advances secured by 

them 

Guarantor; portfolio 

lender (about 28 percent of aasets) 

Guarantor; portfolio 

lender (about 6 percent of aaaets) 

Portfolio lendem 

Portfolio lender 

SOURCE: Congreaeional Budget Office. 
6 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Three GSEs also guarantee securities backed by pools of loans. 

Fannie Mae and Freddie Mac finance most of the residential mortgages they purchase by issuing and guaranteeing mortgage-backed 

securities (MBSs). Such securities pay investors pro rata shares of the 

principal and interest payments on the underlying pools of mortgages. 

Thus, an investor who owns an MBS equal to 10 percent of the outstanding principal of a pool of loans will receive 10 percent of all payments of interest and principal on the mortgages. When fully operational, the Federal Agricultural Mortgage Corporation (Farmer Mac), 

a separate institution within the Farm Credit System, will guarantee 

securities backed by pools of loans for agricultural real estate and rural 

housing, and agricultural loans guaranteed by the Farmers Home Administration. Other financial institutions will issue most of the securities. 

How each GSE earns money depends on its operations. The portfolio lenders earn income from the difference, or spread, between the 

interest they receive on their assets, net of administrative, default, and 

collection costs, and the interest they pay on their liabilities. Earnings 

from GSE guarantor operations derive mostly from the fees that the 

enterprises charge for the financial guarantees they provide, again net 

of administrative, default, and collection costs. Float income--money 

earned by investing the interest and principal payments received from 

borrowers for the short period before the payments are remitted to investors in mortgage-backed securities--is another source of earnings 

from these activities. 

Benefits and Restrictions Under Federal Law 

To enable the GSEs to achieve their public purposes, their charters 

grant them special benefits under federal law. For example, the Treasury Department has discretionary authority to purchase the debt of 

all GSEs except the Farm Credit System. With the exception of agricultural mortgage-backed securities guaranteed by Farmer Mac, GSE 

debt and mortgage-backed securities are exempt from Securities and 

Exchange Commission (SEC) regulation except to the extent that U.S. 

government securities are regulated. Most debt &-mortgage-backed 

securities issued by GSEs are eligible to be bought and sold by the Fed- 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEs 7 

era1 Reserve when it seeks to change the money supply, may be used as 

, collateral for Federal Reserve advances, are of equal standing with 

Treasury debt for investment by most banks and thrifts, and are eligible to collateralize public deposits. These legal benefits make the obligations of most GSEs nearly as liquid as Treasury debt. Moreover, 

the corporate earnings of the Farm Credit Banks and the FHLBs are 

exempt from federal income taxes, the earnings of most GSEs are exempt from state and local income taxes, and the interest paid by some 

enterprises is exempt from state income taxes.2 Table 2 summarizes 

the special benefits granted to each GSE under federal law: 

The federal government has no legal obligation to provide financial assistance to GSEs or otherwise enable them to meet their obligations.3 Nonetheless, the enterprises' obligations are generally believed 

to carry an implicit federal guarantee for several reasons. First, the 

GSEs were chartered by or pursuant to acts of Congress and are subject 

to varying degrees of federal oversight. Second, the government gives 

GSE securities the attributes of and the same preferred investment 

status as Treasury debt, and exempts the obligations of most of the enterprises from the protections for investors deemed to be necessary for 

all debt that is publicly issued by wholly private firms. In so doing, the 

government signals that investors should consider GSE securities to be 

extremely safe. Investors infer that the government stands ready to 

provide financial assistance to a GSE if the enterprise gets into serious 

financial trouble and its ability to discharge its obligations is in doubt. 

Third, the outstanding volume of GSE obligations is huge--over 

$980 billion at the end of 1990. Depository institutions hold a large 

proportion of these obligations. It is widely believed that the federal 

government could not tolerate a default by any GSE because it would 

reduce the market value of all GSE obligations, perhaps significantly, 

and could endanger the 'stability of the entire financial system. 

2. The FHLBe, however, pay an implicit tax on their income through their contributions to the Reaolution Funding Corporation and the Affordable Housing Program. 

3. The Agricultural Credit Ad of 1987 authorized the Treasury to guarantee up to $4 billion in debt 

iesued by the Farm Credit Syetem Financial Assistance Corporation (FAC). a corporation set up to 

finance aeaiatance to financially troubled Farm Credit Syatem member institutions. The Treasury 

guarantee of FAC debt constitutes a partial federal guarantee against Farm Credit System loaaes. 

CBO dm not consider FAC to be a government-sponsored enterprise, although ita transactiona are included in the system's consolidated financial statements. 
8 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 2. LEGAL BENEFITS ENJOYED BY GOVERNMENTSPONSORED ENTERPRISES 

Benefit 

Farm 

Credit Svstem 

Farm 

Credit Farmer Fannie Freddie Sallie 

Banks Mac Mae Mac FHLBs Mae 

Treasury Lending Authorized (Billions of dollars) Nonee 1.5b 2.25 2.25 4.0 1.0 

Eligible for Federal Reserve 

Open-market Purchases Yes c Yes Yes Yes Yes 

Use of Federal Reserve as Fiscal Agent Yes Yes Yes Yes Yes Yes 

Eligible to Collateralize 

Public Deposits (All 

federal; most state/local) Yes Yes Yes Yes Yes Yes 

Exempt from Registering 

with the Securities and 

Exchange Commission 

(1933 Act) Yea No Yes Yes Yes Yes 

Government Securities for 

Purposes of the Securities 

Exchange Act of 1934 Yes No Yes Yes Yes Yes 

Eligible for Unlimited 

Investment bv National 

Banks and ~&te Bank 

Members of the 

Federal Reserve Yes Yes Yes Yes Yes Yes 

Eligible for Unlimited 

Investment by Federally 

Insured Thrifte Yes Yes Yes Yes Yes Yes 

Exemption of Corporate 

Earnings from Federal 

Income Tax Yes No No No Yes No 

Exemption of Corporate 

Earnings from State 

and Local Income Tax Yes No Yes Yes Yes Yes 

Exemption of Interest 

Paid from State Income Tax Yes No No No Yes Yes 

SOURCE: Congressional Budget Oftice adapted from Department of the Treasury, Report of the Secretary of the 

Treasury on Government Sponsored Enterprises (May 1990), p. 4. 

NOTE: Farmer Mac = Federal Agricultural Mortgage Corporation; Fannie Mae = Federal National Mortgage 

Association; Freddie Mac = Federal Home Loan Mortgage Corporation; FHLBs = Federal Home Loan Banks; 

and Sallie Mae = Student Loan Marketing Aasociation. 

a. Treasury is authorized to guarantee up to $4 billion of Financial Assistance Corporation bonds. 

b. Upon required certification from the Federal Agricultural Mortgage Corporation, borrowing from the Treasury is 

authorized to make payments under Farmer Mac guarantees. 

c. Not applicable; entity newly created. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEa 9 

Fourth, the Congress continues to support strongly the public purposes that GSEs serve, and the failure of any GSE could disrupt the 

achievement of its public purposes. The passage of the Agricultural 

Credit Act of 1987 strengthened these reasons for perceiving an implicit federal guarantee of GSE obligations. The act provided substantial financial assistance to the Farm Credit System after it lost $4.6 

billion in 1985 and 1986.4 

GSEs pay an implicit price, levied in terms of restrictions on their 

activities, for the legal and financial benefits they enjoy. Their charter 

acts require them to engage in specific businesses and restrict the 

types of assets they can finance. These restrictions limit their ability 

to diversify their activities among loan products or among financial 

services and other lines of business. They must supply funds to local 

lending markets across the nation throughout the business cycle, although they may adjust the types of loans they buy and the interest 

rates and fees they charge to reflect changes in loan risk. As a result, 

at times GSEs may make or purchase loans that they would not if they 

were wholly private firms. Further, some GSEs pass through a portion 

of the financial benefits they enjoy by virtue of government sponsorship to the lending markets and borrowers they serve. Finally, the 

Department of the Treasury must approve any issuing of debt by all 

the enterprises except the Farm Credit System. The Treasury exercises this authority to avoid congestion in the capital markets, without 

reference to the safety and soundness issues. 

Implications of the Implicit Federal Guarantee 

The implicit federal guarantee of GSE obligations has important consequences for GSEs, the borrowers they serve, and the federal government. The implicit federal guarantee leads investors in a GSE's 

debt or mortgage-backed securities to believe that the federal govern4. To CBO's knowledge, the only case of a GSE failing to pay off a liability occurred when the Federal 

Land Bank of Jackson defaulted on it. trade creditore after the Farm Credit Adminietration placed 

it in receivership in May 1988. See Moody's Investors Service, U.S. Government-Sponsored 

Enterprises (GSEs) (February 1990), p. 6. The Financial Assistance Corporation, created and 

subsidized by the Agricultural Credit Act of 1987 to bail out failing Farm Credit System 

institutions, has provided fun& to the Jackaon Bank's receiver to enable it to make good on its 

portion of the system's consolidated obligations. 
10 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

ment bears most if not all of the risk of the enterprise's activities that 

the owners do not bear. As a result, all of the GSEs can borrow at 

near-Treasury rates, and Fannie Mae and Freddie Mac can sell mortgage-backed securities at prices that exceed those at which wholly private firms issue comparable securities. Further, when the financial 

condition of a GSE deteriorates and its risk increases, investors do not 

raise the yields that they require on the obligations of the GSE by as 

much as they would if the enterprise was a wholly private firm. For 

example, when Fannie Mae and the Farm Credit System suffered large 

losses in the 1980s, the spreads between the market yields on their 

debt and the yields of other GSEs increased by only about 100 basis 

points (1 percent). Moreover, Fannie Mae was able to borrow large 

amounts of funds from capital markets even after high interest rates 

had caused the market value of its assets to become substantially less 

than the market value of its liabilities.5 

These borrowing advantages provide an implicit federal subsidy to 

each GSE. No consensus exists on the best method for estimating the 

value of this subsidy.6 Nonetheless, analysts agree that the greater 

the GSE's exposure to risk--that is, the less capital it has for a given set 

of assets, liabilities, and guarantees--the larger the implicit federal 

subsidy. 

By greatly loosening the tie between the financial condition of a 

GSE and its cost of funds, the implicit federal guarantee reduces the 

degree to which the government can rely on market discipline to prevent the GSE from taking excessive risks. Private investors are averse 

5. For the increases in the yielda on Fannie Mae and Farm Credit System obligationa in the 1980s. see 

Fannie Mae, 1983 Annual Report (1984), p. 15; Congressional Budget Office. CovernmentSponsored Enterprises and Their Implicit Federal Subsidy: The Case of Sallie Mae (December 

1985), pp. 37-38; and General Accounting Off~ce Government-Sponsored Enterprises: The 

Government's Exposure to Risks, pp. 85-89. The Department of Housing and Urban Development 

found Fannie Mae to be insolvent on a mark-to-market basis at the end of calendar years 1978 

through 1984. See 1986 Report to the Congress on the Federal National Mortgage Association (June 

1987), p. 100. Market value accounting is discussed in Box 3. 

6. For analyses of and different approaches to valuing the implicit federal subsidy, see Congressional 

Budget Office, Government-Sponsored Enterprises (December 1985); Edward J. Kane and Chester 

S. Foster, "Valuing Conjectural Government Guarantees of FNMA Liabilities," in Federal Reserve 

Bank of Chicago, 1986 Proceedings of a Conference on Bank Structure and Competition (1986), pp. 

347-368; Robert Van Order. "User Fees and Mortgage Markets," Housing Finance Review, vol. 6 

(1987), pp. 93-114; and James F. Gatti and Ronald W. Spahr, "Valuing the Implicit Government 

Guarantee of GSE Obligations: The Case of the Federal Home Loan Mortgage Corporation" (paper 

prepared for the Congressional Budget Ofice, September 1990). 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 11 

to and require compensation for bearing risk of loss. Prospective investors in a wholly private firm's debt scrutinize the company's financial condition, operations, and earnings prospects, and may obtain the 

judgments of credit-rating agencies about the firm's capacity to meet 

its obligations. In general, the higher the risk of the firm, the higher 

the interest rates investors will require the firm to pay to borrow. 

They may also require loan covenants that limit the firm's ability to 

increase the risk of its activities or its leverage during the life of a debt 

instrument. In the extreme, investors will not purchase additional 

debt from the firm. The requirement that a firm compensate creditors 

for bearing additional risk gives owners and management an incentive 

to make sure that prospective activities and investments are likely to 

generate returns that are adequate to enable the firm to pay its creditors and earn a reasonable return on equity. By enabling investors to 

look to the federal government rather than to a GSE's balance sheet 

and earnings capacity as the ultimate source of funds to meet the 

GSE's obligations, the implicit federal guarantee of GSE obligations 

weakens this incentive to balance the costs and returns of increasing 

risk. 

The implicit federal guarantee does not eliminate all market discipline of GSE risk taking, however. The higher a GSE's capital, the 

greater the incentive of owners and management to limit the institution's risk, since sufficiently large losses would wipe out the owners' 

equity and would probably lead to management's being replaced. The 

consistent profitability and low risk of some GSEs--Sallie Mae is the 

most obvious example--suggest that enterprise owners do respond to 

this incentive and limit risk. Nonetheless, if a GSE's capital is very 

low or unavailable to absorb losses, owners may believe they have 

little stake in the enterprise and, thus, have a strong incentive to increase the risk of new investments and activities. In the extreme, if a 

GSE is insolvent, owners may have an incentive to increase the risk of 

the enterprise in an effort to gamble it back to solvency. 

Growth of GSE Activities 

Loans purchased and securities issued by GSEs have increased rapidly 

in the last two decades. Outstanding GSE debt and mortgage-backed 
12 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

securities totaled over $980 billion at the end of 1990, as shown in 

Table 3. On average, these obligations increased at about 16 percent a 

year in the 1970s and nearly 19 percent a year in the 1980s. Average 

annual growth was substantially higher than the rate of inflation and 

national income growth in both decades. Most of the growth was in the 

housing area, where debt and mortgage-backed securities issued and 

guaranteed by Fannie Mae, Freddie Mac, and the FHLB system 

increased more than fourfold in the 1970s and more than sevenfold in 

the 1980s. Outstanding FHLB system debt declined in 1989 and 1990, 

TABLE 3. GOVERNMENT-SPONSORED ENTERPRISE SECURITIES 

AND GUARANTEES OUTSTANDING AT END OF 

YEAR (In billions of dollars) 

Farm Credit 

System 

Farm Credit 

Banha 

Banks for 

Cooperatives 

Farmer Mach 

Fannie Mae 

Debt 

Mortgagebacked 

securitiee 

Freddie Mac 

Debt 

Mortgagebacked 

securities 

Federal Home 

Loan Bank 

System 

Sallie Mae 

Total 

SOURCE: Congmsional Budget W~ce baaed on information from the G9Es. 

NOTE: Debt includes notes. bonda. and multiclasa debt securities (including aubordineted debt). a. Before 1987, composed of Federal Intermediate Credit Banka and the Federal Land Banks. 

b. Guarantees. 

c. Not yet operating. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 13 

but the growth in Fannie Mae and Freddie Mac's obligations offset the 

drop. Sallie Mae's financing of student loans also rose rapidly, nearly 

tripling between 1985 and 1990. After increasing more than fivefold 

between 1970 and 1985, the Farm Credit System declined by over a 

fifth by the end of 1990. 

Various factors stimulated the rapid growth in GSE activities. 

First, the demand for loanable funds increased during the period as the 

baby boom generation reached the homebuying years and inflation 

raised the values of residential and farm properties and the cost of 

higher education. Second, changes in federal policy and a decline in 

the profitability of the thrift industry reduced thrifts' incentives to 

hold in their portfolios the home mortgages they make. High interest 

rates also gave thrifts an incentive to exchange low-yield, fixed-rate 

mortgages for MBSs. The first of these changes in incentives resulted 

in a short-term increase in mortgage rates, which may have been partially offset by a decline in other interest rates. Third, Fannie Mae and 

Freddie Mac responded to the opportunities presented by these 

changes and to the wave of mortgage refinancings in 1986 and 1987 by 

expanding their use of mortgage-backed securities to finance home 

mortgages that they are eligible to purchase, particularly fixed-rate 

loans. Fourth, as loans financed by the GSEs and their outstanding 

debt and mortgage-backed securities grew, the liquidity of their 

obligations increased, which provided additional pricing advantages 

above those conveyed by the implicit federal guarantee and economies 

of scale. Fifth, the risk-based capital requirements imposed on federally insured depository institutions have also contributed to the 

growth in outstanding mortgage-backed securities issued by Fannie 

Mae and Freddie Mac. As discussed in more detail in Chapter IV, a 

major result of these changes has been a gradually increasing shift of 

the credit risk of home mortgages from depository institutions to 

Fannie Mae and Freddie Mac. 

Alternatives to GSEs 

The government can use other instruments of federal policy to provide 

many of the financial intermediation services that GSEs perform. 

These alternatives include federal credit programs and mixed-owner- 
14 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

ship government corporations. Fully private financial institutions 

may also be able to achieve some of the same objectives. 

Federal Credit Programs. Some federal loan and loan guarantee 

programs have purposes and provide services that are similar to those 

of the GSEs. The Farmers Home Administration (FmHA), for example, makes agricultural loans for many of the purposes for which the 

Farm Credit System lends. The Government National Mortgage Association (Ginnie Mae), an agency within the Department of Housing 

and Urban Development, guarantees securities backed by home mortgages insured by the Federal Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA) or the Farmers 

Home Administration. Ginnie Mae's guarantee makes these securities 

more liquid and marketable, and, therefore, more attractive to investors, than are single federally guaranteed loans. 

Relative to GSEs, federal credit programs have advantages and 

disadvantages as instruments of federal policy. On the plus side, recent reforms of the budgetary treatment of federal credit assistance 

will enable the government to measure more accurately and budget 

explicitly for the subsidy cost of federal loan and loan guarantee 

programs.7 The cost of the implicit federal subsidy provided to GSEs is 

not included in the federal budget or controlled directly by the government. Also, the size of the enterprises and their prominence as private financial institutions arguably may make it more difficult for the 

government to control their activities than those of federal agencies. 

On the negative side, if GSEs were simply eliminated, but federal 

credit programs were not given expanded authority to serve all of the 

borrowers currently served by the enterprises, the risk to the government could increase. In such a situation, some of the higher-risk 

borrowers they serve would receive federal loans or guarantees, while 

lower-risk borrowers would be served by private lenders. The cost to 

the government of assisting the higher-risk-borrowers directly, but not 

7. The reform of the budgetary treatment and control of federal loan and loan guarantee programs were required by aection 13201 of the Omnibus Budget Reconciliation Ad of 1990 (Public Law 

101-508). For a discuasion of the reforms, see Congreesional Budget Office, Credit Reform: 

Comparable Budget Costs for Cash and Credit (December 1989). The new budget treatment is 

summarized in Congressional Budget Office, "An Explanation of the Budgetary Changes Under 

Credit Reform" (Staff Memorandum, April 1991). 
CHAPTER I PUBLIC PURPOSES AND RISKS OF CSEe 15 

the lower-risk ones, would be higher than serving both groups through 

the GSEs. Doing so would cost more because the government could not 

use earnings from loans to the lower-risk borrowers to absorb some of 

the losses on loans to the higher-risk borrowers, as the enterprises do, 

or be protected by the GSEs' capital. Also, the enterprises may manage 

their operations more efficiently and at less cost to the government 

than federal agencies could manage credit programs. 

One option for controlling the federal government's risk exposure 

to GSEs would be to provide an explicit guarantee of all enterprise 

obligations.8 An explicit guarantee would reduce the borrowing costs 

of the enterprises somewhat by eliminating any uncertainty about the 

government's commitment to stand behind them. The cost of this 

uncertainty is largest when a GSE is experiencing financial difficulty, 

when the government would seem to have an interest in minimizing its 

expenses. 

The estimated annual subsidy cost of the guarantee could be measured and included in the federal budget. This cost would not be subject to the annual appropriation process, however, but would be treated 

as an entitlement under the control of the authorizing committees, as 

are VA guarantees of home mortgages, for example. In theory, the 

government could control the subsidy cost of the guarantee by charging the enterprises fees that varied with their overall risk. Until there 

is a wider consensus on how to measure this cost, however, it would 

seem prudent to rely on other means to control the cost to the federal 

government of bearing risk. 

Mixed-Ownership Government Corporations. The government can 

also provide financial intermediation services through corporations 

that both private investors and the government own partially but that 

lack the legal benefits granted to GSEs. The College Construction 

Loan Insurance Association (Connie Lee) is a case in point. Sallie Mae 

and the Department of Education jointly own Connie Lee, and the 

President appoints a minority of the firm's directors. However, Connie 

Lee cannot borrow from the Treasury and is not exempt from any of the 

8. Thie option is diecuseed in more detail in Congreasioxkl Budget mce, Government-Sponsored 

Enterprises, pp. 37-40. 
16 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

federal, state, or local laws or regulations from which GSEs are exempt. As noted in Box 1, it is a GSE only in a broad sense. 

The advantage of a mixed-ownership government corporation is 

that the government can limit its exposure to loss to the amount of its 

equity investment. If the outstanding securities or guarantees of a 

mixed-ownership corporation became very large, however, it is unclear 

that the government would allow it to fail, in which case safety and 

soundness issues similar to those a GSE poses would arise. This suggests that mixed-ownership corporations are best used in a limited 

way, such as to test a new line of business, as Connie Lee is doing for 

issuing college construction loans. 

Fully Private Financial Institutions. A third alternative is for the government to rely on fully private financial institutions to serve farmers, 

homebuyers, and students. Enhancements of the technology of financial services and the development of securitization not only have 

helped to expand GSE activities, but also have increased the ability of 

fully private firms to offer the financial services that the enterprises 

provide. Private firms probably would not give all borrowers served by 

the GSEs in all regions access to credit at all points in the business 

cycle, however. Chapters I11 through VI of this report summarize the 

activities of the principal competitors of each GSE. 

Converting GSEs into fully private corporations would help other 

financial institutions to increase their capacity to provide the same 

financial services. Doing so would also prevent the three enterprises 

that have considerable market power--Fannie Mae, Freddie Mac, and 

Sallie Mae--from earning excessive profits. To those ends, the Reagan 

Administration proposed that the government convert Fannie Mae 

into a fully private entity, and explored the possibility of severing the 

government's ties to Sallie Mae.9 Privatization of Freddie Mac has 

9. See Department of Housing and Urban Development, 1987 Report to the Congress on the Fedeml 

National Mortgage Association (September 27, 1989), Chaptera 3 and 4; and Suaan E. Woodward, 

"Privatizing Financial Intermediaries: OPIC. Fannie Mae, and Sallie Mae" (unpubliehed paper). 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 17 

also been considered.10 Such proposals raise the issue of whether the 

government's exposure to the risk of GSEs would actually be reduced 

by converting them to fully private, but equally large, firms. This 

concern might be addressed by dividing a very large GSE into a dozen 

or more smaller firms. Competition would make failure of any one of 

these firms more likely than failure of a single enterprise, but because 

the failure of one or a few firms would not prevent the industry from 

continuing to serve borrowers, the Congress might be willing to tolerate failure. However, this strategy might result in a loss of the operating efficiencies achieved by several of the GSEs. 

Effect of GSE Activities on Treasury Interest Costs 

The implicit federal guarantee of GSE obligations and the large 

volume of enterprise borrowing raise the possibility that GSE activities could cause higher interest rates on Treasury borrowing. In general, the effect on these interest rates is thought to be very small. For 

the most part, funds raised in credit markets by GSEs are subsequently reloaned, with the net effect on the overall level of interest 

rates being very slight. Because the characteristics underlying securities issued by the enterprises make them closer substitutes for Treasury debt than the various loans that GSEs make, issuing enterprise 

securities does raise interest rates on Treasury securities relative to 

other rates of interest. This increase is believed to be very small and 

only temporary, however. 

Impact on the Overall Level of Interest Rates. Concern that GSE borrowing leads to increased pressure on the overall level of interest rates 

would be justified if the -activities of the enterprises raised the total 

demand for borrowing in the economy. If GSEs give prospective homebuyers, farmers, and students greater access to credit than private 

lenders alone would give them, if rationing of credit to other borrowers 

does not offset this increase in borrowing, and if overall saving remains 

the same, greater overall demand for borrowing will put upward pressure on the overall level of interest rates. At this time, no definitive 

10. See Alan R. Winger. "Splitting Up is Hard to Do," in Federal Home Loan Mortgage Corporation 

Secondary Mortgage Markek, (Spring 19871, pp. 12-15. 
18 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

evidence exists on whether the enterprises raise the net overall demand for borrowing. Many analysts believe that some increase occurs, 

however, and there is no evidence that saving rises. The increase in 

net borrowing is likely to be very small, in which case the greater pressure on the overall level of interest rates is small as well. 

Effect on Treasury Rates Relative to Other Rates. Issuing GSE debt 

may cause a small but temporary rise in interest rates on Treasury 

securities relative to other rates of interest. One estimate of the effect 

of the enterprises' borrowing on Treasury security interest rates can be 

found by examining results from portfolio models, which estimate the 

relationships between the relative amounts outstanding and the yields 

of different types of securities. Portfolio models yield estimates of the 

expected change in relative interest rates given a change in the quantity of some asset. They are derived from what is known about the asset preferences of the private sector under usual circumstances and relate asset yields to asset holdings. 

Applying the existing portfolio model results to GSE borrowing is 

not entirely straightforward, but one can obtain a reasonable upperbound estimate of the effects on relative interest rates. Portfolio 

models are designed to show how changes in quantities of broadly defined types of assets affect yields among those types of assets. The 

categories of assets might include long-term (more than one year) and 

short-term Treasury securities, state and local debt, corporate bonds, 

and equities. Such narrowly defined assets as enterprise securities are 

not included explicitly in existing research using these models. Because investors view GSE securities as close substitutes for Treasury 

securities, however, the effect on Treasury rates of a $100 billion increase in enterprise debt would be parallel to that of a $100 billion increase in Treasury debt. 

Results from the portfolio model approach in this case produce an 

upper bound because no allowance is made for the fact that most of the 

credit borrowed by GSEs will be returned to the credit markets in the 

form of an added supply of credit. Only increased pressure on interest 

rates is modeled, while the subsequent relending by GSEs tends to put 

offsetting downward pressure on interest rates. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 19 

Effects on relative interest rates estimated using portfolio models 

turn out to be very small. According to one model, an increase in the 

supply of federal bonds of $100 billion, or 0.6 percent of financial 

wealth, in exchange for money drives up the expected rate of return on 

federal bonds relative to that on short-term Treasury bills by only 0.50 

basis points.11 The same issue of Treasury securities drives up the 

expected relative rate of return on state and local debt by only 0.60 

basis points and on corporate bonds by only 0.49 basis points. The corresponding rate of return on equities would rise by less than 0.01 basis 

points. An alternative model suggests somewhat larger short-term 

effects but similarly insignificant long-term effects.12 In the short run, 

assuming that investors immediately buy and sell securities in 

response to rate changes, the effect on interest rates may be five times 

the long-term effects such as those reported above. Even if the rise in 

interest rates on Treasury bonds is 5 basis points, which is double the 

short-run estimate, these effects are still very small. 

RISKS OF GSEs 

Like other financial institutions, GSEs are exposed to risk--the possibility that returns may be lower than expected. Unexpectedly low 

returns may result from higher than expected loan default or default 

loss rates, unanticipated changes in interest rates, unexpected deterioration in the performance of management or operating systems, and 

unanticipated changes in the enterprise's line of business. The GSEs 

continuously monitor and take actions to control their exposure to 

these risks. The owners of each enterprise are also exposed to the risk 

that the federal government will change its public purposes or operating environment; change the level of federal supervision, regulation, and taxation of its activities; or require it to maintain more capital than the GSE would maintain on its own. This section discusses 

each of the risks to which the enterprises are exposed and their control 

strategies. 

11. J&ey A. Frankel, "Portfolio Crowding-Out. Empirically Estimated," Quarterly Journal of Economics 100 (Supplement, 1985), pp. 1041-1065. 

12. Barry P. Bomvorth, Andrew S. Carron, and Eliaabeth H. Rhyne, The Economics of Federal Credit 

Programs (Washington. D.C.: Bmokings Imtitution. 1987). Appendix A. 
!20 GOVERNMENT-SPONSORED ENTERPRISES April 1091 

Credit Risk 

Credit risk refers to the fact that a GSE's losses from loan defaults vary 

from expectations. The enterprises analyze the factors that correlate 

with the frequency with which borrowers default and the severity of 

default losses, such as the value of loan collateral or borrowers' debt 

service payments as a proportion of income. They use these data to 

form expectations about default losses on specific loans, different types 

of loans, and on total lending activities. The GSEs take expected default losses into account in setting loan interest rates, purchase prices, 

and guarantee fees. If the enterprises could predict exactly the probability and severity of loan default and operated in perfectly competitive markets, they would charge prices that exactly covered those 

expected losses and their operating expenses. However, a GSE's actual 

default losses in any period vary from its expectations. The more actual losses vary, the greater the credit risk to which the GSE is exposed. 

The exposure to credit risk of the five GSEs varies significantly. 

The loans financed by two enterprises--the FHLBs and Sallie Mae--expose them to virtually no credit risk. The FHLBs' credit underwriting 

standards and collateral requirements are so stringent that no FHLB 

advance has ever defaulted. The federal guarantee of the GSLs financed by Sallie Mae implies that virtually all default losses accrue to 

the government, provided that the enterprise complies with federal 

regulations regarding the servicing of GSLs. The Farm Credit System 

is exposed to a good deal of credit risk on the agricultural loans it finances. Famie Mae and Freddie Mac are also exposed to credit risk, 

but to a lesser degree. 

GSEs limit expected default losses in three ways. First, they establish guidelines for underwriting, or selecting, the loans they purchase or guarantee. Underwriting guidelines address, for example, 

how the market value of loan collateral is appraised, how the financial 

condition of borrowers is evaluated, the maximum debt-servicing burden for borrowers that is accepted, and acceptable loan-to-value (LTV) 

ratios. Second, GSEs that purchase loans from other financial institutions and contract with those firms to service the loans also issue 

sellerlservicer guidelines. These guidelines address factors such as the 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEa 21 

financial condition of an institution and the experience of its management. Third, some enterprises require that certain loans carry credit 

enhancements, which are legal agreements that transfer a portion of 

default losses to another party. Credit enhancements may take the 

form of private mortgage insurance, recourse agreements under which 

sellers retain full or partial responsibility for default losses on loans 

sold to a GSE, sellers' pledges of collateral, or other arrangements. 

The Farm Credit System, Fannie Mae, and Freddie Mac use geographic diversification to minimize their exposure to credit risk. Diversification decreases the fluctuation of returns because, in most economic environments, default losses on agricultural loans and home 

mortgages originated in different regions of the country tend to be offset by earnings on loans in other regions. Fannie Mae and Freddie 

Mac easily take advantage of geographic diversification because they 

are unitary firms with nationwide operations. The Farm Credit System's ability to take advantage of geographic diversification (as well as 

diversification of other risks that vary regionally) is more limited, 

because the system's cooperative structure limits its ability to share 

risk exposure among institutions. 

To monitor default losses, GSEs track average delinquency, foreclosure, and loss rates. Data may be kept for each loan program, by 

origination year, and for loans with identical characteristics, such as 

LTV ratios that correlate with default. Some GSEs also estimate the 

market values of the collateral of loans, such as the values of residential real estate, or monitor other indicators of borrowers' capacity to 

pay, such as the performance of local economies. 

To monitor their exposure to credit risk, some enterprises subject 

the loans they have financed to credit stress tests. A credit stress test 

is an analysis of how an extremely adverse economic scenario would affect a GSE's default losses and capital position. Box 2 discusses the use 

of stress tests to analyze the enterprises' exposure to credit risk and 

interest rate risk, and the adequacy of their capital. 
22 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

BOX 2 

Using Stress Tests to Assess the Risk Exposure 

and Capital Adequacy of GSEs 

Some of the government-sponsored enterprises and their regulators 

use stress tests to assess their exposure to credit risk and interest rate 

risk and the adequacy of their capital. A stress test is a simulation 

analysis of how extremely stressful economic conditions--that is, a 

"worst-case scenariow--would affect the performance of the assets financed by a GSE, the cost of financing those assets, and the enterprise's net income and capital position. There are four steps in devising a stress test for a GSE. 

Selecting a Scenario. An economic scenario that conceivably could 

occur and that would be severe enough to threaten the financial 

viability of the enterprise must be identified. The scenario should 

reflect real economic relationships and the likelihood of specific 

historical events recurring, and be tailored to the specific risks to 

which the GSE is exposed. 

The GSEs use different stress tests to test their exposure to risk 

and their capital adequacy. The Farm Credit System is vulnerable to 

a severe decline in the agricultural sector. Accordingly, Chapter I11 

presents the results of a stress test that subjects the system to an 

agricultural downturn like the one that took place in the mid-1980s. 

Fannie Mae is exposed to losses caused by large increases in interest 

rates. One of that GSE's interest rate stress tests assumes that rates 

would increase to the levels of the 1979-1984 period. Fannie Mae and 

Freddie Mac would experience large default losses if a severe decline 

in employment and residential real estate values occurred nationwide. To reflect this, the credit stress tests they employ reflect experience in Texas in the mid-1980s and during a scenario modeled 

after the Great Depression, respectively. 

Estimating Asset Performance. The performance of the GSE's assets 

during the stressful scenario must be estimated. With a credit stress 

test, historical information about the performance of different types of 

loans, if available, should be used to estimate the frequency and timing of loan defaults and the severity of default losses. Loan prepayments must also be estimated. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 

BOX 2 

Simulating GSE Behavior. ~ssum~tions' must be made about how 

the GSE behaves during the scenario. Important questions include 

whether the enterprise pays dividends or purchases new loans, how 

new purchases are priced, and how assets are financed. 

Selecting the Desired Survival Period. Finally, a fundamental policy 

judgment must be made about how long the GSE should remain 

solvent during the stressful scenario. This is a decision about how 

much capital the enterprise should have. Capital can be measured 

according to Generally Accepted Accounting Principles (GAAP), 

which value assets and liabilities at historical costs, or on a market 

value basis. 

Stress tests have several advantages as tools for analyzing the 

risk exposure and capital adequacy of GSEs. On the plus side, they 

give the enterprises and the government an opportunity to test 

different plausible scenarios to identify those that pose the greatest 

threat to each GSE. The scenarios used to set capital standards can 

be changed over time to reflect changes in economic relationships, 

borrowers' behavior, financial technology, and the risks taken by the 

enterprises. Also, stress tests can take into account the unique features of a GSE, such as the geographic diversification of the loans it 

has financed. Further, they provide simple and easily understood 

criteria for capital adequacy. 

Stress tests take into account a GSE's future cash flows in assessing its ability to withstand severe economic conditions. In principle, 

simulations that employ measures of the market values of an 

enterprise's assets and liabilities can provide equivalent information, 

especially with respect to exposure to interest rate risk, since market 

values reflect the value today of future cash flows. 

A stress test is only as good as its assumptions. The usefulness of 

any test can be assessed by conducting sensitivity analyses, which 

examine how the results of the test vary as its major assumptions are 

changed. Sensitivity analyses are most useful for examining the 

reasonableness of assumptions about loan defaults and prepayments. 

They are less useful for assessing the reasonableness of behavioral 

assumptions, since recent experience may not be a useful guide to a 

GSE's behavior under extreme economic conditions. 
24 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Interest Rate Risk 

A GSE is exposed to interest rate risk to the extent that changes in 

market interest rates will reduce its net income. Interest rate risk 

exists whenever the cash flows generated by an institution's assets and 

liabilities are not perfectly synchronized. These cash flows will fail to 

be perfectly matched if the maturities of assets and liabilities are not 

the same, assets and liabilities change their rates of interest in different periods, or borrowers have the option to prepay their loans before 

the scheduled maturity dates. 

To see how maturity mismatching creates interest rate risk, consider a GSE that holds a portfolio of 30-year loans and finances them 

with one-year notes. On average, the enterprise will make money, 

since long-term interest rates generally are higher than an average of 

short-term rates. However, if interest rates rise, the GSE will have to 

roll over the liabilities at the new, higher rates well before the assets 

are repaid. When this occurs, its net interest income will decline. 

Conversely, if the enterprise finances short-term loans with long-term 

debt, when interest rates fall it will have to reinvest repaid funds at 

the new, lower rates, before it retires its liabilities. Again, its net interest income will fall. 

Even if a GSE matches each of its assets with a liability of the 

same maturity, it still will be exposed to interest rate risk if the interest rates on the assets and liabilities change at different times. Suppose, for example, that a GSE funds a variable-rate asset, whose interest rate is reset annually, with a fixed-rate liability of the same 

maturity. If interest rates decline, the enterprise's net interest income 

will fall when the loan rate is reset. 

~orrowers' prepayment options--legal rights to pay off loans before 

their scheduled maturity dates--also expose a GSE to interest rate risk. 

Changes in interest rates affect the probability that borrowers whose 

loans an enterprise has financed will exercise prepayment options. 

Suppose, for example, that a GSE purchases 30-year, fixed-rate mortgages that it expects to be repaid in 10 years on average, and finances 

the loans with 10-year debt securities. If rates fall, the probability that 

the borrowers will prepay their loans will increase, making the 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEs 25 

maturity of the loans less than the enterprise expected. The GSE will 

have to reinvest the unexpected prepayments at the new, lower 

interest rates, which will lower its net interest income relative to its 

expectations. 

The GSEs use four techniques to measure their exposure to interest rate risk.13 First, some enterprises monitor the differences between the dollar amounts of their assets and liabilities that will mature in selected time periods. The smaller this difference, or maturity 

gap, in a period, the less a change in interest rates will cause a GSE's 

net interest income in the period to change. In general, an analysis of 

maturity gaps is accurate only if the repayment and repricing schedules of an enterprise's assets and 1iabilities.are very similar or identical. Second, a GSE can use interest rate stress tests. Such tests simulate the enterprises' financial performance under a single, extreme interest rate scenario. 

Third, some GSEs use analysis of the durations of their assets and 

liabilities and market value accounting to assess the sensitivity of 

their mark-to-market net worth to changes in interest rates. An enterprise's mark-to-market net worth is equal to the market value of its 

assets less the market value of its liabilities. This measure may be 

viewed as the amount of money that would be realized if the assets and 

liabilities were liquidated in piecemeal fashion (see Box 3). A GSE can 

express its overall exposure to interest rate risk in terms of the difference, or gap, between the durations of its assets and liabilities. Duration is a measure of the sensitivity of the market values of financial 

instruments to changes in interest rates. The longer the duration of a 

security, the more a given change in interest rates will change its 

market value. 

13. For more detailed discussionn, see General Accounting Office, Government-Sponsored Enterprises: 

The Government's Exposure to Risks, pp. 33-36; Jan E. Luytjes, Determining the Appropriate 

Measure oflnterest Rate Risk from a Regulatory Perspective (Federal Home Loan Bank Board. Office 

of Policy and Economic Research, Research Paper No. 154, February 1989); and Alden L. Toevs and 

William C. Haney, "Measuring and Managing Interest Rate Riek: A Guide to AsseVLiability 

Modele Ueed in Banks and Thrifts," in Robert B. Platt, ed., Controlling Interest Rate Risk: New 

Techniques and Applications for Money Management (New York: John Wiley & Sons, 1986), pp. 

256-350. 
26 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

BOX 3 

Historical and Market Value Accounting for GSEs 

Government-sponsored enterprises use both historical cost and market value 

accounting. GSEs use Generally Accepted Accounting Principles (GAAP), 

which focus on historical costs, to report their financial condition and performance to investors. GSEs use market value accounting for planning, 

asset and liability management, and management of interest rate risk, and 

to assess the economic gains from alternative transactions. 

Under GAAP, a financial institution records its financial assets and liabilities at the prices at which they are purchased or issued. They are carried 

at these historical, or book, values until they are repaid or sold. GAAP net 

worth or capital is equal to the book value of the firm's assets less the book 

value of its liabilities. 

Historical cost accounting, as embodied in GAAP, has significant advantages and disadvantages for financial institutions, including GSEs. On 

the plus side, historical values are easily known, and different firms generally apply GAAP rules fairly consistently. On the negative side, GAAP 

ignores the effect of changes in interest rates on the market values of financial assets and liabilities. Also, GAAP treats GSE mortgage-backed securities as contingent liabilities and counts the default costs and fees they produce as they occur. Thus, GAAP capital ignores the net present value of the 

expected cash flows on a GSE's financial guarantee business. Further, 

GAAP requires financial institutions to report the cost of defaults that they 

can reasonably estimate, but this amount is less than the cost of all defaults 

that they expect to occur in future years. 

Market value accounting differs from historical cost accounting in two 

respects. First, items not included on the GSE's GAAP balance sheet--such 

as financial guarantees or the value of future business--are counted. Second, 

all items are valued at current market prices or their equivalents. Market 

prices reflect current and likely future changes in interest rates, and in some 

cases may reflect the market's perception of credit risk. For prepayable 

mortgages and GSE debt securities that the enterprises can prepay, market 

prices also reflect investors' expectations about how likely future 'interest 

rates will affect the timing of payments. A GSE's mark-to-market net worth 

is equal to the market value of its assets less the market value of its liabilities plus the market value of any expected future income from guarantee 

fees. Where no value is assigned to current or future business opportunities, 

an enterprise's mark-to-market net worth is approximately equal to the 

amount that could be realized if it was liquidated on a piecemeal basis. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEB n 

BOX 3 

A GSE's mark-to-market net worth can be significantly different from 

its GAAP capital. This was the case, for example, when the increases in 

interest rates in the early 1980s caused a large decline in the mark-tomarket net worth of Fannie Mae, which had funded long-term mortgages 

with short-term debt. It also is the case today for Fannie Mae and Freddie 

Mac. The excess of expected future fee income over expected future costs 

from these GSEs' guarantees of mortgage-backed securities substantially 

increases their mark-to-market net worth but is not reflected in their GAAP 

capital. The guarantee business of Farmer Mac will have the same effect if it 

is equally profitable. 

Market value accounting also has advantages and disadvantages for 

GSEs. On the plus side, market value accounting is an essential tool for 

their planning and risk management, particularly management of interest 

rate risk. Also, market prices are available for many of the assets of most 

GSEs. On the negative side, there are no generally accepted standards for 

market value accounting. Although the GSEs use similar techniques for 

estimating their mark-to-market net worth, particularly for taking into 

account the effect of interest rates on market values, significant differences 

exist. There is a notable absence of consensus on how to account for expected 

future default losses. 

Despite these limitations, mark-to-market net worth can be superior to 

GAAP net worth as a measure of the current financial condition of GSEs 

that are exposed to interest rate risk or operate financial guarantee businesses. As discussed in Chapter 11, if a federal supervisory agency clearly 

defined the assumptions that an enterprise used to estimate its mark-tomarket net worth, the measure could be used to set a minimum capital requirement for it. 

SOURCE: Congressional Budget Office based on Allen Berger. Kathleen A. Kuester, and 

James M. O'Brien, "Some Red Flaga Concerning Market Value Accounting," in 

Federal Reserve Bank of Chicago, Banking System Risk: Charting a New Course 

(Chicago: Federal Reserve Bank of Chicago, 1989), pp. 515-546; and Paul T. 

Peterson and Michael J. Kenny, "Implementing Mark-to-Market Accounting: 

Freddie Mac's Score Card for Managing Interest-Rate Risk," Secondary Mortgage 

Markets (Federal Home Loan Mortgage Corporation, Summer 1990). 
!28 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Fourth, some GSEs combine market value accounting and analysis of asset and liability durations with simulations of future interest 

rates. One approach begins with current interest rates, projects a large 

number of interest rate paths, estimates the present value of the cash. 

flows of the GSE's assets and liabilities along each path, and averages 

the present values to obtain an estimate of the enterprise's markto-market net worth. The GSE then estimates the sensitivity of its 

mark-to-market net worth by varying the assumptions about current 

interest rates.14 This technique can also be used to analyze the effect 

of different funding strategies on the GSE's sensitivity to changes in 

interest rates. A related approach measures how the GSE's return on 

its mark-to-market net worth over a period varies across a wide range 

of interest rate paths. 

The GSEs use six types of assettliability strategies to control interest rate risk. First, one enterprise finances floating-rate loans with 

floating-rate notes that are indexed to the same Treasury bill rate. 

Second, some GSEs require borrowers to pay penalties for prepaying 

their loans. In principle, the penalties can be varied to offset the 

changes in the market values of the loans caused by changes in interest rates. Third, enterprises issue debt that they can prepay, or call, 

in the same way that borrowers can prepay their loans, so that changes 

in interest rates alter the market values of the assets and liabilities by 

similar amounts. Fourth, GSEs finance prepayable mortgage loans 

with mortgage-backed securities. Securitizatidh passes most of the 

prepayment risk of the mortgages on to investors, although the market 

value of the fee income that the GSE earns for guaranteeing the mortgage-backed securities is somewhat sensitive to changes in interest 

rates. Fifth, some GSEs purchase assets and issue liabilities that they 

estimate will stabilize their mark-to-market net worth or returns over 

a wide range of future interest rates. Sixth, some enterprises use 

hedging techniques such as interest rate swaps (contracts to exchange 

floating- for variable-rate interest payments, or vice versa) and Treasury bill futures contracts to reduce their interest rate risk. 

14. The Ofice of Thrift Supervision has proposed that federally insured thrift institutions use one 

version of this approach to estimate their mark-to-market net worth and ita sensitivity to changes 

in interest rates. See Department of the Treasury, Ofice of Thrift Supervision. 12 CFR Part 567, 

Notice of Proposed Rulemaking, "Regulatory Capital: Interest Rate Risk Component," Federal 

Register, December 31,1990, pp. 53529-53571. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 29 

Management, Operations, and Business Risks 

To control credit and interest rate risk effectively, control its operating 

costs, and earn a competitive rate of return, a GSE must be well managed and operate efficiently. Each year the enterprise may purchase or 

guarantee hundreds of thousands of loans and make millions of payments to investors. Some GSEs monitor the financial condition and 

performance of thousands of financial institutions that sell loans to 

them and service loans for them. Bad management decisions or policies and deficient operating practices can lead to unanticipated fluctuations in a GSE's costs and income and, in the extreme, to major 

changes in its financial condition. 

GSEs control their exposure to management and operations risks 

through strategic and operational planning, policymaking processes, 

control systems, management information systems, and personnel administration. The 1990 Treasury and GAO reports include preliminary reviews of the management processes and operating practices of 

each GSE.15 

The business risk of a GSE is the risk associated with participating 

in particular lines of business. The development of new products or 

technologies or other factors may reduce the demand for an enterprise's services, particularly if wholly private financial institutions can 

compete effectively with it. Three GSEs--Fannie Mae, Freddie Mac, 

and Sallie Mae--are exposed to little or no business risk because they 

have significant market power arising from the implicit federal guarantee of their obligations, their other benefits under federal law, and 

economies of scale. The Farm Credit System and the FHLB system are 

exposed to some business risk because private firms offer competitive 

alternatives to some of their services. 

15. See Department of the Treasury, Report of the Secretary of the Treasury on Gouernment Sponsored 

Enterprises, pp. A-59 to A-65, B-47 to B-54, C-35 to C-38, D-44 to D-47, and E-15 to E-17; and 

General Accounting Office, Gouernment-Sponsored Enterprises: The Government's Exposure to 

Risks, pp. 59-13. 
30 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

How GSE Capital Affects the Government 

A GSE's capital is equal to stockholders' equity (owners' investment in 

the firm) plus any liabilities that can or are likely to be interrupted 

before federal assistance is provided. This capital limits the government's exposure to the credit risk, interest rate risk, and management 

and operations risks of the enterprise both prospectively and retrospectively. Prospectively, it encourages owners and managers to take into 

account a wide range of possible outcomes, thereby minimizing their 

incentive to ignore potential costs to the government. Retrospectively, 

it is the amount of coinsurance available to absorb an enterprise's 

losses before the government must pay them. 

The government has an interest in assuring that each GSE's capital is neither too low nor too high. Capital must be sufficient to protect 

against the risk of unanticipated losses that would lead to federal 

assistance, and to give owners incentives to limit the enterprise's risk 

taking in order to protect their own investments. But a higher capital 

standard reduces not only the implicit subsidy that the GSE receives 

but also the GSE's return on equity, which ironically could make it 

more difficult to meet a higher capital standard. If the return on 

equity fell below the returns available on assets of similar risk, the 

GSE would be unable to attract new capital and would be forced to rely 

on retained earnings to meet the standards. In addition, low dividend 

yields could cause a GSE to shrink unless federal assistance is provided 

or owners are prevented from liquidating their investments. As an 

alternative to requiring a GSE to maintain high levels of capital, the 

government could require it to reduce its credit, interest rate, or management and operations risks, or to shift some of its.risks to private 

creditors. 

Risk of Changes in Federal Policy 

GSE owners are also exposed to the risk of changes in federal policy. 

Changes in charter act restrictions or benefits can change the operating costs or risk exposure and reduce the profitability of an enterprise. GSEs that invest in federally guaranteed loans are exposed to a 

risk that the government would change the terms of existing guar- 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 31 

antee contracts, although such action seems quite unlikely. Sallie 

Mae, which invests principally in GSLs or assets collateralized by 

GSLs, is most exposed to this risk. (An additional risk to Sallie Mae is 

that the government may change the terms of the substantial explicit 

subsidy paid to lenders.) Even changes in federal law not directly 

related to an enterprise can affect its risk. For example, the 1990 Omnibus Budget Reconciliation Act reduced spending by the Commodity 

Credit Corporation (CCC) on farm price supports. The cuts will lower 

farm income and may increase the exposure to credit risk of the Farm 

Credit System and Farmer Mac. 

In the last 18 months, increased attention to the risks and capital 

adequacy of GSEs has also increased the probability that the government will subject some GSEs to greater federal regulation or more 

stringent capital requirements. The uncertainty about capitalization 

may have contributed to the declines in 1990 in the market values of 

the stock of Fannie Mae and Freddie Mac. Legislative action on the 

issues of GSE regulation and capitalization would help reduce this 

uncertainty and might make it easier for the firms to raise additional 

capital, if the government requires it. 

POSSIBLE CHANGES IN FEDERAL POLICY 

The fundamental policy judgment about a GSE is whether the achievement of its public purposes is worth the amount of risk that the government must accept--the implicit federal subsidy that it must pay. A 

closely related decision concerns the level of GSE capital that will 

strike an acceptable balance between the objectives of minimizing the 

risk of the GSE by giving owners a significant stake in the GSE's financial health, on the one hand, and assuring that the enterprise is 

profitable enough to remain viable and achieve its public purposes, on 

the other. Because the government has a stake in the public purposes 

of each GSE and bears some of its risk, these choices are policy issues 

that must be decided by federal officials. 
32 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

In assessing alternative approaches to striking a balance between 

the benefits and risks of using GSEs, the Congress may want to consider three types of changes in current federal policy. First, changes in 

an enterprise's charter act could be used to alter its permitted activities or its ability to take credit risk or interest rate risk. Second, the 

Congress could elect to strengthen federal supervision of the safe and 

sound operation of the GSEs, and to provide guidelines to supervisory 

agencies with respect to using their authorities and coordinating supervision and program regulation of the enterprises. Third, the Congress could elect to shift more of the enterprises' risks to private investors by requiring them to increase their capital or by requiring investors in their debt to bear greater risk. 

PLAN OF THE REPORT 

This report examines policy options of each type. Chapter I1 develops a 

framework for understanding program regulation and supervision of 

the safety and soundness of GSEs. It discusses specific issues in designing more effective regulation and supervision and in setting federal capital requirements for the enterprises. A proposal to centralize 

their supervision is analyzed. The chapter also examines the potential 

use of private assessments of GSE risks to minimize the risk of supervisory failure. 

Chapters I11 through VI analyze the exposure to credit risk and interest rate risk of each GSE and how well they are capitalized with 

respect to each of these risks. The exposure to business risk of the 

Farm Credit System and the FHLB system is examined. Current federal supervision and regulation of the enterprises and possible changes 

in current supervisory arrangements are also discussed. Chapter I11 

focuses on the Farm Credit System, including Farmer Mac, and supervision of the system by the Farm Credit Administration. Chapter IV 

examines Fannie Mae and Freddie Mac and HUD's regulation of those 

two GSEs. Chapter V analyzes the FHLB system and its supervision 

by the Federal Housing Finance Board. Chapter VI discusses Sallie 

Mae, which has no federal supervisor of safety and soundness. 
CHAPTER I PUBLIC PURPOSES AND RISKS OF GSEe 33 

The report's conclusions about the GSEs' exposure to credit risk 

and interest rate risk and their capitalization are based on data provided by them. To reach a definitive conclusion about each enterprise's 

exposure to these risks and its overall capital adequacy, and to assess 

its exposure to management and operations risks, which CBO has not 

assessed, the government would have to conduct thorough examinations of the GSEs' operations. At present, only the member institutions of the Farm Credit System are subject to regular federal examinations. 

CHAPTER I1 

FEDERAL SUPERVISION AND 

REGULATION OF GSEs 

Under current law, several federal agencies are responsible for monitoring and regulating the activities of the government-sponsored enterprises (GSEs). In analyzing the duties and powers of these agencies 

and possible changes, it is useful to distinguish between the supervision of their safety and' soundness and the regulation of their programs. The purpose of supervision is to limit the government's exposure to risk by ensuring that the risks the GSEs assume are no greater 

than necessary to accomplish their public purposes. The objective of 

program regulation is to assure that the enterprises engage only in activities authorized by the Congress and achieve their public purposes. 

The responsibilities and statutory authority of the executive 

branch agencies that now supervise and regulate the GSEs vary considerably. The Farm Credit Administration (FCA) is not a program 

regulator but has most of the supervisory authority and enforcement 

powers of the bank and thrift supervisory agencies with respect to the 

activities of the Farm Credit System. The Congress strengthened the 

FCA's role after the system suffered large losses in the 1980s. The 

Federal Housing Finance Board (FHFB) has broad supervisory authority over the Federal Home Loan Bank (FHLB) System, and programmatic authority to assure that the banks perform their mission to 

provide affordable housing. The Department of Housing and Urban 

Development (HUD) has general regulatory authority over the Federal 

National Mortgage Association (Fannie Mae) and the Federal Home 

Loan Mortgage Corporation (Freddie Mac), but it is not clear that 

HUD's powers are adequate to ensure the safety and soundness of 

these GSEs. The department also has regulatory authority over their 

programs. No federal agency has supervisory authority over the 

Student Loan Marketing Association (Sallie Mae). This variation in 

responsibilities and statutory authority has raised issues about the 

government's ability to assure the safe and sound operation of the 

GSEs, and has sparked efforts to reform their supervision and regula- 
36 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

tion. This chapter explores general strategies for reform and the issues 

they raise. 

ELEMENTS OF SUPERVISION 

OF SAFETY AND SOUNDNESS 

Supervision of safety and soundness is not unique to GSEs. Federal 

and state agencies are responsible for supervising the safety and 

soundness of several other types of firms that provide financial services--depository institutions, insurance companies, pension funds, 

and broker-dealers.1 In each case, the objective is to help liability 

holders to avoid the adverse consequences of the insolvencies of institutions. For example, state supervision seeks to prevent insolvencies of 

insurance companies and pension funds in order to protect life insurance beneficiaries, property and casualty insurance claimants, and 

present and future pension recipients, for whom the cost of monitoring 

the risk of these entities is high. 

The objective of federal supervision of the safety and soundness of 

GSEs is most similar to the objective of the supervision of depository 

institutions. In both cases the government is protecting itself as the 

ultimate guarantor of the institution's liabilities. This objective is a 

means to achieving other important social goals at an acceptable cost. 

The federal government insures deposit accounts, which are the major 

means of payment in the economy, at banks and thrifts to protect small 

depositors and to prevent the runs that can follow insolvencies. Supervision of depository institutions protects the government as the deposit 

insurer. Similarly, the federal government implicitly guarantees GSE 

obligations so that the enterprises can raise funds cheaply and easily to 

achieve their public purposes. The government can use supervision of 

GSEs to protect itself as the implicit guarantor of GSE obligations. 

1. A framework for understanding supervision of the safety and soundness of all types of financial 

services firm is developed in Lawrence J. White, 'The Theory of Financial Regulation in the New 

Environment of Liberalization" (paper preeented at "Recent Developments in Finance: Conference 

in Honor of Arnold W. Sametz." October 5, 1990). The framework is applied to depository institutions in Lawrence J. White, The S&L Debacle (New York: Oxford University Press, 1991). Chapters 10 and 11. 
CHAPTER n FEDERAL SUPERVISION AND REGULATION OF CSEe 37 

Because supervision of the safety and soundness of depository institutions and of GSEs have very similar objectives, the elements of 

supervision of banks and thrifts can be used to analyze existing federal 

supervison of 'the GSEs and to define alternative approaches. Specifically, the elements of federal supervision of depository institutions are 

the supervisory agency's institutional capacity, its mandate to ensure 

safety and soundness, and its statutory authority to carry out that 

mandate.2 The remainder of this section examines each element in 

detail. 

Institutional Capacity 

Institutional capacity includes the ability to hire, train, and retain a 

competent and professional staff that can understand the activities and 

techniques of risk management of the financial institution being supervised and of similar firms, and that can directly represent the government in litigation. The Congress has assured that the bank and 

thrift regulatory agencies have sufficient institutional capacity by 

authorizing the agencies to assess regulated institutions and allowing 

them to set their own staffing ceilings and salaries, outside the civil 

service salary structure, and to determine the size of their budgets. 

The cost of insulating the agencies from normal budgetary controls is 

arguably worth the benefit of avoiding any unnecessary government 

losses that might result from inadequate supervision. 

A GSE supervisory agency must compete for personnel not only 

with the bank regulatory agencies, but also with the enterprises and 

other financial institutions that provide similar services, such as Wall 

Street investment banking firms. To compete successfully for financially sophisticated staff, the agency may have to be able to pay more 

than the bank regulatory agencies pay senior federal bank examiners. 

2. The discussion draws upon Thomas H. Stanton, Federal Supervision of Safety and Soundness of 

Government Sponsored Enterprises (prepared for the Administrative Conference of the United 

States, December 4, 1990), pp. 38-82; and White, "The Theory of Financial Regulation in the New 

Environment of Liberalization," pp. 20-23. For complementary analysee of the elements of 

supervision of the safety and eoundnees of depository inatitutiona, eee Carter H. Golembe and David 

S. Holland, Federal Regulation of Banking 1986-87 (Washington, D.C.: Golembe Associates, Inc., 

1986), Chapters 4,11, and 12; and Federal Deposit Insurance Corporation, Deposit Insurance in the 

Nineties: Meetingthe Challenge (Draft Staff Study, January 4,1989), Chapter 5. 
38 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Another approach would be to establish separate grades for GSE supervisory personnel within the civil service salary structure. 

Statutory Mandate 

A statutory mandate to supervise the safety and soundness of a financial institution is a statement of the agency's responsibility to protect the government from risk of loss. This mandate may be explicitly 

stated or implicit in various provisions of law and in legislative 

history. The safety and soundness mandate of the federal bank and 

thrift regulatory agencies may be inferred from the legislative history 

of their enabling statutes, their statutory responsibility to protect the 

deposit insurance funds, and their powers to enforce federal capital requirements and other limits on risk taking. 

Failing to give a GSE supervisory agency a clear statutory mandate to assure an enterprise's safety and soundness, or to clarify the 

importance of achieving this objective before obtaining programmatic 

goals, carries the risk that the agency will pursue programmatic objectives while ignoring excessive exposure to risk. The pattern of HUD's 

regulation of Fannie Mae in the 1970s, discussed in detail in Chapter IV, illustrates this risk. 

Statutory Authority 

The statutory authority of a supervisor of the safety and soundness of a 

financial institution may have several components. The Federal Deposit Insurance Corporation (FDIC), the Ofice of the Comptroller of 

the Currency (OCC), and the Ofice of Thrift Supervision (OTS) can require financial disclosure and reporting and can examine the books 

and records of federally insured depository institutions, set binding 

capital requirements on them, enforce those requirements and other 

restrictions on risk, and appoint a conservator or receiver for a failing 

institution. 

Reporting and Examination. The bank and thrift regulatory agencies 

require depository institutions to file regular reports of financial condi- 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEs 39 

tion and use the reports to monitor changes in risk. Agency examiners 

perform regular examinations of institutions in order to verify the accuracy of reported information and to assess any exposure to management and operations risks. 

Bank and thrift examiners use CAMEL ratings to summarize the 

overall safety and soundness of banks. They rate each institution's 

Capital adequacy, Asset quality, Management quality, the quantity 

and quality of its Earnings, and its Liquidity. These five factors are 

not strictly separate. A bank's capital adequacy, for example, depends 

on its ratings on the other factors. Examiners rate each factor on a 

scale of one to five, with one being the most favorable. The five ratings 

are then combined into a single, composite rating of the bank's overall 

risk. 

Capital Requirements. The Congress has set a statutory minimum 

capital requirement for federally insured thrifts of 3 percent of assets. 

The OCC requires all federally insured banks to comply with the same 

standard, which protects the government against each institution's exposure to interest rate, management, and operations risks. 

The bank and thrift regulatory agencies also have authority to set 

binding capital standards on insured depository institutions. By the 

end of 1992, the regulatory agencies will have fully phased in riskbased capital requirements that are consistent with international 

agreements among bank regulators known as the Basle Accords. The 

standards protect against each institution's exposure to credit risk. 

They apply risk weights to different classes of assets and require institutions to maintain book-value capital equal to a percentage of total 

risk-weighted assets. The regulators reserve the right to impose higher capital requirements on an institution if examinations reveal special risks such as rapid growth, concentration in a single kind of loan, 

or geographic concentration. 

Enforcement Powers. The bank and thrift regulators have several 

types of enforcement powers. These include the ability to revoke an 

institution's charter or terminate federal insurance of its deposits, 

issue directives requiring it to increase its capital, order a firm to cease 

and desist from unsafe and unsound practices, remove an institution's 
40 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

officers and directors for good cause, impose civil monetary penalties 

on the firm, restrict its payment of dividends, and disapprove risky 

activities. 

Authority to Appoint a Conservator or Receiver. The agencies also 

have authority to appoint a conservator or receiver for an insured depository institution. A conservator administers the affairs of an institution once it is determined to be operating in an unsound manner 

and seeks to restore it to financial health. A receiver administers the 

affairs of an institution that has been closed. The receiver takes possession of (but not title to) the institution's assets, liquidates or otherwise disposes of them, and uses the proceeds to pay creditors. 

ADAPTING FEDERAL SUPERVISION TO 

THE UNIQUE CHARACTERISTICS OF GSEs 

Government-sponsored enterprises and federally chartered depository 

institutions are privately owned financial institutions created by the 

government to achieve public purposes. There are significant differences, however, in the lending powers, operations, size, and geographic 

scope of the two types of institutions. Depository institutions can make 

more kinds of loans than can individual GSEs, but they usually make 

loans in more limited geographic areas. Individual banks and thrifts 

also purchase only a small fraction of the number of loans financed by 

some GSEs. Depository institutions number in the thousands, but 

there are only a few enterprises. The GSEs are not exposed to the liquidity risk that depository institutions face. Finally, some of the enterprises can provide the government with highly sophisticated and 

potentially quite accurate measures of their exposure to credit risk and 

interest rate risk. Some depository institutions may also be able to do 

this. 

These important differences suggest that the elements of federal 

supervision of banks and thrifts must be adapted to take into account 

the unique characteristics of GSEs in order to define alternative reforms of current federal supervision of the enterprises that would limit 

the government's exposure to risk. This section considers several 

approaches. They include options to rely on increased federal over- 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEe 41 

sight and the ability to remove GSE boards of directors, require that 

supervision of low-risk GSEs be streamlined, select the enforcement 

powers given to a supervisory agency and address its use of those 

powers, and specify the steps that a supervisory agency would take if a 

GSE was insolvent or near insolvency. Because the Farm Credit Administration and the Federal Housing Finance Board already possess 

substantial statutory authority, the options apply principally to supervision of Fannie Mae, Freddie Mac, and Sallie Mae. A different strategy for limiting the government's exposure to risk--privatization--is 

discussed later in this chapter. 

Relying on Federal Oversight and Early Warning 

A minimalist approach to reforming supervision of the three GSEs that 

have publicly traded stock outstanding--Fannie Mae, Freddie Mac, and 

Sallie Mae--would rely on the discipline of stockholders and federal 

monitoring of their activities to protect the government. The Department of Housing and Urban Development, in the case of the first two 

enterprises, and the Treasury Department, in the case of Sallie Mae, 

would use their existing statutory authority to examine each GSE's 

strategic plans and annual budgets and business plans, and to monitor 

its financial condition on the basis of publicly available data. If either 

department detected planned or actual changes in risk, it could alert 

the President and the Congress. HUD and the Treasury could also 

recommend to the President that the board of directors of a GSE be removed, if the secretary of either department found that the enterprise 

was increasing its risk significantly or beginning to incur losses. 

This option would minimize the risk that federal supervision of 

these three GSEs would impose unnecessary burdens on them. There 

are a number of objections to the approach, however. First, monitoring 

by the Treasury or HUD might not detect changes in the risk of the 

GSEs until they had occurred, especially if the changes had not been 

planned. Although management would seem to have strong incentives 

not to initiate unplanned increases in risk, they might do so if they expected sufficiently high returns. Second, each GSE is exposed to management and operations risks, namely, the danger that management 

weaknesses or operating deficiencies will damage the enterprise's fi- 
42 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

nancial condition significantly without the harm showing up on the 

balance sheet. It seems unlikely that the Treasury or HUD could limit 

the government's exposure to these risks without the institutional 

capacity and statutory mandate and authority to examine each GSE 

thoroughly and take action to be sure that problems detected in examinations are corrected. Third, this approach would not impose any 

federal capital requirements or adopt any other risk-related performance yardstick by which to assess the risk of these three enterprises. 

Although private credit ratings could provide such a yardstick, they 

would have some shortcomings, as discussed below. Fourth, the departments and the President might be reluctant to remove the board of 

a GSE, especially if increased risk taking had not led to losses. In contrast, a supervisory agency with a statutory mandate to ensure the safe 

and sound operation of the enterprises and sufficient enforcement 

powers would probably be less reluctant to act to protect the government. The burdens of such supervision could be minimized by streamlining the supervisory process. 

Streamlinin~ Supervision of Low-Risk GSEs 

The analysis in this report suggests that two GSEs--the FHLB system 

and Sallie Mae--expose the government to very little risk. Fannie Mae 

and Freddie Mac are found to be relatively well capitalized with respect to their exposure to credit risk and interest rate risk. Their consistent profitability and the incentives provided by their publicly 

traded stock suggest that they probably do not have any serious management weaknesses or operating deficiencies at this time. 

If a supervisory agency concluded that the risk posed by any of 

these enterprises was acceptably low, the Congress could require the 

agency to take steps to make its monitoring less burdensome than is 

the federal government's supervision of banks and thrifts. Specifically, 

the Congress could direct the agency to streamline the regulatory reporting and disclosures and the federal examinations of a GSE--or, in 

the case of the FHLB system, of individual banks--if the agency determined that it posed a low level of risk to the government. A streamlined supervisory process could take the following form. The supervisory agency would require a GSE to disclose its credit and interest 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEs 43 

rate risk by reporting the application of financial models and stress 

tests to its activities. The agency would specify the models and tests 

after consulting with the enterprise, assure itself that they were 

updated as necessary, and employ a variety of techniques to validate 

them. Validation would also include conducting on-site examinstions 

to assure that data were timely and accurate. Alternatively, the supervisory agency could perform its own stress tests, in consultation with 

the GSE, and simply require the enterprise to provide the data necessary to run the tests. 

The GSE would be required to provide the supervisor with annual 

business plans, updated quarterly and whenever material departures 

from the plans were contemplated. The business plans could be accompanied by analyses, performed using agreed-upon models, of the consequences of the business plans for the GSE's credit risk, interest rate 

risk, and capital position, and would indicate how the enterprise 

planned to capitalize any new activities. The regulator would be free 

to request additional information about the GSE's risks and business 

plans, and to indicate whether it would require greater capitalization 

than the GSE planned for new activities. If so, the enterprise could 

decide, based on market conditions and its desired rate of return, not to 

engage in the activities. The supervisory agency might also institute 

special reporting requirements or examinations to assure that, as new 

activities were carried out, their risk was not substantially greater 

than initially projected. 

This approach to reporting and disclosure would allow the regulator's examination procedures to become more sophisticated and less 

exhaustive than those of federal bank and thrift regulators. The examiners would be able to concentrate on evaluating the adequacy of 

the GSE's management systems and practices and on testing whether 

a GSE's financial models were conceptually sound and accurately reflected the characteristics and performance of the enterprise's assets 

and liabilities (or in validating data provided to enable the agency to 

run its own stress tests). 

If such a streamlined approach were used, two issues would require active attention by the supervisory agency. First, the models 

that the GSE or the agency used would have to be adjusted continually 
44 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

as markets and financial knowledge changed. The regulator would require the legal authority to obtain accurate and complete information 

about any models and techniques used by the enterprise, the technical 

capacity to evaluate them, and the ability to require the GSE to furnish the data necessary to run any stress tests of its own. Second, if a 

GSE suffered losses that brought it out of compliance with its federal 

capital standard--whether intentionally or as a result of adverse economic conditions--the regulator might conclude that streamlined selfreporting and limited examinations were no longer sufficient and take 

steps that would signal an end to streamlined supervision. The Congress could provide the agency with the institutional capacity and 

statutory authority to institute more extensive examinations and more 

detailed monitoring of the GSE at that point. The supervisor could also 

be given powers to enforce its capital standards or other financial requirements and to stop an enterprise from engaging in any significant 

unsafe and unsound practices that it detected. The selection of enforcement powers is addressed below. 

A supervisor that chose to apply this streamlined regulatory scrutiny to a GSE would require a flexible institutional capacity. On the 

one hand, the agency probably would require a far smaller staff, but 

much more extensive computer capabilities, than the bank regulatory 

agencies need to supervise the average depository institution. On the 

other hand, the agency would need to have an arrangement with the 

bank regulatory agencies to borrow examiners if a GSE got into 

trouble and required closer scrutiny in short order. Some of the agency's examiners probably would have to possess experience assessing 

the management quality of large money-center banks. 

There are several reasons not to require the Farm Credit Administration to devise a streamlined supervisory process for the member 

institutions of the Farm Credit System (FCS). The system's institutions make many different types of agricultural loans, the terms of 

which vary. Consequently, the FCA must use bank-type examinations, in which the quality of individual loans or small numbers of 

similar loans is evaluated, to assess the risk exposure of nearly all FCS 

institutions. Market prices or their equivalents are not available on a 

large proportion of the system's loans, which limits the usefulness of 

market value accounting. Finally, when the FCA has used credit 
CHAPTER II FEDERAL SUPERVISION AND REGULATION OF GSEe 45 

stress tests to assess capital adequacy, it has tested each association 

and bank separately, rather than the system as a whole. It would seem 

prudent, therefore, to continue to delegate to the agency the ability to 

decide to streamline supervision of individual institutions. 

A streamlined supervisory process might be appropriate for the 

individual FHLBs, particularly if the banks retained current capital 

levels, collateral requirements for advances, and procedures for managing exposure to interest rate risk. If the system's capital was significantly reduced, however, the FHFB would have to weigh the potential benefits of less burdensome supervision against the potential dangers posed by the combination of less intensive monitoring and increased exposure to risk. 

Selecting and Limiting the Use of Enforcement Powers 

With the exception of the Farm Credit Administration and the Federal 

Housing Finance Board, federal agencies do not have extensive enforcement powers over the GSEs. If one or more of the agencies were 

given additional explicit powers, it might not be necessary to give them 

all the powers of the bank and thrift supervisors. The ability to issue 

cease and desist orders, issue capital directives, and remove officers or 

directors who failed to comply with either type of mandate would 

probably suffice. These powers would imply a variety of less draconian 

and implicit enforcement tools, such as letters of agreement, and would 

give a GSE supervisory agency sufficient leverage to deter or stop excessively risky activities or unsafe and unsound practices. 

In granting explicit enforcement powers to a GSE supervisory 

agency, the Congress could use statutory language or legislative history to be reasonably sure that the agency would not abuse the powers 

and that the enterprise could anticipate how they would be used. To 

prevent abuses, the Congress might want to direct the agency to use 

the powers only to address safety and soundness concerns, and to prohibit their use to promote programmatic objectives. The supervisory 

agency could also be required to issue regulations that defined certain 

conditions that it would consider to be unsafe and unsound practices. 

These conditions would be considered grounds for seeking a cease and 
46 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

desist order or applying other specific sanctions. Of necessity, the 

agency would have to retain the authority to act in other cases as well, 

even if the offending practices had not been defined beforehand. Without such flexibility, its ability to correct previously unforeseen practices that it deemed to be unsafe and unsound would be compromised. 

Considerable care would have to be taken in writing legislative 

language and history to avoid undue restriction or ambiguities that 

would result in the courts rather than the Congress determining the 

scope of the enforcement powers of a GSE supervisory agency. Another 

approach would be to rely on the protections against arbitrary actions 

provided in the Administrative Procedure Act, supplemented by a requirement that judicial review be offered to enterprises against whom 

enforcement actions are taken. 

Dealing with an Insolvent GSE 

Dealing with a GSE that is insolvent or near insolvency is more complex than handling a failed depository institution. The Congress chartered each enterprise to serve particular loan markets on a nationwide 

basis and is likely to want to assist one that would not be viable without assistance, rather than allow a supervisory agency to liquidate it. 

This approach suggests that the Congress might want to give a supervisor of the safety and soundness of a GSE authority to appoint a conservator for an enterprise that was insolvent or near insolvency, but 

not authority to appoint a receiver. A conservator could be directed to 

continue any of the GSE's operations, such as financing fixed-rate residential mortgages with mortgage-backed securities, whose risks are 

known with a reasonable degree of accuracy. The supervisor could be 

required to submit, within a predetermined period after a conservator 

was appointed, a plan for recapitalizing or otherwise lowering the risk 

of the enterprise.3 

3. The argument for limiting the supervisory agency's authority to the appointment of a conservator 

does not apply to the Farm Credit System, since sound institutions generally are available to lend 

in the geographic areas previously covered by an association or bank that is being liquidated by a 

receiver. 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEe 47 

Determining when a GSE is insolvent or close to insolvency and 

whether to appoint a conservator or receiver are complex and somewhat subjective judgments. In determining solvency, a supervisor 

must take into account the GSE's capital measured on a GAAP (Generally Accepted Accounting Principles) basis, its mark-to-market net 

worth, and its franchise value--the value of intangible assets and all 

current and future business opportunities. A GSE's special benefits 

under federal law can make its franchise value quite substantial. The 

supervisory agency must assess whether the risk of harming that 

source of value would be minimized by appointing a conservator or by 

allowing current management to continue to operate the enterprise. If 

adverse economic conditions rather than management failure had 

caused a GSE's losses, the agency might decide that the drastic step of 

conservatorship was unnecessary. 

The advantage of giving a supervisory agency the power of conservatorship rather than relying on the legislative process to deal with 

a failing GSE is that swift action might prevent the enterprise from 

increasing the risk of its activities in order to gamble its way back to 

financial soundness. Even if severe economic conditions had caused 

the problem and the government was willing to provide financial assistance, such action might be prudent to protect the government from 

having to absorb additional losses. If serious management errors had 

caused the problem, conservatorship probably would not do much more 

damage to the GSE's franchise value. 

PRIVATIZATION AS AN ALTERNATIVE 

TO ENHANCED SUPERVISION 

The owners of a stockholder-owned GSE might find privatization of the 

enterprise more attractive than any change in current federal oversight. The certain cost of losing the legal benefits of government sponsorship and the enhanced ability to borrow afforded by an implicit federal guarantee, as well as the certain benefit of being able to expand 

into other lines of business, might be preferable to the risk that federal 

supervision might be poorly informed and, therefore, impose unnecessary burdens on the GSE. 
48 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

The Congress might find this option attractive if genuine privatization--a separation that increased competition in the market in which 

the GSE participates--can be achieved and the government's exposure 

to risk truly reduced, and if fully private financial institutions can 

achieve the public purposes for which the enterprise was established. 

These conditions may exist for Sallie Mae. Chapter VI, therefore, examines one approach to privatizing the GSE. 

USING PRIVATE ASSESSMENTS OF GSE RISKS TO 

MINIMIZE THE POSSIBILITY OF SUPERVISORY FAILURE 

Government supervisors of the safety and soundness of financial services firms sometimes fail to protect the interests of taxpayers. In the 

thrift crisis, for example, officials failed to do so by permitting insolvent, federally insured savings and loans to remain in business and 

by allowing mounting losses to go unrecognized. A GSE supervisory 

agency could fail in a similar fashion by allowing an enterprise to engage in very risky activities or poor management practices, by neglecting to publicize that a GSE had suffered significant losses and was 

out of compliance with federal capital requirements, by failing to require it to recapitalize, or by allowing an enterprise that was insolvent 

or close to insolvency to increase its risk exposure in an effort to gamble its way back to health. 

A general strategy for minimizing the risk of supervisory failure 

would be to obtain independent private assessments of the financial 

condition and overall exposure to risk of each GSE. Three approaches, 

which are not necessarily mutually exclusive, could be taken. 

Requiring Reproducible Federal Reports on 

GSE Risk Exposure and Capital Adequacy 

The Congress could require the federal agency responsible for supervising the safe and sound operation of a GSE to issue a quarterly or 

semiannual report containing its quantitative assessments of the enterprise's exposure to credit risk and interest rate risk and its capital 

adequacy. If market prices for the GSE's assets or similar financial 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATTON OF GSEs 49 

instruments are easily obtained, the agency would be required to disclose the enterprise's mark-to-market net worth. The GSE would also 

be required to make publicly available the empirical data that it had 

provided to the agency on which the assessments were based. Interested analysts would also be able to obtain, for a fee, copies of the computerized and statistical models used by the agency. 

The purpose of disclosing this information would be to enable private and governmental analysts outside the supervisory agency to reproduce and to evaluate the agency's assessments of the GSE's exposure to credit risk and interest rate risk and its capital adequacy.4 

These analysts would be able to discover and publicize quickly any 

major weaknesses in an agency's techniques or any failure to disclose a 

significant decline in its performance on a stress test or its mark-tomarket net worth. The possibility of independent review would give 

the supervisory agency a strong incentive to use the best possible 

methods and to report any significant changes in risk exposure in a 

timely manner. This incentive would exist even if private or other governmental analysts did not regularly attempt to reproduce the agency's findings. 

This option would require regular disclosure to the public of proprietary information that the GSEs currently keep confidential. The 

data would include, for example, summary information on the characteristics of the loans purchased by an enterprise in each region of the 

country in each year, how each group of assets has performed in each 

year, and the average prices that the GSE has charged and is expected 

to charge for its services. No information on how the enterprise sets 

prices or on the terms of specific transactions need be disclosed. 

The release of such information could cause the price of a GSE's 

stock to fluctuate or even put it at a competitive disadvantage. These 

risks could be minimized by requiring all the enterprises to release the 

mandatory information simultaneously. Each GSE would also be free, 

of course, to accompany the data with disclosures that explained any 

potentially troubling developments to analysts and investors. 

4. The genesis of thie idea ie Edward J. Kane, "Reforming Regulatory Incentives: Banks, Thrifts, and 

GSEs" (paper presented at "A Crisis in Values: Real Estate and the Financial System," conference 

eponsored by the National Taxpayere Union, February 11,1991). 
80 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Alternatively, the Congress could establish procedures by which a 

supervisory agency and the GSEs for which it was responsible regularly informed private consultants or the General Accounting Office 

(GAO) about the methods and empirical data on which it based its 

assessments. The private firms or GAO would be required to attempt 

to reproduce the agency's quantitative assessments, to evaluate its 

findings, and to report to the agency or to the Congress. The cost of 

hiring the private firms or creating a staff within GAO to perform this 

function would make this alternative more expensive than simply 

disclosing publicly the methods used by the agency and the data provided by the GSEs. 

Quantitative methods can be used to assess the risk exposure of 

the Farm Credit System in only the most general way. An alternative 

approach would be to give private firms or the GAO access to, and ask 

them to evaluate the results of, the Farm Credit Administration's most 

recent examinations of individual FCS institutions. (GAO already has 

authority to audit them.) Because of the large number of institutions, 

however, they would have to be studied selectively or only on a periodic 

basis. The cost of doing so could be higher than the expense of using 

private firms or GAO to evaluate quantitative assessments of the risks 

of the other GSEs. 

Using Credit Ratings to Assess the 

Government's Exposure to GSE Risks 

Private credit-rating agencies specialize in assessing the default risk of 

debt and asset-backed securities issued by private firms and state, 

local, and national governments (see Box 4). The Treasury has proposed that the agencies be hired to provide credit ratings that would 

indicate the government's exposure to the risks of GSEs.5 Some 

analysts have raised questions, however, about whether the agencies 

could use the methods they employ to rate the default risk of fully private debt, the information value of ratings that assessed the govern5. Department of the Treasury, Report of the Secretary of the Treasury on Government Sponsored 

Enterprises (May ISSO), p. 9. 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEs 51 

BOX 4 

The Private Credit-Rating Process 

Private credit-rating agencies evaluate the default risk of debt and asset-backed 

securities issued by private firms (including financial institutions), states and municipalities, and sovereign governments. The agencies define the term "default" as an 

event in which a debtor fails to make a scheduled payment to a creditor. There are 

five agencies--Moody's Investors Service, Standard & Poor's Corporation (S&P), Duff 

& Phelps Credit Rating Co., Fitch Investors Service, and McCarthy, Crisanti, and 

Maffei. Moody's and S&P are the industry leaders. These firms exist because investors often lack the experience, resources, or capacity to analyze the default prospects of individual debt securities effectively and at low cost. Issuers pay the agencies to evaluate their ability to meet their obligations. 

The agencies assign letter ratings that indicate the relative default risk of the 

securities and are comparable for all types of issuers and obligations. Ratings for 

senior debt securities range from triple-A, the highest, to single-C, the lowest. 

Securities that receive the top four ratings--triple-A, double-A, single-A, and 

triple-B--are known as investment grade, and securities rated double-B to single-C 

are known as noninvestment grade. Numbers, or pluses and minuses, are used to 

distinguish different degrees of creditworthiness among obligations with the same 

letter rating. Thus, a security rated Aa3 (or AA-1 is superior to a debt rated A1 (or 

A + ). Investors take the ratings into account when deciding the prices they will pay 

for the securities when they are first issued and then traded in the secondary market. 

In assigning a credit rating to a security, the agencies assess various factors 

that will affect the issuer's ability to make all payments of principal and interest in a 

timely fashion over the life of the obligation. For a financial institution, these factors 

include the firm's industry risk and market strategy, the credit quality of its assets, 

its projected earnings and cash flow, its liquidity and financial flexibility, its capitalization, its exposure to interest rate risk, and the quality of its management. 

These factors are similar to those that the federal bank and thrift regulatory agencies evaluate to assign CAMEL ratings to federally insured depository institutions. 

To analyze exposure to interest rate risk and the adequacy of capital, an agency 

may simulate the firm's cash flows over the life of the obligations being rated to 

assess the probability that revenues will be sufficient to cover expenses, and the 

amount of shortfalls that may occur. It may also analyze historical data to evaluate 

how much capital a financial institution has relative to the credit quality of its 

assets. To combine quantitative assessments with its evaluation of qualitative factors into a rating, an agency must make a judgment call, relying on its experience in 

evaluating a large number of similar financial institutions. 

The rating agencies provide ratings for each specific debt issue, but all debt of a 

specific type issued by a firm--all its subordinated debt, for example--receives the 

same rating. The agencies monitor the financial condition and risk of firms that 

have issued debt and the performance of asset-backed securities to determine if 

changes in the obligations' ratings are appropriate. The ratings of all senior obligations issued by a corporation are reevaluated whenever the firm issues additional 

debt or significant new information is available, and at least annually. 
52 GOVERNMENT-SPONSORED ENTERPRISES April lee1 

ment's exposure to a GSE's risk, and whether obtaining ratings would 

impose costs on the enterprises. 

Using Methods of Rating Agencies to Assess the Government's Exposure to Risk. Credit ratings of debt securities issued by private firms 

are ordinal indicators of the relative risk that issuers will default--that 

is, fail to make scheduled payments in a timely fashion--and of the 

amount of likely default losses. Default risk exists if a firm may fail to 

have sufficient cash to meet its obligations and be unable to raise additional funds by selling assets or issuing debt. Creditors will not lend 

a firm money to pay interest or retire debt if they expect that the firm 

will not be able to pay them back. The firm will be able to repay if it 

can generate revenues that exceed expenses. If creditors do not expect 

that it will be able to do so, they will refuse to lend the firm more 

money, and it will default. 

Because of the implicit federal guarantee, investors in GSE obligations are subject to minimal default risk. Instead, each enterprise exposes the government to the risk that it may fail to earn enough money 

to be able to meet its obligations without either borrowing on the 

strength of the implicit federal guarantee or receiving federal assistance. This risk is essentially the same as the default risk to which a 

fully private firm exposes its creditors. 

In assigning a credit rating to an issuer's obligations, the rating 

agencies must make assumptions about the consequences of a decline 

in its financial condition. In most cases, they must simply assume the 

likely responses of creditors. Other situations present subtler issues. 

For example, in evaluating the default risk of the obligations of depository institutions, particularly money-center banks, the rating 

agencies give significant weight to the protection offered by governmental support. They make assumptions about the nature and timing 

of federal action to assist a failing institution and the probability that 

losses would be imposed on creditors. Similarly, at the request of a parent firm, the agencies will provide privately a rating that indicates the 

risk to which a wholly owned subsidiary exposes the firm. To formulate this rating, the agencies must assume how the parent firm would 

respond to a deterioration in the subsidiary's financial condition. 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEs 53 

To assess the risk that a GSE poses to the government, the agencies would have to assume how the government would respond to a 

decline in its financial condition. The simplest assumption would be 

that the government would take no action before an enterprise became 

incapable of meeting its obligations without borrowing or requiring 

federal assistance. Although the government might not actually 

behave this way in practice, the assumption would enable the agencies 

to assess the government's exposure to risk. This assumption would be 

equivalent to assuming, in the case of a fully private firm, that 

creditors will force it to default only when it no longer has the capacity 

to pay its bills without borrowing. 

Information Value of Credit Ratings. Credit ratings that indicated the 

government's exposure to a GSE's risks would have advantages and 

disadvantages as sources of information about the enterprises. Three 

positive features should be noted. First, the rating agencies have considerable experience in assessing the overall risk of financial institutions that engage in lines of business similar to those of the GSEs. 

These institutions include portfolio lenders that hold agricultural and 

home mortgage loans, private mortgage insurers, and issuers of private-label, mortgage-backed securities. The agencies can readily 

adapt to the GSEs the techniques they use to assess the default risk 

posed by such firms. Second, the agencies would probably be independent of the legislative and supervisory processes and have little stake 

in their outcome. They also could lose business if they gave a prominent enterprise a high rating that its subsequent performance called 

into question. Third, the, agencies specialize in making judgments 

about the overall risk of debt issuers. 

On the negative side, the methods that the rating agencies use are 

tailored to match the needs of investors who hold diversified portfolios 

of rated debt securities and who, therefore, do not have a large stake in 

any particular issuer. The quantitative techniques they use to assess 

exposure to credit risk and, especially, interest rate risk are less 

sophisticated than those used by several GSEs. The rating agencies 

base their assessments of a firm's exposure to management and operations risks on a relatively small number of meetings with its senior 

management and other officials. This contrasts with the practice of the 
54 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Office of the Comptroller of the Currency, which maintains a staff to 

conduct continuous examinations at each of the money-center banks. 

Further, research suggests that credit ratings of debt issued by 

fully private firms may be lagging indicators of changes in the default 

risk of the debt. Some studies have found that investors react to nonrating financial data and adjust the prices of bonds traded on the secondary market before publication of changes in ratings.6 Such evidence would suggest that the rating agencies do not have significantly 

better information than investors. Other studies, however, have found 

that ratings are one factor among many that can affect bond prices, 

and thus provide additional information about a firm's financial 

health. Even in those cases, however, the market's reliance on ratings 

was found to decrease as the time from a bond's last rating increased.7 

Another concern about credit ratings is that the market prices of 

enterprise obligations would not provide an independent check on the 

judgment of the agencies. The prices of publicly traded debt that the 

rating agencies have evaluated provide market tests of the ratings. If 

an agency rates a corporation's debt triple-A but the debt trades like 

single-A in the market, the agency will have an incentive to reevaluate 

the risk of the firm and revise its rating. Conversely, if the corporation's debt is rated single-A but trades like triple-A, the firm will have 

an incentive to provide information to the rating agency to justify a 

higher rating. Because GSE obligations would continue to benefit 

from an implicit federal guarantee, their market prices would not fully 

incorporate information provided by the rating agencies about changes 

in the government's exposure to default risk. The absence of the same 

degree of market discipline of the rating process could affect the rating 

agencies' performance, although they would have their reputations at 

stake. 

The institutional structure of the Farm Credit System should be 

taken into account in assessing the value of credit ratings that would 

6. See, for example, Mark I. Weinatein, 'The Effect of a Rating Change Announcement on Bond 

Rice," Journal of Financial Economics (December 1977), pp. 329-350. 

7. See, for example, Louis H. Ederington, Jess B. Yawitz, and Brian E. Roberts. The Informational 

Content of Bond Ratings (National Bureau of Economic Research Working Paper No. 1323, April 

1984). 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEe 58 

indicate the government's exposure to the risk of the system. The significant differences in risk of individual Farm Credit System institutions and districts and questions about the effectiveness of arrangements to share losses among them cast doubt on the utility of a single 

measure of the system's overall risk. 

Costs of Ratings. The dollar cost of purchasing rztings from the agencies would be small. However, the existence of two ratings of a GSE's 

obligations--one indicating the default risk to investors, and the other 

indicating the government's exposure to risk--might lead investors to 

raise somewhat the yields they required on the enterprise's securities. 

This could affect the GSE's earnings, but also might provide some additional market discipline. It is uncertain whether any possible effect of 

two ratings could be distinguished from other factors that affect GSE 

debt yields. 

Requiring the GSEs to Issue Risky Subordinated Debt 

The government could also obtain private assessments of each GSE's 

overall risk by requiring the enterprises to issue subordinated debt 

that did not carry an implicit federal guarantee and, therefore, exposed 

investors to the risk of default. Market prices of such debt would provide indicators of the government's relative exposure to each GSE and 

of changes in that exposure. Two types of obligations have been proposed: subordinated income bonds and puttable (redeemable) subordinated debt.8 Both types of securities would have a junior claim on an 

enterprise's assets and could be repaid only after other debts with a 

senior claim, including any loans by the Treasury, had been repaid. 

The obligations would differ from the subordinated debt now issued by 

some GSEs in that strict loan covenants would lead investors to expect 

to incur losses under certain clearly defined conditions. The govern8. Requiring GSEa to ieeue eubordinated income bonds in discweed in Edward L. Golding, "Regulating 

the Secondary Mortgage Market." Secondary Mortgage Markets (Federal Home Loan Mortgage 

Corporation, Fall 1990), pp. 3-6. Requiring enterprise8 to issue puttable subordinated debt han 

been propoeed in James F. Gatti and Ronald W. Spahr. The Burden of Government Sponsored 

Enterprisee: The Case of the Federal Home Loan Mortgage Corporation" (mimeograph, February 19,1991), pp. 40-41. For a similar plan for federally insured commercial banks, see Larry D. Wall, 

"A Plan for Reducing Future Deposit Insurance Logsea: Puttable Subordinated Debt," Economic 

Review (Federal Ft.efJe~e Bank of Atlanta. July/Auguet 1989). pp. 2-17. 
60 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

CREATING A NEW AGENCY TO 

SUPERVISE AND REGULATE ALL GSEs 

One general strategy for reforming federal supervision of GSEs would 

be to alter the institutional capacity and the statutory mandate and 

authority of the federal agencies that now oversee the enterprises. 

Chapters 111 through VI discuss various options that are consistent 

with this strategy. 

A very different strategy would centralize supervision of all GSEs 

in a single federal agency.10 An existing bank or thrift regulatory 

agency could assume this responsibility. Significant conflicts of interest can arise between some of the enterprises and depository institutions or their federal regulators, however. For example, agricultural 

banks compete directly with member institutions of the Farm Credit 

System. Fannie Mae, Freddie Mac, and the bank and thrift regulators 

have different views about the treatment of depository institutions' 

income from servicing mortgages sold to the GSEs for the purpose of 

determining compliance with federal capital requirements. Such conflicts strongly suggest that assigning the task of supervising the enterprises to a bank or thrift regulatory agency would be unwise. 

A more feasible option would be to establish an independent 

agency headed by a board of directors. The chairman of the board 

would be a private citizen appointed by the President and approved by 

the Senate. The Secretary of the Treasury and the Chairman of the 

Federal Reserve Board would also be voting members. The Secretaries 

of Agriculture, Education, and HUD would be nonvoting members, 

who could express their views when the board considered capital requirements and other issues that would affect borrowers in particular 

sectors. The agency would be given adequate institutional capacity 

and statutory authority to ensure the safe and sound operation of each 

GSE, and a statutory mandate to do so. It also would be given the 

authority to regulate programs that HUD now possesses with respect 

to Fannie Mae and Freddie Mac, and that the FHFB has over the 

FHLBs. One division of the agency would examine and supervise the 

10. A centralized supervisor of all GSEs was first proposed in Ronald C. Moe and Thomas H. Stanton. 

"GovernmentSpomored Enterprises as ~ederal Instrumentalities: Reconciling Private ~ana& 

ment with Public Accountability," Public Administratton Revrew (JulylAupat 1989). pp. 321-329. 
CHAPTER n FEDERAL SUPERVISION AND REGULATION OF GSEe 61 

Farm Credit System, since FCS member institutions are primary 

lenders. Another division would handle Farmer Mac and the other 

GSEs that engage in secondary market operations. The FCA and the 

FHFB would become part of the new agency, and HUD would no longer 

have a direct role in supervising Fannie Mae and Freddie Mac. 

Two principal arguments can be made for creating such an agency. 

First, the agency would have greater responsibility, would be accountable to a broader range of interests, and could be more visible than are 

the existing agencies that oversee GSEs--HUD, the FCA, and the 

FHFB--at least in their supervisory capacities. The voting members of 

the new agency's board would be primarily responsible for protecting 

the interests of the general taxpayer, who arguably is most interested 

in preventing any particular GSE from imposing losses on the government. The board would also be ultimately accountable for losses 

that any of the five GSEs actually imposed on the government in the 

future. The breadth of its mandate could make its activities more 

visible than those of the separate agencies that now are responsible for 

one or two GSEs. In combination, these factors would minimize the 

possibility that one or a pair of the enterprises could dominate the decisions of, or capture, the agency's board. 

Second, there are some similarities in the activities of the GSEs 

that provide support to lenders--Farmer Mac, Fannie Mae, Freddie 

Mac, the FHLBs, and Sallie Mae. Centralizing responsibility for examining and supervising these enterprises in a single agency would 

eliminate some duplication of personnel and other resources. 

The principal argument against this option is that a single agency 

might not be able to develop sufficient expertise in housing, higher 

education, and agriculture to supervise all the GSEs effectively at the 

same time. The agency might also focus principally on the three largest enterprises--Fannie Mae, Freddie Mac, and the FHLB system-- 

which serve the housing finance system, and not become sufficiently 

familiar with lending to agriculture and students. A failure to develop 

adequate expertise could lead the agency to adopt a standardized approach to monitoring and establishing capital requirements that would 

fail to account adequately for the differences among the G-SEs. Merging the FCA into a centralized agency would give it significant ex- 
62 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

pertise in agricultural finance, however. The agency could also be required to streamline the supervisory process for GSEs that it determined exposed the government to a sufficiently low amount of risk, in 

order to minimize their regulatory burden. The Congress could also 

limit the supervisory agency's discretion in setting capital standards, 

as discussed below. 

The objection may also be raised that the new agency's board 

would not be sufficiently independent, since the Secretary of the Treasury could seek to represent the policy objectives of the Administration 

in ofice, rather than the interests of the general taxpayer. This risk 

could be addressed by having the board consist solely of private citizens 

appointed by the President, with the consent of the Senate. 

ISSUES IN SETTING FEDERAL CAPITAL 

REQUIREMENTS FOR GSEs 

The Congress could improve federal supervision of the GSEs' safety 

and soundness by imposing new capital requirements on one or more of 

the enterprises, or by revising the processes by which federal agencies 

responsible for supervising their safety and soundness set capital requirements for the GSEs. At present, three GSEs have federal capital 

standards. The FCA is phasing in minimum risk-based capital requirements for Farm Credit System institutions that are similar to the 

risk-based standards imposed on federally insured banks. The Federal 

Home Loan Bank Act and FHFB regulations impose capital standards 

on the FHLB system as a whole. The charters of Fannie Mae and 

Freddie Mac set a ceiling on the ratio between the assets that each 

GSE holds in portfolio and its regulatory capital, which includes subordinated debt and reserves to cover loan losses. Because these restrictions ignore each enterprise's mortgage-backed securities, the government cannot use them to control the two GSEs' exposure to risk. 

A principal purpose of a federal capital requirement for a GSE is to 

give management an incentive to limit risk to the minimum necessary 

to achieve the enterprise's public purposes. To accomplish this objective, a capital requirement must have three attributes. First, the requirement must be based on risk. The enterprise must know that the 
CHAPTER n FEDERAL SUPERVISION AND REGULATION OF GSEB 6s 

government will require it to increase (decrease) its capital if it increases (decreases) the riskiness of its operations. A capital standard ' 

for a GSE that was not risk-based would not enable the government to 

control its exposure to risk as effectively as a risk-based one. Unless 

competition from fully private firms was strong, the enterprise might 

be able to pass on the cost of complying with a standard that was not 

related to risks in its prices and thus maintain its rate of return on 

equity, leaving its owners with no additional incentive to limit risk 

taking. Second, a risk-based capital requirement must reflect all three 

elements of a GSE's overall risk: credit risk, interest rate risk, and 

management and operations risk. Third, a standard must enable the 

supervisory agency to tell the enterprise in advance the amount of 

capital that new business will require, so that the GSE can set prices 

and decide whether to pursue investment opportunities in a businesslike manner. 

If the Congress decided to impose new capital requirements for 

GSEs or revise existing ones, questions would arise about the appropriateness of statutory minimum capital standards, whether and how the 

Congress should limit supervisory discretion in setting risk-based capital requirements, the treatment of management and operations risks 

in setting risk-based standards, whether and how to set comparable requirements for the three housing GSEs, and the economic effects of 

requiring GSEs to maintain higher capital than they would maintain 

on their own. The remainder of this section analyzes these issues. 

Establishing Statutory Minimum Capital Standards 

The Congress could set a statutory minimum capital requirement for 

each GSE equal to a flat percentage of all assets financed by the enterprise. Like the 3 percent minimum requirement for banks and thrifts, 

a minimum standard would not vary with risk. Thus, it would not 

create the incentives to.manage risk prudently that a welldesigned, 

risk-based standard could provide. Instead, its purpose would be to 

erect a floor under any risk-based capital requirement for the GSE. 

Under current law, the FHLB system is subject to a minimum capital 

requirement. The system must maintain capital equal to at least 8+ 

percent of its outstanding consolidated obligations. 
64 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

A statutory minimum capital requirement would protect the 

government against a GSE's exposure to management and operations 

risks, which cannot be measured with precision, and against errors in 

supervisory judgment in setting risk-based capital requirements. For 

GSEs that are exposed to significant interest rate risk or that issue a 

substantial amount of financial guarantees, it would be most useful to 

express a minimum requirement in terms of mark-to-market net worth 

and the market values of all assets financed. The Congress could delegate to the supervisory agency the responsibility for defining appropriate standards for determining a GSE's mark-to-market net worth. 

The principal objection to setting in statute a minimum capital 

standard for a GSE is that the supervisory agency might be unable to 

impose a higher risk-based capital requirement if it believed doing so 

was necessary to protect the government. This problem could be 

avoided by delegating the choice of the specific amount to the agency. 

Mandating a period for public comment on proposed regulations would 

offer protection against the risk that the agency would set an excessively high minimum standard. 

Limiting Supervisory Discretion in Setting Risk-Based Requirements 

If the Congress gave a supervisory agency the authority to set a riskbased capital requirement for a GSE, it might want to limit the agency's ability to set a standard that was excessive. One option would be 

to allow the enterprise to reach a "safe harbor" if two credit-rating 

agencies gave it an acceptably high rating that indicated the government's exposure to the risk of a default. Under this approach, the crucial judgment would be the choice of a minimum rating. 

Moody's Investors Service has investigated the default rates of 

corporate bonds with different credit ratings. Table 4 displays the 

average 10-year cumulative default rates of issuers rated by Moody's 

that had bonds outstanding in the 1970-1981 period. The rates are the 

average percentages of issuers in each rating category on January 1 of 

those years that defaulted in the next 10 years. The data indicate that 

the risk of default is significantly lower for investment-grade bonds 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEs 65 

TABLE 4. AVERAGE 10-YEAR CUMULATIVE DEFAULT 

RATES FOR CORPORATE BONDS RATED BY 

MOODY'S INVESTORS SERVICE, BY RATING 

CATEGORY (In percent) 

Rating 

Bonds Rated by 

Moody's and 

Issued 1970-1981a 

Investment Grade 

Aaa 

Aa 

A 

Baa 

Noninvestment Grade 

SOURCE: Congressional Budget Oftice based on Moody's Investors Service, Corporate Bond Defaults 

and Default Rates, 1970-1 990 (New York: Moody's Investors Service, January 1991). 

a. Default rates are the percentages of issuers in each rating category on January 1 of a year that 

defaulted during the next 10 years. 

than for noninvestment-grade debt. As the ratings of investmentgrade bonds improve, the most significant reduction in risk occurs 

between triple-B (which Moody's terms Baa) and single-A.11 

Using credit ratings to create a "safe harbor" from federal capital 

requirements would make it difficult for the supervisory agency to tell 

an enterprise in advance the amount of capital that a new line of business is likely to require. As discussed above, the information value of 

ratings that indicate the government's exposure to a GSE's risk is 

somewhat limited. It would be appropriate, therefore, to require thorough federal examinations of the enterprise to assure that its exposure 

to management and operations risk was low. Additional protection 

11. Research on corporate bonds rated by Standard & Poor's and issued in 1971 through 1987 has found 

similar average 10-year cumulative default rates. See Edward I. Altman, "Measuring Corpbrate 

Bond Mortality and Performance," The Journal of Finance, vol. 44, no. 4 (September 19891, pp. 

909-922. 
66 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

could be obtained by establishing triple-A or, perhaps, double-A as the 

minimum rating that would be acceptable. 

Alternatively, the Congress could outline in general terms one or 

more stress tests that a supervisory agency would use to assess a GSE's 

exposure to credit risk or interest rate risk, and indicate how long the 

enterprise would be required to survive each test. Chapter IV discusses in detail the advantages and disadvantages of taking this approach to limiting HUD's discretion in setting a risk-based capital 

standard for Fannie Mae and Freddie Mac. These arguments apply to 

the other GSEs as well. 

Including Management and Operations Risks 

in a Risk-Based Capital Standard 

Deciding how much capital to require to protect the government 

against a GSE's exposure to management and operations risks is a difficult judgment call. One option, discussed above, is to establish a statutory minimum capital requirement for the enterprise. Another option is to include a component for management and operations risks in 

a risk-based capital requirement. 

One approach would be to allow a supervisory agency to require 

capital equal to a specific percentage of all the assets financed by a 

GSE. Giving the agency this flexibility would recognize that the assumptions of any stress tests, particularly about how the enterprise 

would behave, are uncertain. It also would recognize that the GSE's 

management and operating systems could deteriorate enough to cause 

financial losses to accumulate without showing up on its balance sheet 

as a decline in capital. But the agency could set a management and 

operations risk component that was quite high, thereby imposing a 

significant additional cost on a GSE that performed well on stress 

tests. One way to mitigate this cost would be to allow the enterprise to 

comply with this portion of the capital standard by issuing subordinated debt that exposed investors to risk. If interest payments on the 

debt were tax deductible, issuing it would be cheaper than raising 

capital by issuing stock. 
CHAPTER I1 FEDERAL SUPERVISION AND REGULATION OF GSEe 67 

Another approach would be to set a ceiling on the amount of capital that a supervisory agency could require a GSE to maintain to protect the government against its exposure to management and operations risk. This option could force the agency to monitor and examine 

the enterprise much more closely, which could impose significant costs 

on the GSE. Also, the agency would have to rely on enforcement powers to require changes in the management and in the operating systems of an enterprise that it found to be deficient. It is not clear that 

these tools could be used to protect the government more or less effectively than could the flexibility for an agency to use its best judgment 

in setting the management and operations component of a capital requirement. 

Establishing Comparable Capital 

Standards for the Housing GSEs 

As discussed in Chapters IV and V, Fannie Mae and Freddie Mac hold 

much less capital than the FHLB system, even though the system has 

lower exposure to risk than the other two. This difference means that 

FHLB advances provide a smaller implicit federal subsidy to lenders 

that borrow from the system than do Fannie Mae and Freddie Mac's 

purchases of the mortgages they are eligible to buy. This is one factor 

contributing to the ability of the latter two GSEs to dominate the market for conventional mortgages, particularly fixed-rate loans. Other 

important factors include their economies of scale and other operating 

efficiencies, the inefficiencies of some depository institutions, and the 

federal capital requirements for depository institutions, which since 

1989 have favored the securitization of home mortgages. 

Setting comparable federal capital requirements for these three 

GSEs would eliminate the disparity in the implicit federal support that 

each provides to the lenders they serve. It would increase the profitability of thrifts and other lenders that use FHLB advances and would 

be a step toward enabling them to compete on an equal footing with 

Fannie Mae and Freddie Mac in the market for financing conventional mortgages. 
68 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

The government could set comparable capital standards for the 

three GSEs by imposing a uniform minimum requirement, or by requiring them to have enough capital to pass the same credit and interest rate stress tests and to maintain comparable amounts of capital 

to cover their exposure to management and operations risks. Making 

the capital standards comparable could involve lowering the capitalization of the FHLB system, raising the capitalization of Fannie 

Mae or Freddie Mac, or both. A choice about the appropriate level of 

capitalization would be a judgment about the relative risks and benefits of these GSEs. Of course, even if comparable standards were imposed, the enterprises could end up with different amounts of capital as 

a percentage of assets, since their exposure to credit risk and interest 

rate risk differs (as may their exposure to management and operations 

risks). 

Economic Effects of Federal Capital Requirements 

If government capital standards required a GSE to maintain more 

capital than it would maintain on its own, the enterprise could respond 

by limiting the financing of loans it accepted, by raising the prices or 

fees it charged, or by accepting lower returns on equity. If the GSE's 

ability to raise its prices were limited by competition from wholly 

private financial institutions or another GSE, it would lose market 

share to them, which would limit the benefits the enterprise provides 

to the borrowers and lenders it serves. But higher capital standards 

would also reduce the government's exposure to risk. 
CHAPTER I11 

FARM CREDIT SYSTEM 

The Farm Credit System (FCS) is a specialized lender for the agricultural sector. The system differs from other GSEs in three important respects. First, while the other enterprises maintain secondary loan 

markets or serve other financial institutions, the FCS primarily makes 

loans directly to individual borrowers. Second, the FCS is the only 

GSE that is supervised by an agency with powers similar to those of 

the federal bank regulators, is subject to minimum risk-based capital 

standards, and finances a federal insurance fund. Finally, the FCS is 

more dependent on the financial well-being of a single sector of the 

economy than are the other GSEs. 

When agriculture experienced a serious downturn in the mid1980s, the FCS suffered considerable losses. The Congress responded 

to the FCS's losses by authorizing up to $4 billion in financial assistance, requiring extensive changes in the structure of the system, and 

changing the authority of its supervisor, the Farm Credit Administration (FCA). Some of these changes are just beginning to be put in 

place. The substantial recent changes in the structure of the FCS 

make it difficult to provide a definitive assessment of the risk inherent 

in the system. 

The analysis in this chapter will show that the system is in much 

better financial shape today than it was three or four years ago but 

that portions of the system remain extremely vulnerable to an economic downturn in agriculture. Further, its single-sector orientation 

and the statutory restrictions on its activities make the FCS a greater 

risk to the government than the other GSEs--even though it has fewer 

assets than all but the Student Loan Marketing Association (Sallie 

Mae). 
70 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

THE FARM CREDIT SYSTEM IN THE 

AGRICULTURAL FINANCE SYSTEM 

The Congress created the FCS to improve the supply of credit to 

agriculture. The system has evolved over time to reflect the changing 

needs of agriculture. 

Public Purposes and Activities of the FCS 

The FCS is a multitiered, federated cooperative with about 275 member institutions organized in 12 districts that cover every state and 

Puerto Rico.1 Like all cooperatives, the FCS is owned by its members. 

The objectives of the FCS have been to improve farmers' and ranchers' 

access to credit markets, to increase farmers' control over their credit 

supplies, and to provide a competitive yardstick against which commercial agricultural lenders can be measured. 

The FCS is the largest lender in agricultural real estate. In addition, the system provides production credit for farmers, finances 

rural housing, and is a major source of credit for agriculturally oriented cooperatives. The FCS has recently been granted authority to 

provide credit to rural municipalities for the construction of sewer and 

water facilities. 

Historical Development and Performance 

The Farm Credit System has evolved over its nearly 75-year history 

from focusing mainly on farm real estate lending to providing credit for 

a wide variety of agricultural and agriculturally related needs (see Box 

5 on pages 72 and 73). Loans made by the system increased dramatically after World War 11, but the returns it earned in those years were 

relatively low. 

1. A federated cooperative is one in which the members are other cooperatives. For example, in the 

FCS the Farm Credit Banks are owned by the FCS's local-level cooperative associations. 
CHAPTER n~ FARM CREDIT SYSTEM 71 

Historical Development. The initial components of the system were 

created between 1916 and 1933. The Federal Land Banks (FLBs) were 

chartered in 1916 to correct a lack of credit markets serving farmers, 

and to encourage the development of agriculture in the United States. 

The Congress created 12 district FLBs to finance long-term real estate 

loans to agriculture. These loans were originated and serviced at the 

local level by Federal Land Bank Associations. After 1923, each of the 

12 districts also had a Federal Intermediate Credit Bank (FICB). The 

FICBs were initially designed to be intermediaries between commercial banks wishing to make farm production loans (for the purchase of 

nonland inputs such as seeds, fertilizer, or machinery) and national 

Figure 1. 

Lending by the Farm Credit System, 1945-1988 

SOURCE: Congressional Budget Office using data from the Farm Credit System. 

NOTE: Excludes lending by the Banks for Cooperatives. 
72 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

BOX 5 

Current Organizational Structure 

and Ownership of the Farm Credit System 

The Farm Credit System is a multitiered, federated cooperative that is 

national in scope. The current institutional structure of the FCS is quite 

complex, with a greater variety of types of institutions within the individual 

districts than before 1987, and the potential exists for substantial further 

changes. 

The FCS now has 262 associations. These fall into four different types, 

each with a different set of authorities. The type with the most comprehensive authority is the Agricultural Credit Association, which can make 

and hold both production loans and land acquisition loans. Federal Land 

Credit Associations are authorized to make and hold farm real estate loans. 

Production Credit Associations are limited to making and holding short- and 

intermediate-term loans for the acquisition of production inputs such as 

seeds, chemicals, or machinery. Finally, Federal Land Bank Associations 

make and service real estate loans that are ultimately shown on the balance 

sheet of a Farm Credit Bank. 

At the district level, 11 districts have a Farm Credit Bank (FCB). FCBs 

were formed from the merger of district Federal Land Banks and Federal 

Intermediate Credit Banks. The Jackson district still has a Federal Intermediate Credit Bank because the Federal Land Bank in that district was 

placed into receivership in 1988. The St. Paul and Sprin$ield districts each 

have a Bank for Cooperatives, holdovers from the pre-1987 era when each 

district had a Bank for Cooperatives. The National Bank for Cooperatives 

(CoBank), formed in 1989, is the result of merging the other 10 district 

Banks for Cooperatives and the Central Bank for Cooperatives. CoBank and 

the two remaining Banks for Cooperatives have authority to lend nationwide. 

At the national level, the system has a number of specialized institutions. The Farm Credit Leasing Services Corporation provides leasing services to producers and to agricultural and other rural cooperatives. The 

Farm Credit System Financial Assistance Corporation (FAC) sells bonds 

guaranteed by the federal government that are used to assist financially 

strapped system institutions. Authorization to sell these bonds is given by 

the Financial Assistance Board, which is a federal agency, and is predicated 

on acceptance by the board of a financial recovery plan for the affected 

institution. The board will cease to exist at the end of 1992. The FCS is 

responsible for repayment of all FAC bonds, as well as Treasury payments of 

interest on the debt or to cover any defaults. 
CHAPTER III FARM CREDIT SYSTEM 73 

BOX 5 

The FCS raises its funds not from deposits (as a commercial bank 

would) but from bond and note sales on national capital markets. The 

system has a single seller of debt securities, the Federal Farm Credit Banks 

Funding Corporation, headquartered near New York City. Securities issued 

by the FCS are the joint and several liabilities of the district banks and 

Banks for Cooperatives. This means that should a bank be unable to meet 

its obligations to its bondholders, all other banks in the system are jointly 

and severally liable for the bonds in question. 

Finally, the Federal Agricultural Mortgage Corporation, commonly 

known as Farmer Mac, is nominally part of the FCS. While Farmer Mac is 

regulated by the system's supervisor, the Farm Credit Administration, it is 

covered neither by joint and several liability nor by the system's federal insurance fund. 

Farm Credit System Organization 

(System Regulator--Farm Credit Administration) 

Local District National 

Federal Land 

Bank Associations 

Production Credit 

Associations 

Federal Land Credit 

Associations 

Agricultural Credit 

Associations 

Farm Credit Banks 

Spring5eld 

Baltimore 

Columbia 

Louisville 

St. Louis 

St. Paul 

Omaha 

Wichita 

Texas 

Western 

Spokane 

Banks for Cooperatives 

CoBank 

St. Paul 

Springfield 

Federal Farm Credit 

Banks Funding 

Corporation 

Farm Credit Leasing 

Services Corporation 

Federal Intermediate 

Credit Bank- Jackson Farm Credit System 

Financial Assistance 

Corporation 

Federal Agricultural 

Mortgage Corporation 
74 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

capital markets. By 1933 this arrangement was judged a failure, and 

Production Credit Associations (PCAs) were created to provide the 

FCS with local offices through which to make production loans. The 

Banks for Cooperatives (BCs) were also created in 1933. BCs, as the 

name suggests, make loans to agricultural cooperatives, as well as rural utilities and other eligible entities. 

Historical Performance. As Figure 1 on page 71 indicates, the growth 

in outstanding loans held by the FCS has been quite dramatic since 

1945. Loans outstanding in 1945 at the FICBs, PCAs, and FLBs 

totaled slightly more than $1.3 billion. The FLBs accounted for more 

than $1.1 billion of the total. By 1990, gross loan volume, excluding 

loans made by the BCs, was $41.4 billion. At its peak in 1982, the FCS 

(less the BCs) had $64.5 billion in loans outstanding to farmers. 

The growth in lending by the FCS was only slightly greater than 

the growth in total debt held by farmers. In nominal terms, farm debt 

held by the FCS was about 27 times greater in 1988 than in 1945, 

while total farm debt had increased slightly less than 21 times over the 

same period. Because total indebtedness by farmers has increased 

dramatically since World War 11, the market share of the FCS has not 

increased as dramatically as has loan volume. As shown in Figure 2, 

the FCS's market share grew from a low point in the early 1950s of 

about 12 percent of total farm lending to a peak of 34 percent in 1982, 

and declined to 26.6 percent by 1988. 

The financial health of the FCS, as measured by returns on assets, 

is depicted in Figure 3. Return on assets is defined as pretax income 

divided by total assets. Over the period 1960 to 1983, the return on 

assets for each of the main portions of the system--Federal Land 

Banks, Federal Intermediate Credit Banks, the Banks for Cooperatives and the Central Cooperative Bank, and the Production Credit 

Associations--was consistently positive but relatively low. The return 

on assets averaged about 0.5 percent for the FLBs, about 0.7 percent 

for the FICBs, about 0.8 percent for the PCAs, and about 1.4 percent 
CHAPTER 111 FARM CREDIT SYSTEM 76 

Figure 2. 

Market Share of the Farm Credit System, 1945-1988 

SOURCE: Congressional Budget Office using data from the Farm Credit System. 

for the BCs. As a cooperative, the FCS has objectives other than maximizing returns on assets. 

Causes of the System's Decline in the 1980s 

After many decades of profitability, the financial condition of the FCS 

deteriorated sharply in the 1980s. The system lost $4.6 billion in 1985 

through 1987. Several external and internal factors combined to cause 

this dramatic reversal of fortune.2 

2. The FCS was not the only agricultural lender that suffered financial setbacke during the 1980s. 

Commercial banks, insurance companies, and the Farmers Home Administration also experienced 

sharp decreaees in income from agricultural lending and, subsequently. increases in loan write-offs. 
76 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

A key external factor was the relatively deep recession of 1982 and 

1983, caused in part by an unanticipated move by the Federal Reserve 

to a deflationary monetary policy. At the same time, the value of the 

dollar increased quite dramatically. Slower rates of worldwide economic growth, coupled with the higher-valued dollar, resulted in lower 

agricultural exports from the United States. Because the FCS lends 

primarily to agriculture, its financial performance depends on that sector's economic health. 

Figure 3. 

Return on Assets of the Major Components 

of the Farm Credit System, 1960-1983 

Percent 

3.0 

2.5 

2.0 

1.5 

1 .o 

0.5 

V 

-0.5 

1960 1965 1970 1975 1980 1985 

FlCBs 

and CBC 

- 

SOURCE: Congressional Budget Office using data from the Farm Credit Administration. 

NOTE: FLBs = Federal Land Banks; FlCBs = Federal Intermediate Credit Banks; PCAs = Production 

Credit Associations; BCs = Banksfor Cooperatives; CBC = Central Bank for Cooperatives. 
CHAPTER 111 FARM CREDIT SYSTEM 77 

These external factors would not, by themselves, have been expected to result in the magnitude of losses experienced by the FCS in 

the mid-1980s. Several FCS policies contributed significantly to this 

outcome. Like most agricultural lenders at that time, the FCS, exclusive of the BCs, practiced asset-based lending, at least in a de facto 

sense. Asset-based lending means that real estate loans were based 

more on the current or expected value of the asset backing the loan-- 

land--than on the expected income-generating potential of that asset. 

Because agricultural land values had increased almost without interruption since World War 11, and because land was seen as a good hedge 

against inflation, it was felt that asset-based lending posed very little 

risk to the lender. As noted, the FCS was not alone in practicing assetbased lending. However, because it was the dominant lender in the 

agricultural real estate market, the FCS had the greatest exposure 

when that market went into a tailspin. 

The internal factor that probably contributed most to the financial 

woes of the FCS in the mid-1980s was the system's practice of basing 

interest rates on the average cost of funds. It was felt that this practice 

posed little risk, since few of the system's loans had fixed interest rates. 

When the cost of funds is rising, average-cost pricing conveys a price 

advantage over competitors who base their loan rates on the current 

rates they have to pay for funds. During the late 1970s and early 

1980s, the FCS's practice of average-cost pricing gave it a pricing advantage over other agricultural lenders, and its portfolio grew quite 

rapidly. Interest rates were extremely high during this period, and the 

FCS made the mistake of issuing a substantial amount of long-term 

debt to finance its burgeoning portfolio. Once issued, most system 

bonds are not callable. Noncallable bonds generally pay lower interest 

rates than comparable callable bonds because the seller of noncallable 

bonds does not have the discretion of simply paying off any remaining 

indebtedness and retiring a bond issue. 

In contrast, during periods of falling interest rates, average-cost 

pricing means that loan rates are higher than those available from 

lenders using marginal cost pricing. When interest rates fell in the 

1980s, the system's use of average-cost pricing, combined with the significant mismatch between the maturities of its assets and liablities, 

meant that loans from the FCS carried rates that were often con- 
78 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

siderably higher than those offered by its competitors. This interest 

rate differential led many borrowers to pay down their debt or refinance it through other lenders. When debt was paid down or refinanced, the system was left with a good deal of long-term, high-cost, 

noncallable bonds on which it had to pay interest, and a weakened demand for loans, which competitors could make at lower rates. 

Legislative Responses to the System's Financial Problems 

The Congress passed legislation addressing the problems of the FCS in 

1985, 1986, and 1987. The 1985 legislation eliminated the FCA's 

ability to determine the system's operating policies, transforming it 

into an arm's-length supervisor of the safety and soundness of the FCS. 

The 1985 act also attempted to formalize loss-sharing agreements between FCS districts and required all FCS institutions to have an annual outside audit. In 1986, the system was given authority to use alternative accounting rules to forestall recognition of losses. By 1987, it 

was apparent that those legislative attempts to fix the problems of the 

FCS were going to be inadequate. The Agricultural Credit Act of 1987 

made more extensive changes. It reformed the structure of the system, 

created the Farm Credit System Financial Assistance Corporation, 

established an instirance fund for the FCS, endorsed the practice of 

charging differential interest rates, and required the FCA to set and 

enforce minimum capital standards. The law also established the 

Federal Agricultural Mortgage Corporation to guarantee securities 

backed by agricultural mortgages and to create a secondary market for 

such securities. Each of these changes is discussed below. 

System Consolidation. The 1987 act changed the institutional structure of the FCS by: 

o Creating the Farm Credit Banks (FCBs) by merging the Federal Land Bank and Federal Intermediate Credit Bank in 

each district. There are now 11 FCBs.3 

3. The Federal Land Bank in the Jackeon district was placed in receivership in 1988. Authority to 

make real eatate loans in the Jackson dietrict has been transferred to the Texas Farm Credit Bank. 
CHAPTER I11 FARM CREDIT SYSTEM 79 

o Permitting the merger of Production Credit Associations and 

Federal Land Bank Associations at the local level. These 

merged institutions, called Agricultural Credit Associations 

(ACAs), have direct lending authority and offer their members both short-term and long-term loans. 

o Permitting the conversion of Federal Land Bank Associations to Federal Land Credit Associations, which have direct 

lending authority for real estate loans only. 

o Permitting the Central Bank for Cooperatives and the 12 district Banks for Cooperatives to merge. All but two of the district BCs joined with the Central Bank for Cooperatives to 

form CoBank. The BCs in the St. Paul and Springfield districts have retained their individual identities. All three 

BCs have authority to lend anywhere in the nation. 

o Suggesting that 12 district banks were no longer needed and 

that the system should examine the feasibility of reducing 

the number of districts from 12 to no fewer than 6. While a 

number of mergers have been discussed, none has yet taken 

place. 

The FCS Financial Assistance Corporation and Board. In order to 

provide the assistance needed to ensure the survival of the FCS, the 

1987 act created the Farm Credit System Financial Assistance Corporation (FAC). The Farm Credit System Financial Assistance Board 

(FAB), which holds authority over the sale of FAC bonds, is a federal 

agency. The board consists of the Secretaries of Agriculture and the 

Treasury and a representative of the agricultural sector. The FAC is 

authorized to issue up to $4 billion of 15-year bonds for assistance to 

FCS institutions--the interest and principal being guaranteed by the 

government. To qualify, an institution applying for assistance must 

submit a recovery plan that is approved by the board. The FAB 

authorizes the FAC to issue bonds and to use the proceeds to purchase 

preferred stock in the assisted institutions. Once bonds are issued, the 

federal government pays all interest for the first five years, half of the 

interest in years six through ten, and none thereafter. The FCS is 

responsible for the remaining interest, for the principal amount when 
80 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

due, and for the eventual repayment of interest previously paid by the 

government. To date, $1.3 billion of FAC bonds have been sold, $0.4 

billion to pay back capital preservation agreements executed among 

system institutions before 1987 (the FCS is responsible for all interest 

on this portion of the debt). Current CBO projections indicate that 

total sales should be less than $2.5 billion by the time FAC's bondissuing authority expires at the end of fiscal year 1992. Analysis suggests that some districts may have difficulty repaying their obligations 

to FAC. 

The FCS Insurance Corporation. The 1987 act created an insurance 

fund for the system, which is managed by the Farm Credit System 

Insurance Corporation. The board of the Insurance Corporation comprises the members of the FCA board, and is chaired by a member 

other than the FCA board's chairman. The act established a target 

minimum balance for the fund, known as the secure base amount, 

equal to 2 percent of total outstanding system liabilities or whatever 

amount the Insurance Corporation might deem necessary to ensure the 

actuarial soundness of the fund. Until the secure base amount is 

reached, premiums are to be calculated as a function of the volume of 

accruing loans (loans on which payments are expected to be made in 

full and on time) and nonaccruing loans (loans on which payments are 

not expected to be made in accordance with the contract terms) on the 

books of member institutions. The 1987 act called for premium payments to begin in 1990 based on the volume of accruing loans at the 

close of 1989 and, starting in 1991, on the basis of both accruing and 

nonaccruing loans at the close of 1990. Nonaccruing loans have a higher premium rate than accruing loans. Because the Insurance Corporation is a federal agency, the insurance fund is an on-budget account 

and its assets are federal funds. As of the end of 1990, $438 million had 

accrued in the fund. After 1992, the money in the insurance fund will 

be available to assure the timely repayment of principal and interest 

owed to investors in FCS securities.4 

4. The accounting treatment of the insurance fund has generated controversy between the eystem, 

which currently treats it as a restricted asset on its combined financial statement, and the Farm 

Credit Administration, which does not believe it should be considered an asset since the system 

does not have control over it. 
CHAPTER ~n FARM CREDIT SYSTEM 81 

Differential Interest Rates. Until the 1987 act, most FCS institutions 

had one rate of interest for each type of loan. A beginning farmer and a 

farmer who had been an active member of the FCS for 20 years without 

any delinquencies paid the same rate of interest on their loans. To be 

sure, the amount the FCS would be willing to lend to these two hypothetical borrowers might well differ. The 1987 act endorsed the practice of differential pricing based on the riskiness of lending to different 

borrowers but required the FCS, upon request, to justify the rates 

charged. Currently, most districts and associations practice differential pricing. 

Additional Responsibilities for the Farm Credit Administration. The 

1987 act completed the transformation of the FCA into a full-fledged, 

arm's-length supervisor of the safety and soundness of the system. The 

act also required the FCA to set interim and final minimum capital 

requirements for each institution in the FCS. The FCA set the minimum permanent capital standard at 7 percent of the amount of riskadjusted assets, but the FCA may require a given institution to maintain a greater percentage. Because of their central importance to the 

ability of the FCS to withstand cyclical downturns in the farm economy, capital standards will be discussed in a subsequent section. 

The Federal Amicultural Mortgage Corporation. The Federal Agricultural Mortgage Corporation (Farmer Mac) is part of the FCS, but it 

does not participate in the joint and several liability of other institutions for the system's consolidated obligations. This means that if 

Farmer Mac gets into financial trouble, the other components of the 

FCS have no liability to its creditors, and vice versa. Farmer Mac is 

also not covered by the insurance fund. The purpose of Farmer Mac is 

to increase the access of agricultural lenders to national capital markets. Loans for agricultural real estate and rural housing that satisfy 

the underwriting standards established for Farmer Mac are collected 

by institutions called poolers, which issue securities backed by the 

loans. Farmer Mac provides a guarantee of securities representing no 

more than 90 percent of the principal balance of the loans in the pool. 

In most cases, the poolers, or the institutions originating the loans, will 

have to keep the 10 percent of the securities backed by the pool that are 

not guaranteed (and are subordinated) or establish a reserve equal to 
82 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 5. CONSOLIDATED BALANCE SHEETS AND INCOME 

STATEMENTS FOR THE BANKS AND ASSOCIATIONS 

OF THE FARM CREDIT SYSTEM, BY DISTRICT, 

YEAR-END 1990 (In millions of dollars) 

Farm Credit Banks and Related Associations 

Springfield Baltimore Columbia Louisville St. Louis St. Paul Omaha 

Balance Sheet 

Assets 

Accruing Loansa 1.696 3,113 3,986 3,512 3,226 5,418 3.518 

Nonaccruing Loans 23 39 182 132 244 473 237 

Other Assetsb ' 444 563 1,287 415 564 1,270 694 

Less Loan Loss 

Reserves -40 -37 -155 -74 -117 -240 -213 

Total 2,122 3.677 5,301 3,985 3,917 6,920 4,237 

Liabilities and Capital 

System Liabilities 1,882 3,221 4,510 3,440 3,417 6,219 3,764 

Capital at Risk 

Retained earninge 164 337 601 309 340 252 199 

At-risk stock 76 111 37 223 21 259 117 

Subtotal 240 448 638 532 361 511 316 

Protected Stock 0 9 152 12 138 190 157 

Total 2,122 3,677 5,301 3,985 3,917 6,920 4,237 

Income Statement 

Net Intereet Margin 51 79 147 127 101 138 95 

Other Incomec 7 5 18 11 11 29 6 

Operating Expenses -44 -60 -74 -69 -67 - 94 -46 

Insurance Payments -3 -5 -6 -6 -5 -9 -6 

Provisions for Loan 

Losses -3 -1 -6 30 3 26 -0 

Net Income 8 17 79 94 43 90 49 ...................................................................... (Continued) 

SOURCE: Congreseional Budget Ofice ueing data from the Farm Credit Administration. 

NOTES: Repreeenta only data for the banka and aseociatione in the system. Certain transactions 

associated with the Jackson Federal Land Bank in receivership, the Financial Aseietance 

Corporation. and the Insurance Corporation are not included. If these transactions were included, the system's net income would be $608 million, es reported in the FCS'e Annual 

Information Statement-1990. 

FICB = Federal Intermediate Credit Bank. 
CHAPTER I11 FARM CREDIT SYSTEM 83 

TABLE 5. Continued 

Farm Credit Banke Banbs for Cooperatives 

Jackson System 

Wichita Texas Western Spokane FICB CoBank Springiield St. Paul Total 

Balance Sheet 

Assets 

Liabilities and Capital 

Income Statement 

a. Includes accrued intereet receivable. 

b. Includes caeh. inveatmenta, and other nonearning asseta such as buildings owned by the Farm Credit 

System. 

c. Includes fees for services and other miscellaneoue adjustments. 

d. Less than $500,000. 
84 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

10 percent of the value of the pool.5 The guaranteed securities may be 

sold to investors in national capital markets. Farmer Mac was also 

recently authorized to issue and guarantee securities backed by the 

guaranteed portions of loans guaranteed by the Farmers Home Administration (FmHA). Farmer Mac issued its first guaranteed securities backed by FmHA-guaranteed loans in early April 1991. 

Recent Performance and Outlook 

Since 1987 the system has returned to profitability, earning $704 million in 1988, $695 million in 1989, and $553 million during 1990.6 

Moreover, the source of earnings has changed during the past three 

years. In 1988, negative loan loss provisions accounted for virtually all 

of the system's net income.7 In other words, the system earned almost 

nothing from current operations in 1988. Negative loan loss provisions 

imply that net income in the pre-1988 period was somewhat better 

than reported and that net income in 1988 was somewhat overstated. 

The system has continued to post negative loan loss provisions, but the 

magnitude of these reversals and their share of net income have fallen 

considerably. In 1989, negative loan loss provisions equaled 41 percent 

of net income as reported by the FCS, but in 1990 they accounted for 

only about 4 percent of net income. 

There are several reasons for the improved performance of the 

FCS. The most important, of course, is that the general farm economy 

has been much healthier during the past three years than during the 

1985-1987 period. This means that borrowers are better able to service 

their debt, the amount of nonaccruing loans has fallen, and the FCS 

has been able to lower its loan loss reserves. Second, interest expenses 

5. This will not provide as much protection as would a statutory 10 percent minimum capital 

requirement for Farmer Mac, because each reserve is only available to absorb losses on one pool. 

6. The 1990 figure reflecta the FCA's accounting treatment, which excludes certain transactions 

aseociated with the Jackson Federal Land Bank in receivership. the Financial Assistance Corporation, and the Insurance Corporation. The FCS reported net income of $608 million in 1990. 

7. Loan loss reserves appear on the balance sheet of a lender and are funds that the institution has set 

aside to cover expected loeses on loans. Negative loan loas provisions occur when an institution 

decides that loases will be less than it had expected in an earlier period. 
CHAPTER n~ FARM CREDIT SYSTEM 85 

for the system have dropped significantly--from 11.2 percent of total 

system debt in 1985 to 8.4 percent in 1990. Finally, operating costs for 

the system have also declined since 1985. Operating expenses during 

1990 were 27 percent less than in 1985, but remained at about 1.5 percent of total assets. Table 5 on pages 82 and 83 provides additional 

details about the status of each FCS district at the end of 1990. 

Despite the improved performance of the FCS as a whole, portions 

of the system remain quite vulnerable. The section of this chapter that 

discusses the capitalization of the system will examine the question of 

vulnerability in some detail. The FCA uses.a CAMEL rating system to 

summarize the financial well-being of system institutions. An institution's CAMEL rating reflects an evaluation of its Capital adequacy, 

the quality of its Assets, the adequacy of its Management, its Earnings, and its Liquidity. Each of these five categories receives a score of 

between 1 and 5, with a 5 indicating weakness and a 1 indicating 

strength. The five individual scores are then weighted to achieve a 

cumulative score of between 1 and 5.8 A cumulative score of 1 or 2 indicates minimal concern about the safety and soundness of an institution, while scores of 4 or 5 indicate considerable concern. 

The two most recent CAMEL ratings for FCS banks, FLBAs, and 

direct lending associations are summarized in Table 6. Banks and 

direct lending associations are rated annually, so the current rating is 

for 1990 and the previous rating is for 1989. FLBAs, in contrast, are 

rated once every three years, so the current ratings shown were made 

sometime between 1988 and 1990 and the previous rating sometime 

between 1985 and 1987. The most recent rating includes all of the FCS 

banks (FCBs and BCs), 139 of the 141 then-existing FLBAs, and 132 of 

the 149 direct lending associations. The data in Table 6 show that the 

FCS is improving its financial condition, but that some of its institutions have significant weaknesses. For each of the three types of insti8. The weighta used by the examiners to derive the cumulative wore are judgmentally determined. 

The scores for capital levels, asset quality, and management are relatively more important than 

those for earnings and liquidity. In addition, there may be interactions between the components. 

For example. if the examiner feels that the management of an institution ie particularly strong and 

has a sound business plan in place, deficiencies in asset quality may be given less weight. 
86 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 6. CAMEL RATINGS FOR INSTITUTIONS IN THE FARM 

CREDIT SYSTEM 

CAMEL 

Rating 

Current Rating Previous Rating 

Percentage Percentage 

Number of Total Number of Total 

District Banks 

Total Number 15 15 

Average Rating 2.87 3.00 

Federal Land Bank Associations (FLBAs) 

Total Number 139 126 

Average Rating 3.06 3.46 

Production and Agricultural Credit Associations 

Total Number 132 105 

Average Rating 2.65 2.86 

SOURCE: Congressional Budget Office using data from the Farm Credit Administration. 

NOTES: A CAMEL rating reflecte an evaluation of an institution's Capital adequacy, the quality of its 

Assets, the adequacy of its Management, its Earnings, and ita Liquidity. Each of these five 

categories receives a score of between 1 and 5, with a 5 indicating weakness and 1 indicating 

strength. 

For the banks and direct lending associations, the current ratings are for 1990, and the 

previous ratings are for 1989. For the FLBAE, the current ratings are for sometime between 

1988 and 1990. and the previous ratings are for sometime between 1985 and 1987. 
CHAPTER In FARM CREDIT SYSTEM 87 

tutions considered, the average CAMEL rating was lower in the current period than in the previous period, indicating an improved financial condition9 In particular, the number of institutions with the 

worst CAMEL rating declined quite dramatically between the two 

rating periods. For the FLBAs and direct lending associations, it is not 

clear to what extent this improvement is the result of improved financial conditions or reflects the dissolution of some of the weaker associations. 

Although the overall financial condition of FCS institutions apparently has improved, 67 percent of the banks, 71 percent of the 

FLBAs, and 45 percent of the direct lending associations had CAMEL 

ratings of 3 or higher, indicating some degree of concern about their financial well-being. There is also some concern about the quality of the 

system's assets. The FCA notes an increase in the volume of nonaccruing and other high-risk loans at some institutions, particularly 

direct lending associations. Specifically, the proportion of high-risk 

loans in the overall portfolio of assets increased during 1990 in five of 

the district Farm Credit Banks and two of the Banks for Cooperatives. 

A significant proportion of this increase, however, was caused by the 

adoption of more conservative accounting standards by two districts at 

the behest of the FCA. 

The outlook for the FCS is inextricably tied to the outlook for the 

farm sector as a whole. While it is true that agriculture is in much 

better financial shape than it was two or three years ago--farmers have 

much lower debt loads and the sector has experienced two successive 

years of record or near-record income levels--substantial uncertainties 

about the health of the farm sector remain. For example, the apparent 

collapse of the GATT (General Agreement on Tariffs and Trade) 

negotiations could signal future problems for U.S. agricultural ex9. For lack of data, the average CAMEL rating for each group ie not weighted by the size of the imtitutiona involved. Thie could be an important shortcoming if the larger imtitutiona within each group 

have woree CAMEL ratings, eince thie would bim the average downward and make the group's financial condition appear better than warranted. 
88 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

ports.10 At the same time, the recently enacted Farm Bill provides 

substantially less income protection for farmers. Finally, farm incomes are affected by volatile and uncontrollable changes in interest 

rates and oil prices. Many analysts are forecasting that real net farm 

income will decline by between 5 percent and 10 percent in 1991 relative to the record level reached in 1990. In light of these considerations, the financial condition of the FCS will merit close scrutiny over 

the next few years. 

Certainly the FCS is in much better shape today than in 1987. Yet 

parts of the system remain vulnerable to a financial shock. The 1987 

Agricultural Credit Act created a number of institutional safeguards 

to forestall future demands on the taxpayer to assist the FCS. The 

most important of these are the minimum capital standards and the 

insurance fund. Neither of these safeguards is fully in place. Until 

they are fully implemented at the start of 1993, the system will be in a 

period of heightened vulnerability. 

CREDIT RISK 

Defaults on loans made by the FCS depend on the performance of the 

agricultural sector. The system is exposed to credit risk because the 

performance of agriculture can deviate from expectations, for economic 

or environmental reasons. Economic sources of variability in the farm 

sector's performance include changes in macroeconomic policy (such as 

a switch from an expansionary to a restrictive monetary policy), 

changes in farm policy (such as unexpected reductions in support 

prices), and changes in trade policies (such as increased protectionism 

in export markets). Environmental factors that affect the financial 

health of the farm sector include weather disturbances and uncontrolled infestations by pests. It is very difficult, perhaps impossible, to 

anticipate many of these economic and environmental changes. 

10. The 1990 Omnibua Budget Reconciliation Act included language that authorized additional ex- penditures for agricultural export promotion programs should there be a breakdown in the GATT 

negotiations. In that event, additional funds would go to the Export Enhancement Program, which 

subsidizes the export of agricultural commodities. 
CHAPTER ~n FARM CREDIT SYSTEM 89 

Aside from economic and environmental hazards, the FCS may incur unnecessary credit risk through inadequate evaluation and screening of loan applications. An unnecessary level of credit risk can arise 

from improper loan standards, or deviations from appropriate loan 

standards. Deviations from loan standards might occur in an effort to 

respond to competition or to satisfy other, possibly nonquantifiable, 

reasons for making a loan (such as the character of the borrower). 

Management and Control of Credit Risk 

The FCS and the FCA currently have a number of procedures for monitoring and controlling credit risk within the system. The district 

banks have agreements with their member associations specifying 

minimum levels of financial performance that must be met in order to 

remain in good standing with the banks. Failure to remain in good 

standing could result in a district bank's refusal to borrow additional 

funds for an errant association. District banks also have general supervisory authority over their associations. 

The associations themselves have several means of managing or 

controlling credit risk. For example, most FCS institutions use creditscoring techniques when evaluating loan applications. Deviations 

from these standards are, however, permitted in response to particular 

conditions. Most associations also have loan review committees that 

attempt to maintain quality control standards, classify loans correctly 

(as accruing, nonaccruing, or high risk), and establish adequate loan 

loss reserves. Finally, since the 1987 Agricultural Credit Act, most 

associations use differential pricing in recognition of the different degree of credit risk posed by different types of borrowers. 

The Farm Credit Administration, as the system's supervisor, plays 

a critical role in managing and controlling credit risk. The FCA monitors each FCS institution's quarterly reports in an effort to spot developing problems. Through its examination and enforcement powers, 

which will be discussed in greater detail in a later section of this chapter, the FCA can force institutions to change practices that are generating unacceptable levels of credit risk. 
90 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Indicators of Loan Performance 

Three indicators of the performance of loans made by FCS institutions 

are the percentage of loans considered to be of poor quality, high-risk 

loans and other property owned as a percentage of gross loans, and loan 

loss reserves as a percentage of high-risk loans.11 Table 7 provides a 

summary of these measures of credit risk, by FCS district, at the end of 

the fourth quarter of 1989 and the third quarter of 1990. 

Poor-quality loans include all those classified by the system as 

"sub~tandard,'~ "doubtful," or "loss1'--each of these classifications reflecting a concern about the ability of these borrowers to service their 

debts.12 The system considers the quality of the loan portfolio satisfactory if 10 percent or less of gross loan volume is considered to be of 

poor quality. Poor loan quality of between 10 percent and 20 percent of 

gross loans is considered "minimally-acceptable-to-some-weakness,'l 

while poor loan quality of more than 20 percent of gross loan volume is 

unsatisfactory. At the end of the third quarter of 1990, the loan quality 

of six banks was considered satisfactory, that of one unsatisfactory, 

and that of the remaining eight to be in the minimally-acceptable-tosome-weakness category (see Table 7). On average, loan quality improved slightly during the period of December 1989 to September 1990. 

The relationship between gross loan volume and high-risk loans 

plus other property owned, which is mostly farmland that has been 

foreclosed upon and not yet disposed of by the system, is meant to measure the proportion of the bank's portfolio that might generate few or 

no returns if the farm sector suffered an economic downturn. The system's internal standards for this ratio are as follows: less than 5 percent is considered satisfactory, 5 percent to 9 percent minimally ac11. High-risk loans include nonaccruing loam, loam that have been restructured, and loans requiring more than normal amounta of servicing, which may indicate a likelihood of default. Nonaccruing 

loans include those for which intereat or principal is 90 days delinquent and loam for which full 

collection of principal and intereat is in serious doubt. Loan lose reserves are earnings that have 

been earmarked to cover expected losees on loam. 

12. The use of "poor-quality loans" and "high-risk loans" aa indicators of the strength of the FCS 

portfolio could overatate its weahnaes. For example. all loam that have beem restructured are 

classified aa high-risk and of poor quality--even thoee that are making timely payments of interest 

and principal and are adequately collateralized. This is particularly true at the St. Paul FCB and, 

to a lesser extent, the Omaha FCB, because these districts account for the bulk of reetructured loan8 

within the system. 
CHAPTER m FARM CREDIT SYSTEM 91 

ceptable, and more than 10 percent unsatisfactory. Interestingly, 

Table 7 shows that as of September 1990, all of the banks in the FCS 

were either in the satisfactory range for this measure (five banks) or 

TABLE 7. INDICATORS OF CREDIT QUALITY IN THE FARM CREDIT 

SYSTEM, BY DISTRICT BANK (In percent) 

Allowance 

for Loan 

High-Risk Losses as a 

Loans and Percentage of 

Percentage Other Property High-Risk 

of Poor- as a Percentage Loans and 

Quality Loans* of Gross Loansb Accrued Interestb 

Se~tember December Se~tember December Se~tember December 

Springfield 

Baltimore 

Columbia 

Louisville 

St. Louis 

St. Paul 

Omaha 

Wichita 

Texas 

Western 

Spokane 

Jacksonc 

CoBank 

Springfield 

St. Paul 

Farm Credit Banks 

Banks for Cooperatives 

SOURCE: Congressional Budget Office using data from the Farm Credit Banks Funding Corporation. 

a. Includes all those classified as "substandard," "doubtful," or "loss" in the Farm Credit Syetem's 

"Credit Monitoring Report." 

b. Other property is mainly farmland that has been foreclosed upon and not yet disposed of. Other 

property and accrued interest are included in both high-risk loans and gross loam. 

c. Federal Intermediate Credit Bank. 

d. Springfield Bank for Cooperativee had no loam judged to be of high risk. 
92 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

in or on the edge of the unsatisfactory range (ten banks). None were in 

the middle range. Since the start of 1990, the ratio had improved in 

seven districts, deteriorated in seven, and was unchanged in one. 

Finally, the ratio of loan loss reserves to high-risk loans provides a 

measure of the volume of loans that have a higher-than-average probability of default relative to the resources set aside by the system to 

deal with such an eventuality. The system does not have a standard 

for this measure, but the smaller the ratio the greater the likelihood 

that the reserves would be insufficient to cover any losses associated 

with loan defaults and foreclosures. This percentage ranges from a low 

of about 13 percent for the St. Paul and Western FCBs to a high of 76 

percent in the Springfield FCB. What might be of greatest concern is 

that many of the districts having the lowest ratios of loan loss reserves 

to high-risk loans are also those with portfolios of the poorest quality 

as measured by the two other indicators of credit quality discussed 

above. 

Managing Credit Risk at Farmer Mac 

Farmer Mac will be exposed to credit risk. The corporation must absorb any losses incurred on a pool of loans backing securities it has 

guaranteed in excess of the 10 percent share held by the originators or 

poolers of the loans. Farmer Mac will attempt to minimize the risk of 

such losses by enforcing standards with respect to the geographic and 

commodity diversification of the loans in the pools backing the securities it guarantees; by maintaining underwriting and appraisal standards for loans allowed into pools and monitoring compliance with the 

standards; by using a stress test to assess the credit risk of each pool 

and to require additional reserves or subordinated securities, if desired; and by monitoring the pool's performance. Farmer Mac guarantees of securities backed by loans guaranteed by the Farmers Home 

Administration will expose it only to the risk of delayed payment by 

the FmHA. 
CHAPTER n~ FARM CREDIT SYSTEM 9s 

INTEREST RATE RISK 

The Farm Credit System is exposed to interest rate risk from three 

sources. First, there may be a mismatch between the maturities of the 

loans made by the FCS and the securities sold to fund those loans. 

Second, borrowers can repay loans made by the system ahead of schedule, while most of the bonds used to finance the loans cannot be called, 

or prepaid, by the FCS. Third, the system would incur losses if it failed 

to adjust its variable-interest-rate loans in response to changes in interest rates. The May 1990 Treasury report on GSEs estimates that 

the interest rates on nearly 80 percent of all loans on the books of the 

Farm Credit Banks can be adjusted in response to changes in the cost 

of funds.13 

The ability of FCS institutions to change the rates charged on the 

majority of their loans does not necessarily remove this source of interest rate risk, for two reasons. First, the FCS can pass on changes in interest rates only to the extent that its borrower members are able and 

willing to absorb those changes, a qualification that is clearly most 

relevant in a period of rising interest rates. If the system's cost of funds 

increases but the costs of its competitors do not, an increase in the rates 

charged by the FCS could induce its borrowers to refinance their debt 

with other lenders. Likewise, an increase in interest rates could force 

some of its borrowers into nonaccruing status--transforming interest 

rate risk into credit risk. Second, FCS loans are not indexed to an external measure of interest rates. These loans typically have a target 

index, but the decision to raise or lower rates is made by the managements and boards of the various FCS institutions. If management or 

the board decides not to match an increase in its cost of funds, the institution's net interest income will decline. 

Management and Control of Interest Rate Risk 

The FCS has several mechanisms in place to manage its exposure to 

interest rate risk, some of which have been put in place or upgraded 

13. Department of the Treasury, Report of the Secretary of the Treasury on Government Sponsored 

Enterprises (May 1990), p. D-36. 
94 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

since 1987. First, as noted above, FCS institutions can vary the interest rates on most loans. Districts do this in different ways. Some 

districts act as if these loans were tied to an external index, and reprice 

them on a regular basis. Other districts appear to take greater cognizance of the interest rates charged by their competitors. Thus, while 

the high proportion of variable-rate loans contained in its portfolio 

provides the system with the potential to shifi the cost of changes in interest rates to borrowers, its success in doing so is still somewhat uncertain. To reiterate, a direct linkage to an external interest rate 

might eliminate the FCS's exposure to interest rate risk only at the 

expense of increasing its exposure to credit risk. 

Second, the district banks and the Farm Credit Banks Funding 

Corporation now monitor the banks' portfolios (including assets held 

by local associations) in order to spot and respond to mismatches between loan and bond maturities. One focus of their analyses is the 

maturity and duration gaps of the banks' portfolios. As discussed in 

Chapter 1, maturity gap analysis assesses the differences in the 

amounts of an institution's assets and liabilities that will undergo repricing in different maturity periods. Duration gap analysis assesses 

the difference between the timing of the cash flows from an institution's assets and liabilities, considering the cash flows in terms of their 

net present value. 

Responding to Prepayment Risk 

The system is addressing prepayment risk by using interest rate 

swaps, prepayment penalties, and other variations in the terms of its 

loans. The system also has begun to experiment with more reliance on 

callable bonds rather than noncallable bonds, which have been more 

traditional for the FCS. Both the inclusion of prepayment penalties 

and the sale of callable bonds, which carry higher interest rates, increase the cost of borrowing from the system. 
CHAPTER nx FARM CREDIT SYSTEM BB 

TABLE 8. SENSITIVITY OF THE ESTIMATED MARK-TO-MARKET 

NET WORTH OF FARM CREDIT BANKS AND DISTRICTS 

TO A CHANGE OF ONE PERCENTAGE POINT IN 

INTEREST RATES, YEAR-END 1990 

Change in Mark-to-Market 

Net Worth from a Change of 

One Percentage Point 

in Interest Rates (Percent) 

Districts 

(Number) 

Greater than 10 

5 to 10 

3 to 4.9 

0 to 2.9 

-2.9 to 0 

-4.9 to -3 

SOURCE: Congressional Budget Ofice using data from the Farm Credit Banks Funding Corporation. 

NOTE: Estimates made by the Columbia, Louisville. Omaha, St. Paul, Springfield, Texas, and Wichita 

Farm Credit Banks and the three banks for cooperatives are for those institutions only. Estimates made by the Baltimore. St. Louis, Spokane, and Western Farm Credit Banks and the 

Jackson Federal Intermediate Credit Bank are for the banks and the associations they serve. 

Measures of Interest Rate Risk 

Estimates of the change in the mark-to-market net worth of an institution caused by a change in interest rates probably provide the best 

single measure of its exposure to interest rate risk.14 Table 8 indicates 

the percentage change in the estimated mark-to-market net worth at 

year-end 1990 of system banks and districts caused by an increase in 

interest rates of 100 basis points (one percentage point). A positive 

value in Table 8 means that mark-to-market net worth declines if interest rates increase. The larger the absolute magnitude of the change 

in mark-to-market net worth, the more sensitive is the bank's net income to a change in interest rates. Changes of 10 percent or more in 

absolute magnitude are considered by the system to indicate a sig14. Mark-to-market net worth, which is determined by eetimating the current market value of the 

imtitution's assets and liabilities, is not without its shortcomings as an indicator of exposure to 

interest rate risk. To calculate the change in mark-to-market net worth caused by a change in 

interest rates, it is necessary to make assumptiom about loan prepayments. Each bank within the 

FCS calculates thie measure independently ueing different assumptions. 
96 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

nificant exposure to interest rate risk. As Table 8 indicates, none of 

the entities exceeds this level. The average change for the system is. 

1.3 percent. 

Further, the banks in the three districts with substantial sensitivity to changes in interest rates are also the most active in managing 

gaps between the maturities of their assets and liabilities. CBO also 

examined, but does not report here, the system's efforts to manage 

maturity gaps. The system uses, among other things, interest rate 

swaps and the futures market to reduce maturity gaps. Interest rate 

swaps occur when lenders exchange responsibilities for making interest rate payments on outstanding obligations. Such an exchange allows both institutions to match the maturities of assets and liabilities 

more closely. 

Two conclusions can be drawn about the system's exposure to interest rate risk. First, the system currently has relatively little exposure to interest rate risk. Second, the efforts of the various parts of the 

system to manage interest rate risk vary considerably in degree. 

Farmer Mac's Exposure to Interest Rate Risk 

Under authority granted in the 1990 Farm Bill, Farmer Mac is authorized to create pools of agricultural loans guaranteed by the Farmers Home Administration and to sell guaranteed securities backed by 

those loans. The process of assembling the pools will expose Farmer 

Mac to interest rate risk, but it has plans to monitor and control its exposure. 

CAPITALIZATION OF THE FARM CREDIT SYSTEM 

The level of capital of a financial institution is an important indicator 

of its financial health. Capital enables a lender to cope with unexpected financial problems without becoming insolvent. An assessment 

of the capital adequacy of the FCS is complex, because of the system's 

decentralization and the role of the insurance fund. 
CHAPTER 111 FARM CREDIT SYSTEM 97 

Structure and Levels of Capital 

Because the FCS is a cooperative, a portion of its capital comes from 

direct investments by its members and a portion from income earned 

that was not returned as cash to its members. Direct investment in the 

system by its members comes in the form of borrower stock, which 

members must purchase in order to obtain loans from the FCS. Some 

of the borrower stock in the system is protected and is not included in 

the permanent capital stock of the FCS. The remainder of borrower 

stock is at risk, in the sense that the system could use this capital to 

cover any losses incurred. Retained earnings in the FCS can be in the 

form of allocated or unallocated capital.15 Table 5, which shows the 

level of capital by district, indicates that the bulk of the capital now 

held by the system is at risk, with approximately 60 percent of the 

at-risk capital in the form of retained earnings and 40 percent in the 

form of at-risk borrower stock. 

The 1987 Agricultural Credit Act directed the Farm Credit Administration to define minimum capital standards for system institutions. In May 1988, the FCA proposed that the minimum capital level 

be set at 7 percent of risk-weighted assets.16 This minimum capital 

standard will be phased in over time, with full compliance to be 

achieved by the beginning of 1993. 

15. A cooperative can retain income in either of two ways. First, it can retain income directly. However, if it does, it must pay the corporate income tax on its net income. Capital generated in this 

fashion is generally called "unallocated capital" on the balance sheet. Alternatively, the cooperative can declare a patronage refund for its members (the size of the refund is usually determined by 

the amount of business done with the cooperative) and pay part of the refund in cash and part in 

additional equity in the cooperative. As long as at leaat 20 percent of the refund is in cash, the 

cooperative pays no tax on income returned as patronage (the recipient pays tax on the full value of 

the refund, not just the cash portion). Capital generated by this means appears as "allocated 

capital" on the balance sheet. 

16. The Farm Credit Administration aaeigns assets held by FCS inatitutiona to one of five categories. 

each with its own risk weight. For example, agricultural loans are in category 5 with a risk weight 

of 100 percent. Assets in category 1, such ae cash, demand deposits, and claims on Federal Reserve 

Banks, have a risk weight of zero. Those in category 2, such as Treasury and federal agency debt, 

have a risk weight of 10 percent. Category 3 asaeta, such as GSE securities and state or local 

governmentobligations, have a risk weight of 20 percent. Those in category 4 have a risk weight of 

50 percent and include rural housing loans on which the FCS has a first lien. These risk weights 

parallel those applied to the assets of federally insured banks and thrifte. Since the bulk of FCS 

assets are agricultural loans, the minimum risk-adjusted capital level for most direct lending 

institutions is roughly 7 percent of total assets. 
98 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

The FCA set the minimum capital standard at a level that it believed would ensure the safety and soundness of the FCS. In setting 

the minimum level, the FCA analyzed a number of scenarios to find 

the amount of capital needed by system institutions in the event of a 

moderate downturn in the farm economy. Based on FCA analysis, the 

combined Federal Land Banks and FLBAs would have needed permanent capital equal to about 10 percent of risk-adjusted assets at the 

start of the downturn, in 1984 or so, in order to have survived the 1980s 

without any sort of external assistance. A financial downturn that was 

less severe than the one experienced in the mid-1980s was used to set 

the minimum capital standards, since they are intended to protect 

against normal business risk rather than economic catastrophe. 

In addition, the Farm Credit Administration analyzed the capital 

requirements of other financial institutions and their actual capital 

positions. The competitive position of the system could be undermined 

if its capital requirements were significantly higher than those of other 

agricultural lenders. Holding capital as equity has a cost, in terms of 

forgone interest on loans that would otherwise have been made. The 

FCA concluded that a 7 percent minimum risk-based capital requirement adequately addressed its concerns about safety and soundness. 

There are differences between what FCS institutions and commercial 

banks may count as capital--FCS institutions may not count loan loss 

reserves, for example. 

As of September 1990, all but 11 of the FCS institutions, which 

then numbered 305, had achieved risk-adjusted capital levels of 7 percent or more, and only one bank, the Spokane FCB, was not in compliance with the interim capital standard established by the FCA. In the 

fourth quarter of 1990, the members of the Spokane FCB agreed to increase their equity position in the bank in order to bolster their capital 

position and come into compliance with the interim requirements. Finally, the FCA's regulatory authority allows it to require institutions 

to maintain more than the minimum level of capital if this is necessary 

to assure safety and soundness. 
CHAPTER 111 FARM CREDIT SYSTEM 99 

The FCS Insurance Fund 

Collateral pledged by FCS institutions to back debt issued for them, 

and their earnings and at-risk capital stock, are the first sources of 

funds to protect investors in the system's securities. Should internal 

sources prove insufficient, however, the FCS Insurance Corporation, 

which was created as part of the 1987 Agricultural Credit Act, may 

provide supplementary funds. The premium rate and the ultimate size 

of the fund were defined in the act, which also required that the 

Insurance Corporation be managed by a board of directors composed of 

the board of directors of the FCA. Because the Insurance Corporation 

is an agency of the U.S. government, premiums paid into it are counted 

as receipts (and hence reduce the budget deficit), and indemnities paid 

out of it are on-budget expenses. 

Premium Structure. The structure of premiums was determined, in 

part, by the desire to avoid one of the primary shortcomings of the federal insurance funds of other financial organizations. Most other insurance funds make no link between the risk that an institution poses 

to the fund and the premium it must pay for insurance. When premiums do not reflect risk, some analysts argue, insurance can create incentives for taking excessive risks. The Congress attempted to address 

this concern in the case of the insurance fund by defining the premiums in terms of the performance of the loans in a bank's portfolio. For 

accruing loans, the insurance premium is 0.0015 times the principal 

outstanding. For loans that have fallen into nonaccruing status, the 

insurance premium is 0.0025 times the principal outstanding. (For 

loans guaranteed by the federal government, the rate is 0.00015 times 

outstanding principal.) 

While this premium structure is superior to that of other federal 

insurance funds, it is not without shortcomings. First, it is not clear 

whether the differential between the rate for accruing loans and that 

for nonaccruing loans is sufficiently great to discourage excessive risk 

taking. Second, the penalty for risk taking is assessed after, rather 

than before, the loan has fallen into nonaccruing status. Not only is 

this a less effective method of discouraging excessive speculation, but 

the penalty is assessed when the institution is least able to pay it. 
100 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Target Amount for the Fund. The 1987 act set, as the target for the 

ultimate size of the fund, a level of 2 percent of the value of the system's insured liabilities or such other level as the Insurance Corporation may deem to be actuarially sound. The size of the fund that will 

provide actuarial soundness depends on a host of factors, many of 

which are beyond the control of the Insurance Corporation or the FCS. 

For example, the demands on the capital in the insurance fund will 

depend heavily on the performance of the farm economy--which, as has 

been noted, is heavily dependent on exports, interest rates, and energy 

prices. The response of farmers to declines in their incomes is also 

crucial. It is not clear whether farmers would tighten their belts in 

order to make their loan payments, or whether sound borrowers who 

faced the prospect of losing their capital investment would flee to other 

lenders, threatening the financial viability of the system. The system 

has addressed the latter problem by reducing the amount borrowers 

are required to invest in the FCS and by placing greater restrictions on 

when borrower stock can be retired. 

Neither the performance of the farm economy nor the response of 

farmers to economic stress can be predicted with a great deal of confidence. The experience of the 1980s is generally believed to have been 

worse than anything the system is likely to undergo in the future, 

given the changes that have been made in the structure of the FCS and 

in its business operations. The target of 2 percent of total insured liabilities may be reasonable in light of the minimum capital standards 

that are being put in place, the enhanced statutory authority of the 

FCA, and improved management within the system. Further, the Insurance corporation's board can increase the target level if it can establish that more funds are needed to assure the actuarial soundness of 

the fund. The next section will provide a partial test of the reasonableness of the 2 percent target. 

A Scenario Analysis of the System's Capital Adequacy 

In order to gauge the ability of the system to weather a financial downturn without drawing on the resources of the government, CBO conducted a simple scenario analysis. The scenario assumes that, starting 

in 1991, macroeconomic factors result in a decline in the quality of the 
CHAPTER In FARM CREDIT SYSTEM 101 

system's assets similar to the decline experienced in the period beginning in 1984. The scenario further assumes that the system fully 

controls interest rate risk, so that its net interest margins are not 

affected by the downturn in the farm economy (a complete set of the 

assumptions is provided in Appendix A). Projected interest income and 

interest expenses for the system are based on CBO's projected rates for 

three-month Treasury bills. In order to deal with the extensive institutional change that has occurred since 1987, the scenario assumes that 

within each district the banks and the associations have operated as if 

they were a single entity during the 1984-1990 period and continue to 

do so. In particular, all at-risk capital within the district, whether held 

by the bank or the associations, is assumed to be available to the district bank to offset losses. A simplified accounting model, based on 

data from the FCA, is used to generate income and balance sheet figures for the FCS, by district, for the 1991-1996 period.17 

The choice of this scenario does not in any way represent a prediction by CBO that this is what will happen to the FCS during the 

next five years. Rather, the scenario was designed solely to examine 

the financial resilience of the system if faced with another difficult economic environment. 

Summarizing the Results. The projection shows a substantial decline 

in gross loan volume (accruing plus nonaccruing loans) from $52.8 billion in 1990 to $36.5 billion in 1996 (see Table 9). Substantial losses 

are incurred by the system in 1992 and 1993, though the losses are 

slightly less than half as large as those experienced during the 1985- 

1987 period. The losses are driven by increases in operating costs (as 

the cost of servicing loans increases) and loan loss provisions (to offset 

possible loan write-offs). 

17. The structure and complexity of the FCS pose analytical problems. The "bottom-up" organizational structure means that cooperatives at the local level have a substantial degree of autonomy, 

while the powers of the national-level institutions are fairly circumscribed. As a conaequence. 

there is a great deal of variation in the practices and financial condition of the different elements 

that make up the system, and analysis done at the aggregate system level has only a limited value. 

However, an analysis of the capital adequacy of each part of the FCS (15 banks and 262 aesociations at present) is far beyond the scope of this report. In the scenario analysis conducted by CBO. 

the balance sheets of FCS institutions were aggregated at the level of the 15 banks, although Table 

9 reports the results of the simulation at the system level. 
102 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 9. A SCENARIO ANALYSIS OF THE CAPITAL ADEQUACY OF 

THE FARM CREDIT SYSTEM, ASSUMING A REPETITION 

OF THE 1980s (In millions of dollars) 

Actual Estimated 

1990 1991 1992 1993 1994 1995 1996 

Balance Sheet 

Assets 

Accruing Loans 50,159 43,722 37,895 34,026 33,683 34,181 34.974 

Nonaccruing Loans 2,602 806 2,311 3,484 2,908 1,924 1,514 

Other Assetsa 11,855 6,913 6,866 9,518 8,228 7,699 9,251 

Less Loan Loss Reserves -1.516 -1.343 -2,288 -2,676 -2.002 -1,091 -720 

Total 63,100 50,098 44,784 44,352 42,817 42,712 45,018 

Liabilities and Capital 

System Liabilities 56,412 43,811 40,270 40,879 39,356 38,704 40,642 

Capita1 at Risk 

Retained earnings 3,511 3,637 2,228 1,433 1,593 2,229 2,657 

At-risk stock 1,939 1,660 1,494 1,405 1,361 1,374 1,394 

Subtotal 5,450 5,296 3,722 2,838 2,954 3,602 4,051 

Protected Stock 1,238 ------ 991 793 634 507 406 325 

Total 63,100 50,098 44,784 44,352 42,817 42,712 45,018 

Capital Targetb 

Capital Shortfallc 

Insurance Fund 

Performance Indicators 

2,459 2,568 2,726 3,105 2,997 2,990 3,151 

0 0 202 1,048 1,285 1,101 1,294 

438 561 665 771 880 992 1,108 

Income Statement 

Net Intereat Margin 1,326 1,278 985 734 731 795 846 

Other Incomed 151 126 94 90 56 65 70 

Operating Expenses -864 -1,081 -1,211 -714 -708 -678 -584 

Insurance Paymenta -82 -68 -63 -60 -58 -56 -56 

Provisions for Loan Loeses - 22 - -130 -1.214 -846 2 510 153 

Net Income 5530 126 -1,409 -795 160 636 428 

SOURCE: Congressional Budget Ofice projectiom using data from the Farm Credit Administration. 

a. Includes caah, inveatmenta, and other nonearning asseta such aa buildings owned by the Farm Credit 

System. 

b. Capital target equals interim FCA standards in 1990-1992, 7 percent of assets in 1993-1996. The 

amount required in the latter period overstates the final standards somewhat, because many of the 

assets of the Banks for Cooperatives have low risk weights. 

c. Capital shortfall is the cumulative amount by which individual districts and banka fall short of the 

capital targets. 

d. Includes fee8 for servicee and other miscellaneous adjustments. 

e. Certain transactions msociated with the Jackson Federal Land Bank in receivership, the Financial 

Assistance Corporation, and the Insurance Corporation are not included. If these transactions were 

included, the system's net income would be $608 million, aa reported in the FCS's Annud Informtion Statement- 1990. 
CHAPTER In FARM CREDIT SYSTEM 103 

Most important, the scenario indicates that while the capital of the 

system as a whole exceeds the 7 percent minimum level for most of the 

projection period, some individual districts do not. In this scenario, 

seven districts fail to meet their minimum capital standards. Four of 

them dip below this level by relatively small amounts during three or 

four years; the other three have insufficient capital throughout most of 

the projection period and show few signs of recovery. In fact, for one 

district, total capital is less than the minimum required from 1992 

onward. 

The results also indicate that, after 1992, the capital shortfall 

could not be completely offset by payments out of the insurance fund. 

The lack of improvement in the financial condition of three districts 

and the magnitude of their capital shortfalls suggest that institutions 

in these districts might well face receivership under the assumptions 

employed in the scenario. 

The scenario assumed that the system could maintain its interest 

rate margins. To test the sensitivity of the results to this factor, an alternative scenario was constructed in which the interest margins declined by 50 basis points in 1991 relative to the original scenario, by 

100 basis points in 1992 and 1993, and by 50 basis points in 1994. If 

the system experienced this type of reduction in interest rate margins, 

compared with the original scenario, total losses would increase by 49 

percent, the capital shortfall by 1996 would be 44 percent greater, and 

8 of the 15 banks would fail to maintain minimum capital standards 

during the projection period. Three of the eight banks that fail to 

maintain minimum capital standards do so by relatively small, transitory amounts, while the others have large and continuous shortfalls. 

Qualifying the Results. These results are dependent on a number of 

simplifying assumptions. It seems clear, for example, that while the 

system has made great strides in managing interest rate risk, it is 

somewhat unrealistic to assume that all interest rate risk could be 

avoided during a downturn in the farm economy. At a minimum, problems that might have shown up as interest rate risk (reduced interest 

rate margins) during the 1980s could easily appear as credit risk (borrowers' inability to pay the higher interest rates being passed on to 

them by the FCS) in some future downturn. 
116 GOVERNMENT-SPONSORED ENTERPRlSES April l@@l 

evitably decrease its competitiveness, its market share, and its ability 

to fulfill its public purpose. 

Adequacy of the FCA's Authority to Remlate Farmer Mac 

As noted above, the FCA has more limited statutory authority with 

respect to Farmer Mac than it has with respect to other FCS institutions. Although the FCA could use its enforcement powers to respond to any financial problems that might develop at Farmer Mac, it 

would seem to be unable to take preventive measures, such as prospectively defining unsafe and unsound practices or setting capital 

standards, to ensure that Farmer Mac operates in a safe and sound 

manner from the start. If Farmer Mac got into difficulty, the FCA 

might also not be able to appoint a conservator or receiver in order to 

minimize the government's losses. The question can be raised whether 

the FCA has enough authority to assure the safe and sound operation 

of Farmer Mac and to minimize the government's exposure to risk. 

In setting the 10 percent reserve requirement for securities guaranteed by Farmer Mac and limiting the FCA's statutory authority over 

it, the Congress has indicated a desire to retain responsibility for 

setting the guidelines within which Farmer Mac must operate, rather 

than delegating that task to the FCA. This approach is thought to 

strike the appropriate balance between allowing Farmer Mac to exercise its judgment about its business practices and the credit risk exposure it is willing to accept, and ensuring that its activities do not expose the government to excessive risk. Until Farmer Mac is fully operational, the current situation appears to entail little risk. However, 

if Farmer Mac generates a significant volume of business, the adequacy of the FCA's authority could become a more prominent issue, 

particularly if Farmer Mac experienced losses on any securities it had 

guaranteed. 

The most straightforward way to strengthen the FCA's authority 

over Farmer Mac would be to give it statutory authority equivalent to 

a federal bank regulator with respect to Farmer Mac. If the FCA used 

a broader grant of authority to prospectively define unsafe and unsound practices and to set capital standards for Farmer Mac, the corpo- 
CHAPTER In FARM CREDIT SYSTEM 117 

ration's freedom would be restricted, although it would probably continue to function. An alternative approach would be to require the 

FCA to report promptly to the Congress on any practices of Farmer 

Mac that posed an unreasonable risk to the government. 

Reforms Proposed in the Administration's Fiscal Year 1992 Budget 

The President's budget for fiscal year 1992 suggested a number of reforms for the FCS: requiring separate boards for the FCA and the Insurance corporation; indexing variable-rate loans to rates on Treasury 

debt of comparable maturity; requiring assisted system institutions to 

repay loans from the Financial Assistance Corporation (rather than 

allowing them not to repay); and reducing the number of districts from 

12 to no more than 5. Because consolidating the district banks was 

examined earlier in this chapter, the discussion below is limited to the 

Administration's first three proposals. 

Some of the suggestions offered in the President's budget appear to 

be largely management issues rather than broad policy issues. The 

FCA or the system itself would seem to be better placed to make decisions about these issues. For instance, there may not be as much potential for conflict between the FCA's duty to supervise the system and 

the Insurance Corporation's function of absorbing losses as the Administration has suggested. If the perception of a conflict did arise, the system might be expected to request a structural change in the insurance 

board, since the FCS would have to recapitalize the fund if its balance 

had to be used to cover losses at institutions that had been inadequately supervised by the FCA. (Federally insured commercial banks 

and thrifts have not taken this type of self-protective action in an attempt to prevent potential increases in deposit insurance premiums, 

however.) Another consideration is that if the FCA and the Insurance 

Corporation maintained separate boards and examining capacities, the 

system's costs would be higher in the long run.20 Lowering costs was 

one of the primary reasons offered for reducing the number of FCS 

20. The operating cod of the imurance fund would be paid out of the premiume charged to FCS 

inatitutione, eo the direct operating costa of the eyetem would not increase if the insurance fund had 

a eeparate board and operating authority. Rather, the increased costs would be in the form of a longer period during which the inauranee fund was short of ita target level. 
118 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

districts. Finally, there is some concern that the Insurance Corporation does not have an adequate staff under its control--a problem that 

could be remedied by requiring it to hire more staff. 

The President's budget suggests that variable-rate loans made by 

the system be indexed to Treasury rates as a means of reducing interest rate risk. Such a change would make the rate decision on FCS 

loans more mechanical but could transform interest rate risk into 

credit risk if borrowers were less likely to service debt at higher rates 

of interest. Beyond that, such indexing would be an effective means of 

reducing interest rate risk only to the extent that the system's cost of 

funds and the Treasury rates moved consistently. If the FCS's cost of 

funds diverged from its historical relationship to Treasury rates, as 

they did during the mid-1980s, strict indexing could actually increase 

the system's exposure to interest rate risk. 

There are two arguments for requiring repayment of Financial 

Assistance Corporation debt. First, if FCS institutions defaulted on 

any obligations to the FAC, the insurance fund would be drawn down 

to repay the bonds, reducing the protection it provided to the federal 

government, at least in the short term. Failure to repay assistance 

subjects the institution to a penalty dividend rate that will provide an 

incentive to repay. Second, full repayment of FAC debt would also be 

in the interest of the system as a whole if capital markets perceived 

failure to repay as a sign of financial weakness. 

Requiring assisted institutions to repay FAC debt could cause the 

preferred stock issued to FAC to be reclassified as a liability under 

GAAP. This could cause the institutions to fail to comply with the 

FCA's minimum capital standards. 

Moving the FCA into a New Agency 

Responsible for Supervising All GSEs 

As discussed in Chapter 11, one option for reforming federal regulation 

of GSEs would be to create a new agency and give it responsibility for 

supervising the safety and soundness of all the enterprises. The FCA 

and the FCS Insurance Corporation would be moved into this new 
CHAPTER m FARM CREDIT SYSTEM 11s 

agency, their boards would be abolished, and the responsibility for 

making decisions about regulation of the FCS, including Farmer Mac, 

and for disbursing funds from the insurance fund, would be lodged in 

the board of the new agency. Supervision of Farmer Mac would reside 

in a division of the agency that would handle all GSEs that serve lenders. Because the FCS consists of primary lenders, supervision of system institutions would be in a separate division. 

Moving supervision of the FCS to a new, centralized GSE regulator probably would not reduce the cost to the system of federal supervision of its activities. The FCS's decentralized structure, focus on 

direct lending, and ties to agriculture make it quite different from the 

other GSEs. As a result, a new agency probably could not achieve 

economies of scale by monitoring and examining the FCS in the same 

way that it would other GSEs. 

A centralized supervisor of the GSEs' safety and soundness could 

decide that all of the enterprises should meet a uniform standard with 

respect to the risk posed to the government. Because all the other enterprises are substantially less risky than the FCS, a uniform standard 

could lead the agency's board to impose higher capital standards on 

FCS institutions than the FCA has put in place, or to seek authority to 

increase the size of the insurance fund or impose higher premiums, in 

order to reduce the government's exposure. Such'actions would make 

the system less competitive and reduce its ability to fulfill its policy 

mission. 

CHAPTER IV 

FEDERAL NATIONAL MORTGAGE 

ASSOCIATION AND FEDERAL HOME 

LOAN MORTGAGE CORPORATION 

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are the largest 

government-sponsored enterprises (GSEs). They are integral components of the nation's housing finance system and dominate the secondary market for the conventional home mortgages that they can purchase. The reduced role of thrift institutions and the wave of mortgage 

refinancings of the 1980s enabled these GSEs to increase their activities dramatically in the second half of that decade. At the end of 1990, 

they had financed nearly $740 billion in conventional and federally 

insured or guaranteed home mortgages, more than two and one-half 

times the level at year-end 1985. The two enterprises have issued or 

guaranteed three-quarters of all outstanding GSE securities. 

Fannie Mae and Freddie Mac use a variety of techniques to limit 

their exposure to risk. The mortgages they finance are protected by 

borrowers' down payments, property appreciation, insurance, and 

agreements with lenders. Because their loan portfolios are nationally 

diversified, the most serious threat to their financial condition would 

be from default losses caused by a prolonged, nationwide recession or 

depression. Both enterprises appear to have enough capital to withstand such a downturn for an extended period. Although Fannie Mae 

takes some interest rate risk, its exposure declined dramatically in the 

1980s, and it maintains a significant amount of capital to cover this 

risk. Freddie Mac takes much less interest rate risk than Fannie Mae. 

Both GSEs have been consistently profitable in recent years and will 

be able to increase their capitalization significantly in the next five 

years without issuing additional stock. 

The Department of Housing and Urban Development (HUD) has 

general regulatory authority and some program regulatory authority 

over Fannie Mae and Freddie Mac. Substantial questions remain, 

however, about whether the department has sufficient statutory au- 
122 GOVERNMENT-SPONSORED ENTERPRISES April lWl 

thority and institutional capacity to assure that the GSEs are adequately capitalized and operate in a safe and sound manner. 

This chapter discusses the role that Fannie Mae and Freddie Mac 

play in the housing finance system, examines their exposure to credit 

risk and interest rate risk, and analyzes their capitalization and the 

degree to which they expose the federal government to risk. The chapter also examines HUD's supervision and regulation of the two GSEs' 

activities, policy options that would improve the department's ability 

to assure their safe and sound operation, and the potential effects of requiring them to increase their capitalization. 

The analysis is based on data provided by Fannie Mae and Freddie 

Mac. CBO has not assessed the exposure to management and operations risks of either GSE, and therefore has reached no conclusions 

about their overall risk or capital adequacy. However, given the consistent profitability of each enterprise in recent years and the incentives provided by their publicly traded stock, currently these risks 

probably are not significant. To be confident about the enterprises' 

overall exposure to risk and their capitalization, the government 

would have to conduct a thorough examination of their operations in 

order to verify the data they provided and to assess their exposure to 

management and operations risks. 

FANNIE MAE AND FREDDIE MAC 

IN THE HOUSING FINANCE SYSTEM 

Fannie Mae and Freddie Mac provide a link between lenders that 

make home mortgages and the capital markets. This section discusses 

the public purposes and activities of the enterprises, their historical 

development and performance, the expansion of their market share, 

and the economic effects of their activities. 

Public Purposes and Activities 

Fannie Mae and Freddie Mac have several public purposes, which were 

explicitly restated in the Financial Institutions Reform, Recovery, and 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 129 

Enforcement Act of 1989 (FIRREA). Together with the other GSE that 

supports lending for home mortgages, the Federal Home Loan Bank 

System, they smooth out regional imbalances in the supply of mortgage funds and integrate local and regional mortgage markets into the 

capital markets. Fannie Mae and Freddie Mac also increase the efficiency of the secondary market for conventional mortgages. Further, 

the two enterprises devote a portion of their mortgage purchases to the 

goal of providing adequate housing for low- and moderate-income families, so long as the purchases generate a reasonable economic return. 

Mortgage Purchases. Fannie Mae and Freddie Mac support the mortgage markets by purchasing loans originated by primary lenders such 

as thrifts, commercial banks, and mortgage banks. The GSEs buy primarily conventional, single-family, fixed- and adjustable-rate first 

mortgages. Most of the fixed-rate mortgages (FRMs) they purchase 

have maturities of 30 or 15 years; the adjustable-rate mortgages 

(ARMs) they buy usually have 30-year maturities. However, because 

interest rates are adjusted frequently on ARMs, they have shorter 

durations than FRMs of equal maturity. Both enterprises also buy 

mortgages for multifamily housing and second mortgages, other conventional mortgages that do not have a fully developed secondary 

market, and loans insured by the Federal Housing Administration 

(FHA) or guaranteed by the Department of Veterans Affairs (VA). In 

addition, Fannie Mae and Freddie Mac buy participation interests in 

loans held by lenders, under which the GSEs and the lenders share any 

default losses on a pro rata basis. The enterprises have standard purchase programs for loans that meet their underwriting guidelines, and 

also negotiate purchases of mortgages or pools of loans. They charge 

fees to lenders for committing to purchase loans. 

The original balances of the mortgages that Fannie Mae and 

Freddie Mac may purchase are limited by law to specific amounts, 

which are adjusted each year to reflect the percentage increase (in the 

year ending the previous October) in the national average purchase 

price for all conventionally financed homes, as reported by the Federal 

Housing Finance Board (FHFB). In 1991, the limit is $191,250 for first 

mortgages on single-family homes. Higher limits are set for loans that 

finance dwellings for more than one family, and a lower limit exists for 

second mortgages. Each ceiling is 50 percent higher in Alaska, 
124 GOVERNMENT-SPONSORED ENTERPRISES Apdl 1991 

Hawaii, and Guam. The 1991 limits are 2 percent higher than those 

that prevailed in 1990. In recent years, the ceilings have increased 

more rapidly than the median selling prices of existing homes, expanding the proportion of the conventional mortgage market open to 

Fannie Mae and Freddie Mac.1 The loans that the GSEs are eligible to 

purchase are commonly known as conforming mortgages. 

Mortgage purchases by Fannie Mae and Freddie Mac increased 

dramatically in the 1980s, as shown in Table 11. The largest increases 

were concentrated in two years. The GSEs' purchases jumped nearly 

fivefold in 1982, when lenders, primarily thrifts, exchanged nearly $33 

billion of mortgages for more liquid mortgage-backed securities. Their 

purchases doubled in 1986, when falling interest rates spurred a huge 

wave of refinancings of existing mortgages. In 1990, the enterprises 

bought about $191 billion in loans. Purchases of conventional 30-year 

and intermediate fixed-rate mortgages accounted for almost 80 percent 

of this total. Fannie Mae's purchases made up slightly more than 60 

percent of the loans financed by the GSEs. 

Mortgage-Backed Securities. Fannie Mae and Freddie Mac finance 

most of their mortgage purchases by issuing guaranteed mortgagebacked securities (MBSd.2 They sell MBSs to capital market investors, or swap them with lenders in exchange for conforming mortgages. 

Under Generally Accepted Accounting Principles (GAAP), the mortgages backing these securities are not considered to be assets of the 

GSEs. Instead, the MBSs are treated as contingent liabilities, since 

their guarantees expose the enterprises to the credit risk of the mortgages backing the securities. The GSEs earn income by charging fees 

for guaranteeing the MBSs they issue, and by investing the interest 

1. Between 1985 and 1991, the limit for first mortgagen on single-family homen rose from $115,300 to 

$191.250, an increase of nearly 66 percent. The median selling price of existing homes rose from 

$76,600 to $95,200, an increase of about 26 percent. Conventional mortgage loane eligible for purchase by Fannie Mae and Freddie Mac increased from 74 percent to more than 80 percent of all con- ventional loam during thoee years. See Dwight M. Jafee and Kenneth T. Rosen. "Mortgage Securitization Trendn." Journal ofHousing Research, vol. 1, no. 1 (1990), p. 131. 

2. Fannie Mae refers to ita mortgage-backed securities aa MBSe. and Freddie Mac ume the term 

mortgage-participation certificates or PCa. This report refers to both as MBSs. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 1!46 

TABLE 11. MORTGAGE PURCHASES BY FANME MAE AND 

FREDDIE MAC, 1981-1990 (In millions of dollars) 

- - 

30-Year Fixed Rate 

Fannie Mae 4,261 20,266 19,054 18.755 27,533 60,784 48,420 30,189 52,066 76,080 

Freddie Mac 3,709 23,588 22,220 19,153 33,504 73,209 54,047 27,994 48,480 47,409 

Intermediate Fixed Rate 

Fannie Mae 0 0 79 213 3,019 8,810b 15.302 8.478 10,559 19,953 

Freddie Mac 0 0 165 801 6,497 22,904 15,097 6,729 8,613 9,393 

Conventional Second 

Fannie Mae 176 1,553 1,408 937 871 498 139 433 520 702 

Freddie Mac 8 21 22 18 33 90 69 59 1.207 686 

Adjustable Rate 

Fannie Mae 107 3,210 5,612 8,087 10,736 7,305 10,481 28.269 17,993 14,529 

Freddie Mac 27 63 315 767 823 2.262 4.779 7,253 17,835 16,286 

. Multifamily 

Fannie Mae 2 9 140 1,106 1,200 1,877 1,483 4,180 4,836 3.181 

Freddie Mac 0 0 18 708 1,902 3,538 2,016 1.191 1.824 1,338 

Federal Houeing AdminietratiodDepartment of Veterane Affairs 

Fannie Ma@ 2,284 901 186 190 482 438 1,784 503 940 698 

Freddie Mac 0 0 213 438 1,253 1,471 833 849 631 406 

Fannie Mae 6,830 25,939 26,479 29,288 43,841 79,712 77,609 72,052 86,914 115,143 

Freddie Mac 3,744 23,671 22,952 21.885 44.012 103,474 76.840 44,075 78,589 75.518 

SOURCE: Congressional Budget oilice usingdata from Fannie Mae and Freddie Mac. 

NOTE: n.a. = not applicable. 

a. Includes FHANA mortgagee fmanced with mortgage-backed eeeurities (MBSa). 

b. Intermediate fixed-rate mortgage8 finand with MBSs only. Portfolio purehasea of intermediate fixed-rate loans are 

included in the 30-year, fixed-rate category in thia year. 

c. Includes only FHANA mortgagee retained in portfolio. 
128 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

and principal payments received from borrowers for the short period 

before payments are remitted to investors in MBSs. Both GSEs issue 

MBSs backed primarily by conventional mortgages (intermediate- or 

long-term, fixed- or adjustable-rate, single-family loans, and long-term 

multifamily loans). FHA-insured mortgages and VA-guaranteed loans 

account for only a small portion of the collateral of some of the GSEs' 

mortgage-backed securities. 

An investor in a Fannie Mae or Freddie Mac MBS is entitled to a 

fixed fraction of all the interest and principal payments received on the 

mortgages in the pool backing the securities. The amount of the 

fiaction equals the proportion of the MBS issue owned by the investor. 

Fannie Mae guarantees the timely payment of principal and interest 

on its MBSs. Freddie Mac guaranteed timely payment of interest and 

ultimate payment of principal on its MBSs until 1990, when the GSE 

began issuing enhanced MBSs that provide both a guarantee of timely 

payment and a more rapid remittance of funds. Investors in MBSs 

previously issued by Freddie Mac can convert the securities to the enhanced version for a fee. 

The implicit federal guarantee of MBSs issued by Fannie Mae and 

Freddie Mac enhances the credit quality of the securities. The guarantee and the large outstanding volume of the MBSs also make them 

much more liquid--rapidly convertible to cash--than MBSs issued by 

wholly private firms. For both reasons, the yields that investors require on Fannie Mae and Freddie Mac's securities backed by fixed-rate 

mortgages are, on average, about 0.2 to 0.3 percentage points less than 

the yields on comparable securities issued by wholly private firms that 

carry a double-A rating, which is the rating most commonly given to 

such securities. 

REMICs. Fannie Mae and Freddie Mac also issue mortgage-related securities such as real estate mortgage investment conduits (REMICS).~ 

For a fee, the GSEs also guarantee REMICs issued by other financial 

institutions. REMICs are backed either by pools of mortgages or mort3. Freddie Mac pioneered the original type of mortgage-related eecuritim, known an collateralized 

mortgage obligatione (CMOs). Ieeuers muat show CMOs as liabilities on their balance sheeta, but 

RBMICe may be camed off the balance sheet ae contingent liabilitim. and have more favorable tax 

treatment. 
CHAPTER IV FANNlE MAE AND FREDDIE MAC l!H 

gage-backed securities and are sold in different classes. The securities 

in each class may differ in various ways, for example, in the priority 

with which investors receive principal payments on the collateral, in 

whether the interest rate on securities in the class is fixed or variable, 

or in whether interest is paid when due or is accrued. Issuers of 

REMICs can tailor these features to attract investors with different 

preferences. Over one-half of the MBSs issued by each GSE in 1990 

went into REMICs, which have brought more investors into the secondary mortgage market. 

Portfolio Lending. Both GSEs issue debt to finance the mortgages and 

other assets in their portfolios. Fannie Mae funds a sizable portfolio, 

both as an investment and to maintain the liquidity of mortgages for 

which there is no well-developed secondary market. Freddie Mac 

maintains a much smaller portfolio, principally for assembling pools of 

mortgages for securitization, but also as a means of investing in a 

small volume of loans that cannot be financed with MBSs. At year-end 

1990, mortgages and MBSs retained in portfolio accounted for about 28 

percent of the mortgages financed by Fannie Mae; Freddie Mac held 

about 6 percent of the loans it had financed in portfolio. 

Purchases of Mortgages for Low- and Moderate-Income Housing. 

Fannie Mae and Freddie Mac purchase mortgages that finance housing for low- and moderate-income families. Current HUD regulations, 

which were issued in 1978, define such loans to include certain FHAinsured or federally subsidized mortgages, and loans financing singlefamily dwellings purchased at prices that do not exceed 2.5 times the 

Bureau of the Census's estimate of the median family income for the 

standard metropolitan statistical area (SMSA). The government no 

longer uses the SMSA designation, but divides urban areas into metropolitan statistical areas (MSAs) and primary metropolitan statistical 

areas (PMSAs), which are aggregations of several MSAs. In the fourth 

quarter of 1989 and the first quarter of 1990, Freddie Mac purchased 

about 0.4 million conventional, single-family mortgages on units in all 

MSAs. Thirty-seven percent of these loans met the HUD definition. 

In 1990, Famie Mae purchased 1.1 million conventional, single-family 
123 GOVERNMENT-SPONSORED ENTERPRISES April 1091 

loans on units in the 300 largest MSAs and PMSAs. Over 36 percent of 

those loans met the HUD definition.4 

Historical Development and Performance 

Although Fannie Mae and Freddie Mac have very different histories, 

today they have essentially the same statutory authorities and federal 

oversight. Both enterprises also have been consistently profitable in 

recent years. 

History. In 1934, the government authorized the chartering of privately owned, federally supervised national mortgage associations to 

purchase and sell FHA-insured home mortgages. No associations were 

created, however, and the Reconstruction Finance Corporation chartered the Federal National Mortgage Association in 1938 to buy and 

sell FHA-insured mortgages and to finance its activities by borrowing 

from the Treasury or the public. Ten years later the association was 

authorized to invest in mortgages insured by the Veterans Administration. 

The Congress reorganized Fannie Mae and gave it a statutory 

charter in 1954. Its authority was expanded to encompass three principal activities: providing liquidity to the secondary mortgage market, 

providing special assistance to certain types of mortgages, and managing and liquidating the portfolio of mortgages it had previously acquired. The Congress also began the process of shifting Fannie Mae to 

private ownership, a process that would be accomplished by requiring 

each mortgage seller to purchase a certain amount of common stock 

based on the amount of loans it sold to Fannie Mae, so that preferred 

stock owned by the Treasury could be gradually retired. 

The Housing and Urban Development Act of 1968 completed the 

transformation of Fannie Mae into a government-sponsored enterprise. The act created the Government National Mortgage Association 

(Ginnie Mae), an agency within HUD, to perform the special assistance 

4. The percentages assume the Census Bureau's estimate of median family income in 1990. An alternative approach would eetimate the perceatage of loam purchaeed that met the HUD definition in 

the year they were originated. 
CHAPTER IV FANNTE MAE AND FREDDIE MAC 129 

and management and liquidation functions previously assigned to 

Famie Mae. Fannie Mae was reconstituted into a federally chartered 

corporation owned by shareholders and governed by a 15-member 

board of directors, five of whom were to be appointed by the President.5 

The new enterprise retained the statutory purpose of providing supplementary assistance to the secondary mortgage market, was placed under the regulatory oversight of HUD, and was authorized to issue mortgage-backed securities. 

The Emergency Home Finance Act of 1970 authorized the creation 

of Freddie Mac to provide a secondary market for conventional home 

mortgages. The legislation gave Fannie Mae parallel authority to purchase conventional loans. Until 1989, Freddie Mac was owned by the 

Federal Home Loan Bank (FHLB) System and its member thrift institutions and governed by the members of the FHLB Board. FIRREA 

severed Freddie Mac's ties to the FHLB system, created an 18-member 

board of directors to run the GSE, and subjected it to HUD regulation. 

Today, Fannie Mae and Freddie Mac have the same public purposes 

and federal oversight, and there are only minor differences in their statutory authorities. Both enterprises are subject to federal income taxation. 

Performance. Although Fannie Mae has been consistently profitable 

in recent years, the GSE suffered losses in the early 1980s, and its 

viability was in doubt for a time. Fannie Mae had financed a portfolio 

of long-term mortgages with short-term debt, exposing it to considerable interest rate risk. When interest rates rose sharply in 1979 and 

1980, the interest expense on the GSE's portfolio rose significantly, its 

net interest income (interest income less interest expense) became 

negative, and it became deeply insolvent on a market value basis.6 

From 1980 through 1985, the enterprise expe~ienced losses in four out 

of the six years. 

5. The board waa later expanded to 18 members, five of whom are appointed by the President. 

6. HUD has entimated that Fannie Mae's mark-to-market net worth--the market value of ita aseete 

minue the market value ofita liabilitiw--wae negative at the end of 1979 through 1984. At the end 

of 1981, the GSE's mark-to-market net worth waa estimated to be negative $10.8 billion, nearly 20 

percent of the market value of ita msete. Sea Department of Housing and Urban Development, 

1986Report to Congress on the Federal National Mortgage Association (September 1987). p. 100. 
130 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 12. FANNIE MAE'S CONSOLIDATED BALANCE SHEETS 

AND INCOME STATEMENTS, 1981-1990 

(In millions of dollars) 

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 

Balance Sheet 

Assets 

Net Mortgage 

Portfolios 69,626 69,228 75,130 84,038 94,497 93,949 93,470 99,867 107,756 113,875 

Cash and 

Inveatmenta 1,066 2,463 1.719 1,889 1,929 1,862 5,925 8,148 11,870 14,046 

All Other 

Aaseta 986 1.300 1.534 1.871 2.650 3.810 4,064 4.243 4.689 5,192 

Total 61,578 72,981 78,383 87,798 99,076 99,621 103,459 112,258 124,315 133,113 

Liabilities 

Net Debentures, 

Notes, and Bonds 

Due within 

one year 17,365 25,781 26,860 31,261 31,939 31.294 29,718 36.599 36,346 38,453 

Due after 

one year 41.186 43,833 47,734 52.458 62,046 62,269 67,339 68,860 79,718 84,950 

All Other 

Liabilities 1,947 2,414 2.789 3.161 4.082 4.876 4.591 4.539 5.260 5,769 

Total 60,498 72,028 77,383 86,880 98,067 98,439 101,648 109,998 121,324 129,172 

Stockholders' Equity 

Additional Paidin Capital 268 302 308 308 372 448 773. 777 787 810 

Less Treasury 

Stac kb - -2 - -2 - -2 -2 -- -2 - c - -96 - -101 - -87 -163 

Total 1,080 963 1,000 918 1,009 1,182 1,811 2,260 2,991 3,941 ...................................................................... (Continued) 

SOURCE: Congressional Budget Omce using data from Fannie Mae. 

a. Includes mortgage-backed securities held in portfolio at year-end of $1.6 billion (19861, $4.2 billion 

(1987), $8.1 billion(1988), $11.7 billion, and $11.8 billion (1990). 

b. Represents the cost of stock repurchased by Fannie Mae to manage capital and fund ita obligations 

under its employee stock ownership plan and stock options programs. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 131 

TABLE 12. Continued 

Balance Sheet 

Contingent Liabilities 

Mortgage-Backed 

Securities8 717 14,450 25,121 36,215 54,987 97,174 139,960 178,250 228,232 299.833 

Capital Ratios (Percent) 

EquityIAssete 

plus MBSs 1.73 1.09 0.97 0.74 0.66 0.61 0.76 0.80 0.88 0.94 

CapitaUAeseta 

plus MBSsd 1.90 1.25 1.10 0.85 0.76, 0.74 0.90 0.94 1.01 1.06 

Income Statement 

Net Interest 

Income -429 -464 -9 -90 139 384 890 837 1,191 1.593 

MBS Guaranty 

Feee c 16 54 78 112 175 263 328 408 536 

Gain (Loss) 

on Sales 

of Mortgages c 58 118 21 11 31 -81 12 9 7 

Net Miscel1aneousIncome 60 63 56 53 73 83 53 69 60 107 

Provision for 

Loseem 27 -36 -48 -86 -206 -306 -360 -365 -310 -310 

Administrative 

Expemes ---- -49 -60 -81 -112 -142 -175 -218 -254 -286 

Retax 

Income -391 -423 90 -136 -13 192 568 663 1,104 1,647 

Provision for 

Federal Income 

Taxes 185 202 -41 65 6 -87 -192 -156 -297 -474 

Extraordinary 

Item 29 

Net Income 

(Lose) -206 -192 49 -71 -7 105 376 507 807 1,173 

c. Lees than $500,000. 

d. Capital equals equity plus reserves. 
132 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

In 1981, new management began effecting four major changes in 

business strategy to return Fannie Mae to profitability. First, Fannie 

Mae ceased to commit to buy mortgages at a fixed price if they were 

delivered within one year. These commitments had led to losses when 

interest rates rose. Second, the GSE attempted to reduce its exposure 

to interest rate risk. The initial step was to begin purchasing mortgages of shorter duration, especially ARMs. Doing so increased the 

GSE's exposure to credit risk, however, because some ARMs financed 

at that time had interest rate buydowns and other features that made 

borrowers more vulnerable to rate increases. The enterprise also 

shortened the duration of its liabilities to avoid locking in high costs 

for servicing the debt. This action involved taking some additional 

interest rate risk, but worked out well when rates declined in 1984. At 

that point, Fannie Mae began lengthening the duration of its 

liabilities, which slowed the GSE's return to profitability by increasing 

its interest expense, but enabled it to make its earnings more stable. 

Third, to reduce its negative net interest income, the GSE rapidly 

increased the size of its portfolio between 1981 and 1985. Fourth, it 

began issuing MBSs in late 1981. MBS guarantee fees provide a stable 

stream of income that serves as a hedge against fluctuations in the net 

interest income on the portfolio. 

These and other changes in business strategy, as well as favorable 

movements in interest rates, enabled Fannie Mae to return to profitability. By the end of 1990, the GSE had experienced its fourth consecutive year and twelfth consecutive quarter of record profits. Fannie 

Mae's performance in the last decade is summarized in Table 12 on 

pages 130 and 131, which displays its income statements and balance 

sheets for 1981 through 1990. 

Freddie Mac has always been profitable. As shown in Table 13, 

the GSE's income from its portfolio and MBSs, less financing costs, increased for the ninth straight year in 1990. The enterprise's net, aftertax income increased rapidly from 1981 to 1984. Profits fell in 1985 as 

a result of incurring a federal income tax liability for the first time, but 

then resumed large annual increases through 1989. In 1990, earnings 

declined slightly because of a one-time additional provision of $100 

million to cover potential losses on the conventional, multifamily mortgages financed by Freddie Mac. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 133 

Figure 4. 

Quarterly Pretax Income of Fannie Mae and Freddie Mac as a 

Percentage of Assets and Mortgage-Backed Securities 

Percent 

SOURCE: Congressional Budget Office using data from Fannie Mae and Freddie Mac. 

0.4 

0.3 

0.2 

-0.2 

-0.3 

-0.4 

The GSEs' profits provide a useful summary of their performance 

over time. Figure 4 shows the quarterly pretax income of each enterprise as a percentage of all assets and MBSs. The fluctuations in 

Fannie Mae's pretax income per dollar of assets early in the decade 

reflect the accounting recognition of losses resulting from high interest 

rates. Its pretax income per dollar of assets has been consistently positive since 1985 (when income from MBS guarantee fees became substantial), has increased steadily since mid-1986, and, since mid-1988, 

has been higher than Freddie Mac's.7 The latter's pretax income per 

dollar of assets was fairly consistent throughout the period. 

- 

7 

Freddie Mac 

I1 

I1 Fannie Mae 

- I1 

'! ,' 

L, 

- 

I I I I 1 I I I 1 1 

7. Fannie Mae experienced a large, one-time increme in earning0 in the fourth quarter of 1987 aa a 

reault of a new accounting etandard for recognizing fee income from mortgage purchaee commitmenta. 
134 GOVERNMENT-SPONSORED ENTERPRISES April lWl 

TABLE 13. FREDDIE MAC'S CONSOLIDATED BALANCE SHEETS 

AND INCOME STATEMENTS, 1981-1990 

(In millions of dollars) 

Balance Sheet 

Assets 

Net Mortgage 

Portfolio 5,169 4,649 7,447 9,968 13,486 13,012 12,258 16,815 21,328 21,395 

Cash and 

Temporary 

Investments 629 756 712 710 687 3,612 4,670 5,525 5,396 6.808 

Mortgage Securities Purchaeed 

Under Agreementa to Resell 0 0 0 1,513 509 4,495 5,859 9,107 5,765 9,063 

All Other 

Aaeeta ---- 528 594 758 933 1,617 2,110 2,887 2.906 2,973 3.313 

Total 6,326 5,999 8,917 13,124 16,299 23,229 25,674 34.352 35,462 40,579 

Liabilities 

Principal and 

Interest Due 

on MBSa 204 546 953 1,188 2,247 5,958 4.192 5,011 6,670 6,427 

Debt Securities 

Due within 

one year 1.533 1,275 2,146 4.467 3.760 6,556 11,777 18.482 16,385 19,697 

Due after 

oneyear 3,537 2,928 2,712 2,365 2,646 1,863 1,609 1,620 2,426 3,991 

Repurchaee 

Agreements 410 320 265 150 200 0 523 0 0 0 

Multiclaae 

Securities 

Due within 

one year 0 0 36 190 375 659 351 265 289 262 

Due after 

one year 0 0 1,633 3,024 4,773 4,310 3,301 4,479 5,003 4,425 

All Other 

Liabilitiee --- 392 634 760 1.144 1.519 2.940 2.839 2.911 2.774 3.641 

Total 6,076 5,703 8,495 12,618 16.520 22,276 24,492 32,768 33,547 38,443 ...................................................................... (Continued) 

SOURCE: Congressional Budget Ofiice ueing data fromFroddie Mac. 

a. Capital equals equity plua reserves. 

b. Equals intereat and discount on mortgages plum interest on investments and management and guarantee income (from mortgage-backed eecurities (MBSs)), minua inhreet and related debt expensee. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 135 

TABLE 13. Continued 

Balance Sheet 

Stockholders' Equity 

Common Stock 

Nonvoting 100 100 100 100 100 100 100 100 100 0 

Voting 0 0 0 0 0 0 0 0 150 150 

Preferred Stock 0 0 0 150 150 150 150 150 0 0 

Additional Paidincapital 100 100 100 0 0 0 0 104 105 107 

Retained 

Earninge - 50 - 96221 356 529 ~~~1.5601,879 

Total 250 296 421 606 779 953 1,182 1,584 1,915 2,136 

Contingent Liabilities 

MortgageBacked 

Securities 19,897 42,952 57,720 70,026 99,909 169,186 212,635 226,406 272,870 316,359 

Capital Ratios (Percent) 

CapitaUAssete 

plus MBSea 1.29 0.82 0.84 0.94 0.85 0.65 0.64 0.76 0.77 0.77 

Income Statement 

Net Intereat 

Margin on 

Portfoliob 70 107 257 371 500 600 791 957 1,089 1,273 

Other Income 8 16 6 21 22 72 14 -5 16 7 

Provision for 

LOSS~E -17 -26 -46 -54 -79 -120 -175 -204 -260 -450 

Administrative 

Expenaes ---30 -37 -53 - -71 - -81-110-150-194-217-243 

Pretax 

Income 31 60 164 267 362 442 480 554 628 587 

Proviaion for 

Federal Income 

Taxes 0 0 0 0 -164 -195 -179 -173 -191 -173 

Extraordinary 

Item - 0 - 0-4 - 0 - 10 - 0 - 0 - 0 - 0 - o 

Net Income 

(Loas) 31 60 160 267 208 247 301 381 437 414 - .- - 
136 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Expanding Market Share and Economic Effects 

The activities of Fannie Mae and Freddie Mac expanded significantly 

in the 1980s as the thrift industry became a less important source of financing for mortgages.8 Although thrifts continued to originate about 

35 percent to about 45 percent of all residential mortgages during the 

decade, the share of outstanding mortgage debt financed by them fell 

from 46 percent at year-end 1981 to 26 percent in mid-1990 (see Table 

14). This trend reflected a change in the incentives for thrifts to hold 

mortgages. The change was caused by alterations in federal policies, 

more volatile interest rates, and a decline in the industry's profitability. Fannie Mae and Freddie Mac expanded their shares, as did 

commercial banks, to fill the gap created by the reduced role of the 

thrifts. The proportion of residential mortgage debt financed by the 

enterprises increased from 7 percent to 24 percent in that' period. The 

increase in the GSEs' activities in turn increased the thrifts' incentives 

to hold MBSs, which took an increasing share of thrifts' portfolios, at 

the expense of whole mortgages, particularly conforming FRMs. 

Changing Role of the Thrifts. In the 1970s and early 1980s, the federal 

government reduced the tax benefits that had given profitable thrift 

institutions a significant incentive to invest in home mortgages.9 The 

government also eased restrictions on thrifts' investment in other assets such as corporate loans, bonds, or equity, and gradually eliminated the ceilings on the rates payable on deposit accounts. These policies had enabled thrifts to subsidize interest rates on conventional 

mortgages. Research suggests that rates on conventional FRMs in the 

8. This section follows Patric H. Henderahott, The Market for Home Mortgage Credit: Recent Changes 

and Future Prospects (National Bureau of Economic Research Working Paper No. 3548, December 

1990). which summarizes the literature and provides a useful overview of recent trends and the 

GSEs' role. 

9. Thrifts had been allowed to compute loan loss reserves that exceeded a reasonable provision for 

normal losse~, ae long ae the institutions invested a large portion of their assets in homing-related 

loans or liquid assets. This tax preference permitted profitable thrifts to tranefer large portions of 

their profits to reserves, thereby avoiding federal income taxes. Between 1962 and 1969, the 

tranefer was limited to 60 percent of taxable income. Between 1969 and 1979, the fraction was gradually reduced to 40percent. The Tax Reform Act of 1986 lowered the fraction to 8 percent. 
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138 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

mortgage assets. Research suggests that this reduction in supply 

caused rates on conventional FRMs to rise by about 0.5 percentage 

points in 1982 through 1986 relative to the levels that would have 

existed if other sources of funds had been immediately available.11 

Expansion of the GSEs' Activities. This short-term rise in conventional FRM rates induced Fannie Mae and Freddie Mac to expand their 

mortgage purchases and MBS issues, particularly after the large drop 

in interest rates in 1986 increased the demand for mortgage funds to 

refinance existing loans. Their increased activities and their economies of scale in processing information and securitizing mortgages enabled them to achieve a dominant position in the market for conforming FRMs--conventional fixed-rate loans with original balances below 

the GSEs' purchase limits. The proportion of newly originated conforming FRMs securitized by the enterprises rose from an estimated 4 

percent before 1981, to more than 50 percent in 1986 through 1988, 

and to 69 percent in 1989. 

Reduction in Interest Rates on Conforming FRMs. One consequence of 

Fannie Mae and Freddie Mac's emerging dominance in the conforming 

FRM market has been a reduction in interest rates on those loans. 

Since 1986, competition between the GSEs, and increased competition 

among the mortgage lenders who make loans that the enterprises purchase, has passed through to borrowers a large portion of the reduction 

in the yields on FRM-backed securities issued by the GSEs. This reduction arises from the implicit federal guarantee and the greater 

liquidity of the MBSs. As a result, in recent years mortgage lenders 

have quoted rates on conforming FRMs that are about 0.3 percentage 

points (30 basis points) lower than the rates on conventional FRMs 

with higher loan balances that are not securitized by Fannie Mae or 

Freddie Mac.12 

Because Fannie Mae and Freddie Mac have not been as active in 

the conforming ARM market, their purchases and competition among 

11. Hendershott and Van Order, "Integration of Mortgage and Capital Markets." 

12. Patric H. Hendershott and James D. Shilling, "The Impact of the Agenciee on Conventional 

Fixed-Rate Mortgage Yields," Journal of Real Estate Finance and Economics, no. 2 (Kluwer 

Academic Publishers, 1989). pp. 101-115. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 139 

lenders that sell ARMS to them do not appear to have reduced interest 

rates on those loans. The lower that fixed rates are, both in absolute 

terms and relative to adjustable rates, the more borrowers prefer fixedrate mortgages. Both the absolute fall in interest rates on conforming 

FRMs, and the reduction in the difference between those rates and interest rates on ARMS, have reduced ARMS' share of mortgage originations. This reduction in turn has contributed to the growth in the 

share of all conforming mortgages purchased by the GSEs. 

Effects on Thrifts' Activities. The reduction in interest rates on conforming FRMs has lowered the returns that thrifts expect to earn from 

holding such loans in portfolio, relative to the returns from selling the 

loans to Fannie Mae and Freddie Mac and servicing them for the GSEs. 

As a result of this change, increased competition in the thrift industry, 

and the implementation of risk-based capital requirements for f'ederally insured depository institutions, thrifts in recent years have sold 

to the enterprises most of the conforming FRMs that they have originated. The capital standards require banks and thrifts to have capital 

equal to 1.6 percent of their holdings of GSE mortgage-backed securities, and to 4 percent of their investment in whole mortgages, by the 

end of 1991. The lower capital cost of investing in Fannie Mae and 

Freddie Mac's MBSs will tend to increase the proportion of outstanding 

mortgage debt fmanced with those GSE securities in the future. 

Integration of Mortgage Markets into the Capital Markets. The 

expansion of the activities of Fannie Mae and Freddie Mac in the 1980s 

enabled them to integrate regional mortgage markets into the capital 

markets. Evidence for this success comes from research that has found 

that the speed with which mortgage rates adjusted to changes in capital market rates increased significantly in the 1980s, and that in most 

years since 1984, mortgage rates have been close to the levels that 

would exist if the mortgage and capital markets were fully integrated.13 

Emergence of Issuers of Private-Label MBSs. The recent success of 

Fannie Mae and Freddie Mac has led wholly private firms to develop a 

significant capability to securitize residential mortgages. Issuance of 

13. Hendemhott and Van Order, "Integration of Mortgage and Capital Markets!' 
140 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

private-label MBSs has greatly increased, rising from $2.4 billion in 

1985, to $14.2 billion in 1988 and 1989, and to more than $24.3 billion 

in 1990. Thirty-two firms marketed over 160 issues in 1990. Three 

firms--Citicorp, Residential Funding Corporation, and Prudential 

Home Mortgage Securities Corporation--eac h issued more than $3 billion in MBSs.14 Wall Street investment banking firms now quote daily 

prices for some of the larger issues of private-label MBSs. Nearly all of 

the mortgages backing these securities were nonconforming loans 

when they were securitized. The implicit federal guarantee and greater liquidity of the GSEs' mortgage-backed securities, their levels of 

capital, and the enterprises' economies of scale enable them to pay 

higher prices for conforming loans. As a result, lenders generally are 

not willing to sell conforming mortgages to private-label issuers. 

The rapid expansion of the private-label MBS market suggests 

that wholly private MBS issuers might be able to achieve the GSEs' 

public purposes of smoothing regional imbalances in mortgage funds 

and integrating mortgage markets into the capital markets. It is not 

clear, however, that such firms would maintain a secondary market for 

mortgages originated in all regions of the country at all points in the 

business cycle, as the GSEs do. 

CREDIT RISK 

If Fannie Mae and Freddie Mac could predict exactly the rates at which 

the home mortgages they purchase would default and how much they 

would lose on each default, they would charge MBS guarantee fees and 

mortgage purchase prices that covered these costs (plus a markup for 

profit). At best, the GSEs can use historical data to estimate the 

average frequency and severity of defaults and to assess how different 

factors cause rates to vary around these average values from year to 

year. Because mortgages financed by the enterprises may perform 

worse than expected, they are exposed to credit risk. 

14. Financial World Publicatione, The Mortgage Market Statistical Annual for 1991 (Washington. D.C., 

1990), p. 132. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 141 

Fannie Mae and Freddie Mac are exposed to comparable credit 

risk. Since the major changes in Fannie Mae's underwriting guidelines in 1985, the two GSEs' guidelines for single-family mortgages 

have been virtually identical, and the single-family loans each has 

purchased have had quite similar risk-related characteristics and geographic distributions. The performance of the mortgages purchased by 

each enterprise since 1985 has also been comparable. If Fannie Mae 

and Freddie Mac continue to compete vigorously, they are likely to continue to be exposed to similar credit risk. Competition induces them to 

maintain similar underwriting guidelines and prices in order to avoid 

a deterioration in the quality of the loans they purchase. This section 

examines how Fannie Mae and Freddie Mac manage and control their 

exposure to credit risk and discusses indicators of the performance of 

the loans they have financed. 

Management and Control of Credit Risk 

Fannie Mae and Freddie Mac control the default losses they expect to 

incur through underwriting guidelines, property appraisal standards, 

sellerlservicer eligibility requirements and guidelines, and management controls. Consistent with restrictions in their charter acts, they 

control their actual losses by requiring private mortgage insurance on 

mortgages with loan-to-value (LTV) ratios in excess of 80 percent, and 

through agreements with lenders and other credit enhancements.15 

The GSEs also control the variance of losses by taking advantage of 

geographic diversification. 

Underwriting Guidelines and Property Appraisal Standards. The 

underwriting guidelines issued by Fannie Mae and Freddie Mac are 

the standards for conforming mortgages. The GSEs require lenders 

that sell loans to them to assess the borrower's ability and willingness 

to repay the loan, as indicated by appropriate documentation of his or 

her employment history, income, financial condition, ratios of mortgage costs and other necessary expenses to income, and credit history. 

Property appraisal standards require' lenders to obtain appraisals of 

15. A mortgage's LW ratio ie the ratio between the outatanding loan balance and the value of the 

property. 
142 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

the market value of properties. Sellers must give weight to the ap- ' 

praisal and the borrower's creditworthiness in underwriting a loan. 

SellerIServicer Eligibility Standards. Lenders are eligible to sell 

mortgages to and service loans for Fannie Mae or Freddie Mac if they 

meet standards related to financial condition (including net worth), 

management quality, operations, and insurance coverage. Lenders 

must follow specific procedures when originating and servicing loans 

(and in foreclosing on them if borrowers default). Each GSE uses onsite examinations and off-site reporting to monitor lenders' compliance 

with these standards and the performance of loans they have sold or 

serviced. The enterprises take into account information on loan performance when pricing new purchases of mortgages from lenders. 

Box 7 discusses how Fannie Mae and Freddie Mac change their underwriting guidelines, property appraisal standards, and sellerlservicer 

guidelines to limit their exposure to credit risk. 

Management Controls. The GSEs use management controls to limit 

their exposure to credit risk on specific mortgage purchases. Small 

transactions involving loans that meet their underwriting guidelines 

are handled routinely. Large purchases and negotiated transactions 

are reviewed by senior corporate management in the regional or central offices. More than half of each enterprise's recent mortgage purchases have been negotiated transactions. 

Credit Enhancements. The charters of Fannie Mae and Freddie Mac 

allow the GSEs to purchase a mortgage with a loan-to-value ratio 

greater than 80 percent only if the loan carries credit enhancement 

(unless the seller has retained at least a 10 percent participation in the 

loan). The most important form of credit enhancement is private mortgage insurance, which typically covers default losses up to 25 percent 

of the loan's outstanding balance. The insurance protects the GSEs 

from a large portion of default losses, so that the cost of default to the 

enterprises is typically much lower for insured loans. The enterprises 

must approve and have written eligibility and reporting requirements 

for private mortgage insurers. Both Fannie Mae and Freddie Mac also 

improve the quality of loans through recourse agreements, under 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 143 

BOX 7 

Changes in Policy to Limit Exposure to Credit Risk 

Fannie Mae and Freddie Mac frequently change their underwriting guidelines, property appraisal standards, and seller/servicer eligibility guidelines 

in order to limit their exposure to credit risk . For example, in 1985 Fannie 

Mae eliminated adjustable-rate mortgages (ARMs) with graduated payments and other products that had performed poorly, restricted ARMs with 

95 percent loan-to-value ratios, and required a larger down payment and 

tighter property appraisal standards, among other changes designed to 

improve the credit quality of new mortgages it purchased. 

In 1990, Fannie Mae announced that it would require each lender desiring to sell reduced documentation mortgages--loans accompanied by less 

certain proof of the borrower's income or employment--to do so only on a 

negotiated basis. Freddie Mac announced that it would phase out the purchase of mortgages originated with reduced documentation, and would purchase no more than $10 million in mortgages annually from any seller on a 

nonnegotiated basis. 

The GSEs base such decisions on historical data on the performance of 

different types of loans, of loans made to different types of borrowers, or of 

loans originated or serviced by different types of lenders, and on judgments 

about future performance. When one enterprise makes a major change in 

underwriting guidelines, the other usually follows within a short period to 

avoid being sold riskier loans by lenders. Since 1985, the two GSEs' underwriting guidelines for single-family loans have been quite similar. 

which sellers agree to repurchase loans that default, and by requiring 

sellers to pledge collateral. Because the federal government requires 

banks and thrifts to retain the same amount of capital for mortgages 

sold with recourse as for loans they retain, lenders are less likely to be 

willing to enter into recourse agreements in the fbture, and the GSEs 

will be less able to use this type of credit enhancement. To partially 

offset this trend, the enterprises are using third-party alternatives, 

such as spread accounts and pool insurance policies.16 In addition, 

both GSEs benefit from FHA insurance and VA guarantees of a few 

loans, and from the fad that sellers own participation interests in some 

16. Lenders can deposit mortgage interest paymenta in excess of interest due to MBS investors in 

spread accounts, where the funds are available to cover delinquencies or absorb default losses. 

They also can purchase insurance against a portion of any losses on the mortgagee in a pool in ex- cess of loeaes that are covered by ineurance of the individual loans. 
144 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

mortgages. The participations require the enterprises and the sellers 

to share any default losses on a pro rata basis. Table 15 shows the percentages of mortgages financed by Fannie Mae and Freddie Mac that 

were covered by credit enhancements at the end of 1990. 

Geographic Diversification. Fannie Mae and Freddie Mac also reduce 

the fluctuation in their earnings and lower the amount of capital they 

need to hold against their exposure to credit risk by maintaining 

nationally diversified mortgage portfolios. Geographic diversification 

decreases the fluctuation of returns because, in most economic environments, default losses on loans originated in one region of the 

country tend to be offset by earnings on mortgages in other regions. 

Data on the performance of 300,000 conventional loans originated in 

1976 through 1980 and purchased by Freddie Mac suggest that if all 

the loans financed by the GSE were backed by properties located in 

only one of its five regions, it would need to have about two to three 

TABLE 15. MORTGAGES FINANCED BY FANNIE MAE AND 

FREDDIE MAC COVERED BY CREDIT ENHANCEMENTS, 

YEAR-END 1990 (As a percentage of unpaid principal balance) 

Type of Credit 

Enhancement 

Fannie Mae All 

Portfolio MBSs Total Freddie Mac 

Private Mortgage 

Insurance 17 18 18 18 

Recourse or Collaterala 6 28 22 8 

FHANA 12 4 6 2 

Participationsb 8 2 3 20 

Spread Accounts - c - c - c - 2 

Total 43 52 49 49 

SOURCE: Congressional Budget Office using data from Fannie Mae and Freddie Mac. 

NOTES: For Fannie Mae, a few mortgage types have been excluded, and month-end eetimates of the 

outstanding balances of some loam have been made. 

MB8 = mortgage-backed eecurities; FHA = Federal Housing Administration; VA = Department of Veterane Affairs. 

a. Not also covered by mortgage insuranee. 

b. Not also covered by recourse agreements. 

c. Less than 1 percent. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 1% 

times as much capital to meet a capital standard based on a credit 

stress test.17 

The geographic diversification achieved by Fannie Mae and 

Freddie Mac affects both mortgage borrowers and the federal government. The GSEs charge the same prices to purchase or guarantee pools 

of loans from different regions of the country, even though the risk of 

lending differs by region. This benefits borrowers in regions with more 

volatile economies, and imposes costs on borrowers in regions that are 

more stable economically. The government benefits because diversification protects the enterprises from severe downturns in regional 

economies, such as the decline that occurred in the Southwest in the 

1980s. The most serious threat to the GSEs' financial condition arising 

from default losses would come from a prolonged, nationwide recession 

or depression. Fannie Mae and Freddie Mac's capital standards, discussed later in this chapter, are therefore intended to enable them to 

survive such an event. 

Indicators of Credit Risk and Loan Performance 

Fannie Mae and Freddie Mac assess their exposure to credit risk by 

monitoring several characteristics of the loans they purchase, the most 

important being the loan-to-value ratios. The GSEs monitor loan performance by tracking delinquency and foreclosure rates. They establish reserves to cover losses on loans that they expect to default. 

Loan-to-Value Ratios. A borrower's equity is the most important 

determinant of the probability that a mortgage will default. At the 

time of origination, borrower's equity is very close to one minus the 

LTV ratio. Consequently, changes in the initial LTV ratios of loans 

purchased by Fannie Mae and Freddie Mac in each year are good indicators of changes in the credit risk posed by new business. Table 16 

shows the percentages of conventional fixed- and adjustable-rate mortgages financing single-family dwellings purchased by Fannie Mae and 

17. John M. Quigley and Robert Van Order, "Defaults on Mortgage Obligations and Capital Requirementa for U.S. Savings Institutione: A Policy Perspective" (mimeograph, April 1990). 
146 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 16. FANNIE MAE AND FREDDIE MAC'S CONVENTIONAL 

SINGLE-FAMILY MORTGAGE PURCHASES AND 

MBS ISSUES, 1985-1990, BY LOAN-TO-VALUE 

(LTV) RATIO (In percent) 

LTV Ratio 

Outstanding 

as of 

1985 1986 1987 1988 1989 1990 12/31/90 

Fixed-Rate Mortgages 

Not available 

0 to 80 

81 to 90 

91 to 100 

Adjustable-Rate Mortgages 

Not available 

0 to 80 

81 to 90 

91 to 100 

Fannie Mae 

Purchases for Portfolio 

Mortgage-Backed Securities Issued 

Fixed-Rate Mortgages 

Not available 0 0 0 0 

0 to 80 72 79 79 77 

81 to 90 14 15 16 17 

91 to 100 13 6 5 6 

Adjustable-Rate Mortgages 

Not available 0 0 0 0 

0 to 80 84 85 84 66 

81 to 90 14 13 15 32 

91 to 100 1 2 1 2 

Fixed-Rate Mortgages 

Not available 

0 to 80 

81 to 90 

91 to 100 

Adjustable-Rate Morgages 

Not available 

0 to 80 

81 to 90 

91 to 100 

Freddie Mac (All Purchases) 

SOURCE: Congreeeional Budget mce using data from Fannie Mae and Freddie Mac. 

NOTE: For Fannie Mae, LTV ratioe are at the time of loan origination. For Freddie Mac, LTV ratioa are 

at the time of purchase by the GSE. a. Less than 0.6 percent. 
CHAPTER IV FAN'NIE MAE AND FREDDIE MAC 147 

Freddie Mac in 1985 through 1990 and outstanding at year-end 1990 

that had different LTV ratios. For Fannie Mae, the ratios are at the 

time of loan origination. For Freddie Mac, the ratios are at the time of 

purchase by the GSE. Loans with LTV ratios of higher than 80 percent 

carry private mortgage insurance. 

In 1986, the proportion of mortgages with the highest, most risky 

LTV ratios (greater than 90 percent) purchased by Fannie Mae declined ~ign~cantly. This change reflected the major tightening of the 

GSE's underwriting standards implemented in 1985, which was described in Box 7. The proportion of ARMS in the lowest risk category-- 

LTV ratios of 80 percent or less--purchased for Fannie Mae's portfolio 

increased significantly in 1990. The proportion of FRMs in each category purchased by Freddie Mac was relatively constant over the 

period. For Freddie Mac's purchases of ARMS, the proportion of loans 

in the highest risk category declined, and the proportion of lams in the 

lowest risk category increased, at a relatively consistent rate during 

the 1985-1990 period. 

Repayment of loan principal lowers the LTV ratio of a mortgage 

and increases the borrower's equity. Appreciation in home prices has 

the same effect. Consider a $100,000, 30-year FRM used to finance a 

$125,000 home. If the interest rate on the loan is 10 percent, after five 

years the outstanding balance has declined to about $96,500. If the 

property has appreciated at 4 percent per year, the market value of the 

house has increased to about $152,000. Taking into account amortization and appreciation, the LTV ratio of the mortgage is now about 63 

percent. The borrower's equity has increased from 20 percent of the 

home's value at origination to about 37 percent five years later. In 

periods of rapid inflation of home prices, appreciation is by far the most 

important cause of changes in the credit risk of home mortgages. 

Freddie Mac has developed its own home price index to estimate 

the mark-to-market LTV ratios (the LTV ratios at origination plus 

amortization and home price appreciation) of the mortgages it has financed.18 The GSE uses the estimated mark-to-market LTV ratios to 

18. See Jease M. Abraham and William S. Schauman, "New Evidence on Home Prices from Freddie 

Mac Repeat Sales" (paper presented at the American Real Estate and Urban Economies Aaeociation 

Midyear Meetings, May 30.1990). 
148 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

assess the credit risk of the loans and to determine the adequacy of its 

capital. The index suggests that annual appreciation in home prices 

nationwide averaged about 3 percent in 1981 and 1982, 6 percent in 

1983 through 1985, and 10 percent in 1986 through 1989, but fell to 2 

percent in 1990. 

The inflation of thk 1986-1990 period reduced the average estimated mark-to-market LTV ratio of the loans financed by Freddie 

Mac. The GSE estimates that the mean mark-to-market LTV ratio of 

the single-family FRMs it financed fell from 61 percent at the end of 

1987 to about 54 percent at the end of 1989, and rose to about 56 percent at the end of the third quarter of 1990. The recent increase reflects the slowing of home price appreciation in the last year. At yearend 1990, about 70 percent of the mortgages financed by Fannie Mae 

and Freddie Mac had been originated before 1989 and, therefore, had 

experienced at least one year in which home price appreciation had 

averaged 10 percent. 

Delinquency and Foreclosure Rates. Fannie Mae and Freddie Mac 

monitor the performance of the mortgages they finance by tracking 

delinquency and foreclosure rates. A loan is seriously delinquent if 

payments are past due 90 days or more, and in foreclosure when the 

legal process commences because the borrower has defaulted. Figure 5 

compares the rates at which conventional single-family mortgages financed by Fannie Mae, Freddie Mac, and the mortgage banking industry were delinquent or in foreclosure at the end of 1981 through 

1990. Fannie Mae's delinquency and foreclosure rates for those loans 

have been consistently higher than Freddie Mac's. The rates for 

single-family loans in Fannie Mae's portfolio rose at the end of 1985 

and 1986 because many of the ARMS it purchased in 1984 and 1985 

had high LTV ratios and so-called teaser rates, that is, interest rates 

two percentage points or more below what they would have been if the 

hll rate had been in effect. Borrowers who took out loans with teaser 

rates tended to default more frequently when the full rates went into 

effect. The delinquency and foreclosure rates for all single-family 

loans financed by Fannie Mae have been declining steadily since 1986, 

reflecting changes in the GSE's underwriting standards implemented 

in 1985 and early 1987, and are significantly below those for the 

mortgage banking industry, as are those financed by Freddie Mac. At 
CHAPTER N FANNIE MAE AND FREDDIE MAC 149 

year-end 1990, the delinquency and foreclosure rate for conventional 

single-family mortgages was 0.58 percent for Fa.nnie Mae and 0.42 percent for Freddie Mac. The rate for single-family loans financed with 

Fannie Mae's MBSs, the majority of which were originated after the 

1985 change in underwriting guidelines, was 0.33 percent. 

Figure 5. 

Percentage of Conventional Single-Family Mortgages 

Financed by Fannie Mae, Freddie Mac, and Mortgage Banks 

That Were Seriously Delinquent or in Foreclosure 

Percent 

I I 

SOURCE: Congressional Budget Office using data from Fannie Mae, Freddie Mac, and the Mortgage 

Bankers Association. 

Fannie Mae 

Portfolio 

Fannie Mae 

MBSs 

Fannie Mae 

Total 

Freddie Mac 

Mortgage 

Banks 

NOTES: A loan is seriously delinquent if payments are 90 days or more past due. For Fannie Mae, 

the data also include loans on which lenders are exercising forbearance. 

Data for the mortgage banks are not seasonally adjusted; 1989 and 1990 figures are from 

the traditional series. 

- 

- - - - - - 

, 

- 
150 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Conventional multifamily mortgages account for a small proportion of the loans financed by Fannie Mae and Freddie Mac. At the end 

of 1990, Fannie Mae had financed $14.2 billion in such loans and 

Freddie Mac had financed $11 billion. Fannie Mae had recourse to the 

lender on $6.7 billion of its mortgages, and 91 percent of the loans with 

recourse were backed by collateral. The other $7.5 billion was loans for 

which the GSE was "at risk" for default losses. Figure 6 compares the 

serious delinquency and foreclosure rates for conventional multifamily loans financed by the GSEs at the end of 1988 through 1990. 

The rates for Fannie Mae's multifamily loans were higher than those 

for Freddie Mac's program until 1990, when Fannie Mae's rates declined, and Freddie Mac's increased substantially. Freddie Mac's 

charge-offs for losses on multifamily loans also increased more than 

fourfold between 1988 and 1990. 

Freddie Mac believes that the performance of its multifamily program deteriorated for three reasons. First, the credit risk of its multifamily portfolio had increased in the second half of the 1980s because it 

had not adjusted its underwriting guidelines to reflect growing softness in that market. Second, the GSE purchased some multifamily 

loans from lenders that were not capable of originating and servicing 

them well. Third, Freddie Mac was not well prepared to handle the 

volume of delinquencies and foreclosures that occurred. In 1990, the 

GSE responded to the situation by suspending purchases of most new 

multifamily loans, adding servicing staff, obtaining appraisals of all 

multifamily properties with seriously delinquent loans, acting more 

quickly on delinquent loans, and inspecting properties more frequently. Freddie Mac expects to resume purchasing new multifamily 

loans once improved management and operating systems are in place. 

Loan Loss Reserves. Fannie Mae and Freddie Mac set aside reserves to 

cover losses on loans that default. Consistent with Generally Accepted 

Accounting Principles, each GSE maintains its total loan loss reserves 

at a level that management believes to be sufficient to provide for 

future losses that can be reasonably estimated. At year-end 1990, 

Freddie Mac added a special one-time provision of $100 million to its 

loan loss reserve. The GSE believes that, with this provision, the reserve is sufficient to cover potential losses on its multifamily loans. 
CHAPTER IV FANNJE MAE AND FREDDIE MAC 15l 

Fannie Mae and Freddie Mac charge losses from loan defaults and 

sales of acquired properties against their reserves. Charge-offs for 

losses on each GSE's conventional single-family and multifamily programs in the 1981-1990 period followed essentially the same trends as 

the serious delinquency and foreclosure rates, with some lag to reflect 

the time required to foreclose on defaulted loans and dispose of acquired properties. In recent years each enterprise's charge-offs have 

consistently been less than additions to their reserves, resulting in absolute growth in the reserves. 

Figure 6. 

Percentage of Conventional Multifamily Mortgages Financed by 

Fannie Mae and Freddie Mac That Were Seriously Delinquent or 

in Foreclosure at Year-End, 1988-1990 

Percent 

SOURCE: Congressional Budget Office using data from Fannie Mae and Freddie Mac. 

NOTE: A loan is seriously delinquent if payments are overdue by 90 days or more. 
154 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Since 1988, Fannie Mae has issued callable debt on a regular 

basis. When interest rates fall, Fannie Mae can retire such debt and 

reduce its interest expense, which partially matches the fall in its interest earnings resulting from accelerated prepayments of its mortgage assets. During 1990, callable debt accounted for about 70 percent 

of the enterprise's long-term debt issues. At the end of 1990, callable 

debt represented nearly 22 percent of the GSE's outstanding long-term 

debt. The issuance of callable debt enabled Fannie Mae to reduce its 

duration gap to three months at the end of 1990, as shown in Figure 7. 

Callable debt increases the GSE's interest expense, since investors require higher interest rates on the instruments, but the ability to retire 

the debt when interest rates fall and mortgage prepayments accelerate 

enables it to stabilize its net interest income. Fannie Mae intends to 

increase the proportion of its liabilities that are callable in order to 

continue to reduce its intetest rate risk. 

The relative rates of growth of Fannie Mae's portfolio and mortgage-backed securities reflect management decisions about how to 

fund the GSE's mortgage purchases. These decisions are based on 

simulations of the returns from a mortgage purchase financed with 

debt, over a wide range of future interest rates. If expected average 

returns are deemed high enough to compensate for taking the risk that 

changes in rates would lead to low actual returns, the enterprise funds 

the mortgages with debt. Otherwise, Fannie Mae places the mortgages 

in a pool and sells mortgage-backed securities. 

Freddie Mac's Financing Strategy. Freddie Mac has always sought to 

minimize its exposure to interest rate risk by securitizing nearly all 

the mortgages it purchases. In recent years, the GSE has carried out 

this strategy in two ways. First, it has attempted to finance only 5 percent of its mortgage holdings with debt. Second, Freddie Mac has 

structured the debt issued to finance its portfolio to minimize the sensitivity of the GSE's mark-to-market net worth--the market values of its 

assets and income from MBS guarantee fees minus the market value 

19. Continued 

lengthen durations. Principal and intereet paymenta munt be invented at current market interest 

ratea. Thun. if the duration of Fannie Mae'n aeseta had not been longer than the duration of ita 

liabilitien, ita net intereet income would have declined more when intereat ratea fell than they 

would have increased when intereet rates roee. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 166 

of its liabilities--to changes in interest rates. This approach to measuring and controlling interest rate risk is examined below. 

Measuring the GSEs' Exposure to Interest Rate Risk 

Fannie Mae and Freddie Mac are exposed to interest rate risk to the 

extent that changes in market interest rates will reduce their net income. To assess their exposure, a measure of net income must be selected. One possible indicator is the change in the enterprise's estimated mark-to-market net worth. A second is the return that the enterprise will earn on its mark-to-market net worth over a selected investment horizon, or holding period. A third measure is the GSE's net 

income measured on a GAAP basis over a period that is long enough to 

capture significant changes in cash flows. All three measures can provide useful information about an enterprise's exposure to interest rate 

risk. 

Fannie Mae and Freddie Mac use these approaches to measure 

their exposure to interest rate risk. Freddie Mac analyzes the sensitivity of its mark-to-market net worth to instantaneous changes in current interest rates. To decide how to finance the assets in their portfolio, Fannie Mae analyzes holding-period returns to assess their sensitivity to changes in interest rates. The GSE assesses how the after-tax 

returns on its mark-to-market net worth over a three-year holding 

period would respond to gradual changes in interest rates. Fannie Mae 

uses interest rate stress tests to assess the adequacy of its capital. The 

tests assess how adverse movements in interest rates over a five-year 

period would affect the enterprise's GAAP net income. The remainder 

of this section discusses each GSE's estimates of its mark-to-market 

net worth and its exposure to interest rate risk. 

Estimating Mark-to-Market Net Worth. Each GSE regularly estimates its pretax mark-to-market net worth and uses the estimates 

internally to manage interest rate risk and to make financing decisions. Freddie Mac was the first financial institution in the United 

States to publish estimates of its mark-to-market net worth and has 

done so since the third quarter of 1989. The GSE's outside accoun- 
166 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

tants, Arthur Andersen and Company, audit its estimates and market 

value accounting procedures. 

Freddie Mac's estimated mark-to-market net worth at the end of 

1990 was $6.2 billion before taxes, up from $5.2 billion at the end of the 

fourth quarter of 1989. The largest component was the $4.2 billion 

estimated market value of the MBS guarantee fees that Freddie Mac 

expects to collect in the future. The remaining $2.0 billion represented 

the estimated market value of the mortgages and other assets in the 

GSE's portfolio, net of the market value of the debt issued to financed 

them. Loss reserves, real estate owned, physical plant, and a few other 

items were counted at their book value. Taking into account estimated 

income taxes on the difference between the enterprise's mark-tomarket net worth and its GAAP net worth, its estimated mark-tomarket net worth after taxes was $4.8 billion at the end of 1990. 

Fannie Mae estimated that its pretax mark-to-market net worth 

at the end of 1990 was $6.1 billion. This amount consisted of the estimated market value of the mortgages in its portfolio, less the market 

value of the debt used to finance them, plus the book value of other 

entries on the balance sheet ($4.7 billion), plus the estimated market 

value of future guarantee fees from its outstanding MBSs ($1.3 billion). Conceptually, the net market value of the portfolio has two components: the market value of the hypothetical guarantee fees that 

Fannie Mae could collect for guaranteeing securities backed by the 

mortgages in the portfolio if the loans had been securitized ($0.3 billion), and the market value of the mortgages and other assets in the 

portfolio less the hypothetical fees and the market value of debt ($4.4 

billion). To manage its assets and liabilities, Fannie Mae also separates the latter figure into two components: the mortgage investment 

portfolio (mortgages in the portfolio net of debt used to finance them, 

less hypothetical guarantee fees--$3.9 billion), and the liquid investment portfolio and all other assets and liabilities ($0.5 billion). 

Fannie Mae and Freddie Mac take similar approaches to estimating their pretax mark-to-market net worth, but there are impor- 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 157 

tant differences in the technical assumptions that the GSEs make.20 

For example, the enterprises have different assessments of how fast 

mortgages will prepay at different interest rates, and of how future 

interest rates will vary from the long-term average. In addition, the 

estimates define the market value of exposure to credit risk quite 

differently. Freddie Mac defines this liability to be equal to GAAP 

loan loss reserves. Fannie Mae defines it as the present value of the 

annual premiums that the GSE would have to pay to a private mortgage insurer for assuming the credit risk on the mortgages in its portfolio and backing its MBSs (less estimates of the administrative costs 

and return on equity of the insurer). If Fannie Mae had used Freddie 

Mac's definition of the market value of credit risk, the former's estimated pretax mark-to-market net worth at year-end 1990 would have 

been $7.2 billion--about $1.1 billion higher. The differences in assumptions make it somewhat difficult to compare the estimates cited above, 

illustrate the sensitivity of such estimates to assumptions, and indicate some of the current limitations of mark-to-market analysis. 

The Department of Housing and Urban Development or another 

federal supervisory agency could require Fannie Mae and Freddie Mac 

to use the same technical assumptions and comparable models to estimate their pretax mark-to-market net worth. The estimates would 

provide a measure of the economic net worth of the GSEs that could be 

disclosed to the public on a quarterly basis. As discussed in Chapter 11, 

the government could also set a minimum capital requirement for 

Fannie Mae and Freddie Mac that required them to maintain a pretax 

mark-to-market net worth that was a specific percentage of the market 

value of their assets and MBSs. 

Sensitivity of Pretax Mark-to-Market Net Worth to Instantaneous 

Changes in Interest Rates. Freddie Mac routinely assesses its exposure to interest rate risk by measuring the sensitivity of its pretax 

mark-to-market net worth to immediate changes in current interest 

rates. The analysis has two steps. First, current interest rates are assumed to increase or decrease instantaneously by one to five percentage points, thus providing 10 "shocks" to those rates. Second, 

20. For a general introduction to the estimation techniques wed, see Andrew S. Carron and Ma jorie 

Hogan. "The Option Valuation Approach to Mortgage Pricing," Journal of Real Estate Finance and 

Economics, vol. l(1988). pp. 131-149. 
158 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Freddie Mac's mark-to-market net worth is estimated under each new 

set of interest rates. The interest rates used to calculate the market 

values of the GSE's assets and liabilities are higher or lower by the 

amount of the assumed changes in interest rates. 

The analysis shows that the estimated market value of Freddie 

Mac's MBS guarantee fees and the enterprise's mark-to-market net 

worth are more sensitive to sudden declines in current interest rates 

than to sudden increases (see Figure 8, which shows these estimates 

Figure 8. 

Sensitivity of Freddie Mac's Estimated Pretax Mark-to-Market 

Net Worth to Instantaneous Changes in lnterest Rates 

Net Worth (Billions of dollars) 11 I 1 

1 1 I I I I I I I I 

-5 -4 -3 -2 -1 0 1 2 3 4 5 

Change in Interest Rates (Percentage points) 

SOURCE: Congressional Budget Office using data from Freddie Mac. 

NOTE: Based on Freddie Mac's assets at year-end 1990. 

Total with 

Replacement 

Business 

Total 

Guarantee 

Fee Income 

Portfolio 

- 

- 

- 

------ 
CHAPTER IV FA- 'MAE AND FREDDIE MAC 189 

for year-end 1990). This reflects the fact that mortgage prepayments 

accelerate more rapidly when interest rates decline than they decelerate when interest rates increase. The faster prepayments reduce the 

market value of future income from guarantee fees more than lower 

rates increase the present value of the cash flows. Even if increases or 

decreases of five percentage points in current interest rates are assumed, the estimated market value of the GSE's MBS guarantee fees 

and its estimated pretax mark-to-market net worth remain positive. 

According to Freddie Mac, the enterprise's estimated pretax mark-tomarket net worth has been similarly insensitive to assumed instantaneous changes in interest rates since the third quarter of 1988, when 

the GSE began doing such analyses. 

Freddie Mac also estimates its pretax mark-to-market net worth 

assuming that, as the mortgages it has financed are repaid, it will replace them on a one-for-one basis with new loans of the same type. The 

"replacement business" is assumed to earn a constant profit per dollar 

of assets in each future year, the return being equal to the enterprise's 

net revenue target for its MBS business. This assumption ,is equivalent to assuming that Freddie Mac will continue to benefit indefinitely 

from an implicit federal guarantee and to operate as it does today. As 

shown in Figure 8, the assumed replacement business increases the 

GSE's mark-to-market net worth under all assumed levels of current 

interest rates, but especially for the hypothetical declines in interest 

rates, under which prepaid mortgages are assumed to be replaced with 

new loans that earn a profit. 

To assess each GSE's relative exposure to interest rate risk, CBO 

asked Fannie Mae to estimate how the immediate interest rate shocks 

of plus and minus one to five percentage points would affect its 

estimated pretax mark-to-market net worth as of the end of 1990. 

Figure 9 displays the results of the analysis. As with Freddie Mac, the 

estimated market value of Fannie Mae's income from guarantee fees 

remains positive under all the assumed interest rate shocks. For instantaneous declines of three percentage points or more, or increases of 

four percentage points or more, however, the estimated market values 

of the GSE's mortgage investment portfolio and other assets and liabilities become negative. For declines of four or five percentage points, 
160 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Figure 9. 

Sensitivity of Fannie Mae's Estimated Pretax Mark-to-Market 

Net Worth to Instantaneous Changes in Interest Rates 

Total 

Guarantee - 

AllOther ------ . 

SOURCE: Congressional Budget Office using data from Fannie Mae. 

NOTES: Based on Fannie Mae assets at year-end 1990. 

Guarantee fees for mortgagebacked securities (MBSs) include those for actual and hypothetical MBSs. 

Fannie Mae's pretax mark-to-market net worth becomes negative.21 

The sensitivity of the market value of Fannie Mae's portfolio investments (minus associated liabilities) to large changes in interest rates 

mainly reflects the sensitivity of Fannie Mae's assets. The market 

value of its liabilities are less sensitive to changes in rates. 

21. Even if Fannie Mae used the less conservative approach to estimating the liability from ite 

expoeure to credit risk employed by Freddie Mac, its mark-to-market net worth would still become 

negative if interest rates declined instantaneously by four or five percentage pointa. 
CHAPTER IV FANNJE MAE AND FREDDIE MAC 161 

Although the estimates in Figures 8 and 9 are not strictly comparable, they indicate that Fannie Mae is exposed to more interest rate 

risk than Freddie Mac. Fannie Mae's exposure is higher largely because it has financed 28 percent of its mortgages with mostly noncallable debt. In other words, in the current interest rate environment, 

Fannie Mae's portfolio is expected to earn significantly more money 

per dollar of assets than its MBS business, but if large changes in interest rates occurred instantaneously, the market value of the portfolio's earnings would decline much more. 

Sensitivity of Holding-Period Returns. Fannie Mae does not use analyses of instantaneous changes in interest rates to assess its exposure to 

interest rate risk, since very large changes in interest rates are unlikely to occur overnight. Instead, the GSE assesses how a large number of hypothetical interest rate paths would affect the return on its 

mark-to-market net worth over a three-year holding period. The 

change in rates in each month of each scenario is consistent with the 

volatility of interest rates in recent decades. Fannie Mae analyzes the 

holding-period return on the market value of the two most important 

components of its pretax mark-to-market net worth: its mortgage investment portfolio and its actual and hypothetical MBS guarantee fee 

income. The annual after-tax, holding-period return on Fannie Mae's 

mortgage investment ,portfolio is defined as the change in the portfolio's market value plus the net interest income it earns during the 

period. The holding-period return of Fannie Mae's MBS business is 

equal to the change in the market value of MBS guarantee fees plus 

the GSE's fee income earned during the period. 

Fannie Mae estimates that the annual after-tax return, over a 

three-year holding period, on the market value of its mortgage investment portfolio at year-end 1990 is likely to be much higher than the 

return on the market value of its actual and hypothetical MBS guarantee fees. However, for very large changes in interest rates over the 

period, the return on the GSE's mortgage investment portfolio is less 

than zero percent, indicating that the gain in market value from net 

interest income less income tax payments will be more than offset by 

the decline in market value caused by changes in interest rates. This 

would occur only under the most extreme scenarios, in which the 

10-year Treasury rate was 4.9 percentage points higher, or 3.5 per- 
162 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

centage points lower, than year-end 1990 rates at the end of three 

years. The annual holding-period return on the market value of 

Fannie Mae's MBS guarantee fees would be negative only at the end of 

scenarios in which the 10-year Treasury rate was 2.5 percentage points 

lower by the end of the period. The annual holding-period return on 

the two components combined would be negative only in the most extreme scenarios, in which rates rose by 4.9 percentage points or fell by 

3.5 percentage points. 

A major implication of this analysis is that the largest negative 

projected change in the market value of Fannie Mae's combined mortgage investment portfolio and MBSs under these interest rate scenarios is just under 27 percent32 This is the largest decline that the 

GSE estimates it could suffer if monthly changes in interest rates over 

the next three years are consistent with observed rate volatility in the 

last two decades, and if differences between long-term and short-term 

interest rates and rates on mortgages and other securities retain their 

current relationships. For Fannie Mae's pretax mark-to-market net 

worth to be negative at the end of the three-year holding period, the 

after-tax return for that period would have to be lower than negative 

100 percent. Even so, the GSE still could suffer significant losses from 

rapid and extreme changes in interest rates. Fannie Mae employs interest rate stress tests to assess its exposure to this risk. 

Interest Rate Stress Tests. Like Fannie Mae's analysis of holdingperiod returns, its interest rate stress tests take into account both the 

fact that large changes in interest rates are not likely to occur instantaneousli, and the enterprise's ability to earn money as rates 

change. The first stress test used by Fannie Mae assumes that interest 

rates follow the pattern observed from January 1978 through December 1982. The second stress test assumes that all interest rates would 

increase by six percentage points in a year--0.5 percentage points a 

month for 12 months--and then remain at that level for four years. 

Both tests assume that Fannie Mae's mortgage purchases are high 

22. Annual holding-period returna muet be adjusted to obtain changes in pretax mark-to-market net 

worth over a holding period. For example, the highest annual holding-period return estimated by 

Fannie Mae is about 20 percent. This annual return equals a 72 percent increase in market value 

at the end of three years l(1.0 + 0.213 -1.01. Similarly, Fannie Mae's loweat estimated annual 

holding-period return is about negative 10 percent. This equals a 27 percent decline in market 

value at the end of the three-year period f(1.0 - 0.2)s -1.01. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 163 

enough only to offset liquidations, resulting in no growth in its portfolio over the five-year period; that the overall maturity of outstanding debt, as well as the overall mix between short-term and long-term 

debt, remain constant; and that Fannie Mae's provisions for losses and 

charge-offs are the same as in its corporate business plan.23 

Fannie Mae has run the second stress test, which is more severe, 

beginning with the GSE's balance sheet and the interest rates that 

prevailed at the end of 1990. In the scenario, Fannie Mae's net interest 

income increases by 9 percent in 1991, falls to 4 percent below the 1990 

level in 1992, and is above the 1990 level in each of the next three 

years. Its net income, while below the record $1.2 billion level of 1990 

for most of the five-year period, is over $1 billion in every year. 

Several factors contribute to this earnings stability. First, a significant amount of Fannie Mae's long-term debt is still outstanding at 

the end of 1995.24 Second, its ARMS and nonmortgage investment 

portfolio offer protection in an environment of rising rates. Third, a 

slowdown in prepayments increases the proportion of lower-rate mortgages that are repaid. At year-end 1995, the enterprise's capital is 

more than double the year-end 1990 amount of $4.5 billion. Capital, as 

a percentage of assets and mortgage-backed securities, increases from 

1.1 percent at year-end 1990 to more than 2.3 percent at year-end 1995. 

Fannie Mae's performance in this test has improved since November 1989, when it was last run. At that time, net interest income increased nearly 18 percent in the first year of the scenario, but fell by 29 

percent to 37 percent in subsequent years. The improvement reflects 

three factors. First, the GSE reduced its duration gap from six to three 

months during 1990. Second, the proportion of its long-term debt that 

is callable more than doubled during the period. The duration of callable debt lengthens as interest rates rise, matching some of the change 

23. The teats are described in more detail in Department of the Treasury, Report of the Secretury of the 

Treasury on Government Sponsored Enterprises, pp. A-53 to A-56. 

24. Becauae a large portion of Fannie Mae's long-term debt matures ahr 1995, it would be intereating 

to know how the GSE is projected to perform if the high level of raten in the atress teat are assumed 

to continue indefinitely. If the government decided to base the intereat rate component of a capital 

standard on this test, this information would help the government decide how long the enterprise 

should be required to remain solvent on a GAAP baais. 
184 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

in the duration of the fixed-rate mortgages in Fannie Mae's portfolio. 

Third, interest rates on Treasury securities with maturities of one to 

five years fell between November 1989 and December 1990. 

CAPITALIZATION 

The overall risk of Fannie Mae and Freddie Mac is a function of each 

GSE's exposure to credit risk, interest rate risk, and other risks. The 

distribution of each enterprise's risk between owners and the government is a function of its capitalization. From the government's perspective, each GSE's capital consists of stockholders' equity--owners' 

investment in the firm--plus any liabilities on which payments can be 

interrupted before federal assistance is provided. Fannie Mae and 

Freddie Mac are adequately capitalized if the benefits they provide to 

the mortgage markets and to borrowers are worth the price of the risk 

they pose to the government and they have strong incentives to balance the costs and returns of new activities so as to avoid increasing 

the government's exposure to risk. The government can strike a balance between the risks and benefits of the enterprises by monitoring 

their capital and requiring them to meet federal capital requirements. 

The stockholders' equity of both Fannie Mae and Freddie Mac, as 

measured under Generally Accepted Accounting Principles, is less 

than 1 percent of all their assets and MBSs. This ratio is a misleading 

indicator of the adequacy of their capital, however, because it fails to 

account for the income they will earn from their future MBS guarantee 

fees. To take this future income into account in assessing the adequacy 

of their capital and to set the capital standards that they impose on 

themselves, Fannie Mae and Freddie Mac conduct stress tests that 

simulate how large default losses and changes in interest rates would 

affect their performance and financial condition. The government can 

also use stress tests to assess the capital adequacy of the GSEs. 

This section discusses the components of the capital of Fannie Mae 

and Freddie Mac and the statutory leverage ratio to which the GSEs 

are subject, and summarizes their internal capital standards. The section also summarizes the results of stress tests that the Office of Man- 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 106 

agement and Budget (OMB) recently performed to assess each enterprise's capital adequacy. 

Components and Trends of Capital 

The stockholders' equity of Fannie Mae and Freddie Mac was $3.9 billion and $2.1 billion, respectively, at the end of 1990, as shown in 

Table 17. Retained earnings were the largest component, representing 

over 70 percent of Fannie Mae's equity and 88 percent of Freddie 

Mac's. Fannie Mae's equity was equal to about 0.9 percent of a11 assets 

TABLE 17. CAPITAL (STOCKHOLDERS' EQUITY AND RESERVES) OF 

FANNIE MAE AND FREDDIE MAC, YEAR-END 1990 

- 

Fannie Mae Freddie Mac 

~tockholders' Equity 

Common stock 

Additional paid-in capital 

Retained earnings 

Treasury stock at costa 

In Millions of Dollars 

Total 3,941 2,136 

Reserves 539 627 

Total Capital 4,480 2,763 

As a Percentage of Assets and Mortgage-Backed Securities 

Stockholders' Equity 

Total Capital 

SOURCE: Congreaeional Budget OflFice using data from Fannie Mae and Freddie Mac. 

a. Repreeenta the coat of stock repurchased by Fannie Mae and used to manage capital and fund ita 

obligatiom under ita employee etock ownership plan and etock option8 programe. 
170 GOVERNMENT-SPONSORED ENTERPRISES April lfBl 

As an overall assessment of its capital adequacy, Fannie Mae recently analyzed how it would perform if it simultaneously experienced 

the mortgage default rates assumed in the credit risk component of its 

capital standard and the very high interest rates assumed in the stress 

test in which interest rates increase by six percentage points. This additive stress test is conservative, for two reasons. First, the probability 

of this combination of events occurring is very low, since the severe 

default rates assumed by the GSE are likely to occur in a deflationary 

period of low inflation and low interest rates. Second, Fannie Mae assumed that mortgages purchased during the five-year projection period 

would also experience very high default rates. In the combined stress 

test, net income is projected to fall dramatically, dropping to less than 

one-third of the 1990 level in 1993, and rising to only $0.5 billion in 

1995. Nonetheless, the GSE's capital is projected to increase in dollar 

terms by more than 50 percent during the five-year period. At all 

times, Fannie Mae's capital is projected to be more than adequate to 

meet its internal capital standard. 

Freddie Mac's Internal Capital Standard 

Freddie Mac's internal capital standard is based on a stress test that 

analyzes how the GSE would perform during a severely deflationary 

period. The test assumes a stylized Great Depression scenario developed by Moody's Investors Service in the 1980s to assess the claimspaying ability of private mortgage insurers. The GSE's objective is to 

have enough capital, defined as stockholders' equity plus reserves, to 

remain solvent on a GAAP basis for the full 10 years of the scenario. 

Because declining interest rates hurt Freddie Mac more than rising 

rates--prepayments accelerate more in the former than they slow down 

in the latter--the Great Depression scenario represents both a credit 

and an interest rate stress test (see Appendix B). 

Freddie Mac used the Great Depression stress test to analyze its 

capital adequacy at the end of 1987 through 1990. As shown in 

Table 19, at the end of 1987 and 1988 Freddie Mac was projected to survive a Great Depression scenario for more than five years and nine 

years, respectively. The improvement in 1988 reflected the aging and 

home price appreciation of loans purchased in the 1986-1987 period 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 171 

and the increase in the GSE's capital as a percentage of its assets in 

that year. Seasoning, home price appreciation, and improvements in 

the assumptions of Freddie Mac's model improved its score further, to 

more than 11 years, in 1989. Because home price appreciation averaged only 2 percent in 1990, at the end of that year the GSE was projected to survive for slightly more than 10 years. The figures indicate 

that Freddie Mac was in compliance with its internal capital standard 

at the end of 1989 and 1990. 

As a supplementary test of its capital adequacy, Freddie Mac also 

simulates its performance during a severe credit crunch modeled after 

the 1979-1984 period of high interest rates and stagnant economic conditions. The stress test provides an assessment of the GSE's exposure 

to increases in interest rates. In the first four years of the 10-year scenario, short-term interest rates rise by 4 percentage points, and mortgage interest rates rise by 5.5 percentage points. Rates decline slowly 

over the remaining years of the scenario. Annual appreciation of home 

prices declines steadily throughout the period. Each time that Freddie 

Mac has run this test, its net income and total capital have been projected to increase in each year of the scenario, indicating that large increases in interest rates do not pose a risk to the GSE. 

TABLE 19. PROJECTED YEARS FREDDIE MAC SURVIVES 

A SIMULATED GREAT DEPRESSION SCENARIO, 

YEAR-END 1987-1990 

Years of 

Book-Value Solvencya 

SOURCE: Congreseional Budget Mce ueing data from Freddie Mac. 

a. heddie Mac wed the same model to conduct the eimlllationa in each year. However, the eetimatee 

for year-end 1989 md 1990 reflect improvements in the model'e aaeumptiona, which are deecribed in 

Appendix B. Without the changea, the GSE'e emre would be about 11 yeare at year-end 1989 and 

about 9.9 yeare at year-end 1990. Scores of more than 10 yearn are approximatione. 
172 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

OMB's Assessment of the Capital Adequacy 

of Fannie Mae and Freddie Mac 

The President's budget for fiscal year 1992 summarizes the results of 

stress test analyses of the capital adequacy of Fannie Mae and Freddie 

Mac performed by the Ofice of Management and Budget.25 OMB's 

approach was similar to Freddie Mac's simulation of its ability to survive a stylized, 10-year Great Depression scenario. Appendix B discusses OMB's analysis in detail. 

OMB found that both Fannie Mae and Freddie Mac would survive 

a simulated Great Depression that began in the year 2000. Freddie 

Mac was projected to lose money in the fourth through the ninth years 

of the downturn, and to return to profitability during the tenth year. 

Fannie Mae was projected to earn money throughout the simulated 

depression, but to experience a much higher level of default losses than 

Freddie Mac. The latter finding resulted from OMB's conservative 

assumption that Fannie Mae's future default losses would be consistent with the pattern of 1988 and 1989. 

Based on these simulations, OMB concluded that the government's 

current financial exposure to the operations of Fannie Mae and Freddie Mac is close to zero under a Great Depression scenario. OMB qualified this conclusion, however, by stating that the government's exposure would remain minimal as long as the GSEs continue to operate as 

efficiently, profitably, and safely as they have in recent years, and 

stated that effective regulatory oversight is necessary to assure that 

they do so. 

OMB's analysis is the first attempt by a federal agency to assess 

independently whether Fannie Mae and Freddie Mac have enough 

capital to survive a high level of default losses caused by a severe, 

nationwide economic downturn. CBO has concluded that the basic results of OMB's research--that both GSEs would survive for an extended 

period of time--are valid. Nonetheless, OMB's approach has some technical shortcomings. One defect is the assumption that Fannie Mae's 

25. Ofice of Management and Budget, Budget of the United States Government, Fiscal Year 1992, Part 

TWO-229. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 173 

future default loss rates will be significantly worse than Freddie Mac's. 

Another important shortcoming is that, under OMB's assumptions, 

each GSE1s exposure to credit risk would be less when the depression 

began in the year 2000 than it is today. Further, the analysis ignores 

the credit risk posed by each GSE1s multifamily loans. To use OMB's 

technique, HUD or another supervisor of Fannie Mae and Freddie Mac 

would want to simulate the GSEs' performance in a downturn assumed 

to begin immediately and to include multifamily loans. 

HUD's SUPERVISION AND REGULATION 

OF FANNIE MAE AND FREDDIE MAC 

The Department of Housing and Urban Development has general 

regulatory authority over Fannie Mae and Freddie Mac and certain 

limited powers over their financial management policies and their 

programs. HUD has regulated Fannie Mae since it became a GSE in 

1968. The Financial Institutions Reform, Recovery, and Enforcement 

Act transferred regulation of Freddie Mac from the members of the 

Federal Home Loan Bank Board to HUD in 1989. 

HUD's interpretation of its regulatory mission has changed significantly over time. For many years the department's sole objective 

apparently was to assure that Fannie Mae complied with HUD's view 

of the GSE's responsibilities under its charter. Since the passage of 

FIRREA, HUD has interpreted its role more broadly to include the 

responsibility of assuring that neither enterprise poses unreasonable 

risks to the government. Consistent with this mission, the department 

has begun to improve its ability to supervise the safety and soundness 

of Fannie Mae and Freddie Mac. However, there are questions about 

whether HUD has sufficient statutory authority and institutional 

capacity to be effective. This section explores these issues.26 

26. The discussion draws on Department of Housing and Urban Development, 1986 Report to the 

Congress on the Federal National Mortgage Association (June 27,1987). pp. 156-169: and 1988-89 

Report to the Congress on the Federal National Mortgage Association (June 1990), pp. 46-51. 
174 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Statutory Mandate and Authority to 

Supervise Safety and Soundness 

When Fannie Mae was chartered in 1968, the Congress wanted HUD 

to have some role in the financial management policies of the GSE. 

The department was given authority to increase the statutory limit on 

the ratio between the enterprise's senior debt (debt whose owners have 

first claim on assets) and its regulatory capital; to approve Famie Mae 

issuances of stock, debt, and other instruments; to approve any stock 

purchase requirements that the GSE imposed on servicers; and to examine, audit, and require reports from the enterprise. HUD has these 

authorities over both GSEs today, except that its authority to approve 

issuances of securities is now restricted to sales of stock and debt that 

is convertible to stock. The department also may limit the total 

amount of cash dividends that Fannie Mae and Freddie Mac may pay 

per share of common stock in any fiscal year. The limit must be based 

on what HUD determines to be a fair rate of return, given the current 

earnings and capital condition of each GSE.27 

The department also has general regulatory authority over Fannie 

Mae and Freddie Mac and may issue regulations to assure that the 

purposes of each GSE's charter are accomplished. The Congress has 

placed limits on HUD's exercise of this authority. The legislative history of each GSE's charter clearly states that HUD's regulatory powers 

shall not extend to either enterprise's internal affairs--such as personnel, salary, and other usual corporate matters--except where necessary to protect the financial interests of the government or to assure 

that the purposes of the charter acts are carried out. 

There is significant disagreement about the limits of HUD's general regulatory authority. Fannie Mae does not believe that the department has authority to set capital standards that are more restrictive than the statutory leverage ratio or that apply to MBSs. The GSE 

also believes that HUD's authority to restrict dividends is not a general enforcement power. Freddie Mac contends that HUD could rely on 

its general regulatory authority to set more restrictive capital stan27. In addition. the President has the ability to remove Fannie Mae'e directors for good cause, which 

could be interpreted ae extending to directore' approval of exceeeively rieky activitiee. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 175 

dards, issue capital directives or cease and desist orders, or disapprove 

risky activities, at least if it had promulgated appropriate regulations 

concerning the use of such powers to assure the safe and sound operation of the GSEs. HUD's current view appears to be close to that of 

Freddie Mac. Because of this disagreement, it might be prudent to 

clarify HUD's statutory mandate and authority in legislation. 

Before the enactment of FTRREA, HUD narrowly interpreted its 

statutory mandate and authority. The department made no attempts 

to assure the financial health of Fannie Mae. The primary objective of 

HUD's regulation was to assure that the GSE achieved its public purposes, particularly with respect to financing low- and moderate-income 

housing. In the 1980s, responsibility for overseeing the enterprise was 

shifted among several offices in HUD. In none of these was an experienced staff developed to monitor the risk posed by the GSE's activities. 

The department has not used its authority to examine Fannie Mae. 

In 1990, HUD began to interpret its role more broadly to include 

the responsibility of assuring that both Fannie Mae and Freddie Mac 

do not pose unreasonable risks to the government. The department 

took several steps. The Secretary created a Financial Institutions Regulatory Board (FIRB) to assist him in exercising his regulatory authority over the two GSEs and to carry out his responsibilities as a 

member of the Oversight Board of the Resolution Trust Corporation 

(RTC) and of the Federal Housing Finance Board, which regulates the 

Federal Home Loan Bank System. The new FIRB comprises the Undersecretary of HUD, the General Counsel, the Assistant Secretary for 

Housing, the Assistant Secretary for Policy Development and Research, the Assistant Secretary for Community Planning and Development, and the President of Ginnie Mae. The board formulates regulatory options and makes recommendations to the Secretary on actions 

and decisions. 

HUD also allocated five full-time professional staff positions--four 

for economists and one for an examiner--to provide analytical and policy support to the new FIRB. The staff will report to the Assistant 

Secretary for Policy Development and Research and receive support 

fkom HUD's Office of General Counsel and other offices in the department. In the first six months of its existence, the staff has focused on 
176 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

improving HUD's ability to monitor the risk exposure of Fannie Mae 

and Freddie Mac. It also has begun to collect extensive data on their 

assets and liabilities and on the historical performance of the mortgages they have financed. Building on an existing HUD model that 

simulates Fannie Mae's cash flows, which has been used to assess the 

GSE's exposure to interest rate risk, the staff intends to develop additional stress tests to assess the exposure of both enterprises to credit 

risk and interest rate risk. 

In July 1990, HUD held hearings on possible changes in its regulations concerning Fannie Mae, and on the issuance of regulations concerning Freddie Mac. The department has recently drafted new regulations that would apply to both GSEs. 

Institutional Capacity to Supervise Fannie Mae and Freddie Mac 

Despite the creation of the new FIRB and a new regulatory staff, 

HUD's institutional capacity to supervise the safety and soundness of 

Fannie Mae and Freddie Mac remains limited, especially when compared with that of the other GSE regulators. The department does not 

have the ability to assess the enterprises for the cost of maintaining a 

regulatory staff, but must rely on annual appropriations. HUD also is 

subject to the civil service salary structure, which means that it cannot 

hire experienced bank or thrift examiners to develop an in-house 

capacity to examine Fannie Mae and Freddie Mac. Instead, the regulatory staff is planning to use outside consultants to design and conduct 

the first federal examinations of the GSEs. Finally, it seems very 

unlikely that the department has allocated sufficient positions to be 

able to monitor the enterprises effectively. By way of comparison, the 

Office of the Comptroller of the Currency (OCC) continuously maintains an examination staff at each of the money-center banks. OCC 

staff also conduct off-site monitoring. 

Role as a Program Regulator 

HUD has two types of programmatic authority over Fannie Mae and 

Freddie Mac. The department has authority to approve new conven- 
CHAPTER N FANNIE MAE AND FREDDIE MAC 177 

tional mortgage purchase programs, and to require the GSEs to purchase a reasonable amount of mortgages for low- and moderate-income 

housing. 

The department must approve proposals by either GSE to purchase conventional mortgages, home improvement loans, and mortgages for manufactured homes, if the purchases would constitute new 

programs or activities. In 1984, the Congress required HUD to approve a Fannie Mae request for a new mortgage purchase program 

within 45 days or report to the Congress explaining why the request 

has not been granted. If HUD needs additional information from 

Fannis Mae, this period may be extended by 15 days. Under FIRREA, 

the same deadlines apply to Freddie Mac's requests for program approvals. 

The implicit federal guarantee of obligations issued by the two enterprises, their economies of scale, and their lower costs of issuing securities enable them to dominate markets that they are permitted to 

enter. HUD believes that its statutory responsibility to assure that the 

purposes of the charter acts are carried out requires it, when reviewing 

requests for approval of new programs and activities proposed by the 

GSEs, to consider the significant market power of Fannie Mae and 

Freddie Mac and the actual or potential ability of other financial institutions to provide the same services. In the 1980s, the department's 

review of Fannie Mae's requests for approval often focused on how the 

GSE's advantages might affect competition between the enterprise and 

wholly private firms. HUD also believes it has a responsibility to 

evaluate how proposed new programs and activities would affect consumers. 

In FTRREA, the Congress amended the purposes specified in the 

charter act of each GSE, directing them to provide stability in and ongoing assistance to the secondary mortgage market, and to respond appropriately to the private capital markets. A previous mandate that 

the enterprises provide supplementary assistance to the secondary 

market was deleted. The legislative history of FIRREA also suggests 

that HUD may disapprove a Freddie Mac request for approval of a new 

program only if the proposed activity would not enable the GSE to 

achieve its purposes. Fannie Mae and Freddie Mac interpret these 
178 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

changes as preventing the department from disapproving new programs or activities proposed by either of them on grounds related to 

competition between the GSEs and wholly private financial institutions. HUD argues that, to assess whether proposed programs or activities would provide stability to the secondary market or respond appropriately to the capital markets, the department must evaluate the 

effect of proposed initiatives on the competitive structure of the housing finance system. 

The department also has the authority to require that a reasonable 

portion of each GSE's mortgage purchases be devoted to the national 

goal of providing adequate housing for low- and moderate-income 

families, so long as the enterprises earn reasonable returns. In the late 

1970s, the department attempted to use this authority to force Fannie 

Mae to devote specific percentages of its purchases to housing for these 

families and in central cities. The current regulations embody a compromise struck by HUD and the GSE in 1978 that encourages Fannie 

Mae to devote 30 percent of its purchases of conventional mortgages to 

low- and moderate-income housing, and 30 percent to housing in central cities. If these goals are not met, the Secretary may set annual 

goals for purchases of such mortgages or require the GSE to propose a 

plan to buy more of them. The regulations do not allow HUD to require 

that Fannie Mae purchase specific amounts of such mortgages. 

HUD's pursuit of programmatic objectives related to low- and 

moderate-income housing in the late 1970s conflicted with efforts to 

reduce Fannie Mae's exposure to interest rate risk. In fact, the department disapproved a proposed program that would have enabled the 

enterprise to reduce the risk of its activities (see Box 8). Three factors 

contributed to this action: HUD's program authority, the fact that the 

department had no clear statutory mandate and arguably limited statutory authority to assure the safe and sound operation of Fannie Mae, 

and the policy goals of the Administration in office. 

Because the first two factors still exist today, HUD could again 

seek to have Fannie Mae and Freddie Mac devote resources to low- and 

moderate-income housing at the expense of safety and soundness. This 

danger probablyis not very great, however, for two reasons. First, in 

1984, the Congress repealed the requirement that HUD approve all 
CHAETER TV FANNIE MAE AND FREDDIE MAC 178 

BOX 8 

The Conflict Between HUD's Pursuit of Programmatic 

Objectives and Efforts to Reduce Fannie Mae's 

Risk Exposure in the Late 1970s 

The Department of Housing and Urban Development (HUD) has programmatic authority over Famie Mae and Freddie Mac, but no clear statutory mandate and arguably limited statutory authority to assure the safety 

and soundness of the GSEs. The department's actions in the late 1970s illustrate how this combination can lead a regulator not to attempt to reduce an 

enterprise's risk, and even to frustrate the GSE's attempts to do so. 

In 1978, HUD proposed regulations that would have required Fannie 

Mae to allocate fixed percentages of its mortgage purchases to housing for 

low- and moderate-income families and in central cities. The GSE and 

others disputed the department's legal authority to issue the regulations, 

which generated controversy and consumed considerable time and energy at 

the department and Fannie Mae and in the Congress. Ultimately, HUD accepted a compromise under which Fannie Mae would be encouraged to devote 30 percent of its purchases to mortgages in each category. 

At the same time, Fannie Mae's practice of financing long-term mortgages with short-term borrowings exposed it to considerable and growing 

interest rate risk. HUD was aware of Fannie Mae's increasing exposure. In 

1976, the department's general counsel, a publicly appointed member of the 

GSE's board of directors, raised the issue with the board. However, HUD did 

not demand that Fannie Mae adopt a less risky financing strategy. 

In fact, HUD prevented Fannie Mae from doing so. In February 1979, 

the department refused to approve a mortgage participation program proposed by the GSE more than one year before. Under the program, Fannie 

Mae would have sold participations in a percentage of the payments received 

on pools of mortgages it had purchased. The participations would have 

passed on to investors most of the prepayment risk on the pools of loans, just 

as Fannie Mae and Freddie Mac's MBSs do today. The program would 

have enabled Fannie Mae to reduce the growth in its debt and, thereby, its 

exposure to interest rate risk. As grounds for disapproving the program, 

HUD cited its objective of increasing the volume of Fannie Mae programs 

designed to stimulate the flow of mortgage funds into older urban areas. 

SOURCES: Congreeeional Budget OfFice baaed on Robert R. Elliot. "Memorandum For: 

FNMA Board of Directore; the Corporation'e Ten Percent Annual Target for 

ht Growth." April 23. 1976, in Secondary Market Opemtions of the Federal 

National Mortgage Associatron and the Fedeml Home Loan Mortgage Corpomtwn, Hearinge before the Senate Committee on Banking, Houning, and Urban 

Affairs (December 9,1976). pp. 395-411; and Hilbert Fefferman, 'The Roceee by 

Which HUD Reviewe Ropoeed FNMA Program Changes and Additione" (memorandum prepared for Fannie Mae. March 4,1980). pp. 28-33. 
180 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

issuances of Fannie Mae debt, a power that the department had used to 

achieve leverage over the GSE in the 1970s. Second, the requirement 

that the enterprises earn a reasonable economic return on purchases of 

such mortgages should prevent HUD from requiring them to invest in 

loans that do not meet their underwriting guidelines or that carry 

below-market interest rates. Under current law, if HUD increased its 

recommended purchases of low- and moderate-income loans to levels 

that the enterprises could not achieve without earning below-market 

returns, they could just refuse to comply, arguing that such a directive 

exceeded the department's authority. At that point, HUD would have 

to demonstrate in court that its directive was consistent with the 

charter acts. 

OPTIONS FOR CHANGE IN THE 

CURRENTREGULATORY STRUCTURE 

The Department of Housing and Urban Development's ability to 

assure the safety and soundness of Fannie Mae and Freddie Mac could 

be enhanced in several ways. These measures include strengthening 

the department's institutional capacity, broadening its statutory mandate and statutory authority, requiring the department to streamline 

supervision of Fannie Mae and Freddie Mac if it determined that their 

overall risk was low, and establishing a new supervisory agency within 

HUD. An altogether different approach would be to move supervision 

of the safety and soundness of the GSEs out of the department. This 

section examines these options. 

Strengthen HUD's Institutional Capacity 

The department's institutional capacity could be enhanced by allowing 

it to determine the budget, staffing levels, and salary structure of the 

new regulatory staff for financial institutions, and to assess the GSEs - 

for the cost of the staffs activities and of any time that other HUD staff 

spend on regulatory issues. These changes would enable HUD to determine the size and compensation of the regulatory staff and to compete successfully with the bank regulatory agencies, the enterprises, 

and other large financial institutions when seeking competent and pro- 
CHAPTER IV FANNIE MAE AM) FREDDIE MAC 181 

fessional personnel. The department would be able to train and retain 

a highly qualified group of examiners to conduct regular examinations 

of the enterprises. 

The cost to Fannie Mae and Freddie Mac of these changes would 

probably be low--perhaps several million dollars a year. A significant 

portion of this expense would be for computer services. The enterprises 

also could bear some internal costs arising from increased interactions 

with HUD. They probably would not object to bearing costs of this 

order of magnitude, particularly if HUD used the funds to assemble a 

competent and professional staff. However, to assure that the assessments paid by Fannie Mae and Freddie Mac did not subsidize HUD's 

other activities, the regulatory staff would have to develop a reasonable cost accounting system to keep track of how much time staff in 

other parts of HUD, such as the Ofice of General Counsel, spent on 

regulating the GSEs. 

A more limited option would be to allow HUD to assess Fannie 

Mae and Freddie Mac for the cost of examinations but not of other 

regulatory activities, such as off-site monitoring, computer-based financial modeling, or legal work. The department would pay for those 

expenses out of appropriated funds, which the GSEs would not reimburse. Relying on appropriated funds could prevent HUD from effectively supervising the GSEs, but it would be more difficult for the department to assess the GSEs for the costs of activities that were unrelated to them. 

Strengthen HUD's Statutory Mandate and 

Authority to Supervise Safety and Soundness 

The department's ability to assure the safety and soundness of Fannie 

Mae and Freddie Mac could be enhanced by strengthening its statutory 

mandate, explicitly requiring it to use its general regulatory authority 

to assure the safe and sound operation of the two GSEs, and supplementing that authority. A clear statutory mandate would make HUD 

more likely to respond to signs of financial weakness at either enterprise by taking action to protect the government's interests and to assure that the GSE remained financially viable and capable of achiev- 
182 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

ing its public purposes. The department's general regulatory authority 

could be augmented by requiring HUD to set risk-based capital requirements for the GSEs that were binding, giving it authority to limit 

excessive risk taking, and empowering it to act if either enterprise 

were in serious financial trouble. 

Require HUD to Set Risk-Based Capital Requirements. The Congress 

could require HUD to set binding, risk-based capital standards for 

Fannie Mae and Freddie Mac based on an assessment of each enterprise's overall risk. The department's evaluations would reflect exposure to credit risk, interest rate risk, and other risks, as well as the 

probability, given historical experience, of the occurrence of economic 

conditions severe enough to endanger the financial health of the GSEs. 

The requirement would cover all assets financed by each enterprise 

and require specific amounts of capital. Capital could be measured on 

a mark-to-market or a GAAP basis. 

Giving HUD explicit authority to set capital requirements would 

pose a risk of regulatory failure, in two senses. First, the department 

could set capital standards that were excessive. The Congress could 

minimize this risk by limiting HUD's discretion, as discussed in the 

next section. Second, the department could allow the GSEs to maintain capital levels that were low relative to their risks. To minimize 

this, the Congress could set a statutory minimum capital standard for 

the GSEs. Alternatively, the enterprises could be required to obtain 

private assessments of their risk from private credit-rating agencies, to 

issue subordinated debt, or to disclose data that would enable independent observers to replicate the results of stress tests or other quantitative assessments of risk. Both of these approaches are discussed in 

Chapter 11. 

Establish Procedures to Assure Compliance with Limits on Risk. To 

fulfill a mandate to assure the safety and soundness of Fannie Mae and 

Freddie Mac, HUD would have to- be able to limit the risk of their 

activities. One approach would be to allow the department to intervene in either GSE's operations only if the enterprise had failed to comply with its federal capital requirement. For example, HUD and Fannie Mae or Freddie Mac could be required to follow specific statutory 

procedures if the enterprise was not in compliance with the capital 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 183 

standard. A GSE whose capital fell short of the standard for a specified 

period of time would have to submit a recapitalization plan to the department. HUD would have to approve or disapprove the plan within a 

reasonable period of time. As a condition of approval, the department 

could require that the plan include limits on the GSE's dividend payments, stock repurchases, mortgage purchases, or MBS issuances. If 

the enterprise failed to comply with a plan to increase its capital approved by HUD, or the GSE and the department could not agree, HUD 

would have to go to the Congress for legislation to correct the problem. 

This approach would have the advantage of assuring Fannie Mae 

and Freddie Mac that HUD would not intervene in their operations as 

long as they complied with federal capital requirements and their programs were authorized by their charters, especially if this procedure 

was accompanied by a repeal of the department's authority to approve 

each new program to purchase conventional mortgages proposed by the 

GSEs. The procedure would also allow either GSE, if it was out of compliance with its capital standard, to go to the Congress if it had proposed one or more business plans that had not met with the department's approval. 

The approach would have two important disadvantages. First, if 

either GSE and HUD could not agree upon an acceptable recapitalization plan, the delay required to enact legislation to address the issue 

could result in losses for the government. Second, HUD could not take 

action if examinations or monitoring revealed that the risk of Fannie 

Mae or Freddie Mac had increased to the point that its safety and 

soundness was threatened, but the GSE was still in compliance with 

federal capital requirements. Because GAAP capital tends to be a 

lagging indicator of problems at financial institutions, requiring the 

department to wait could allow hidden losses to mount and make it 

more difficult to implement a recapitalization plan later on. Actions 

that could pose this danger include moves toward very risky financing 

strategies, and purchases of mortgages of lower credit quality. Other 

events could include the development of management deficiencies, 

very large changes in interest rates over short periods, or major failures in operating procedures and controls. 
184 GOVERNMENT-SPONSORED ENTERPRISES Apd 1991 

In effect, under this approach, the government would rely heavily 

on the market discipline of stockholders to prevent a GSE from increasing its risk. Doing so could be unwise, since stockholders probably would have less information than HUD's examiners, and might 

prefer greater risk if they thought an enterprise could earn higher 

returns. However, because the portfolios of Fannie Mae and Freddie 

Mac consist of residential mortgages, are extremely large, and are well 

diversified geographically, the risk that unrecognized losses could become large before either GSE failed to comply with its capital requirement could be lower than for other financial institutions. 

Another approach would be to give HUD explicit enforcement 

powers and to direct the department to use them to assure that Fannie 

Mae and Freddie Mac complied with federal capital requirements and 

operated in a safe and sound manner. As discussed in Chapter 11, the 

most important enforcement powers would be the ability to issue 

capital directives and cease and desist orders, including temporary orders, and the authority to remove directors of a GSE that failed to comply with them. This approach would have the advantage of enabling 

HUD to address GSE activities that it deemed to be unsafe and unsound, whether or not the activities had caused a failure to comply 

with capital requirements. A potential disadvantage is that the department might use such powers to intervene unnecessarily in the 

business decisions of Fannie Mae and Freddie Mac, perhaps to achieve 

programmatic objectives. The Congress could address this concern by 

requiring HUD to define in advance at least some of the practices that 

it would consider to be unsafe and unsound, and by using the legislative history to require the department to exercise enforcement powers 

solely to address concerns about the government's exposure to risk (see 

Chapter 11). 

Establish Procedures for Dealing with Insolvency. Although Fannie 

Mae and Freddie Mac appear unlikely to become insolvent, the Congress might want to put in place procedures that HUD could follow if 

either GSE ever became insolvent or was close to insolvency. One approach, discussed in Chapter 11, would be to allow HUD to appoint a 

conservator. In order to maximize support for the mortgage markets, 

the department could be required to direct a conservator to allow the 

enterprise to continue to securitize mortgages if the expected default 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 186 

losses and exposure to credit risk could be reasonably estimated. HUD 

could also be required to submit legislation addressing the situation 

within a limited period of time after it appointed a conservator. Another option would be to rely solely on the department's general regulatory authority and the legislative process to deal with an insolvent 

Fannie Mae or Freddie Mac. 

The advantage of giving HUD conservatorship power is that swift 

action might prevent an insolvent Fannie Mae or Freddie Mac from 

increasing the risk of its activities in an effort to gamble its way back 

to solvency. Gambling by insolvent thrift institutions in the 1980s increased the cost of the thrift bailout severalfold. Even if a nationwide 

depression had occurred and the government was willing to provide financial assistance to revitalize the GSE, taking such action might be 

prudent to protect the government from having to absorb additional 

losses. Moreover, if a GSE was insolvent or close to insolvency because 

of serious management errors, conservatorship would probably not do 

significant additional damage to the franchise value of the enterprise.28 

Allow HUD to Streamline the Supervisory Process 

Chapter I1 outlined how the government could streamline the supervision of low-risk GSEs. Several factors suggest that this might be appropriate for Fannie Mae and Freddie Mac. The GSEs are fairly well 

capitalized relative to their exposure to credit risk and interest rate 

risk. The stability of their earnings in recent years suggests that the 

quality of their management and their operating systems are generally good. The low-risk nature of residential mortgages and the 

benefits of geographic diversification imply that sophisticated, but 

relatively nonintrusive, monitoring and examinations would soon 

reveal major changes in risk or financial condition. Accordingly, the 

Congress might want to require HUD to streamline the regulatory 

28. The recent experience of Congreaeional action with respect to the ailing Farm Credit System (FCS) 

may be inetructive. The Congrew passed bills addressing the syetem's financial difficulties in 1985 

and 1986. When a third bill providing up to $4 billion in federal financial aseistance was paeeed in 

1987, it included provisions giving the FCS'e regulator, the Farm Credit Adminietration, authority 

to appoint a conservator or receiver for failing FCS institutions. 
186 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

reporting and disclosures by, and federal examinations of, Fannie Mae 

and Freddie Mac if the department concluded that their overall risk 

was low and they were well capitalized. The same requirement could 

be imposed on any other agency with responsibility for supervising the 

two GSEs. A streamlined supervisory process would minimize the 

costs that closer federal supervision would impose on Fannie Mae and 

Freddie Mac. It also could help to foster a positive atmosphere in the 

early years of a new, relatively nonintrusive regulatory relationship 

between HUD, or another supervisory agency, and the GSEs. 

It would appear prudent to allow the supervisory agency to determine whether the overall risk of Fannie Mae or Freddie Mac was low 

enough to justify a minimal level of monitoring and scrutiny, rather 

than to require it in law. If either GSE increased the risk of its activities or suffered losses that brought it out of compliance with federal 

capital requirements, the agency would be able to institute more extensive examinations and more intensive monitoring. To assure that 

the enterprises could become eligible for streamlined supervision, the 

Congress could direct HUD or any other regulator to develop a measure of the overall risk of Fannie Mae and Freddie Mac, and require it 

to institute minimal monitoring and scrutiny if a GSE received a lowrisk rating. 

Establish an Independent Supervisory Agency Within HUD 

The changes in the department's institutional capacity, statutory mandate, and statutory authority outlined above could be supplemented by 

the creation of a new agency within HUD to supervise the safety and 

soundness of Fannie Mae and Freddie Mac. The new HUD agency 

would be directed by an official appointed by the President and confirmed by the Senate. The relationship between the Secretary and the 

director of the agency would be modeled after the relationship between 

the Secretary of the Treasury and the Comptroller of the Currency. 

The agency would perform its functions under the general direction of 

the Secretary, but would retain ultimate statutory responsibility for 

assuring the safe and sound operation of the GSEs. The Secretary 

would retain the current authority to approve new mortgage purchase 

programs, although of necessity the new agency could specify how 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 187 

federal capital requirements would apply to new programs. The Secretary also would retain the ability to require the enterprises to devote a 

reasonable portion of their mortgage purchases to low- and moderateincome housing, provided they earned reasonable returns. 

By making a single agency and its Presidentially appointed director responsible solely for supervising the safety and soundness of Fannie Mae and Freddie Mac and accountable for any losses they imposed 

on the government, this option could increase the likelihood that appropriate action would be taken to protect the government if either 

GSE engaged in excessively risky activities. However, the director of 

the new agency probably would be a less prominent federal official 

than the Secretary of HUD, and the latter, therefore, might have leverage over the agency's decisions. The Secretary might be able to use 

this leverage to influence the agency's decisions about capital requirements and other safety and soundness concerns. 

Move Supervision of Fannie Mae and Freddie Mac 

to a New Supervisor of All GSEs 

One strategy for reforming federal regulation of GSEs would be to centralize supervision of the safety and soundness of all the enterprises. 

One approach would create a new federal agency and give it responsibility for supervising all the enterprises (see Chapter 11). Creation of a 

centralized supervisor of all GSEs might lessen the risk that Fannie 

Mae and Freddie Mac would dominate the decisions of, or capture, 

their regulator. Regulatory capture could take the form of influencing 

HUD to set capital requirements that were low relative to the risks of 

the enterprises. Because a centralized supervisor would be responsible 

for the safety and soundness of all the GSEs, it might be less susceptible to such influence. 

A single agency might also be better able to develop comparable 

capital standards for Fannie Mae, Freddie Mac, and the Federal Homp 

Loan Bank System. Comparability could assure that each provided an 

equal implicit federa'l subsidy to the mortgage lenders it served and 

would be a step toward making thrifts that borrow from the FHLBs 

able to compete with Fannie Mae and Freddie Mac in the conforming 
188 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

loan market. A more level playing field in the mortgage finance system could also help to minimize the risk that Fannie Mae and Freddie 

Mac might use their dominant position in the market for conforming 

fixed-rate mortgages to obtain some of the implicit federal subsidy that 

mortgage borrowers now receive. The GSEs could do so by raising 

their MBS guarantee fees or lowering the prices that they pay for mortgage loans. (Chapter V discusses the effects of the differences in the 

capitalization of the three GSEs in detail.) 

As discussed in Chapter 11, the Secretary of HUD would be able to 

articulate the objectives of the department's housing policy as a nonvoting member of the board of the new agency. Program regulation of 

Fannie Mae and Freddie Mac could be retained by HUD, or transferred 

to the new supervisory agency. As noted above, under current law 

HUD cannot require Fannie Mae and Freddie Mac to provide subsidized financing for mortgages for low- and moderate-income housing. 

It seems unlikely, therefore, that transferring this authority to a new 

supervisory agency would have a significant impact on the allocation 

of resources. Such a move could affect the housing sector, however, if 

the agency required Fannie Mae and Freddie Mac to maintain significantly more capital than they do now. The potential economic consequences of higher capital requirements are discussed in the final section of this chapter. 

A case can be made that HUD, as the most important government 

agency responsible for federal housing policy, should continue to be 

able to assure that Fannie Mae and Freddie Mac achieve their charter 

acts' objectives of supporting the housing finance system. The department could use its expertise in housing finance and housing policy 

issues in monitoring the GSEs' low- and moderate-income mortgage 

purchases and reviewing requests for program approval. A related 

concern is that, if HUD retained its current programmatic authority 

but another agency supervised the safety and soundness of the GSEs, 

or if the Secretary was a nonvoting member of the board of a new centralized supervisory agency but the department had no statutory 

responsibilities, Fannie Mae and Freddie Mac might be less willing to 

address housing policy concerns raised by HUD. 
CHAPTER IV FANNIE MAE AM) FREDDIE MAC 189 

Transfer Supe~sion of the GSEs to the 

Federal Housing Finance Board 

Another option would transfer supervision of Fannie Mae and Freddie 

Mac to the Federal Housing Finance Board, which supervises the Federal Home Loan Bank System. The board might be able to develop 

more extensive expertise in housing finance than a centralized supervisor of all GSEs. However, the FHFB could not take the same approach to supervising the three GSEs, for several reasons. 

The ownership, activities, and tax status of Fannie Mae and Freddie Mac differ significantly from those of the FHLB system. Fannie 

Mae and Freddie Mac have issued publicly traded stock. Consistent 

with their responsibility to shareholders, the government does not require the two GSEs to engage in any subsidized activities, and subjects 

them to federal income taxation. In contrast, the FHLBs are owned by 

the thrifts and other financial institutions that they serve. These owners have a limited ability to influence the activities of the banks, which 

- are largely controlled by the FHFB. The FHFB also has very broad 

statutory authority and is not an arm's-length supervisory agency (see 

Chapter V). One of the reasons that the FHLB system continues to 

exist is to provide subsidies for affordable housing. The banks do not 

pay federal income taxes. 

These differences suggest that the Congress would have to distinguish carefully between the FHFB's statutory authority over Fannie Mae and Freddie Mac and its current authority over the FHLB system. This would require addressing many of the issues about statutory 

authority discussed above. The board also would need time to develop 

expertise in a range of issues concerning the risks to which Fannie Mae 

and Freddie Mac are exposed and how the GSEs control those risks, including underwriting guidelines for mortgage loans and MBS activities, and to promulgate regulations for the two enterprises that differed considerably from those that now apply to the FHLB system. 

This effort probably would require a restructuring and a significant increase in the size of the agency. 
190 GOVERNMENT-SPONSORED ENTERPRISES April 1981 

ISSUES IN SETTING FEDERAL RISK-BASED CAPITAL 

REQUIREMENTS FOR FANNIE MAE AND FREDDIE MAC 

Establishing new federal capital requirements for Fannie Mae and 

Freddie Mac involves many policy judgments. Chapter I1 examined 

three topics that are relevant to several GSEs--whether to establish a 

statutory minimum capital standard, how to incorporate management 

and operations risks into a risk-based standard, and whether and how 

to establish comparable risk-based requirements for the three housing 

GSEs. This section discusses issues raised by the option of giving 

HUD, or another GSE regulator, the authority to impose a binding, 

risk-based standard on Fannie Mae and Freddie Mac. The issues include the treatment of interest rate risk in a capital requirement, providing direction to the agency charged with setting a risk-based standard, and the possible economic effects of requiring the two enterprises 

to increase their capital. 

Including an Interest Rate Risk Component 

in a Risk-Based Capital Standard 

A risk-based federal capital requirement for Fannie Mae and Freddie 

Mac should take into account each GSE's exposure to interest rate risk. 

A standard could do so by making the amount of capital that each enterprise was required to maintain depend on the amount of interest 

rate risk it chose to take. 

The decision about how much capital Fannie Mae and Freddie Mac 

should have to protect against interest rate risk arguably involves a 

basic policy judgment about their public purposes. Some analysts 

assert that the GSEs can adequately support the mortgage market and 

link mortgage lenders to the capital markets by financing conforming 

mortgages with MBSs. This role would require them to maintain 

small portfolios for the sole purpose of assembling pools of mortgages to 

be securitized, as Freddie Mac does. The principal beneficiaries of 

Fannie Mae's large portfolio, these analysts contend, are not mortgage 

lenders or borrowers, but the enterprise's stockholders, who receive 

greater implicit federal subsidies than the owners of Freddie Mac. 

This view implies that the government should require Fannie Mae to 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 191 

reduce the size of its portfolio to about 5 percent to 10 percent of the 

assets it has financed. 

An alternative perspective is that, although Fannie Mae's portfolio exposes the GSE to greater interest rate risk, it also provides the 

benefits discussed below. In this view, the government should determine the appropriate trade-off between the cost of Fannie Mae's 

greater exposure to interest rate risk and these benefits by including 

an interest rate risk component in a federal capital standard for the 

two GSEs. 

Interest rate stress tests would provide the simplest and most 

easily understood way to set the interest rate component of a capital 

requirement for Fannie Mae and Freddie Mac. One reasonable rule for 

selecting a stress test is that it has to assume a plausible worst-case 

scenario for the enterprises, that is, a pattern of interest rates that is as 

adverse as any judged to be within the realm of possibility. If a credit 

stress test is also used in setting a capital standard, another way of 

stating this rule is that the scenarios must be equally improbable. 

Otherwise, Fannie Mae and Freddie Mac would be more vulnerable to 

a worst-case change in interest rates than a worst-case decline in employment and residential real estate values. A number of scenarios 

would probably satisfy this rule. Whatever scenarios are chosen, it 

would be useful to know how each GSE performed over a long period, so 

that the government would have the maximum amount of information 

when deciding how long it would require them to survive. 

Requiring Fannie Mae to Hold More Capital Against Interest Rate 

Risk. If a capital standard required Fannie Mae to hold more capital 

against its exposure to interest rate risk than its internal capital standard requires, the risk that the GSE posed to the would 

decline. At the same time, there would be fewer situations in which 

the enterprise believed that it would be profitable to finance mortgages 

with debt, and its portfolio would grow more slowly or shrink in size. 

A reduction in Fannie Mae's portfolio operations could have three 

consequences. First, investors would expect a lower return on their 

equity in the GSE. The riskiness of that return might also decline, 

since the GSE's capitalization would be higher, and its net income 
192 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

might be less likely to vary with changes in interest rates. How the 

change affected the market price of Fannie Mae stock would depend on 

how these two effects were valued by investors. 

Second, Fannie Mae's ability to provide several types of services to 

the secondary mortgage market could be diminished. In some interest 

rate environments--specifically, when the spreads between MBS yields 

and the yields on Fannie Mae's callable debt are sufficiently large-- 

Fannie Mae can finance mortgages more cheaply with such debt than 

with MBSs. By serving as an additional source of funds, purchases for 

the GSE's portfolio may tend to reduce the volatility of mortgage rates 

relative to other interest rates. Also, Fannie Mae uses its portfolio to 

invest in mortgages that are difficult to securitize. In 1990, the GSE 

purchased about $6.8 billion of such nonstandard mortgages, which 

represented about 30 percent of the mortgages it purchased for its 

portfolio. In contrast, virtually all the loans purchased by Freddie Mac 

can be easily securitized. 

Third, mortgages that would have gone into Fannie Mae's portfolio 

would be financed with MBSs issued by the two enterprises. This could 

increase the interest rate risk exposure of investors in the MBSs. In 

1990, about two-thirds of Fannie Mae MBSs, and about half of Freddie 

Mac MBSs, went into REMICs. Although data are sketchy, federally 

insured depository institutions, particularly commercial banks, apparently purchase a large fraction--perhaps one-third--of REMIC classes. 

Banks and thrifts also purchase a large fraction of the GSEs' MBSs 

that are not placed in REMICs. On average, these institutions are less 

able to manage their exposure to interest rate risk--by estimating 

mortgage prepayments, issuing callable debt, and diversifying their 

portfolios with assets and liabilities of different interest rate sensitivities--than Fannie Mae or Freddie Mac. Consequently, there is a remote possibility that setting a capital requirement that led Fannie 

Mae to finance more of its mortgage purchases with MBSs could actually increase the federal government's exposure to risk from both the 

implicit federal guarantee of the GSE's securities and federal deposit 

insurance. The government could minimize this possibility by incorporating an interest rate risk component in federal risk-based capital 

standards for depository institutions, as the Office of Thrift Supervision has proposed to do for thrifts. 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 193 

Continuing to Allow Freddie Mac to Increase Its Exposure to Interest 

Rate Risk. The interest rate risk component of a federal capital requirement for the two GSEs could continue to allow Freddie Mac to increase its exposure to interest rate risk in exchange for higher nominal 

returns. The enterprise has not chosen to do so in the past because it 

believes that the returns from developing a larger portfolio would not 

provide sufficient compensation for the required increase in its exposure to interest rate risk. Freddie Mac's risk preferences would have to 

change for it to alter its financing strategy. The GSE would also have 

to be willing to pay the start-up costs of developing a market in callable 

debt. Freddie Mac might be willing to change its strategy if it believed 

that Fannie Mae could use earnings from its portfolio to achieve pricing advantages and increase its market share. Any increase in Freddie 

Mac's exposure to interest rate risk would increase the risk that it 

posed to the government, to the extent that the GSE did not increase 

its capitalization. 

Providing Statutory Direction About Setting 

a Risk-Based Capital Requirement 

If the Congress gave HUD or another supervisory agency the authority 

to set a binding, risk-based capital requirement for Fannie Mae and 

Freddie Mac, it could provide guidance about how the agency should 

use the authority. This could be done by providing general statutory 

direction to the agency, or by placing greater statutory restrictions on 

its actions. 

Providing General Guidance and Requirin~ the Use of Stress Tests. 

HUD could be required to base a capital standard on stress tests that 

evaluated each GSE'S exposure to credit risk and interest rate risk, and 

on the department's evaluation of each enterprise's exposure to management and operations risks. In developing the tests, HUD could be 

required to take into account factors that affect mortgage defaults and 

prepayments, and to use empirical data to model the relationships. 

The department could also be required to publish the tests for public 

review and comment, just as it does for proposed regulations. HUD 

could change the tests on the basis of new information, but there would 

be a reasonable limit on how frequently it could do so, say, no more 
194 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

than once a year. The Congress could also implement a statutory minimum capital standard for Fannie Mae and Freddie Mac, expressed in 

terms of mark-to-market net worth. The department would be required to develop a methodology, in consultation with the GSEs, for 

estimating their mark-to-market net worth on a consistent basis. 

This approach would enable HUD to adapt the stress tests used to 

set a risk-based capital requirement for Fannie Mae or Freddie Mac to 

reflect changes in the overall risk of the economy. The performance of 

the economy has often defied expectations in the last two decades. The 

risk of a severe, nationwide downturn, or a large, sustained increase in 

interest rates--the two events that pose the most risk,, to the enterprises--may increase in the future. It may therefore be prudent to 

allow the department to adjust the stress tests used to set capital requirements for the GSEs if an increase in overall economic risk occurs. 

HUD could also adapt stress tests to reflect changes in analytical techniques. Giving the department this flexibility could carry the danger 

that it would impose stress tests that required Fannie Mae and Freddie 

Mac to survive extremely severe economic conditions for a very long 

period--much more than a decade, for example. However, the required 

public review and comment probably would reveal any aspects of a proposed test that were unreasonable, which would diminish the likelihood that HUD could impose unreasonably severe tests. 

Providing guidance and requiring the use of stress tests also would 

give HUD flexibility with respect to incorporating management and 

operations risks into a risk-based capital standard. Two arguments 

can be advanced for doing so. First, any stress test makes assumptions 

about how GSEs will behave in extremely adverse economic environments. Inevitably, there is considerable uncertainty about such assumptions. The department could be better informed about this uncertainty than the Congress. Second, the management quality or operating systems of Fannie Mae or Freddie Mac could deteriorate 

enough to cause financial losses to accumulate without showing up on 

the GSE's balance sheet as a decline in capital. This could happen, for 

example, if the delinquency and foreclosure rates of loans serviced by 

certain large seller/servicers worsened dramatically, but the enterprise took no steps to minimize its losses. If the department conducted 

thorough examinations of each GSE, it would be in a position to deter- 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 196 

mine the appropriate amount of capital to protect against exposure to 

these risks. 

This approach might allow HUD to require excessive amounts of 

capital to protect against nonquantifiable risks. Requiring public review and comment of the proposed capital standard could limit this 

risk. Another option, discussed in Chapter 11, would be to allow Fannie 

Mae and Freddie Mac to reach a "safe harbor" from HUD's efforts to increase their capital if two private credit-rating agencies gave them a 

specified credit rating. One disadvantage of the latter remedy is that, 

if HUD discerned an unreasonable exposure to risk at a GSE that had 

achieved the required ratings, its hands would be tied. If the department conducted regular and thorough examinations of the enterprises' 

operations and required them to produce sophisticated data on their 

risk exposure, it would have better information about them than the 

rating agencies. 

Requiring Specific Stress Tests and Capital Percentages for Management and Operations Risks. Alternatively, the Congress could place 

significantly tighter statutory restrictions on HUDts discretion. This 

could be done by specifying the stress tests or other criteria that the 

department would be required to use to set the credit risk and interest 

rate risk components of a capital requirement for Fannie Mae and 

Freddie Mac. For example, the GSEs could be required to have enough 

capital to absorb mortgage default rates that were 50 percent higher 

than those experienced on conventional loans originated in Texas in 

the first half of the 1980s. The amount of capital that HUD could require the GSEs to have to cover management and operations risks 

could be limited to a fixed percentage of the amount of capital necessary to comply with the credit risk and interest rate risk components of 

the capital standard. 

This approach would enable the Congress to decide the severity of 

the economic stresses that Fannie Mae and Freddie Mac should be able 

to survive. If the systemic risk of the economy changed enough to warrant a change in the Congressional standard, HUD could seek to convince the Congress to strengthen it. However, limiting the department's discretion in this way would set a precedent of the Congress's 

micromanaging HUDts decisions with respect to the capital adequacy 
198 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

of the GSEs. This precedent would create the risk that, if either enterprise ever suffered losses that brought it out of compliance with its 

capital standard, the Congress would direct the department to weaken 

the standard. In short, the approach could limit HUD's incentive and 

ability to take independent action to assure the safe and sound operation of the GSEs. 

Possible Economic Effects of Requiring 

the GSEs to Maintain More Capital 

The federal government could require Fannie Mae and Freddie Mac to 

increase their capitalization more rapidly in the next few years than 

the GSEs would on their own. As discussed in Chapters I1 and V, higher capitalization could be required as part of a policy of imposing comparable capital requirements for the three housing GSEs. Higher capital levels at Fannie Mae and Freddie Mac would reduce the government's exposure to risk, but would impose costs on owners or borrowers. 

As noted above, under baseline economic and operating assumptions, in the next five years Fannie Mae could increase its capital from 

1.1 percent of assets and MBSs to about 2 percent. Under similar assumptions, Freddie Mac could increase its capitalization during that 

period from about 0.8 percent of all assets to about 1.2 percent. CBO 

expects that the GSEs could achieve such increases if they did not significantly increase the risk of their activities or their dividend payout 

rates, and economic conditions and mortgage rates remained stable. 

To achieve larger increases, the GSEs would have to issue stock, reduce the volume of mortgages they purchased, or increase the prices 

charged for their services. These changes would impose costs on owners or on the lenders and borrowers that the enterprises serve. 

Potential Effects on Owners. If the GSEs issued stock or reduced their 

new mortgage purchases, but did not increase MBS guarantee fees or 

lower mortgage purchase prices, their expected earnings per share 

would decline. Lower expected returns could change the market value 

of Fannie Mae and Freddie Mac's common stock. It is not clear, however, whether and by how much stock prices would change, for two rea- 
CHAPTER IV FANNIE MAE AND FREDDIE MAC 1B1 

sons. First, because both enterprises would be better capitalized, their 

overall risk would be lower and investors could require lower after-tax 

returns on equity. Second, share prices may already assume lower 

earnings per share. A reduction in uncertainty could even increase 

demand among investors and raise stock prices. 

Potential Effects on Mortgage Borrowers and Housing Markets. Fannie Mae and Freddie Mac could cover the costs of more rapid growth in 

capitalization by raising the prices they charge, that is, by increasing 

MBS guarantee fees and lowering mortgage purchase prices. Higher 

prices would increase earnings and avoid any reduction in earnings per 

share from issuing additional stock. 

The simplest way to assess how higher capitalization could affect 

prices is to examine the relationship between the initial capital investment that Fannie Mae and Freddie Mac make when they finance a 

loan, and the fee they would charge to guarantee securities backed by 

such loans. CBO estimates that a 25 percent increase in the initial 

capital investment made for newly purchased 30-year, fixed-rate mortgages would raise MBS guarantee fees by 3 to 5 basis points; a 50 percent increase would raise fees by 5 to 10 basis points; and a 100 percent 

increase, by about 10 to 15 basis points. These estimates assume that 

the required increase in capitalization would apply only to newly purchased mortgages. If the enterprises were required to issue stock to 

increase the capital backing all the mortgages they have financed, 

they would have to increase guarantee fees on new purchases much 

more in order to maintain returns. The estimates also assume that 

each GSE targets an after-tax return on equity of 16 percent. If their 

pricing assumed higher target returns, the increases required to support a larger initial capital investment would be larger. As noted 

above, however, higher capitalization might allow them to reduce target returns without hurting stockholders, which suggests that the estimated fee increases may be too large. Also, the enterprises might be 

willing to accept somewhat lower returns. 

Whatever the effects, competition among the lenders that the enterprises serve could pass most if not all of the price changes through to 

borrowers in the form of higher interest rates on mortgages. In the 

next decade, however, innovations in data processing and telecom- 
198 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

munications will continue to reduce the cost of originating and servicing mortgages. Some analysts argue that, as a result of these eficiencies and competition among lenders and servicers, there would be 

little net change in mortgage interest rates.29 

An increase of 10 basis points in the interest rate on a 30-year, 

fixed-rate mortgage is equivalent to a borrower's having to pay an additional 1 percent--or one point--to purchase the. home. Some borrowers would respond to such a cost increase by reducing the amount 

they were willing to pay for housing. This reduction in demand could 

reduce housing prices and construction activity in the short run. Housing prices would recover somewhat in the long run as growth in underlying demand caught up with supply. 

Any permanent increase in mortgage rates caused by higher capitalization of Fannie Mae and Freddie Mac would have positive and 

negative effects on thrifts and other financial institutions that hold 

mortgages and MBSs. On the positive side, expected returns from investing in mortgages originated in the future (or MBSs backed by 

them) and financing the assets with debt would be higher. On the 

negative side, the market values of outstanding mortgages and MBSs 

would be lower. 

29. See, for example, Swan M. Wachter, "The Limits of the Homing Finance System," Journal of 

Housing Research, vol. 1, no. 1 (1990). p. 168. 
CHAPTER V 

THE FEDERAL HOME LOAN BANK SYSTEM 

The Federal Home Loan Bank '(FHLB) System provides funds to depository institutions, primarily thrift institutions, to finance lending 

for residential mortgages. Despite the current problems in the thrift 

industry, the FHLB system is very sound and appears to pose a negligible amount of risk to the federal government. The exposure of the 

FHLBs to credit risk is low, mainly because their loans to thrifts are 

collateralized by high-quality mortgage assets. The FHLBs also successfully control their exposure to interest rate risk. The system is 

well capitalized at present given the low risks of its operations, and the 

system's regulator, the Federal Housing Finance Board (FHFB), has 

broad authority to limit the risk taking of the FHLBs. Although the 

profitability of the FHLB system is expected to be affected by the thrift 

crisis, it should remain high enough to meet the system's financial 

obligations. 

Despite this upbeat assessment, the FHLB system is at a critical 

juncture. Financial markets have evolved considerably since 1932 

when the FHLB system was created. These markets (in conjunction 

with other governmental agencies) can now offer the services, though 

at somewhat higher prices, that were once provided only by the FHLB 

system. Thus policymakers must decide whether the system continues 

to provide social benefits that deserve special governmental support. 

If the FHLB system is preserved, policymakers will probably want 

to address two other issues facing the system. First, the system is required by law to pay a fixed amount to offset the cost of resolving the 

thrift crisis. Such payments are likely to lead to a reduction in the system's membership and assets and, ironically, to a modest increase in 

the total costs of resolving the thrift crisis. Setting these payments as 

a proportion of the net income of the FHLB system (instead of as a fixed 

amount) would eliminate these effects. Second, the FHLB system is 

more heavily capitalized than are the Federal National Mortgage 
200 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), and this discrepancy is one factor that puts the 

depository institutions served by the FHLB system at a competitive 

disadvantage in financing conventional mortgages. Making the capital standards comparable for all three GSEs would equalize the implicit federal subsidies provided to them and would be a step toward 

leveling the playing field in the housing finance system. 

This chapter describes the current activities of the FHLBs and 

shows how they maintain their exposure to credit risk, interest rate 

risk, and business risk at low levels. It does not, however, address operations and management risks, although these risks are probably not 

large.1 Then, two methods that the government uses to control the 

overall risk taking of GSEs--capital requirements and regulatory authority--are analyzed. The section on regulatory authority, however, 

provides only a preliminary evaluation of the FHFB. A definitive assessment is not yet possible, because the FHFB was created little more 

than one year ago to replace the now extinct Federal Home Loan Bank 

Board (FHLBB), the agency that also regulated the thrift industry 

before 1990. The chapter concludes with a discussion of policy options 

for addressing the problems facing the system. 

CURRENT ACTIVITIES OF THE FHLB SYSTEM 

The FHLB system has traditionally been an important participant in 

housing finance in the United States. The system was created in 1932 

as a network of 12 regional banks operating independently of each 

other but in a coordinated fashion overseen by a common regulator. 

Since their inception, the FHLBs have helped housing markets by providing services to their members. Membership was originally limited 

to savings and loan institutions (which are required by law to become 

members) and savings banks and insurance companies (both of which 

are allowed voluntary membership). The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) extended 

I. For information on the management and operations risk of the FHLB system, see Department of 

the Treasury, Report ofthe Secretary of the Treasury on Government Sponsored Enterprises (May 

1990); and General Accounting Ofice, Government-Sponsored Enterprises: The Government's 

Exposure to Risks (August 1990). 
CHAPTER V TBE FEDERAL HOME LOAN BANK SYSTEM 201 

voluntary membership to commercial banks and credit unions that 

have more than 10 percent of their portfolio in home mortgages or related assets. All members are required to purchase stock in their 

regional bank, which gives them limited ownership rights.2 The current activities of the FHLB system include providing loans, risk management services, and banking services to members; helping to fund 

the resolution of the thrift crisis; and financing programs for affordable 

housing. 

Advances 

The most important activity of the FHLB system is the provision of 

loans (called advances) to its members. These advances provide members with a source of funds for short-term liquidity and for longer-term 

housing finance. The FHLBs raise money for these advances primarily 

by issuing bonds (called consolidated obligations) to investors in international capital markets. In essence, the FHLB system intermediates 

funds from international capital markets to local lenders and their 

housing markets, helping to ease regional imbalances in the demand 

for and the supply of funds for home mortgages. 

The significance of advances to the FHLB system is clearly illustrated in its balance sheets and income statements (see Tables 20 and 

21). At the end of 1990, advances to member institutions represented 

about three-quarters of the FHLB's outstanding assets, and consolidated obligations represented a similar amount of its outstanding liabilities. Similarly, receipts from advance borrowings are the largest 

source of income for the FHLBs, while payments to holders of consolidated obligations are their largest expense. 

Uses of Advances. FHLB advances provide members with a source of 

short-term liquidity to meet such needs as large seasonal or unex2. Members receive a dividend on thia stock, but do not receive capital gains; nor is the stock traded. 

Some regional FHLBe allow members to inveat more than the required amounta in FHLB stock. 

Voluntary members, upon leaving the system (or involuntary members, upon liquidation), have 

always been allowed to redeem their stock inveetment at par, although redemption ie at the 

diecretion of the FHLB (and the FHFB, if redemption adversely afFecta the safety and soundness of 

the FHLB system). The memberslownem elect the majority of the board of directore of their 

regional bank, and the remaining directors are appointed by the regulator. 
202 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

pected withdrawals by depositors. Even though an institution may be 

sound, large withdrawals can cause serious problems, mainly because 

much of its portfolio may be tied up in relatively illiquid home 

mortgages. Access to advances can stabilize the source of funds to an 

institution, allowing it to maintain lending to its local housing market. 

About half of the $117 billion of FHLB advances at the end of 1990 had 

a maturity of one year or less, and were probably used to meet shortTABLE 20. BALANCE SHEET OF THE FEDERAL HOME LOAN 

BANK SYSTEM (In millions of dollars, year-end) 

Assets 

FHLB Advances 48,963 65,194 66,001 58,978 74,616 

Cash and 

Investments 4,633 8,552 12,934 10,397 18,713 

Other Assets 751 934 1,328 3.115 3,664 

Total 54,347 74,680 80,262 72,490 96,993 

Liabilities 

Consolidated 

Debta 37,268 54,131 55,967 48,931 65,085 

Deposits 10,074 11,934 14,732 11,873 18,844 

Other Liabilities 975 1.835 2,149 3,952 4.359 

Total 48,318 67,880 72,848 64,756 88,289 

Capital 

Stock 5,160 5,827 6,269 6,395 7,200 

Retained 

E arningsb 869 974 1,144 1.340 1.504 

Total 6,029 6,801 7,414 7,734 8,704 ...................................................................... (Continued) 

SOURCE: Congreeeional Budget Office ueing audited financial reporb provided by the Federal Houeing Finance Board. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 203 

terh liquidity needs. The FHLBs also offer medium- and long-term 

advances to members, providing a source of funds for home mortgage 

lending. At the end of 1990, about 15 percent of outstanding FHLB 

advances had a maturity of five or more years. 

Prices of Advances. The FHLB advances are priced quite competitively and are among the cheapest sources of funds for most members. 

TABLE 20. Continued 

FHLB Advances 

Cash and 

Investments 

Other Assets 

Total 

Consolidated 

Debta 

Deposits 

Other Liabilities 

Total 

Stock 

Retained 

Earningsb 

Total 

Assets 

Liabilities 

Capital 

8,313 9,485 11,281 13,177 13,385 11,104 

1,792 2.323 2.619 2.343 820 521 

10,105 11,808 13,745 15,520 14,205 11,625 

a. Leee pea-through8 to Freddie Mac. 

b. Lese contributions to the Financing Corporation and the Resolution Funding Corporation. 
a61 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 21. INCOME STATEMENT OF THE FEDERAL HOME 

LOAN BANK SYSTEM (In millions of dollars, year-end) 

Interest Income 

Interest and Fees 

on Advances 4,481 6,994 8,702 6,754 7,516 

Investment 

Income 622 942 1,266 1,257 1,378 

Other Interest 

Income 36 43 50 42 - 40 

Total 5,139 7,980 10,019 8,053 8,934 

Interest Expense 

Interest on Consolidated Obligations 3,377 5,674 7,397 6,207 6,727 

Interest on 

Deposits 1,290 1,686 1,597 1,382 1,331 

Other Interest - 1 11 17 7 - 30 

Total 4,668 7,371 9,011 7,597 8,088 

Net Interest Income 471 609 1,008 456 846 

Net Income 

Total Interest 

Income 5,139 7,980 10,019 8,053 8,934 

Total Noninterest 

Income - 15 - 20 66 415 427 

Total 5,154 7,999 10,084 8,468 9,361 

Total Interest 

Expense 4,668 7,371 9,011 7,597 8,088 

Total Noninterest 

Expense - 69 - 93 - 111 - 140 390 

Total 4.738 7.464 9.122 7.737 8.478 

Net Income 417 535 962 73 1 883 ...................................................................... (Continued) 

SOURCE: Congreeeional Budget Office uaing audited financial reporb provided by the Federal Houeing Finance Board. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 206 

TABLE 21. Continued 

Interest and Fees 

on Advances 

Investment 

Income 

Other Interest 

Income 

Total 

Interest on Consolidated Obligations 

Interest on 

Deposits 

Other Interest 

Total 

Net Interest Income 

Total Interest 

Income 

Total Noninterest 

Income 

Total 

Total Interest 

Expense 

Total Noninterest 

Expense 

Total 

Net Income 

Interest Income 

Interest Expense 

Net Income 
206 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

The "all-in" costs of many other sources of funds (certificates of deposit, 

commercial paper, and medium-term notes) are generally higher than 

the all-in costs of FHLB advances of comparable maturities.3 But 

FHLB advances are not the cheapest source of funds for all thrifts. For 

thrifts with low operating costs, certificates of deposit may be cheaper 

(on an all-in cost basis) than FHLB advances. Moreover, the all-in 

costs of reverse repurchase agreements (reverse repos)--loans that generally use mortgage-backed securities (MBSs) as collateral and are 

brokered by Wall Street investment firms--are just as low as (and in 

1987 were lower than) those for an FHLB advance.4 But whole mortgages (that is, mortgages that are not converted to MBSs) are generally not accepted as collateral for reverse repos. In the few instances 

when they are accepted, more collateral is required, which raises the 

effective price of these repos above the costs of an FHLB advance. Furthermore, whole mortgages that cannot eventually be securitized by 

Fannie Mae, Freddie Mac, or others are not accepted as collateral for 

reverse repos. 

The interest rates on FHLB advances are competitive for two reasons. First, the FHLBs' cost of funds is low. The interest rates on the 

consolidated obligations issued by the FHLBs are not too far above the 

rates on Treasury securities of comparable maturities, reflecting the 

implicit federal guarantee of these obligations and the liquidity and 

marketability afforded them by GSE status. Second, the operating 

costs of the FHLB system have been relatively low, allowing the 

FHLBs to achieve a satisfactory profit level while maintaining only a 

relatively moderate markup over the rates on consolidated obligations. 

Together these factors have led the average interest rates on advances 

3. The all-in cost represents the total cost of fun&, including not only the interest rate but also the 

costs of broker fees, issuance costs, commitment fees, deposit insurance fees, reserve requirements, 

and collateral costa. For more details, see Jerry Hartzog, Richard Nelson. S. Wayne Passmore, and 

Patricia Remch, Thrift Financing Strategies: An Analysis of the All-In Cost of Retail and Wholesale 

Funding for Thrift Institutions (Federal Home Loan Bank of San Francisco, October 1990). 

4. Although reveree repurchase agreements are short-term financial instruments, Wall Street 

investment firms can create synthetic long-term debt inetruments wing reverse repos and other 

financial instruments (such as interest rate swaps). The all-in cost of such synthetic long-term debt 

appears to be quite close to that of FHLB advances, although these eetimates are imprecise. 
CHAPTER V THE FEDERAL HO~E LOAN BANK SYSTEM 207 

to be roughly 60 to 65 basis points above comparable Treasury securities.5 

Users of Advances. Most of the advances are used by very large savings institutions, primarily because these institutions hold most of 

their industry's assets. In the third quarter of 1990, about 80 percent 

of the outstanding advances to the thrift industry were to members 

with $1 billion of assets or more. In total, these members hold about 70 

percent of the thrift industry's assets. Although asset holdings play 

the major role in explaining demand for advances, other factors matter 

as well. About half of all thrifts with assets of less than $1 billion had 

no outstanding advances from the FHLBs in the same period, which 

may reflect economic factors (such as the fact that advances are not always the cheapest source of funds for some thrifts) and historical factors (the fact that some thrifts have always relied on deposits in their 

local communities rather than on funds borrowed from the FHLBs). 

Risk Management Services 

The FHLBs also help members to control interest rate risk. Members 

are vulnerable to changes in interest rates when they finance fixedrate mortgages with variable-rate deposits. If interest rates rise, the 

payments to their depositors can exceed the revenue from their mortgages, causing a decline in profitability. 

The most common way in which FHLBs help members control interest rate risk is by setting up an interest rate swap, which is a contract between two parties who agree to exchange the interest payments 

on part of each other's obligations. For example, an FHLB might agree 

to pay part of the interest costs on a member's variable-rate deposits, if 

in turn the member agrees to pay part of the interest costs on the 

FHLB's fixed-rate obligations. Such an agreement allows the member 

to convert a variable-rate obligation to a fixed-rate one, thus lowering 

5. Thie etatement ie based on a weighted average of advances of different maturitiea collected by the 

FHFB in January 1991. Analyeis of the apreade in earlier yeare shows that they depend on both the 

maturity of the advance and market conditione. The epreade, eepecially thoee at short maturities. 

have narrowed significantly from their peake in 1988 and 1989, when the etock of outatanding 

consolidated debt rose to its higheet level. 
208 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

the effects of changes in interest rates on the member's portfolio. 

These swaps can help the FHLBs manage their own interest rate risk 

as well, as discussed in the section on interest rate risk. 

The FHLBs also help members control interest rate risk by offering advances with a range of maturities, giving members greater flexibility in matching the maturities of their assets with those of their liabilities. For example, a member could finance a long-term, fixed-rate 

mortgage with a long-term, fixed-rate advance, and thus reduce its interest rate risk. Long-term advances, however, are not used very much 

to manage risk as only about 15 percent of the outstanding advances at 

the end of 1990 had a maturity of five years or more. 

Banking Services 

The FHLBs also provide banking services to members. These services 

include deposit accounts (such as simple checking accounts, overnight 

accounts, and term accounts), lock boxes, and check collection, processing, and settlement. The deposit accounts, many of which are interest-bearing, represented about 20 percent of the system's total liabilities at the end of 1990 and were the second largest source of funds to 

the FHLBs after consolidated obligations. Providing these services, 

however, appears to be more costly (and the profit margins lower) than 

providing loans to members in the form of short- and long-term advances. Because of these lower profit margins, the FHLBs of Dallas 

and Seattle have decided to cut back provision of these services. In addition, some analysts have questioned whether these services contribute to the FHLB's mission of housing finance, and the FHFB has 

initiated a study to address these questions and to determine what role 

the FHLBs should play in providing these services. 

Financing the Resolution of the Thrift Crisis 

The FHLBs also have helped to finance the resolution of the thrift 

crisis. FIRREA directed the FHLBs to make a one-time payment of 

$2.1 billion from their retained earnings, as well as a $300 million annual payment, to help cover the principal and interest costs on bonds 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 209 

issued by the Resolution Funding Corporation (REFCORP), an offbudget federal borrowing corporation established to finance the resolution of insolvent thrifts. REFCORP was authorized in August 1989 to 

float $30 billion of these bonds. The FHLBs have also contributed $680 

million to the Financing Corporation (FICO), a similar corporation 

created to recapitalize the Federal Savings and Loan Insurance Corporation (FSLIC), which insured savings and loan institutions (S&Ls) 

until 1989. The effect of these activities on the FHLB system can be 

seen in its balance sheet (see Table 20). Retained earnings fell from 

$2.6 billion at year-end 1987 to $0.5 billion at year-end 1990.6 

Community Investment and Affordable Housing 

The Financial Institutions Reform, Recovery, and Enforcement Act of 

1989 requires that the FHLBs fund two programs for community investment and affordable housing. For both programs, the FHLBs offer 

low-cost advances to members who in turn provide loans to designated 

groups.7 The first is the Community Investment Program, which supports loans made by members to homebuyers with incomes that do not 

exceed 115 percent of the median income in their area and to community-based organizations involved in commercial and economic development activities for low-income people. The program is oriented 

toward loans that may not meet the underwriting guidelines of Fannie 

Mae or Freddie Mac or for which no other secondary market exists. 

The FHLBs support these loans by providing advances, priced at the 

FHLBs' cost of funds plus administrative expenses. The total amount 

of advances provided in 1990 by the Community Investment Program 

was $497.5 million. 

The second program is the Affordable Housing Program, which 

provides advances at subsidized interest rates to institutions that 

6. The $300 million payment for REFCORP does not appear on the income statement. Inetead, the 

payment is made from reteined earninga shown on the balance sheet. The reason for this unueual 

procedure is technical and related to the current accounting treatment of reserves. The procedure 

may be changed in 1992, but no final decision has been made. 

7. Although the members often provide loans to low-income borrowers, the FHLB system itaelfis not 

expoeed to possibly greater risk, becauae the advances are heavily collateralized with highquality 

asseta in members' portfolios. 
810 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

finance homeownership by low-income households and provide funds 

for the purchase, construction, and rehabilitation of rental housing in 

which at least 20 percent of the funded units are affordable to households with very low incomes.8 Savings institutions are required to 

pass the subsidy dollar-for-dollar on a present value basis from the advance to the mortgage. Although an evaluation of this program is premature at present, it appears to be meeting many of its goals. In 1990, 

slightly more than half of the funds was targeted to households with 

very low incomes, and about two-thirds of the loans were devoted to 

rental housing projects. 

The subsidy for the Affordable Housing Program is paid by the 

FHLBs from their net income. This payment is a percentage of the 

preceding year's net income of the FHLBs, but is subject to a minimum 

fixed amount. The percentage was set at 5 percent annually for the 

1990-1993 period, 6 percent in 1994, and 10 percent in 1995 and beyond. The minimum fixed amounts are $50 million annually for the 

1990-1993 period, $75 million in 1994, and $100 million in 1995 and 

beyond.9 So far, the FHLBs have spent or are planning to spend more 

than the minimum required on the program--$79 million in 1990 and 

$59 million in 1991. The fixed minimum amount, however, is likely to 

become a binding constraint in the future if the income of the FHLB 

system declines, as discussed in the section on business risk. 

CREDlT RISK 

Although the interest rate and other terms on a loan can compensate a 

financial institution for expected losses from default, the institution 

remains exposed to unexpected losses, which is the fundamental risk of 

providing credit. The exposure of the FHLBs to credit risk is quite 

small. Most of the system's assets are advances, which are backed by 

high-quality collateral. Because of the collateral, the advances have 

an unmeasurably low probability of default; no member of the system 

8. Low-income households are defined ae those with incomes of no more than 80 percent of the median 

income in their area. Households with very low incomes are defined LIB thorn with incomes of no more than 60 percent of the median. 

9. The regulator of the FHLBa can temporarily sunpend the Affordable Housing Program if it determines the program contribuh to the system's financial imtability. 
CHAPTER .V THE FEDERAL HOME LOAN BANK SYSTEM 211 

has ever defaulted on an advance in almost 60 years of the system's 

operation. 

Most of the other assets of the FHLB system also present little 

credit risk. The second largest category of assets in the FHLB portfolio 

is cash and investments, which represented 27 percent of the outstanding assets in 1990 (see Table 20). Almost all of these investments 

were in Treasury securities, GSE obligations, mortgage-backed securities guaranteed by Fannie Mae or Freddie Mac, or federal funds, which 

are typically overnight loans to large commercial banks to help these 

banks meet their reserve requirements. The credit risk of each of these 

assets is very low. 

The FHLB system has controlled its exposure to credit risk on its 

advances using three methods. First, each bank has established underwriting standards, which are rules that limit the amount of credit 

extended to any single borrower. The exact form of these rules and the 

specific limits are determined by each individual bank, although many 

of these rules are similar at all banks. Second, each borrower must 

hold at least 5 percent of the value of its outstanding advances as 

FHLB stock, which the borrower would lose in the event of default. 

Third, all advances must now be backed by collateral of relatively high 

quality, whose value exceeds the value of the advance, thus providing a 

strong incentive for borrowers to repay. These collateral rules were 

strengthened by FIRREA, which specified the types of assets that 

would be eligible to count as collateral. In addition, the FHLBs have 

established guidelines on the amount of collateral needed to secure an 

advance (see Box 9 for more details). The types of eligible collateral 

are limited to four c1asses:lO 

o First mortgages on improved residential property that are 

not more than 90 days delinquent; 

o Securities issued or guaranteed by the federal government or 

a GSE; 

10. Collateral to obtain an advance must come from one of these claese~. If the value of this eligible 

collateral falle after the member obtains the advance, the FHLBs can mk the member to put up 

additional collateral, but this additional collateral dm not have to meet the eligibility rules set in 

FIRREA. 
212 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

BOX 9 

Risk Classes for Determining Collateral Requirements 

The FHLBs have set guidelines for determining the amount of collateral needed to secure an advance. The guidelines place a borrowing institution in one of three risk classes based on its creditworthiness. Each risk class has its own set of rules. The FHLBs are free to 

set more stringent collateral rules than suggested by these guidelines, and some banks have done so. 

The most restrictive class requires the borrower to place the collateral on delivery status, which means that the borrower must 

physically deliver the collateral to the FHLB. Borrowers are subject 

to the restrictive delivery status if the level of their regulatory capital 

is less than 2 percent of liabilities. Borrowers may also be subject to 

these restrictive rules at the discretion of the regional FHLB. Advances made to members in delivery status must be backed by collateral that has a market value of at least 125 percent of the advance if 

market values are determined quarterly, or 110 percent if market 

values are determined monthly. 

A class of intermediate restrictiveness requires the borrower to 

place the collateral on listing status, which means that the borrower 

must specifically identify the collateral securing the advance and 

segregate it from other assets in its portfolio. In general, borrowers 

with capital between 2 percent and 3 percent of liabilities are placed 

on listing status, although the exact standards vary among regions. 

Advances made to members in listing status must be backed by collateral under the same rules as members in delivery status. 

The least restrictive class places borrowers' collateral on blanket 

status, which means that borrowers are free to dispose of any portion 

of collateral provided that the remaining amount is sufficient to meet 

the collateral requirements. In general, borrowers receive blanket 

status if their regulatory capital is greater than 3 percent of liabilities, and they are operating profitably, although some banks use more 

stringent rules or different measures of capital. Under blanket 

status, members do not have to determine the market values of the 

collateral as do members in other status groups. Instead, they can use 

book values. Members in blanket status must have collateral with 

book values ranging from 100 percent to 175 percent of the advance. 

The median book value of such collateral was 170 percent of the value 

of the advance. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 213 

o Deposits in an FHLB; 

o Other real estate, provided that it has a readily ascertainable 

value, that the FHLB has first claim on the collateral in the 

event of default, and that advances secured by such real 

estate do not exceed 30 percent of the member's capital. 

The FHLBs have the right to call for more collateral if the market 

value of the collateral backing outstanding advances is deemed insufficient. During the mid-1980s, the FHLB of Dallas successfully used 

this right to protect itself from the effects of declining real estate 

values in its district. Such a right implies that the FHLB system could 

be well protected even during a severe nationwide downturn in the 

economy. 11 

Although advances were usually overcollateralized before passage 

of FIRREA in 1989, the collateral rules were not uniform at all banks. 

Moreover, the collateral was sometimes of lower quality, as many 

banks simply required that the advance be secured by any asset with 

ascertainable value and in which the bank had a first claim in the 

event of default. 

Because advances made before FIRREA could be backed by other 

forms of collateral currently not eligible to secure advances, FIRREA 

also developed a set of transition rules. Under the law, an advance 

made before FIRREA can be renewed using ineligible collateral, but in 

such a situation the bank must follow an FHFB-approved plan for reducing these outstanding advances in an orderly manner. currently, 

only a small fraction of outstanding advances are backed with ineligible collateral, according to the FHFB. 

11. Although the FHLB ayetern iteelf would be well protected, the taxpayer would still be exposed to 

risk became such a downturn would probably cause additional inaolvencies among the nation's 

depository institutions, raising the mete of providing federal deposit insurance. For more details on 

federal deposit insurance and options for reform, see Congressional Budget Office, Reforming 

Federal Deposit Insurance (September 1990). 
214 GOVERNMENT-SPONSORED ENTERPRISES April 1091 

INTEREST RATE RISK 

The FHLB system is exposed to interest rate risk from two sources. 

First, if the maturities of the assets and liabilities in an FHLB differ, 

then changes in interest rates can affect its net income. For example, if 

an FHLB financed a short-term asset with long-term debt, then a fall 

in interest rates would reduce its interest income from assets below its 

interest expense from liabilities. Second, changes in interest rates can 

affect the net income from loans that can be prepaid by borrowers. 

Suppose, for example, an FHLB had financed a long-term, prepayable 

asset (such as a loan) with a long-term liability. If interest rates fall, 

some of these assets would be prepaid as some borrowers refinance at 

lower rates. Such actions reduce the lender's income because the 

lender has to reinvest the prepayment income in a lower-yielding 

asset. Two assets in the FHLB portfolio are subject to this prepayment 

risk: FHLB advances and mortgage-backed securities. 

The FHLB system has controlled its exposure to interest rate risk 

relatively well. As a simple, albeit indirect, measure of this success, 

the net interest income of the FHLB system relative to the average 

value of its assets (the net interest margin) has remained positive and 

relatively stable, largely within a range of 90 to 120 basis points over 

the past 15 years (see Figure 10). This performance occurred despite 

wide fluctuations in interest rates over much of this period. More 

sophisticated measures of interest rate risk are presented later in this 

section. 

Management and Control of Interest Rate Risk 

The FHLBs have employed four methods to control their exposure to 

interest rate risk. First, each bank attempts to match the maturities of 

its assets and liabilities. Long-term, fixed-rate advances are matched 

with consolidated bonds of similar maturities, and similar matches are 

found for short-term assets and liabilities. Variable-rate advances are 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 215 

Figure 10. 

Net Interest Margin of Federal Home Loan Banks, 1974-1990 

SOURCE: Congressional Budget Office using audited financial reports provided by the Federal 

Housing Finance Board. 

NOTE: Net interest margin is net interest income divided by average assets. 

Percent 

1.8 

matched with either variable-rate bonds or short-term discount 

notes.12 Such matching helps to ensure that a change in interest rates 

affects both sides of the balance sheet in a similar way at the same 

time. 

1.6 

Second, several FHLBs use interest rate swaps to reduce their 

risk. Such contracts essentially convert long-term liabilities into 

short-term ones (or vice versa), and thus provide the FHLBs with flexibility in synchronizing the maturities of their assets and liabilities. 

Although partners to a swap can be members of the FHLB system, the 

- - 

12. Some bah alao control the intereat rate rink of variable-rate aaneta by netting floors and cape on the amount by which rates can change. 
216 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

majority of these swaps are with nonmembers.13 At the end of 1990, 

swap agreements covered about $32 billion--or 19 percent--of outstanding assets. 

Third, a few FHLBs also hedge their interest rate risk by using the 

cash, futures, and options markets. These markets are used primarily 

to lock in an interest rate for the period between when an advance is 

made and when its supporting consolidated obligation is issued (consolidated obligations are issued only on a monthly basis, but advances 

are made daily). No hedge in the futures market is perfect, however, 

and changes in interest rates can have different effects on the value of 

the hedge and the underlying security, which can lead to losses. FHFB 

regulations limit the risk of using these markets by requiring that the 

hedges be tied to specific assets or liabilities and be used solely to reduce interest rate risk. At year-end 1990, futures hedging amounted to 

about $0.9 billion. 

Fourth, the FHLBs have developed methods for controlling the 

prepayment risk of mortgage-backed securities and advances. For 

mortgage-backed securities, the prepayment risk is limited by rules 

that prevent FHLBs from investing too heavily in these assets. Current FHFB regulations allow the banks to hold mortgage-backed 

securities and related assets, provided their value does not exceed 50 

percent of the bank's capital. For advances, the FHLBs discourage prepayments by imposing a fee on borrowers who choose to do 90.14 The 

fee is approximately equal to the present value of the cash flow lost to 

the FHLB because the rate on a new advance is lower than the rate on 

the prepaid advance.15 Thus, if the bank reinvests the prepaid loan 

13. Intereat rate swaps introduce a "counterparty" risk, namely, the possibility that the other party 

could fail to live up to the agreement. In such a case, the FHLB suffers losses if it is unable to find a new swap partner willing to trade on the original term and if interest rates have changed from the 

time that the original swap wm made. The FHFB control8 the impact of the counterparty risk by 

limiting the total amount of swap activity, defining acceptable partiea for a swap, and requiring more collateral from lower-rated parties. 

14. The only exception is that the FHFB doen not require banks to impose prepayment fees on variablerate advances that reprice at least every six months, although banh are free to do so if they wish. 

15. Although banka have some discretion in setting the penalty, the FHFB requires that the prepayment fee be between 90 percent and 110 percent of the preaent value of the cash lost. The discount 

rate used to calculate the preaent value is the rate on new advances of the same maturity. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 217 

balance plus the prepayment fee in a new advance, its net income will 

be roughly the same as before the prepayment. 

The prepayment fee, however, does not eliminate all of the interest 

rate risk on an advance. If the bank is unable to reinvest the prepayment income in a new advance, the bank could be forced to invest in a 

lower-yielding asset, causing net income to fall. The FHLB of Dallas is 

currently facing such a situation--and its income has been affected by 

it.16 The FHFB is considering revising the regulations on investments 

in mortgage-backed securities to give FHLBs more opportunity to 

invest in these assets. Such a change, however, would raise the risk of 

prepayment in the portfolio, but these risks probably present less of a 

threat than the banks' current inability to invest prepaid advances in 

assets that cover costs. While such changes appear necessary for reducing the risks of the system in the short run, they raise questions 

about its long-run purpose. Specifically, if the FHLBs cannot make advances, to what extent should they be allowed to make other investments? 

Indicators of Interest Rate Risk 

The interest rate risk of the FHLB system can be examined by assessing how changes in the level of interest rates affect the mark-tomarket net worth of individual FHLBs. The mark-to-market net 

worth of a GSE is the value of liquidating the GSE's assets and liabilities on a piecemeal basis (and thus excludes the franchise value of the 

GSE and other intangibles that make the whole GSE worth more than 

the sum of its parts). This net worth provides the first line of defense in 

protecting the federal government against losses. If a relatively small 

increase in interest rates had a large effect on mark-to-market net 

16. The Dallas bank provided a large number of advancee to help insolvent (and other) thrifta in the 

Southweat deal with liquidity problems in 1988, financing these advances with liabilities tied to the one- and the three-month London Inter-Bank Offer Rate (LIBOR) through swap agreemente. As 

the Resolution Trust Corporation liquidated these insolvent thri€ta, the advances were prepaid, but 

because of the poor demand for advances in the Dallas region, not all of the prepaid advances could 

be invented in new advances. Inatead, the bank invested as much income as permitted in mortgagebacked securities, and the rest was put in overnight federal funds. When the interest rate on 

federal fun& dipped below the LIBOR in January 1991, the earnings of the bank, though remaining positive, fell aomewhat. 
218 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 22. ESTIMATED CHANGE IN THE MARK-TO-MARKET NET 

WORTH OF THE FEDERAL HOME LOAN BANKS FROM 

AN INCREASE OF ONE PERCENTAGE POINT IN 

INTEREST RATE23 

Regional Banks 

Percentage Change in 

Mark-to-Market Net Worth 

Boston 

New Y ork 

Pittsburgh 

Atlanta 

Cincinnati 

Indianapolis 

Chicago 

Des Moines 

Dallas 

Topeka 

San Francisco 

Seattle 

SOURCE: Congressional Budget Office using data from the Federal Housing Finance Board. 

worth, the risk of exhausting net worth and, becoming insolvent would 

be quite high; a low sensitivity of mark-to-market net worth to changes 

in interest rates would indicate little interest rate risk. 

Estimates of how an increase in interest rates of one percentage 

point would affect the mark-to-market net worth of the FHLB system 

suggest that the system's interest rate risk is small (Table 22),17 The 

FHLB of Seattle shows the largest estimate--its net worth would fall 

5.6 percent for a one percentage-point increase in interest rates--but 

even for this bank, virtually all of the net worth would remain intact 

17. The estimates assume a parallel shift in the yield curve and take account of not only the usual onbalance-sheet assets and liabilities, but aleo the off-balance-sheet activities, such aa interest rate 

swaps and hedges in the caah, futures, and options market. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 219 

after such a shock. The other regional FHLBs show less sensitivity, 

with estimates for eight of the twelve FHLBs below 3 percent. 

For most of the FHLBs, higher interest rates would lower their 

mark-to-market net worth slightly, which is probably prudent in the 

current environment. As the Resolution Trust Corporation prepays. 

advances held by insolvent thrifts, the average duration of the assets of 

the FHLBs will shorten relative to that of their liabilities, which implies that a rise in interest rates will have a smaller adverse effect on 

their mark-to-market net worth. Thus the small negative sensitivities shown in Table 22 are expected to move toward zero as the insolvent thrifts are resolved.18 

BUSINESS RISK 

Government-sponsored enterprises are also exposed to risk from operating in a specific line of business, and such risks can affect their 

profitability. For example, if demand for the goods and services provided by a GSE falls, its profitability could decline if it is unable to 

reduce its costs sufficiently. Although the FHLBs are likely to experience such a decline in demand, they should be able to reduce costs 

enough to keep their business risk at acceptable levels. 

The major business of the FHLB system--providing advances--will 

probably shrink over the next several years, for two reasons. First and 

foremost, the traditional industry served by the FHLB system--the 

thrift industry--is shrinking. Second, certain provisions of FIRREA 

18. A zero mmitivity minimizes the intereat rate riak to the FHLB eyetem itaelf, but eome analyste 

argue that this is not wholly desirable. Them analysts believe that federal policy should aim to 

minimize the combined intereat rate rieb of the FHLBe and their members (largely federally 

insured depoeitory inetitutiona) becauee taxpayere are reeponaible for the failures of both groups 

through either the implicit guarantee of coneolidated obligations or the explicit guarantee of 

federal deposit ineurance. Since the mark-to-market net worth of moet membere deteriorates when 

intereat rates rim, such a policy would require the mark-to-market net worth of the FHLBs to 

improve in such a situation. Although this argument is appealing, calculating the combined 

intereat rate seneitivities is quite difficult at preaent, and if not done correctly, this alternative 

policy of targeting a non-zero aeneitivity could expose the FHLBs to unneceseary rieb. 
a20 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

TABLE 23. ADVANCES MADE BY FEDERAL HOME LOAN BANKS 

TO MEMBER INSTITUTIONS AS OF DECEMBER 31, 1990 

Recipient of 

Advances 

Advancee by Regional Bank (Percent) 

System 

Total Boston New York Pittsburgh Atlanta Cincinnati 

Members in Comervatorship 9 4 10 21 11 2 

Membere with Capital Ratiosa 

Less than zero 13 6 3 1 26 13 1 

Between zero and 1.6 9 4 24 10 9 0 

Between 1.5 and 3.0 14 12 3 11 17 38 

Between 3.0 and 6.0 46 34 22 19 40 38 

Greater than or equal to 6.0 - 9 - 40 - 10 - 15 - 10 - 2 1 

All Membera 100 100 100 100 100 100 ...................................................................... (Continued) 

SOURCE: Congreaeional Budget Ofice using data from the Federal Housing Finance Board. 

impede the recruitment of new members into the system. Consequently, the demand for advances and income from those advances is 

likely to fall in the future. 

The shrinkage of the FHLB system should not significantly increase its risk of failure because the shrinkage is likely to occur in an 

orderly fashion. Although interest income from advances will fall, the 

FHLBs should be able to reduce their interest expense by issuing fewer 

consolidated obligations. If the FHLB system shrinks enough, additional cost savings could be found by merging some of the smaller 

regional banks with the larger ones. A likely by-product of a smaller 

FHLB system, however, is a modest increase in the cost of resolving 

the thrift crisis. 

Decline in the Demand for Advances by the Thrift Industry 

The FHLB system will almost certainly experience a major decline in 

its business of providing advances to the thrift industry in the coming 

years. Two factors account for such an outlook. First, a large number 

of outstanding FHLB advances are currently held by insolvent members. As the Resolution Trust Corporation (RTC) resolves these insti- 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 231 

TABLE 23. Continued 

Recipient of 

Advances 

Advancee bv Regional Bank (Percent) 

Indiana- Dee Sen 

polis Chicago Moines Dallas Topeka Francisco Seattle 

Members in Comervatorship 0 7 0 20 31 5 0 

Members with Capital Ratios@ 

Less than zero 0 10 20 30 1 3 22 

Between zero and 1.5 0 2 8 0 36 5 1 

Between 1.5 and 3.0 9 2 25 11 1 21 9 

Between 3.0 and 6.0 86 52 44 38 28 64 43 

Greater than or equal to 6.0 3 - 27 - 3 - 1 - 25 

Total 100 100 100 100 100 100 100 

a. Ratio of capital to tangible asseta (percent). 

tutions, the advances will be prepaid.19 Since most of the mortgage 

assets from these insolvent members will be sold to institutions who 

are not members of the FHLB system, the asset base of the FHLB 

members will shrink. As a result, fewer advances will be needed to 

meet liquidity and other needs. 

The distribution of outstanding advances to FHLB members by 

capital-to-asset ratio is shown in Table 23. As of the end of 1990, about 

30 percent of the outstanding FHLB advances were held by insolvent 

or near-insolvent institutions (those in conservatorship or with capitalto-asset ratios of less than 1.5 percent). The regional distribution of 

these advances is even more striking--about 70 percent of the advances 

by the FHLB of Topeka are to insolvent or near-insolvent members. 

Since the end of 1990, some of these advances have been prepaid, and 

more prepayments are expected in 1991. As this occurs, the asset base 

of FHLB members--and demand for FHLB advances--will decline. 

Second, demand for advances will also fall because some solvent 

savings institutions are downsizing to meet the new and higher capital 

standards mandated by FIRREA. As of September 30,1990,17 percent 

of the S&Ls not in conservatorship failed to meet these new standards, 

19. The advances to insolvent inetitutions are overcollateralized just as other advances are, so providing advances to insolvent institutions pcaes little credit risk to the FHLBs. 
GOVERNMENT-SPONSORED ENTERPRISES Apd 1991 

and because many of these thrifts are having trouble finding investors 

to put up additional capital, they are being forced to sell existing assets 

and reduce their size. As a result, their demand for advances will fall. 

Problems of Attracting New Members 

Even though FIRREA opened up membership in the FHLB system to 

commercial banks and credit unions, the response by these potential 

members has not been overwhelming. Between January 1990 and 

February 1991, the system had attracted about 100 new members to its 

base of almost 3,000 members, and another 84 applications for membership were pending approval. But over the same period, the system 

lost about 400 members through mergers, resolutions, acquisitions, 

and voluntary withdrawals. Moreover, the commercial banks that 

have joined the system since passage of FIRREA represent only a small 

fraction of the total banks eligible for membership.20 

The modest response of eligible institutions to the possibility of 

membership in the FHLB system stems from many factors, but among 

the most important is a perception that holding FHLB stock may not 

be a good investment. Although no member has ever lost its initial investment in FHLB stock, and the stock has usually returned dividend 

yields well above Treasury bill rates, potential members fear that 

future legislative action could confiscate FHLB slack to pay for the 

thrift crisis.21 

If the system fails to attract new members, gross income from advances will fall, and as it does, the fixed payments to REFCORP and 

the Affordable Housing Program will take an ever larger fraction from 

it, which will cause dividend yields to fall significantly. Without new 

members, outstanding advances could fall to about $70 billion--roughly the current level of outstanding advances to members that are not in 

20. The aggregate numbere on the recruitment of new member9 mask eome eiBnificnnt differencee at 

the regional level. Some banke have been succeseful in recruiting new members, with moat of the 

new recruits concentrated in five districts: Boston, Cincinnati, Pittsburgh, Seattle. and 

Indianapolis. 

21. FIRREA tobk only retained earning0 from the FHLB ayetem, not members' initial etoek inve& 

menta. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 239 

conservatorship and that meet the capital rules imposed by FIRREA. 

If advances fall to this level and interest spreads on advances and consolidated obligations remain near current levels, then the dividend 

yield on FHLB stock could fall about 300 basis points to the 6 percent 

to 7 percent range. This estimate is quite rough, however, and very 

sensitive to the assumptions on interest rate spreads. For example, if 

interest rate spreads change by 10 basis points, the dividend yield 

changes by 100 basis points.22 Moreover, these estimated dividend 

yields are sensitive to assumptions about the number of new members 

who join the system. 

If potential members could be persuaded to join and borrow, the 

FHLB stock could provide returns high enough to compensate for the 

perceived risk that the capital stock could be confiscated. Unfortunately, these expectations of low returns are largely self-fulfilling. To 

the extent that potential members decide not to join, the system 

shrinks, causing dividend yields to fall and justifying the original decisions not to join. 

Effect of Lower Dividend Yields on 

the Costs of Resolving the S&L Crisis 

Requiring the FHLB system to make fixed payments to REFCORP and 

the Affordable Housing Program makes the cost of resolving the S&L 

crisis slightly higher than it would otherwise have been. The FHLB 

stock is an asset of the S&L industry, and as the dividend yields on this 

stock fall, the industry's net income will experience a further decline. 

To the extent that these losses will be incurred by S&Ls that are already insolvent (and thus are the ultimate responsibility of the federal 

government), part of the fixed payment made by the FHLBs will be 

shifted back to the general taxpayer. More is involved than a simple 

shifting of costs among different groups, however. As insolvent S&Ls 

not in conservatorship (that is, not under government control) lose 

22. Thia estimate of the average dividend yield of the aptem mash some regional diiTerencea,which are likely to be sigrdicant. Districts that have been less affected by the SLL crisis and are able to 

attract new recruita will be able to pay dividend yields higher than 6 percent or 7 percent. 
M4 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

more money, they face greater incentives to invest in riskier assets.23 

These S&Ls have everything to gain if the gamble pays off--and 

nothing to lose if it does not. Lower dividend yields will also push a 

small number of near-insolvent S&Ls into insolvency, which will also 

raise the costs of resolving the crisis. 

The exact magnitude of the effects of fmed payments on the costs of 

resolving the S&L crisis is impossible to calculate, because the extent 

to which these payments cause insolvent S&Ls not in conservatorship 

to take additional risks is unknown. But it is possible to estimate 

roughly how much income S&Ls lose as dividend yields on FHLB stock 

fall. Given estimates of the FHLB stock held by each S&L, the effect 

on net income of a decline in dividend yields is simply the product of a 

change in yields and the value of the FHLB stock. Such estimates are ' 

close to an upper bound, since the calculation assumes that dividend 

yields drop before any stock is redeemed. In reality, dividend yields 

will drop as insolvent S&Ls are closed by the RTC and FHLB stock is 

redeemed. 

Based on these assumptions, CBO estimates that $50 million of 

the $400 million in annual fixed payments could be borne by insolvent 

S&Ls (those in conservatorship or operating with capital-to-asset 

ratios less than zero) if dividend yields fall the expected 300 basis 

points (see Table 24). Since these institutions are (or may eventually 

be) under government control, these costs will ultimately be borne by 

the general taxpayer. A decline of 200 basis points in the yield on 

FHLB stock reduces the net income of these insolvent S&Ls by $33 

million, and a decline of 400 basis points leads to losses of $66 million. 

These costs, however, are very small compared with the current size of 

the S&L crisis. In January 1991, CBO estimated that the total cost of 

resolving the S&L crisis is likely to be over $200 billion in present 

value terms. 

23. The ability (and incentive) of ineolvent SLLs to inveet in rieky aseeta was significantly reduced, but 

not eliminated, by several provisione of FIRREA. In addition, the Ofice of Thrift Supervision is 

monitoring innolvent SLLe much more closely than it8 predeeeseor, the Federal Home Loan Bank 

Board. For more details on FIRREA, see James R. Barth, George J. Benston, and Philip R. Wiest. 

The Financial Inatitutiom Reform. Recovery and Enforcement Act of 1989: Description, Effecta. 

and Implications." Issues inBank Regulation (Winter 1990). pp. 3-11. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 225 

TABLE 24. EFFECT OF LOWER FHLB DIVIDEND YIELDS 

ON THE S&L INDUSTRY (In millions of dollars) 

Decline in S&W Net 

Number Income Resulting from a 

of Total FHLB FHLB Drop in Dividend Yields of 

%La Saih Aesets Advances Stock 200bps 300 bps 400 bps 

With Capitol Ratioen 

hs than zero 108 85,548 11,111 828 17 25 33 

Between zero and 1.5 94 80,115 9,357 769 15 23 31 

Between 1.5 and 3 148 140,932 15,432 1,119 22 34 45 

Between 3 and 6 845 497,712 48,421 4,103 82 123 164 

Greater than or equal to 6 1.147 200.268 5.420 1.505 - 30 - 45 3 

Total 2,521 1,083,227 100,388 9,146 183 274 366 

SOURCE: Congressional Budget Ofice using data from the Federal Housing Finance Board. 

NOTE: These estimates are based on data as of December 31.1990. 

SBL = eavinge and loan; FHLB = Federal Home Loan Banks; bps = basis points. 

a. Ratio of capital to tanable meets (percent). 

CAPITALIZATION OF THE FHLB SYSTEM 

As the preceding sections showed, the FHLBs are not exposed to significant credit or interest rate risk. Paradoxically, they are required to 

hold relatively large amounts of capital relative to their assets. In 

contrast, Fannie Mae and Freddie Mac are permitted by the government to maintain much lower capital ratios. These differences imply 

that Fannie Mae and Freddie Mac receive a larger implicit federal subsidy,than that given to the FHLB system. 

Current Levels of Capital in the FHLB System 

The FHLB system is well capitalized, with the value of capital averaging about 7 percent of assets at the end of 1990 (Figure 11). The 

capital-to-asset ratio has declined sharply over the past two years, but 

practically all of this decline stemmed from a one-time loss in retained 

earnings mandated by FIRREA. Capital ratios may continue to de- 
236 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

SOURCE: Congressional Budget Office using audited financial reports provided by the Federal 

Housing Finance Board. 

Figure 11. 

Aggregate Capital-to-Asset Ratio of the Federal Home Loan Banks 

CapitallAssets (Percent) 14 

cline, but they will probably not fall too much farther, because the system has a relatively strict set of capital standards. 

12 

The current levels of capital are more than sufficient to assure the 

system's safety and soundness, for two reasons. First, the assets of the 

FHLB carry very little credit risk. If the capital ratios were adjusted to 

reflect the riskiness of the assets, the risk-adjusted capital ratios of the 

FHLB system would probably be higher than the unadjusted ratio of 7 

percent.24 

- - 

Second, the legal nature of the FHLBs' consolidated obligations 

provides an additional line of defense against failure of the system. 

24. For more detailn. nee Federal Home Loan Bank of Atlanta, "Report to the Bank Preeidenta' Finance 

Committee from the Task Force on Proponed Rink-Bad Capital Raquirement" (August 28.1990). 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 337 

These bonds are the joint and several liability of the entire FHLB system, meaning that all of the regional FHLB banks are responsible for 

the bonds of any particular bank in the event of a default. Joint and 

several liability protects the federal government in both prospective 

and retrospective ways. Prospectively, it creates incentives for managers of FHLB district banks to moni:or each others' activities and to 

inform the regulator about activities that appear to increase the risks 

to the system as a whole.25 Retrospectively, it protects the federal government because the government is implicitly liable only if the net assets of the entire FHLB system are exhausted. Such a requirement reduces the risk to the taxpayer by spreading some of the risk of failure 

across the whole system. 

Capital Standards of the FHLB System 

The Federal Housing Finance Board enforces two types of capital standards designed to limit the riskiness, of the FHLB system. First, members are required to hold some of their hnds as capital in the FHLB 

system. Second, federal regulations require that the FHLB system as a 

whole must hold a minimum amount of capital against its outstanding 

consolidated obligations. 

Stock Requirements for Members. Each member of the FHLB system 

must purchase stock in its regional bank, with the amount determined 

by the value of the member's total assets, home mortgages, and outstanding advances. Lower stock requirements are given to members 

deemed to be qualified thrift lenders (QTLs), which, after July 1,1991, 

are institutions with 70 percent or more of their portfolio invested in 

mortgages or related assets.26 QTL members must hold FHLB stock in 

an amount not less than any of the following: 

25. This point is more than hypothetical: when the FHLB of Dallas accepted FSLIC notes, the value of 

which some analyeta quek-ioned, as collateral for advances during the 19808, it faced-considerable 

pressure (including the threat of lawsuite) from other banks to stop the practice. 

26. The major exception to this rule is that savings banks automatically receive the preferential 

treatment given to QTL members, regardless of the share of home mortgages and related aseta in 

their portfolio. The qualifying aseeta for other institutione are loans to purchase, refinance. 

(Continued) 
228 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

o 0.3 percent of their total assets; 

o 1 percent of their home mortgage assets; 

o 5 percent of their outstanding advances. 

Non-QTL members must comply with the first two requirements 

above, but are required to hold more stock against outstanding advances.27 For example, a member with only 10 percent of its portfolio 

in qualifying assets is required to hold FHLB stock equal to 50 percent 

of its advances. The way in which this third stock requirement varies 

with the share of mortgage assets in a member's portfolio is shown in 

Figure 12. Because of the peculiarities of these rules, there is a break 

in the minimum stock requirements at the percentage needed to qualify for QTL status--in this case, 70 percent. 

Non-QTL members face another restriction as well, namely, that 

advances to non-QTL members by any bank cannot exceed 30 percent 

of that bank's total outstanding advances. This restriction is likely to 

become a binding constraint in the near future for non-QTL members 

of the FHLB of Des Moines. This FHLB recently accepted a large commercial bank as a member. Other regional banks may face similar 

constraints if they recruit very large commercial banks into the system 

as well. 

Rules on the Aggregate Level of Consolidated Obligations. Federal 

regulations impose a minimum capital standard on the system as a 

whole. The system must have capital in excess of 8+ percent of the outstanding consolidated obligations. In addition, the value of assets in 

the FHLB system that are free from any lien or pledge must exceed the 

26. Continued 

construct, improve, or repair residential housing, home-equity loam; mortgage-backed securities; 

obligationa of deposit insurance agencies; and other miscellaneous assets. The total portfolio is 

defined as the tangible assets less the liquid asseta required for regulatory purposes. The capital 

rules before July 1,1991, are different from those presented in the text. 

27. Specifically, they muat hold etock in exceee of 5 percent of total advances divided by the fraction of 

mortgage and related asseta in their portfolio. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 228 

value of outstanding consolidated obligations. At the end of 1990, the 

system exceeded these minimum standards, with the aggregate level of 

capital relative to consolidated obligations at 9.8 percent. 

Figure 12. 

Stock Requirements on FHLB Advances for 

Members of the Federal Home Loan Bank System 

Stock Requirement (Percent) 

- 

- 

- 

Non-QTL Members 

- 

QTL Members 

- J 

Share of Home Mortgages in Portfolio (Percent) 

SOURCE: Congressional Budget Office calculations based on information from the Federal Housing 

Finance Board and from the Financial Institutions Reform, Recovery, and Enforcement Act 
230 GOVERNMENT-BPONBORED ENTERPRISES April 1991 

Effects of the Capital Standards on Competition 

in Housing Finance Markets 

The capital standards for the FHLB system and the thrift industry, 

along with other factors, have put savings institutions at a competitive 

disadvantage vis-a-vis Fannie Mae and Freddie Mac in financing conventional mortgages, particularly fmed-rate loans. Unless these and 

other rules are changed, current trends suggest that in the long run 

most conventional loans will be securitized by Fannie Mae and Freddie 

Mac, and these two GSEs are likely to dominate the market for loans 

that they are eligible to purchase. 

Over the past decade, savings institutions have been shifting away 

from holding conventional whole mortgages in their portfolios. The 

share of outstanding residential mortgage debt financed by the thrift 

industry fell from 46 percent in 1981 to 26 percent in mid-1990 (see 

Table 14 in Chapter IV). In contrast, the share of mortgage debt financed by MBSs issued by Fannie Mae and Freddie Mac rose from 7 

percent to 24 percent over the same period. Savings institutions have 

not dropped out of the mortgage market, however. Instead, they have 

boosted their holdings of mortgage-backed securities. 

Not all mortgage products can be securitized and sold on national 

capital markets, however, and thrifts (and other lenders) will continue 

to play an important role in originating and holding these mortgages. 

For example, Fannie Mae and Freddie Mac are not permitted to purchase conventional mortgages whose value exceeds certain limits, and 

they will not purchase mortgages that do not meet their underwriting 

guidelines.28 Although private conduits are beginning to play a larger 

role in securitizing loans that Fannie Mae and Freddie Mac cannot 

buy, there will continue to be a niche for lenders who originate and 

hold these specialized whole-mortgage products. 

These developments have occurred in part because Fannie Mae 

and Freddie Mac can bear the credit risk of conventional mortgages 

28. In 1991, the purchaae limit is $191,250 for first mortgagee on single-family homee, except for 

mortgagee from Alaska, Hawaii, and Guam where these limits are 50 percent higher. Higher limits 

are also set for loam that finance multifamily dwellings, and a lower limit exists for second 

mortgages. 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 231 

more cheaply than can thrifts and other lenders. Four factors account 

for much of the cost advantage for these two GSEs. First, unlike many 

thrifts, Fannie Mae and Freddie Mac have achieved a broad geographic 

diversification of their portfolios, which reduces their exposure to 

credit risk and lowers their costs. Second, Fannie Mae and Freddie 

Mac have very large operations and, as a result, have achieved economies of scale that many thrifts, because they are smaller, do not have. 

Third, the capital standards for the FHLB system are much higher 

than those for Fannie Mae and Freddie Mac. This disparity allows 

Fannie Mae and Freddie Mac to outbid the thrifts (which rely in part 

on FHLB advances as a source of funds) in the purchase of conventional mortgage loans and still pay their shareholders an attractive 

return. Fourth, federal capital standards for the thrifts and other 

lenders create incentives for them to hold MBSs rather than whole 

mortgages. These standards require lenders to have capital levels 

equal to at least 4 percent of whole-mortgage holdings, but only 1.6 

percent of MBS holdings. 

These competitive advantages may allow Fannie Mae and Freddie 

Mac to capture the market for financing most conforming loans and 

nearly all conforming fixed-rate loans. Such a possibility raises concerns that these two GSEs could at some point exercise their market 

power and capture for their shareholders some of the implicit subsidy 

of their agency status, instead of passing it along to borrowers in the 

form of lower interest rates.29 

FEDERAL REGULATION AND SUPERVISION 

Along with capital, federal regulation and supervision play an important role in limiting the risk taking of a GSE. In the case of the 

29. Although euch market power would allow these two GSEe to capture some of their implicit subeidy, 

it is unlikely that they would use their market power to set interest rates on conventional 

mortgages at monopolistic levels. if they did, thrifta and other lenders would be induced to enter 

that market, driving interest rates down to levels reflecting their costa, plus an adjustment for 

normal profib. But because thrifts do not receive as large a subsidy as do Fannie Mae and Freddie 

Mac, thrifts would not be able to prevent these two GSEs from capturing some of the subsidy. For a more detailed description of this process, see William Baumol. John Panzar. and Robert Willig, 

Contestable Markets and the Theory of Market Structure (New York: Harmurt Brace Jovanovich, 

Inc., 1982). 
232 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

FHLBs, the regulator has more than sufficient authority to prevent the 

system from suffering significant losses. 

Throughout most of its history, the FHLB system was regulated by 

the Federal Home Loan Bank Board (FHLBB), the same agency responsible for regulating the thrift industry. In 1989, however, 

FIRREA abolished the FHLBB and created a new agency, the Federal 

Housing Finance Board, to take over the regulation and supervision of 

the FHLB system. FIRREA provided the FHFB with the explicit authority to accomplish four objectives: supervise the banks, ensure that 

the banks carry out their mission of housing finance, ensure that the 

banks remainadequately capitalized and are able to raise funds in the 

capital markets, and ensure that the banks operate in a safe and sound 

manner. In addition, FIRREA requires that the FHLB system provide 

funds to REFCORP and the Affordable Housing Program, implying 

that a fifth objective of the FHFB is to ensure that the system has sufficient net income to cover these payments. 

Statutory Authority of the Regulator 

The FHFB has been given broad powers--much broader than those provided to the regulators of the other GSEs and arguably more encompassing than necessary to ensure the safety and soundness of the 

FHLB system. The FHFB has the authority to determine the compensation of the board members of each FHLB, to suspend or remove any 

of those board members (as well as any other bank employee), and to 

liquidate or reorganize a bank if necessary. The FHFB has the final 

word on each bank's budget, quarterly dividend payments, and applications for new members. Although the FHFB lacks the explicit authority to issue banklike cease and desist orders, it can obtain injunctions from the courts to stop unsafe practices. These powers give the 

FHFB more than sufficient authority to achieve its objectives. 

At present, the FHFB is exercising these broad powers quite 

fully--and in a few instances may be more involved than necessary in 

the management of the individual FHLBs. Although such extensive 

involvement does not present a significant risk to the taxpayer and 

clearly remains within the FHFB's legal authority, it can slow deci- 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM aS3 

sionmaking within the system. For example, the FHFB recently rescinded an earlier rule that gave the regional FHLBs flexibility to exceed their budgets by as much as 10 percent. The rescission effectively 

prevents the banks from spending even one dollar more than budgeted 

without prior approval from the FHFB. As another example, the 

FHFB recently ruled that the regional banks need its approval before 

making capital expenditures of more than $10,000 for banking services 

(such as check processing). This limit prevents the banks from purchasing fairly small items, such as high-powered personal computers 

for banking services, without the consent of the regulator. The FHFB 

justifies this limit on the grounds that it is currently reviewing 

whether these banking services contribute to the FHLBs' mission of 

housing finance. Pending the outcome of this review, the FHFB wants 

to control the banks' capital investments in this area. 

Start-Up Problems of the Regulator 

In its first full year of operation, the FHFB experienced some difficulties in accomplishing its goals, but none of these problems seriously 

threatened the safety and soundness of the system. In fact, many of 

them were inevitable, reflecting the problems of trying to develop a 

new regulatory agency. Moreover, the FHFB has already taken action 

to correct some of these problems. 

The FHFB faced three types of difficulties during the first year. 

First, the FHFB inherited from the previous regulator an inadequate 

system of information management and control. For example, the 

Federal Home Loan Bank Board allowed each bank to develop its own 

methods of tracking collateral. As a result, these methods are currently not comparable across the banks, making it impossible to present a simple table on the amount of collateral that does not meet the 

eligibility guidelines set in FIRREA. In other areas, the FHFB does 

not have timely data on the amount of capital that each member has 

invested in the FHLB system, and during 1990 the FHFB did not have 

historical data on each bank's balance sheet and income statements in 

an electronic form that could be used for financial analysis. Since the 

beginning of 1991, however, the FHFB has addressed this problem and 

developed a computerized data base for financial management. 
!&4 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Second, the FHFB has been slow in conducting on-site examinations of the banks, largely because it has taken time to recruit competent staff. The FHFB had only one on-site examiner to inspect all 12 

banks throughout most of 1990, and conducted no on-site examinations 

during that year. The FHFB, however, had a staff of 20 analysts to 

conduct off-site monitoring of the FHLBs during 1990. Moreover, the 

FHFB recently hired two additional on-site examiners and has budgeted funds for hiring an additional six examiners by year-end. A 

schedule for on-site examinations of the banks has been set for 1991, 

and the first one was conducted on March 15. 

Third, there have been delays in approving both budgets and membership applications. The 1991 budgets for the regional banks were 

not approved by the FHFB until three weeks into the beginning of the 

new year, and during 1990 the application process set up by the FHFB 

for new members was complex, slow, and redundant. Although some 

regional banks successfully recruited new members, the FHFB took 

months to approve these applications. The delay in approving budgets 

resulted because the directors for the FHFB were not appointed until 

the middle of December 1990 and needed time to review these budgets. 

The delay in approving new members, however, was probably unnecessary, because all new members must meet the collateral and underwriting standards for advances, which play the primary role in limiting risk. In January 1991, the FHFB directors streamlined the membership process to reduce these delays, but it is too early to evaluate 

the effects of this new policy. 

POLICY OPTIONS FOR THE FEDERAL 

HOME LOAN BANK SYSTEM 

Policymakers are faced with three choices that will affect the future of 

the FHLB system. First, they must decide whether the system continues to serve public policy objectives effectively. Financial markets 

have evolved considerably since 1932 when the FHLB system was 

created, and these private markets (in concert with other government 

agencies) can now provide all of the services once provided only by the 

FHLBs. These private-market alternatives, however, may cost more. 

Thus policymakers should decide whether the services offered by the 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 236 

FHLBs have sufficient social benefits to justify retaining the FHLB 

system. If the services provided by the system are not viewed as having a special social value, most economists would agree that the system 

deserves no special subsidies and should be phased out. 

Second, if policymakers decide that the FHLB system should be 

retained, they may wish to consider options to help offset the projected 

shrinkage of the system. In particular, some of the provisions of 

FIRREA have created destabilizing dynamics that impede the recruitment of new members into the system and thus contribute to its 

shrinkage. Simple legislative changes can eliminate these problems. 

Third, policymakers may wish to rethink the role of the FHLB 

system in the context of the other two housing GSEs--Fannie Mae and 

Freddie Mac. The capital rules for the FHLB system are much tougher 

than those imposed on Fannie Mae and Freddie Mac. Making the 

capital standards more reflective of the risks posed by each of the housing GSEs would improve the viability of the FHLB system and would 

be a step toward creating a more level playing field in the nation's 

housing finance system. 

Is the FHLB System Still Needed? 

Economists generally agree that government intervention in the 

private economy is justified if private markets fail to provide the 

optimal allocation of resources to different sectors. The FHLB system 

was originally created in 1932 to deal with such a failure in the market 

for housing finance. Before the inception of the FHLB system, home 

mortgages in each community were financed almost exclusively with 

the savings deposits of that community. But such a system of housing 

finance was vulnerable to fluctuations in local economic conditions. 

The FHLB system helped to overcome this problem by creating a link 

between national capital markets and local housing markets. In doing 

so, the FHLB system stabilized funds to the housing markets, reduced 

the riskiness of housing investment, and lowered the costs of homeownership. 
236 COVERNMENT-SPONSORED ENTERPRISES April 1991 

But private financial markets have evolved since the 1930s and 

can now provide many of the services once provided only by the FHLB 

system. In addition, thrifts now have access to the discount window at 

the Federal Reserve for emergency funds, and other governmental 

agencies can (or could be designed to) fulfill the system's role in financing the resolution of the thrift crisis and programs for affordable 

housing. Thus the FHLB system no longer plays an essential role in 

overcoming imperfections in the housing finance system. As a result, 

analysts who believe that the government should intervene in the 

economy only if the private market cannot provide a comparable service would support phasing out the FHLB system. Not all analysts, 

however, share this view of the government's role in the economy. 

Policymakers therefore must decide whether the free market today 

could provide sufficient resources to the housing sector. If they believe 

it could not, they must decide how large a subsidy this market should 

receive, who should get it, and how it should be administered. 

Addressing this issue fully is beyond the scope of this report on the 

risks posed by GSEs, but it is worth noting that if policymakers wish to 

subsidize the housing market, the FHLB system does not make a major 

contribution toward- this goal under current laws and regulations. Because the FHLBs are required to be highly capitalized, the all-in costs 

of FHLB advances are not much lower than those of some privately 

provided alternative funds. Such pricing may partly explain why 

about half of all thrifts have no outstanding advances from their regional FHLB. Furthermore, CBO is not aware of any evidence that 

these slightly subsidized prices on FHLB advances to savings institutions result in lower mortgage rates to borrowers. As a consequence, 

eliminating the current system would probably not have a major impact on the mortgage markets, although elimination would certainly 

raise the costs of funds to some thrifts and reduce their net income, and 

could diminish their activities in the mortgage markets. In addition, 

eliminating the system could adversely affect federal spending on programs for affordable housing, unless alternative programs (that could 

replace those administered by the FHLBs) were funded. 

Of course, if the FHLB system were redesigned and allowed to reduce its capital to the level of that of Fannie Mae and Freddie Mac, the 

interest rate on FHLB advances would fall significantly, with its 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 237 

spread over comparable Treasury securities dropping to one-half of its 

current level without affecting dividend yields. Such a change in 

capital standards would raise the size of the subsidy provided by the 

FHLB system and draw more of the economy's resources into the housing sector. But such a subsidy must be paid for by accepting a higher 

level of risk. Whether this is desirable is a value judgment that only 

policymakers can decide. 

If policymakers decide to eliminate the FHLB system, it should be 

accomplished gradually. A poorly designed and hasty shutdown of the 

system could lead to some temporary disruptions in financial and 

housing markets and could inadvertently cause talented managers and 

employees of the system to leave the system prematurely, raising risks 

to the federal government during the shutdown. A gradual phase-out 

with a well-defined timetable could help to mitigate both of these effects. 

Eliminating the Problems Created bv FIRREA 

Two provisions of FIRREA have reduced the viability of the FHLB 

system and impeded the recruitment of new members: the fured minimum payments for REFCORP and the AfTordable Housing Program, 

and the rules that define qualified thrift lenders. 

Changing the Fixed Minimum Payments. Changing the fixed payments of $300 million for REFCORP and $100 million for the Affordable Housing Program ,(AHP) to percentages of income could improve 

the viability of the FHLB system. These fixed payments currently 

represent a destabilizing influence on the system. As the system 

shrinks, these payments take an ever larger fraction of its net income, 

causing dividend yields to fall and discouraging new members from 

joining. Lower dividend yields also reduce the net income of insolvent 

thrifts, which adds to the costs of resolving them. Changing these payments to a percentage of net income would help to maintain dividend 

yields even if the FHLB system shrinks. Although such changes make 

the system more viable and more capable of generating higher incomes 

(and possibly higher payments for REFCORP and the AHP), growth is 

not guaranteed. If such growth fails to materialize, payments to the 
238 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

AHP would be lower and the taxpayer would pay a larger share of the 

bill for REFCORP. 

Changing the Rules for Qualified Thrift Lenders. The current membership rules generally require financial institutions that are not 

qualified thrift lenders to purchase significantly more FHLB stock in 

order to get FHLB advances. Such stock requirements reduce the attractiveness of membership for non-QTL institutions because of the 

perceived riskiness of this stock investment. Setting less stringent 

QTL rules could increase membership among these institutions--perhaps by quite a bit, since many potential members (especially commercial banks) are non-QTL institutions. 

In addition, non-QTL members face other restrictions that also 

limit the attractiveness of membership. Current statutes limit the 

advances made to non-QTL members by any bank to no more than 30 

percent of that bank's total outstanding advances. This restriction is 

likely to become a binding constraint in the near future for non-QTL 

members of the FHLB of Des Moines and possibly other districts as 

well. Raising the proportion of advances allowed to non-QTL members 

(or eliminating this restriction altogether) could help to offset the 

shrinkage of the system's membership and assets. 

Policymakers may also wish to consider eliminating the distinction between QTL and non-QTL institutions based on the strict percentage of the bank's assets invested in home mortgages. This percentage does not necessarily have a close relation to a bank's influence 

on housing and mortgage markets. For example, a large commercial 

bank may have less than 70 percent of its portfolio in home mortgages, 

but because it is so large, the dollar value of its mortgage holdings--and 

its influence on the housing markets--may be quite substantial. In the 

aggregate, commercial banks now hold almost as much mortgage debt 

as do thrifts, although fewer than 2 percent of the commercial banks 

pass the QTL test. 

Some savings and loan institutions, however, view the preferential 

treatment given to QTL members as one of the few surviving advantages of an S&L charter and oppose allowing non-QTL members 

(such as commercial banks) equal access to the FHLB system. But the 
CHAPTER V THE FEDERAL HOME LOAN BANK SYSTEM 239 

benefits of preferential access are not large, because the all-in costs of 

FHLB advances are not much lower than those of alternative sources 

of funds. Furthermore, improving the profitability of the FHLB system through expanded membership may provide benefits that offset 

the losses in the value of an S&L's charter. 

Creating a Level Playing Field for the Housing GSEs 

The FHLB system receives a much smaller implicit federal subsidy 

than do Fannie Mae and Freddie Mac, because the system is required 

to hold much larger amounts of capital against its assets than either of 

the other two GSEs. This differential subsidy is one factor, among 

many, that provides competitive advantages to Fannie Mae and 

Freddie Mac over wholly private lenders who rely on FHLB advances. 

Making the capital standards for the FHLBs comparable with those of 

Fa~ie Mae and Freddie Mac would eliminate this advantage. Such a 

change would enhance the competitive position of wholly private 

lenders, which may help to ensure continued competition in the market for conventional mortgages, reducing the chance that Fannie Mae 

and Freddie Mac could capture the implicit government subsidy for 

their shareholders instead of delivering it to mortgage borrowers. 

The outcome of such a competition between wholly private lenders 

and Fannie Mae and Freddie Mac, however, is by no means certain. As 

discussed earlier, real economic factors also account for the competitive 

strength of Fannie Mae and Freddie Mac. These two GSEs can finance 

mortages at relatively low costs, because their portfolios are geographically diversified, their operations are large enough to achieve 

substantial economies of scale, and their management teams are 

highly skilled. Although some wholly private lenders are exceptionally well run and have made extraordinary progress in reducing 

their costs, many other lenders have not had as much success. Moreover, the relative efficiency of financing mortgages through wholly private lenders rather than through MBSs is unknown at present. But 

making the levels of implicit federal subsidies comparable between 

these two financing methods would be a step toward letting the market--rather than governmental rules-decide which was more efficient 

in providing services. 
240 GOVERNMENT-SPONSORED ENTERPRISES April 1981 

Making the playing field truly level, however, involves more than 

simply adjusting the capital standards. The tax rules on the different 

players in this market would have to be harmonized. In particular, the 

explicit corporate tax rates on Fannie Mae and Freddie Mac would 

have to be made comparable with the implicit tax rates on the FHLB 

system (resulting from the payments to REFCORP and the Affordable 

Housing Program). In addition, the myriad of other regulations affecting these GSEs and wholly private lenders would also have to be 

harmonized, although accomplishing such a task would be difficult. 

Comparability across the housing GSEs could be achieved by requiring all three to obtain a high rating from a private rating agency 

without any implicit guarantee from the federal government, or to 

survive the same stress tests for credit and interest rate risk and maintain comparable capital to protect against management and operations 

risks. Comparability could involve lowering the capital requirement of 

the FHLB system, or raising the requirements for Fannie Mae and 

Freddie Mac, or both. If the capital rules for the FHLBs are eased, the 

banks would be able to pay higher dividend yields or provide lower advance rates, which could attract new members and improve the system's viability. But such easing would involve a trade-off of higher 

risks, and the degree of risk (and the implicit subsidy) depends in part 

on the level of the capital standard selected. 

Policymakers may also wish to level the playing field further by 

allowing the FHLBs to issue MBSs, like Fannie Mae and Freddie Mac. 

Giving the FHLBs authority to issue MBSs, however, could lead to 

higher risks. To control these additional risks, it may be desirable to 

consolidate the district banks into one bank. Consolidated management of the system would make it easier for the banks to establish and 

maintain uniform standards that participating lenders would have to 

meet in order to sell mortgages to the system. In addition, consolidation would allow the system to react quickly and decisively to problems 

as they emerged and to modify these standards as needed. 
CHAPTER VI 

STUDENT LOAN MARKETING ASSOCIATION 

The Student Loan Marketing Association (Sallie Mae) is a privately 

owned, federally chartered financial intermediary that has achieved 

its public purposes of providing financing and liquidity to the student 

loan market by issuing debt in the capital markets and providing funds 

to lenders who deal directly with students. The risk to the government 

and taxpayers arises--as with all GSEs--from the implicit federal guarantee of Sallie Mae's debt securities and the possibility that the enterprise might not be able to meet all of its debt obligations without federal assistance. 

In the case of Sallie Mae, the consensus--including this report--is 

that the risk to the 'government is quite small, probably negligible, at 

present. But the implicit federal guarantee raises the policy issue of 

what action--if any--the federal government should take now to address the possibility that Sallie Mae might adopt a significantly more 

risky financial posture in the future. At least three federal strategies 

are available. The first is to sever the link between the federal government and Sallie Mae, thus terminating all federal responsibility for 

the debt of the enterprise. The second is to put in place an enhanced 

"early warning" system for detecting increases in risks the association 

assumes. The third is to give a federal agency statutory authority to 

limit Sallie Mae's ability to choose more risky lines of business and 

modes of operation. The first strategy is appealing if it increases competition in the education finance system, assures continued access by 

education to the capital markets, and achieves a genuine separation. 

If, however, the government wishes to maintain a close relationship 

with the dominant firm in this market, then adding an early warning 

or supervisory mechanism to an otherwise unchanged Sallie Mae could 

be prudent. If the third option is chosen, consideration could be given 

to establishing a streamlined supervisory process or permitting Sallie 

Mae to reach a "safe harbor" from federal regulation, provided that the 
242 GOVERNMENT-SPONSORED ENTERPRISES April 1981 

enterprise continues to adhere to the highest commercial standards of 

safety and soundness. 

This chapter examines Sallie Mae's role in financing higher education and the federal exposure to risk from the firm's operations. The 

government's risk is quite low because Sallie Mae's current exposure to 

risk is minimal.1 The chapter also examines several specific options 

for limiting the GSE's ability to increase the government's exposure to 

risk in the future. 

SALLIE MAE AND POSTSECONDARY EDUCATION FINANCE 

In 1972, the Congress established Sallie Mae as a shareholder-owned 

corporation to provide funding to institutions that make loans to students enrolled in postsecondary schooling. Its creation was one of several related Congressional initiatives to assure financing of student 

loans by the private sector. 

Students as Credit Risks 

From the perspective of a commercial lender, a college student is often 

an unattractive credit risk. As potential borrowers, students rarely 

have an established credit record or sizable assets. Instead, they tend 

to have little income, uncertain earnings prospects, "unconventional" 

living arrangements, and a tendency to move frequently from one residence to another. At best, such a candidate for a bank loan would be 

regarded as a credit prospect whose loan would be more costly to service than a loan to a high-quality borrower. 

Part of the motivation for federal intervention in the market for 

student loans stems from an appreciation of these barriers to commercial lending for postsecondary education and the fear that, left unaddressed, too little spending for postsecondary study would occur. 

Further, the federal government's broader geographic presence and its 

ability to tax a student's future earnings gives the government some 

1. CBO has asseaeed Sallie Mae's exposure to risk on the bmie of publicly available data. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 243 

advantages over local commercial lenders in managing the credit risk 

students pose. At the same time, the federal government is inexperienced in processing and managing the large body of information required to originate, monitor, and service millions of relatively small 

loans to individuals. Consequently, federal policy toward student 

loans is aimed at reducing credit risk to the lender and thereby lowering rates to students, raising gross returns to lenders to compensate for 

the high servicing costs of student loans, and capitalizing on private 

experience with loan servicing. 

Current Structure of the Student Loan System 

Today, under the Higher Education Act of 1965, as amended, the federal guaranteed student loan (GSL) programs provide low-interest 

loans to students (and parents of students) attending participating 

universities, colleges, and trade schools. Commercial lenders, or in 

some cases state agencies and schools, originate these loans, which are 

guaranteed by state or nonprofit guarantee agencies and then reinsured by the federal government (see Box 10). The GSL programs assure lenders of a gross rate of return above the Treasury bill rate and 

guarantee agaipst default losses. Before Sallie Mae was created, however, lenders were sometimes reluctant to participate in these programs because the loans were illiquid (hard to turn into cash) and 

long-term and because the costs of servicing the loans increase when 

the student leaves school. 

Sallie Mae complements the GSL programs, therefore, by providing originators with an optionto sell student loans and--thereby-- 

accomplish the dual objectives of converting the loan back into cash 

and transferring the servicing costs to the GSE. Sallie Mae also constitutes a source of funds that originators may tap to make and hold 

student loans. Through its public policy purposes of creating a resale or 

secondary market for GSLs and providing debt financing for lenders, 

Sallie Mae has increased the supply of privately originated student 

loans. 
244 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

BOX 10 

The Guaranteed Student Loan Program 

The term guaranteed student loans now refers to four distinct types of loans: Stafford 

Loans, Parent Loans to Undergraduate Students (PLUS), Supplemental Loans to 

Studenta (SLS), and Consolidation Loans. There are also other federal student loan 

programs. 

Stafford Loans. In July 1988, the original Guaranteed Student Loan (GSL) program 

was renamed the Stafford Loan program. Under this need-based program, borrowers 

pay below-market rates of interest that are stipulated by law. For example, borrowers currently are charged 8 percent for the first four years of repayment and 10 

percent for the remainder of the term. To provide an attractive rate of return to the 

lender, the federal government pays a quarterly "special allowance" in addition to 

the rate paid by the borrower. This allowance is calculated quarterly by (1) determining the average rate on the 91day Treasury bills auctioned during the quarter, 

(2) adding 3.25 percent, (3) subtracting the interest rate paid by the borrower, and (4) 

dividing by four. In addition to paying a special allowance, the federal government 

subsidizes these loans by paying all of the interest on the loan while the student is 

enrolled as a full- or part-time student and for a grace period, usually defined as the 

six months after the student leaves school. 

PLUS and SLS Loans. Both the PLUS and SLS programs provide supplemental 

loans for postsecondary education. PLUS loans provide additional funds to parents of 

dependent children, while SLS loans provide funds to independent undergraduate, 

graduate, and professional students. Borrowers pay a variable interest rate, capped 

at 12 percent, based on the 52-week Treasury bill rate. This rate, which changes annually, is set at 11.49 percent until June 30, 1991. The federal government may or 

may not pay a special allowance. If the bond equivalent rate on the most recent 52- 

week Treasury bill auction held before June 1 plus 3.25 percent is greater than 12 

percent, then the government pays a special allowance. If this interest rate calculation is less than 12 percent, no special allowance is paid. The special allowance is 

calculated using the same formula used for Stafford loans. Unlike the Stafford Loan 

program, under PLUS and SLS the borrower commences payment immediately upon 

disbursement. 

Consolidation Loans. The Higher Education Amendments of 1986 authorized lenders to consolidate loans administered under the various guaranteed student loan programs. The interest rate paid by borrowers is the greater of 9 percent or the weighted 

average of the constituent loans. The special allowance for Consolidation Loans is 

calculated using the same formula applied to Stafford loans. 

Other Student Loan Programs. The credit market for student loans is not limited to 

the GSL programs. Guaranteed loans for graduate students in the health professions 

are available through the Health Education Assistance Loan (HEAL) program. The 

interest rate paid by the borrower under this program is determined quarterly, based 

on the average of the bond equivalent rates on 91-day Treasury bills auctioned the 

previous quarter, plus 3.0 percent. No subsidy in the form of a special allowance 

exists for these loans and interest accrues from the time of disbursement. However, 

repayment of the loan does not commence until the end of a grace period subsequent 

to completing full-time training. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 245 

Organizational Structure and Ownership 

A 21-member board of directors governs Sallie Mae: 7 appointed by the 

President of the United Sates, 7 elected by educational institutions 

holding voting common stock, and 7 elected by financial institutions 

holding voting common stock. The President designates the chairman 

of the board from among the 21 members. No officers or employees of 

Sallie Mae serve on the board. 

Ownership of Sallie Mae is vested in the holders of its voting and 

nonvoting common stock and preferred stock. Ownership of voting 

stock is held exclusively by educational and financial institutions eligible to participate in the GSL programs. As of December 31, 1990, 

Sallie Mae had outstanding, 4.3 million shares of preferred stock, 11.9 

million shares of common voting stock, and 82.1 million shares of nonvoting common stock. The market value as of December 31, 1990, was 

$3.8 billion. 

Although Sallie Mae is exempt from all state, local, and District of 

Columbia taxes, except for real property taxes, it is subject to federal 

income taxes. Interest on the debt obligations of Sallie Mae are also 

subject to federal income taxes, but are exempt from taxation by state, 

municipal, or local political subdivisions, subject to certain limitations. 

Financing and Operating Services 

Sallie Mae provides funds and loan liquidity to lenders of student loans 

through two distinct forms: the Warehousing Advance Program and 

Loan Purchase Program. Through the Warehousing Advance Program, Sallie Mae lends money to financial and educational institutions 

and to state agencies to enable the borrower to make or hold student 

loans and other education-related loans. Warehousing loans are fully 

secured by borrowers' pledges of federally insured assets, such as GSLs 

or Treasury or agency debt. Interest rates on these loans may be either 

fixed or variable: those bearing variable rates of interest vary with 

either the 91-day Treasury bill rate or the London Interbank Offer 

Rate (LIBOR). Under the Loan Purchase Program, Sallie Mae buys 

student loans from originators. Many lenders prefer to originate and 
246 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

hold loans when the student is in school and the loan is inexpensive to 

service (because no payments have to be collected from students) and to 

sell loans just before the student leaves school when servicing becomes 

more complex and expensive. Some lenders, however, find it advantageous to sell loans while the student is in school or after the loan is in 

repayment. 

Together, warehousing advances and loan purchases provide lenders with financing throughout the life cycle of the GSL. Sallie Mae's 

holdings of warehousing advances and student loans, as of December 

31, 1990, were $9.5 billion and $19.2 billion, respectively. These two 

categories of loans constitute 70 percent of Sallie Mae's total assets. 

Most remaining assets are in cash and short-term investments. As 

indicated in the note to Table 25, the principal short-term investment 

of the association is federal funds sold, or very short-term (usually one 

to three days) loans to highly rated commercial banks. Sallie Mae favors this investment for its high liquidity and yield. Other investments include U.S. Treasury securities and student loan revenue 

bonds. Some of these investments are held to hedge some of Sallie 

Mae's financing activities. 

In addition to purchasing loans and making warehousing advances, Sallie Mae has the authority (provided by the 1986 amendments to the Higher Education Act) to buy, sell, insure, or underwrite 

obligations made to finance plant and equipment for institutions of 

higher education. Sallie Mae now offers secured financing to educational institutions for academic facilities. Sallie Mae also holds 75 percent of the outstanding voting common stock of the College Construction Loan Insurance Association (Connie Lee), a mixed-ownership, 

for-profit corporation chartered by the Congress in 1986 to insure and 

reinsure educational facilities obligations. In addition to purchasing 

$52.9 million in Connie Lee stock, Sallie Mae has agreed to purchase 

an additional $25.0 million to finance Connie Lee's reinsurance operations if these funds are needed. The commitment expires December 

31, 1997, or when Connie Lee begins its direct insurance activities. 

Sallie Mae has also provided management services to Connie Lee and 

appoints three of the eleven directors to the board. Sallie Mae is not 

liable for the debts and obligations of Connie Lee. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION a47 

TABLE 25. CONSOLIDATED SALLIE MAE BALANCE SHEETS AND 

INCOME STATEMENTS, 1981-1990 (In millions of dollars) 

Balance Sheet 

Assets 

Student Loam 

Purchased 2.072 3.222 4.581 5,573 6.799 8,176 10.043 13.202 16.029 19,242 

Warehousing 

Advances 2.755 3.191 3,285 4,230 5,481 6.527 8,357 7.989 8,601 9,528 

All Other htaa 345 t.094 L252 1,817 2.171 3.530 4.463 7,437 10.858 12.354 

Total 5,171 7.507 9,119 11,620 14.450 18,232 22.864 28,628 35,488 41,124 

Liabilities 

Short-term 

Borrowings 419 1,343 352 2,437 3,000 4,517 6,571 9,820 14,965 14,801 

All Other 

Liabilities 

Total 8,616 11.044 13.775 17.577 22.179 27.827 34.451 

Stockholders' Equity 

Common Stock 

Nonvoting 

Voting 

Referred Stmk 

Additional Paid-in 

Capital 

Retained Earninga 

Lees Treasury 

Stoek 

Total 

Capital R&8 (Percent) 

Equitylhaeta 

(Percent) 1.31 1.38 5.51 4.96 4.68 3.59 2.99 2.80 2.92 2.66 

Income Statement 

146 194 235 262 313 373 418 479 

Net Miseellaneoua 

Income 1 2 

Pretax Income 33 69 

Provieion for 

Federal Income 

Taxes 15 31 

Net Income 

(ha) 18 38 -~ 

SOURCE: Congreeaional Budget Ofiice using data from Sallie Mae. 

NOTE: ma. = not applicable. a. Includee cash. federal funds eold, Treasury securitiea, and ntudent loan revenue and facilities bonde. 

On December 31, 1990, federal funds--short-term loane to commercial banha--accounted for $7 billion, or more than 55 percent of "all other aseeta." Other inventmenta and cmh totaled $4.2 billion. 
248 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Guarantee agencies, lenders, and schools also use Sallie Mae's 

management systems and operational support services. In 1987, Sallie 

Mae began offering--for a fee--new and upgraded computerized management systems and operational support to lenders to improve the 

processing of student loans. To improve communications between 

guarantee agencies and lenders and reduce the process time for loan 

guarantees, Sallie Mae also offers an electronic communication system 

that provides guarantors with the ability to receive, process, and return loan guarantees to lenders in 24 hours. 

The management and operational support that Sallie Mae offers to 

its clients benefits not only lenders but also Sallie Mae itself. The lender relies on these services to increase the efficiency of loan servicing 

operations, thereby reducing costs and increasing returns. In addition, 

the GSE's systems assure that the lender's servicing procedures are in 

compliance with federal regulations and with Sallie Mae's operating 

requirements. For Sallie Mae, use of these operating systems by the 

lender increases growth in its own assets and earnings. By offering its 

operational support services in conjunction with commitments to forward purchase (guarantees to purchase loans held by the lender) Sallie 

Mae not only assures the lender of a future market for student loans, 

but also generates future asset growth for itself. In 1989, almost 25 

percent of Sallie Mae's purchase volume came from commitments to 

forward purchase with clients using Sallie Mae's operational support 

products and services. 

Sallie Mae's Funding Sources 

The way in which Sallie Mae obtains its funds has gone through almost 

a complete cycle since its inception. Originally, Sallie Mae secured its 

operating funds by borrowing from private sources. Sallie Mae also 

sold debt instruments with an explicit federal guarantee until June 

1974, at which time Sallie Mae was required to begin obtaining funds 

primarily by issuing guaranteed debt obligations to the Federal 

Financing Bank (FFB). The Department of Education issued these 

obligations with the approval of the Treasury Department. In January 

1982, after signing an agreement with the Treasury Department, 

Sallie Mae began borrowing exclusively in the private market without 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 249 

the use of an explicit federal guarantee. As of December 31, 1990, 

Sallie Mae's liabilities totaled $40.0 billion. This amount includes 

$14.8 billion in short-term borrowings, $24.2 billion in long-term 

notes, and $1.0 billion in other liabilities, principally accrued interest 

payable. 

Secondary Market Structure and Competition 

The secondary market now has numerous competitors for student 

loans. These include large commercial banks as well as state and private nonprofit agencies. Some of these institutions, such as the New 

England Education Loan Marketing Corporation and the Nebraska 

Higher Education Loan Program, deal exclusively with loan purchases, while other institutions both originate and purchase loans. 

Sallie Mae not only holds the largest share of all guaranteed student 

loans, but its share is much greater than that of any of its competitors; 

while Sallie Mae held 27 percent of all guaranteed loans outstanding 

as of September 30,1989, Citibank, possessing the second largest guaranteed student loan portfolio, held only 4 percent. 

Sallie Mae's dominance of the market stems largely from cost factors. Its management has aggressively controlled costs through such 

means as product specialization and economies of scale. In addition, 

the firm has been managed to the highest standards of commercial 

credit. Sallie Mae's internal financial strength, combined with the 

guarantee of its debt, has enabled the firm to borrow at near-Treasury 

interest rates. Through its advantages in operating economies and low 

funding costs, Sallie Mae is able to carry on its activities at a lower cost 

than its competitors. 

CREDIT RISK 

Sallie Mae's exposure to credit risk is small because most of its assets 

are either guaranteed by the federal government or fully collateralized 

by federally guaranteed claims. Unless a GSL has not been properly 

serviced, Sallie Mae has a direct claim for 100 percent of principal to 

the guarantee agencies and an indirect claim to the federal govern- 
250 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

ment. In the case of the Health Education Assistance Loan, Sallie Mae 

has a direct claim to the government. However, Sallie Mae could experience losses as a result of the insolvency of a guarantee agency, 

default on an insufficiently collateralized warehousing advance, or the 

bankruptcy of a firm with which Sallie Mae has financial agreements2 

Risk from Guarantee Agencies 

Agencies that guarantee GSLs receive 100 percent reinsurance from 

the federal government so long as their annual default rates are less 

than 5 percent of their total guarantees. Agencies with default rates 

greater than 5 percent must pay from their own resources the difference between the insured amount due to the holder of the defaulted 

GSL and the amount recovered from the federal government (at least 

10 percent of the amount due). These costs may eventually deplete the 

reserves of the guarantee agency and force the agency into default on 

its guarantee commitments. 

One example of this risk involved the Higher Education Assistance Foundation (HEAF) case (see Box 11). In that instance, although 

the U.S. government had no legal obligation to do so, all GSL holders 

were fully protected from loss. If that case indicates current federal 

policy toward the liabilities of the guarantee agencies, then Sallie 

Mae's exposure to credit risk from this quarter is very small. 

Risk from Warehousing Loans 

Lending, or warehousing advances, are also subject to default losses, if 

the loans are not sufficiently collateralized. Sallie Mae is aware of this 

risk and has policies in place to require 100 percent (or more) of highquality collateral to secure these advances. To date, Sallie Mae has not 

incurred any losses from defaults on warehousing advances. 

2. In addition to ita intsreet rate exchange agreement8 (diecuseed in the next eection), Sallie Mae has 

entered into currency exchange agreements to hedge the foreign exchange risk inherent in iesues of 

Sallie Mae debt that are either denominated in foreign currencies or indexed to foreign currencies. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 261 

BOX 11 

Federal Reimbursement of Guarantee Agencies: 

The HEAF Case 

Guarantee agencies receive income from several sources including insurance premiums, collections on defaulted loans (the agency retains 30 percent 

of the amount collected), investment income, administrative cost allowances, 

and federal advances. The primary source of funds, however, is reinsurance 

payments from the federal government, accounting for 62 percent of all 

guarantee agency income in 1989. The rules for receiving federal reinsurance payments are as follows: In a given fiscal year, reinsurance is 100 

percent of the loan amount until the agency has applied for default reimbursement on 5 percent of its total loan volume. At that point, the reimbursement rate drops to 90 percent of the loan amount. After 9 percent of the 

total loan portfolio has been presented for default claims, the reimbursement 

drops to 80 percent. This rule does not apply to new agencies, which receive 

100 percent reimbursement. Guarantees can be transferred from old agencies to new ones so that 100 percent reimbursement can be obtained. Obviously, the financial difficulties of firms experiencing high default rates will 

be compounded by reduced reimbursement under these rules. Such was the 

case for the Higher Education Assistance Foundation (HEAF). 

Until the summer of 1990, HEAF guaranteed one-third of all new student loans. Many, however, were loans with high default rates, disbursed to 

students at vocational and trade schools. An excessive number of defaults 

coupled with reduced reinsurance payments caused the agency to lose $11 

million in 1989 and face possible bankruptcy by July 1990. In order to avoid 

financial collapse, HEAF sought to merge with the Nebraska Student Loan 

Program. This merger would have allowed HEAF to transfer its delinquent 

loans to a newer agency, which under reinsurance rules was still receiving 

100 percent reimbursements on its loans. The Department of Education prohibited the merger, but assured lenders that the guarantees would be honored. Meanwhile, Sallie Mae lent HEAF $200 million on a fully collateralized basis to stay afloat until the new fiscal year began in October. At 

that time, HEAF would begin receiving 100 percent reimbursement until it 

reached the annual 5 percent default limit for full reimbursement. 

In the final resolution, the department chose to spread HEAF's portfolio 

among the other guarantee agencies. Three plans had been offered: transferring HEAF's loans to the United Student Aid Fund (USAF), the other 

national guarantee agency; making Sallie Mae a guarantor and transferring 

the loans there; or distributing the loans among the guarantee agencies. 

Under the department's resolution, the risks associated with the loans were 

spread among several state agencies. Sallie Mae did not become a guarantor, but is managing the distribution of these loans through its subsidiary, 

Minnesota Guarantor Servicing Inc. 
%a GOVERNMENT-SPONSORED ENTERPRISES April 1991 

Risk from Exchange Agreements 

To hedge against the adverse effects of changes in interest rates on 

income, Sallie Mae enters into interest rate exchange agreements under which it pays a floating interest rate in exchange for fixed interest 

rate payments (see detailed discussion in next section). If the party 

with which Sallie Mae exchanges interest payments defaults on its 

promise, Sallie Mae is subject to losses equal to the cost of replacing the 

agreement. Sallie Mae has employed various means of minimizing this 

risk, such as carefully screening and monitoring the credit quality of 

those with whom it enters such agreements. Sallie Mae has suffered 

only one loss of modest size ($300,000) on such a default. 

INTEREST RATE RISK 

In managing its funding activities, Sallie Mae has sought to minimize 

its exposure to interest rate risk. Interest rate risk occurs when the 

margin between interest income and interest expense is affected by 

changes in the level of interest rates. Interest income on most of Sallie 

Mae's assets tends to move with the open-market interest rates on 

Treasury securities to which they are indexed. For example, the rate of 

interest received by Sallie Mae on a Stafford loan is 3.25 percent above 

the average Treasury bill rate, adjusted every three months for 

changes in the average 91-day Treasury bill rate. 

If Sallie Mae were to finance its variable-rate loans with fixed-rate 

debt, however, a fall in interest rates would reduce interest income but 

leave interest expense unchanged. In that case, Sallie Mae would 

suffer losses. To avoid this risk, Sallie Mae has matched the interest 

sensitivity of its debt with the interest sensitivity of its assets. On 

occasion, however, the GSE believes that it can minimize its long-term 

interest costs (and maximize its net interest income) by issuing fixedrate debt. To avoid the risk inherent in this mismatch between assets 

and liabilities, Sallie Mae uses interest rate exchange contracts, or '1 swaps." Under these agreements, Sallie Mae pays a variable interest 

rate stream in exchange for a flow of payments sufficient to meet its 

fixed-rate obligations. With such a hedge in place, Sallie Mae's 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 253 

interest expense varies with its interest income, and a positive income 

spread is assured. 

An analysis of Sallie Mae's asseuiability maturity gap indicates 

why its interest rate risk is small. Table 26 shows the dollar volume of 

the GSEYs assets and liabilities with (swap-adjusted) maturities of 

three months or less, three to six months, and so on. If the maturity of 

every dollar of assets was matched exactly with a dollar of liabilities 

having the same maturity, the portfolio would be perfectly matched 

and the firm would have zero interest rate risk. As shown in Table 26, 

the asseffliability maturity gaps are a very small percentage of total 

assets. 

TABLE 26. SALLIE MAE MATURITY GAP ANALYSIS 

(In millions of dollars, year-end 1990) 

Liabilities Gap as a Percentage 

Maturity Assets and Equity Gap of Total Assets 

3 months 

or less 35,147 35,365 -218 0.53 

3 months 

to 6 months 2,272 2,194 78 0.19 

6 months 

to 1 year 72 151 -79 0.19 

1 to 2 

years 607 496 111 0.27 

2 to 5 

years 1,265 884 381 0.93 

Over 5 years 1,761 2,034 -273 - 0.66 

Total 41,124 41,124 0 

SOURCE: Congreseional Budget Ofice ueing data Born Sallie Mae Information Statement, February 

12.1991. 
264 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

EARNINGS HISTORY 

The conclusions reached in the preceding pages about the low level of 

risk in the Sallie Mae portfolio are consistent with the observed stability of the firm's earnings. Since Sallie Mae began operating, it has 

consistently earned profits. Neither recession, nor sharp swings in 

interest rates, nor declines in real estate and commodity prices have 

had much effect on its earnings. The stability of earnings per dollar of 

assets, as shown in Figure 13, means that the principal determinant of 

Sallie Mae's earnings has been the book value of assets held by the 

firm. The major significance of this is that Sallie Mae's earnings have 

Figure 13. 

Pretax Income for Sallie Mae as a 

Percentage of Average Total Assets 

Percent 

1- 1982 1 984 1986 1 988 1990 

SOURCE: Congressional Budget Office using data from Sallie Mae. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 266 

not been heavily influenced by events external to the firm--market 

interest rates or recessions, for example. 

Much of the 1983-1984 increase in Sallie Mae's pretax income per 

dollar of assets and subsequent 1986-1990 decrease evident in Figure 

16 can be explained by the behavior of equity capital shown in Figure 14. In 1983, as Sallie Mae began to borrow in the credit markets 

without an explicit federal guarantee, Sallie Mae's management increased its equity capital nearly five times (from $103 million to $503 

million). This increase was accomplished by an issue of preferred stock 

that produced a net inflow of $245 million, and an issue of nonvoting 

common stock that netted over $100 million. The increased use of 

Figure 14. 

Book Value of Sallie Mae's Capital as a 

Percentage of Average Total Assets 

Percent 

@1 

SOURCE: Congressional Budget Office using data from Sallie Mae. 
a86 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

equity funding of assets reduces interest expense and raises net income. Since 1986, Sallie Mae has been repurchasing its voting and 

nonvoting common stock on the open market. The effect of these stock 

buy-backs is to increase the proportion of Sallie Mae's assets that are 

financed by debt. These stock purchases, therefore, raise interest expense and reduce earnings per dollar of assets, but increase earnings 

per dollar of equity. Sallie Mae's stock repurchase plan is intended 

precisely to raise the rate of return on the book value for equity. 

The relatively low level of risk Sallie Mae assumes is also corroborated by a statistical analysis carried out by CBO that indicates that at 

least 97 percent of the variation in quarterly pretax reported income 

for Sallie Mae can be explained solely by the change in the book value 

of its assets held for the quarter. This is a high percentage compared 

with the proportion of income that can be explained by such means for 

other GSEs and fully private intermediaries. Such a statistical result 

can be obtained for Sallie Mae only because it is such a low-risk firm. 

The implication is that factors external to Sallie Mae have a much 

smaller effect on its income than they do for most other firms. The financial markets also appear to have recognized the low risk of Sallie 

Mae's earnings. Sallie Mae stock at year-end 1989 was priced such 

that pretax earnings as a percentage of the market value of equity was 

approximately the pretax rate of return on riskless Treasury bills. 

PROGRAM RISK 

Some observers believe that the greatest threat to Sallie Mae's financial viability comes from the government itself. Sallie Mae is currently attuned to and depends on existing federal policy toward postsecondary education. That policy, of course, could be changed. If, for 

example, the GSL program were to be dropped in favor of a direct federal loan program for students, the change could adversely affect the 

financial outlook for Sallie Mae. 

The existing stock of GSL contracts, however, assures Sallie Mae 

of opportunities to generate earnings for the next seven to ten years, 

even if the GSL program were to be terminated. During this transition, Sallie Mae would shrink in absolute size, but the firm's investors 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 267 

would not be exposed to loss from the downsizing of the firm. In fact, 

with a built-in transition period, Sallie Mae probably would be able to 

adapt its specialized financial knowledge and low-cost loan servicing 

operations sufficiently that it could continue to play a role in financing 

postsecondary education. For example, if the government establishes a 

federal direct loan program, Sallie Mae might be a successful bidder for 

loan servicing. If the federal direct loan program is targeted at low-income students, Sallie Mae might be able to develop a direct loan program for moderate- and higher-income students. 

CAPITALIZATION 

A firm's equity capital--or excess of asset value over liabilities--is its 

principal defense against unanticipated and uncontrollable losses that 

would otherwise destroy the firm's ability to meet its commitments to 

creditors and to continue as an ongoing entity. The extent to which a 

firm possesses equity capital, therefore, is a major factor in determining its safety and soundness from the point of view of creditors who are 

protected by the subordination of owners' claims to those of debt 

holders. From the federal government's point of view, equity capital is 

important because the implicit federal guarantee is widely understood 

not to include a guarantee of owners' claims. Accordingly, the greater 

the proportion of GSE assets that equity finances, the smaller the federal government's exposure to risk from GSE operations. The more 

risky the GSE, the greater the level of equity capital required to avoid 

an increase in federal risk. 

Determining the appropriate level of capital for a GSE is not easy, 

however. Higher levels of capital reduce the government's potential 

liability, but also reduce the after-tax rate of return on equity. Interest 

payments to creditors are deductible from income before the calculation of federal income taxes. Dividend payments to equity holders are 

not deductible, however. At the limit, capital requirements could be 

raised to 100 percent so that Sallie Mae would have to finance each 

dollar of GSLs acquired with equity capital and the federal government's exposure to risk would be zero. Such a funding structure, however, would increase significantly Sallie Mae's federal tax liability and 

reduce returns to investors. Lower levels of required capital increase 
268 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

the rate of return to investors, but simultaneously increase risk to the 

government. 

The federal government has allowed Sallie Mae to choose the 

appropriate capital level for the firm. Sallie Mae's book value of equity 

capital is now just below 3 percent of total assets. This capital ratio is 

less than half that of the low-risk Federal Home Loan Banks but 

greater than the corresponding ratio for any other GSE (when assets 

financed with mortgage-backed securities are included) except for the 

high-risk Farm Credit System. In its report on GSEs issued last May, 

the Treasury found that Sallie Mae's capitalization substantially exceeds the minimum risk-based capital requirements for insured commercial banks.3 In addition, the major credit rating agencies regard 

Sallie Mae as being of strong credit quality, independent of the implicit 

federal guarantee of its debt.4 

Financial stress tests, which are routinely used to assess the effect 

of adverse economic scenarios on firms, also indicate that Sallie Mae is 

adequately capitalized and would be able to maintain positive earnings 

through. economic conditions that would threaten the existence of 

many other financial intermediaries. In one stress test performed by 

the Office of Management and Budget in which it was assumed that 

Sallie Mae's performing assets drop by 1.2 percent and the special 

allowance drops by 100 basis points (to 225), Sallie Mae's net income 

remains positive throughout the scenario.5 Thus, Sallie Mae did not 

need to use any of its capital to weather this shock. 

3. Department of the Treasury, Report of the Secretary of the Treasury on Government Sponsored 

Enterprises (May 1990), p. F-38. 

4. For example, "Moody's rates the senior debt of the Studeht Loan Marketing Association (Sallie 

Mae) Aaa. This rating reflects Sallie Mae's impressive management and strong financial 

fundamentals." Moody's Bank Cmdit Report: Student Loan Marketing Association (October 1989), 

p. 1. CBO interprets this statement a~ indicating that Moody's would give Sallie Mae a triple-A 

rating even if it were not a ME. 

5. Office of Management and Budget. Budget of the United States Government, Fiscal Year 1992 

(February 1991), p. 237. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 259 

CURRENT FEDERAL OVERSIGHT OF SALLIE MAE 

Although no single federal agency has specific regulatory responsibility for Sallie Mae's safety and soundness, the GSE is subject to operating restrictions and oversight. The most important is probably 

periodic Congressional oversight. Congressional review of Sallie Mae's 

operations exercises an important influence on management, and on 

occasion leads to mandated restrictions, such as the statutory prohibition enacted in 1986 on the GSE's ownership of a bank, savings and 

loan, savings bank, or credit union. Sallie Mae is also required to report annually the results of an independent audit of its accounts to the 

Secretary of the Treasury. 

The Secretary of the Treasury also has statutory authority to examine all financial records of the association. The Secretary is required to report annually to the President and to the Congress on the 

financial condition of Sallie Mae including ". . . assets and liabilities, 

capital and surplus, or deficit; a statement of surplus or deficit analysis; a statement of income and expense; a statement of sources and 

applications of finds; and such comments and information as may be 

deemed necessary to keep the President and the Congress informed of 

the operations and financial condition of the Association, together with 

such recommendations with respect thereto as the Secretary may deem 

advisable . . . ." In the past, the Secretary has fulfilled this requirement by sending copies of Sallie Mae's annual reports to the Congress. 

OPTIONS FOR LIMITING FUTURE 

FEDERAL EXPOSURE TO RISK 

The Congress could limit the government's fiture exposure to risk 

from Sallie Mae's operations in a variety of ways. Options include 

achieving genuine privatization of the GSE, improving the financial 

"early warning" system by directing the Treasury Department to use 

its current authority to monitor the enterprise's activities more closely 

and to recommend Presidential action to forestall increases in risk, requiring greater use of private risk assessment of the GSE, or subjecting it to a new federal regulator created to supervise the safety and 

soundness of all GSEs. 
260 GOVERNMENT-SPONSORED ENTERPRISES April lWl 

Each of these strategies has some appeal, but little urgency,in the 

case of Sallie Mae. Over five years ago, CBO outlined the advantages 

of these approaches to controlling federal risk, including full privatization of Sallie Mae.6 Since then, the privatization option has been 

discussed in various policy forums, but no action has been taken.7 

Similarly, increased monitoring and regulation of Sallie Mae has been 

suggested by the U.S. General Accounting Office.8 

The lack of urgency in the case of Sallie Mae stems from the fact 

that the firm--without a safety and soundness regulator--has conducted its business in such a way as to have limited the federal exposure to risk to an insignificant level. Sallie Mae has carefully controlled its risks and maintained a level of capital that seems to have 

been appropriate. A well-informed and motivated regulator would 

have required exactly this type of behavior. 

A question relevant to policy is why unregulated management has 

followed a low-risk strategy for the firm. Sallie Mae's management 

has indicated that a riskier business strategy has never had any appeal 

to the association's board of directors. From the beginning of the association, the board has directed management to structure the firm's operations in such a way that its growth in earnings would be steady and 

predictable. The association's objectives have always been inconsistent with a risky strategy. Another factor may have been that, 

given its specialization in the GSL market, Sallie Mae's gross interest 

income was fixed as a spread over the Treasury bill rate. This created 

an incentive for Sallie Mae to keep its interest expense as close to the 

Treasury bill rate as possible, to maximize net interest income. One 

means of doing so was to operate with as little risk as possible. Sallie 

Mae also had strong incentives to minimize servicing costs because 

such savings largely accrue to the firm. 

6. Congre~sional Budget Office, Government-Sponsored Enterprises and Their Implicit Federal 

Subsidy: The Case of Sallie Mae (December 1985). pp. 40-44. 

7. Susan Woodward. "Privatizing Financial Intermediaries: OPIC. Fannie Mae, and Sallie Mae" 

(unpublished paper). The author describe8 the privatization diecueeions in which she participated 

while on the staff of the Council of Economic Advieen, Executive Ofice of the President. 

8. General Accounting OtT~ce. Government-Sponsored Enterprises: The Government's Exposure to 

Risks. GAOIGGD-90-97 (Auguet 1990). p. 4. 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 261 

Privatize Sallie Mae 

One of the major difficulties to be overcome by attempts at privatization is that the severing of all federal responsibilities for the GSE's 

debt must be credible. This requirement is made all the more difficult 

because the current federal guarantee of Sallie Mae's debt is not explicit. One approach to a credible renunciation of the implicit guarantee is to make it explicit. Under this approach, the federal government 

would explicitly guarantee the timely payment of interest and principal for all outstanding securities issued by Sallie Mae before the effective date. This guarantee should be extended by statute. When the 

guarantee is made explicit, a schedule should also be announced for its 

withdrawal; one option would be to guarantee existing issues to their 

maturity or for three years, whichever is less. 

One shortcoming of this plan is that it would leave the Student 

Loan Marketing Association as the issuer of more than $40 billion in 

outstanding debt. Given the power of the notion of an institution's 

being too big to fail, the markets might continue to perceive Sallie Mae 

debt as implicitly guaranteed by the federal government, despite the 

expiration of the explicit guarantee. 

This shortcoming suggests that the effective privatization of Sallie 

Mae would require dividing the firm into several independent entities. 

Specifically, Sallie Mae could be required to divest itself gradually of 

its component operations, assets, and liabilities by distributing to its 

current common and preferred shareholders, shares in each of several, 

new, fully private, independent firms created from Sallie Mae. The 

new entities would have none of the links to the federal government 

that normally distinguish GSEs, such as a lihe of credit at the Treasury or exemption from the Securities and Exchange Commission's 

registration requirements or state laws that protect investors. They 

would also be subject to the antitrust laws. 

By creating several new and correspondingly smaller entities, 

markets might be persuaded that the federal government would not 

intervene to protect creditors from loss in the event of insolvency by 

one of these firms. This result requires that none of the surviving 

entities be too big to fail. In addition, this approach could significantly 
282 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

increase competition in the secondary market for GSLs and assure the 

continued access of primary lenii'ers to the capital markets. 

A significant difficulty presented by this approach would be the 

need to determine efficient divisions of Sallie Mae. One approach 

would be to try to divide the firm by function; another would be to try 

to create a number of mini-Sallie Maes. Some economies of scale are 

also likely to be lost, however, even if an otherwise desirable restructuring of Sallie Mae can be identified. 

As the components of Sallie Mae are spun off to form new, fully private firms, the market value of its stock would fall with the reduced 

earnings of the shrinking firm. These declines would be fully offset for 

stockholders by the value of the new stock distributions--provided that 

the value of the whole is the sum of the parts. The spin-off process 

could continue until the transformation was complete and Sallie Mae 

disappeared as a distinct entity. Alternatively, the process could be 

terminated somewhat short of complete dissolution if the government 

wished to maintain a standby presence in the secondary market for 

student loans. In this case, however, the government might wish to 

purchase the residual elements of the firm, and operate it directly as a 

fully owned federal entity. Such an arrangement would eliminate the 

neither-fish-nor-fowl ambiguity inherent in the GSE structure. 

If genuine privatization were achieved in this manner, the primary student loan market would benefit from increased competition, 

Sallie Mae shareholders would gain from the removal of the operating 

restrictions imposed by Sallie Mae's charter, and taxpayers would gain 

from the elimination of their implicit, contingent liability for Sallie 

Mae's debt. It is not clear, however, that the gains to these three types 

of beneficiaries would be sufficient to offset the substantial legal and 

administrative costs that such a restructuring would entail. 

Increase Treasum Department Oversight and Earls Warning 

A second option would be to require the Department of the Treasury, 

under existing authority, to examine Sallie Mae's five-year strategic 

plan and annual budget and business plan. This action could enable 
CHAPTER VI STUDENT LOAN MARKETING ASSOCIATION 2fM 

Treasury to anticipate changes in planned risk at Sallie Mae and to 

alert the Resident and the Congress in time to block them, if desired. 

The President could be given authority to remove Sallie Mae's board of 

directors at the recommendation of the Secretary of the Treasury, if the 

Secretary found that the GSE was increasing its risk significantly. 

This approach requires the Treasury to take a greater role in 

monitoring Sallie Mae's risk than it has assumed to date. No amount 

of monitoring can assure that the government will detect an increase 

in the riskiness of Sallie Mae. For example, changes in the structure of 

the GSL program may force Sallie Mae into unplanned departures 

from its long-term business plan. Also, management may take steps to 

increase risk that were not contemplated in advance, although it has 

substantial incentives not to do so. If Treasury must rely on monitoring business plans to detect greater risk taking, that recognition of risk 

may come too late to prevent an increase in risk by Sallie Mae. At that 

point the Secretary could recommend removal of the board. 

A shortcoming of this approach is that the Treasury Secretary and 

the President might be reluctant to remove the board of a GSE, especially if increased risk taking had not led to losses. A supervisory 

agency with a statutory mandate to assure the safe and sound operation of Sallie Mae and with sufficient enforcement powers would probably be less reluctant to act to stop a large increase in risk. 

Require Private Risk Assessment 

Sallie Mae could also be required to make itself more susceptible to 

private risk assessment. For example, as discussed in Chapter 11, the 

GSE could be required to issue subordinated debt that subjected investors to some risk of loss. Depending on how the debt was structured, 

the debt would be worthless, would convert to equity, or would not pay 

interest, under specified conditions that indicated a deterioration in 

Sallie Mae's financial condition. Changes in the credit ratings or market prices of such instruments could be used as an early warning signal 

of changes in Sallie Mae's earnings prospects and the government's exposure to risk. 
264 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

One could argue, however, that Sallie Mae common stock is both 

unguaranteed and priced to reflect Sallie Mae's earnings prospects. 

The stock price, according to this view, already contains nearly as 

much information as could be obtained from pricing subordinated debt 

and bonds whose interest was contingent on Sallie Mae's earnings. 

Subiect Sallie Mae to a Centralized Supervisor of All GSEs 

As discussed in Chapter 11, one approach to reforming regulation of 

GSEs would be to create a new agency with responsibility for supervising the safe and sound operation of all the enterprises. The agency 

would have statutory authority to examine Sallie Mae, impose a 

risk-based capital requirement on the GSE, enforce that capital standard and other limits on risk taking, take action if Sallie Mae became 

insolvent or close to insolvency, and assess Sallie Mae for the cost of 

supervisory activities. 

Effective supervision requires a detailed knowledge of the operations of the regulated entity. A centralized GSE regulator would have 

to become quite knowledgeable about Sallie Mae's affairs. Achieving 

this expertise could be costly for both Sallie Mae and the supervisory 

agency. A poorly informed supervisory agency, however, might set a 

capital requirement that did not take into account Sallie Mae's true 

exposure to risk and thereby impose unnecessary costs on Sallie Mae 

shareholders, as well as lenders, student,, and postsecondary education institutions. Because SLMA poses so little risk to the government 

today and has strong incentives to continue to operate in a low-risk 

manner, there are no guarantees that the potential benefits from effective supervision--prevention of greater risk taking by the GSE--are 

worth the potential costs associated with poorly informed supervision. 

The high information needs and costs essential to effective, controlling regulation could be substantially reduced in either of two 

ways, as discussed in Chapter 11. First, the Congress could direct the 

supervisory agency to streamline monitoring and supervision of Sallie 

Mae as long as the GSE posed little risk to the government. A streamlined regulatory process would minimize the explicit and implicit cost 

of more intensive monitoring. Alternativeiy, Sallie Mae could reach a 
CHAPTER VI STUDENT LOAN MARKETING ASBOCIATION 266 

"safe harbor" from regulatory interference by obtaining a triple-A 

rating, irrespective of the implicit federal guarantee of its obligations, 

from two private rating agencies. The GSE probably could obtain such 

a rating at very little cost to stockholders. If Sallie Mae achieved and 

maintained the rating, the supervisory agency would be able to 

monitor Sallie Mae, but could not require any changes in its operations. However, if the enterprise fell out of compliance with the standard, it would be required to submit a business plan to the supervisory 

agency that would enable it to comply within one year. If Sallie Mae 

failed to comply within that period, the agency could use enforcement 

powers to impose a business plan on it. 

Both approaches appear to be feasible and to offer protection 

against supervisory failure that would impose excessive costs on Sallie 

Mae. As discussed in Chapter 11, one shortcoming of allowing the GSE 

to reach a regulatory "safe harbor" is that changes in credit ratings can 

lag changes in a financial institution's condition and risk exposure. It 

is unlikely, however, that Sallie Mae's financial condition could deteriorate significantly in a short period of time. Also, the requirement 

that the GSE maintain a very high rating would provide significant 

protection for the government. 

APPENDIXES 

APPENDIX A 

ASSUMPTIONS USED IN THE SCENARIO 

ANALYSIS OF THE CAPITAL ADEQUACY 

OF THE FARM CREDIT SYSTEM 

The objective of the scenario analysis conducted by CBO was to 

examine how the Farm Credit System (FCS) might fare under conditions similar to those experienced during the 1984-1990 period. 

These years were the most difficult for the FCS since the Great Depression, and a repeat of them would represent something like a worst-case 

scenario for the system. It was not possible, nor did it appear reasonable, to try to duplicate this experience exactly. The institutional 

structure of the system and the financial condition of its borrowers are 

significantly different in 1991 from what they were in 1984. 

ASSUMPTIONS ABOUT THE BALANCE SHEET 

The scenario developed by CBO assumes that credit risk is the most 

important threat to the financial condition of the FCS. This is expressed initially in a deterioration of the system's balance sheet. Specifically, the scenario attempts to test the vulnerability of the system 

to a significant decline in loan volume and quality. Each district within the FCS is analyzed individually. 

With respect to accruing loans, the scenario assumes that the 

volume of accruing loans during the 1991-1996 period follows a pattern 

similar to that experienced during the 1984-1990 period. In addition, 

it assumes that the ratio of nonaccruing loans to accruing loans during 

the 1984-1990 period is repeated in the 1991-1996 period. The implicit 

assumption underlying the scenario is that, in response to hard financial times, farmers will borrow less and be less capable of servicing existing debt. 

The level of "other nonearning assets" during the projection period 

is defined in relation to accruing loans during the historical period. 

For instance, if other nonearning assets were equal to 3 percent of 
270 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

accruing loans in 1984, it was assumed that a similar relationship 

would prevail in 1991. 

For "investments and cash," the levels in the projection period are 

based on a modified version of the historical trend. One of the responses of the system to the declining quality of its portfolio in the 

mid-1980s was to increase significantly the level of cash and investments. Cash and investments have not returned to pre-1984 levels in 

most districts, which accounts for the dramatic decline in cash and 

investments between 1990 and 1991. This decline, which CBO does 

not expect to occur, contributes to the substantial drop in total FCS 

assets between 1990 and 1991. It was deemed improbable that the 

system, if facing another downturn in the farm economy starting in 

1991, would increase its cash and investments to the same extent that 

it did in 1984 and 1985. Accordingly, for the projection period, the rate 

of change experienced by each district was reduced. Interest is assumed to be earned on cash and investments at the rate projected by 

CBO for three-month Treasury bills. 

It was assumed that 20 percent of the existing loan loss reserves 

would be used each year to resolve problem loans. The level of loan loss 

reserves in any given year during the projection period is, therefore, 

assumed to be equal to the previous year's level of reserves less 20 

percent, plus any additions or subtractions made in the current year. 

With respect to liabilities, it was assumed that protected stock 

would decline by 20 percent per year as this source of equity is retired 

and not replaced. Minimum capital standards are assumed to be 7 percent of total assets. This overstates the actual amount of capital that 

would be required to satisfy the capital standards, especially at the 

Banks for Cooperatives, since not all FCS assets have a 100 percent 

risk-weight. If capital is greater than 7 percent of total assets, at-risk 

stock is assumed to change at the same percentage rate as gross loan 

volume during the projection period. If capital levels fall below 7 percent, at-risk stock is not redeemed by the system. Retained earnings 

during the projection period are equal to retained earnings in the previous period plus net income. Finally, system liabilities expand or contract to ensure that the two sides of the balance sheet are equal. 
APPENDIX A CAPITA^ ADEQUACY OF THE FARM CREDIT SYSTEM a?i 

ASSUMPTIONS ABOUT THE INCOME STATEMENT 

While the initial effect of the downturn in the farm economy is reflected in the balance sheet of the FCS, it is soon transmitted to the 

income statement. The primary means of transferral come in the operating costs of the various districts and in the provisions for loan 

losses that must be made. Operating costs are assumed to increase at a 

rate slightly below that experienced in the 1980s, since some of the 

institutional capacity and expertise for dealing with increases in nonaccruing loans still exists within the system. Loan loss provisions are 

linked to the level of nonaccruing loans. The relationship between 

nonaccruing loans and loan loss provisions that occurred during the 

1980s is assumed to recur in the projection period. 

The system is assumed to be better able to maintain interest 

margins in the 1991-1996 period than it was during the 1984-1990 

period, for two fundamental reasons. First, as noted in Chapter 111, the 

system formerly used average-cost pricing for its loans. During the 

1980s, when interest rates were falling, average-cost pricing meant 

that other lenders were able to offer much more attractive rates to borrowers. As a result, many of the more financially viable borrowers 

served by the FCS were able to leave the system by refinancing their 

debt with other lenders. The recent shift to marginal cost pricing is assumed to eliminate the pricing advantage previously enjoyed by the 

FCS's competitors. As a result, there are fewer competitive pressures 

to reduce interest margins. 

The second factor justifying the assumption that interest margins 

are maintained during the post-1991 period is that the system has 

made important improvements in its ability to manage interest rate 

risk. There are fewer gross mismatches in the maturities of loans and 

securities, and more sophisticated mechanisms are in place for 

identifying and coping with gaps that develop. Accordingly, the district banks are assumed to price their loans at 2 percent above their 

cost of funds, and this margin does not fall as the level of nonaccruing 

loans increases. 
ma GOVERNMENT-SPONSORED ENTERPRISES ~pri~ 1991 

Noninterest income in each district during the projection period is 

defined as a proportion of interest income. The proportion is equal to 

the percentage prevailing during the historical period. 

Insurance premiums are calculated as stipulated in the 1987 act: 

0.0015 times the volume of accruing loans plus 0.0025 times the volume of nonaccruing loans. The volume of both loan categories is assumed to be measured at the end of each calendar year. 
APPENDIX B 

INTERNAL CAPITAL STANDARDS AND 

CAPITAL ADEQUACY OF 

FANNIE MAE AND FREDDIE MAC 

This appendix discusses the internal capital standards of Fannie Mae 

and Freddie Mac and the recent analysis of their capital adequacy by 

the Office of Management and Budget. 

FANNIE MAE'S CAPITAL STANDARD 

Fannie Mae's internal capital standard has separate components for 

the credit risk of mortgages held in portfolio and financed with mortgage-backed securities (MBSs), the interest rate risk of the mortgages 

in the GSE's portfolio, and the credit risk and interest rate risk of all 

other assets in the portfolio. Each of these components is examined 

below. 

Mortgage Credit Risk 

The component for mortgage credit risk in Fannie Mae's standard requires the GSE to hold enough capital to absorb the losses associated 

with certain lifetime default rates on the mortgages it has financed. 

The default rates that the standard assumes are based on an analysis 

of the performance of conventional 30-year, single-family, fixed-rate 

mortgages (FRMs) originated in Texas in 1981 and 1982 that Fannie 

Mae purchased and for which it has detail on individual loans. The 

GSE used information on the incidence and timing of actual defaults 

on the mortgages through the third quarter of 1989 to project their lifetime default rates. These estimated rates range from 0.8 percent for 

loans with a loan-to-value (LTV) ratio at origination of no more than 

60 percent, to 10.0 percent for mortgages with an initial LTV ratio 
!274 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

of 75 percent to 80 percent, to 28.0 percent for loans with an initial 

LTV ratio of more than 90 percent.1 

Fannie Mae's capital standard assumes default rates equal to the 

projected experience on the 1981-1982 Texas loans for all 30-year, 

single-family, owner-occupied mortgages that are unseasoned (less. 

than five years old) and on which it does not have recourse to lenders or 

to the Federal Housing Administration (FHA) or the Department of 

Veterans Affairs (VA). The standard assumes lower default rates for 

unseasoned, nonrecourse FRMs of intermediate maturities, and higher 

rates for unseasoned, nonrecourse adjustable-rate mortgages (ARMS) 

and multifamily loans. For all types of seasoned mortgages, the assumed default rates are half as large as they are for unseasoned loans.2 

To determine how much capital it must hold in order to absorb the 

losses associated with the default rates assumed for different types of 

nonrecourse loans, Fannie Mae simulates the lifetime cash flows from 

the mortgages. The simulations assume that the loans will default at 

the rates assumed by the capital standard, that the timing of defaults 

is consistent with the experience of the 1981-1982 Texas loans studied 

by Fannie Mae, and that the GSE finances the loans with MBSs. The 

cash flows include projected default costs, income from guarantee fees, 

float income (interest earned from the short-term investment of payments from borrowers), earnings on capital, administrative expenses, 

federal income taxes, and dividends. Projected default costs include 

interest paid while the loans are in foreclosure, expenses related to 

foreclosing on the mortgages and disposing of the properties, and, most 

important, the difference between the unpaid loan balances and the 

prices for which the houses are sold. Fannie Mae assumes levels of de1. By way of comparieon, Standard & Poor'e (%PI aeeumee that a "prime" pool of mortgagee with 

initial LTV ratios of 80 percent would have a 10 percent default rate in a "double A" depreesion. 

S&P aeeumea that a prime pool of loam with initial LTV ratioa of 95 percent that were covered by 

private mortgage insurance would have a 30 percent default rate. A prime pool coneista of 300 or 

more 30-year, single-family FRMs, for which the properties are owner-occupied, detached home9 

and well diversified geographically in areas with strong eeonomiee, and the initial balances of the 

loans were less than $300,000. See Standard & Poor's Corporation, S&P's Structured Finance 

Criteria (New York: 1988), pp. 82-83. 

2. For more detail on the projected lifetime default rates by initial LTV ratio of the 1981-1982 Texae 

loans studied by Fannie Mae, aa well ae the adjuatmenta in these rates that the GSE'e capital 

standard makes for differencen in mortgage type and seasoning. see Department of the Treasury. 

Report of the Secretary of the Treasury on Government Sponsored Enterprises (May 1990). pp. A-38 

to A-39. 
APPENDIX B CAPITAL STANDARDS OF FANNIE MAE AND FREDDIE MAC na 

fault costs based on its experience. The simulations calculate the initial capital investment required to absorb all the projected default 

costs and maintain a positive capital balance in each year over the life 

of the mortgages. 

Credit Risk on Nonrecourse Mortgages. Fannie Mae's internal capital 

standard assumes a weighted average default rate of 8.9 percent on the 

unseasoned, nonrecourse, single-family, owner-occupied, 30-year 

FRMs financed by the GSE at year-end 1990. The GSE estimates that 

an initial capital investment of 0.8 percent (80 basis points) of outstanding principal is required to cover the projected losses on those 

loans. For all the nonrecourse mortgages financed by the GSE, the assumed weighted average default rate is 8.2 percent, and the required 

initial capital investment is 0.74 percent (74 basis points) of outstanding principal. The latter equates to an overall leverage ratio for 

the credit risk of nonrecourse mortgages of 135-to-1. The assumed default rates and required leverage ratio are the same as the capital 

standard required at the end of 1989. If the initial LTV ratio, product 

type, or seasoning of Fannie Mae's nonrecourse mortgages changed 

significantly in the future, the assumed default rates and the leverage 

ratio required by its capital standard would also change. 

In 1990, at the request of the Department of the Treasury, Fannie 

Mae analyzed how changes in the three major assumptions employed 

in its simulations would affect the initial capital investment that its 

capital standard would require to cover the projected lifetime default 

losses on the unseasoned, nonrecourse, single-family, owner-occupied, 

30-year FRMs it had financed at year-end 1990. First, the sales price 

of foreclosed properties, which Fannie Mae had assumed to be 72 

percent of the unpaid principal balance, was varied from 64 percent to 

72 percent, to reflect more closely the enterprise's recent experience. 

Second, the average lifetime default rate was varied from 8.25 percent 

to 9.5 percent. The latter rate more closely tracks Fannie Mae's 

experience in 1982 and 1983, which were the peak default years for 

conventional loans originated in Texas in the 1980s and purchased by 

the enterprise. Third, the projected lifetime default rate for loans with 

lower LTV ratios at origination was varied from 5 percent to 10 per- 
W6 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

cent.3 Based on the sensitivity analyses, the Treasury concluded that 

the initial capital investment required to cover the losses on newly 

originated, nonrecourse, single-family, owner-occupied, 30-year FRMs 

financed by Fannie Mae could be up to 55 percent higher than estimated by the GSE.4 

Credit Risk on Recourse Mortgages. Fannie Mae's internal capital 

standard requires the GSE to hold capital equal to 0.4 percent (40 basis 

points) of the unpaid principal balance of mortgages that are covered 

by recourse agreements, backed by collateral, insured by the FHA, or 

guaranteed by the VA. According to Fannie Mae, this amount far exceeds the level of capital necessary to absorb losses on the recourse 

loans if they experienced default rates equal to the projected lifetime 

default rates on the 1981-1982 Texas loans studied by the enterprise. 

This initial capital investment equates to a 250-to-1 leverage ratio for 

the credit risk on nonrecourse loans. 

Interest Rate Risk of Mortgages 

Fannie Mae's standard requires that it hold capital equal to the 

greater of 2 percent of the unpaid principal balance of the mortgages it 

holds in portfolio, or the amount necessary to pass a stress test in 

which rates rise by 6 percentage points within one year and remain at 

that level for four years. As discussed in Chapter IV, Fannie Mae 

projects that it would earn over $1 billion in net income in each of the 

five years of this interest rate stress test if rates had risen starting at 

year-end 1990. Thus, the GSE's capital standard currently requires it 

to hold capital equal to 2 percent of the mortgages it holds in portfolio. 

3. Standard & Poor's is willing to give a single-A rating to private-label, mortgage-backed securities 

collateralized by a pool of mortgages with initial LTV ratios of 80 percent or less if an 8 percent 

default rate on the loam in the pool would not came the MBSs to default. See Standard and Poor's 

Corporation, S&P's Structured Finance Criteria, p. 84. 

4. See Department of the Treaeury, Report on the Seeretury of the Treasury on Government Sponsored 

Enterprises, pp. A-75 to A-79. In CBO's view, the first two sennitivity analyses were reasonable. 

The third was more questionable, since the experience of Fannie Mae and Freddie Mac suggesta 

that loans with lower LW ratios perform eignificantly better than Standard & Poor's assumes. 
APPENDIX B CAPITAL STANDARDS OF FANNIE MAE AND FREDDIE MAC 277 

Risks of,Other Portfolio Assets 

Fannie Mae's standard requires it to hold capital equal to 2 percent of 

the book value of nonmortgage assets held in its portfolio, to cover the 

credit and interest rate risk of those assets. Management believes that 

the risks posed by these assets--which consist principally of short-term 

investments, cash and cash equivalents, and receivables from currency 

swaps (contracts under which the GSE receives payments in foreign 

currencies)--are small. 

FREDDIE MAC'S CAPITAL STANDARD 

Freddie Mac's capital standard requires the GSE to have enough capital to remain solvent on a GAAP basis during a simulated Great Depression scenario. In the 10-year scenario, home prices nationwide are 

assumed to be flat in the first year, to fall by 10 percent annually in 

years 2 through 5, to be flat in the sixth year, and then to rise slowly in 

years 7 through 10. Short-term interest rates and mortgage rates are 

assumed to decline by 5 percentage points by year 5, and then to rise by 

2 percentage points in the remaining five years.5 

The stress test assumes that Freddie Mac would pay no dividends 

and purchase no mortgages during the Great Depression scenario. The 

first assumption clearly is not conservative, since neither the severity 

of the downturn nor the losses that the GSE would experience would be 

evident in the initial years of the 10-year period. The impact of the 

second assumption is not as clear-cut. On the one hand, a more realistic assumption is that Freddie Mac would continue to purchase mortgages in the first few years. Many of these loans would experience 

high default losses. On the other hand, the assumption means that the 

GSE does not purchase loans taken out to refinance mortgages with 

low mark-to-market LTV ratios. In this respect, the assumption 

5. The Great Depression scenario is outlined in Moody's Investors Service, Annual Industry Outlook: 

Private Mortgage Insurance (New York: May 1986). Appendix I. Moody's now rates private 

mortgage insurers and private-label MBSs by assessing how they would perform over a large 

number of randomly generated economic scenarios, rather than during a stylized Great Depression. 

See Moody's Investors Service, Moody's Approach to Rating Residential Mortgage Pass-Throughs 

(New York: April 1990). pp. 7-10. 
278 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

worsens the enterprise's average default experience during the scenario. 

Freddie Mac suffers losses in this stress test for three reasons. 

First, declining home prices cause the GSE to experience high mortgage default rates. As prices fall, the estimated mark-to-market LTV 

ratios of its mortgages decline. Freddie Mac uses statistical models 

that relate the probability of loan default to the estimated mark-tomarket LTV ratio to project the proportion of mortgages that default in 

each year of the scenario. To perform the analysis each year, the GSE 

updates its estimate of the mark-to-market LTV ratios of the loans it 

had financed at year-end. Second, declining interest rates accelerate 

loan prepayments and lower the income available to pay default claims 

after the first few years. Freddie Mac uses statistical models that relate the probability of loan prepayment to the spread between current 

mortgage rates and the interest rates on the mortgages it has financed.6 Third, lower interest rates mean lower float income. The enterprise calculates float income based on the short-term interest rates 

assumed in the scenario. 

To assess how the defaults, prepayments, and reduced float income 

would affect its income and capital position, Freddie Mac projects pro 

forma income statements and balance sheets during the scenario. The 

losses from mortgage defaults reflect assumptions based on the GSE's 

experience about the time between default and foreclosure, the amount 

of time before a foreclosed property is sold, and the costs of disposing of 

it. The amount of time that each private mortgage insurer is assumed 

to remain in business, and be able to pay claims owed to Freddie 

Mac, is based on its credit rating. For example, firms rated double-A 

are assumed to last seven years, while firms rated single-A are 

assumed to last five years. Lenders with which the GSE has recourse 

agreements are assumed to default on their obligations to absorb a 

portion of default losses. 

6. For assessments of Freddie Mac's default and prepayment models. see Price Waterhome, Report on 

Assessment of Freddie Mac's Capital Adequacy (Washington, D.C.: February 5. 1990), pp. V-2 to 

V-7; and Department of the Treasury, Report of the Secretary of the Treasury on Government 

Sponsored Enterprises, pp. B-90 to B-91. 
APPENDIX B CAPITAL STANDARDS OF FANNIE MAE AND FREDDIE MAC a79 

In 1990, at the request of the Department of the Treasury, Freddie 

Mac analyzed how changes in the major assumptions employed in its 

Great Depression stress test would change the amount of capital 

required for the GSE to last the full 10 years. The Treasury asked 

Freddie Mac to test the sensitivity of the results of the analysis to 

changes in home price appreciation before the start of the downturn, 

transactions costs, the proportion of default losses that are recovered 

on loans covered by primary mortgage insurance, the time required to 

sell foreclosed properties, prepayment rates, and default rates. The 

analyses assumed that the downturn began at the end of 1989. If home 

prices were assumed to increase 2 percent less in each year before the 

start of the Great Depression scenario, Freddie Mac would have required about 38 percent more capital initially to last the full 10 years. 

The results were much less sensitive to changes in the other assumptions.7 

Freddie Mac recently improved some of the assumptions of the 

model that it uses in its Great Depression stress test. The GSE 

changed the price index used to estimate the mark-to-market LTV 

ratios of multifamily mortgages to make it more conservative, and 

updated the credit ratings of private mortgage insurers. Freddie Mac 

also corrected the model to reflect the fact that the scenario's low 

interest rates would allow it to save interest costs by calling some debt. 

As discussed in Chapter IV, with these improvements Freddie Mac is 

projected to last somewhat longer in the Great Depression scenario assumed to begin at year-end 1989 or 1990. 

OMB'S ANALYSIS OF CAPITAL ADEQUACY 

In late 1990, the Office of Management and Budget (OMB) analyzed 

the capital adequacy of Fannie Mae and Freddie Mac using a stress 

test that is very similar to the Great Depression scenario on which 

Freddie Mac bases its internal capital standard. As discussed in Chapter IV, OMB projected that both GSEs would survive the full 10 years 

7. See Department of the Treasury, Report of the Secretmy of the Trec~ury on Government Sponsored 

Enterprises, pp. B-91 to B-92. 
280 GOVERNMENT-SPONSORED ENTERPRISES April 1991 

of the scenario. OMB's stress test differed from Freddie Mac's in several respects, however. 

The most important difference is that OMB simulated the performance of Fannie Mae and Freddie Mac over 20 years, rather than 

10. For the first decade of the 20-year period, OMB assumed that annual appreciation in home prices would average 4 percent nationwide, 

consistent with expected general price inflation, and that mortgage 

rates would be stable at 10 percent. The assumption of steady appreciation in home prices is not conservative, since it causes the estimated 

mark-to-market LTV ratios of the mortgages financed by each enterprise to decline significantly before the depression hits. Each GSE was 

assumed to grow by purchasing mortgages with the same distribution 

of LTV ratios as the loans it purchased in 1990. The proportion of each 

enterprise's assets financed with debt and MBSs was projected to remain roughly the same. Dividend payments were increased to maintain capital as a proportion of all assets and MBSs at year-end 1990 

levels. The 10-year deflationary period was assumed to begin in the 

year 2000. 

OMB assumed that Fannie Mae and Freddie Mac would purchase 

enough new mortgages in the depression to replace loans that were 

paid off or defaulted. This is a conservative assumption, since many of 

the newly purchased loans quickly default in the scenario. The analysis did not assume that the GSEs would raise MBS guarantee fees on 

this new business. OMB's simulations focused solely on single-family 

loans. They did not consider either GSE's multifamily mortgage programs. 

OMB used statistical models of defaults based on FHA-insured 

mortgages, and then adjusted the models somewhat to fit each GSE's 

actual default experience in 1988 and 1989. This procedure was 

reasonable for Freddie Mac, since the enterprise's default experience 

on single-family loans has been relatively consistent over time. It was 

very conservative for Fannie Mae, since a very large portion of the 

GSE's defaults in 1988 and 1989 were from loans originated before 

1985. As argued in the credit risk section of Chapter IV, the credit risk 

of the single-family loans financed by the two enterprises at year-end 

1990 is quite similar, because about 90 percent of the loans financed by 
APPENDIX B CAPlTAL STANDARDS OF FANNIE MAE AND FREDDIE MAC %I 

each were originated aRer their underwriting guidelines became virtually identical in 1985. The average initial LTV ratios of the loans 

bought by each enterprise since 1985 are also very similar. 

In February 1991, OMB corrected some errors in its model and 

repeated the analysis of each GSE's capital adequacy, assuming that 

the depression would begin at the start of 1992. OMB again projected 

that both Fannie Mae and Freddie Mac would survive the full 10 years 

of the downturn. 

U.S. GOVERNMENT PRINTING OFFICE : 1991 0 - 292-859