United States General Accounting Office

GAO Report to Congressional Committees

October 1997 FEDERAL HOUSING

ENTERPRISES

OFHEO Faces

Challenges In

Implementing a

Comprehensive

Oversight Program

GAO/GGD-98-6

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-275470 

October 22, 1997

Congressional Committees

This report addresses requirements that we assess the operations of the Office of Federal

Housing Enterprise Oversight (OFHEO) contained in Sec. 430 of the Department of Veterans

Affairs/Department of Housing and Urban Development Appropriations Act of 1997 (P.L.

104-204). The report assesses OFHEO’s capacity to fulfill its mission of helping to ensure the

safety and soundness of the Federal National Mortgage Association and the Federal Home Loan

Mortgage Corporation.

As such, the report provides information on OFHEO’s development of risk-based capital

standards, implementation of an examination program, establishment of mission support

functions, and participation in a U.S. initiative to assist Mexico in developing a secondary

mortgage loan market. We also provide recommendations to the acting director of OFHEO on

strengthening reporting to Congress on the development of the risk-based capital standards and

ensuring adequate resources for the examinations program.

We are sending copies of the report to other appropriate congressional committees, the Acting

Director of OFHEO, the Chairman of the Board of Governors of the Federal Reserve System, the

Comptroller of the Currency, the Federal National Mortgage Association, the Federal Home

Loan Mortgage Corporation, and other interested parties. We will also make copies available to

others upon request.

Major contributors to this report are listed in appendix V. If you have any questions about this

report, please call me on (202) 512-8678.

Thomas J. McCool

Director, Financial Institutions

 and Markets Issues
B-275470 

List of Congressional Committees

The Honorable Christopher Bond

Chairman

The Honorable Barbara A. Mikulski

Ranking Minority Member

Subcommittee on Veterans Affairs,

 HUD, and Independent Agencies

Committee on Appropriations

United States Senate

The Honorable Alfonse M. D’Amato

Chairman

The Honorable Paul S. Sarbanes

Ranking Minority Member

Committee on Banking,

 Housing, and Urban Affairs

United States Senate

The Honorable Robert F. Bennett

Chairman

The Honorable Barbara Boxer

Ranking Minority Member

Subcommittee on Financial Services

 and Technology

Committee on Banking,

 Housing, and Urban Affairs

United States Senate

The Honorable Richard H. Baker

Chairman

The Honorable Paul E. Kanjorski

Ranking Minority Member

Subcommittee on Capital Markets, Securities,

 and Government Sponsored Enterprises

Committee on Banking and Financial Services

House of Representatives

Page 2 GAO/GGD-98-6 Federal Housing Enterprises
B-275470 

The Honorable Jerry Lewis

Chairman

The Honorable Louis Stokes

Ranking Minority Member

Subcommittee on Veterans Affairs,

 HUD, and Independent Agencies

Committee on Appropriations

House of Representatives

Page 3 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

Purpose There is a widespread perception in the financial markets that, during a

financial emergency, the U.S. government would rescue either or both of

the two largest federal housing enterprises, the Federal National Mortgage

Association (Fannie Mae) and the Federal Home Loan Mortgage

Corporation (Freddie Mac), which had combined financial obligations of

$1.5 trillion at year-end 1996. To lower the probability that such a costly

government intervention would ever be considered necessary, it is

important that the Office of Federal Housing Enterprise Oversight (OFHEO)

fulfill its mission of helping to ensure the safety and soundness of Fannie

Mae and Freddie Mac (the enterprises) pursuant to the Federal Housing

Enterprises Financial Safety and Soundness Act of 1992 (the act). OFHEO’s

primary means for fulfilling its mission are establishing capital standards

for the enterprises and conducting on-site examinations to assess their

management practices and financial condition.

The Department of Veterans Affairs (VA)/Department of Housing and

Urban Development (HUD) Appropriations Act of 1997 required GAO to

assess OFHEO’s fulfillment of its safety and soundness mission. Based on

discussions with congressional staff, GAO established the following two

major objectives to respond to the mandate: (1) identify the reasons why

OFHEO has not issued final risk-based capital standards for the enterprises

even though there was a December 1, 1994, deadline for doing so and

(2) assess OFHEO’s implementation of its safety and soundness examination

responsibilities.

Background Congress established and chartered the enterprises as

government-sponsored, privately owned and operated corporations to

enhance the availability of mortgage credit across the nation during both

good and bad economic times. The enterprises are to accomplish this

mission by purchasing mortgages from lenders (banks, thrifts, and

mortgage bankers) who can then use the proceeds to make additional

mortgage loans to home buyers. The enterprises issue debt to finance

some of the mortgage assets that they retain in their portfolios. A majority

of the mortgages, however, are pooled to create mortgage-backed

securities (MBS) that may be sold to investors or repurchased by the

enterprises and held in their portfolios. The enterprises charge fees for

guaranteeing the timely payment of principal and interest on MBS held by

investors. At year-end 1996, the enterprises had combined debt obligations

of $487 billion and combined MBS obligations to investors of $1.021 trillion

(a total of about $1.5 trillion).

Page 4 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

The federal government’s creation of and continued relationship with

Fannie Mae and Freddie Mac have created the perception in the financial

markets that it would not allow the enterprises to default on their debt and

MBS obligations, even though there is no requirement that it do so. As a

result, Fannie Mae and Freddie Mac can borrow money in the capital

markets at lower interest rates than comparably creditworthy private

corporations that do not enjoy federal sponsorship, and at least a portion

of the financial benefits that accrue to the enterprises have been passed

along to homeowners in the form of lower mortgage interest rates.

However, the potential also exists that the government would choose to

intervene to rescue the enterprises in a financial emergency. In fact, during

the 1980s, the government did provide limited regulatory and financial

relief to Fannie Mae when it experienced significant financial difficulties,

and, in 1987, Congress authorized $4 billion to bail out the Farm Credit

System, another government-sponsored enterprise.

Recognizing the potentially large costs that Fannie Mae and Freddie Mac

pose to taxpayers, Congress passed the act, which established OFHEO as an

independent regulator within HUD whose mission is to help ensure the

enterprises’ safety and soundness. Under the act, OFHEO’s director, who is

presidentially appointed and must be confirmed by the Senate, has wide

independent authority to ensure that OFHEO fulfills its safety and

soundness mission. For example, the director has the authority to take

enforcement actions against the enterprises without the review and

approval of the HUD Secretary. OFHEO had a budget of about $15.5 million in

fiscal year 1997 and a professional staff of about 85 individuals consisting

of full-time staff, temporary staff, contract employees, and detailees from

bank regulatory agencies. OFHEO’s budget is subject to the congressional

appropriations process, but its expenditures are financed, to the extent

provided in appropriations acts,1

 by annual assessments on Fannie Mae

and Freddie Mac rather than with taxpayer funds.

As required by the act, OFHEO is to carry out its oversight function in part

by establishing minimum capital standards. The act also mandated that

OFHEO develop a stress test that serves as the basis for the risk-based

capital standards. Under the act, the purpose of a stress test is to lower

taxpayer risks by simulating in a computer model situations where the

enterprises are exposed to adverse credit and interest rate scenarios and

requiring them to hold sufficient capital to withstand these scenarios for a

10-year period plus an additional 30 percent to cover management and

operations risk. The act establishes the broad outlines of a stress test, but

1

OFHEO’s budget authority is included in the annual VA/HUD Appropriations Act.

Page 5 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

OFHEO is required to complete several projects to further specify the

adverse credit and interest rate scenarios and their impacts on the

enterprises. Under the act, the stress test and risk-based capital standards

were to have been completed by December 1, 1994. The act also requires

OFHEO to conduct annual, on-site safety and soundness examinations of the

enterprises to assess their operations and financial condition. In OFHEO’s

opinion, this requirement can be and has been met without conducting

full-scope2

 enterprise examinations on an annual basis.

Since the mid-1980s, Fannie Mae and Freddie Mac have been consistently

profitable, and, in 1997, the Standard & Poor’s credit rating firm gave both

enterprises relatively high “AA-” government risk credit ratings.3

 However,

OFHEO officials have pointed out that current profitability does not

guarantee future profitability. Since Congress passed the act, which

established OFHEO in 1992, enterprise assets, which consist primarily of

mortgages and MBS that the enterprises retain in their portfolios, have

more than doubled. Although potentially more profitable than issuing MBS

to investors, larger retained holdings of mortgages and MBS expose the

enterprises to potentially greater losses resulting from fluctuations in

interest rates.

To identify the reasons why OFHEO has not issued risk-based capital

standards, GAO interviewed OFHEO and enterprise officials, as well as

former HUD officials who worked on enterprise safety and soundness

issues at HUD prior to OFHEO’s creation. GAO also reviewed a variety of

OFHEO documents, such as internal memorandums and written

explanations of the stress test development process provided at GAO’s

request. GAO did not assess the adequacy or appropriateness of OFHEO’s

approach to developing the stress test. Since OFHEO has not completed its

development of risk-based capital standards, GAO could not evaluate the

usefulness of specific steps OFHEO has taken to reach a final rule

promulgating a risk-based capital standard. GAO assessed OFHEO’s

implementation of its examination responsibilities by determining the

organization’s adherence to an examination schedule and plan that was

established in September 1994.

2

Full-scope examinations are generally understood to mean thorough assessments of all of the

management practices and business strategies of a financial institution that could affect its safety and

soundness.

3

Standard & Poor’s assessed the risks that the enterprises’ financial activities pose to the U.S.

government. The firm rates companies on a scale ranging from “AAA” for the lowest credit risks to

“CC” for the greatest credit risks.

Page 6 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

Results in Brief To fulfill its statutory safety and soundness mission, OFHEO is to establish

risk-based capital standards that are sufficient to withstand the rigors of a

complex stress test and implement a comprehensive and timely

examination program. To date, OFHEO has not fully completed either of

these tasks.

OFHEO has not established the risk-based capital standards because it must

first develop the stress test. Development of a stress test has been

protracted primarily due to (1) the complexity of the development process

as specified in the act and (2) OFHEO’s initial decision in 1994 to develop its

own sophisticated stress test rather than adopting and modifying stress

tests that were already under development. OFHEO officials told GAO that

they chose not to adopt existing stress tests because, in their judgment,

those tests did not provide an adequate basis for understanding the risks

facing the enterprises or the capital necessary to offset those risks. OFHEO

officials also said that the organization faced significant and

time-consuming challenges in acquiring expertise, obtaining accurate

financial information from the enterprises, initiating the federal

rulemaking process, and completing several financial modeling and

computer programming projects.

OFHEO has already missed its December 1994 statutory deadline for

completing a stress test and establishing risk-based capital standards by

almost 3 years. Tasks remaining include making key policy decisions

about the stress test and continuing to translate its components into

proposed and final rules. OFHEO now estimates that it will not complete

this part of the statutory mandate until 1999. Because the risk-based

capital standards are among OFHEO’s primary tools for helping to ensure

the enterprises’ safety and soundness, GAO believes that it is essential that

OFHEO complete the tasks remaining to develop those standards as

expeditiously as possible.

OFHEO has not fully implemented a timely and comprehensive enterprise

safety and soundness examination program. OFHEO established an

examination plan in September 1994 that provided for a 2-year cycle for

the assessment of six “core” risks, such as interest rate and credit, facing

the enterprises. As of May 1997, OFHEO had completed or initiated

examinations covering five of these six “core” risks. However, OFHEO’s

current 3- to 4-year cycle for assessing the six core risks is considerably

longer than the 2-year cycle established in the plan. In addition, OFHEO has

scaled back the planned coverage of its most recently completed core risk

examination.

Page 7 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

GAO’s analysis found that, among other factors, limited resources allocated

to the examination office were largely responsible for OFHEO’s inability to

comply with the 1994 plan. According to OFHEO officials, the organization

plans to reassess its examination strategy and make changes necessary by

early 1998 to ensure that its examination staff cover all six core risk areas

within a 1-year period. GAO believes that, without a reassessment and

potentially a reallocation of resources, OFHEO may not be able to

implement an annual examination cycle by early 1998 that fully covers all

risk areas, since the organization has been unable to implement a 2-year

cycle with the current assignment of staff to the examination function.

Thus, GAO believes that, in the reassessment of its examination strategy,

OFHEO could usefully include consideration of different examination cycles

and related coverage that could be accomplished with alternative resource

levels.

Principal Findings

OFHEO’s Development of

a Stress Test and

Risk-Based Capital

Standards Has Been

Protracted

In OFHEO’s planning process and its published documents, the organization

has consistently underestimated the time necessary to complete major

components of the stress test and risk-based capital standards. For

example, in 1995 OFHEO estimated that the final rule would be issued in

May 1997, but OFHEO now expects that the process will not be completed

until 1999. GAO’s review identified several reasons why OFHEO did not

comply with the statutory deadline. GAO also found that OFHEO faces

continuing challenges and may not meet its current estimate.

OFHEO’s statutory mandate to develop a stress test and risk-based capital

standards presented complex and time-consuming challenges to the

organization. For example, according to OFHEO, the final stress test must

be flexible and capable of assessing the effects of different credit and

interest rate scenarios on differing components of the enterprises’

mortgage portfolios, such as single family and multifamily mortgages, as

well as new financial products. By contrast, the risk-based capital

standards developed by federal banking regulators permit institutions to

hold the same level of capital against corporate loans that represent high

credit risks as against corporate loans that represent low credit risks.

During OFHEO’s start-up phase in 1993 and 1994, there were strategies

available that OFHEO could have pursued that might have resulted in the

Page 8 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

faster completion of a stress test and risk-based capital standards. As the

foundation of the stress test, OFHEO could have adopted and modified a

stress test under development by HUD in 1992, or the financial models that

the enterprises had established to assess the potential impacts of

alternative credit and interest rate scenarios. However, OFHEO officials

determined that pursuing these strategies would have left the organization

with an inadequate basis for assessing the risks facing the enterprises. For

example, OFHEO officials determined that the available HUD stress test only

allowed for very broad estimates of the potential impacts that different

interest rate and credit scenarios would have on the enterprises’ financial

condition. Consequently, OFHEO concluded that it could develop capital

standards that would be more closely related to enterprise risks by

developing its own sophisticated stress test and associated financial

modeling capability. GAO notes that the implementation of this strategy is

requiring a substantial development period and resource costs.

Between 1994 and 1997, OFHEO experienced other sources of delay in

completing the stress test and risk-based capital standards. For example,

OFHEO had not completed hiring half of its full-time research staff until

1996. OFHEO officials also told GAO that the development of the stress test

has been delayed by OFHEO’s need to (1) obtain accurate enterprise

financial data on a timely basis; (2) initiate the federal rulemaking process,

which involved a substantial commitment of staff time; and (3) complete a

variety of economic and financial modeling and computer programming

projects that involved greater managerial and technical challenges than

OFHEO initially anticipated. OFHEO officials told GAO that most of these

financial modeling and computer programming projects had been

completed by April 1997, although some final testing was required.

Given OFHEO’s history of underestimating the time necessary to complete

the stress test and risk-based capital standards and given the challenges

that remain, GAO is concerned that OFHEO may not meet its current estimate

of issuing a final rule by 1999. To comply with its plan, OFHEO has to initiate

an interagency review of the proposed rule by the Office of Management

and Budget (OMB) and other agencies, and has to make key policy

decisions necessary to complete the stress test. OFHEO must also continue

to translate the complex financial modeling components of the stress test

and risk-based capital standards into proposed and final rules. GAO

believes it is essential that OFHEO complete the tasks remaining to develop

the stress test and establish the risk-based capital standards as

expeditiously as possible because they are among OFHEO’s primary tools

for helping to ensure the enterprises’ safety and soundness.

Page 9 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

OFHEO Has Not Fully

Implemented Its

September 1994

Examination Plan

In September 1994, OFHEO established a “risk-focused” examination

schedule and plan that senior OFHEO officials said they believed was

necessary for helping to ensure the safety and soundness of Fannie Mae

and Freddie Mac. The plan, as subsequently modified, identified six core

risks facing the enterprises, such as credit and interest rate risks, and

established a 2-year cycle for OFHEO examiners to assess each of these six

risks. In addition, the plan identified specific areas that OFHEO examiners

were to assess during each scheduled examination. OFHEO’s risk-focused

examination strategy is generally consistent in concept but not in timing

with risk-focused examination strategies that the Office of the Comptroller

of the Currency (OCC) and the Federal Reserve System have established to

assess the safety and soundness of large commercial banks. For example,

OCC and Federal Reserve System examiners are to assess the major

risks—such as credit and interest rate—facing large commercial banks

but, as required by law, they are to do so on an annual basis.4

Between September 1994 and May 1997, OFHEO made important progress in

implementing the plan, such as completing or initiating examinations at

both enterprises that addressed five of the six core risks. However, GAO

found that OFHEO was not able to implement other important components

of the 1994 plan. For example, OFHEO’s current 3- to 4-year examination

cycle for covering the six core risk areas is considerably longer than the

2-year cycle established in the 1994 plan. Moreover, OFHEO also scaled back

the planned coverage of its core business risk examination. OFHEO

completed this risk examination in May 1997 but covered only one of the

four areas identified in the 1994 plan. OFHEO’s relatively long examination

cycle and limited examination coverage raise questions about the

organization’s ability to fully monitor the enterprises’ financial activities

and risks. In particular, with its current examination schedule, OFHEO may

not be able to do another on-site examination of the enterprises’ interest

rate risks until 1999 or 2000, even though such risks may have increased

because of increased holdings of debt-financed mortgage assets, since the

previous interest risk examination was completed in 1996.

In May 1995, GAO reported that limited staff resources had impeded OFHEO’s

initial efforts to implement the 1994 plan.5

 This situation persisted

between 1995 and 1997. As of June 1997, OFHEO’s examination office had 17

4

The Federal Deposit Insurance Corporation Improvement Act of 1991 (Pub. L. No. 102-242, as

amended) requires bank regulators to do full-scope examinations of large banks (total assets of

$250 million or more) on an annual basis.

5

Government-Sponsored Enterprises: Development of the Federal Housing Enterprise Regulator

(GAO/GGD-95-123, May 30, 1995).

Page 10 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

authorized positions of which 12 were reserved for line examiners and

specialists directly responsible for conducting examinations; the other 5

positions consisted of the office director and deputy director, executive

secretary, and 2 financial analysts. In its two most recently completed core

risk examinations, OFHEO assigned 9 and 8 of its line examiner and

specialist positions, respectively, to each examination for 1 year to

complete them. This significant staff commitment limits OFHEO’s ability to

complete examinations covering three core risks per year, the minimum

necessary to cover all six risks in the 2-year period stipulated in the 1994

plan. In addition, as of March 31, 1997, OFHEO’s examination office had five

vacancies, including the director position, which had further limited its

capacity to implement the 1994 plan. By August 1997, an OFHEO official

reported that the organization had filled three of the examination office

positions, including the director position, and the two others were in the

process of being advertised.

OFHEO officials said that another important factor that has contributed to

OFHEO’s inability to fully implement the 1994 examination plan was the

time that OFHEO examination staff needed to develop an understanding of

the enterprises’ operations and risk management. Prior to 1993 when

OFHEO began operations, the enterprises had not been subjected to an

examination oversight program. OFHEO officials said that the first round of

examinations has taken longer than initially anticipated in 1994 because of

the time necessary to obtain basic information about the enterprises’

operations and risk management practices.

OFHEO officials told GAO that the organization plans to reassess its

examination program and make changes as necessary to ensure that the

enterprises’ safety and soundness are adequately monitored. They also

said that the planned reassessment is to include a review of the adequacy

of OFHEO’s examination staff resources to ensure that it has a sufficient

number of line examiners and specialists to cover all core risk areas

within a 1-year period. OFHEO’s acting director said that OFHEO may have

some flexibility to increase its examination staff resources by shifting staff

from its research activities as the stress test and risk-based capital

standards are completed.

GAO believes that, without a reassessment of resources, OFHEO may not be

able to implement an annual examination cycle by early 1998, since it has

not implemented a 2-year cycle with its existing allocation of resources to

the examination function. In fact, as of June 1997, OFHEO had not yet

initiated important components of the 1994 plan, such as the remaining

Page 11 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

core risk examination, which could take considerable time to complete.

Thus, GAO believes that by including in the reassessment an analysis of the

staff resources necessary to adequately carry out alternative examination

cycles, such as 1 or 2 years, OFHEO could help ensure a fuller consideration

of the trade-offs associated with examination coverage provided versus

costs involved and thereby engage in a more informed decisionmaking

process.

Recommendations Because it is essential that OFHEO complete its efforts to develop and issue

risk-based capital standards as soon as possible, it is important that

congressional oversight be provided to help ensure that OFHEO’s current

plan to do so is accomplished in a timely manner. To that end, GAO

recommends that OFHEO’s director periodically report to Congress on

OFHEO’s progress toward complying with the current estimate of

completing a stress test and risk-based capital standards by 1999. GAO also

recommends that OFHEO’s director (1) assess the examination staff

resources necessary to adequately cover all risk areas on 1- and 2-year

examination cycles, (2) identify the most appropriate examination cycle

after considering the trade-offs between examination coverage and

resource requirements that would be involved, and (3) develop a strategy

for obtaining the necessary examination office resources, which may

involve reallocating existing resources over time.

Agency Comments

and GAO’S Evaluation

OFHEO’s acting director provided written comments on a draft of this

report, which are summarized in chapters 2 and 3 and reprinted in

appendix IV. OFHEO also provided technical comments that were

incorporated in the report where appropriate.

OFHEO generally agreed with the report’s findings and recommendations.

With respect to the reasons for the protracted development of the stress

test and risk-based capital standards, OFHEO cited the complexity of the

process as specified in the act and OFHEO’s decision to develop its own

stress test rather than redesigning existing stress tests. OFHEO also said

that GAO’s report should not be interpreted to suggest that using an

existing stress test would have produced an acceptable result. With regard

to OFHEO’s examination program, OFHEO said that the office plans to

transition to an annual cycle by year-end 1997. In addition, the acting

director stated that OFHEO will review the adequacy of its examination staff

resources to ensure that a comprehensive program can be implemented.

Page 12 GAO/GGD-98-6 Federal Housing Enterprises
Executive Summary

GAO did not take a position on the adequacy or appropriateness of OFHEO’s

approach to developing the stress test. To do so would have required that

GAO demonstrate whether the other alternatives could have been modified

sufficiently to meet the requirements of the act in a shorter period of time.

Rather, GAO pointed out that there were potential trade-offs associated

with the time that would have been required to adopt and modify existing

stress tests compared to the comprehensive development approach that

OFHEO chose. While OFHEO has agreed to review the adequacy of its

examination resources, GAO believes it is essential that OFHEO promptly

specify the resources necessary to carry out an appropriate examination

cycle and develop a plan to obtain these resources as may be necessary.

Page 13 GAO/GGD-98-6 Federal Housing Enterprises
Contents

Executive Summary 4

Chapter 1 

Introduction

18

Background 18

Congress Established OFHEO to Help Ensure the Safety and

Soundness of the Enterprises

22

Overview of the Enterprises’ Financial Performance and Business

Strategies

28

Objectives, Scope, and Methodology 33

Chapter 2 

OFHEO’s

Development of a

Stress Test and

Risk-Based Capital

Standards Has Been

Protracted

36

OFHEO Has Consistently Underestimated the Time Necessary to

Complete Stress Test Development

37

The Complexity of the Development Process Has Contributed to

Delays

38

OFHEO’s Decision to Develop a Sophisticated Stress Test Has

Been a Key Factor in the Ongoing Development Process

40

OFHEO’s Need to Hire Expertise and Obtain Accurate Financial

Data Proved Time-Consuming

43

OFHEO Faces Continuing Challenges in Implementing the Final

Risk-Based Capital Rule by 1999

47

Conclusions 49

Recommendations 50

Agency Comments and Our Evaluation 50

Chapter 3 

OFHEO Has Not Fully

Implemented a

Comprehensive

Enterprise Safety and

Soundness

Examination Program

52

OFHEO Established a Detailed Enterprise Examination Schedule

and Plan in 1994

53

OFHEO Has Not Been Able to Fully Implement the 1994

Examination Plan

56

Limited Examination Staff Resources Impeded OFHEO’s Ability

to Implement the 1994 Examination Schedule and Plan

59

OFHEO Plans to Reassess Its Examination Strategy and Staff

Resources

65

Conclusions 65

Recommendations 66

Agency Comments and Our Evaluation 67

Page 14 GAO/GGD-98-6 Federal Housing Enterprises
Contents

Chapter 4 

OFHEO’s

Implementation of

Key Mission Support

Functions

68

OFHEO Has Implemented Its Financial, Human Resources, and

Contract Management Functions

68

OFHEO’s Participation in Mexico Initiative Did Not Involve

Research or Examination Staffs

72

OFHEO’s Financial and Staff Resources, 1993-1997 73

OFHEO’s Relationship With HUD 74

Appendixes Appendix I: Financial Modeling and Computer Programming

Projects OFHEO Has Initiated to Complete Development of the

Stress Test and Risk-Based Capital Standards

76

Appendix II: OFHEO Officials Have Participated in a U.S.

Government Initiative Assisting Mexico in Developing a

Secondary Mortgage Loan Market

78

Appendix III: OFHEO’s Staffing Levels, Fiscal Years 1993 to 1997 80

Appendix IV: Comments From the Office of Federal Housing

Enterprise Oversight

83

Appendix V: Major Contributors to This Report 87

Tables Table 1.1: Total Enterprise Debt and Net MBS Outstanding as of

December 31, 1996

21

Table 1.2: OFHEO’s Full-Time, Temporary, Contractor, and Bank

Regulator Detailee Staff as of March 31, 1997

25

Table 1.3: OFHEO’s Obligations, Fiscal Years 1996 Through 1998 26

Table 1.4: Fannie Mae Year-end Profitability Data, 1990 to 1996 29

Table 1.5: Freddie Mac Year-end Profitability Data, 1990 to 1996 29

Table 1.6: Fannie Mae and Freddie Mac Total Asset Growth

Rates, 1992 to 1996

31

Table 1.7: Growth of Enterprises’ Retained Mortgage Assets as

Percentage of Mortgages in Total Portfolio, 1992 to 1996

31

Table 2:1: OFHEO’s Planned Completion Dates for Developing

the Stress Test and Issuing the Final Risk-Based Capital

Standards

37

Table 3.1: OFHEO’s Examination Plan for Monitoring the Six

Core Risks on a 2-Year Cycle

54

Table 3.2: OFHEO’s Completed, Ongoing, and Planned

Examinations as of May 1997

57

Table 3.3: OFHEO Line Examination Positions Assigned to

Completed Enterprise Core Risk Examinations

62

Page 15 GAO/GGD-98-6 Federal Housing Enterprises
Contents

Table 4.1: OFHEO’s Pay Band Levels and Positions in Each Band

in 1996

70

Table 4.2: OFHEO Contracts By Value, 1994 to 1997 72

Table 4.3: OFHEO’s Obligations, Fiscal Years 1993 Through 1997 73

Table 4.4: OFHEO’s Full-time, Contractor, and Bank Regulatory

Detailee Staff, at End of Fiscal Years 1993-1997

74

Table II.1 OFHEO’s International Travel Related to the Mexico

Initiative, Fiscal Years 1995 and 1996

79

Table III.1: OFHEO’s Full-time, Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-end 1993

80

Table III.2: OFHEO’s Full-time, Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-end 1994

80

Table III.3: OFHEO’s Full-time, Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-end 1995

81

Table III.4: OFHEO’s Full-time, Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-end 1996

81

Table III.5: OFHEO’s Full-time, Contractor, and Bank Regulator

Detailee Staff as of March 31, 1997

82

Figures Figure 1.1: OFHEO’s Organizational Structure 23

Figure 3.1: Line and Nonline Full-Time Permanent Positions in

OFHEO’s Office of Examination and Oversight

61

Page 16 GAO/GGD-98-6 Federal Housing Enterprises
Contents

Abbreviations

ANPR Advanced Notice of Proposed Rulemaking

APA Administrative Procedure Act

FHEO Office of Fair Housing and Equal Opportunity (HUD)

FMS Financial Management System (Department of Veterans

Affairs)

HAAS HUD Administrative Accounting System

HUD Department of Housing and Urban Development

HUDCAPS HUD Central Accounting and Program System

LTV loan-to-value ratio

MBS Mortgage-Backed Security

NPR Notice of Proposed Rulemaking

OCC Office of the Comptroller of the Currency

OEO Office of Examination and Oversight (OFHEO)

OFA Office of Finance and Administration (OFHEO)

OFHEO Office of Federal Housing Enterprise Oversight

OGC Office of General Counsel (OFHEO)

OMB Office of Management and Budget

OPA Office of Policy Analysis (OFHEO)

ORACS Office of Research and Capital Standards (OFHEO)

PASA Participating Agency Service Agreement

PEMS Performance Evaluation Management System (OFHEO)

SEDESOL Mexico’s Secretariat for Social Development

USAID United States Agency for International Development

VA Department of Veterans Affairs

Page 17 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1 

Introduction

Congress has a long-standing concern that the safety and soundness of the

two largest government-sponsored enterprises,1

 the Federal National

Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage

Corporation (Freddie Mac), be maintained so that they can meet their

intended purposes and that their financial activities do not pose risks to

taxpayers. Consequently, Congress passed the Federal Housing

Enterprises Financial Safety and Soundness Act of 1992 (the act),2

 which

established the Office of Federal Housing Enterprise Oversight (OFHEO)

within the Department of Housing and Urban Development (HUD) as an

independent financial safety and soundness regulator of Fannie Mae and

Freddie Mac (the enterprises). For reasons relating to the federal charters

and structures of the enterprises—which had combined financial

obligations of $1.5 trillion at year-end 1996—investors and rating agencies

perceive the enterprises’ securities as implicitly guaranteed by the federal

government, despite there being no such statutory obligation. We have

been mandated by the Department of Veterans Affairs (VA)/HUD

Appropriations Act of 19973 to assess OFHEO’s fulfillment of its safety and

soundness mission. Based on discussions with congressional staff, our

major objectives were to (1) identify why OFHEO has not finalized

risk-based capital standards for the enterprises even though there was a

December 1, 1994, deadline for doing so and (2) assess OFHEO’s

implementation of its enterprises’ safety and soundness examination

responsibility. We are also providing information on OFHEO’s

implementation of key mission support functions and participation in a

U.S. government initiative to assist Mexico in developing a secondary

mortgage loan market.

Background The enterprises help ensure that mortgage funds are available to home

buyers by buying mortgages from mortgage originators, such as

commercial banks, thrifts, and mortgage bankers. In turn, the originators

use the funds supplied by the enterprises to make additional mortgage

loans thereby helping ensure a continuous supply of mortgage credit

nationwide during both good and bad economic periods.

1

Government-sponsored enterprises are federally chartered, privately owned corporations designed to

provide a continuing source of credit nationwide to specific economic sectors. In addition to Fannie

Mae and Freddie Mac, the Federal Home Loan Banks also promote housing lending.

2

Housing and Community Development Act of 1992, Pub. L. No. 102-550, Title XIII, 12 U.S.C. 4501, et.

seq.

3

Pub. L. No. 104-204 § 430, 110 Stat. 2874, 2930 (September 26, 1996).

Page 18 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

The enterprises hold some of the mortgages they purchase in portfolio as

direct investments on their books and issue debt and equity securities to

finance these holdings. However, a majority of mortgages that the

enterprises buy from mortgage originators are “securitized”—that is, the

enterprises package them into mortgage pools to support

mortgage-backed securities (MBS). These mortgage pools receive interest

and principal payments from the mortgages in the pools and pass them on

to the investors who purchased MBS. The enterprises guarantee the timely

payment of principal and interest on MBS held by investors, administer the

payments, and charge “guarantee fees” for providing these services. The

enterprises may also repurchase MBS and hold the securities in their

mortgage portfolios.

The enterprises are government-sponsored in that they operate under

federal charters that convey certain benefits, impose certain restrictions,

and permit the enterprises to earn a profit while serving public policy

purposes, such as providing liquidity4

 to mortgage markets. In 1992,

Congress expanded the enterprises’ public purpose by requiring annual

goals for the purchase of mortgages on housing serving very-low, low-, and

moderate-income and other households that are underserved by the

residential mortgage market.5

 These goals are to be set, monitored, and

enforced by HUD. The charters restrict the enterprises to buying mortgages

that do not exceed a set dollar amount, known as the conforming loan

limit.6

A major factor that enhances the enterprises’ profitability is the financial

markets’ perception that there exists an implied federal guarantee of their

debt and MBS obligations. Investors perceive that this implied guarantee

decreases the risk of default on the enterprises’ financial obligations.

Consequently, this perception reduces the enterprises’ borrowing costs

because investors are willing to accept lower expected returns on

enterprise debt than they would for similar private firms without

government ties. Likewise, interest rates on MBS are lowered by this

4

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

prices of the traded securities.

5

Federal Housing Enterprises Safety and Soundness Act of 1992, Pub. L. No. 102-550, §§ 1331-1334, 12

U.S.C. §§ 4561-4564.

6

The conforming loan limit depends on how many housing units are financed by a single residential

mortgage loan. Currently, the conforming loan limit on a single-unit residence is $214,600.

Page 19 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1 

Introduction

perception.7 Their lower funding costs allow the enterprises to increase

their purchases and give them a cost advantage over their potential

competitors. This perception of a federal guarantee remains, even though

laws chartering the enterprises contain explicit language stating that there

is no such guarantee.

The market perception of the implied federal guarantee is based on,

among other things, federal ties to the enterprises, including

government-sponsored status, each enterprise’s $2.25 billion conditional

line of credit with the Department of the Treasury, and their exemptions

from state and local income taxes and securities registration fees imposed

by the Securities and Exchange Commission. In 1996, we estimated that

the financial benefits that accrue to the enterprises from their federal

sponsorship ranged from about $2.2 billion to $8.3 billion on a pretax basis

and from about $1.6 billion to $5.9 billion on an aftertax basis in 1995.8

 We

also reported that approximately 80 percent to 95 percent of these

estimated benefits were derived from the lower funding costs that the

enterprises accrue as a result of the perception of a federal guarantee.

Enterprise Activities

Benefit Homeowners but

Pose Potential Financial

Risks to Taxpayers

It is widely accepted that the enterprises’ activities have generated

benefits to mortgage borrowers, such as lower mortgage interest rates. For

example, in our 1996 report, we estimated that the activities of the

enterprises resulted in a savings on single-family fixed-rate home

mortgages below the conforming loan limit of about 15 to 35 basis points.9

Thus, a borrower with a $100,000 thirty-year, fixed-rate mortgage saves

about $10 to $25 a month on mortgage payments as a result of the

enterprises’ activities.10 For the approximately $2 trillion in outstanding

7

Investors will accept lower expected returns on enterprise MBS, just as for enterprise debt, because

of the perception of an implied federal guarantee. This, in turn, lowers the cost of funding mortgages

through issuance of MBS.

8

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

May 13, 1996). Some analysts contend that these benefits pass entirely through to mortgage borrowers

in the form of lower mortgage rates, while others contend that some of the value of the benefits could

be retained by the enterprises in the form of higher profits or higher expenditures, such as for

compensation. See FNMA and FHLMC: Benefits Derived From Federal Ties (GAO/GGD-96-98R,

Mar. 25, 1996).

9

A basis point equals 1/100 of a percentage point. See Housing Enterprises: Potential Impacts of

Severing Government Sponsorship (GAO/GGD-96-120, May 13, 1996).

10These estimates are based on an analysis of the increases in mortgage rates that would likely occur if

the federal government fully severed its ties with the enterprises, and the perception of a federal

guarantee were removed. Assuming that federal ties remain, we estimated that the rate on

single-family fixed-rate housing mortgages below the conforming loan limit are lowered by 15 to 35

basis points. See Housing Enterprises: Potential Impacts of Severing Government Sponsorship

(GAO/GGD-96-120, May 13, 1996).

Page 20 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1 

Introduction

conventional conforming fixed-rate mortgages in 1995, we estimated that

the aggregate annual savings in mortgage payments were in the range of

$3 billion to $7 billion. Other benefits of the enterprises are that they have

reduced regional disparities in interest rates and mortgage availability, and

spurred the development of new technologies that facilitate the home

financing process.

However, the potential also exists that, in the event of a financial

emergency, the federal government would choose to intervene and assist

either Fannie Mae or Freddie Mac or both in meeting their debt and MBS

obligations, which stood at a combined $1.5 trillion at year-end 1996 (see

table 1.1),11 potentially exposing the taxpayers to losses. In fact, during the

early 1980s when short-term interest rates rose dramatically, Fannie Mae

experienced substantial financial difficulties because the enterprise had

funded its mortgage portfolio with short-term debt. As rates increased,

Fannie Mae had to issue new short-term debt at higher rates to replace

existing short-term debt that came due. Because interest earned on the old

mortgages in portfolio was less than interest expenses on new debt,

Fannie Mae experienced total losses of about $277 million between 1981

and 1984. (The type of risk Fannie Mae faced in the early 1980s is referred

to as interest rate risk.) In response, the federal government provided

limited tax relief and regulatory forbearance in the form of relaxed capital

requirements. Similarly, in 1987, Congress authorized $4 billion to support

the Farm Credit System—another government-sponsored

enterprise—when it experienced financial difficulties.

Table 1.1: Total Enterprise Debt and

Net MBS Outstanding as of

December 31, 1996

Dollars in billions

Enterprise

Debt

outstanding

Net MBS

outstandinga Total

Fannie Mae $331 $548 $879

Freddie Mac 156 473 630

Total $487 $1,021 $1,509

aExcludes MBS that the enterprises have repurchased and hold in their portfolios.

Sources: Fannie Mae and Freddie Mac.

11Even in the event of a major financial disaster and the insolvency of both enterprises, it is unlikely

that the government would lose $1.5 trillion in providing support to the enterprises. This is because the

government, as the conservator of the enterprises, would foreclose on the residences securing the

mortgages, and the government could liquidate these properties to help offset its initial expenditures.

Page 21 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

Congress Established

OFHEO to Help

Ensure the Safety and

Soundness of the

Enterprises

Recognizing the potentially large financial costs that Fannie Mae and

Freddie Mac posed to taxpayers, in 1992, Congress passed the act, which

established OFHEO as an independent regulator within HUD whose mission

is to help ensure the enterprises’ safety and soundness. One of OFHEO’s

most important means of helping to ensure the enterprises’ financial

soundness is to establish capital requirements that are related to potential

risks that the enterprises face. Further, the act gave OFHEO broad authority

to examine the activities of the enterprises, such as the requirement that

OFHEO conduct annual on-site examinations of the enterprises to assess

their financial condition. During fiscal year 1997, OFHEO had a budget of

about $15.5 million and a total staff—full-time staff, temporary staff,

contract employees, and detailees from bank regulatory agencies—of 85

individuals as of March 31, 1997,12 to carry out its safety and soundness

responsibilities and to perform administrative support functions.

The act established OFHEO as an independent office within HUD with

respect to safety and soundness matters, and reserved for the Secretary of

HUD the responsibility to oversee the enterprises’ efforts to meet the

housing goals as well as general regulatory power over the enterprises.

However, the act also clarified that the duty to ensure that Fannie Mae and

Freddie Mac are adequately capitalized and operate in a safe and sound

manner belongs to OFHEO exclusively. OFHEO was intended to operate

separately from HUD as a safety and soundness regulator and to be staffed

with experts in financial analysis or financial institution oversight.

OFHEO is under the management of a presidentially appointed and

Senate-confirmed director. The act provided the director with numerous

exclusive authorities (i.e., without the review and approval of the

Secretary of HUD), such as powers to examine the operations of the

enterprises, determine capital adequacy, and take enforcement actions.

The act also gave the director exclusive authority to manage OFHEO, which

includes preparing annual budgets and hiring personnel. Thus, the director

leads and directs OFHEO’s activities by setting internal and external

policies, managing overall operations, and serving as the chief

spokesperson for the organization. OFHEO’s first director was appointed on

June 1, 1993, and resigned on February 13, 1997, to become the

Administrator of the Small Business Administration. As of June 1997,

OFHEO was headed by the acting director, while the President and Congress

considered potential candidates for the organization’s new director.

12OFHEO’s staffing levels tend to fluctuate throughout the year as full-time staff resign or are hired and

contractors and detailees either complete or begin their assignments.

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Chapter 1 

Introduction

OFHEO is organized into six offices, which report to the director and deputy

director. Figure 1.1 illustrates OFHEO’s organizational structure.

Figure 1.1: OFHEO’s Organizational Structure

Director

Deputy Director

Office of General

Counsel

General Counsel

Office of Congressional

and Public Affairs

Director for

Congressional

Affairs

Director for

Public

Affairs

Office of Research,

Analysis and

Capital Standards

Director

Office of Policy

Analysis

Chief Economist

Office of Examination

and

Oversight

Director

Office of Finance

and

Administration

Director

• The Office of the General Counsel (OGC) has responsibility for preparing

regulations required by the act and advising the director on legal issues,

including financial institutions regulatory issues, applicable corporate law

principles, and general legal matters.

• The Office of Congressional and Public Affairs is responsible for handling

public and press inquiries, briefing Members of Congress and staff on

matters relating to OFHEO, monitoring legislative development, and

bringing congressional concerns to the attention of the director.

Page 23 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1 

Introduction

• The Office of Finance and Administration (OFA) is responsible for ensuring

that OFHEO has the infrastructure to function independently. This office is

to provide human resources management, budget formulation and

execution, financial and strategic planning, contracting and purchasing,

office automation, travel, records and document security, and related

administrative support services. OFA is also responsible for developing

annual budgets and serving as the liaison with the Office of Management

and Budget (OMB).

• The Office of Examination and Oversight (OEO) is responsible for

designing and conducting annual on-site examinations of Fannie Mae and

Freddie Mac, as required by law, and performing additional examinations

as determined by the director.

• The Office of Policy Analysis (OPA) is responsible for providing and

coordinating economic and policy advice to the director on all issues

related to regulation and supervision of the enterprises. This office is also

to direct and conduct research and assess the impact of issues and trends

in the housing and mortgage markets on OFHEO’s regulatory

responsibilities.

• The Office of Research, Analysis and Capital Standards (ORACS) is

responsible for developing and implementing a financial “stress test,”

which uses interest rate and credit risk scenarios prescribed in the act to

determine the enterprises’ risk-based capital requirements. The office is

also responsible for conducting research and financial analysis on issues

related to the enterprises’ activities, such as simulating Treasury yields

and associated interest rate movements.

Compared to other federal financial regulators, such as the Federal

Reserve System and the Office of the Comptroller of the Currency (OCC),

which have thousands of employees, OFHEO is a small organization. Table

1.2 shows the distribution of OFHEO’s authorized and onboard permanent

employees as of March 31, 1997, among the six offices discussed above. As

table 1.2 indicates, OFHEO had an authorized staffing level of 72 full-time

permanent positions but had only 58 full-time permanent staff on board as

of March 31, 1997. OFHEO supplements its permanent full-time staff with

full-time and part-time temporary employees, contractors, and detailees

from other financial regulatory agencies that perform key functions on a

reimbursable basis. For example, OFHEO has used contract staff and bank

regulatory detailees to assist in developing capital standards and in

performing on-site safety and soundness examinations. As of March 31,

1997, OFHEO had 6 full-time temporary staff, 1 part-time temporary staff, 19

contractor staff, and 1 bank regulatory detailee on board. Thus, OFHEO had

Page 24 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1 

Introduction

a total onboard staff of 85 individuals (58 full-time permanent, 7

temporary, 19 contract, and 1 detailee).

Table 1.2: OFHEO’s Full-Time, Temporary, Contractor, and Bank Regulator Detailee Staff as of March 31, 1997

Unit

Full-time

permanent

positions

Full-time

permanent staff

Full-time

temporary staff Contract Detail

Director 7 5

Research, Analysis, and Capital Standards 17 14 4a 14

Examination and Oversight 17 12 3 1

General Counsel 9 8 1

Finance and Administration 11 11 1 2

Policy Analysis 6 4 1

Congressional and Public Affairs 5 4

Total 72 58 7 19 1

aOne of the four staff members was part-time.

Source: OFHEO.

Table 1.3 shows actual, estimated, and requested OFHEO obligations for

fiscal years 1996 through 1998. Most OFHEO expenses cover personnel and

contractor services. For fiscal year 1997, OFHEO estimated in its fiscal year

1998 budget request to Congress that it will spend about $9.1 million

(about 59 percent of its $15.5 million total) on personnel services (i.e.,

expenses related to personnel compensation and benefits, but exclusive of

contractors). According to OFHEO, it sets its salaries and benefits, as

required by the act, by maintaining comparability with federal banking

regulatory agencies. The second largest category of expenses (“other

services”) generally covers OFHEO’s contractor services. In fiscal year 1997,

OFHEO expects to spend nearly $3.8 million (about 25 percent of total

obligations) on specialized technical services associated with developing

and maintaining its research capability and computer models, examination

services, and specialized legal services. All other expenses constitute a

smaller percentage of OFHEO’s total obligations. These expenses cover such

fundamental items as computer acquisition, travel, and rent, some of

which fluctuate with changing numbers of staff and contractors on

location.

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Introduction

Table 1.3: OFHEO’s Obligations, Fiscal

Years 1996 Through 1998 Dollars in thousands

Obligation category

Actual

1996

Estimated

1997

Requested

1998

1997-1998

change

Personnel services $7,234 $9,119 $9,572 $453

Other services 4,800 3,793 3,664 –129

All other 2,758 2,588 3,076 488

Total $14,792 $15,500 $16,312 $ 812

Source: OFHEO’s fiscal year 1998 budget request to Congress.

Although OFHEO’s financial plans and forecasts are to be included in the

budget of the United States and are subject to the appropriations process,13

the organization is not funded with tax dollars. Rather, the act requires the

enterprises to pay annual assessments to cover OFHEO’s costs. Each

enterprise is required to pay an amount in proportion to the ratio of its

individual assets to the total combined assets of both enterprises. The

assessment is to be paid semiannually into a Department of Treasury fund,

known as the Federal Housing Enterprises Oversight Fund.

OFHEO Carries Out Its

Oversight Mission by

Developing Capital

Standards and Conducting

Examinations

Under the act, OFHEO is to establish two sets of capital standards to help

ensure the safety and soundness of the enterprises and minimize taxpayer

risks. The first standard, which is called the “minimum capital” standard,

requires a minimum amount of capital that an enterprise must hold.

Minimum capital is computed on the basis of capital ratios specified in the

act that are applied to certain on-balance-sheet and off-balance-sheet

obligations of the enterprises. The ratios are (1) 2.50 percent of aggregate

on-balance-sheet assets; (2) 0.45 percent of the unpaid principal balance of

outstanding MBS and substantially equivalent instruments; and

(3) 0.45 percent of other off-balance-sheet obligations (with some

exclusions), except as the OFHEO Director adjusts the ratio to reflect

differences between the credit risk of such obligations and MBS. OFHEO has

classified Fannie Mae and Freddie Mac as “adequately capitalized” under

the minimum standard in each quarter beginning in the quarter that ended

on June 30, 1993.14

13OFHEO’s budget authority is included in the annual VA/HUD Appropriations Act.

14OFHEO issued the final rule implementing the minimum capital standard on July 8, 1996, and the

final rule was first used to classify the enterprises as adequately capitalized in the third quarter of 1996.

Prior to the issuance of the final rule, OFHEO classified the enterprises as adequately capitalized

under interim standards.

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Introduction

The act also requires OFHEO to establish a stress test to serve as the basis

for the development of risk-based capital standards. The stress test is

intended to lower taxpayer risks by simulating in a computer model

situations where the enterprises are exposed to adverse credit and interest

rate shocks, and requiring the enterprises to hold sufficient capital to

withstand these shocks. The capital amount must be adequate to last

during a 10-year period (the stress period), within specific parameters

relating to credit risk,15 interest rate risk,16 new business, and other

activities. The act defines an enterprise’s required risk-based capital level

as equal to the amount calculated by applying the stress test, along with an

additional 30 percent of that amount to allow for management and

operations risk.17 Further, the act required the director to issue final

regulations establishing the stress test within 18 months of the Director’s

appointment (i.e., by December 1, 1994). However, as we discussed in our

May 1995 report on OFHEO’s operations,18 OFHEO did not meet this deadline.

As of April 1997, OFHEO’s acting director said that OFHEO expects to issue a

proposed rule implementing the stress test and risk-based capital

standards by September 1998, with a final rule to be issued in 1999. We

discuss OFHEO’s development of the stress test and risk-based capital

standards in chapter 2 of this report.

In the absence of risk-based capital standards, OFHEO’s primary means of

monitoring the safety and soundness of the enterprises is its examination

program. The act gave OFHEO broad authority to examine the enterprises

and requires annual on-site examinations. At such examinations, OFHEO

full-time staff, with the assistance of temporary contractors and detailees

from bank regulatory agencies, are to assess the financial condition of the

enterprises and recommend improvements as necessary. OFHEO also has

the authority to take enforcement actions against the enterprises, such as

cease and desist orders, to stop unsafe and unsound practices. Further,

OFHEO has the authority to place an enterprise into a conservatorship when

certain circumstances exist and the enterprise is unable to meet its

15In general, credit risk is the risk of loss arising from borrowers failing to repay their loans and/or

other parties failing to meet their obligations to administer or guarantee loans. Credit risk is inherent

in the daily operations of all financial firms, including the enterprises.

16In general, interest rate risk is the exposure to possible losses and changes in value arising from

changes in interest rates.

17In general, management risk and operations risk are the exposure to financial loss from inadequate

systems, management failure, faulty controls, or human error.

18Government Sponsored Enterprises: Development of the Federal Housing Enterprise Financial

Regulator (GAO/GGD-95-123, May 30, 1995).

Page 27 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 1 

Introduction

financial obligations or is critically undercapitalized. We discuss OFHEO’s

examination program and the adequacy of its resources in chapter 3.

Overview of the

Enterprises’ Financial

Performance and

Business Strategies

Since the mid-1980s, Fannie Mae and Freddie Mac have been consistently

profitable. In 1997, the enterprises received relatively high ratings for

financial performance and management from the Standard & Poor’s credit

rating company. Nevertheless, the enterprises have adopted business

strategies in recent years that OFHEO officials believe could potentially

weaken their future financial performance. For example, since OFHEO’s

creation in 1992, the enterprises have substantially increased their

holdings of mortgage assets in lieu of issuing MBS to investors. According

to OFHEO’s former director, increased holdings of mortgage assets

potentially expose the enterprises to greater interest rate risks. OFHEO has

also reported that there is some evidence that the enterprises have taken

on increased credit risk since 1992. The enterprises have also developed

sophisticated strategies since the early 1980s that were intended to better

manage the interest and credit risks that they face.

Enterprises Have

Consistently Done Well

Financially in Recent Years

Tables 1.4 and 1.5 show selected year-end profitability data for Fannie Mae

and Freddie Mac for the years 1990 through 1996. As the tables indicate,

during those years, the enterprises consistently earned profits for their

stockholders; this occurred despite significant downturns in regional

mortgage markets, such as those in New England and California during the

early 1990s. In 1996, Fannie Mae had a net income of $2.7 billion, while

Freddie Mac had a net income of about $1.2 billion. The financial data also

indicate that since 1990 the enterprises have consistently achieved a return

on average common equity, a common measure of profitability, exceeding

20 percent. By contrast, the return on average common equity for the

commercial banking industry between 1990 and 1996 was about

12.5 percent.

Page 28 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

Table 1.4: Fannie Mae Year-End

Profitability Data, 1990 to 1996 Dollars in billions

Year Net income

Return on average

common equity

1990 $1.17 33.7%

1991 1.36 27.7

1992 1.62 26.5

1993 1.87 25.3

1994 2.13 24.3

1995 2.14 20.9

1996 2.73 24.1

Sources: Fannie Mae and OFHEO.

Table 1.5: Freddie Mac Year-End

Profitability Data, 1990 to 1996 Dollars in billions

Year Net income

Return on average

common equity

1990 $ .41 20.5%

1991 .56 23.6

1992 .62 21.2

1993 .79 22.2

1994 .98 23.2

1995 1.09 21.9

1996 1.24 22.1

Sources: Freddie Mac and OFHEO.

On February 3, 1997, the Standard & Poor’s rating firm gave both Fannie

Mae and Freddie Mac a relatively high “point-in-time”19

risk-to-the-government credit rating of “AA-.”20 OFHEO commissioned

Standard & Poor’s to evaluate the enterprises’ financial condition and

issue the ratings pursuant to its authority under the act. In the Standard &

Poor’s report accompanying the rating, the firm generally cited the

enterprises for their consistent profitability, demonstrated ability to

19Under a “point-in-time” credit rating, Standard & Poor’s rates the financial condition of a company on

a single day; in the case of the enterprises, the ratings were for February 3, 1997. Standard & Poor’s

issued a point-in-time credit rating because OFHEO did not ask the firm to rate the enterprises on an

ongoing basis.

20Standard & Poor’s uses long-term issuer credit ratings ranging from “AAA” for the highest credit

rating to “CC” for highly speculative. According to OFHEO, the risk-to-the-government rating evaluates

the risk that Fannie Mae or Freddie Mac will become financially troubled and require government

assistance. According to Standard & Poor’s, the AA- rating is probably higher than the ratings that the

enterprises would receive in the absence of government sponsorship.

Page 29 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

withstand regional downturns in mortgage markets during the early 1990s,

historically conservative credit and interest rate risk strategies, and the

quality of their management. In addition, Standard & Poor’s stated that the

enterprises’ domination of the secondary conforming mortgage market

and the benefits of their ties to the federal government, such as relatively

low borrowing costs, also justified the “AA-” rating. However, Standard &

Poor’s did find that both enterprises could face capital adequacy shortages

if a severe, nationwide downturn occurred in the mortgage markets or

interest rates rose precipitously.

Enterprise Growth Has

Been Rapid, Which Has

Implications for Interest

and Credit Risks

Although Fannie Mae and Freddie Mac have been consistently profitable,

the enterprises have adopted strategies that could potentially increase

their interest rate and credit risks. Since 1992, when Congress passed the

act that established OFHEO, the enterprises’ combined assets have more

than doubled in size, although Freddie Mac’s growth has been relatively

faster (see table 1.6 ). During 1996, Fannie Mae’s total assets21 grew at

about an 11 percent annual rate, and Freddie Mac’s assets grew at about a

27 percent annual rate. In 1995, Fannie Mae’s total assets grew at about a

16 percent annual rate, and Freddie Mac’s assets grew at about a

29 percent annual rate. Table 1.7 indicates that the enterprises’ retained

mortgage portfolios, which include whole mortgages and MBS that the

enterprises have repurchased, have been growing as a percentage of their

total mortgage portfolios (retained mortgages plus outstanding MBS held by

investors), although this growth has also been relatively faster at Freddie

Mac. For example, Freddie Mac’s retained mortgage assets as a percentage

of its total mortgage portfolio increased from about 8 percent at year-end

1992 to about 23 percent at year-end 1996. Fannie Mae’s retained mortgage

assets increased from about 27 percent of its total mortgage portfolio at

year-end 1992 to about 34 percent at year-end 1996. In previous reports on

bank and thrift failures, we found that rapid asset growth in the double

digit range, unless carefully managed, can result in a deterioration in

management controls and ultimately poor financial performance.22

21The enterprises’ total assets generally consist of retained mortgages, investments, cash and cash

equivalents, accrued interest receivable, receivables from currency swaps, acquired property and

foreclosure claims, and other assets. MBS guarantees are off-balance-sheet items and therefore not

part of total assets.

22See, for example, Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26, Mar. 4, 1991).

Page 30 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

Table 1.6: Fannie Mae and Freddie Mac

Total Asset Growth Rates, 1992 to

1996

Dollars in billions

Growth rate 1992 1993 1994 1995 1996

Fannie Mae

Total assets $181 $217 $273 $317 $351

Annual growth N/A 20% 26% 16% 11%

Freddie Mac

Total assets $60 $84 $106 $137 $174

Annual growth N/A 40% 26% 29% 27%

Fannie Mae and Freddie

Mac

Total assets $241 $301 $379 $454 $525

Annual growth N/A 25% 26% 20% 16%

N/A = Not applicable.

Sources: Fannie Mae, Freddie Mac, and OFHEO.

Table 1.7: Growth of Enterprises’

Retained Mortgage Assets as

Percentage of Mortgages in Total

Portfolio, 1992 to 1996

Dollars in billions

1992 1993 1994 1995 1996

Fannie Mae

Retained mortgage assets $156 $190 $221 $253 $287

Net MBSa $424 $471 $486 $513 $548

Retained as percentage of

total portfolio 27% 29% 31% 33% 34%

Freddie Mac

Retained mortgage assets $34 $56 $73 $108 $138

Net MBSa $408 $439 $461 $459 $473

Retained as percentage of

total portfolio 8% 11% 14% 19% 23%

aExcludes MBS that the enterprises have repurchased and hold in their portfolios.

Sources: Fannie Mae, Freddie Mac, and OFHEO.

According to OFHEO’s 1996 annual report, the enterprises’ increasing

reliance on retained mortgage assets, which are financed by debt and

equity, potentially exposes them to greater interest rate risk. The

enterprises have incentives to finance mortgages (or repurchase

previously issued MBS) with debt because the difference between mortgage

yields and borrowing costs generally exceeds MBS guarantee fees.

However, the increased proportion of retained mortgage assets could

Page 31 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

expose Fannie Mae and Freddie Mac to greater interest rate risks because

they assume the risks for changes in the market value of the retained

mortgage assets due to fluctuations in interest rates. By contrast, when the

enterprises issue MBS to investors, the investors who purchase the

securities assume responsibility for losses due to interest rate fluctuations.

In testimony before the House Subcommittee on Capital Markets,

Securities, and Government-Sponsored Enterprises on April 17, 1996,

OFHEO’s former director expressed concern that the combined retained

mortgage assets of the enterprises exceeded $360 billion at year-end 1995,

which, at that time, was more than twice the combined portfolio that the

enterprises had when OFHEO was created in 1992. Nevertheless, at year-end

1996, the enterprises’ combined retained mortgage assets had grown

another $63 billion to $424 billion, or about 17 percent, since year-end

1995.

OFHEO’s 1996 annual report also suggested that the enterprises may be

facing somewhat increased credit risks in the future. The report attributed

the potentially increasing credit risks to the fact that fewer homeowners

chose to refinance their existing mortgages in 1994 and 1995 because

mortgage interest rates were higher than they had been in 1992 and 1993.

According to the annual report, refinanced mortgages tend to be less risky

than mortgages that have not been refinanced because they have lower

loan-to-value (LTV) ratios,23 and those who choose to refinance generally

have equity in their homes. The enterprises have also embarked on

business strategies that have resulted in a larger share of mortgage

purchases with higher LTV ratios. Between year-end 1992 and year-end

1995, the percentage of Fannie Mae mortgage purchases with LTV ratios

exceeding 90 percent rose from 6 percent of all purchases to 19 percent of

all purchases. Freddie Mac’s percentage of mortgage purchases with LTV

ratios exceeding 90 percent increased from 3 percent of all purchases to 14

percent of all purchases. At Fannie Mae, credit losses, provision for loss

expenses plus foreclosed property expenses, increased from $335 million

in 1995 to $409 million in 1996 (about a 22-percent increase) while Freddie

Mac’s credit losses increased from $541 million in 1995 to $608 million in

1996 (a 12-percent increase).

23In general, loans with lower LTV ratios represent smaller borrower risks to mortgage loan originators

and the enterprises than loans with higher LTV ratios. The LTV ratio is determined by dividing the

balance of the mortgage loan outstanding by the estimated value of the residential property. Thus, the

LTV ratio on an outstanding mortgage balance of $60,000 on a single-family residence with an

estimated value of $100,000 would be 60 percent. The enterprises generally require private mortgage

insurance or other credit enhancements on mortgage loans with LTV ratios exceeding 80 percent.

Page 32 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

Enterprises Have

Implemented Strategies to

Mitigate Risks

The enterprises have developed strategies to lower the interest rate risks

that they face from increased mortgage asset holdings. For example, both

enterprises issue callable bonds that can be paid off early if interest rates

fall. By calling the bonds and issuing new debt as interest rates fall, the

enterprises curtail interest expenses. Conversely, if rates increase, the

enterprises continue to pay below-market rates on their existing bonds.

The enterprises have also developed other methods, including using

certain derivative products, to control the volatility of their interest

expenses as the economy varies.24

The enterprises also use strategies to minimize potential credit risks. For

example, for mortgage purchases with LTV ratios exceeding 80 percent, the

enterprises usually require mortgage insurance from highly rated

providers or other kinds of credit protection. The enterprises also have

nationwide, geographically diversified mortgage portfolios that afford

protection against regional downturns in housing markets, as has been

demonstrated in the past. In addition, according to OFHEO’s 1996 annual

report, the enterprises have further protected themselves against credit

risk by shifting an increasing percentage of the primary risk of default to

mortgage originators, such as commercial banks. Lenders bear primary

default risk if they pledge collateral or agree to repurchase mortgages that

default. The OFHEO report states that the percentage of Freddie Mac

purchased mortgage loans where the lender bears primary default risks

rose from 12 percent of purchases in 1994 to 22 percent in 1995.

Objectives, Scope,

and Methodology

The VA/HUD Appropriations Act of 1997 required us to do a comprehensive

audit of OFHEO’s overall operations concerning staff organization,

expertise, capacity, and contracting authority to ensure that OFHEO’s

resources are adequate and being used appropriately to ensure that the

enterprises are adequately capitalized and being safely operated. Based on

discussions with congressional staff, we established the following three

objectives to assess OFHEO’s overall operations and its capacity to fulfill its

safety and soundness mission: (1) identify the reasons that OFHEO did not

complete the stress test and risk-based capital standards by December 1,

1994, (2) assess OFHEO’s implementation of its examination

responsibilities, and (3) review the status of OFHEO’s implementation of key

mission support functions and determine whether OFHEO’s participation in

a U.S. government initiative to assist Mexico in developing a secondary

24Derivatives are financial products whose value is determined by an underlying reference rate, index,

or asset. The underlying include stocks, bonds, commodities, interest rates, foreign currency exchange

rates, and indexes that reflect the collective value of various financial products.

Page 33 GAO/GGD-98-6 Federal Housing Enterprises
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Introduction

mortgage market has had a material impact on OFHEO’s ability to fulfill its

mission.25

To identify the reasons for OFHEO’s delays in developing the stress test and

risk-based capital standards, we interviewed senior officials in OFHEO’s

Office of Research and Capital Standards (ORACS), as well as former HUD

officials who worked on enterprise safety and soundness issues prior to

OFHEO’s establishment in 1992. We also reviewed key OFHEO documents,

such as internal memorandums, written explanations of the development

of the stress test that OFHEO provided at our request, and staff vacancy and

attrition data in ORACS. We also met with senior Fannie Mae and Freddie

Mac officials to obtain their views on OFHEO’s development of the stress

test and capital standards. The scope of our work did not involve assessing

the adequacy or the appropriateness of OFHEO’s approach to developing the

stress test. Since OFHEO has not yet completed the development of

risk-based capital standards, we could not evaluate the usefulness of

specific steps OFHEO has taken to reach a final rule promulgating a

risk-based capital standard.

With respect to assessing OFHEO’s implementation of its safety and

soundness responsibilities, we interviewed senior examination officials

and their counterparts at the enterprises. We also reviewed the following

documents: (1) OFHEO’s September 1994 examination schedule and plan,

(2) OFHEO’s draft examination handbook, (3) statistics on the number of

staff assigned to each exam as well at the time needed to complete each

exam, and (4) attrition and vacancy data for OFHEO examiners. We

assessed OFHEO’s compliance with the 1994 plan and compared OFHEO’s

plan with plans that the Office of the Comptroller of the Currency (OCC)

and the Federal Reserve System have established for examining large

commercial banks. The scope of our work did not involve making an

independent assessment of the accuracy of OFHEO’s examination findings,

conclusions, and/or recommendations.

We reviewed the status of OFHEO’s implementation of key mission support

functions by interviewing officials in the Office of Finance and

Administration. We also reviewed relevant documentation such as

administrative policies and procedures, contracts, and cost data.

25In floor debate regarding the VA/HUD Appropriations Act of 1997, two Senators expressed concern

that foreign travel by OFHEO officials had diverted the organization from completing the risk-based

capital standards within established deadlines. OFHEO’s participation in the Mexico initiative during

1995 and 1996 represented its largest foreign travel expense.

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We assessed the impact of OFHEO’s participation in the Mexico initiative by

reviewing cost and travel data and identifying staff members who made

foreign trips. We also asked senior OFHEO officials to estimate the amount

of time that they have devoted to developing presentations for the

initiative and going on foreign travel. We did not independently verify the

cost and travel data or OFHEO officials’ estimates of the time that they

devoted to the Mexico initiative.

We did our work between December 1996 and April 1997 in accordance

with generally accepted government auditing standards.

We provided copies of a draft of this report to OFHEO for review and

comment. The Acting Director provided written comments on the draft

report’s analysis and recommendations, which are summarized in chapters

2 and 3 and reprinted in appendix IV. OFHEO also provided technical

comments on the draft report, which have been incorporated where

appropriate.

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OFHEO’s Development of a Stress Test and

Risk-Based Capital Standards Has Been

Protracted

The act required OFHEO to develop a stress test and risk-based capital

standards as essential components of the organization’s mission to help

ensure the safety and soundness of Fannie Mae and Freddie Mac.

Although OFHEO faced a deadline of December 1, 1994, to issue a final rule

implementing the stress test and capital standards, OFHEO officials estimate

that the final rule will not be issued until 1999.

Our review found that the delay in the ongoing development process had

been caused primarily by (1) the complex challenges of developing the

stress test as required by the act and (2) OFHEO officials’ decision in 1994

that the organization develop its own sophisticated stress test rather than

adopting and modifying stress tests that were already under development.

OFHEO concluded that it could develop capital standards that would be

more closely related to enterprise risks by developing its own

sophisticated stress test and associated financial modeling capability.

However, we note that it has also involved a substantial development

period and resource costs. Related factors that have contributed to the

delay in OFHEO’s ongoing development of the stress test have included the

time necessary to hire expert staff, obtain accurate financial data, and

initiate the federal rulemaking process. These tasks have taken more time

than OFHEO initially anticipated in 1994.

To meet its anticipated issuance of the final rule by 1999, OFHEO faces

other important challenges. In particular, senior OFHEO officials must

coordinate the issuance of the stress test with executive branch agencies,

such as OMB, HUD, and the Department of the Treasury, and make key

policy decisions about various components of the stress test. In addition,

OFHEO’s attorneys and others must continue to translate the economic and

financial modeling components of the proposed stress test and capital

standards into proposed and final rules that comply with applicable

federal statutes. Given the importance of the risk-based capital standards,

we believe it is essential that OFHEO complete the tasks remaining to

develop those standards as expeditiously as possible.

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OFHEO’s Development of a Stress Test and

Risk-Based Capital Standards Has Been

Protracted

OFHEO Has

Consistently

Underestimated the

Time Necessary to

Complete Stress Test

Development

OFHEO’s development of a stress test and risk-based capital standards is an

essential component for helping to ensure the safety and soundness of

Fannie Mae and Freddie Mac. Essentially, the purpose of the stress test

that OFHEO is required to develop under the act is to lower potential

taxpayer risks by requiring the enterprises to hold sufficient capital to

withstand a severe interest rate shock coupled with adverse credit

conditions over a 10-year period, plus an additional 30 percent to protect

against management and operations risk. Under the act, OFHEO was to have

completed the final rule implementing the stress test and risk-based

capital standards by December 1, 1994, but, as discussed earlier and

shown in table 2.1, OFHEO did not comply with this mandate.

Table 2:1: OFHEO’s Planned

Completion Dates for Developing the

Stress Test and Issuing the Final

Risk-Based Capital Standards

OFHEO plan

Estimated completion of major components of the stress

test and capital standards

May 1994 Complete stress test by December 1995 and publish final rule

by March 1996.

July 1995 plan Complete stress test by January 1996 and publish final rule by

May 1997.

September 1996 plan Complete stress test by March 1997. OFHEO 1996 annual

report stated that the completed stress test would be put

forward for public comment in 1997.

April 1997 plan Propose completed stress test by September 1998 and issue

final rule in 1999.

Sources: OFHEO’s acting director and OFHEO’s 1996 annual report.

In OFHEO’s planning process and its published documents, the organization

has consistently underestimated the time necessary to complete major

components of the stress test and resulting risk-based capital standards.

For example, in its May 1994 plan for the development of the stress test,

OFHEO estimated that the final rule would be issued in March 1996.

Moreover, OFHEO’s revised July 1995 and September 1996 plans also

underestimated the time necessary to complete the stress test and

risk-based capital standards. In OFHEO’s 1996 annual report, the former

director stated that in 1997 the organization would have developed, tested,

and put forward for public comment an operational stress test. However,

in April 1997, OFHEO’s acting director said that the organization does not

expect to submit an operational stress test for public comment until 1998,

with the final rule expected to be issued in 1999.

The remainder of this chapter provides a general discussion of the reasons

why OFHEO did not comply with the statutory deadline and points out

Page 37 GAO/GGD-98-6 Federal Housing Enterprises
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OFHEO’s Development of a Stress Test and

Risk-Based Capital Standards Has Been

Protracted

several continuing challenges that the organization faces in complying

with its current estimate for issuing a final rule.

The Complexity of the

Development Process

Has Contributed to

Delays

The complex requirements of the stress test as specified in the act have

contributed to the time being taken by OFHEO to complete the process.

OFHEO is legislatively required to develop a stress test to establish

risk-based capital standards. In addition, the act establishes the broad

outlines of the stress test, but requires OFHEO to complete several

important projects before the final rule can be issued.

OFHEO’s Mandate to

Develop Capital Standards

Presented Complex

Challenges

OFHEO’s development of a stress test and risk-based capital standards for

the enterprises presented highly complex challenges. According to OFHEO,

the stress test should be flexible and allow OFHEO to adjust the enterprises’

capital requirements on a periodic basis as the financial risks that they

face change. For example, under the completed stress test, an enterprise

would be required to hold additional capital if OFHEO determined that the

enterprise had made changes in its asset and liability structure that would

result in greater losses under alternative credit and interest rate shock

scenarios. Similarly, OFHEO, via the stress test, could require Fannie Mae or

Freddie Mac to hold additional capital against new activities that may

represent greater risks than their more traditional activities.

By contrast, the risk-based capital standards that have been developed by

OCC, the Federal Reserve System, and the Federal Deposit Insurance

Corporation for federally regulated banks categorize assets into broad

groups, which may not account for changes in the institutions’ business

practices that could affect their risk profiles. For example, banks are

permitted to hold the same level of capital for loans made to corporations

with high credit ratings as they are required to hold for corporations with

speculative credit ratings. In addition, federal bank regulators have not

established and implemented uniform risk-based capital standards to

address interest rate risks.26 Instead, regulators assess the interest rate

risks facing banks during scheduled examinations and make case-by-case

decisions as to whether the banks hold adequate capital to protect against

these risks.

26Section 305 of the Federal Deposit Insurance Corporation Improvement Act of 1991 required bank

and thrift regulators to revise risk-based capital standards in order to take adequate account of interest

rate risk and other risk factors, such as concentrations of credit and nontraditional products risks. 12

U.S.C. 1828 note.

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Risk-Based Capital Standards Has Been

Protracted

OFHEO Must Complete

Several Complex Tasks to

Develop the Stress Test

and Risk-Based Capital

Standards

The act establishes the broad outlines of a stress test involving the impact

of adverse credit and interest scenarios on the enterprises’ financial

condition. According to OFHEO’s 1995 and 1996 annual reports, OFHEO must

further specify the adverse credit and interest rate scenarios for the stress

test by carrying out the following complex tasks:

Develop a credit stress benchmark: Under conditions specified in the act,27

OFHEO is required to identify the region and time period associated with the

highest mortgage default and loss severity rates in the United States, and

then simulate the effect of these stressful conditions on the enterprises’

nationwide total mortgage portfolios.

Identify an appropriate house price index: Changes in home prices, and

the corresponding changes in loan-to-value ratios (LTV), affect mortgage

defaults and loss severity. The act requires that OFHEO reflect these factors

by establishing the current LTV ratios of enterprise mortgages outstanding

at the start of the stress test. For this purpose, the act specifies the use of

an appropriate house price index, such as the Department of Commerce’s

Constant Quality Home Price Index or an index of similar quality used by

the federal government.

Develop a methodology to assess the performance of various mortgage

types, such as single and multifamily mortgages, under differing credit and

interest rate risk scenarios: The act requires that the stress test reflect

differing risk characteristics of various mortgage types. For example, the

differences in risk for single-family home mortgages, which primarily serve

as residences and capital investments, and multifamily building mortgages,

which primarily serve as income-producing businesses. Multifamily loans

are less homogeneous and tend to be subject to more diverse risks than

single-family mortgages.

Determine the risks of enterprise commitments: In developing the stress

test, OFHEO is required to assume that the enterprises fulfill all outstanding

commitments to purchase mortgages or to issue securities. OFHEO must

determine how to translate the contractual commitment into portfolio

27“With respect to mortgages owned or guaranteed by the enterprise and other obligations of the

enterprise, losses occur throughout the United States at a rate of default and severity (based on any

measurements of default reasonably related to prevailing practice for the industry in determining

capital adequacy) reasonably related to the rate and severity that occurred in contiguous areas of the

United States containing an aggregate of not less than 5 percent of the total population of the United

States that, for a period of not less than 2 years, experienced the highest rates of default and mortgage

losses, in comparison with such rates of default and severity of mortgage losses in other such areas for

any period of such duration.”

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Risk-Based Capital Standards Has Been

Protracted

assets and associated funding, and into MBS, so that their credit and

interest rate risk can be factored into the stress test.

Develop an interest rate model to better understand interest rate risks

facing the enterprises: The act requires that the specified stressful credit

conditions be combined with one of two interest rate scenarios that result

in the highest capital requirement.28 In one scenario, the 10-year constant

Treasury yield rises during the first year of the stress period and remains

at the new level for the remainder of the stress period.29 In the other

scenario, the 10-year yield decreases during the first year of the stress

period and remains at that level for the remainder of the stress period.30

Other market interest rates must be simulated relative to the 10-year note

yield in a manner reasonably related to historical experience. OFHEO must

develop appropriate interest rate models to simulate the specified interest

rate changes on the enterprises’ financial condition.

OFHEO’s Decision to

Develop a

Sophisticated Stress

Test Has Been a Key

Factor in the Ongoing

Development Process

When OFHEO began operations in June 1993, there were potential strategies

that it could have pursued that might have resulted in the faster

completion of a stress test and risk-based capital standards. For example,

OFHEO could have adopted an enterprise stress test that had been under

development by HUD after making several significant adjustments to bring

it into compliance with the act. Or, Fannie Mae officials told us that OFHEO

could have adopted an approach that the enterprise had developed to

assess the impacts of various credit and interest rate shocks on its

financial condition. Instead, OFHEO officials decided to create a new and

comprehensive stress test that they believed would provide a better basis

for establishing risk-based capital standards than modifying existing stress

tests. OFHEO officials concluded that their strategy will result in capital

standards that better reflect enterprise risk. However, we note that

implementation of the strategy has resulted in the protracted period of

28Rising interest rates increase interest expenses as debt turns over and decrease the value of existing

assets that are paying a below market rate. When interest rates decline, homeowners tend to prepay

mortgages more quickly, resulting in a decrease of the net average interest rates received by the

enterprises on mortgages held in their portfolios.

29Under the act, the 10-year constant maturity Treasury yield increases to the greater of (1) 600 basis

points above the average yield during the preceding 9 months or (2) 160 percent of the average yield

during the preceding 3 years, but in no case to a yield greater than 175 percent of the average yield

during the preceding 9 months.

30The 10-year constant maturity Treasury yield decreases to the lesser of (1) 600 basis points below the

average yield during the preceding 9 months or (2) 60 percent of the average yield during the preceding

3 years, but in no case to a yield less than 50 percent of the average yield during the preceding 9

months.

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OFHEO’s Development of a Stress Test and

Risk-Based Capital Standards Has Been

Protracted

time and the substantial resources that are being devoted to completing

the process.

OFHEO Had Alternative

Strategies to Choose From

in Developing a Stress Test

One possible strategy that OFHEO could have chosen was to make

significant adaptations to a stress test for the enterprises that HUD had

developed by 1992. HUD used the results of its stress test in its annual

reports to Congress where it assessed the financial condition of the

enterprises if subjected to mortgage credit conditions that existed during

the Great Depression.31 HUD’s stress test, which was similar to that used by

credit rating agencies, such as Moody’s Investors Service, began with the

development of economic relationships among key variables such as

interest rates, house prices, and unemployment in the national economy.

According to the former HUD officials who developed the stress test, they

wanted a test that would be able to simulate the consequences of a variety

of economic scenarios, such as rising unemployment rates and subsequent

mortgage default rates, on the enterprises’ financial condition.

However, these former HUD officials also said that the stress test would

have required extensive development to meet the requirements of the act.

The former officials said that the HUD stress test assigned enterprise

balance sheet items into broad asset and liability categories, or “buckets,”32

and would still have required the disaggregation of enterprise assets and

liabilities based on risk characteristics. The former officials added that in

1992, HUD lacked the staff and computer resources necessary to make such

detailed assessments. They also said that the HUD stress test did not meet

the act’s requirement that OFHEO specify credit risk relationships for the

enterprises based on historic mortgage default rates in specific areas of

the country (the credit stress benchmark).33 The former HUD officials said

that developing such a geographic credit stress benchmark would have

31U.S. Department of HUD, 1991 Report to Congress on the Federal Home Loan Mortgage Corporation

(December 1992) and 1991 Report to Congress on the Federal National Mortgage Association

(December 1992).

32In such a “bucket analysis,” financial analysts normally create simplified, called synthetic, assets and

liabilities that are meant to mimic the general characteristics of the overall assets or liabilities

contained in the bucket. The approach lacks specificity but requires less time input by analysts and

fewer computer resources.

33According to HUD’s reports, the HUD stress test is perhaps more stringent than the one called for in

the act; consequently, the HUD stress test may require higher capital levels at each enterprise at any

one point in time than the capital levels ultimately established by OFHEO. We identified one source for

this discrepancy: the HUD test postulated a Depression scenario. The credit risk specified in the act

depends on default and loss severity data that lend themselves to statistical analysis. According to

OFHEO, the enterprises’ historical loan data are generally only statistically reliable since the first

quarter of 1980. Credit conditions since 1980 have been more favorable than those that occurred

during the Depression.

Page 41 GAO/GGD-98-6 Federal Housing Enterprises
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OFHEO’s Development of a Stress Test and

Risk-Based Capital Standards Has Been

Protracted

required substantial additional work. Nevertheless, the former officials

said that they believed the adaptations necessary to bring the HUD stress

test into compliance with the act could have been completed faster than

the time it is taking OFHEO to develop its stress test.

Alternatively, Fannie Mae officials told us that OFHEO could have adopted

an approach to developing the stress test similar to the approaches that

Fannie Mae follows to assess the impacts of various credit and interest

rate scenarios. The officials said that Fannie Mae’s approach—which they

referred to as “top down”—combines assets and liabilities with similar

performance characteristics into aggregated categories and tests their

performance under specified interest and credit risk scenarios.34 Using

such an approach, a Fannie Mae official said that OFHEO could possibly

have met the 18-month deadline. In addition, Fannie Mae officials said that

any stress test and risk-based capital standards that OFHEO ultimately

develops must be consistent with the enterprises’ capacity to implement

them and the enterprises’ business practices.

OFHEO could also have chosen other options requiring different levels of

aggregation of enterprise assets and liabilities.35 For such options, the

trade-off between resource requirements and specificity in estimating

enterprise risks would be similar to the two options previously discussed.

OFHEO Decided to

Develop Its Own

Sophisticated Stress Test

According to an internal OFHEO memorandum dated February 22, 1994,

senior OFHEO officials determined that the alternative strategies discussed

above were not sufficient to serve as the basis for the statutory stress test.

For example, OFHEO officials determined that, among other limitations, the

HUD stress test was insufficient because it would have limited OFHEO’s

ability to evaluate the impacts of various economic scenarios and business

strategies on the enterprises’ financial condition. In our discussions with

OFHEO officials, they said that the HUD stress test had other significant

limitations that made it unusable. For example, ORACS’ director said that

the HUD stress test lacked the capacity to assess the consequences of

34Our ability to demonstrate a comparison between Fannie Mae’s approach and OFHEO’s approach is

limited because we cannot disclose information that Fannie Mae considers to be proprietary or

components from OFHEO’s stress test development that are not in the public domain.

35For example, 30-year fixed-rate mortgages can be aggregated according to coupon rates on the

mortgage loans (i.e., the interest rates paid by borrowers). Aggregation simplifies the analysis at the

possible loss of specificity in estimating risks. For example, homeowners with mortgage rates below

prevailing mortgage rates on newly originated mortgage loans tend to default less frequently than

homeowners paying higher interest rates.

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Risk-Based Capital Standards Has Been

Protracted

adverse interest rate and credit scenarios on the enterprises’ derivative

instruments.

In 1994, OFHEO officials also determined that they could not use the

enterprises’ existing financial models for assessing the impact of various

credit and interest rate scenarios and developing the stress test for several

reasons. For example, OFHEO officials determined that, although the

enterprises’ financial models may have been sufficient to meet their

business needs, the models were not adequate for meeting the

requirements of the statutory stress test. OFHEO officials also decided that

the financial models used by the enterprises differed substantially and,

therefore, OFHEO needed to develop a common model to ensure regulatory

consistency. In addition, OFHEO officials wanted the organization to

develop an independent capacity to assess the risks facing the enterprises

and to make regulatory decisions as it was deemed necessary.

Consequently, OFHEO officials told us that in 1994 they decided to develop a

comprehensive and sophisticated stress test to comply with the act’s

requirements and establish the organization’s regulatory independence. To

develop such a stress test, OFHEO officials said that they needed to collect

and test extensive data on the historical performance of enterprise loans

as well as their current books of business on a disaggregated basis. OFHEO

officials also determined that the organization needed to develop

sophisticated models and computer programs to assess how alternative

economic scenarios would affect the enterprises’ financial condition and

capital positions. OFHEO officials said that they believed that the final stress

test will result in risk-based capital standards that better reflect the risks

facing the enterprises.

OFHEO’s Need to Hire

Expertise and Obtain

Accurate Financial

Data Proved

Time-Consuming

Our review identified several other factors that have contributed to

OFHEO’s ongoing development of the stress test and risk-based capital

standards. First, once senior OFHEO officials had made the decision to

develop a sophisticated stress test, the organization had to hire expert

staff and purchase a powerful computer network system capable of

running financial models. Second, OFHEO officials said the enterprises did

not always provide accurate financial data on a timely basis. Third, OFHEO

officials initiated the federal rulemaking process, which involved

significant staff time and resources. Finally, between 1994 and 1997, OFHEO

had to initiate and complete several economic modeling, financial

modeling, and computer programming projects, which proved more

challenging than the organization had initially anticipated.

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Protracted

OFHEO Had to Obtain

Needed Expertise and a

Computer Network

The need to hire expertise and acquire a sophisticated computer network

are factors that contributed to the time needed for the ongoing

development of the stress test and risk-based capital standards. According

to the ORACS director, OFHEO viewed hiring and developing a capable staff

of permanent employees and contractors as another means for the

organization to establish itself as a viable, independent regulatory agency.

ORACS has focused its hiring efforts on individuals who had substantial

expertise in housing economics, the capital and mortgage markets,

computer programming, or computer systems. We reviewed OFHEO

personnel records and determined that the ORACS staff have extensive

experience in housing economics, financial analysis, residential mortgage

markets, and computer systems. In addition, senior ORACS officials have

postgraduate degrees and experience in relevant settings, such as

securities firms or other federal financial regulatory agencies.

However, OFHEO also provided hiring data that indicate that it took ORACS a

substantial period of time to recruit the individuals deemed necessary to

develop and implement the stress test and risk-based capital standards.

For example, the data indicated that 7 of the 14 full-time staff in ORACS in

May 1997 were hired in 1995 and 1996. In addition, OFHEO’s acting director

said that between October 1996 and April 1997, OFHEO lost several key staff

members from ORACS and its Office of Policy Analysis, including a senior

policy analyst, a senior economist, and a systems administrator, which

further contributed to the challenges of completing the stress test and

capital standards within established deadlines. Moreover, it has taken

considerable time for OFHEO to hire key contract staff to develop essential

components of the stress test. For example, OFHEO did not contract with

Price Waterhouse to develop financial reporting software and a

consolidated data format for both enterprises until August 1995.

OFHEO also needed to acquire a sophisticated computer network on which

the financial models are to be run. In 1994, based on an analysis of

available computer hardware and software, OFHEO officials decided to

purchase a powerful computer network. According to OFHEO’s acting

director, the computer network did not become fully operational until late

1994. Without the computer network, OFHEO’s growing ORACS staff could

not make significant progress on many of the complex economic

modeling, financial modeling, and computer software projects necessary

to develop the stress test and risk-based capital standards.

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OFHEO Encountered

Some Difficulties

Obtaining Accurate

Financial Data on a Timely

Basis

OFHEO officials said another factor that has contributed to the ongoing

development of the stress test was that OFHEO and the enterprises had to

establish a workable system for delivering large amounts of financial data.

OFHEO required large amounts of historical and current financial data from

the enterprises so that it could, among other tasks, determine the

benchmark loss experience and develop models of mortgage performance;

such work was necessary before the impact of the various credit and

interest rate scenarios on the enterprises financial condition could be

determined. OFHEO first requested that the enterprises provide

comprehensive financial data on loan performance in May 1994 and the

enterprises responded over the next 18 months. Although ORACS’ director

stated that the enterprises generally made good faith efforts to supply the

requested data, various problems and delays were encountered. For

example, he said that the enterprises did not always provide all necessary

data in their initial submissions, which resulted in repeated follow-up

requests. Also, he said that OFHEO technical staff sometimes encountered

problems and delays contacting their counterparts at the enterprises

without first being routed through regulatory compliance officials.

OFHEO officials also stated that they encountered some difficulties

obtaining accurate financial data from Freddie Mac on a timely basis and

that this has delayed the development of the stress test. OFHEO initiated a

targeted examination of “data integrity” issues at Freddie Mac in

August 1996 which, when completed in November 1996, stated that

Freddie Mac had not established adequate controls to ensure the accuracy

of information submitted to OFHEO. According to OFHEO, Freddie Mac has

agreed to correct these problems. However, a Freddie Mac official told us

that data integrity issues did not result in delayed completion of the stress

test.36

Fannie Mae officials we contacted said that OFHEO’s initial requests for

information imposed certain regulatory burdens on the enterprise. In

keeping with their view that OFHEO could have relied on a “top-down”

approach to developing the stress test, Fannie Mae officials said they did

not fully understand why OFHEO required such a substantial amount of data

about individual mortgage loans. They said that requesting such detailed

mortgage loan data is not necessary and slows the development of the

stress test. OFHEO officials said they needed individualized loan data to

36The Freddie Mac official said that error-free data are not essential in the early stages of designing a

financial model and that testing of data can be accomplished through the use of smaller data sets. In

addition, the official said that Freddie Mac has provided OFHEO with substantial support in its

development of the risk-based capital standards and associated financial models.

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better model the enterprises’ financial condition and better understand the

potential impacts of various credit and interest rate scenarios.

Freddie Mac officials we interviewed had a different perspective toward

OFHEO’s development of the stress test and the potential for regulatory

burden. Freddie Mac officials told us that they do not know what stress

test OFHEO will ultimately develop. They said that OFHEO should take the

time necessary to “do the job right,” and attributed this view to the

position that both enterprises are currently well capitalized and therefore

the risk of delay is low. Freddie Mac officials also said that they

understood OFHEO’s position that developing an in-house understanding of

enterprise risks was important. Freddie Mac officials, however, expressed

the concern that OFHEO could end up developing a stress test that relied

too heavily on disaggregated information. The officials said that their

potential concerns with a highly refined stress test and capital standards

were that they could create (1) a regulatory burden; and (2) unintended

consequences by ignoring beneficial linkages, such as those associated

with hedging activities, among financial assets and liabilities.

OFHEO Officials Initiated

Rulemaking Process

OFHEO officials also cited the protracted federal rulemaking process as a

factor that has contributed to the ongoing development of the stress test

and risk-based capital standards. The officials said that complying with the

federal rulemaking requirements placed important demands on the time of

OFHEO’s staff. For example, ORACS’ director said that the office staff

responsible for the development of the stress test worked with OFHEO

attorneys in drafting rulemaking proposals, which are summarized below.

ORACS’ director and other officials said that OFHEO’s staff must frequently

assume such time-consuming responsibilities to compensate for the

organization’s relatively small size as compared to other federal financial

regulators.

On February 8, 1995, OFHEO issued an Advance Notice of Proposed

Rulemaking (ANPR), which solicited public comment for a period of 120

days on a variety of technical and policy issues and a range of alternative

approaches to modeling the enterprises’ credit and interest rate risks. ANPR

covered such subjects as defining the credit stress benchmark, assessing

the default and loss characteristics of a wide range of mortgage types, and

the effects of high inflation rates on mortgage losses. When the period for

public comment closed in June 1995, OFHEO had received a total of 15

comments from a variety of interested parties, including the enterprises

and two mortgage banking firms, which OFHEO officials said they have

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considered in the development of the stress test. On June 10, 1996, OFHEO

published a Notice of Proposed Rulemaking (NPR), which described two

key elements of the stress test—the benchmark loss experience and the

house price index. These issues are discussed below and in appendix I.

During 1997, OFHEO staff are working on a second NPR that will cover issues

not addressed in the first NPR, such as interest rates and mortgage

performance.

OFHEO Managed Multiple

Projects to Develop the

Stress Test and Capital

Standards

OFHEO also initiated and completed several complex and time-consuming

projects between 1994 and 1997 to develop the stress test and risk-based

capital standards. The projects that OFHEO initiated included

(1) establishing the credit stress benchmark, (2) developing a consistent

format for data provided by Fannie Mae and Freddie Mac, (3) identifying

an appropriate house price index, and (4) developing econometric models

and computer programs to simulate enterprise financial performance.

Most of these projects had been completed by June 1997 (see app. I).

According to OFHEO’s acting director, OFHEO faced significantly greater

technical and managerial challenges than initially anticipated, developing

an integrated financial model to simulate the behavior of the enterprises’

assets, liabilities, and off-balance-sheet obligations under adverse credit

and interest rate conditions. This financial model is to serve as the

foundation of the final stress test.37 According to ORACS’ director, however,

OFHEO had largely completed the integrated financial model by April 1997,

although some final testing and documentation projects were to have been

completed during the summer of 1997.

OFHEO Faces

Continuing Challenges

in Implementing the

Final Risk-Based

Capital Rule by 1999

OFHEO faces continuing challenges in meeting its proposed deadline of

issuing the final rule implementing the stress test and risk-based capital

standards by 1999. In particular, OFHEO officials must coordinate the

interagency review process and make key policy decisions about the stress

test. Further, OFHEO must translate the components of the stress test and

capital standards into proposed and final rules in compliance with federal

statutes.

37OFHEO refers to the model as the Financial Simulation Model. OFHEO’s work on the model includes

assessing the impact of fluctuations in interest rates on mortgage performance, determining the impact

of rising house prices on the enterprises’ financial condition, estimating mortgage prepayment and

default and loss severity rates, and simulating the cash flows of enterprise assets, liabilities, and

off-balance-sheet obligations and translating these cash flows into pro forma accounting statements.

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OFHEO Must Coordinate

Interagency Review

Process

OFHEO’s acting director said that OFHEO plans to share the basic

components of the stress test and related financial models on an informal

basis with OMB, HUD, and Treasury in the summer of 1997. He said that

given the complexity of the stress test and its related financial models, it

will be important to provide information about them at the earliest

possible stage. The acting director said the informal interagency review

process can go forward before the stress test is finalized because the goal

will be to explain the technical components of the stress test and related

financial models to OMB and Treasury technical staff and to receive their

comments and analysis.

OFHEO Needs to Make

Key Policy Decisions

About the Stress Test

OFHEO’s acting director told us that the organization needs to make key

policy decisions about various components of the stress test by early 1998.

OFHEO’s chief economist said that OFHEO’s technical staff had the

responsibility to lay out options on various complicated issues that are

necessary to complete the stress test, such as assumptions about future

interest rates, the shape of the yield curve, the enterprises’ future debt

issuances, and the relationship between home prices and interest rates,

but it is up to OFHEO management to choose the appropriate option. Once

these decisions have been made, then OFHEO will have a better idea as to

how the stress test will affect the enterprises’ financial condition and

risk-based capital levels.

OFHEO Must Translate the

Components of the Stress

Test Into Proposed and

Final Rules While

Protecting Proprietary

Enterprise Data

OFHEO’s general counsel told us that once ORACS completes development of

the stress test, OFHEO’s staff will face the task of translating the stress test

into proposed and final rules. The general counsel stated that OFHEO wants

to avoid having the final rule successfully challenged in court under the

Administrative Procedure Act (APA). OFHEO’s general counsel said that

another concern that will confront the organization in drawing up the

proposed and final rules will be the need to give adequate notice to the

public to provide for comment on the development of the stress test as

required by APA without compromising proprietary enterprise data.

Enterprise officials we contacted said they are very concerned that OFHEO

not disclose proprietary information during the rulemaking process. In

fact, Fannie Mae officials told us that OFHEO has already publicly disclosed

some proprietary information in research papers. Although the Fannie

Mae officials said that OFHEO researchers attempted to disguise the

proprietary data through high-level aggregation, the officials said that this

high-level approach was not effective because OFHEO only supervises two

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companies. OFHEO’s acting director stated that the research papers did not

disclose proprietary enterprise data. He also said that OFHEO has

established a rigorous policy for preventing the release of such proprietary

data; for example, OFHEO researchers are to submit all proposed papers to

senior officials who determine if the papers disclose confidential

information.38

Conclusions The stress test and risk-based capital standards that OFHEO is legislatively

required to develop are essential means by which the organization is to

fulfill its mission of helping to ensure the safety and soundness of Fannie

Mae and Freddie Mac. The stress test is to simulate the effects that various

adverse credit and interest rate shocks would have on the enterprises, and

the risk-based capital standard is to be designed to ensure that the

enterprises hold adequate capital to withstand such stress for a period of

10 years. OFHEO has already missed the December 1, 1994, deadline for

completing the process by almost 3 years and estimates that it will be 1999

at the earliest before this statutorily mandated task is completed.

Although developing the stress test under the act presented complex

challenges, OFHEO’s decision in 1994 to develop its own sophisticated

stress test rather than adopting and modifying stress tests that were

already under development resulted in a substantial commitment of time

and resources. Related factors contributing to the delay in implementing

this decision included OFHEO (1) failing to hire its full complement of

research staff until 1996 or get its computer network operational until late

1994, (2) experiencing delays in obtaining accurate enterprise financial

data, (3) devoting considerable staff time and resources to the federal

rulemaking process, and (4) encountering greater managerial and

technical challenges than initially anticipated in developing an integrated

financial model that serves as the basis of the stress test. An OFHEO official

said that this financial model had largely been completed by April 1997,

although final testing needed to be completed during the summer of 1997.

We recognize the complexity of the challenges that OFHEO has faced.

However, we note that OFHEO has consistently underestimated the time

needed to complete its tasks. Given OFHEO’s history of failing to meet its

own publicly announced completion targets and considering the

challenges that remain, we are concerned that OFHEO may not meet its

current estimate of issuing a final rule by 1999. For example, to meet the

38Fannie Mae and OFHEO officials have a basic disagreement as to what constitutes disclosure of

proprietary information. On this subject, Freddie Mac officials also indicated a disagreement with

OFHEO.

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schedule in the current plan, OFHEO must coordinate the interagency

review process and make key policy decisions, such as forecasts about

future interest rates. In addition, OFHEO must translate the complex

components of the stress test and capital standards into proposed and

final rules as required by APA while protecting against the unauthorized

disclosure of proprietary enterprise data.

We believe it is essential that OFHEO take all feasible steps to comply with

its plan and complete the stress test and risk-based capital standards as

soon as possible because they are critical to helping maintain the safety

and soundness of Fannie Mae and Freddie Mac. Although the enterprises

have been consistently profitable in recent years, their rapid growth and

potentially increasing interest rate risks pose potential costs to taxpayers

that exceeded $1.5 trillion at year-end 1996. Without a stress test and

risk-based capital standards in place, OFHEO’s capacity to lower such

taxpayer risks is limited.

Recommendations Given the history of OFHEO’s failure to meet its own publicly announced

plan to complete the stress test and risk-based capital standards, strong

congressional oversight appears necessary to ensure that OFHEO issues its

final rule in a timely manner. Accordingly, we recommend that OFHEO’s

director report to Congress periodically on the organization’s progress

towards compliance with its current plan. We also recommend that the

director include in such reports information on the status of OFHEO’s

progress towards important milestones, such as its (1) projected

completion of final testing on the financial model that comprises the stress

test, (2) progress toward completing the interagency review process,

(3) estimated completion of key policy decisions regarding the stress test

by early 1998, and (4) progress in translating the components of the stress

test into proposed and final rules. Finally, we recommend that the director

inform Congress of any problems that may arise in completing the stress

test and risk-based capital rules by 1999 and of actions that the

organization plans to take to correct such problems.

Agency Comments

and Our Evaluation

In written comments, OFHEO’s acting director agreed with the report’s

analysis of why the development of the stress test and risk-based capital

standards has been protracted and stated that OFHEO is implementing our

recommendation that Congress be informed of progress in completing the

final rule. He emphasized that the complexity of the development process

as specified in the act and OFHEO’s decision to develop its own

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sophisticated stress test have been the primary factors in delaying the

completion of the final rule. The acting director also said that the report

should not be interpreted to suggest that using the HUD stress test or using

the enterprises’ financial models would have produced an acceptable

result. As examples, he said that the HUD stress test did not include the

credit stress benchmark, and a simplified stress test would not adequately

address the enterprises’ increased interest rate risks resulting from their

larger retained mortgage portfolios. He said that the enterprises’ mortgage

portfolios are becoming increasingly complex and involve large volumes

of derivative instruments. Among other reasons, the acting director said

that relying on the enterprises’ financial models would not have been

appropriate because it potentially would have jeopardized OFHEO’s

independence as a regulatory agency.

We did not take a position in the report on the adequacy or

appropriateness of OFHEO’s approach to developing the stress test and

risk-based capital standards. To do so would have required that we

demonstrate whether the other alternatives could have been modified

sufficiently to meet the requirements of the act in a shorter period of time.

Given that the time is long past when such a demonstration would have

affected OFHEO’s approach, we chose not to pursue such an assessment.

Rather, we pointed out that there were potential trade-offs associated with

the time that would have been necessary to adopt and modify the HUD

stress test, or another aggregated type of stress test, and the

comprehensive development approach that OFHEO has chosen.

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OFHEO’s examination program is its primary means of helping to ensure the

safety and soundness of Fannie Mae and Freddie Mac in the absence of

risk-based capital standards. Since 1994, OFHEO has made important

progress in fulfilling its essential examination oversight function, such as

by establishing a “risk-focused” examination strategy, defining six “core

risks” facing the enterprises, and by completing or initiating on-site

examinations to monitor five of these risks. However, OFHEO has also

scaled back the implementation of a detailed examination schedule and

plan that was developed in September 1994. In particular, OFHEO’s current

3- to 4-year cycle for examining the six core risks facing the enterprises is

considerably longer than the 2-year cycle established in its 1994

examination plan, and OFHEO’s most recently completed core risk

examination covered fewer areas than planned. Without a more timely and

comprehensive examination program, OFHEO faces limitations in its ability

to monitor the risks facing the enterprises, such as their potentially greater

interest rate risks resulting from increasing holdings of debt-financed

mortgage assets.

The evidence we obtained indicated that, among other factors, limited

resources applied to the examination function were largely responsible for

OFHEO’s inability to fully implement the 1994 examination plan. Our

analysis found that to complete each core risk examination, OFHEO was

required to commit a significant majority of its 12 line examiner and

specialist positions to the examination for a period of 1 year as well as

noncore risk—or targeted risk—examinations that were required. As a

result, OFHEO may lack the line examiner and specialist staff resources

necessary to complete examinations covering three core risks per year,

the minimum necessary to cover all six core risks in a 2-year cycle. In

addition, staff attrition in 1996 and early 1997 left the examination office

with 5 vacancies out of 17 authorized full-time positions—a vacancy rate

of 30 percent—as of March 31, 1997, which further limited OFHEO’s ability

to implement the 1994 plan. By August 1997, an OFHEO official reported

that the organization had filled three of the positions and two others were

being advertised.

OFHEO officials said that they recognize the need to shorten the 3- to 4-year

examination cycle to adequately assess the enterprises’ financial condition

and management practices. During 1997, OFHEO plans to reassess its

examination strategy and make changes to shorten the examination cycle

for all six core risks to 1 year. In the reassessment of its examination

strategy, OFHEO could usefully include consideration of different

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examination cycles and related coverage that could be accomplished with

alternative resource levels.

OFHEO Established a

Detailed Enterprise

Examination Schedule

and Plan in 1994

In September 1994, OFHEO established a detailed examination strategy,

schedule, and plan to help ensure the safety and soundness of Fannie Mae

and Freddie Mac. The plan identified six “core risks,” such as interest rate

risk, facing the enterprises, and established a 2-year cycle for OFHEO

examination staff to assess these risks. OFHEO’s examination plan is

generally consistent in substance but not in timing with risk-focused

examination plans that OCC and the Federal Reserve System have

established to annually assess the safety and soundness of large

commercial banks. Although we recognize that large banks may engage in

a wider variety of potentially risky activities than the enterprises, we

believe a generally consistent examination approach by OFHEO and the

bank regulators is important because the potential exists that a large bank

or enterprise failure could cause substantial taxpayer losses.39

OFHEO’s Examination

Program Called for

Assessing Enterprise Risks

on a 2-Year Cycle

The act requires OFHEO to conduct annual, on-site safety and soundness

examinations of the enterprises to assess their operations and financial

condition. According to an OFHEO attorney, this requirement can be and

has been met without conducting full-scope enterprise examinations on an

annual basis. Full-scope examinations are generally understood to mean

thorough assessments of all of the management practices and business

strategies of a federally regulated financial institution that could affect its

safety and soundness.

During 1994, senior OFHEO officials established a “risk-focused”

examination schedule and plan to assess the risks facing Fannie Mae and

Freddie Mac on a 2-year cycle. Under the plan OFHEO adopted in

September 1994 and has subsequently modified,40 OFHEO identified six core

risks, which OFHEO officials believed represent the greatest risks to the

enterprises. These six core risks are corporate governance, interest rate,

credit, operations, business, and information technology. Although there

are six core risks, OFHEO’s plan stipulated that examiners could cover these

39The Federal Deposit Insurance Corporation administers the Bank Insurance Fund, which uses

premiums paid by banks to protect the depositors of failed banks. The potential exists that during a

financial emergency, a large bank failure or series of large bank failures could drain the Bank

Insurance Fund, thereby requiring a taxpayer bailout. As discussed in the report, the potential exists

that the government would choose to rescue the enterprises if they could not meet their debt and MBS

obligations.

40For example, OFHEO did not identify information technology risks as a core risk until 1995.

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risks in five exams by consolidating the credit risk and interest rate risk

components into a single risk management examination (see table 3.1).

The risk management examination was also intended to cover five other

risk areas, such as asset growth and composition, which OFHEO does not

consider to be core risks. Under the plan, the four other core risk

examinations designated specific areas that OFHEO examiners were to

cover. For example, the business line examination was to assess the

adequacy of the enterprises’ risk management of the following businesses:

single-family mortgage guarantee, multifamily mortgage guarantee,

portfolio, and financial services.

Table 3.1: OFHEO’s Examination Plan

for Monitoring the Six Core Risks on a

2-Year Cycle

Exam type Summary of examination objectives

Corporate governance risk Assess enterprise board of directors oversight,

organization structure, internal controls, and information

flows.

Risk management Assess interest rate risk, credit risk, and five other risk

areas.

Business risk Assess risks in four enterprise business areas, including

single-family mortgages, multifamily mortgages, portfolio,

and financial services.

Operations risk Assess operational practices in four areas, such as

securitization.

Information technology risks Assess the enterprises’ use of computer technology and

associated risks.a

aOFHEO did not identify information technology risk as a core risk until 1995. However, the

September 1994 plan did identify information technology risk as an area that required a targeted

examination.

Source: OFHEO.

OFHEO’s 1994 examination plan also identified other risks that examiners

were to assess within a 2-year period. These exams were considered to be

more targeted than the exams established to assess the six core risks. In

particular, OFHEO examiners were to assess the books and records of both

enterprises to determine the accuracy and reliability of their financial

reporting. These books and records examinations were to encompass the

financial reporting underlying the enterprises’ public financial statements

and the internal reporting supporting management processes. The plan

also called on OFHEO examiners to assess the enterprises’ use of

sophisticated derivative instruments. In addition, the plan called for OFHEO

to develop the capacity to monitor the enterprises’ financial condition on

an off-site basis, such as by collecting periodic financial information from

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the enterprises that show trends in asset growth, financial performance,

and funding.

OFHEO uses a “top-down” approach to examinations to assess the six core

risks as well as targeted risks. The examination of a particular risk is to

begin with a “Level I” review in which examiners evaluate board of

directors oversight and planning and review internal and external audits.

The examiner is to proceed to a Level II review if deficiencies in the

management of risk are found. This level of review usually would involve

additional testing of controls. If a Level II exam does not resolve all areas

of concern, a Level III review—a detailed review of the control

environment, including extensive transaction testing—is to be conducted.

OFHEO Examination Plan

Is Generally Consistent in

Substance but Not in

Timing With Plans

Developed by Bank

Regulators

The risk-focused examination plan and 2-year cycle OFHEO established in

1994 is generally consistent in concept but not in timing with risk-focused

examination plans that OCC and the Federal Reserve have recently

established to examine large commercial banks. By law, bank regulators

are required to conduct full-scope examinations of the financial condition

and safety and soundness of large banks at least once a year.41 OCC has

chosen to implement the full-scope requirement by developing a

risk-focused examination system that identifies nine major risks, such as

interest rate and credit risks, facing national banks; some of these risks are

similar to the core risks OFHEO has identified as facing the enterprises.

According to OCC, its staff are to assess each of the risks facing particular

national banks on an off-site basis prior to initiating an examination. These

off-site assessments are to be accomplished by reviewing previous

examination reports and available financial data among other documents.

OCC staff are then to focus the majority of their time and resources on the

greatest risks facing particular banks during the on-site examination

process. The Federal Reserve System has established a risk-focused

annual examination program, which is similar to that of OCC, for large

banks under its supervisory responsibility.

We recognize that large commercial banks engage in a variety of

potentially risky activities, such as trading securities and lending for many

purposes, on a worldwide basis, while the enterprises’ activities are

generally confined to a single line of business, mortgage purchases, in the

United States. Consequently, it could be argued that large banks should be

subjected to a more rigorous level of supervision and examination than the

41See Federal Deposit Insurance Corporation Act of 1991, Pub. L. No. 242, § 111(a), as amended, 12

U.S.C. § 1820d. Under this act, bank and thrift regulators are required to do annual, full-scope

examinations of banks or thrifts with total assets of $250 million or more.

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enterprises. However, as pointed out in our previous reports, we believe

that the enterprises should generally be subjected to a similar level of

supervision as banks, although some modifications to adjust for their

differing risk characteristics may be necessary.42 For example, banks and

the enterprises share some risk characteristics, such as interest rate,

credit, business, and management risks, and the failure of either an

enterprise or a large commercial bank could potentially impose losses on

taxpayers.

OFHEO Has Not Been

Able to Fully

Implement the 1994

Examination Plan

Our review found that, despite making important progress, OFHEO has not

been able to fully implement the enterprise examination schedule and plan

that was established in September 1994. Although OFHEO has completed or

initiated examinations covering five of the six core risks, at its current rate

it will take OFHEO 3 to 4 years to examine all six core risk areas, which is

considerably longer than the 2-year cycle established in the 1994 plan.

Moreover, OFHEO scaled back the planned coverage of the most recently

completed core risk examination. OFHEO’s relatively long examination

cycle and limited examination coverage raise questions about its capacity

to fully assess the enterprises’ management, financial practices, and risks

on a timely basis.

OFHEO Has Made

Progress in Implementing

the 1994 Plan

Between August 1994 and May 1997, OFHEO made important progress in

implementing the 1994 examination schedule and plan. As of May 1997,

OFHEO had completed or initiated examinations covering five of the six

core risk areas, and OFHEO plans to initiate the remaining core examination

covering operations risk in 1997 (see table 3.2). OFHEO also completed

three targeted examinations covering the enterprises’ use of nonmortgage

derivative contracts, the enterprises’ compliance with a flood insurance

statute,43 and data integrity issues at Freddie Mac.

42We have observed that bank regulation is a useful starting point for determining the regulatory

structure that should apply to government-sponsored enterprises, such as Fannie Mae and Freddie

Mac. As examples, we have stated that government-sponsored enterprises should be subject to capital

standards and periodic on-site examinations. See Government-Sponsored Enterprises: A Framework

for Limiting the Government’s Exposure to Risks (GAO/GGD-91-90, May 22, 1991) and

Government-Sponsored Enterprises: The Government’s Exposure to Risks (GAO/GGD-90-97, Aug. 15,

1990).

43The National Flood Insurance Reform Act of 1994 requires the enterprises to implement procedures

that are reasonably designed to ensure that adequate flood control insurance is in place over the term

of the mortgage loans the enterprises purchase after September 28, 1995. Pub. L. No. 103-325 § 522, 42

U.S.C. § 4012a(b)(3). According to an OFHEO official, OFHEO ensures that the enterprises comply

with these requirements on a biennial basis.

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Table 3.2: OFHEO’s Completed,

Ongoing, and Planned Examinations

as of May 1997

Exam type Start datea End datea

Core risks

Corporate governance August 1994 June 1995

Risk management (credit and interest

rate risks)

May 1995 June 1996

Business June 1996 May 1997

Information technology March 1997 Planned September

1997

Operations Planned 1997 Planned 1997 or 1998

Targeted

Nonmortgage derivatives May 1994 November 1994

Flood insurance January 1996 May 1996

Freddie Mac data integrity August 1996 November 1996

aIncludes both Fannie Mae and Freddie Mac exams. The end date is for the enterprise exam that

OFHEO completed last. All of the Fannie Mae and Freddie Mac exams were completed within

several weeks of one another.

Source: OFHEO.

OFHEO’s examination office has also established an off-site capacity to

monitor the enterprises’ financial condition and safety and soundness as

specified in the 1994 plan. The Office of Examination and Oversight (OEO)

staff collects financial information from the enterprises and produces

internal reports that discuss relevant supervisory issues. OEO’s acting

director said that the examination staff works closely with ORACS staff to

develop a better understanding of the enterprises’ financial activities. He

also said that OFHEO plans to more fully integrate off-site monitoring into

the examination process. For example, OFHEO plans to produce internal

reports focusing on each of the six core risks. These reports would be

reviewed by examiners prior to initiating a risk-based examination,

potentially creating examination efficiencies.

OFHEO Has Not

Implemented Other

Important Components of

the 1994 Examination Plan

Despite making progress, OFHEO has not implemented other important

components of the 1994 examination plan. As shown in table 3.2, OFHEO

completed examinations covering four—corporate governance, credit,

interest rate, and business—of the six core risk areas between 1995 and

1997, plans to complete the information technology examination in 1997,

and plans to initiate the operations risk examination in 1997, which may

not be completed until 1998. Therefore, OFHEO’s first cycle for covering all

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six core risk areas will take 3 to 4 years (1994 to 1997 or 1994 to 1998)44

rather than the 2-year cycle established in the 1994 plan.

OFHEO also scaled back the planned coverage of its most recently

completed core risk examination. The core business risk examination that

OFHEO completed in May 1997 covered risk management in one of the four

business areas specified in the 1994 plan—the single-family guarantee

component. OFHEO’s inability to cover the other three business areas (in

particular, the multifamily mortgage guarantee business) has limited the

organization’s capacity to fully monitor the enterprises’ safety and

soundness. OFHEO’s 1997 annual report states that the enterprises’

purchases and new guarantees on multifamily mortgages tripled from

$3 billion at year-end 1992 to $9 billion at year-end 1996. According to the

annual report, multifamily mortgage loans are relatively risky. For

example, although the delinquency rates on the enterprises’ multifamily

mortgages have improved significantly since 1992, they are still higher

than the delinquency rates on the enterprises’ single-family mortgages.45

In addition, OFHEO was not able to implement the objective in the 1994

examination schedule and plan that it assess the books and records of the

enterprises to assess the accuracy of their financial reporting. We pointed

out in chapter 2 that OFHEO did initiate a “data integrity” examination at

Freddie Mac in 1996 that identified significant problems in the controls

over data submitted to OFHEO for development of the stress test and

risk-based capital standards. Thus, such examinations appear to be

important for ensuring accurate enterprise financial data. OFHEO has not

yet initiated a data integrity or books and records targeted examination at

Fannie Mae, although it plans to do so as part of the information

technology examination, according to OFHEO officials.

OFHEO’s Capacity to Fully

Assess Enterprise

Risk-Taking Is Limited

OFHEO’s inability to fully implement the 1994 examination schedule and

plan limits its capacity to fully assess the enterprises’ management

practices, financial condition, and risks. For example, although Fannie

Mae and Freddie Mac have been consistently profitable in recent years, we

pointed out in chapter 1 that the enterprises have adopted business

strategies that could potentially weaken their future financial

44OFHEO initiated the corporate governance risk exam in August 1994.

45Single-family mortgage loan delinquency rates at both enterprises equaled .58 percent of outstanding

single-family mortgages in 1996. During 1996, Fannie Mae’s delinquency rate on multifamily mortgages

was .68 percent, which was well below the delinquency rate of 2.65 percent in 1992. Freddie Mac’s

delinquency rate on multifamily mortgages was 1.96 percent in 1996, having fallen from 4.45 percent in

1992.

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performance, such as by growing at rapid rates and potentially incurring

greater interest rate risks through increased holdings of debt-financed

mortgage assets. Under its current 3- to 4-year examination cycle,

however, OFHEO may not be able to do an on-site examination to assess the

enterprises’ interest rate risks until 1999 or 2000, since the previous risk

management examination was completed in 1996.

Limited Examination

Staff Resources

Impeded OFHEO’s

Ability to Implement

the 1994 Examination

Schedule and Plan

The evidence indicates that limited examination staff resources were

largely responsible for the fact that OFHEO has not been able to fully

implement the 1994 examination plan. In particular, OFHEO has too few

examiners and specialists to fully cover the six core risks within a 2-year

period. Although OFHEO supplements its examination staff with temporary

contractors and detailees, their use has not been sufficient to ensure

compliance with the plan. OFHEO officials said that another contributing

factor was the time that its examiners needed to develop an understanding

of the enterprises’ operations and risk management.

OFHEO’s Limited

Examination Staff

Resources Have Been a

Long-Standing Concern

In testimony before the House Banking, Finance, and Urban Affairs

Committee, Subcommittee on Housing and Community Development on

October 29, 1993, OFHEO’s former director stated that the organization was

relatively understaffed as compared to other federal financial regulators.

For example, the former director said that OFHEO was relatively

understaffed as compared to the Federal Housing Finance Board, the

Office of Thrift Supervision, and OCC, and that OFHEO staff were responsible

for assessing more assets per employee than other regulators. OFHEO’s

former director told us in December 1996 that the small size of the

examination office remained an area of concern. In our 1995 report on

OFHEO’s development as an independent regulator, we also stated that

limited staff resources had impeded OFHEO’s ability to implement its

examination program; for example, OFHEO had just seven staff members in

its examination office at year-end 1994.46 In addition, OFHEO officials we

contacted said that limited staff resources impeded their ability to

implement the 1994 plan.

Another factor that OFHEO officials cited for the organization’s inability to

fully comply with the 1994 plan was that the examination staff needed to

take the time necessary to develop an understanding of the enterprises’

operations and risk management practices. OFHEO’s acting director said

that prior to 1993 when OFHEO began operations, Fannie Mae and Freddie

46GAO/GGD-95-123.

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Mac had never been subjected to a safety and soundness examination

program. Consequently, he said that OFHEO’s first cycle of examinations

has proved more time-consuming than OFHEO officials initially anticipated

in 1994. He also said that subsequent examination cycles would proceed

faster because of the experience gained during the first cycle.

Each Core Risk

Examination That OFHEO

Has Initiated Tied Up a

Significant Majority of Line

Examination Staff for

About 1 Year

We analyzed OEO’s allocation of examination staff resources and found

that it appears to lack an adequate number of positions to cover the six

core risks within a 2-year period. During fiscal year 1997, OEO had 17

authorized full-time permanent positions (see fig. 3.1). As the figure

indicates, 12 of the 17 positions were assigned to line examiners and

specialists, those individuals who are assigned full-time to conduct the

labor-intensive tasks associated with core risk and targeted examinations

(such as conducting and writing up interviews with enterprise officials,

reviewing policies, collecting and analyzing financial data, reviewing the

enterprises’ asset and liability management practices, writing examination

drafts, and documenting findings).

Although OEO’s director and deputy director also play a vital role in the

examination process, such as by reviewing examination reports and

communicating findings to senior enterprise officials, they have other

responsibilities that claim their time as well. As examples, the director and

deputy director are to establish policies and plans for the office, prepare

annual budgets, and conduct internal and external meetings, among other

responsibilities. The two financial analyst positions are primarily

responsible for conducting OFHEO’s off-site financial monitoring program.

The remaining position is for the executive secretary, who is responsible

for maintaining the correspondence of the office and other administrative

support functions.

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Figure 3.1: Line and Nonline Full-Time Permanent Positions in OFHEO’s Office of Examination and Oversight

Director

Deputy Director Executive Secretary

Senior Information 

Systems Specialist

Financial Analyst

Financial Analyst

Senior Capital Markets

Specialist

Senior Enterprise

Examiner

Senior Enterprise

Examiner

Senior Enterprise

Examiner

Senior Accounting

Specialist

Senior Enterprise

Examiner

Senior Secondary

Mortgage Specialist

Senior Enterprise

Examiner

Senior Secondary

Mortgage Specialist

Senior Enterprise

Examiner

Examination Manager

Line examiner or specialist position

Nonline examiner or specialist position

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In the two most recent core risk examinations,47 OFHEO needed to commit

a significant majority of its line examination staff to each exam for a

period of about 1 year to complete them (see table 3.3). Specifically, OFHEO

assigned nine of its line examiners and specialists full-time to the business

risk examination and eight examiners full-time48 to the risk management

examination. In addition, OFHEO assigned a financial analyst to work on the

risk management examination even though this individual’s primary

responsibility is to produce off-site financial reports. Further, OFHEO’s staff

of line examiners and specialists is required to do targeted examinations,

such as of the enterprises’ compliance with flood insurance requirements.

With such a large majority of its line examination and specialist staff

assigned to one core risk management examination for a whole year and

with various targeted examination requirements, it appears that OFHEO

lacks adequate examination resources to cover three core risks per year,

the minimum necessary to cover all six core risk areas on a 2-year cycle as

stipulated in the 1994 plan.

Table 3.3: OFHEO Line Examination

Positions Assigned to Completed

Enterprise Core Risk Examinations

Examination type

Line examiners and

specialists assigned

Total line examiner

and specialist

positions

Exam start and

end dates

Business

9 12

June 1996 to

May 1997

Risk management

8a 12

May 1995 to

June 1996

aIncludes an examiner who resigned from OFHEO approximately 75 percent of the way through

the examination. Also, excludes a financial analyst who was assigned to the examination.

Source: OFHEO.

Examination Office Has

Had Attrition

During 1996 and 1997, OFHEO’s examination office experienced significant

attrition of permanent full-time staff, which has further limited its ability to

implement the 1994 plan. During 1996, three full-time permanent

staff—two examiners and a capital markets specialist —resigned, and, in

January 1997, OEO’s director passed away. As of March 31, 1997, OEO had

five full-time permanent position openings, which represented a vacancy

rate of 30 percent. Of the five vacancies in the examination office, one was

47We did not include OFHEO corporate government risk examination in this analysis because it was

initiated in 1994 when the examination office only had a total of seven staff, including the director,

deputy director, and executive secretary.

48One OFHEO examiner resigned approximately 75 percent of the way through the risk management

examination.

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for the director, three were for line examiner or specialist positions, and

one was for a financial analyst.

According to OEO’s acting director, the office places a high priority on

filling these vacancies in 1997 through a competitive civil service

announcement because the vacancies further limit OEO’s capacity to do

examinations on a timely basis. As of August 1997, an OFHEO official said

that the organization had filled the OEO director position, a financial

analyst position, and a specialist position. In addition, the official said that

OFHEO was in the process of announcing the other two specialist positions.

OFHEO officials told us that the organization prefers to recruit senior-level

examiners who have substantial experience in overseeing the operations

of financial companies. OFHEO officials said they adopted this strategy for

the following reasons: (1) experienced examiners can more quickly

understand the operations of the enterprises, (2) OFHEO grants

considerable latitude to its examiners so they must have credibility with

senior enterprise officials, (3) senior examiners allow OFHEO to minimize

its staffing levels, and (4) it is too expensive to establish an examiner

development program that would focus on recruiting more junior-level

examiners. However, OFHEO officials also said that it can be difficult to

attract and retain senior examiners because they are also in demand by

large financial corporations and other financial institution regulators that

may be able to offer higher salaries and career opportunities than OFHEO.

We reviewed the backgrounds of OFHEO’s full-time examination staff and

found that they have substantial backgrounds in examining financial

institutions and financial analysis. For example, the acting director had

served a total of 15 years with the Office of Thrift Supervision and OCC.

Other staff had also worked for financial regulators and had postgraduate

degrees in finance, business, accounting, and/or professional certifications

from relevant accrediting organizations.

OFHEO’s Use of

Contractors May Have

Been Affected by Cost and

Other Factors

OEO’s acting director said that OFHEO plans to continue supplementing its

examination staff with contract employees and detailees from other

financial regulators. In the past, contract employees and detailees have

performed most functions of OFHEO examiners, such as conducting

examinations and documenting their findings. However, OEO officials said

that OFHEO examiners make all final examination conclusions and

recommendations that are based on the work of the contract employees

and detailees. In April 1997, OFHEO’s contract with a private firm for

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examination and related support services expired. The firm provided five

examiners who worked on the risk management examination and three

examiners who worked on the business risk examination. This contract

was replaced by another contract that was signed in March 1997 to

provide support for OFHEO’s ongoing information technology risk

examination. OFHEO plans to use its full-time staff, including new hires, to

staff the operations risk examination that is also scheduled to begin in

1997.

Despite relying on contractors to supplement its full-time examination

staff, OFHEO has not been able to fully implement the 1994 plan. One factor

that may have limited OFHEO’s use of contractors is cost. For example,

OEO’s acting director estimated that hiring a contractor full-time for 1 year

costs approximately $175,000 to $200,000 per year.49 By contrast, he

estimated that OFHEO’s compensation and travel costs for a full-time

examiner are about $125,000. He also estimated that OFHEO’s compensation

and travel costs for a detailee from a bank regulatory agency vary from

about $100,000 to $150,000, depending upon whether the detailee normally

works in a regional office and OFHEO must pay temporary housing costs in

the Washington, D.C., area.

Another factor that appears to have limited OFHEO’s use of contractors is

an ongoing dispute between Fannie Mae and OFHEO over the potential

disclosure of proprietary information; OEO’s acting director said that OFHEO

temporarily stopped using contractors during the course of the risk

management exam as a result of this dispute. Fannie Mae officials told us

that they believe OFHEO lacks the statutory authority to use contractors as

full-fledged examiners. Instead, Fannie Mae officials said they believe that

OFHEO only has the authority to use contractors for temporary technical

assistance. Fannie Mae officials said that contractors could disclose

proprietary information gained during the examination process to the

enterprise’s direct competitors. In response, OFHEO’s general counsel told

us that the organization has statutory authority to use contractors during

the examination process. The general counsel also said that OFHEO has

implemented adequate procedures to protect proprietary enterprise

information. Among other procedures, OFHEO generally requires

contractors to (1) sign oaths to the effect that they will not disclose

proprietary information obtained from the enterprises and (2) turn over to

OFHEO officials materials obtained from the enterprises during the

examination process.

49OFHEO limits its contractor costs by hiring on a part-time basis.

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OFHEO Plans to

Reassess Its

Examination Strategy

and Staff Resources

OEO’s acting director stated to us that OFHEO plans to shorten the time that

it takes to complete the core risk examinations. He said that OFHEO plans

to initiate an assessment of its examination program during 1997 and to

make procedural changes as necessary to enhance enterprise oversight by

early 1998. The acting director stated that OFHEO plans to assess the

appropriate mix of full-time staff, contractors, and detailees as well as

potential examination strategies that would shorten the current

examination cycle for assessing the core risks from 3 to 4 years to 1 year

rather than the 2-year cycle in the 1994 plan. The acting director stated

that shortening the examination cycle to 1 year is a reasonable goal

because OFHEO plans to fill its five vacant positions during 1997, which

would facilitate a faster examination cycle. Moreover, the acting director

said that the experience OFHEO has gained during the first round of

examinations should also shorten subsequent examination cycles. OFHEO

has hired OCC’s former Chief National Bank Examiner as a consultant to

advise the organization on assessing its examination strategy.

OEO’s acting director said that, as part of its reassessment, OFHEO plans to

determine the appropriate number of examiners and specialists necessary

to shorten the examination cycle to 1 year. According to OFHEO’s acting

director, OFHEO may shift resources from ORACS to OEO after the stress test

and risk-based capital standards are completed. Consequently, OFHEO may

have some flexibility over time to increase the resources in its

examination office without necessarily increasing its overall staffing levels

or budget.

Conclusions OFHEO’s examination program, along with the development of minimum

and risk-based capital standards, is an essential component for helping to

ensure the safety and soundness of Fannie Mae and Freddie Mac. Since

OFHEO began operations in 1993, the organization has made important

progress in developing a viable examination program. This progress

included developing a risk-focused approach to examinations, identifying

six core risks facing the enterprises, and completing or initiating

examinations to cover five of those six risks. In addition, OFHEO has

completed special exams of the enterprises’ nonmortgage derivatives

activities, compliance with flood insurance requirements, and data

integrity issues at Freddie Mac.

OFHEO has also assembled an examination staff that has substantial

experience in monitoring financial institutions. However, limited staffing

levels and staff attrition—among other factors, such as the need for OFHEO

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to develop an understanding of the enterprises’ operations and risk

management—have compelled OFHEO to scale back the implementation of

a detailed examination schedule and plan that it established in 1994. As a

result, OFHEO has a 3- to 4-year cycle for examining the enterprises, which

is considerably longer than the 2-year cycle in the plan. OFHEO also reduced

the planned coverage of its business risk examination. In our view, OFHEO’s

inability to fully implement a comprehensive examination program limits

the organization’s ability to adequately monitor the enterprises’

management practices and financial condition.

According to OFHEO officials, the organization plans to reassess its

examination strategy and to make changes as necessary to shorten the

examination cycle from 3 to 4 years to 1 year. We are concerned that,

without a reassessment of resources, OFHEO may not be able to implement

an annual enterprise examination program that adequately covers all risk

areas by early 1998. Thus far, OFHEO has not been able to implement a

2-year examination cycle that fully covers all identified risk areas with

examination office resources currently assigned. In fact, as of June 1997,

OFHEO had not completed the first cycle of examinations and important

tasks remained. Thus, OFHEO’s plan to implement, even after it fills existing

OEO vacancies, an annual examination strategy by early 1998 represents a

substantial additional challenge to an examination staff that already has a

significant workload.

Therefore, we believe that including in OFHEO’s assessment an analysis of

the staff resources necessary to adequately carry out alternative

examination cycles, such as 1 or 2 years, could help ensure a fuller

consideration of the trade-offs associated with examination coverage

provided versus costs involved and thereby result in a more informed

decisionmaking process.

Recommendations We recommend that OFHEO’s and OEO’s director promptly (1) conduct an

analysis to determine the examination office staff positions and financial

resources that would be needed to cover all core and targeted risk areas

within 1- or 2-year examination cycles; (2) identify the most appropriate

examination cycle after considering the trade-offs between examination

coverage and resource requirements that would be involved; and

(3) develop a strategy for obtaining the necessary examination office

resources, which may involve reallocating OFHEO’s existing full-time and

contracting positions over time.

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Agency Comments

and Our Evaluation

In written comments, the acting director of OFHEO agreed with our findings

and recommendations regarding the examination program. The acting

director attributed OFHEO’s relatively long 3- to 4-year examination cycle to

the fact that the enterprises had not been subjected to a safety and

soundness examination program prior to OFHEO’s creation. He also stated

that upon completion of the first round of examinations at year-end 1997,

OFHEO will have completed the “discovery” process that is essential to

understanding the quantity and quality of risk at the enterprises. The

acting director further stated that OFHEO will transition to a “continuous

examination process” at year-end 1997 that will allow for an annual

examination cycle. Moreover, the acting director said that OFHEO’s

previous examination work would allow it to prioritize future examination

activities while dramatically increasing the efficiency of the examination

process.

The acting director agreed with the report’s finding that adequate

resources must be committed to the examination program. He also said

that OFHEO should be able to attract and retain qualified examiners in the

future as a result of its increasing visibility in the regulatory community

and efforts to ensure pay comparability. Further, the acting director stated

that OFHEO will continue to review the adequacy of its examination staff

resources and supplement its permanent examination staff with expertise

from within OFHEO, bank regulatory detailees, and contractors.

While OFHEO has agreed to review the adequacy of its examination staff

resources, we believe it is essential that OFHEO promptly specify the

resources necessary to carry out an appropriate examination cycle and

develop a plan to obtain the permanent staff, detailees, and contractors

that may be required.

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OFHEO’s Implementation of Key Mission

Support Functions

In response to our statutory mandate to assess OFHEO’s overall operations,

we reviewed OFHEO’s implementation of key functions that support the

organization’s safety and soundness mission-related activities. These

mission-related support functions are OFHEO’s financial, human resources,

and contract management systems. Despite some initial implementation

challenges, OFHEO officials we contacted said that these mission-support

functions are now operating satisfactorily.

We also assessed whether OFHEO’s participation in a U.S. government

initiative to assist Mexico in developing a secondary mortgage loan market

has diverted OFHEO from fulfilling its safety and soundness mission.

Although OFHEO officials made 10 trips to Mexico in 1995 and 1996 to

support the initiative, the trips did not involve staffs directly responsible

for developing the stress test or conducting examinations. In addition,

most of OFHEO’s foreign travel and related costs were paid by the United

States Agency for International Development (USAID).

In this chapter, we also provide trend information on OFHEO’s budget and

staff resources and discuss OFHEO’s relationship with HUD to provide

further perspectives on how OFHEO has deployed its resources during its

first 4 years of operations.

OFHEO Has

Implemented Its

Financial, Human

Resources, and

Contract Management

Functions

Since our first report on OFHEO’s operations,50 the organization has

implemented its financial management, human resource, and contracting

mission support functions. According to OFHEO officials, the organization

experienced some problems in making the support functions fully

operational. In particular, OFHEO experienced repeated problems with

HUD’s operations of its financial management systems, which OFHEO

officials said compelled them to convert to a different financial

management system offered by VA. Nevertheless, OFHEO officials said that

they are now generally satisfied with the operational performance of these

support functions.

OFHEO Switched to a New

Financial Management

System in 1996 After

Repeated Problems With

HUD’s Systems

When OFHEO began its operations in June 1993, it relied on HUD’s financial

management system, which was called the HUD Administrative Accounting

System (HAAS). Under HAAS, OFHEO staff reviewed invoices and sent

approved invoices to HUD for payment processing. However, we reported

in 1995 that HAAS did not meet OFHEO’s needs because, among other

reasons, OFHEO staff had limited access to the system and experienced

50GAO/GGD-95-123.

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substantial delays in how HUD recorded OFHEO obligations and expenses.

Also, HUD staff confused OFHEO with another HUD agency, the Office of Fair

Housing and Equal Opportunity (FHEO), which resulted in errors in OFHEO’s

financial reports. In October 1995, HUD converted OFHEO to its new

accounting system, the HUD Central Accounting and Program System

(HUDCAPS).

Although HUDCAPS offered improvements over HAAS, OFHEO officials said

that they remained dissatisfied with system access and performance and

the level of support provided by HUD. For example, OFHEO officials said that

HUD staff continued to inaccurately record transactions and did not

provide OFHEO with the support necessary to correct errors. In addition,

OFHEO officials said that there were prolonged periods when HUDCAPS was

unavailable, and OFHEO staff were unable to record transactions. These

deficiencies with HAAS and HUDCAPS caused OFHEO officials to initiate a

search for a new financial management system.

In 1996, OFHEO entered into a “cross-servicing” arrangement51 with VA, a

franchiser under the Government Management Reform Act,52 to operate

OFHEO’s financial management system beginning in fiscal year 1997. During

the first half of fiscal year 1997, OFHEO officials concentrated on the

conversion of the organization’s financial accounting activities from

HUDCAPS to the VA Financial Management System (FMS).

OFHEO officials said that the VA FMS has met their initial performance

expectations, but the conversion process was more difficult than initially

planned due to the amount of reconciliation needed to the financial data

contained in the HUD records. OFHEO officials said that they plan to have the

organization’s fiscal year 1997 financial statements audited by an

independent accounting firm.

OFHEO Has Implemented

Its Human Resource

Management Systems

Under the act, OFHEO has exclusive authority over hiring and compensation

levels for its personnel. The act further specifies that OFHEO personnel may

be paid without regard to certain provisions of federal law53 relating to

51A “cross-servicing” agreement is an interagency agreement where one agency agrees to provide

specific services to another agency. As a small independent office, OFHEO is able to secure

administrative services from larger organizations having the capability to provide services on a cost

reimbursement basis.

52Pub. L. No. 103-356, § 403 (1994), 31 U.S.C. § 501 note. This act establishes pilot programs at six

agencies designated by OMB to provide administrative support services to other agencies.

53The act provides that OFHEO personnel may be paid without regard to provisions of Title 5, United

States Code, relating to classification and General Schedule pay rates. See 12 U.S.C. § 4515(a).

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classification and general pay rates. In concert with the act, OFHEO has

developed an independent classification and qualification system and pay

structure. Occupations are to be based in part on the type of work done

relative to OFHEO’s mission, the nature and subject matter of the work, and

the fundamental qualifications required. The act also provides that OFHEO’s

compensation levels should be comparable with those of OCC, the Federal

Reserve System, the Federal Deposit Insurance Corporation, and the

Office of Thrift Supervision. According to OFHEO, pay band levels are based

on comparisons with similar occupations in those other federal financial

regulatory agencies. OFHEO’s broad pay band structure is comprised of

seven band levels, plus the executive-level director position, which is set

by law. OFHEO’s staff members’ pay band levels also depend upon the

complexity of the work, scope of responsibility, and supervisory

responsibility. Table 4.1 shows the levels and number of positions

assigned to those levels.

Table 4.1: OFHEO’s Pay Band Levels

and Positions in Each Band in 1996

Level Pay range

Positions

in level

I $15,876 - 26,460 0

II 21,168 - 42,337 8

III 31,753 - 58,213 8

IV 42,337 - 79,381 5

V 52,921 - 105,842 22

VI 79,381 - 137,594 20

VII 89,966 - 142,886 8

Director 133,600 1

Total 72

Source: OFHEO.

OFHEO officials also said that the organization’s performance management

system, the Performance Evaluation Management System (PEMS), was fully

implemented by March 31, 1995, and that OFHEO began its first rating cycle

in April 1995. Changes in base pay occur once a year, at the end of the

PEMS performance review cycle, and are to be based solely on merit. An

OFHEO official said that the organization is currently evaluating PEMS to

ensure that it remains an effective tool for assessing the performance of

the staff.

Page 70 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 4 

OFHEO’s Implementation of Key Mission

Support Functions

According to an OFHEO official, on September 30, 1996, OFHEO’s Schedule A

authority54 to hire employees expired and by January 1997, the

organization had converted to the federal civil service competitive hiring

system and procedures. OFHEO officials expressed generally negative views

on the impact that the conversion from Schedule A hiring authority to civil

service hiring authority will have on the organization. The director of

ORACS said that the civil service procedures could impede OFHEO’s capacity

to hire necessary expert staff. OFHEO’s Director of the Office of Finance

and Administration said that it is too soon to evaluate the impact of the

conversion. However, she did say that the competitive service

requirements are much more time-consuming and cumbersome than the

Schedule A procedures.

OFHEO’s Contracting

Authority Considered

Adequate for Mission

Support

During its start-up phase, OFHEO used HUD for procuring contracting

services but experienced various difficulties. In our first report on OFHEO’s

operations,55 we stated that HUD was not staffed to provide the expedited

procurement processing that OFHEO’s start-up mode of operations required.

In June 1994, OFHEO hired its own procurement contracting officer and

exercised its contracting authority as provided in the act. According to an

OFHEO official, HUD’s general counsel has written a legal opinion stating

that OFHEO is subject to both the Competition in Contracting Act and the

Federal Acquisition Regulation. OFHEO officials we contacted said that the

organization has all of the contracting authority necessary to provide

mission support. Table 4.2 lists all of the contracts OFHEO entered into

between 1994 and the second quarter of fiscal year 1997. With the

exception of one contract terminated because of nonperformance, OFHEO

officials said they are generally satisfied with their contractors’

performance.

54Schedule A hiring authority is one of the federal government’s excepted appointing authorities used

for hiring employees under special circumstances. This temporary authority, granted by the Office of

Personnel Management, permits agencies to fill positions without following the extensive

requirements of the competitive service. Schedule A hiring authority may be used if, for example, a

crash program or a new organization must be staffed so quickly that there is not time for following

established competitive service procedures.

55GAO/GGD-95-123.

Page 71 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 4 

OFHEO’s Implementation of Key Mission

Support Functions

Table 4.2: OFHEO Contracts by Value, 1994 to 1997

Contractor Task description Award date End date

Contract

amount

General Analytics Corporation ADP-related work 07/06/94 09/30/97 $6,235,000

Haynes & Associates, Inc. Examination-related work 06/02/95 04/12/97 1,911,000

Price Waterhouse Design & development work for the

financial simulation model

08/31/95 09/30/00

1,450,000

Computer Temporaries, Inc. Various temporary services 04/04/94 09/30/97 1,057,000

Manufacturing Technology, Inc. ORACS computer network 05/26/94 09/01/94 518,000

Strategic Compensation Association Executive compensation study 09/27/96 09/30/00 289,000

Home Associates, Inc. Construction of OFHEO space 03/31/97 03/31/97 234,000

Ernst & Young LLP Information system & technical

examination support

03/21/97 12/31/01

212,000

Standard & Poor’s Rating Services Credit rating of enterprises 09/30/96 03/31/97 200,000

INTEX Solutions, Inc. Simulate cashflow performance of

financial products

09/30/96 09/30/01

173,000

Risk Management Technologies Design and development of financial

database

08/08/95 03/07/96

101,000

Source: OFHEO.

OFHEO’s

Participation in

Mexico Initiative Did

Not Involve Research

or Examination Staffs

We assessed whether OFHEO’s participation in a U.S. government initiative

to assist Mexico in developing a secondary market for mortgage loans has

had a substantial impact on delaying the development of the stress test

and risk-based capital standards. A total of 8 OFHEO officials—the former

director, 4 senior officials, and 3 staff members—made a total of 10 foreign

trips related to the Mexico initiative in 1995 and 1996.56 Other participants

in the initiative included officials from OCC, the enterprises, and private

sector institutions that specialize in housing finance. Under an agreement

with USAID, USAID provided about $159,000 to OFHEO in 1996 to provide

technical assistance to Mexico and for travel-related purposes. See

appendix II for a more detailed discussion of OFHEO’s participation in the

Mexico initiative and related costs.

Based on a review of OFHEO’s travel records and discussions with senior

staff, we do not believe that OFHEO’s participation in the Mexico initiative

was a significant factor in delaying the development of the stress tests and

capital standards or OFHEO’s inability to fully implement its examination

program. For example, staff from OFHEO’s two principal mission-related

56Except for the former director, OFHEO officials did not all participate in each of the 10 foreign trips.

See appendix II of this report, table II.1.

Page 72 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 4 

OFHEO’s Implementation of Key Mission

Support Functions

offices, ORACS and OEO, did not participate in the initiative or foreign trips.

Other than the former director, the four senior staff who did participate in

the initiative, the current acting director, the chief economist, the director

of congressional affairs, and the director of public affairs estimated that

they spent less than 5 percent of their time in 1996 on the Mexico

initiative.57 For example, the chief economist estimated that he spent only

about 2 weeks in 1996 traveling to Mexico and preparing for presentations.

OFHEO officials said that the organization benefits from participating in

outside activities, such as the Mexico initiative, because they increase staff

development and allow the agency to gain exposure to and credibility with

participants in the mortgage finance markets. The other three OFHEO

officials who went on some of the foreign trips were staff members in

OFHEO’s Office of the Director.

OFHEO’s Financial

and Staff Resources,

1993-1997

Since OFHEO began its operations in June 1993, its obligations increased

from about $2.1 million at fiscal year-end 1993 to about $14.8 million at

fiscal year-end 1995 (see table 4.3). This growth reflects the staff and

contractors hired that OFHEO considered necessary to carry out its mission,

such as developing capital standards and conducting examinations. During

fiscal year 1996, OFHEO’s obligations remained flat at $14.8 million and then

increased by an estimated 5 percent in fiscal year 1997. Table 4.4 shows

the growth of OFHEO full-time, contractor, and detailee staff for fiscal years

1993 through 1997. Appendix III provides additional information about

OFHEO’s staffing resources.

Table 4.3: OFHEO’s Obligations, Fiscal

Years 1993 Through 1997 Dollars in thousands

Obligation category

Actual

1993

Actual

1994

Actual

1995

Actual

1996

Estimated

1997

Personnel servicesa $163 $2,690 $5,783 $7,234 $9,119

Other servicesb 1,956 2,473 5,858 4,800 3,793

All otherc 7 1,323 3,139 2,758 2,588

Total $2,126 $6,486 $14,780 $14,792 $15,500

Growth (%) N/A 205% 128% N/A 5%

N/A = Not applicable.

aObligations for the salaries and benefits of OFHEO personnel.

bObligations for contractor services.

cObligations for rent, travel, computer acquisition, etc.

Source: OFHEO.

57OFHEO did not provide an estimate of the time that the former director devoted to the Mexico

initiative.

Page 73 GAO/GGD-98-6 Federal Housing Enterprises
Chapter 4 

OFHEO’s Implementation of Key Mission

Support Functions

Table 4.4: OFHEO’s Full-Time,

Contractor, and Bank Regulatory

Detailee Staff, at End of Fiscal Years

1993-1997

Staff 1993 1994 1995 1996 1997a

Full-time permanent 7 37 63 66 58

Full-time temporary 1 4 4 10 7b

Contract N/A N/A 24 20 19

Detailee N/A N/A 2 5 1

Total 8 41 93 101 85

N/A = Not applicable.

aAs of March 31, 1997.

bIncludes one part-time temporary staff member.

Source: OFHEO.

OFHEO’s Relationship

With HUD

OFHEO’s relationship with HUD has provided mixed benefits. For example,

OFHEO’s acting director said that OFHEO’s association with HUD allows OFHEO

staff to keep apprised of developing housing and housing-finance issues. In

addition, the acting director said that he believes that HUD has benefited

from its relationship with OFHEO. For example, he said that OFHEO’s review

and comments on HUD’s proposed regulations implementing its oversight

of the enterprises’ compliance with the act’s housing-related goals resulted

in improvements. However, OFHEO officials also said that HUD has not

always been able to provide adequate support, such as in the case of its

financial management systems.

In a previously issued report,58 we commented on the current regulatory

structure for the government-sponsored housing enterprises. One of the

issues discussed was whether the regulation should be done in a

stand-alone organization or an office within an executive branch agency.

58See Government-Sponsored Enterprises: Advantages and Disadvantages of Creating a Single Housing

GSE Regulator (GAO/GGD-97-139, July 9, 1997). This report commented on the potential benefits of

merging OFHEO with the Federal Housing Finance Board.

Page 74 GAO/GGD-98-6 Federal Housing Enterprises
Page 75 GAO/GGD-98-6 Federal Housing Enterprises
Appendix I 

Financial Modeling and Computer

Programming Projects OFHEO Has Initiated

to Complete Development of the Stress Test

and Risk-Based Capital Standards

Between 1994 and 1997, OFHEO initiated several financial modeling and

computer programming projects to complete the development of the

stress test and risk-based capital standards. Most of these projects had

been completed by April 1997. The following summarizes several of the

more important projects:

OFHEO developed the benchmark loss experience by November 1995: To

develop the benchmark loss experience, OFHEO reviewed nationwide data

provided by the enterprises that showed the loss histories on 5.6 million

mortgage loans dating back to 1979. Based on this analysis, OFHEO has

proposed that the benchmark loss experience be based on mortgage loans

originated in Arkansas, Louisiana, Mississippi, and Oklahoma during 1983

and 1984.

OFHEO translated the enterprises’ financial data into a common format.

This project was completed by January 1996: According to OFHEO, the

stress test and capital standards must treat the assets, liabilities, and

off-balance-sheet obligations of both enterprises equally and consistently.

OFHEO determined that the most efficient way of doing this was to translate

both enterprise balance sheets into comparable standardized terms and

units and run them through a single financial model. OFHEO has also

reported that the most challenging aspect of this process was translating

Fannie Mae and Freddie Mac’s huge data files into a consistent format to

support stress test research. The process was further complicated by the

differences in the ways that the enterprises record and report financial

information. According to OFHEO, a contractor, Price Waterhouse, is

continuing to transform the data so that it can be accessed more efficiently

by OFHEO staff.

OFHEO decided to create a house price index rather than relying on an

existing index. This project was completed in March 1996: To respond to

the act’s stress test requirement that it assess the impact changing house

prices would have on the enterprises’ mortgage portfolios, OFHEO

determined that it needed to develop a new house price index rather than

rely on the one available from the Department of Commerce. OFHEO’s

house price index combines similar indexes that had been published

jointly by Fannie Mae and Freddie Mac. OFHEO made some technical

changes to publish an index that OFHEO officials said better met the

organization’s regulatory requirements. OFHEO’s index, first published in

March 1996, provides historical house price information on mortgage

loans purchased by the enterprises since 1975. According to OFHEO, the

organization’s house price index is superior to the Department of

Page 76 GAO/GGD-98-6 Federal Housing Enterprises
Appendix I 

Financial Modeling and Computer

Programming Projects OFHEO Has Initiated

to Complete Development of the Stress Test

and Risk-Based Capital Standards

Commerce index for the purpose of determining the current values of

single-family properties securing enterprise loans.59

OFHEO developed econometric models and computer programs to simulate

the financial performance of the enterprises. This work was completed by

June 1997. OFHEO developed software to simulate the cash flows of all

enterprise financial instruments and contracts, based on interest rate and

mortgage performance models. OFHEO also developed econometric models

to estimate mortgage default rates and loss severities and developed

computer programs to simulate operating decisions and translate cash

flow simulations into pro forma financial statements.

59OFHEO’s index is produced using data on single-family detached properties financed by conforming

conventional mortgages purchased by the enterprises. Thus, mortgages on properties that exceed the

conforming loan limit are excluded. The Department of Commerce index includes such

nonconforming loans, which was a reason OFHEO determined that the index was not appropriate for

the stress test.

Page 77 GAO/GGD-98-6 Federal Housing Enterprises
Appendix II 

OFHEO Officials Have Participated in a U.S.

Government Initiative Assisting Mexico in

Developing a Secondary Mortgage Loan

Market

The proposal for OFHEO’s collaborative efforts to facilitate a secondary

mortgage market in Mexico resulted from the May 1995 U.S.-Mexico

Binational Commission meeting during which the former HUD Secretary

and Mexico’s Secretariat of Social Development (SEDESOL) Minister

proposed a conference to be held in Mexico City in July 1995, to explore

relevant policy issues. On September 11, 1995, OFHEO officials met with a

subgroup of participants from the Mexico City conference, including the

World Bank, USAID, Freddie Mac, and U.S. private sector institutions, to

discuss ways to facilitate the development of a Mexican secondary

mortgage loan market.

Funding for most of OFHEO’s initiative was provided by USAID in the form of

a Participating Agency Service Agreement (PASA), which went into effect

on September 30, 1995. Under this agreement, USAID funds were used to

pay for direct expenses (travel, conferences, studies, etc.) related to

providing technical assistance to Mexico’s SEDESOL in the development of

products, methodologies, and strategies to eliminate barriers to the

successful development and implementation of a securitized secondary

mortgage market in Mexico. Total PASA funds with USAID were $159,000 in

fiscal year 1996, the first fiscal year of the agreement.

During fiscal year 1996, OFHEO used PASA USAID funds to provide technical

assistance to Mexico. This assistance included sponsoring seminars and

papers on mortgage markets and related issues. For example, in

April 1996, OFHEO sponsored a seminar and incurred nontravel-related

expenses of $6,850 for such services as interpretation, transcription

(English and Spanish), video and recording coverage, printing, copying,

postage, office materials, telephone and fax charges, and a $6,400

consulting fee for a summary of the proceedings and interviews with

senior Mexican bankers in preparation for a project analyzing mortgage

data. Other uses of PASA funds by OFHEO included shooting footage for a

video on the development of a secondary mortgage market in Mexico and

assembling a glossary, in Spanish, of housing finance and secondary

mortgage market terms.

During fiscal years 1995 and 1996, 8 OFHEO officials—the former director, 4

senior officials, and 3 staff members—made 10 foreign trips related to the

Mexico initiative (see table II.1). Travel expenses for these foreign trips

totaled about $49,999 with USAID paying $27,018 in fiscal year 1996 and

OFHEO expending a total of $22,981 of its own funds in fiscal years 1995 and

1996. The four senior OFHEO officials—the acting director, chief economist,

director of congressional affairs, and director of public affairs—who

Page 78 GAO/GGD-98-6 Federal Housing Enterprises
Appendix II 

OFHEO Officials Have Participated in a U.S.

Government Initiative Assisting Mexico in

Developing a Secondary Mortgage Loan

Market

participated in the foreign trips relating to the Mexico initiative estimated

that they spent 5 percent or less of their time on Mexico-related work in

fiscal year 1996. OFHEO did not provide any estimates on the amount of

time that the former director spent on the Mexico initiative. Due to the

relatively small amount of time committed to the Mexico initiative, OFHEO’s

acting director said he does not believe that the organization’s

participation had a material impact on the development of risk-based

capital standards. In addition, he said that staff from OFHEO’s ORACS and

OEO did not participate in the initiative. OFHEO’s support staff were used to

create and distribute written materials and to administer the PASA

agreement with USAID. The three other OFHEO employees who participated

in some of the foreign trips are staff members in OFHEO’s Office of the

Director.

Table II.1 OFHEO’s International Travel

Related to the Mexico Initiative, Fiscal

Years 1995 and 1996 Travel date

OFHEO

employees Itinerary Funds Cost

FY 1995

June 1995 4 DC-Mexico-DC OFHEO $5,507

July 1995 5 DC-Mexico-DC OFHEO 8,074

FY 1996

November 1995 2 DC-Mexico-DC USAID 3,401

February 1996 3 DC-Mexico-DC USAID 3,063

April 1996 6 DC-Mexico-DC USAID 10,353

May 1996 5 DC-Mexico-DC OFHEO 5,988

May 1996 1 NY-Mexico-DC OFHEO 617

June 1996 1 DC-Turkey-DC OFHEO 2,795

August 1996 4 DC-Mexico-DC USAID 5,384

September 1996 4 DC-Costa Rica-DC USAID 4,817

Total $49,999

Source: OFHEO.

OFHEO’s acting director cited several benefits to OFHEO from its

participation in initiatives undertaken with PASA funds. He said the primary

benefit for OFHEO was that it allowed the organization to establish contacts

with personnel in the mortgage industry and develop its stature as an

independent regulator. In addition, he said that OFHEO was able to share

information on its role and activities with interested parties.

Page 79 GAO/GGD-98-6 Federal Housing Enterprises
Appendix III 

OFHEO’s Staffing Levels, Fiscal Years 1993

to 1997

Table III.1: OFHEO’s Full-Time,

Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-End 1993

Unit

Full-time

permanent

positions

Full-time

permanent

staff

Full-time

temporary

staff Contract Detail

Director 3

Research, Analysis,

and Capital Standards 1 1

Examination and

Oversight

General Counsel

Finance and

Administration 2

Policy Analysis

Congressional and

Public Affairs 1

Total 7 1

Source: OFHEO.

Table III.2: OFHEO’s Full-Time,

Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-End 1994

Unit

Full-time

permanent

positions

Full-time

permanent

staff

Full-time

temporary

staff Contract Detail

Director 6

Research, Analysis,

and Capital Standards 8 2

Examination and

Oversight 7

General Counsel 3 2

Finance and

Administration 6

Policy Analysis 3

Congressional and

Public Affairs 4

Total 45 37 4

Source: OFHEO.

Page 80 GAO/GGD-98-6 Federal Housing Enterprises
Appendix III 

OFHEO’s Staffing Levels, Fiscal Years 1993

to 1997

Table III.3: OFHEO’s Full-Time,

Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-End 1995

Unit

Full-time

permanent

positions

Full-time

permanent

staff

Full-time

temporary

staff Contract Detail

Director 7 7 1 1

Research, Analysis,

and Capital Standards 14 14 2 12

Examination and

Oversight 14 13 7 1

General Counsel 8 8 1 1

Finance and

Administration 11 10 4

Policy Analysis 6 6

Congressional and

Public Affairs 5 5

Total 65 63 4 24 2

Source: OFHEO.

Table III.4: OFHEO’s Full-Time,

Contractor, and Bank Regulatory

Detailee Staff, Fiscal Year-End 1996

Unit

Full-time

permanent

positions

Full-time

permanent

staff

Full-time

temporary

staff Contract Detail

Director 8 7 1

Research, Analysis,

and Capital Standards 17 15 5 11

Examination and

Oversight 17 14 1 7 4

General Counsel 8 9 1 1

Finance and

Administration 11 11 1 2

Policy Analysis 6 5 1

Congressional and

Public Affairs 5 5

Total 72 66 10 20 5

Source: OFHEO.

Page 81 GAO/GGD-98-6 Federal Housing Enterprises
Appendix III 

OFHEO’s Staffing Levels, Fiscal Years 1993

to 1997

Table III.5: OFHEO’s Full-Time,

Contractor, and Bank Regulator

Detailee Staff as of March 31, 1997

Unit

Full-time

permanent

positions

Full-time

permanent

staff

Full-time

temporary

staff Contract Detail

Director 7 5

Research, Analysis,

and Capital Standards 17 14 4a 14

Examination and

Oversight 17 12 3 1

General Counsel 9 8 1

Finance and

Administration 11 11 1 2

Policy Analysis 6 4 1

Congressional and

Public Affairs 5 4

Total 72 58 7 19 1

aOne of the four staff members was part-time.

Source: OFHEO.

Page 82 GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV 

Comments From the Office of Federal

Housing Enterprise Oversight

Page 83 GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV 

Comments From the Office of Federal

Housing Enterprise Oversight

Page 84 GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV 

Comments From the Office of Federal

Housing Enterprise Oversight

Page 85 GAO/GGD-98-6 Federal Housing Enterprises
Appendix IV 

Comments From the Office of Federal

Housing Enterprise Oversight

Page 86 GAO/GGD-98-6 Federal Housing Enterprises
Appendix V 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

William B. Shear, Assistant Director

Wesley M. Phillips, Evaluator-in-Charge

Thomas J. Givens, III, Senior Evaluator

Office of the General

Counsel, Washington,

D.C.

Paul G. Thompson, Attorney

(233512) Page 87 GAO/GGD-98-6 Federal Housing Enterprises
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