United States General Accounting Office

GAO Report to the Chairman, Committee on

Banking and Financial Services, House

of Representatives

March 1998 GOVERNMENTSPONSORED

ENTERPRISES

Federal Oversight Needed

for Nonmortgage

Investments

GAO/GGD-98-48

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-277819 

March 11, 1998

The Honorable James A. Leach

Chairman, Committee on Banking

 and Financial Services

House of Representatives

Dear Mr. Chairman:

This report responds to your request dated April 10, 1997, and

supplemented on May 13, 1997, that we gather and analyze information on

nonmortgage investment activities at three government-sponsored

enterprises (GSEs): the Federal Home Loan Mortgage Corporation (Freddie

Mac), the Federal National Mortgage Association (Fannie Mae), and the

Federal Agricultural Mortgage Corporation (Farmer Mac) (called

enterprises in this report).1

 In your request, you expressed concerns that

these enterprises may be using their benefits in financial markets resulting

from their government ties to make investments that may not serve the

public purposes as expressed in their federal charters.2

 Specifically, you

requested that we examine (1) the enterprises’ legal authority for making

nonmortgage investments and federal regulatory oversight of that activity,

(2) the relationship between nonmortgage investment policies and

practices and missions of the enterprises, and (3) the extent to which the

enterprises have undertaken nonmortgage investments for arbitrage

profits—using the funding advantage from government sponsorship to

purchase nonmortgage investments that generate profits. In relation to the

third objective, you also asked us to provide information on the

enterprises’ compensation structures for directors and senior managers

and whether these structures create incentives for making nonmortgage

investments.

Background Congress created GSEs to help make credit available to certain sectors of

the economy, such as housing and agriculture, in which the private market

was perceived as not effectively meeting credit needs. GSEs receive

benefits from their federal charters that help them fulfill their missions.

Freddie Mac and Fannie Mae (the housing enterprises) have federal

charters granting each of them explicit benefits, which include

(1) exemption from registering their securities with the Securities and

1

At Farmer Mac, nonmortgage investments are defined as investments other than those in agricultural

mortgages (also referred to as nonagricultural-mortgage investments in this report).

2

We provided the preliminary results of our work on Freddie Mac and Fannie Mae in our letter to you,

Housing Enterprises: Investment Authority, Policies, and Practices (GAO/GGD-97-137R, June 27, 1997).

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Exchange Commission (SEC), (2) exemption from state and local corporate

income taxes, and (3) use of the Federal Reserve as a transfer agent.

Farmer Mac is subject to SEC registration requirements, but it uses the

Federal Reserve as a transfer agent, and Farmer Mac officials told us that

it is exempt from state income taxes in most states. The most important

benefit that all three enterprises receive is an implicit one stemming from

investors’ perception that the federal government would not allow the

enterprises to default on their obligations. Due to this perception,

investors do not demand yields on investments in enterprise debt and

mortgage-backed securities that are as high as those on comparable

financial instruments issued by corporations without government

sponsorship. One result of government sponsorship, therefore, is a

reduction in debt costs compared with debt costs in similar corporations

without government sponsorship.

Freddie Mac and Fannie Mae were chartered by Congress to enhance the

availability of residential mortgage credit across the nation. The housing

enterprises accomplish this mission by purchasing residential mortgages

from lenders. The housing enterprises retain some of the mortgages they

purchase in their own portfolios, but a majority of the mortgages are

pooled into mortgage-backed securities (MBS) that are sold to investors in

the secondary residential mortgage market. As of December 1996, Freddie

Mac had about $463 billion in MBS obligations and $156 billion in debt

obligations outstanding. The corresponding figures for Fannie Mae were

about $548 billion and $331 billion, respectively. Therefore, combined MBS

and debt obligations of these housing enterprises totaled about $1.5

trillion.

Farmer Mac was chartered by Congress to enhance the availability of

agricultural mortgage credit across the nation. Farmer Mac is making

efforts to establish a secondary mortgage market for agricultural

mortgages along the lines the housing enterprises have established for

residential mortgages. Farmer Mac issues, and guarantees payment on,

agricultural mortgage-backed securities (AMBS). One type of AMBS, called

Farmer Mac I securities, is backed by agricultural mortgages not

containing federally provided primary mortgage insurance. The other type

of AMBS, called Farmer Mac II securities, is backed by agricultural

mortgages containing primary mortgage insurance provided by the

Department of Agriculture. Farmer Mac is a small financial institution in

comparison to the housing enterprises. As of December 31, 1996, Farmer

Mac had about $642 million in AMBS (of which about $226 million were

owned by others, and about $416 million were held by Farmer Mac) and

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about $546 million in debt obligations outstanding. Therefore, combined

AMBS owned by others and debt obligations of Farmer Mac totaled about

$772 million.

The housing enterprises pass along, at least in part, the benefits they

receive from government sponsorship, such as lower debt costs, to

residential borrowers. In a previous study, we estimated that interest rates

on single-family, fixed-rate, conforming mortgages were probably 15 to 35

basis points lower than they would have been without government

sponsorship of the enterprises.3

 Limiting the activities of the housing

enterprises primarily to funding conforming residential mortgages helps

create a mechanism for the benefits they receive, such as lower debt costs,

to be passed through to borrowers. Such limitations are consistent with

the special purpose charters imposed by Congress. Congress gave the

Department of Housing and Urban Development (HUD) general regulatory

authority over the housing enterprises so that HUD can ensure that the

missions of these enterprises as stated in their respective charter acts are

being fulfilled. HUD also has regulatory authority to approve new mortgage

programs proposed by the housing enterprises. In consideration of the

potential risks to taxpayers from an enterprise default on its financial

obligations, Congress created safety and soundness regulators for the

enterprises. HUD’s Office of Federal Housing Enterprise Oversight (OFHEO)

is the safety and soundness regulator of the housing enterprises. The Farm

Credit Administration (FCA), through its Office of Secondary Market

Oversight (OSMO), has regulatory responsibility with respect to Farmer

Mac, including specific authority over safety and soundness matters.

Results in Brief Legally, the enterprises have broad investment authority. To date,

regulatory oversight activities for the three enterprises have focused on

whether nonmortgage investments are safe and sound and not on whether

the nonmortgage investment policies and practices are mission related.

OFHEO and OSMO have determined that the enterprises’ nonmortgage

investment portfolios do not raise safety and soundness concerns.

To ensure that the enterprises use their government-provided benefits to

achieve a public purpose, Congress gave HUD and FCA mission regulatory

authority. Recently, this oversight has become especially important

3

Housing Enterprises: Potential Impacts of Severing Government Sponsorship (GAO/GGD-96-120,

May 13, 1996). A single-family housing unit is defined as a housing unit in a structure with four or

fewer total units. The housing enterprises are restricted in statute to purchasing residential mortgages

below the conforming loan limit; in 1997, this limit was $214,600 on single-unit residences. A basis

point is one one-hundredth of a percentage point.

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because Farmer Mac has substantially increased its holdings of

nonagricultural-mortgage investments and the housing enterprises have

proposed new types of nonmortgage investments. As of June 30, 1997,

nonmortgage investments constituted about 15 percent of on-balance

sheet assets at Fannie Mae and 10 percent at Freddie Mac; 66 percent of

Farmer Mac’s assets were in nonagricultural-mortgage investments.

HUD has not developed criteria to determine if nonmortgage investments

are consistent with enterprise charter purposes. In August 1997, HUD

indicated its plan to promulgate regulations addressing the housing

enterprises’ nonmortgage investment activities and their relation to the

housing enterprise mission. The advance notice of proposed rulemaking

was published in December 1997.

In October 1997, FCA indicated that, for now, it did not have concerns that

Farmer Mac’s nonmortgage investment activity is inconsistent with its

charter mission. However, FCA also stated that the debt issuance strategy

associated with the investments is intended to be temporary and to

develop over a reasonable period of time. Therefore, according to FCA, its

position could change if over time evidence does not show that such

investments play a role in helping Farmer Mac achieve its mission.

Enterprises have invested in nonmortgage assets to varying degrees with

somewhat different rationales for how these investments further their

charter purposes. Each enterprise has an investment policy4

 that specifies

permissible credit ratings, maturities, and concentration limits and

describes the relationship of investments to earnings and to achievement

of the enterprise’s mission.5

 As of June 30, 1997, nonmortgage investments

constituted about 15 percent of on-balance sheet assets at Fannie Mae and

10 percent at Freddie Mac; 66 percent of Farmer Mac’s assets were in

nonagricultural-mortgage investments. The housing enterprises’

nonmortgage investments, as reported, included cash and cash

equivalents, asset-backed securities (ABS),6

 private corporate securities,

and state and municipal bonds. Farmer Mac’s nonagricultural-mortgage

investments expanded in calendar year 1997 from $155 million to

4

We do not report specific details of these investment policies because of the proprietary nature of

such enterprise information.

5

Credit rating agencies such as Standard and Poor’s give securities ratings related to the credit risk

associated with the investment. Concentration limits place a cap on the maximum share of assets that

can be accounted for by investments in a single company’s securities.

6

ABS are similar to MBS but are backed by nonmortgage assets, such as receivables on car loans and

credit cards.

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$931 million and now consist primarily of other government agency

securities and corporate debt issues.

Freddie Mac officials indicated that its nonmortgage investments have

been held for cash management purposes and as an investment vehicle,

which could make capital available (i.e., employ capital) to help fund

future anticipated demand for residential mortgages. This year, Freddie

Mac created an investment fund to contain nonmortgage investments with

maturities exceeding 5 years to make capital available to help fund future

unexpected demand for residential mortgages. Fannie Mae officials

indicated that nonmortgage investments are held for cash management

purposes and as an investment vehicle to employ capital not currently

needed to fund mortgages. In contrast, according to officials of Farmer

Mac, its nonagricultural-mortgage investments are part of a debt issuance

strategy designed to lower funding costs. By lowering funding costs,

officials said that Farmer Mac will be able to better price its AMBS products

in the secondary market, which these officials expect to trigger greater

product demand and, thus, enable Farmer Mac to better meet its mission.

The relationship between longer term nonmortgage investments and the

enterprises’ mission goals is not always clear, because long term

nonmortgage investments may not facilitate liquidity in the residential

mortgage market as well as short-term investments.7

 However, it is clear

that nonmortgage investments generate arbitrage profits. In this report, we

are defining the term “arbitrage” to mean using the funding advantage

from government sponsorship to raise funds for making nonmortgage

investments (see app. I). In our analysis, we found that the various

nonmortgage investments fall along a continuum representing the degree

to which they facilitate liquidity in the residential mortgage market and

thus are more clearly related to the enterprises’ missions. On one end are

short term nonmortgage investments, such as term federal funds, which

facilitate liquidity although they might also generate arbitrage profits. On

the other end are long-term investments that generate arbitrage profits but

whose relationship to the mission in facilitating liquidity is less clear.

Although arbitrage profits on nonmortgage investments are relatively

small in percentage terms at the housing enterprises, such profits

presently are a primary income source at Farmer Mac.

7

A market is more liquid if investors can buy and sell large amounts of holdings without affecting the

prices of traded securities. Liquidity allows the housing enterprises to fund residential mortgages

during different market conditions. Longer term nonmortgage investments are less liquid than shorter

term investments in the sense that their market values are subject to larger fluctuations with changes

in interest rates.

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Our review of compensation practices and board member responsibilities

at the enterprises suggests that individual incentives to generate corporate

profits are structured in a manner that is fairly typical of major

corporations and financial institutions without federal charters limiting

their activities (see app. II). These incentives, by their close tie to

corporate earnings, can create tensions between increasing shareholder

value and fulfilling the public mission. It is this tension that highlights the

importance of mission oversight. Without effective mission oversight, the

incentives to use the benefits of government sponsorship to increase

shareholder value could, over time, erode the public mission. If this were

to occur, long term nonmortgage investments could become an increasing

part of the housing enterprises’ portfolios and Farmer Mac’s temporary

approach could become a permanent strategy even if it does not enhance

Farmer Mac’s ability to purchase agricultural mortgages.

Scope and

Methodology

We reviewed the enterprises’ charters and relevant statutes to examine the

enterprises’ legal authority for making nonmortgage investments and

regulatory oversight of that activity. We obtained and analyzed publicly

available and proprietary information on the enterprises’ investment

policies, practices, and justification of those policies and practices to

examine the relationship between nonmortgage investment policies and

practices and missions. We reviewed literature on the role of the housing

enterprises in the residential mortgage market to examine the extent to

which the enterprises have undertaken nonmortgage investments for

arbitrage profits. We also interviewed officials at the enterprises, HUD,

OFHEO, and FCA; and we received written responses to questions submitted

to the Department of the Treasury.

We obtained and analyzed information the enterprises considered to be

proprietary that included information packages prepared for board

members of the enterprises; detailed information on nonmortgage

investments, their yields, and maturity; yield and other characteristics of

enterprise debt issued to fund the nonmortgage investments; and

compensation policies for senior officers and board members. We do not

report specific details of the enterprises’ investment policies and practices

or compensation policies because of the proprietary nature of such

enterprise information.

Our interviews with officials at OFHEO and FCA on their regulatory oversight

of nonmortgage investments included discussion of proprietary

information relied upon by the regulators in making their safety and

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B-277819 

soundness determinations regarding nonmortgage investments. We did not

verify their findings leading to the safety and soundness determinations.

Generally, the financial practices that the housing enterprises used to limit

the interest rate and credit risks of their nonmortgage investments were

fairly straightforward. From the data we collected at the housing

enterprises and interviews with housing enterprise and OFHEO officials, we

obtained a general understanding of OFHEO’s determinations. In contrast,

the financial practices that Farmer Mac used to limit the interest rate risk

of its nonagricultural-mortgage investments were not as straightforward

and were not fully captured by the specific data we collected from Farmer

Mac. Therefore, we were not able to obtain as complete an understanding

of FCA’s determinations.

We obtained written comments on a draft of this report from each of the

three enterprises, HUD, OFHEO, FCA, and Treasury. Their comments are

discussed near the end of this report and are reprinted in appendixes III

through IX. We conducted our work in Washington, D.C., from April 1997

through October 1997 in accordance with generally accepted government

auditing standards.

Each Enterprise Has

Broad Investment

Authority but Is

Subject to Regulatory

Oversight

The charters of all three enterprises provide them with broad investment

powers. OFHEO has clear authority to regulate investments by the housing

enterprises if such investments pose a safety and soundness concern. HUD

has general regulatory authority over the housing enterprises and is

charged with making such rules and regulations as shall be necessary and

proper to ensure that the purposes of the respective charter acts are

accomplished. In addition to general regulatory authority, HUD also has

authority to approve new mortgage programs that could contain

nonmortgage investment components. FCA, through OSMO, has safety and

soundness and general regulatory authority with respect to Farmer Mac.

The Enterprises Have

Broad Legal Authority to

Make Investments

Each enterprise has broad investment powers in its charter. The Freddie

Mac charter act provides that the funds of the corporation “may be

invested in such investments as the Board of Directors may prescribe.”8

The Fannie Mae charter act empowers the corporation, among other

things,

“to enter into and perform contracts, leases . . . or other transactions, on such terms as it

may deem appropriate . . . to lease, purchase, or acquire any property, real personal or

8

12 U.S.C. § 1452(d).

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mixed . . . and to sell, for cash or credit, lease, or otherwise dispose of the same, at such

time and in such manner as and to the extent that it may deem necessary or appropriate, . .

. and to do all things as are necessary or incidental to the proper management of its affairs

and the proper conduct of its business.”9

The Farmer Mac charter act empowers it to, among other things, “ . . .

purchase or sell any securities or obligations . . . necessary and convenient

to the business of the Corporation.”10

One general rule of law is that a corporation’s powers can be no broader

than the purposes for which the corporation is organized. This rule is

particularly relevant where, as in the case of the enterprises, the

corporation is organized for special, as opposed to general, purposes.

Thus, even though the enterprises have broad investment powers, the

exercise of those powers should not be unrelated to the accomplishment

of the special purposes for which the enterprises were created. Under

general corporate law, this relationship has been described as the logical

relation of the activity to the corporate purpose expressed in the charter.

OFHEO and FCA Have

Clear Authorities to Limit

Nonmortgage Investments

for Safety and Soundness

Reasons

OFHEO, as safety and soundness regulator, is charged with ensuring that the

housing enterprises are adequately capitalized and operate safely and in

accordance with the Federal Housing Enterprises Financial Safety and

Soundness Act of 1992 (the 1992 Act).11 OFHEO has regulatory and

enforcement authority, without the review or approval of HUD, with

respect to matters generally related to enterprise safety and soundness

and to a few specific matters, including certain capital distributions and

executive compensation at the enterprises.12 Therefore, OFHEO has

authority to supervise an enterprise investment that affects the

enterprise’s safety and soundness without consultation with HUD. Actions

taken by OFHEO with respect to other matters not specified in the 1992 Act

9

12 U.S.C. § 1723a(a).

1012 U.S.C. § 2279aa-3 (c) (12). For the purpose of this report, we take no position as to whether

Farmer Mac’s investment authority is limited pursuant to 12 U.S.C. § 2279aa-6(e)(2), which states as

follows: “The Corporation (and affiliates) may issue debt obligations solely for the purpose of

obtaining amounts for the purchase of any securities (guaranteed by Farmer Mac and backed by pools

of qualified loans), for the purchase of qualified loans . . . and for maintaining reasonable amounts for

business operations (including adequate liquidity) relating to activities under this subsection . . . .” FCA

officials explained to us their view that the provision has a specific purpose and does not limit Farmer

Mac’s investment authority.

11P. L. No. 102-550, Title XIII, codified at 12 U.S.C. §§ 4501-4641.

12See 12 U.S.C. § 4513(b).

Page 8 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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as exclusive to OFHEO are subject to the review and approval of the

Secretary of HUD.

FCA, through OSMO, has regulatory responsibility for Farmer Mac. Among

other things, OSMO is responsible for ensuring that Farmer Mac holds

adequate capital for the activities it performs and operates in a safe and

sound manner. OSMO is also responsible for supervising the safety and

soundness of Farmer Mac’s program and investment activities.

The Enterprises’ Nonmortgage

Investments Have Not Created

a Safety and Soundness

Concern

OFHEO has concluded that each housing enterprise’s nonmortgage

investment policies and practices have not constituted a safety and

soundness concern. Its conclusion was largely based on how each

enterprise matched the maturities (and related characteristics) of its debt

obligations used to finance its nonmortgage investments with those

investments and the high credit standards and generally short maturities of

the nonmortgage investments.

As of April 1997, OSMO concluded that Farmer Mac’s

nonagricultural-mortgage investment activities had not raised a safety and

soundness concern. OSMO found that the size of Farmer Mac’s investment

portfolio was not unsafe and unsound relative to the statutory capital

requirement, and the composition of the portfolio was not unsafe or

unsound.

Regulators Have Not

Focused on Nonmortgage

Investments and Their

Relationship to Charter

Missions

Although OFHEO and FCA have examined safety and soundness implications

of nonmortgage investments, HUD and FCA told us that prior to

mid-April 1997 they had not focused on nonmortgage investment policies

and practices in carrying out their general regulatory authority with

respect to the enterprises’ charter missions. The scope of HUD’s general

regulatory authority as it relates to nonmortgage investments is not clearly

defined in statute. However, as discussed later in this report (see p. 11),

HUD has initiated action to determine how it should implement this

authority. FCA has general regulatory authority that would allow oversight

of Farmer Mac’s investment activities. However, FCA said it has no

activities under way that are expected to culminate in regulation of

Farmer Mac’s investments.

HUD Has General Regulatory

Authority

Section 1321 of the 1992 Act provides that except for the specific powers

granted OFHEO, HUD has “general regulatory power” over each housing

enterprise.13 HUD also is charged with making “such rules and regulations

1312 U.S.C. § 4541.

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as shall be necessary and proper to ensure” that the provisions of the 1992

Act concerning new mortgage programs and housing goals and the

purposes of the respective charter acts are accomplished.14

The scope of HUD’s authority under this section is not defined. With respect

to investments, the statute does not set forth any criteria other than the

charter acts themselves as a basis for HUD’s exercise of its general

regulatory power and rulemaking authority. As discussed previously, the

charter acts provide Fannie Mae and Freddie Mac with broad authority to

make investments. This raises a question about the extent to which HUD

has authority to regulate nonmortgage investments by the housing

enterprises.

Fannie Mae expressed the legal opinion, as supported by an opinion letter

from legal counsel, that HUD may not “prospectively regulate” Fannie Mae’s

investment discretion. Fannie Mae based its opinion on, among other

things, the legislative history of provisions formerly contained in the

Fannie Mae and Freddie Mac charter acts. With respect to HUD’s general

regulatory authority, these provisions contained language substantially

identical to that set forth in the 1992 Act.15 The Committee reports

accompanying these provisions stated as follows:

“It is the intent of the committee that the regulatory powers of the Secretary will not

extend to (the enterprise’s) internal affairs, such as personnel, salary, and other usual

corporate matters, except where the exercise of such powers is necessary to protect the

financial interests of the Federal Government or as otherwise necessary to assure that the

purposes of the (charter act) are carried out.”16

Fannie Mae asserted that its investment practices are internal corporate

affairs subject to its broad discretion. Thus, according to the enterprise,

the above-quoted legislative history and other Congressional statements

indicate Congress’ intention that HUD should not exercise its general

regulatory authority with respect to Fannie Mae’s investment activities

except in the “extreme situation” where those activities endanger its

statutory mission.

It is unclear that Congress intended to limit HUD’s authority with respect to

nonmortgage investments, particularly in light of the special purposes of

14Id.

15See 12 U.S.C. § 1452(b) (1991 Supp.) (Freddie Mac); 12 U.S.C. § 1723a(h) (1988) (Fannie Mae).

16See S. Rep. No. 1123, 90th Cong., 2d Sess. 82 (1968); H.R. Rep. No. 1585, 90th Cong., 2d Sess. 71

(1968); H.R. Rep. No 54, pt. 3, 101st Cong. 1st Sess. 2 (1989).

Page 10 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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the housing enterprise charters and the broad statutory language

establishing the Secretary’s general regulatory power and rulemaking

authority. But even if, as Fannie Mae contends, nonmortgage investments

are usual corporate matters, HUD could take regulatory action, such as

requiring reports of nonmortgage investment activities, in cases where HUD

appropriately determines the action is necessary to ensure the

accomplishment of the enterprises’ charter acts.

HUD Has Begun a Rulemaking

Effort

Since April 1997, HUD has been evaluating the scope of its authority with

respect to the mission-relatedness of enterprise investments. HUD officials

said they are considering a range of possible regulatory standards for

enterprise investments that could be appropriate and within the scope of

HUD’s statutory authority. On the one end of the range being considered is

a narrower standard based on an enterprise activity being reasonably

related to the enterprise’s mission; and on the other end is a broader

standard based on an activity not conflicting with the enterprise’s mission.

HUD’s mission regulation actions since the passage of the 1992 Act have

focused on developing numeric goals governing enterprise purchase of

mortgages serving very-low-, low-, and moderate-income households and

other underserved borrowers; promulgating rules containing numeric

goals; and enforcing the numeric standards. HUD officials told us that the

activities of HUD’s Office of Government Sponsored Enterprises Oversight

have continued to focus on the numeric goals and fair lending issues.

HUD officials said that they had not focused attention on nonmortgage

investment practices at the enterprises prior to the mid-April 1997 public

disclosure of and publicity surrounding Freddie Mac’s nonmortgage

investment in long-term Phillip Morris bonds. At that time, HUD requested

information from Freddie Mac on its nonmortgage investments and

received a reply from Freddie Mac on April 28. In our August 1997

discussion with HUD, officials told us they have decided to use their general

regulatory authority to request reports from the housing enterprises on

their investment policies and practices. HUD’s plan is to monitor

investment trends so that it can determine if the investments are

consistent with the enterprises’ missions and purposes as defined in their

charters. On November 13, 1997, HUD’s Director of Government Sponsored

Enterprises Oversight made her first request for a report on nonmortgage

investment activity from the housing enterprises.

In August 1997, HUD told us it had reached the decision to begin a

rulemaking effort by publishing an advance notice of proposed rulemaking

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soliciting comments on how HUD should carry out its general regulatory

authorities with respect to nonmortgage investments by the housing

enterprises. HUD received executive branch approval and published the

advance notice on December 30, 1997.

FCA Has General Regulatory

Authority

FCA has general regulatory authority over Farmer Mac. Under the Farm

Credit Act of 1971, FCA has general regulatory authority over institutions in

the Farm Credit System,17 one of which is Farmer Mac.18 FCA officials told

us that the agency implements this authority through OSMO. As required by

statute, the Director of OSMO is selected by and reports to the FCA Board.19

Moreover, the statute charges FCA with ensuring that OSMO is adequately

staffed to supervise Farmer Mac’s secondary market activities, although,

to the extent practicable, the personnel responsible for supervising the

corporation should not also be responsible for supervising the banks and

associations of the Farm Credit System. This regulatory structure provides

for a degree of separation between FCA’s general regulatory responsibilities

and its safety and soundness responsibilities with respect to Farmer Mac.

However, the structure does not appear to limit FCA’s general regulatory

authority.20

During our review, we conducted three interviews with FCA and OSMO

officials that included discussion of general regulatory authorities as they

apply to nonagricultural-mortgage investments. Over the course of these

interviews, we observed an evolution in their thinking on this topic. At the

beginning of our review, the OSMO director told us that its focus in

examining nonagricultural-mortgage investments had been on matters

pertaining to safety and soundness. Toward the end of our review, it

appeared to us that FCA and OSMO officials began to focus some attention

on the relationship between nonagricultural-mortgage investments and

mission achievement.

17FCA is charged with providing “for the examination of the condition of, and general regulation of the

performance of the powers, functions, and duties vested in, each institution of the Farm Credit

System” and has general rulemaking authority and incidental powers to carry out the purposes of the

Farm Credit Act of 1971. 12 U.S.C. §§ 2243, 2252.

1812 U.S.C. § 2279aa-1(a)(2).

1912 USC 2279aa-11(a)(3)(c).

20FCA’s regulatory role with respect to Farmer Mac raises a concern about regulatory conflict of

interest. The Farm Credit System is a major portion of the primary market for agricultural mortgage

loans, and Farmer Mac is the secondary market for these loans. As regulator of both markets, FCA

may be subject to conflicts of interest. See H.R. Rep. No. 102-210, pt. 2, at 17-19, pt. 1 at 5-6;

Government-Sponsored Enterprises—Federal Agricultural Mortgage Corporation (GAO/T-GGD-91-62,

July 24,1991), before the Subcommittee on Policy, Research, and Insurance of the House Committee

on Banking, Finance, and Urban Affairs. OSMO’s role is intended to address this potential conflict of

interest.

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In October 1997, FCA indicated that, for now, it did not have concerns that

Farmer Mac’s nonmortgage investment activity is inconsistent with its

charter mission. However, FCA also stated that the debt issuance strategy

associated with the investments is intended to be temporary and to

develop over a reasonable period of time. Therefore, according to FCA, its

position could change if over time evidence does not show that such

investments play a role in helping Farmer Mac achieve its mission.

HUD Approved Fannie

Mae’s Proposed Mortgage

Protection Plan Under Its

New Mortgage Program

Authority

The enterprises may at times propose new mortgage programs that

contain nonmortgage investment components. In addition to its general

regulatory authority, HUD also has regulatory authority to approve new

mortgage programs proposed by the housing enterprises. HUD used this

authority to review Fannie Mae’s proposed mortgage protection plan

(MPP),21 which it approved on June 23, 1997. On that date, OFHEO’s acting

director provided the Secretary of HUD a letter with his determination that

MPP would not create a “risk of significant deterioration of the financial

condition” of Fannie Mae; this determination is required for the Secretary

of HUD’s approval. Under the proposed program, Fannie Mae would

purchase a cash value life insurance policy—essentially a nonmortgage

investment22—on a first-time homebuyer after the selected borrower’s

residential mortgage was purchased by Fannie Mae and the borrower

agreed to accept such coverage. The policy would protect Fannie Mae and

the homebuyer against the risk that the mortgage would not be paid due to

the borrower’s death. The policy also would offer limited protection

against default and foreclosure due to disability and job loss. Due in part

to potential tax benefits available under current tax law when HUD

approved MPP, and in part to Fannie Mae’s relatively low cost of capital,

Fannie Mae expected that MPP would be profitable. Since HUD’s approval,

however, a new tax bill was signed into law that, according to Treasury,

substantially reduced the tax benefits that were available to Fannie Mae

under the MPP. Fannie Mae officials told us that Fannie Mae has decided

not to go forward with the program.

21Fannie Mae disagreed with HUD’s characterization of MPP as a new mortgage program. Fannie Mae

argued that MPP was a logical extension of its existing mortgage products.

22Cash value life insurance is a nonmortgage investment because Fannie Mae would pay premiums to a

life insurance company and would receive a tax-deferred or tax-exempt return, part of which would be

guaranteed and part of which might not be guaranteed, based in part on the yields on the assets held

by the life insurance company. Unless Fannie Mae contractually specified that its premiums be

invested solely in mortgages, the premiums it paid to the life insurance company generally would be

invested in a wide range of securities.

Page 13 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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In commenting on a draft of this report, HUD stated that it did not possess

detailed knowledge of the intricacies of the life insurance industry at the

time MPP was submitted for review. We did not see evidence that HUD

provided Fannie Mae’s MPP proposal to anyone with experience in

evaluating cash value life insurance. HUD determined that although it

would have been helpful, detailed industry expertise was not necessary to

HUD’s review and understanding of MPP’s potential benefits to borrowers

and its related costs. A Treasury attorney with expertise in life insurance

provided basic information about life insurance products to HUD. However,

according to HUD officials, HUD determined that providing information on

MPP to Treasury was not necessary as it had obtained sufficient

information and analysis to complete its work. In its written response to

us, Treasury said: “Since HUD has the statutory responsibility to rule on

Fannie Mae’s request to undertake the MPP, and since HUD did not ask for

the Treasury’s assistance in making its determination regarding the MPP,

the Treasury did not seek to obtain additional information from Fannie

Mae.”

HUD’s new mortgage program review authority states that the Secretary

can disapprove a new mortgage program if he finds that the program is not

in the public interest. HUD did not include tax revenue losses in its analysis

for the public interest determination. In commenting on a draft of this

report, HUD stated its belief that tax issues were within the scope of the

MPP review but that in making its public interest determination, HUD would

find it difficult to conclude that a practice that is permissible under

current tax law was nevertheless against the public interest. Consequently,

in its legal analysis, HUD took the position that as long as the MPP program

is permissible under the current laws, MPP should not be regarded as

against the public interest solely on the basis of a potential adverse impact

on federal revenues or the concomitant favorable impact on Fannie Mae’s

tax position.

Because tax consequences were a major factor in Fannie Mae’s MPP

proposal, we asked Treasury whether it was concerned that HUD’s public

interest determination left out tax policy considerations. Treasury’s

written response stated: “The Treasury defers to HUD’s interpretation of its

statutory authority and responsibilities.” The response also stated:

“The Treasury has long been concerned about the revenue loss from the favorable tax

treatment of cash value life insurance with business policyholders or beneficiaries, and the

MPP highlighted these concerns. However, this tax policy concern was not limited to the

Page 14 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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MPP. In August, Congress passed and the President signed a tax bill that dealt with some of

the principal tax policy concerns associated with the MPP.”

The Relationship of

the Enterprises’

Nonmortgage

Investments to

Earnings and Mission

Nonmortgage investments constituted 10 to 15 percent of on-balance sheet

assets at the housing enterprises at June 30, 1997, and most of these

investments are short term (i.e., maturities of less than 5 years). Freddie

Mac, however, created an investment fund in 1997 authorized to contain

up to $10 billion in nonmortgage investments with maturities of over 5

years. Farmer Mac embarked on a debt issuance strategy in 1997 in which

the debt largely finances nonagricultural-mortgage investments; such

investments grew during the first half of 1997 to about 66 percent of

Farmer Mac’s assets. The housing enterprises stated that they hold

nonmortgage investments primarily for cash management purposes and to

employ capital not currently needed to fund mortgages. Farmer Mac

officials stated that Farmer Mac makes nonagricultural-mortgage

investments primarily to invest funds from debt issuance that exceed

purchases of agricultural mortgages.

Overview of Enterprise

Nonmortgage Investments

Nonmortgage investments constituted about 15 percent of on-balance

sheet assets at Fannie Mae and 9 percent at Freddie Mac as of year-end

1996. Table 1 shows selected statistics on mortgage assets and

stockholders’ equity (i.e., capital) to provide further perspective. For

example, nonmortgage investments were about 2.6 percent of Freddie

Mac’s and about 6.3 percent of Fannie Mae’s total mortgage servicing

portfolio. Nonmortgage investments were more than double Freddie Mac’s

capital and more than four times Fannie Mae’s capital. At Farmer Mac,

nonagricultural-mortgage investments were about one-fourth of

on-balance sheet assets and over three times capital.

As shown in table 1, over 65 percent of Freddie Mac’s nonmortgage

investments and over 40 percent of Fannie Mae’s were short-term

investments in cash, cash equivalents, term federal funds, and eurodollar

deposits. Freddie Mac’s and Fannie Mae’s 1996 annual reports also showed

overall nonmortgage investments by contractual maturity.23 About

23Fannie Mae does not report its financial statistics in as much detail as Freddie Mac does. Therefore,

the statistics are not directly comparable. For example, we understand that for Fannie Mae the “other”

category includes corporate debt, auction rate preferred stock, and state and municipal bonds. In

addition, the Freddie Mac and Fannie Mae data on maturities are not directly comparable. For

example, Fannie Mae’s annual report does not indicate the maturities of asset-backed securities. The

percentages we report include asset-backed securities in total nonmortgage investments. Since we

cannot determine the value of asset-backed securities that have short-term maturities, the percentages

we report may understate the short-term maturity shares for Fannie Mae.

Page 15 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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78 percent of Freddie Mac’s nonmortgage investments had maturities

under 1 year, and about 93 percent had maturities under 5 years. The

corresponding figures for Fannie Mae were 68 and 75 percent. According

to housing enterprise officials, all of their nonmortgage investments were

investment-grade.24 According to the data provided on sales of holdings,

neither housing enterprise appears to have actively engaged in frequent

selling of its nonmortgage investments.

Table 1: Selected Financial Data for the

Enterprises as of December 31, 1996 Dollars in millions

Freddie Mac Fannie Mae Farmer Mac

Total assets $173,866 $351,041 $603

Stockholders’ equity 6,731 12,773 47

Mortgage servicing portfolio 610,820 835,225 643

Nonmortgage investmentsa

—Cash and equivalents

—Term federal funds and

 eurodollar deposits

—Asset-backed securities

—Mortgage-backed securitiesa

—State/municipal bonds

—Commercial paper

—Corporate debt

—Agency debt

—Auction rate preferred stock

—Other

—Accrued interest receivable

Total nonmortgage investments

9,141

1,330

2,086

—

2,009b

819

—

392

243

64

$16,084

850

21,734

12,792

—b

6,192b

—b

11,239b

$52,807

69

—

—

79

—

—

—

2

—

5

—

$155

Note: The mortgage servicing portfolio includes mortgages purchased and held as on-balance

sheet assets in retained portfolio plus mortgages purchased and pooled as off-balance sheet

assets to back mortgage-backed securities. Housing enterprise repurchase agreements were

excluded from nonmortgage investments based on our understanding that such agreements are

mortgage related. Freddie Mac mortgage-related securities held for trading were also excluded.

Definitions used by the enterprises for classifying individual data elements, such as cash

equivalents and term federal funds, may not be strictly comparable.

aFor purposes of this report, Farmer Mac nonmortgage investments denote

nonagricultural-mortgage investments and include residential MBS.

bThese data elements are not individually reported.

Source: 1996 annual reports of Freddie Mac, Fannie Mae, and Farmer Mac; and information

supplied by OFHEO and Fannie Mae.

Between the end of 1996 and the end of the second quarter of 1997

(June 30, 1997), the two housing enterprises’ total assets grew (see table

24Credit rating agencies such as Standard and Poor’s rate bond issuers with ratings ranging from AAA

for the highest credit rating to CC for highly speculative. Investment grade normally means bonds that

have a credit rating of BBB or above.

Page 16 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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2). Freddie Mac’s assets grew about 5.8 percent, and Fannie Mae’s assets

grew about 4.3 percent. Both enterprises’ nonmortgage investments

remained relatively stable at about 10 percent of assets for Freddie Mac

and at about 15 percent of assets for Fannie Mae.

Farmer Mac’s assets more than doubled from $603 million at year-end 1996

to about $1.4 billion at June 30, 1997; its nonagricultural-mortgage

investments grew about sixfold—from $155 million to $931 million—and

accounted for virtually the entire increase in total assets. At June 30, 1997,

these investments totaled about 66 percent of its total on-balance sheet

assets.

Table 2: Enterprise Assets at June 30,

1997 Dollars in millions

Assets Freddie Mac Fannie Mae Farmer Mac

Total assets $184,003 $365,997 $1,408

Total nonmortgage investments 18,325 53,960 931

Nonmortgage investments as a

percentage of total assets

9.96 14.74 66.12

Source: Second quarter financial statements and information supplied by Fannie Mae.

The housing enterprises undertake nonmortgage long-term investments,

and Farmer Mac undertakes nonagricultural-mortgage long-term

investments. These longer term investments (i.e., more than 5 years)

include fixed-rate debt and variable-rate asset-backed securities (ABS).25

The three enterprises fund these investments by issuing debt and

undertaking different strategies, which are incorporated in their

investment policies, to limit interest rate risks.26 Generally, the housing

enterprises (1) match fund their fixed-rate nonmortgage

investments—they issue debt of the same maturity as the investment; and

(2) fund their variable-rate ABS with either short-term debt with the

maturity of that debt matching the reset provision (i.e., the time period

between the dates when the interest rate adjusts) in the ABS or with

variable-rate debt. Enterprise officials told us that to the extent interest

rate risks still exist after they use the above-mentioned practices, they use

hedging strategies to lessen or eliminate such risks.

25Farmer Mac’s longer term nonagricultural-mortgage investments included residential MBS.

26A risk that a financial institution faces is the risk that the interest rates will change in ways that

reduce the value of the institution’s portfolio.

Page 17 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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Housing Enterprises Say

That They Hold

Nonmortgage Investments

for Cash Management and

to Make Capital Available

to Help Fund Mortgage

Purchases

Freddie Mac officials told us that the primary purposes for holding

nonmortgage investments with maturities of under 5 years is for cash

management and to meet future anticipated demands for funding

residential mortgages. About 7 percent of Freddie Mac’s nonmortgage

investments, as of December 31, 1996, had stated maturities exceeding 5

years. However, according to Freddie Mac officials, these investments

with longer stated maturities included asset-backed securities that are

expected to be paid off, and thereby terminate, prior to their stated

maturity dates.

In March 1997, Freddie Mac created a nonmortgage investment fund to

hold securities with maturities exceeding 5 years to be generally funded by

matched maturity noncallable debt. Freddie Mac officials told us that the

primary purpose of this new fund, which is authorized to contain up to

$10 billion, is to meet future unanticipated demands for funding residential

mortgages. Freddie Mac officials told us that the amount of its other

nonmortgage investment funds, which generally have maturities under 5

years, would decline. In addition, they also made the following five points

about the longer maturity investments in the newly created fund:

• Freddie Mac would not likely sell these longer maturity nonmortgage

securities, because the fund is meant to provide a source for funding those

mortgages whose demand is unanticipated.

• If unanticipated demands for funding mortgages did occur, capital to help

support mortgage purchases could be made available by selling the

nonmortgage assets, which would be quicker than raising additional

capital.

• Longer maturity nonmortgage investments do not exhibit the prepayment

risks (i.e., the risk that borrowers would pay off their mortgages early,

thus terminating payment streams) associated with mortgages.

• Match funding these investments (i.e., issuing debt with the same maturity

of the investment) would allow Freddie Mac to access the noncallable

bond market without generating interest rate risk.

• The longer-term nonmortgage investment portfolio would help stabilize

income when necessary to counteract adverse earnings’ impact from other

forces.

Fannie Mae officials told us that the primary purposes for holding

nonmortgage investments are for cash management, as an investment

vehicle to employ capital27 not currently needed to fund mortgages that is

27Here, as earlier in this report, an investment vehicle, which could make capital available is defined as

an investment vehicle to employ capital.

Page 18 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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intrinsically appropriate for a financial corporation of its size, and to

maintain a capital cushion in excess of minimum capital requirements.

They told us that such a capital cushion enables them to respond to capital

markets and fund residential mortgages. Fannie Mae officials told us that

nonmortgage investments with maturities exceeding 5 years are a

relatively small portion of its total business. They told us that most of

these securities are asset-backed securities with variable interest rates and

that the variable rate characteristic reduces the interest rate risk

associated with fixed-rate long-term bonds and, thus, is important to its

overall safety and soundness.

Farmer Mac Makes

Nonagricultural-Mortgage

Investments Primarily to

Invest Funds From Debt

Issuance That Exceed Its

Purchases of Agricultural

Mortgages

In February 1997 Farmer Mac’s board changed its investment policies in

order to increase Farmer Mac’s presence in the capital markets,

particularly the debt markets, to help attract investors to its securities and

thereby reduce its borrowing and securitization costs. The board and

management believe that increasing Farmer Mac’s presence in the debt

markets will improve the pricing of its agricultural mortgage-backed

securities and thereby enhance the attractiveness of the products it offers

through its programs for the benefit of agricultural lenders and borrowers.

Farmer Mac officials said that although the ultimate objective of Farmer

Mac’s increased debt issuance strategy is to invest the proceeds in loans

qualifying for inclusion in its securitization and guarantee programs,

during the initial period in which Farmer Mac is increasing its debt

issuances it will be investing those proceeds in interest-earning

nonagricultural-mortgage investment assets. In commenting on a draft of

this report, Farmer Mac proposed that 2 to 3 years could serve as a

reasonable time frame within which the anticipated increased market

interest in its AMBS will occur.

FCA and OSMO officials said that Farmer Mac’s rationale for its debt

issuance strategy for enhancing the secondary market in AMBS is plausible

at this point in time. However, FCA and OSMO officials noted that the

extensive nonagricultural-mortgage asset holdings are supposed to be

temporary until Farmer Mac’s debt and AMBS costs decline to levels

comparable to those for the housing enterprises. Should Farmer Mac’s

strategy prove unsuccessful, then FCA and OSMO may revisit the

appropriateness of the existing Farmer Mac nonagricultural-mortgage

investment portfolio policy and practices. In the interim, FCA, through

OSMO, is monitoring the Farmer Mac strategy. FCA and OSMO officials said

they have set no time frame for assessing the success of the debt issuance

strategy.

Page 19 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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Nonmortgage

Investments Differ in

the Degree to Which

They Generate

Arbitrage Profits and

Relate to Mission

Enterprise officers and board members have incentives to increase

shareholder value, just as the officers and board members of private

corporations do. However, unlike private corporations, the enterprises

also have public missions stated in their charters. Thus, these enterprise

incentives can create tensions between increasing shareholder value and

fulfilling the public mission. In addition, the enterprises have opportunities

to generate arbitrage profits that can increase shareholder value and that

are not available to private corporations. Financial analysts generally

define arbitrage as profiting from differences in price when the same

security is traded on two or more markets. However, arbitrage can also

arise if securities have different yields by virtue of differences in

government-provided benefits between those securities. We are using this

latter definition of arbitrage in considering enterprise nonmortgage

investments.28 Under this definition, at least some enterprise nonmortgage

investments generate arbitrage profits. In addition to generating arbitrage

profits, nonmortgage investments can contribute to achieving the

enterprises’ missions, although shorter maturity nonmortgage investments

more clearly relate to mission than do longer maturity nonmortgage

investments. Because the enterprises can generate arbitrage profits and

because of the tension between shareholder interests and mission

achievement, it is important for the mission regulators, HUD and FCA, to

ensure that the missions of these enterprises as stated in their respective

charter acts are accomplished.

Enterprise Officers and

Board Members Have

Incentives to Increase

Shareholder Value

According to enterprise officials, the competitiveness of today’s

marketplace literally demands that the enterprises recruit and maintain

the caliber of executive officers and board members that will help ensure

that their corporations remain among the top-performing organizations.

Such action includes the construction of compensation packages that will

attract top performers and that contain incentives that will promote the

achievement of corporate objectives in addition to satisfying shareholder

interests. To ensure that they are in line with current trends, the

enterprises have used consulting firms to review and compare the pay

structure of their officers and board members with the pay structure of

comparable positions in similar private sector financial institutions and

other enterprises. Our review of published literature and other information

28Our definition of arbitrage is similar to the definition of an arbitrage bond defined in a section of the

U.S. tax code. 26 U.S.C. § 148. In this section of the tax code, the definition is in reference to state and

local governments whose funding costs are lowered by virtue of the federal income tax exemption for

interest on state and local bonds. In section 148, an arbitrage bond “means any bond issued as part of

an issue any portion of the proceeds of which are reasonably expected (at the time of the issuance of

the bond) to be used directly or indirectly (1) to acquire higher yielding investments, or (2) to replace

funds which were used directly or indirectly to acquire higher yielding investments.”

Page 20 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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on executive and board compensation the enterprises and OFHEO provided

us suggests that in today’s world, more companies are including

stock-based compensation for their directors and officers to help create an

economic alignment of director and shareholder interests. Like their

competitors, the enterprises award stock-based compensation to their

board members and senior officers with the intention of helping them to

focus on the long-term success of their corporations.

In establishing statutory authority, Congress set the tone for the

governance structure of all three enterprises—Freddie Mac, Fannie Mae,

and Farmer Mac. Each of these shareholder-owned corporations, which

also have a public mission, is governed by a board consisting of

shareholder-elected directors and appointed directors. Statutory authority

provides that the total number of directors elected by shareholders

include 13 at Freddie Mac, 13 at Fannie Mae, and 10 at Farmer Mac; each

of the enterprises must have 5 directors appointed by the president.

According to enterprise officials, the directors have the same or similar

duties and obligations as directors of other private corporations, including

fiduciary responsibilities to shareholders and the establishment of general

operation policies that govern the companies. All directors, whether

elected or appointed, share the same duties and obligations, which are

primarily carried out through participation in and preparation for board

and committee meetings. All directors of the housing enterprises serve

1-year terms unless reelected or reappointed. Appointed directors of

Farmer Mac serve at the pleasure of the president, the elected directors

serve 1-year terms.

In keeping with statutory requirements, the housing enterprises’

compensation structure is built upon a philosophy of comparability29 (i.e.,

compensation is reasonable and comparable to that of similar businesses)

and pay for performance, which includes the achievement of individual as

well as corporate-level objectives. All three enterprises have committees

that set policy and make recommendations concerning compensation.

Annual evaluations allow for salary adjustments based on merit

performance and the need to maintain market competitiveness. Board

members of all three enterprises receive cash compensation in the form of

an annual retainer and stipulated fees for attending board and committee

meetings. In addition to the cash, board members receive long-term

compensation in the form of stock and stock options (see table 3).

Similarly, in addition to their base salaries, senior managers of the

29Through its authority to prohibit excessive compensation at the housing enterprises, OFHEO is

responsible for monitoring compensation to ensure that this philosophy of reasonable and comparable

compensation is carried out.

Page 21 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

enterprises receive bonuses (which are to recognize their individual

contributions to the success of corporate goals), as well as stock and

stock options designed to ensure sustained corporate success. (See app.

II for more detailed information on the enterprises’ compensation

structures.)

Table 3: Compensation Structure for Enterprise Board Members

Board membersa Cash compensation Long-term compensation

Enterprises Elected Appointed Retainer Fees Stock Stock options

Freddie Mac 13 5 yes yes yes yes

Fannie Mae 13 5 yes yes yes yes

Farmer Mac 10 5 yes yes no yes

aFreddie Mac and Fannie Mae have three and two employee directors, respectively. These

directors are compensated in their positions as executive officers. All of Farmer Mac’s board

members are outside directors.

Source: Developed from information provided by the enterprises.

Tension Between

Increasing Shareholder

Value and Achieving

Mission

Private corporations without government sponsorship provide incentives

to their senior management and board members to take actions that will

increase profits and shareholder value. The enterprises have instituted

compensation packages that conform closely to those of private

corporations, including financial institutions, with which they compete for

individuals with specific skills. These compensation packages include

stock-based compensation strategies that have the intent of aligning the

economic interests of managers and directors with shareholder interests.30

The compensation packages that board members at the enterprises

receive do not differ according to whether the board member is

shareholder elected, presidentially appointed, or chosen by another

method. The enterprises told us that the orientation and training activities

they provide new board members do not differ according to how the board

member is selected. The enterprises also told us that board members are

instructed to advocate corporate activities that enhance shareholder value

while supporting the enterprise’s charter purposes. From our analysis, it

appears to us that compensation incentives available to enterprise senior

management and board members, including stock-based compensation,

30Fannie Mae officials emphasized the inclusion of public purpose goals in the compensation of some

senior management officials. For example, they told us that Fannie Mae’s chief executive officer’s

compensation is based, in part, on Fannie Mae’s progress in meeting its $1 trillion commitment for

mortgage purchases serving low-income and underserved borrowers. Freddie Mac officials also

indicated that compensation of some senior managers is partially tied to achievement of mission

requirements.

Page 22 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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reinforce the tension between increasing shareholder value and achieving

mission. At a minimum, stock-based compensation can affect how broadly

board members and senior managers interpret whether the corporate

activities they advocate contribute to fulfillment of mission.

Freddie Mac officials disagreed with our view that a tension exists

between increasing shareholder value and achieving mission. They told us

that the two goals were compatible and codependent. They stated that

Congress wanted a private company to fill a public purpose. With this role,

they noted that if one were to ignore the entity of the shareholder, the

public mission cannot be fulfilled. We note that short of ignoring the

interests of the shareholder, a tension exists. It is this tension that

hightlights the importance of mission oversight. Without effective mission

oversight, the incentives to use the benefits of government sponsorship to

increase shareholder value could, over time, erode the public mission. If

this were to occur, long term nonmortgage investments could become an

increasing part of the housing enterprises’ portfolios and Farmer Mac’s

temporary approach could become a permanent strategy even it it does

not enhance Farmer Mac’s ability to purchase agricultural mortgages.

Arbitrage Can Arise If

Securities Have Different

Yields by Virtue of

Differences in Government

Provided Benefits

In a previous report about the housing enterprises, we concluded that the

greatest benefit to the enterprises from government sponsorship flows

from the market perception of an implied guarantee on enterprise

obligations, because this perception generates a funding advantage—a

reduction in yields on enterprise debt.31 In that report, we indicated that

the funding advantage could be in the range of 30 to 106 basis points. This

range took into account the long-term nature of residential mortgage

investments, and it assumed that the housing enterprises would receive a

credit rating between a high of AAA and a low of A if their government

sponsorship were eliminated. Findings from our analysis of housing

enterprise financial data are consistent with this estimated funding

advantage range and with a credit rating between AA and A.32 Appendix I

contains a more detailed discussion of our analysis.

31Housing Enterprises: Potential Impacts of Severing Government Sponsorship (GAO/GGD-96-120,

May 13, 1996).

32An AA rating is higher, signifying less credit risk, than an A rating; an AA rated corporation has lower

debt costs than an A rated corporation. Therefore, the yield difference (i.e., the funding advantage)

measure between an AA corporation and the housing enterprises is smaller than between an A

corporation and the housing enterprises. Likewise, an AAA rated corporation has lower debt costs

than an AA rated corporation.

Page 23 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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In the previous report about the housing enterprises,33 we indicated that

government sponsorship of the housing enterprises lowered interest rates

on single-family, fixed-rate, conforming mortgages. Although the benefits

of government sponsorship reduce certain mortgage interest rates, there is

no similar effect on the yields of nonmortgage investments, because the

enterprises are not a significant source of funding outside the residential

mortgage market. Thus, there is an additional incentive for the enterprises

to issue debt, whose yield is lower by virtue of government sponsorship, to

invest in nonmortgage investments, whose market yields will be relatively

higher because they are not affected by government sponsorship.

Farmer Mac is a government-sponsored enterprise that also benefits from

the market perception of an implied guarantee on enterprise obligations. It

is, however, a much smaller and less established corporation than either of

the housing enterprises. As a result, it is difficult to estimate Farmer Mac’s

funding advantage. For example, we do not know whether it could remain

in business without government sponsorship or what its credit rating

would be if it became a going concern as a private corporation without

government sponsorship. If its credit rating without government

sponsorship would be less than A, its funding advantage from government

sponsorship could be greater than the advantage for the housing

enterprises. However, Farmer Mac’s securities may be currently perceived

by market participants as more risky than housing enterprise securities.

Farmer Mac documents provided to us in July 1997 indicated that yields

on Farmer Mac debt had been between 1 and 10 basis points higher than

yields on equivalent housing enterprise debt prior to Farmer Mac’s new

debt issuance strategy, and these yield differences had not yet been

eliminated by Farmer Mac’s debt issuance strategy.34

Of the specific nonmortgage investments made by the enterprises, public

information is available on one investment that generated arbitrage profits;

this investment was in Phillip Morris bonds purchased by Freddie Mac.

The Phillip Morris bonds, which had an A rating, were purchased by

Freddie Mac and were funded by Freddie Mac bonds with the same

maturity. The yield difference was slightly over 60 basis points. Freddie

Mac officials told us that its nonmortgage investment fund holding

securities with maturities exceeding 5 years is authorized to contain up to

33GAO/GGD-96-120, May 13, 1996.

34In response to our inquiry, Farmer Mac’s Wall Street traders, at Farmer Mac’s direction, prepared

estimates of yield spreads between Farmer Mac and housing enterprise debt. The estimated yield

spreads generally were between 1 and 10 basis points.

Page 24 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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$10 billion.35 Applying, as an example, an interest rate differential of 60

basis points, a $10 billion fund could generate as much as $60 million

annually in arbitrage profits. If a similar 60-basis-point differential were

applied to Farmer Mac nonagricultural-mortgage investments with

maturities exceeding 5 years, arbitrage profits would represent about

$3.2 million.36

We did not make an overall estimate of arbitrage profits, in part because of

difficulties in estimating the funding advantage. For the housing

enterprises, we have good estimates for the funding advantage on longer

term investments in fixed-rate debt that are match funded. These

enterprises hold nonmortgage investments in variable-rate ABS with stated

maturities of over 5 years. The enterprises told us that many of these

securities have expected maturities of less than 5 years due to borrower

prepayments, and we do not have good estimates for the funding

advantage on these investments. We also do not have good estimates for

the funding advantage on short-term investments. From our review of

variable-rate ABS and short-term investments made by the housing

enterprises, however, it appears that the funding advantage associated

with government sponsorship is lower for these investments than for

longer term, fixed-rate nonmortgage investments.

Shorter Term Investments

Relate to the Housing

Enterprises’ Missions

The public purposes of the housing enterprises, as specified in their

respective federal charters, include providing stability in the secondary

market for residential mortgages and responding appropriately to the

private capital market. Enterprise purchases of residential mortgages

directly contribute to mission achievement. As a general matter, the

housing enterprises said they also take actions they think position them to

serve their respective markets under different financial market conditions

as well as different conditions affecting the residential mortgage market.

The housing enterprises state that their nonmortgage investment holdings

allow them to respond appropriately to capital markets and fund

residential mortgages during different market conditions. They also

emphasize that the yields on their nonmortgage investments are lower

than the yields on their mortgage investments.

Our analysis of the housing enterprises’ nonmortgage investments

indicated that overall, the yields on such investments are lower than on

35Freddie Mac officials told us that its forecasted level for year-end 1997 holdings in the fund is $2

billion.

36As of June 30, 1997, Farmer Mac held $536 million in longer term, variable-rate,

nonagricultural-mortgage investments.

Page 25 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

their mortgage investments. For example, in 1996 Freddie Mac’s average

interest rate on cash and nonmortgage investments was 5.55 percent, and

on mortgages it was 7.46 percent. The respective interest rates for Fannie

Mae in 1996 were 5.68 percent on nonmortgage investments and cash

equivalents and 7.71 percent on mortgages. The general preponderance of

short-term investments in the enterprises’ nonmortgage investments

accounts for the lower overall yield on these investments compared to

mortgage investments. Our analysis of these short-term nonmortgage

investments, such as term federal funds, indicates that they have a clear

relationship to mission in enhancing liquidity, thereby allowing the

enterprises to fund residential mortgages during different market

conditions. In addition, even though they might also generate arbitrage

profits, they are not the primary vehicle through which the housing

enterprises would attempt to generate arbitrage profits. Likewise, since

the yields from these investments are low relative to long-term

nonmortgage investments, it is not likely that the volume of short-term

nonmortgage investments would be substantially affected by the tension

between increasing shareholder value and achieving mission, because

these investments have lower yields than mortgage investments.

Long-Term, Fixed-Rate

Nonmortgage Investments

by the Housing Enterprises

Generate Arbitrage Profits,

and Their Relationship to

Mission Is Less Clear

Freddie Mac officials indicated that nonmortgage investments are an

integral tool for carrying out its housing finance mission and are held for

three principal reasons: (1) cash management purposes; (2) as an

investment vehicle that could make capital available (i.e., to employ

capital) to help fund future anticipated demand to fund residential

mortgages; and (3) as an investment vehicle to employ capital for future

unexpected demand to fund residential mortgages. Freddie Mac created a

fund in March 1997, which it calls its core fund, to invest in securities with

maturities exceeding 5 years to be funded by matched maturity

noncallable debt. The main stated purpose for the core fund is to have

capital employed in case it becomes necessary to fund unexpected

mortgage demand. Although Freddie Mac does not expect to liquidate core

fund investments, Freddie Mac officials told us that liquidation could

occur to fund purchases of residential mortgages if a decline in interest

rates triggered a substantial increase in mortgage prepayments or if a

major mortgage dealer or investor failed. The officials also said that raising

capital to fund unexpected mortgage demand could take up to 4 months,

and therefore it was important to have capital employed in investments

that could quickly be liquidated in case such funds became necessary.

Page 26 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

Our analysis focused on alternative mechanisms available to Freddie Mac

for funding unexpected mortgage demand. We asked Freddie Mac officials

if they were able to supply the necessary liquidity in 1993, when declining

mortgage interest rates caused the highest level of mortgage prepayments

in history, by using financing techniques that did not rely on liquidation of

long-term investments. The officials told us that the enterprises were able

to serve the market by funding purchases of residential mortgages, but this

particular experience was not a guarantee for the future. It is worth noting

that mortgage prepayments reduce the level of the enterprises’

outstanding MBS held by investors; therefore, investment funds to fund

newly refinanced mortgages are made available from investors who

purchase housing enterprise MBS. Thus, in this situation MBS issuance could

provide necessary liquidity without reliance on liquidation of core fund

investments.

We agree that the potential failure of a major mortgage dealer or investor

could bring about a need for additional liquidity in the mortgage market.

However, Freddie Mac has a number of vehicles to provide liquidity, such

as use of proceeds from maturing short-term nonmortgage investments to

purchase residential mortgages, which in turn can be funded by issuance

of MBS. Freddie Mac could also issue MBS backed by on-balance sheet

holdings of residential mortgages, thereby reducing required capital to

support its mortgage servicing portfolio. Such an action would make a

capital cushion available to support funding of the unexpected mortgage

demand, because the enterprises do not have to hold as much capital to

finance off-balance sheet compared to on-balance sheet mortgage assets.37

Fannie Mae officials indicated that nonmortgage investments are held for

three principal reasons: (1) cash management purposes, (2) as an

investment vehicle to employ capital that is intrinsically appropriate for a

financial corporation of its size, and (3) to maintain a capital cushion in

excess of minimum capital requirements. Fannie Mae’s nonmortgage

investments with maturities exceeding 5 years are mostly asset-backed

securities (ABS) with variable interest rates. The market value of the longer

term ABS does not fluctuate as much as the market value of long-term

fixed-rate securities, because most of the ABS have variable interest rates.38

37Currently, the housing enterprises are subject to minimum capital standards that are computed on

the basis of capital ratios. The two capital ratios relevant to this discussion are (1) 2.50 percent of

aggregate on-balance sheet assets and (2) 0.45 percent of the unpaid principal balance of outstanding

MBS.

38The market value of the longer term ABS, however, may fluctuate more than the market value of

short-term nonmortgage investments.

Page 27 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

 Therefore, at times Fannie Mae has sold ABS to finance mortgage

purchases. This activity is consistent with how Fannie Mae employs its

short-term nonmortgage investments. In addition, according to our review

of variable-rate ABS investments by all three enterprises, it appears that the

funding advantage associated with government sponsorship is lower for

these instruments compared to long-term, fixed-rate nonmortgage

investments. Nonetheless, some arbitrage profits are generated from these

investments. Therefore, the ABS investments appear to have characteristics

that differ somewhat from other nonmortgage investments in two

dimensions. First, they appear to be somewhat related to mission, because

they are more liquid than fixed-rate long-term investments but less liquid

than short-term nonmortgage investments. However, fluctuations in the

market value of ABS, in relation to short-term nonmortgage investments,

can reduce their effectiveness in providing liquidity. Second, they appear

to generate arbitrage profits, although at a lower level than other

fixed-rate long-term nonmortgage investments.

Arbitrage Profits Could

Represent a Potential

Source of Funds for

Targeted Housing

Mortgage Programs

In addition to the contribution to mission goals and the generation of

arbitrage profits already presented, there is an additional potential

mission-related rationale for holding nonmortgage investments where the

investment merely provides a potential source of resources that can be

used to fund targeted housing mortgage programs.

Such a rationale appears to be consistent with one offered by HUD in its

analysis of the housing enterprises’ retained mortgage portfolios. HUD’s

report on privatization39 concluded: “Full privatization would reduce the

GSEs’ portfolio operations. This would not have a major impact on the

mortgage market because the MBS market is now well-developed and is an

effective mechanism for allocating interest rate risk.” HUD also concluded,

however: “Most GSE earnings come from their portfolio operations.

Without the cushion of a highly profitable portfolio, the fully privatized

GSEs would reduce their funding of the more risky affordable loans, unless

these loans started carrying much higher interest rates.”40

39HUD, Privatization of Fannie Mae and Freddie Mac: Desirability and Feasibility (July 1996), page 15.

40Ibid. p. 105.

Page 28 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

Farmer Mac’s

Nonagricultural-Mortgage

Investments Generate

Arbitrage Profits:

Relationship to Mission Is

Uncertain

Farmer Mac’s first year with positive net income was 1996. Net income has

grown during the first two quarters of 1997 as Farmer Mac initiated its

debt issuance strategy. Currently, over half of its on-balance sheet asset

holdings are in investments other than agricultural mortgages.

Government sponsorship of Farmer Mac lowers its debt costs, generating

arbitrage profits from such investments. In its semiannual report to the

House and Senate Agriculture Committees transmitted in April 1997, FCA

notes that Farmer Mac can operate at a profit even if its core business

does not expand, as long as it can borrow funds at lower rates than it can

earn on investments. Farmer Mac’s strategy appears to be unique, not at all

similar to the strategies followed by the housing enterprises over the

course of their development, which makes it more difficult to determine

whether the debt issuance policy will help Farmer Mac achieve its mission.

It appeared to us that Farmer Mac’s debt issuance strategy would logically

operate by allowing Farmer Mac to profitably price agricultural mortgage

purchases so that originators would expect higher returns by selling rather

than retaining mortgages in their own portfolios. For example, if the debt

issuance strategy lowered funding costs for Farmer Mac on its AMBS,

Farmer Mac might be able to pay mortgage originators higher prices for

agricultural mortgages and remain profitable. Farmer Mac officials also

told us that their investments in agricultural mortgages have higher returns

than those for its nonagricultural-mortgage investments. Based on this

observation by the Farmer Mac officials, it appeared to us that Farmer

Mac may be able to pay mortgage originators higher prices than it

currently does for agricultural mortgages and remain profitable in this

mission-related segment of its business. We asked the Farmer Mac

officials why Farmer Mac does not, therefore, price its agricultural

mortgage purchases more favorably for mortgage originators to help this

mission-related business expand. Farmer Mac officials stressed other

strategies it is pursuing, such as outreach efforts with agricultural

mortgage originators. We are uncertain as to whether Farmer Mac’s debt

issuance strategy will contribute to mission achievement, because Farmer

Mac’s debt issuance strategy intends to lower funding costs to purchase

agricultural mortgages and issue AMBS. Farmer Mac might become better

able to spend funds to recruit mortgage originators and pay mortgage

originators higher prices for agricultural mortgages while remaining

profitable in its mission-related business if its AMBS costs declined.

However, Farmer Mac already appears to have the ability to spend more

funds for such purposes than it does currently.

Page 29 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

Conclusions Our analysis indicates that in establishing GSEs, Congress has followed the

rationale of focusing GSE activity on specific sectors of the economy.

Freddie Mac, Fannie Mae, and Farmer Mac have federal charters that

specify the purposes of each enterprise and provide the enterprises with

broad authorities as private corporations to manage their day-to-day

business operations, including their investment policies.

The enterprises’ charters also direct them to fulfill specific public

missions. The enterprises have mission regulators with general regulatory

authorities that are charged with ensuring that the missions of these

enterprises are being fulfilled. We agree with a recent HUD evaluation that

it could use its general regulatory authority to potentially limit

nonmortgage investments. HUD has begun a rulemaking effort intended to

develop regulations governing nonmortgage investments by the housing

enterprises to help ensure that such investments are related in some

fashion to mission achievement. We agree that this effort can help HUD

develop criteria to determine the extent to which various nonmortgage

investments are mission related. Although FCA could use its general

regulatory authority over nonagricultural-mortgage investments by Farmer

Mac to help ensure that such investments are related in some fashion to

Farmer Mac’s mission achievement, it has not established a procedure for

doing so. To date, neither HUD nor FCA has developed specific criteria to

determine whether enterprise nonmortgage investments are consistent

with mission achievement.

The enterprises have investment policies that specify permissible credit

ratings, maturities, and concentration limits and describe the relationship

of investments to earnings and to achievement of mission. The enterprises

have incentives as private corporations to increase shareholder value;

these incentives create a tension with achievement of the missions stated

in the federal charters of the enterprises. It is this tension that hightlights

the importance of mission oversight. Without effective mission oversight,

the incentives to use the benefits of government sponsorship to increase

shareholder value could, over time, erode the public mission. If this were

to occur, long term nonmortgage investments could become an increasing

part of the housing enterprises’ portfolios and Farmer Mac’s temporary

approach could become a permanent strategy even if it does not enhance

Farmer Mac’s ability to purchase agricultural mortgages.

Government sponsorship of the enterprises lowers their debt costs, and

they can therefore generate arbitrage profits (i.e., profits resulting from

their funding advantage) by investing in nonmortgage assets. The various

Page 30 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

nonmortgage investments appear to fall along a continuum representing

the degree to which they relate to the housing enterprises’ missions. On

one end are short-term nonmortgage investments, such as term federal

funds, which facilitate liquidity although they might also generate

arbitrage profits. On the other end are longer term investments that

generate arbitrage profits, but they are less clearly related to the

enterprises’ missions in facilitating liquidity in the secondary market,

because fluctuations in their market value reduce their usefulness in

responding to changes in capital and mortgage products.

At this time, it is not clear whether Farmer Mac’s debt issuance strategy

will eventually help it expand purchases of agricultural mortgages in

fulfillment of its mission. Given the uncertainty of when, or if, the Farmer

Mac strategy will be successful, FCA has the responsibility to monitor

Farmer Mac’s strategy to help ensure that the nonagricultural-mortgage

investments, which are a primary source of its earnings, are related in

some fashion to Farmer Mac’s mission achievement. Farmer Mac’s

strategy appears to be unique, not at all similar to the strategies followed

by the housing enterprises over the course of their development. In

presenting this strategy, Farmer Mac officials told us that the strategy’s

contribution to mission achievement should develop over a reasonable

period of time.

Recommendations To provide more focused oversight of the housing enterprises’

nonmortgage investments, we recommend that the Secretary of HUD

promptly implement HUD’s stated intention to develop criteria through

appropriate rulemaking processes to help ensure that the housing

enterprises’ nonmortgage investments are consistent with the purposes

expressed in their charter acts. We also recommend that the Chairman of

the FCA Board direct OSMO to develop the requisite criteria and report

periodically, such as through its semiannual reports to the House and

Senate Agriculture Committees, on the relationship of Farmer Mac’s debt

issuance strategy to the achievement of Farmer Mac’s mission.

Matters for

Congressional

Consideration

To help ensure that the enterprises’ nonmortgage investments

appropriately support their public missions, the appropriate congressional

committees may wish to monitor HUD and FCA actions to establish criteria

and procedures for carrying out their general regulatory authorities. Such

oversight is important to help ensure that corporate incentives to increase

shareholder value do not erode the enterprises’ public mission. If adequate

Page 31 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

progress is not made in a timely way, Congress may wish to consider

providing further guidance to the regulatory agencies.

Agency Comments

and Our Evaluation

We received comments on a draft of this report from each of the three

enterprises, HUD, OFHEO, FCA, and Treasury (see apps. III through IX).

Appendixes III, IV, V, VI, and VIII also contain additional responses to

specific comments by Freddie Mac, Fannie Mae, Farmer Mac, HUD, and

FCA. Farmer Mac, OFHEO, FCA, and Treasury provided technical comments

that were incorporated in the report where appropriate.

The three enterprises agreed with our finding that the enterprises have

broad investment authority and noted our acknowledgement that the

safety and soundness regulators have determined that the enterprises’

nonmortgage investment portfolios do not raise safety and soundness

concerns. However, the enterprises raised a number of concerns and

disagreed with some of our major findings pertaining to the relationship of

nonmortgage investments to mission achievement, arbitrage profits, and

the tension between increasing shareholder value and achieving mission.

Based on Freddie Mac’s disagreement with our findings, it did not concur

with our recommendation to HUD. Although Farmer Mac disagreed with

some of these findings, it agreed with our recommendation to FCA. HUD,

OFHEO, FCA, and Treasury also provided comments, some of which focused

on the three major issues raised by the enterprises.

Relationship of

Nonmortgage Investments

to Mission

Concerning the relationship of nonmortgage investments to mission

achievement, Freddie Mac said (see app. III) that our draft report made the

erroneous assertion that long-term nonmortgage investments are fairly

illiquid, and this assertion provided the basis for our questioning the role

of nonmortgage investments in mission achievement. As shown in

appendix IV, Fannie Mae raised the concern that we had a “brief and

somewhat unclear presentation of how Fannie Mae views the role of

nonmortgage investments in capital management.”

In response to Freddie Mac’s comments, we clarified our discussion of the

role of the various nonmortgage investments in facilitating liquidity in the

secondary market for residential mortgages. Many of the housing

enterprises’ intermediate and longer term nonmortgage investments have

broad and deep markets that make them readily marketable or liquid in

the sense that they can be sold without substantial loss in market value.

However, longer term investments are less liquid than shorter term

Page 32 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

investments in the sense that their market values are subject to larger

fluctuations with changes in interest rates. These fluctuations can reduce

their usefulness in responding to changes in capital and mortgage markets

and facilitating liquidity in the residential mortgage market at a particular

point in time, because their market values can be less than their original

values when liquidation may be warranted. Therefore, we did not change

our conclusion that the relationship between longer term nonmortgage

investments and mission achievement is less clear than that for short-term

nonmortgage investments.

In response to Fannie Mae’s comments, we supplemented our discussion

of Fannie Mae’s primary purposes for holding nonmortgage investments to

include maintaining a capital cushion in excess of minimum capital

requirements. We note, however, that this purpose overlaps with the other

purposes we cite in our report—cash management and providing a capital

cushion to respond to capital markets and fund residential mortgages

(thus facilitating liquidity). Beyond these purposes, Fannie Mae appears to

emphasize the role of nonmortgage investments in Fannie Mae’s earnings

and capital management as well as attention to safety and soundness

concerns. This emphasis is consistent with Fannie Mae’s purposes for its

investment portfolio as stated in its annual report,41 which are to

contribute to corporate profitability, serve as a source of liquidity, and

provide a return on the excess capital of the corporation. This argument

by Fannie Mae, however, does not demonstrate a relationship between

nonmortgage investments and mission achievement beyond the

relationship already established in our report.

Concerning the relationship of nonmortgage investments to mission

achievement and regulatory oversight, HUD said (see app. VI) that our

report fairly characterizes the issues, constraints, and ambiguities involved

in overseeing the housing enterprises’ nonmortgage investment activities.

HUD agreed with, and said it has begun to implement, our recommendation

to the Secretary of HUD. OFHEO (see app. VII) stated that it is appropriate

for Congress to monitor nonmortgage investments at the enterprises and

that Congress may wish to provide more specific guidance to the

regulatory agencies regarding the appropriate range of investment

activities.

Farmer Mac (see app. V) agreed with our finding that FCA has the

responsibility to monitor Farmer Mac’s strategy to help ensure that the

nonagricultural-mortgage investments are related in some fashion to

411996 Fannie Mae Annual Report, page 30.

Page 33 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

Farmer Mac’s mission achievement and our recommendation to the

Chairman of the FCA Board containing an FCA reporting requirement.

However, Farmer Mac took issue with our finding that its debt issuance

strategy and related investment activities may not be mission related. In

particular, Farmer Mac stated that we implied that its debt issuance

strategy will not work because we stated that the strategy is unique.

Farmer Mac also stated that this strategy, by lowering funding costs, can

make funds available to recruit new mortgage originators. In addition,

Farmer Mac provided a detailed description of its debt issuance policy,

how it is expected to lower funding costs, and how the corporation sees

the policy as linked to achievement of its mission.

In response to Farmer Mac’s comments, we made revisions to clarify

Farmer Mac’s position on its debt issuance strategy to include the

potential for making more funds available to recruit new mortgage

originators. We also added clarifying language to indicate that our

characterization of Farmer Mac’s debt issuance strategy as unique was

included as one of several reasons why it is hard to determine whether the

debt issuance policy will be effective in helping Farmer Mac achieve its

mission.42

FCA said (see app. VIII) that our draft report contains a fair representation

of Farmer Mac’s investment activity and FCA’s views with respect to that

activity. FCA appears to show some support for our recommendation to the

Chairman of the FCA Board to report on the relationship of Farmer Mac’s

debt issuance strategy to the achievement of Farmer Mac’s mission.

However, it is not clear whether this willingness to report is limited to

reporting on safety and soundness matters or includes issues of mission

regulation. In addition, FCA said that it does not currently have any

activities under way that are expected to culminate in regulation of the

investment portfolio. In response to FCA’s comments, we revised our

recommendation to the Chairman of the FCA Board to state that requisite

criteria should be developed to assess and report on the relationship of

Farmer Mac’s debt issuance strategy to the achievement of Farmer Mac’s

mission.

Treasury said (see app. IX) that we identified some of the important policy

issues raised by the investment practices of the enterprises. Treasury

stated that it agrees with our recommendation that the enterprises’

42Here we note that in Farmer Mac’s third quarter 1997 SEC filing, Farmer Mac reported: “Loan volume

has not been increasing as rapidly as management anticipated following the enactment of its revised

legislative authorities due, in part, to the longer than expected lead-time between marketing initiatives

and the realization of results.”

Page 34 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

mission regulators should use their general regulatory authority to limit

the enterprises’ nonmortgage investment activity. We note, however, that

our recommendation calls for the mission regulators to develop criteria to

help ensure that nonmortgage investments are consistent with the

purposes expressed in the enterprises’ charter acts.

Arbitrage Profits The second issue relates to our position that the purchase of nonmortgage

investments generates arbitrage profits. In commenting on our draft

report, Freddie Mac took issue with our definition of arbitrage and

asserted that we created a new definition of arbitrage to be responsive to

the requester’s instructions that we report on the extent to which the

enterprises have undertaken nonmortgage investments for arbitrage

profits. Freddie Mac also asserted that under our definition, any profitable

investment Freddie Mac makes would be considered arbitrage, and

therefore we have a circular argument. Freddie Mac states the general

definition of arbitrage used by financial analysts that is also stated in our

report. This general definition, however, does not consider differences in

government-provided benefits among debt issuers. Therefore, we adopted

a definition of arbitrage that is similar to the definition of an arbitrage

bond defined in a section of the U.S. tax code. The definition is in

reference to state and local governments whose funding costs are lowered

by virtue of the federal income tax exemption for interest on state and

local bonds; this definition explicitly accounts for differences in

government-provided benefits. Freddie Mac’s assertion that anything

profitable would be arbitrage according to our definition is not correct. We

note that in an integrated national financial market there would be little if

any opportunity for profit from borrowing and lending for the same time

period with no risk if no funding advantage were present. Under our

definition of arbitrage, arbitrage profit is the amount of profit on

nonmortgage investments associated with the funding advantage from

government sponsorship and not the profit resulting from either

risk-taking or good business judgement.

Treasury agreed with our conclusion that the enterprises’ long term

nonmortgage investments generate arbitrage profits and that some of the

enterprises’ short-term investments may also generate arbitrage profits.

Page 35 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

Tension Between

Increasing Shareholder

Value and Achieving

Mission

All three enterprises took issue with our conclusion that a tension exists

between increasing shareholder value and achieving mission. Freddie Mac

said our draft report suggests that there is an inherent conflict between

private ownership and Freddie Mac’s public mission, which is at odds with

legislative intent and Freddie Mac’s demonstrated record of achievement.

Fannie Mae said that although we provided a good review of the policies

underpinning its executive compensation policy, our “tension” construct

implies a conflict that is theoretical at best. Fannie Mae offered a

construct where senior management is required to achieve multiple

objectives. Fannie Mae adds: “What is unique to the enterprises is that our

mission is elevated by the Charter and enforced through oversight,

regulation and potential legal sanction. The seriousness of our mission

obligations are very clearly understood by managers, Directors and

shareholders alike.” Farmer Mac believes that there is a convergence of,

rather than a tension between, the interests of Farmer Mac’s shareholders

and mission achievement through expanded volume, because of Farmer

Mac’s early stage of development.

In our report, our finding of a tension between increasing shareholder

value and mission fulfillment points to the role of mission regulation in

helping to ensure that the purposes of the charter acts are achieved. We

recognize that Congress granted the housing enterprises federal charters

to direct them to bring private sector operating efficiencies to fulfill a

public purpose in the secondary mortgage market. Congress also granted

regulatory authorities to OFHEO to help ensure that the housing enterprises

operate in a safe and sound manner and to HUD to ensure that the purposes

of the respective charter acts are accomplished. Therefore, it appears that

Congress intended regulatory oversight to address situations in which the

private and public interests may not be aligned. Government sponsorship

of the housing enterprises has created a mechanism for the

government-provided benefits to be passed through, at least in part, in the

form of lower mortgage interest rates. Because this mechanism is not

present for nonmortgage investments, at least some of these investments

could be more profitable on a risk-adjusted basis than mortgage

investments. To the extent that profits from some nonmortgage

investments are less clearly related to mission, reasonable questions can

be raised about whether government benefits are supporting shareholder

interests at the expense of the public mission. Fannie Mae’s view explicitly

acknowledges charter restrictions, regulatory oversight, and multiple

corporate goals. Therefore, it is difficult to distinguish its view from ours,

except that Fannie Mae appears to believe that the mission has been

integrated into its corporate culture. Rather than relying solely on

Page 36 GAO/GGD-98-48 Enterprise Nonmortgage Investments
B-277819 

corporate culture, however, Congress established HUD as a regulator to

ensure that mission objectives are achieved. Farmer Mac’s debt issuance

strategy has expanded the volume of nonagricultural-mortgage

investments. Although it is clear that these investments are profitable and

affect executive compensation, it is not yet clear whether they contribute

to mission achievement.

As arranged with your office, unless you publicly announce the contents of

this letter report earlier, we plan no further distribution until 14 days after

its issue date. At that time, we will send copies to HUD; OFHEO; FCA;

Treasury; the enterprises; the Ranking Minority Member of your

Committee; the Chairman and Ranking Minority Member of the

Subcommittee on Capital Markets, Securities and Government Sponsored

Enterprises; and the Chairman and Ranking Minority Member of the

Senate Committee on Banking, Housing, and Urban Affairs. We will also

make copies available to others on request.

Major contributors to this report are listed in appendix X. Please contact

me or Bill Shear, Assistant Director, at (202) 512-8678 if you or your staff

have any questions.

Sincerely yours,

Thomas J. McCool

Director, Financial Institutions

 and Markets Issues

Page 37 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Contents

Letter 1

Appendix I 

Measuring Arbitrage

Profits

42

Appendix II 

Compensation

Structure for Board

Members and Senior

Managers

45

Appendix III 

Comments From

Freddie Mac

48

GAO Comments 59

Appendix IV 

Comments From

Fannie Mae

61

GAO Comments 66

Appendix V 

Comments From

Farmer Mac

67

GAO Comments 76

Appendix VI 

Comments From the

Department of

Housing and Urban

Development

78

GAO Comment 82

Page 38 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Contents

Appendix VII 

Comments From the

Office of Federal

Housing Enterprise

Oversight

83

Appendix VIII 

Comments From the

Farm Credit

Administration

85

GAO Comment 86

Appendix IX 

Comments From the

Department of the

Treasury

87

Appendix X 

Major Contributors to

This Report

89

General Government Division 89

Office of the General Counsel 89

Tables Table 1: Selected Financial Data for the Enterprises as of

December 31, 1996

16

Table 2: Enterprise Assets at June 30, 1997 17

Table 3: Compensation Structure for Enterprise Board Members 22

Page 39 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Contents

Abbreviations

ABS asset-backed securities

AMBS agricultural mortgage-backed securities

FCA Farm Credit Administration

GSE government-sponsored enterprise

HUD Department of Housing and Urban Development

MBS mortgage-backed securities

MPP mortgage protection plan

OFHEO Office of Federal Housing Enterprise Oversight

OSMO Office of Secondary Market Oversight

SEC Securities and Exchange Commission

S&P Standard and Poor’s

Page 40 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Page 41 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix I 

Measuring Arbitrage Profits

We are defining the term arbitrage to mean using the funding advantage

from government sponsorship to raise funds for making nonmortgage

investments. In a previous report about the housing enterprises, we

concluded that the largest enterprise benefit from government

sponsorship flows from the market perception of an implied guarantee on

enterprise obligations, because this perception generates a funding

advantage—a reduction in yields on enterprise debt.43 In that report, we

indicated that the funding advantage could be in the range of 30 to 106

basis points. This range accounted for the long-term nature of residential

mortgage investments, and it assumed that the housing enterprises would

receive a credit rating between a high of AAA and a low of A if their

government sponsorship were eliminated.

Our definition of arbitrage does not require the enterprise to match fund

its nonmortgage investments. However, our measurement of the yield

differences used to estimate arbitrage profits is based on a comparison of

debt securities with similar maturity and risk. Under this method, if the

debt securities being compared had different maturities, the yield

difference (i.e., yield spread) would reflect both the impact of government

sponsorship and the difference in interest rate risk between the debt

securities. Alternatively, if the debt securities being compared had similar

maturities and risks but differed by virtue of government sponsorship, the

yield difference would reflect the impact of government sponsorship. For

this reason, matched maturity debt provides the best measure of arbitrage,

even though arbitrage is also present when nonmortgage investments are

funded by enterprise debt with different maturities and risks.

In addition to relying on yield differences between enterprise nonmortgage

investments in corporate bonds and matched maturity enterprise debt

used to finance such investments as a measure of arbitrage, another

possible approach to measuring arbitrage is to use statistical techniques to

adjust yield differences between corporate and enterprise debt for

differences in maturity and risk. Such an approach was used in a study

commissioned by the Department of Housing and Urban Development to

evaluate the implications of severing government sponsorship of the

housing enterprises on the enterprises’ debt costs.44 The study included

analysis of yield differences between housing enterprise debt and debt

issued by different groups of corporations (i.e., the benchmark groups)

with A, AA, and AAA credit ratings. The benchmark groups were chosen

43GAO/GGD-96-120, May 13, 1996.

44Brent W. Ambrose and Arthur Warga, “Implications of Privatization: The Costs to Fannie Mae and

Freddie Mac,” in HUD, Studies on Privatizing Fannie Mae and Freddie Mac (May 1996), pp. 169-204.

Page 42 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix I 

Measuring Arbitrage Profits

on the assumption that the housing enterprises would have credit ratings

in this range if their federal charters were revoked. The analysis was

complex, because bond characteristics differ between bonds issued by the

enterprises and other issuers. Ambrose and Warga recognized how

difficult their research task was and qualified their results on the basis of

the statistical complexities.

We relied on the Ambrose and Warga study results for the period 1991

through 1994, in part, in making our estimate that the housing enterprises’

funding advantage from government sponsorship could be in the range of

30 to 106 basis points. Due to the statistical complexities of their analysis,

we concluded that their estimates lacked precision. Therefore, we used

this broad range for the funding advantage on debt.

Recently, the Standard and Poor’s (S&P) credit rating agency rated each

housing enterprise for its government risk rating, which is based on the

probability that the federal government would be called upon in the event

of an enterprise default on its obligations. Each enterprise received an AA

minus rating. S&P indicated that the rating for each enterprise still

accounted for some benefits, namely liquidity of enterprise obligations,

due to government sponsorship. If the enterprises were privatized, S&P said

that each would likely have to raise additional equity capital to maintain

an AA minus rating.

The housing enterprises fund their nonmortgage investments with

noncallable debt. Generally, the Ambrose and Warga yield spread

estimates were smaller for noncallable than for callable debt. On the basis

of the S&P credit ratings and the way the enterprises fund their

nonmortgage investments, we have concluded that the Ambrose and

Warga estimated yield spreads based on the A and AA credit ratings for

issuance of noncallable debt are most relevant for measuring arbitrage

profits. For the 1991 through 1994 period, the range of estimated yield

spreads on noncallable debt between the AA-rated companies and the

housing enterprises was 39 to 46 basis points; when the A-rated companies

were used as the benchmark, the range was 65 to 72 basis points. We

continue to support the Ambrose and Warga estimates and our estimated

range of 30 to 106 basis points for the funding advantage; findings from

our analysis of housing enterprise financial data are consistent with these

estimates.

As indicated in the body of this report, we could not estimate the funding

advantage resulting from government sponsorship for Farmer Mac.

Page 43 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix I 

Measuring Arbitrage Profits

However, we indicated qualitatively how Farmer Mac’s funding advantage

could compare to the funding advantage of the housing enterprises.

Page 44 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix II 

Compensation Structure for Board Members

and Senior Managers

The enterprises’ management and boards of directors have implemented

compensation policies designed to attract and retain individuals from

various disciplines who have the talent and motivation needed to

accomplish the corporations’ objectives. The enterprises seek to closely

link pay with performance and provide compensation that is reasonable

and comparable with compensation for employment in other similar

businesses involving similar duties and responsibilities.45 Through

committees, the enterprises’ boards of directors develop policies and

administer compensation programs that are meant to conform to the

congressional mandate.

Freddie Mac’s overall compensation package consists of both direct

compensation (i.e., cash and stock incentives) and noncash employee

benefit programs. A base salary, an annual cash bonus, and long-term

stock incentives are included in the direct compensation package. Base

salaries are determined primarily by position and individual skills and are

targeted to match the median (i.e., 50th percentile) level of the market as

determined by data obtained from comparator groups (e.g., companies

identified as being in a similar line of business) and market surveys.

Annual cash bonuses, which function as short-term incentives, are based

on a combination of individual and corporate performance and increase as

a percentage of base salary at successively higher levels of responsibility

and accountability. Long-term stock incentives are awarded to officers and

director-level employees (i.e., employees who report directly to officers or

are senior-level technical and professional employees, but not members of

Freddie Mac’s Board of Directors). For officers, long-term stock incentives

are awarded as a percentage of base salary and increase as a percentage of

base salary at successively higher levels of responsibility. The

director-level employee is awarded long-term stock incentives as a

percentage of the director-level salary grade midpoint. Freddie Mac’s

long-term stock incentives include restricted stock, which is awarded to

the corporation’s executive officers, and stock options. Examples of

noncash employee benefits offered to all regular employees include an

individually structured benefits package (i.e., health care, life insurance,

etc.); a pension plan; and an employee stock purchase plan.

Fannie Mae’s compensation package consists of a base salary, employee

benefits, annual incentives, and long-term incentives. The salary is based

on individual skills, experience, performance, etc; benefits include such

45For the housing GSEs, these considerations are set forth at 12 U.S.C. §§ 1452 (c), (h)(2) (Freddie

Mac), 12 U.S.C. §§ 1723a (d)(2), (3)(B) (Fannie Mae). There are no similar statutory provisions

covering compensation at Farmer Mac, but Farmer Mac officials told us that such factors are included

in determining officer and director compensation levels.

Page 45 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix II 

Compensation Structure for Board Members

and Senior Managers

provisions as insurance coverage, vacation pay, sick leave, and retirement.

Annual incentives reward employees for reaching specific objectives or

completing projects that enhance the corporation’s success for that year,

and long-term incentives generally reward executives for shareholder

gains and the achievement of specific corporate objectives.

Today, Farmer Mac’s salaries and other compensation components are

based on surveys of pay structures at other enterprises and other financial

institutions; however, this was not always the case. Although its salary

compensation policies were generally competitive, Farmer Mac officials

told us that other aspects of its compensation were not. In 1995, assisted

by a compensation consultant, Farmer Mac recognized the need to revise

its compensation policies to emphasize the creation of a greater

management equity stake in Farmer Mac’s future. Consequently, the

consultant helped Farmer Mac to establish a baseline compensation

package for its staff that now includes an annual salary, annual bonus to

award current-year contributions to Farmer Mac’s success, and long-term

compensation (stocks and options) to ensure that directors and senior

managers hold an equity interest in the corporation to provide the

incentive to ensure the long-term survival of Farmer Mac. Officers and

employees are also provided certain benefits, such as health and life

insurance and a pension plan.

As of December 31, 1996, Farmer Mac had 21 employees. The proportion

of Farmer Mac’s total compensation package representing incentive

compensation for the 1995-96 plan year was 26 percent for the Chief

Executive Officer and ranged between 13 percent and 19 percent for other

senior management personnel. As recommended by a consultant, a portion

of incentive compensation ranging from 67 percent to 88 percent

represented stock grants and stock option awards. Incentive

compensation was linked to the evaluation of each individual’s

performance, based on standards that included professional competence,

motivation, and effectiveness, as well as the individual’s contribution to

the implementation of strategies designed to achieve the objectives set

forth in Farmer Mac’s business plan for the 1995-96 plan year.

The purpose of Farmer Mac’s stock option plans is to encourage stock

ownership by directors, officers, and other key employees to provide an

incentive for such individuals to expand and improve the business of the

corporation and to assist Farmer Mac in attracting and retaining key

personnel. As with the other enterprises, the use of stock options is an

attempt to align the long-term interests of employees more closely with

Page 46 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix II 

Compensation Structure for Board Members

and Senior Managers

those of Farmer Mac’s stockholders by providing employees with the

opportunity to acquire an equity interest in Farmer Mac.

Page 47 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comment 1.

Now on p. 2.

Page 48 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

See pp. 5, 31,

and 32.

See p. 35.

See pp. 36-37.

Page 49 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

See pp. 5, 31

and 32.

Now on p. 5,

fn. 7.

Now on p. 5.

Now on p. 26.

Now on pp. 15

and 16.

Page 50 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

Page 51 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

See p. 35.

See comment 2.

Now on p. 27.

Page 52 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

Now on p. 20.

Page 53 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

See comment 3.

Now on pp. 5

and 20.

Now on p. 1.

Now on p. 5.

Page 54 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

See p. 36.

See comment 4.

Now on pp. 42

and 43.

See comment 5.

Now on pp. 24

and 25.

Now on p. 20.

Now on pp. 22

and 23.

Page 55 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

Page 56 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

Page 57 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

See pp. 5, 31,

and 32.

See pp. 36

and 37.

Page 58 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

The following comments represent our response to specific comments

made on a draft of this report on January 12, 1998, by the Chairman and

Chief Executive Officer of Freddie Mac.

GAO Comments 1. Freddie Mac said that we calculate nonmortgage assets as a percentage

of on-balance sheet assets and that this exaggerates the size of

nonmortgage investments in relation to Freddie Mac’s total

mortgage-related activities. We calculate nonmortgage investments as a

percentage of (1) on-balance sheet assets; (2) total mortgage servicing

portfolio; and (3) capital (i.e., corporate equity). The second measure

captures Freddie Mac’s total mortgage-related activities. The second

measure is relevant if the sole purpose of the nonmortgage investments is,

by definition, to support the total mortgage servicing portfolio. However,

we provide the first and third measures because of their relevance in cases

where the relationship of nonmortgage investments to mission is not clear.

For example, both measures are relevant for comparisons among different

corporations competing in the financial services industry.

2. Freddie Mac stated that its debt and MBS markets are not immune from

disruption and states the example, “. . . should secondary market investors

begin to sell large amounts of long-term mortgage-backed securities, the

‘spreads’ on these securities against Treasury bond benchmarks would

widen (. . . perhaps significantly).” Freddie Mac added that it could only

make matters worse in this environment by issuing new MBS. Freddie Mac

does not specify the economic conditions that would cause investors to

sell large amounts of MBS so that the value of MBS relative to Treasury

securities would fall, while at the same time there would be such an

unexpected surge in mortgage demand that would require liquidation of

core fund investments. During the course of our assignment, we asked

Freddie Mac to provide analyses indicating the economic conditions that

would require sales of nonmortgage investments from the core portfolio to

purchase mortgages. With respect to the examples Freddie Mac provided,

in our report we analyzed alternative mechanisms available to Freddie

Mac for funding unexpected mortgage demand. These alternatives have

been successfully employed by the housing enterprises in the past to meet

their charter responsibilities. (See pp. 26-27.)

3. Freddie Mac takes issue with our definition of arbitrage, which is

similiar to the definition of an arbitrage bond in the U.S. tax code. It said:

“In the municipal bond context, however, Congress disapproved what it

viewed as the inappropriate conversion of federal Treasury securities into

Page 59 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix III 

Comments From Freddie Mac

municipal bonds, the proceeds of which were never applied for any

legitimate governmental purposes. Freddie Mac’s nonmortgage

investments, in contrast, directly serve our statutory purposes of providing

liquidity and stability to the mortgage market.” Here, we again note that

the relationship between the various nonmortgage investments and

mission achievement is less clear for the longer term than the shorter term

nonmortgage investments. Therefore, we have concluded that the analogy

to municipal bonds in defining arbitrage is appropriate.

4. Freddie Mac disagrees with our use of the range of 30 to 106 basis points

to represent the housing enterprises’ funding advantage on debt. Freddie

Mac’s comments and our response appear in the previous GAO report

establishing this range.46 In its comment letter in this report, it cited its

analysis of the yield spread on 5-year bullet debt between housing

enterprise debt and debt of A and AA rated companies to illustrate Freddie

Mac’s disagreement with our range. Freddie Mac also noted that the data

upon which this range was established are from the 1991 to 1994 time

period. We first became aware of the Freddie Mac analysis when it was

submitted for the record at congressional hearings on July 31, 1996, after

we completed our previous (i.e., privatization) study identifying the 30- to

106-basis-point range. Although we have not thoroughly analyzed the

methodology (including its emphasis on 5-year debt rather than debt

issues with longer maturities) or data relied upon in the Freddie Mac

analysis, we note that the findings on yield spreads from the Freddie Mac

analysis are in the vicinity of the bottom of our range (see reference to the

36-basis-point average cited by Freddie Mac). In addition, our findings

from our analysis of housing enterprise financial data during this

assignment are consistent with the estimated funding advantage range we

established in our previous report and rely upon in this report. The

housing enterprise financial data and the Standard and Poor’s credit

ratings we relied upon for our analysis during the course of this

assignment are more recent than the data relied upon in the Freddie Mac

analysis.

5. Freddie Mac disagreed with our “draft report’s estimates of potential

arbitrage profits based on an assumed portfolio that is nearly 17 times

larger than Freddie Mac’s current longer-term nonmortgage investments.”

We provide this estimate as an example of how much a $10 billion fund,

the authorized level for Freddie Mac’s core fund, can generate in arbitrage

profits. We also make reference to the $2 billion forecasted level for

year-end 1997 holdings in the core fund.

46GAO/GGD-96-120, May 13, 1996, pages 49-53.

Page 60 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IV 

Comments From Fannie Mae

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 61 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IV 

Comments From Fannie Mae

See pp. 32 and 33.

See comment 1.

Page 62 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IV 

Comments From Fannie Mae

See pp. 36 and 37.

Page 63 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IV 

Comments From Fannie Mae

See comment 2.

Page 64 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IV 

Comments From Fannie Mae

Now on p. 2.

Now on p. 10.

Now on p. 16.

Page 65 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IV 

Comments From Fannie Mae

The following comments represent our response to specific comments

made on a draft of this report on January 12, 1998, by the Vice President

for Regulatory Activities at Fannie Mae.

GAO Comments 1. Fannie Mae stated that the yield on the longer term investments is less

than that of mortgage investments. This simple yield comparison does not

take into account the risks, in particular interest rate and prepayment

risks, that accompany residential mortgage investments. Our report states

that government sponsorship of the housing enterprises lowers yields on

single-family, fixed-rate, conforming mortgages. This mechanism is not

present for nonmortgage investments. Therefore, we conclude that on a

risk-adjusted basis, some nonmortgage investments are more profitable

than mortgage investments.

2. Fannie Mae said that we should amplify “the degree to which the

corporation incents and holds management accountable for meeting

mission obligations.” We did not review contracts of individual managers

and members of Fannie Mae’s Board. Because of the proprietary nature of

the information, we could not have provided concrete examples to make

such an amplification.

Page 66 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 67 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

See comment 1.

Page 68 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

Now on pp. 29 and 31.

See p. 25, fn. 36.

Page 69 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

Page 70 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

Page 71 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

See comment 2.

Page 72 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

Now on p. 29.

See comment 3.

Now on p. 31.

See comment 4.

Page 73 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

Now on p. 4.

Now on p. 5.

See p. 31.

See comment 5.

Now on pp. 20-22.

Now on pp. 45-47.

Now on p. 31.

Page 74 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

GAO note:

We did not

reproduce

the

appendix

Page 75 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

The following comments represent our response to specific comments

made on a draft of this report on January 12, 1998, by the President and

Chief Executive Office of Farmer Mac.

GAO Comments 1. Farmer Mac stated that long-term investments with short-term interest

rate resets are generally considered to have short-term liquidity. We have

concluded from our analysis that Farmer Mac’s longer term, variable-rate,

nonagricultural-mortgage investments are subject to greater market value

fluctuations with changes in interest rates than short-term investments. As

a result, they are less useful in facilitating liquidity in the agricultural

mortgage market than short-term investments.

2. Farmer Mac suggested that a reasonable time frame for reaching the

final stage of its debt issuance strategy could be 2 to 3 years following

adoption of the strategy. As far as we know, this is the first time a time

frame has been suggested as a reasonable period of time for the debt

issuance policy to contribute to mission.

3. Farmer Mac took issue with our observation that Farmer Mac’s debt

issuance strategy, which intends to lower the funding costs to purchase

agricultural mortgages and issue AMBS, appears to us to contradict, at least

in part, our observation that Farmer Mac has not offered higher prices for

agricultural mortgages. Farmer Mac states that the agricultural mortgage

origination market is currently very inefficient, and therefore Farmer Mac

is directing funds made available by the debt issuance strategy toward

expanded efforts to recruit new mortgage originators. We revised our

discussion (see page 29) and, rather than referring to a possible

contradiction, we now directly relate these observations to the uncertainty

associated with the effectiveness of Farmer Mac’s debt issuance strategy

on mission achievement.

4. Farmer Mac said that it agrees with our recommendation to the FCA

Board to report on the relationship of Farmer Mac’s debt issuance strategy

to the achievement of Farmer Mac’s mission. Its letter added that FCA

already monitors Farmer Mac’s investment activity. We note, as indicated

in our report, that FCA’s monitoring of Farmer Mac’s investment activity

has focused on matters of safety and soundness. Our recommendation is

specific to FCA’s mission oversight responsibilities.

5. Farmer Mac said that for the quarter ended June 30, 1997, Farmer Mac’s

net income from nonprogram investments represented about 38 percent of

Page 76 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix V 

Comments From Farmer Mac

total net income. In response, we made revisions (see pp. 5 and 31) and

now state that nonagricultural-mortgage investments are a primary source

of income rather than the principal source or majority of income.

Page 77 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VI 

Comments From the Department of Housing

and Urban Development

Note: GAO’s comment

supplementing those in the

report text appears at the

end of this appendix.

Page 78 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VI 

Comments From the Department of Housing

and Urban Development

See comment 1.

Now on p. 14.

See p. 14.

Page 79 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VI 

Comments From the Department of Housing

and Urban Development

See pp. 14 and 15.

Now on p. 14.

Now on p. 14.

Now on p. 11.

Page 80 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VI 

Comments From the Department of Housing

and Urban Development

Now on p. 11.

GAO note:

We did not

reproduce the

enclosure.

Page 81 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VI 

Comments From the Department of Housing

and Urban Development

The following comment represents our response to a specific comment

made on a draft of this report on January 16, 1998, by the Assistant

Secretary for Housing-Federal Housing Commissioner at HUD.

GAO Comment 1. HUD took exception to our characterization of the expertise issue in

HUD’s approval of MPP. In particular, HUD’s comment letter stated that some

statements in our draft report appear to be based on misunderstandings of

statements made by HUD staff. HUD stated that HUD did not possess detailed

knowledge of the intricacies of the life insurance industry at the time MPP

was submitted for review. However, HUD also stated that it concluded it

was unnecessary to provide MPP materials to Treasury because HUD had

obtained sufficient information and analysis to complete its work. HUD said

that this conclusion, rather than a HUD determination that it could not

share the contents of the MPP proposal due to a potential conflict of

interest within Treasury, formed the basis for not providing MPP materials

to Treasury. We made revisions to our report (see pages 13-15) and state

HUD’s position as described in its comment letter.

Page 82 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VII 

Comments From the Office of Federal

Housing Enterprise Oversight

Page 83 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VII 

Comments From the Office of Federal

Housing Enterprise Oversight

Page 84 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VIII 

Comments From the Farm Credit

Administration

Note: GAO’s comment

supplementing those in the

report text appears at the

end of this appendix.

Now on pp. 9-13.

See comment 1.

See pp. 9

and 30.

Page 85 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix VIII 

Comments From the Farm Credit

Administration

The following comment represents our response to a specific comment

made on a draft of this report on January 6, 1998, by the Chairman and

Chief Executive Officer of the FCA Board.

GAO Comment 1. FCA stated that discussion on pages 9 through 13 of our draft report

indicated a misunderstanding of its past and current thinking and position,

namely that FCA has clear safety and soundness authority and has

concluded that no safety and soundness concerns exist at Farmer Mac.

These FCA positions had been expressed in a previous section of the draft

report dealing with safety and soundness oversight. The section FCA

discusses relates to FCA’s general regulatory authority. In response to FCA’s

comment, we added some clarifying language to our discussion on FCA’s

general regulatory authority.

Page 86 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IX 

Comments From the Department of the

Treasury

Page 87 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix IX 

Comments From the Department of the

Treasury

Page 88 GAO/GGD-98-48 Enterprise Nonmortgage Investments
Appendix X 

Major Contributors to This Report

General Government

Division

William B. Shear, Assistant Director

Marion L. Pitts, Evaluator-in-Charge

James R. Black, Senior Evaluator

Edward S. Wroblewski, Senior Evaluator

Office of the General

Counsel

Paul G. Thompson, Senior Attorney

(233519) Page 89 GAO/GGD-98-48 Enterprise Nonmortgage Investments
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