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REVIEW OF THE FEDERAL AGRICULTURAL MORTGAGE CORPORATION

HEARING

BEFORE THE

COMMITTEE ON AGRICULTURE

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

JUNE 2, 2004

Serial No. 108–31

(

Printed for the use of the Committee on Agriculture

www.agriculture.house.gov

COMMITTEE ON AGRICULTURE

BOB GOODLATTE, Virginia, Chairman

JOHN A. BOEHNER, Ohio

Vice Chairman

RICHARD W. POMBO, California

NICK SMITH, Michigan

TERRY EVERETT, Alabama

FRANK D. LUCAS, Oklahoma

JERRY MORAN, Kansas

WILLIAM L. JENKINS, Tennessee

GIL GUTKNECHT, Minnesota

DOUG OSE, California

ROBIN HAYES, North Carolina

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

TIMOTHY V. JOHNSON, Illinois

TOM OSBORNE, Nebraska

MIKE PENCE, Indiana

DENNIS R. REHBERG, Montana

SAM GRAVES, Missouri

ADAM H. PUTNAM, Florida

MAX BURNS, Georgia

JO BONNER, Alabama

MIKE ROGERS, Alabama

STEVE KING, Iowa

CHRIS CHOCOLA, Indiana

MARILYN N. MUSGRAVE, Colorado

DEVIN NUNES, California

RANDY NEUGEBAUER, Texas

——— ———

CHARLES W. STENHOLM, Texas,

Ranking Minority Member

COLLIN C. PETERSON, Minnesota

CALVIN M. DOOLEY, California

TIM HOLDEN, Pennsylvania

BENNIE G. THOMPSON, Mississippi

MIKE MCINTYRE, North Carolina

BOB ETHERIDGE, North Carolina

BARON P. HILL, Indiana

JOE BACA, California

RICK LARSEN, Washington

MIKE ROSS, Arkansas

ANI ́BAL ACEVEDO-VILA ́ , Puerto Rico

ED CASE, Hawaii

RODNEY ALEXANDER, Louisiana

FRANK W. BALLANCE, JR., NORTH

CAROLINA

DENNIS A. CARDOZA, California

DAVID SCOTT, Georgia

JIM MARSHALL, Georgia

BEN CHANDLER, Kentucky

EARL POMEROY, North Dakota

LEONARD L. BOSWELL, Iowa

MIKE THOMPSON, California

MARK UDALL, Colorado

RICK LARSEN, Washington

LINCOLN DAVIS, Tennessee

PROFESSIONAL STAFF

WILLIAM E. O’CONNER, JR., Staff Director

KEVIN KRAMP, Chief Counsel

STEPHEN HATERIUS, Minority Staff Director

ELYSE BAUER, Communications Director

(II)

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C O N T E N T S

Page

Goodlatte, Hon. Bob, a Representative in Congress from the Commonwealth

of Virginia, opening statement ............................................................................ 1

Smith, Hon. Nick, a Representative in Congress from the State of Michigan,

prepared statement .............................................................................................. 3

Stenholm, Hon. Charles w., a Representative in Congress from the State

of Texas, opening statement ................................................................................ 2

WITNESSES

D’Agostino, Davi, Director, Financial Markets and Community Investments,

U.S. General Accounting Office .......................................................................... 4

Prepared statement .......................................................................................... 58

Answers to submitted questions ...................................................................... 76

Dailey, Frederick L., Chairman, Federal Agricultural Mortgage Company ....... 33

Prepared statement .......................................................................................... 81

Edelman, Henry D., President and Chief Executive Officer, Federal Agricultural Mortgage Company ..................................................................................... 35

Prepared statement .......................................................................................... 81

Answers to submitted questions ...................................................................... 91

Pellett, Nancy C., Chairman and Chief Executive Officer, Farm Credit Administration ................................................................................................................. 6

Prepared statement .......................................................................................... 114

Answers to submitted questions ...................................................................... 120

Zerzan, Gregory, Deputy Assistant Secretary, Financial Institutions Policy,

Department of the Treasury ................................................................................ 8

Prepared statement .......................................................................................... 129

SUBMITTED MATERIAL

Clayton, William, AgFirst Farm Credit Bank ....................................................... 110

Doyle, Larry, chief executive officer, Farm Credit Bank of Texas, statement ... 79

Evans, John Jr., chief executive officer, D.L. Evans Bank, Burley, ID, statement ...................................................................................................................... 111

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REVIEW THE FEDERAL AGRICULTURAL

MORTGAGE CORPORATION

WEDNESDAY, JUNE 2, 2004

HOUSE OF REPRESENTATIVES, COMMITTEE ON AGRICULTURE, Washington, DC.

The committee met, pursuant to call, at 10:05 a.m., in room 1300

of the Longworth House Office Building, Hon. Bob Goodlatte (chairman of the committee) presiding.

Present: Representatives: Boehner, Pombo, Smith, Lucas, Moran,

Jenkins, Gutknecht, Ose, Osborne, Pence, Graves, Burns, Rogers,

King, Musgrave, Neugebauer, Stenholm, Peterson, Dooley, Holden,

Etheridge, Baca, Alexander, Marshall, Pomeroy, Thompson, and

Udall.

Staff present: Dave Ebersole, Ryan Weston, Jen Daulby, Callista

Gingrich, clerk; and Teresa Thompson, Howard Conley, and Russell

Middleton.

OPENING STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN CONGRESS FROM THE COMMONWEALTH

OF VIRGINIA

The CHAIRMAN. Good morning. This hearing of the House Committee on Agriculture to review the Federal Agricultural Mortgage

Corporation will come to order.

This morning the committee meets to examine the programs and

financial products of the Federal Agricultural Mortgage Corporation, better known as Farmer Mac. Today’s hearing will focus on

an October 2003 report of the General Accounting Office entitled,

‘‘Farmer Mac: Some Progress Made, but Greater Attention to Risk

Management, Mission, and Corporate Governance Is Needed.’’ In

this report, the GAO makes important observations about Farmer

Mac’s operations, and, as the title suggests, points to several issues

this committee should be aware of in terms of Farmer Mac’s mission and management.

As witnesses pointed out during a 1995 hearing before the Credit

Subcommittee, Farmer Mac’s reason to exist is to provide a secondary market for agricultural real estate mortgages that will translate into long-term, fixed-rate loans for farmers and ranchers. As

envisioned when Congress adopted the Agricultural Credit Act of

1987, that market would be created by Farmer Mac’s development

of a marketable financial instrument known as an agricultural

mortgage-backed security, or AMBS.

As it turns out, more than 8 years after the Congress freed

Farmer Mac from many of the original operational constraints put

2

in place as prudential policies of safety and soundness, the GAO reports that Farmer Mac holds most of the AMBS in its own portfolio, apparently for reasons of profits over the public policy requirements of its charter.

In addition to the GAO, we will hear from the Farm Credit Administration, which has increased over the last several months its

examination and supervision of Farmer Mac’s management and

board activities as well as its portfolio of agricultural real estate

loans and acquired property.

The committee has asked the Treasury Department for its views

on Farmer Mac’s ability to issue obligations to the Treasury should

Farmer Mac need taxpayer assistance to satisfy its guarantee obligations for the timely payment of principal and interest on AMBS

held in the Farmer Mac portfolio. A 1997 Treasury Department letter to FCA held then that Farmer Mac’s statutory $1.5 billion line

of credit at Treasury was available only for AMBS held by private

investors. As I noted a few moments ago, few among the investing

public holds Farmer Mac’s AMBS.

Finally, the committee will hear from Farmer Mac’s board chairman and its president, both of whom, we expect, will offer a balancing view of Farmer Mac’s activities and current financial status.

With that, I will turn to my colleague from Texas, the ranking

Democrat, Mr. Stenholm.

OPENING STATEMENT OF HON. CHARLES W. STENHOLM, A

REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS

Mr. STENHOLM. Thank you, Mr. Chairman, and thank you for

holding this oversight hearing today regarding Farmer Mac.

News articles and a recent report by the General Accounting Office have raised questions about Farmer Mac’s operations. Therefore, this oversight hearing is particularly timely and will give us

an opportunity to review Farmer Mac’s mission. I think it is important that the committee get a better understanding of some of the

issues that have been raised. As you know, Farmer Mac was established as a result of the Agricultural Credit Act of 1987. At that

time, the entire agricultural credit system was under severe stress,

and I am proud to say that we were able to devise a relief package

that strengthened the overall system at little expense to the taxpayer. Farmer Mac was an integral part of that relief package and

was designed to provide a secondary market for agricultural real

estate mortgages. It was also designed to increase the availability

of long-term credit to farmers and ranchers at stable interest rates.

Then, as now, I strongly support the need for that legislation and

the additional dimension that it brings to agricultural lending. The

Farm Credit System, community bankers, and other lenders, compete to provide farmers and ranchers with the credit needs necessary to produce the food and fiber that feeds our Nation and

much of the world. Agricultural lending is no small enterprise,

however, and there is currently $116 billion outstanding in agricultural lending in the United States. Farmer Mac helps in this endeavor by providing greater liquidity and lending capacity to system institutions and community banks for that purpose. Over the

years, we have provided Farmer Mac with additional authorities

and broadened its mandate. Farmer Mac has come under scrutiny

3

in the last few years, however, as have almost all governmentsponsored enterprises, including the Farm Credit System. This

committee is responsible to the American taxpayer, and therefore,

we must ensure that Farmer Mac, in this instance, is operating in

an effective and prudent manner without undue Federal exposure.

I am particularly interested in hearing the views of today’s witnesses on the recommendations made by the GAO with regard to

legislative changes to the statute governing Farmer Mac. We must

ensure that the Farm Credit Administration, Farmer Mac’s regulator, has sufficient regulatory authority and is exercising that authority to ensure Farmer Mac’s safety and soundness. Today’s

hearing will allow us to review the operations of Farmer Mac so

that any necessary and appropriate action can be taken.

Again, thank you, Mr. Chairman. I look forward to the upcoming

testimony.

The CHAIRMAN. I thank the gentleman.

Any other Members with opening statements, those statements

will be made a part of the record.

[The prepared statement of Mr. Smith follows:]

PREPARED STATEMENT OF HON. NICK SMITH, A REPRESENTATIVE IN CONGRESS FROM

THE STATE OF MICHIGAN

Thank you Chairman Goodlatte and Ranking Member Stenholm for holding this

important oversight hearing on the Federal Agricultural Mortgage Corporation.

Farmer Mac (one of five Government Sponsored Enterprises, GSE’s) is the secondary market for agricultural loans and is part of the Farm Credit System. By purchasing loans from agricultural lenders, Farmer Mac allows lenders to provide additional loans to borrowers. For example, if a lender makes a 30-year loan, the lender

can sell the loan to Farmer Mac and use proceeds from the sale to make another

loan, rather than have its funds tied up in the 30-year loan.

Both FCS and Farmer Mac are regulated under the Farm Credit Administration,

which is led by a three-member board appointed by the President. Farmer Mac, created by Congress in 1987 as a result of the farm crisis in the mid-1980s, is a federally chartered and privately operated corporation that is publicly traded on the New

York Stock Exchange.

To relieve structural impediments that had limited Farmer Mac’s ability to function efficiently, Congress passed the Farm Credit System Reform Act of 1996, which

significantly revised Farmer Mac’s statutory authority and had significant impact

on Farmer Mac’s operations. Farmer Mac’s net income has steadily increased from

$4.6 million in 1997 to $22.8 million in 2002, for a total increase of 392 percent.

On- and off-balance sheet program activity is now $5.8 billion. Non-program investments of nearly $1.7 billion resulted in Farmer Mac managing or guaranteeing assets of $7.5 billion at December 31, 2003.

During 2002, negative publicity about financial accounting and corporate governance within Farmer Mac generated congressional interest about the institution’s

safety and soundness and its mission as a GSE. As I understand it, the problem

was that Farmer Mac was holding most of its loans it purchased from system institutions, instead of selling them as securities to investors. While this strategy is potentially more profitable, it is also more risky.

An October 2003 GAO report recommended that Congress consider legislation

that would establish clearer, measurable mission goals for Farmer Mac. GAO also

found concerns with risk management practices (Farmer Mac’s impaired loans increased from zero in 1997 to $75.3 million at the end of 2002), lack of secondary

market development, and lack of independence in Farmer Mac’s board of directors.

I am concerned about measurable accomplishments and the fact that most of the

activity is in the Western United States.

However, since the 2003 GAO report, I believe that Farmer Mac has taken some

of the necessary steps to enhance its risk management practices.

I look forward to the testimony.

The CHAIRMAN. We will now proceed to our first witnesses.

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I would like to welcome our first panel: Ms. Davi D’Agostino, Director of Financial Markets and Community Investments, and Ms.

Jeanette Franzel, Director of Financial Management and Assurance, both of the U.S. General Accounting Office; the Honorable

Nancy C. Pellett, Chairman and Chief Executive Officer of the

Farm Credit Administration, McLean, VA; and Mr. Gregory

Zerzan, Deputy Assistant Secretary for Financial Institutions Policy, Department of the Treasury, also Washington, DC.

Ms. D’Agostino, we will start with you. I will advise all members

of the panel that their complete statement will be made a part of

the record, and we would ask that you limit your remarks to 5 minutes. Welcome.

STATEMENT OF DAVI M. D’AGOSTINO, DIRECTOR, FINANCIAL

MARKETS AND COMMUNITY INVESTMENT, U.S. GENERAL ACCOUNTING OFFICE

Ms. D’AGOSTINO. Thank you, Mr. Chairman.

Mr. Chairman, Mr. Ranking Member, and members of the committee, we are pleased to be here with you today to discuss the results of GAO’s work on Farmer Mac and the report we issued in

October of 2003.

First, I will provide an overview of Farmer Mac, its mission, and

portfolio. And second, I will provide our report findings on certain

aspects of Farmer Mac’s financial risks and its line of credit with

Treasury, mission-related activities, board structure, and oversight

provided by FCA, or the Farm Credit Administration.

First, Farmer Mac is a government-sponsored enterprise, or

GSE, that is to provide a secondary market for agricultural real estate and rural housing loans, and to increase the availability of agricultural mortgage credit. Farmer Mac is also an independent entity within the Farm Credit System, or FCS, which is another government-sponsored enterprise. Farmer Mac is subject to the FCA’s

regulatory authority and examination. Farmer Mac’s statute allows

it to borrow up to $1.5 billion from the U.S. Treasury in extreme

circumstances. Farmer Mac buys agricultural mortgages from lenders and securitizes these loans into guaranteed securities, or

AMBS. For profitability reasons, Farmer Mac has held most of the

AMBS in its own portfolio rather than selling them in the capital

markets to generate cash and instead issues debt to raise money. Currently, Farmer Mac holds about $1.5 billion worth of these

securities on its balance sheet. Farmer Mac also issues long-term

standby purchase commitments and similar agreements—to date,

all with FCS institutions—comprising $3.1 billion of its total $5.8

billion in program assets. These loans are not on Farmer Mac’s balance sheet, because Farmer Mac currently does not own them.

Farmer Mac and the FCS institutions involved in these agreements

are also required to hold less capital against the loans underlying

the agreements than those that are kept on the balance sheet—$66

million instead of $215 million if standbys did not exist.

Farmer Mac is committed to buy the loans under these agreements when the lender wants to sell them to Farmer Mac and

when the loans become delinquent for more than 120 days. In fact,

under these agreements, the worse things get, the less negotiating

power Farmer Mac has over the price of the loans when buying

5

them. We raise concerns about how Farmer Mac managed the increased risk that has accompanied its rapid growth in these standby and related agreements. For example, in a severe agricultural

economic downturn, Farmer Mac could be required to purchase a

large portion of delinquent or defaulted loans under the standby

program, causing unexpected demand for funding or liquidity. We

call this liquidity risk. During such conditions, it could be difficult

for Farmer Mac to raise additional funds through either issuing

debt or selling AMBS to the capital markets.

Now let us turn to the disagreement between Treasury and

Farmer Mac about what Treasury’s $1.5 billion line of credit covers

if Farmer Mac exhausts its reserves against losses and the line of

credit is needed to fulfill Farmer Mac’s obligations under any of its

agreements. Treasury has serious questions about whether it is required to purchase AMBS held by Farmer Mac or its affiliates

where Farmer Mac’s guarantee essentially runs to Farmer Mac

itself. Farmer Mac’s outside counsel, however, argues that Treasury would have to buy the debt obligations regardless of who holds

them.

On mission, we reported that Farmer Mac had increased its mission-related activity since our 1999 report. However, Farmer Mac’s

statute lacks specific or measurable mission goals, so it is difficult

to meaningfully assess whether the increased activities are having

a positive impact on the agricultural real estate market. In addition, Farmer Mac’s loan activities have been largely concentrated

in a small number of financial institutions. During 2003, 80.8 percent of Farmer Mac I loan activities were with 10 institutions, and

its loan activities are further concentrated in the western United

States.

Therefore, we concluded that Farmer Mac had increased its mission activities, but we also concluded that the public benefits derived from them were not clear. We suggested that Congress consider establishing more specific, clearer mission goals for Farmer

Mac. And also, because of Farmer Mac’s strategy of keeping its

issued securities in its own portfolio for profitability reasons, we

concluded that the depth and liquidity of the secondary market for

AMBS is unknown. We recommended that Farmer Mac reevaluate

its current strategy of holding the AMBS in portfolio and issuing

debt to get funding.

Regarding corporate governance, we found that Farmer Mac’s

board structure, set in law, may make it difficult to ensure that the

board fully represents the interests of all shareholders. This structure could also hamper Farmer Mac’s efforts to comply with the

independence requirements of the New York Stock Exchange’s listing standards. Also, Farmer Mac’s board structure, which contains

elements of both a cooperative and an investor-owned publicly traded company, may need to be updated to reflect today’s market environment. For example, two-thirds of board members are elected by

entities that do business with Farmer Mac and hold the only voting

stock, while the common stockholders have no vote. We suggested,

among other things, that Congress consider legislative changes to

amend the structure of Farmer Mac’s board and the structure of

the Farmer Mac class C nonvoting common stock.

6

Finally, regarding FCA’s oversight of Farmer Mac, we reported

that FCA had improved its oversight and strengthened its examination approach, but noted that more needed to be done to enhance the assessment of risk-based capital and Farmer Mac’s accomplishment of its mission. This enhanced focus is especially important given Farmer Mac’s increasing risk profile, its concentration of business with few business partners and in the west, and

its holdings of non-mission-related assets. Since the law does not

include any measurable goals or requirements to assess Farmer

Mac’s progress in furthering its mission, FCA lacks criteria and

procedures to effectively oversee this aspect of Farmer Mac.

We made several recommendations to FCA to enhance the effectiveness of its oversight. To further assist FCA, we also suggested

that Congress consider legislative change that would give FCA

more flexibility in setting minimum capital requirements for Farmer Mac. Since our October report, Farmer Mac and FCA have taken

some action to address certain recommendations or are in the process of implementing several others, but since most of these actions

will not be fully completed for some time, it is too early for us to

tell how effective they are.

In conclusion, our 2003 review showed that Farmer Mac’s income, mission activities, and risks have all increased since we last

reported in 1999. However, its risk management practices did not

keep pace with its growing complexity and risks. We concluded

that Farmer Mac, FCA, and the Congress could each take actions

to ensure that Farmer Mac continues to operate in a safe and

sound manner while fulfilling a clear public policy mission. We believe it is important that Farmer Mac and FCA both devote sufficient resources and continued attention to the matters that we reported. If Congress wishes to retain its public sponsorship of Farmer Mac through its line of credit with the Treasury and its other

benefits, we suggest that Congress consider making change to ensure that Farmer Mac’s public benefits can be measured and evaluated and that FCA has the necessary tools and flexibilities to carry

out its oversight responsibilities.

Mr. Chairman, that concludes our prepared statement.

[The prepared statement of Ms. D’Agostino appears at the conclusion of the hearing.]

The CHAIRMAN. Thank you, Ms. D’Agostino.

Ms. Franzel, do you have additional comments?

Ms. FRANZEL. No, Mr. Chairman, but I will assist in answering

questions at the end of the presentations.

The CHAIRMAN. Great. Thank you.

We will turn, then, to Ms. Pellett. We are pleased to have you

with us as well. And I might add, congratulations on your new appointment as chairman of the FCA.

STATEMENT OF NANCY C. PELLETT, CHAIRMAN AND CHIEF

EXECUTIVE OFFICER, FARM CREDIT ASSOCIATION

Ms. PELLETT. Thank you very much. Thank you, and good morning. Mr. Chairman, members of the committee, I am Nancy Pellett,

Chairman and Chief Executive Officer of the Farm Credit Administration. On behalf of my board colleagues, Doug Flory and Michael

Reyna, I am pleased to be here this morning to discuss FCA’s overVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
7

sight of the Federal Agricultural Mortgage Corporation, generally

known as Farmer Mac.

The mission of the Farm Credit Administration is to ensure a

safe, sound, and dependable source of credit for farmers, ranchers,

aquatic producers, farmer-owned cooperatives, and rural homeowners. To achieve our mission, we oversee the operations of two

government-sponsored enterprises devoted to agriculture and rural

America, the banks and direct lending associations of the Farm

Credit System, and Farmer Mac.

Farmer Mac is a privately owned and publicly traded government-sponsored enterprise that we regulate through our office of

Secondary Market Oversight, which we refer to ask OSMO. As a

publicly traded corporation, Farmer Mac must also comply with

New York Stock Exchange listing standards and requirements.

And, unlike other GSEs, Farmer Mac, by statute, must comply

with Federal securities laws.

In response to the farm credit crisis of the mid–1980’s, Congress,

in 1987, established Farmer Mac to develop a liquidity source similar to that provided for residential mortgages by the housing GSEs

Fannie Mae and Freddie Mac. The 1996 amendments to Farmer

Mac’s authorizing legislation have allowed it to grow its business

and achieve economic viability, which by no means was assured

during the first years of its existence.

In our regulatory oversight role, we issue regulations and conduct an annual examination to ensure the safe and sound operation

of Farmer Mac. The examination combines on-site and off-site activities that result in a report of examination to the Farmer Mac

Board. We have regulatory enforcement powers that are similar to

those of other Federal financial regulators, though somewhat

broader in the area of receivership authorities.

FCA oversight activities of Farmer Mac have increased significantly during the past several years due to Farmer Mac’s rapid

growth and a changing risk profile. For safety and soundness reasons and to be consistent with our past practices, FCA does not

comment on any institution-specific examination findings and recommendations. Therefore, I hope that you will appreciate that I

may not be able to respond to certain questions in open session

that relate to our examination of Farmer Mac.

We agree with the recommendations in the recent GAO report on

Farmer Mac and have taken action in several areas. In April, the

FCA board approved a proposed rule on non-program investments

and liquidity that addresses issues about Farmer Mac liquidity

planning and mission focus. The rule, when finalized, would set

limits on the amount and type of non-program liquidity investments that Farmer Mac would be permitted to hold.

Additionally, FCA is developing a proposed rule to revise numerous aspects of the risk-based capital stress test and is analyzing

additional regulatory requirements that Farmer Mac should consider in its overall capital adequacy planning. Further, we have

made several revisions to Farmer Mac reporting requirements that

will enhance our off-site monitoring efforts of Farmer Mac.

FCA is also analyzing the approaches taken by other regulators

to require their regulated entities to obtain credit ratings. Their

8

analysis will help the FCA board decide whether a formal rule is

needed in this area.

And lastly, in response to the GAO report, we are developing a

plan that will consider different approaches for assessing Farmer

Mac’s impact on the agricultural real estate market. In addition to

the actions we have taken, FCA supports the suggestions GAO

made to Congress. In particular, we support greater flexibility for

the regulator to set capital standards as Farmer Mac grows and its

risk characteristics continue to change.

In conclusion, Mr. Chairman, FCA is committed to Farmer Mac’s

success and the achievement of its statutory mission to serve agriculture and rural America. We continue to enhance our regulatory

oversight of Farmer Mac, and I believe we are well positioned to

ensure Farmer Mac has the capability to succeed in the future.

Thank you for the opportunity to appear before you today, and

I or Tom McKenzie, our director of OSMO who has accompanied

me today, stand ready to answer any questions you or the members

of the committee might have.

[The prepared statement of Ms. Pellett appears at the conclusion

of the hearing.]

The CHAIRMAN. Thank you, Ms. Pellett. And I would also like to

note that you are joined by another Farm Credit Administration

board member, Mr. Doug Florry, seated behind you, who is from

my district in Virginia. Doug, we are pleased to have you with us

as well.

I would also now like to give a special welcome to Mr. Zerzan,

who is a former associate counsel of this committee. He served

under Chairman Bob Smith of Oregon and has moved on to other

important work serving the interests of our country’s financial institutions and the American taxpayer. Mr. Zerzan, welcome.

STATEMENT OF GREGORY ZERZAN, DEPUTY ASSISTANT SECRETARY, FINANCIAL INSTITUTIONS POLICY, DEPARTMENT

OF THE TREASURY

Mr. ZERZAN. Thank you, Mr. Chairman. It is a privilege to be before the committee again. Thank you, Chairman Goodlatte, Ranking Member Stenholm, and members of the committee for the opportunity to testify today on the Federal Agricultural Mortgage

Corporation.

Farmer Mac poses a number of questions for policy makers to

consider. In particular, today I would like to focus on three such

issues: Farmer Mac’s mission achievement, regulatory issues associated with Farmer Mac, and the Treasury Department’s perspective on Farmer Mac’s line of credit.

One useful way to evaluate Farmer Mac’s broad, statutory purpose is to consider whether Farmer Mac has contributed to the development of an active secondary market in agricultural real estate

mortgages, much like the secondary market that exists for residential housing mortgages. The secondary market for residential housing mortgages is characterized by a wide array of investors who,

on any given day, are buyers and sellers of mortgage-backed securities.

Similarly liquid markets for AMBS do not yet exist. Absent a

more aggressive effort by Farmer Mac to sell its AMBS to outside

9

investors, it is difficult to perceive of an active secondary market

for AMBS developing.

The Farm Credit Administration is the regulator of Farmer Mac.

The Treasury Department does not have any direct regulatory

oversight responsibilities with respect to that entity. However, in

December 1995, the House and Senate Agriculture Committees

asked the Treasury to jointly monitor Farmer Mac’s financial condition with the FCA throughout the capital deferral period and beyond, if necessary. We have appreciated the close working relationship we have had with FCA in conducting the joint monitoring requested by Congress, but at this time, with the capital deferral period long over, there will be no continued formal relationship with

FCA on the joint monitoring of Farmer Mac. Having FCA provide

an advanced copy of the report for Treasury to review or having

Farmer Mac or FCA continue to reference a joint monitoring arrangement with Treasury may inadvertently provide the false impression that Treasury exercises some form of oversight of or responsibility for Farmer Mac. Treasury plays no such role.

As noted by GAO, there appears to be some confusion over how

and under what terms Farmer Mac would have access to its line

of credit with Treasury. A Treasury letter to the FCA described

Treasury’s position regarding Farmer Mac’s line of credit as follows, in part: ‘‘We have serious questions as to whether the Treasury would be obligated to make advances to Farmer Mac to allow

it to perform on its guarantee with respect to the securities held

in its own portfolio, that is, where Farmer Mac’s guarantee essentially runs to Farmer Mac itself.’’

Treasury has not changed its position on this issue since that

1997 letter. Investors in Farmer Mac securities should rely on the

underlying credit quality of Farmer Mac when making investment

decisions and not on any potential access to a line of credit with

the Treasury.

In conclusion, Mr. Chairman, our Nation’s interest in maintaining strong agricultural credit markets that serve the needs of farmers and ranchers remains strong. Farmer Mac has improved its

business prospects since it was granted new powers by Congress in

1996, and its capital position has improved over the years. While

Farmer Mac’s role in agricultural mortgage markets has increased,

whether Farmer Mac’s increased business activity contributes to

achieving a significant public purpose remains an issue that Congress should continue to evaluate.

Thank you very much.

[The prepared statement of Mr. Zerzan appears at the conclusion

of the hearing.]

The CHAIRMAN. Thank you, Mr. Zerzan.

I would like to start with a question that gets to the heart of the

issue that is at the table today, and that is the capitalization of

Farmer Mac, and I will ask the same question of the president and

chairman when they are up in a minute. But I would like to ask

each of you if you believe Farmer Mac is sufficiently capitalized

and positioned in the capital markets to withstand a downturn in

the agricultural economy, similar to that experience in the mid–

1980’s when commodity prices fell through the floor and land values followed shortly thereafter.

10

Ms. D’Agostino?

Ms. D’AGOSTINO. I will defer to Jeanette Franzel for that.

Ms. FRANZEL. The scenario similar to the early 1980’s and the

test of Farmer Mac’s current capital, that has simply not been tested. In general, since 1997, Farmer Mac has been operating in good

economic times where land values have been rising and interest

rates have been relatively low. So in this environment, Farmer Mac

has really experienced relatively low credit losses, and they have

not had negative net bottom line losses as would happen in a depressed agricultural real estate market. So capital has not been

stressed, and therefore we really don’t know if capital could absorb

this type of a scenario.

Furthermore, exacerbating the issue, Farmer Mac’s loan loss and

economic modeling does not adequately measure the potential impact of depressed agricultural conditions, such as falling land values. So again, we were unable to determine how well Farmer Mac

could withstand such a downturn because of its reliance on this

model and because Farmer Mac does not really have experience

with this type of scenario.

The CHAIRMAN. Thank you.

Chairman Pellett has requested that she be joined by Tom

McKenzie, the Director of the FCA’s Office of Secondary Market

Oversight, to assist in fielding Members’ questions. So Ms. Pellett,

you or Mr. McKenzie, or both, can answer that question.

Ms. PELLETT. Thank you very much.

Mr. Chairman, I am a farmer, and I am a producer from Iowa,

and I lived through that time of the 1980’s. And heaven forbid if

that ever happened again. That was a time that was very stressful

for producers, their lenders, and also a regulator. And right now,

our Director of OSMO is working with Farmer Mac management

and with the Farmer Mac Board to get their risk management systems in place during these good times so that when, and if, anything like that should happen again, they would be prepared to

weather that storm.

The CHAIRMAN. Thank you.

Mr. McKenzie, do you want to add anything to that?

Mr. MCKENZIE. No, sir. I think Ms. Pellett covered that quite

adequately.

The CHAIRMAN. Very good.

Mr. Zerzan?

Mr. ZERZAN. Thank you, Mr. Chairman. I would demur on

whether or not they could withstand such a stress, because I am

not sure that any of us know that. I would note, as we note in our

testimony, that the failure to develop an active secondary market

for the AMBS and their retention of the AMBS within portfolio certainly does call into question what the GAO noted as their strategy

for dealing with times of high stress which is going to market with

AMBS because they have not allowed a secondary market to develop heretofore, and as the GAO notes in its report, it would be

difficult to understand what the demand for such a product would

be. But I would defer on the question of how exactly they would

withstand such a crisis.

The CHAIRMAN. Thank you.

11

Ms. D’Agostino and Ms. Franzel, you work has focused a great

deal on the Long-Term Standby Commitment to Purchase, or

LTSCP program, that has been used extensively by institutions of

the Farm Credit System. What is the GAO’s view of that program,

and is Farmer Mac able to monitor that portfolio since those loans

are retained on the originator’s books?

Ms. FRANZEL. This program is a little different from some of

Farmer Mac’s other programs, because these agreements are off

balance sheet, and there are variations on the agreement. So currently, Farmer Mac holds $3.1 billion in standby and related agreements, the related agreements are essentially securitized loans

that are under standby agreements, and Farmer Mac would be required to purchase these loans whenever a lender wants to sell

them to Farmer Mac or when the loan becomes 120 days delinquent. If Farmer Mac is buying a performing loan, it can negotiate

the price, but if the loan is 120 delinquent, Farmer Mac must purchase the entire loan and any unpaid interest due to the financial

institution. So this really does change and increase the risk profile

of Farmer Mac. Buying a distressed loan is essentially like buying

the entire farm when it is in financial distress. And so in a distressed agricultural economy, Farmer Mac could be required to use

substantial amounts of cash to purchase these loans. And then once

Farmer Mac purchases the loans, some sort of mechanism would

need to be put in place to recover some value from those loans and

really resolve the issues, sell the underlying assets. And our experience in previous financial institution crises has shown that this is

a very lengthy and expensive process.

So under these agreements, Farmer Mac would need large

amounts of cash up front potentially to purchase the underlying

loans and then incur substantial amounts of time and expense to

sell and resolve the underlying assets. So it really does raise the

risk profile and complexity of Farmer Mac.

The CHAIRMAN. Thank you, Ms. Franzel.

Mr. Zerzan, finally, let me ask you. Assuming that Farmer Mac

needed to come to Treasury for assistance and assuming there is

a continuing dispute about the availability of that assistance for

AMBS held in Farmer Mac’s portfolio, what would you guess to be

the likely outcome of that dispute and the time that it would take

to resolve it, and should Congress clarify this matter now?

Mr. ZERZAN. Thank you, Mr. Chairman.

I think it is difficult to speculate how long it would take to resolve such a dispute. We believe, in the Treasury, it would be

anomalous for Congress to have granted a publicly traded corporation a line of credit with the taxpayers for a guarantee that runs

solely to itself. To the extent that clarification of that congressional

intent is necessary, then certainly I think the Treasury Department, in general, is in favor of clarity. So that would certainly not

be unwelcome.

The CHAIRMAN. Thank you.

Mr. Stenholm.

Mr. STENHOLM. Ms. Pellett, in your estimation, does FCA have

sufficient authority to regulate Farmer Mac?

Ms. PELLETT. Congressman Stenholm, presently, yes; FCA does

have enough authority to regulate Farmer Mac. We do have auVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
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thorities that are very comparable to other regulatory agencies of

the financial institutions. However, we do support GAO’s recommendation to Congress that enhancements are needed in the future. We especially support greater flexibility for FCA as the regulator to set minimum and regulatory capital requirements for

Farmer Mac.

Mr. STENHOLM. Have your auditors and examiners found Farmer

Mac’s board and executive management helpful during examinations?

Ms. PELLETT. I think I should let our Director of OSMO respond

to that, please.

Mr. MCKENZIE. Congressman, I appreciate being here this morning and also the opportunity to work with Farmer Mac over the

last 12 to 15 months.

Any time that the examiners of the financial institutions conduct

examinations of institutions, management culture, adequacy of systems, and the ability to respond to the substantial amount of requests from examiners is stressful at times. So to say that it is

easy on both sides would not be totally accurate, but I would say

yes, the Farmer Mac Board and Farmer Mac management have increasingly been responsive to the regulator, and over the last several months, have had increasingly positive relationships, and

progress is being made from the Farmer Mac Board in oversight

of the institution.

We appreciate that very much and look forward to continuing

our relationship with them.

Mr. STENHOLM. Thank you.

Mr. Zerzan, would you go a little bit further in your conclusion,

the last statement in which you raised a question for Congress,

whether Farmer Mac’s increased business activity contributes to

achieving a significant public purpose? You say it remains an issue

that Congress should continue to evaluate. Would you go a little bit

further to help Congress?

Mr. ZERZAN. Yes, sir.

The point that I am trying to illustrate in this testimony is that

to the extent Congress established Farmer Mac to create a liquid

secondary market for agricultural mortgage-backed securities, similarly to the markets that exist for residential housing mortgages,

that has not been achieved. It has not been achieved largely because Farmer Mac has chosen to retain AMBS largely in portfolio.

Certainly they do provide some benefit and some credit to the agricultural market as a whole by purchasing loans which are made by

other lenders, but in that respect, they are not acting in a capacity

significantly different from other specialized agricultural lenders.

I think it is a question that needs to be continually followed and

considered whether or not another specialized agricultural lender is

what Congress intended to create when it created Farmer Mac or

if, in fact, the goal was to enhance the liquidity of the secondary

market for agricultural mortgage-backed securities.

Mr. STENHOLM. Ms. D’Agostino, just a summation, I guess, of

your testimony, are you satisfied that Farmer Mac is making

progress regarding the recommendations that were made in the

GAO report, especially those dealing with lowering its risk profile?

13

Ms. D’AGOSTINO. It is a little too early for us to be able to evaluate the actions. We met with them recently to discuss their actions.

A lot of the things that they said were planning to do or are in the

process of doing are at such early stages it is really hard for us to

tell at this point whether they fully responded to our recommendations. As you know, we continue to do recommendation follow-up

and circle back with entities that we have reviewed and see where

they stand on implementing our recommendations. We will continue to do that. And if the committee would like us to look even

further, we would be happy to do that additionally, at request. But

it is a little too early for us to tell how much progress they’re making in some of the activities that they are doing now.

Mr. STENHOLM. Thank you.

The CHAIRMAN. Thank you.

The Chair is now pleased to recognize the vice chair of the committee, the gentleman from Ohio, Mr. Boehner.

Mr. BOEHNER. Thank you, Mr. Chairman.

I would like to ask Mr. Zerzan and Ms. Pellett to comment on

this question. In formulating its policy position on a new independent regulator for the housing GSEs, the administration made an affirmative decision that this regulator should be solely and exclusively focused on secondary market activities and not combined

with one of the existing regulators of the primary lending market

to avoid a conflict of interest in the regulatory mission. Does this

issue need to be reviewed and reconsidered with respect to the FCA

since the agency regulates primary lenders in the Farm Credit System as well as Farmer Mac, which was mandated by Congress to

establish and maintain a secondary market for agricultural mortgage loans? Mr. Zerzan, I will let you go first.

Mr. ZERZAN. Thank you, Congressman Boehner.

As I note in my testimony, there is a concern over the possibility

that the dual regulatory role of the FCA over both the Farm Credit

System and by Farmer Mac, which is largely owned by Farm Credit System members, could pose issues with respect to conflicts of

interest. In particular, in my testimony, I note that this is true in

the long-term standby purchase commitment agreements. It is certainly worth monitoring and considering whether or not the current

system is created in such a way that in a time of future difficulties

the FCA might not be conflicted by virtue of it being a dual regulator.

Mr. BOEHNER. Ms. Pellett?

Ms. PELLETT. Thank you, Congressman.

We do recognize that there could be a potential conflict of interest here in our oversight of both the Farm Credit System and

Farmer Mac. However, I would like to note that GAO found no actual evidence where our two oversight responsibilities were not

properly balanced. In our response to GAO, we stated that FCA is

committed to the very highest standard of financial institution supervision possible. And I vow and I pledge to this committee that

this is true now and it will continue to be true. Congress originated

the Office of Secondary Market Oversight as an independent office

within the Farm Credit Administration. The FCA board and the

FCA staff respects that commitment and the original intent and

the independence of the Office of Secondary Market Oversight.

14

Mr. BOEHNER. Well, that is part of my concern is that do you

have the capability of separating the two missions: one of regulating the primary lending institutions and then separately and independently being able to regulate Farmer Mac as a secondary lending organization?

Ms. PELLETT. Congressman, yes; we do have that capability because of the independence of this office. And maybe Mr. McKenzie

could comment on that as well. But again, I want to vow to you

that we do hold high that standard, a very high standard of financial institution supervision and whether it be whichever hat we do

have on, we do honor that.

Mr. BOEHNER. Mr. McKenzie, do you want to comment?

Mr. MCKENZIE. Yes, sir. Thank you, Congressman.

I would say, going back to Chairman Pellett’s opening comments,

my observation, and I have worked on both sides of regulating

Farm Credit System institutions and now recently regulating

Farmer Mac, is that the FCA board and the agency, as a whole,

is committed to providing an adequate, dependable source of credit

through both GSEs, the Farm Credit banks and associations, and

Farmer Mac. They both have a role to play. And the FCA board,

in my observation over several administrations, is that they are, indeed, committed to the success of both GSEs. There is, indeed, separation, and I should share with you my personal view that the

FCA board has been very supportive of the Office of Secondary

Market Oversight’s independence, its resource requests, and its

support as we have been engaged in that office over the last 15

months.

Mr. BOEHNER. Mr. McKenzie, do you have any concerns that the

top ten clients of Farmer Mac constitute 80 percent of the loan volume?

Mr. MCKENZIE. From Farmer Mac’s perspective and our regulation of oversight, there is—from the development of business,

Farmer Mac is a developing entity, a developing GSE. And so it is,

no doubt, trying to fulfill its mission and provide a liquidity source

from whatever available demand that there is from those institutions. We support that accomplishment from the agency standpoint.

We also look at it from a concentration standpoint, both from risk

posed geographically as well as the development, and that the business could go away, so to speak, from too many single sources. But

I would share with you, at this point, we have no major issues from

the regulation of this side of our business of FCA with regard to

concentration of sources of business in meeting Farmer Mac’s mission at this development stage.

Mr. BOEHNER. Just a final comment. The reason I bring up the

question is that with an agency, such as FCA, having a dual role,

in terms of regulating both the banks that originate the loans and

the secondary market, is that we don’t want to be regulating Farmer Mac, the secondary market, in a way that is similar to the originating banks. And there seems to be at least some concern that we

are seeing a mission from the banking side applied to Farmer Mac.

And the concern is inhibiting their ability to truly act as a secondary market.

Mr. MCKENZIE. If I get the gist of your point, Congressman, I

think what I would say in response is that we do examine and regVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
15

ulate Farmer Mac based upon the risks that it faces: agricultural

credit risk, interest rate risk, liquidity risk, and operations risk. I

think we have some of the best agricultural credit risk examiners

in the country. I personally would place them against any other

regulator in assessing that risk. I think we have adequate skills to

address all the risks that Farmer Mac faces. Mr. Zerzan indicated

in his own statement that the risk profiles are changing and are

similar to other specialized lenders while capital requirements of

Farmer Mac are still based upon the secondary market structure.

Management of risk, when you have a secondary market capital

structure that is relatively highly leveraged compared to other retail lenders, management systems, as I have shared with others,

must be pristine. There is minimal room for error. We apply riskbased examinations to approach that regardless of whether it is a

secondary market or whether it is a primary. And, we base it upon

risk and capital levels to absorb that risk.

Mr. BOEHNER. Yes, but my point is they are not a retail lender.

Mr. MCKENZIE. Granted, but the risks, I would say, Congressman, must be also addressed in the same fashion at the core.

The CHAIRMAN. I thank the gentleman.

The gentleman from California, Mr. Dooley.

Mr. DOOLEY. Thank you, Mr. Chairman.

Ms. D’Agostino and Ms. Franzel, in the GAO report where you

spent considerable time talking about the standby agreements,

which when you look at the portfolio of Farmer Mac, it constitutes

a significant, in fact, a majority of their portfolio. I guess, not having the level of expertise I would like to have on this, it almost

seems like we have created an incentive with different capital requirements there, from the 0.75 to the 2.5 or whatever it is, is that

we have a significant incentive for Farmer Mac to enter into these

standby agreements. Is that consistent with the capital requirements that we put in place that provide, obviously, some protection

to the taxpayers and their interests here? Are we providing an adequate level of protection there?

Ms. FRANZEL. Your point, Congressman, is right on target. The

standby agreements do result in reduced capital throughout the

system really without any corresponding change in the substance

of the underlying loans or transactions. So, for instance, once these

loans are put under the standby agreements, the capital requirement, which would have been 7 percent, if they had been loans, get

reduced. The institutions hold 1.4 and Farmer Mac holds 0.75, so

really, it is a combined requirement of 2.17 in capital versus 7 percent, which would have been required if the loans were not under

the agreement. So yes, there is significant incentive for these

agreements so that capital can be reduced by the institutions. And

that results in less capital being held in the system as a whole as

protection in the event of difficult economic times.

Ms. D’AGOSTINO. And in addition, yet at the same time, by entering into standbys, the lenders who do enter into them do free up

capital to then lend more. And in addition, Farmer Mac does make

a significant amount of income from the fees off of the standby

agreements. So you have this tension and issue going on here

where on the one hand stanbys generate fees for Farmer Mac and

on the other hand, they lower the capital held by the FCS and

16

Farmer Mac and it makes it difficult. This is why we recommend

that FCA get more flexibility in setting capital requirements so

that they can risk weight specific products for the specific facts and

circumstances they are dealing with and the risks posed thereby.

Mr. DOOLEY. So is the actual capital requirement then is where

the Farmer Mac, in their testimony, contend that they have capital

that is six times what their risk-based amount would need to be,

but is that figure most likely based on their portfolio that is not

in the standby account, or have we structured this so that the capital requirements are also weighted based on the standby versus

the mortgages that they are holding?

Ms. D’AGOSTINO. In one respect, the statutory capital requirements were set long before standby agreements ever existed. So the

statutory requirements never envisioned products like this coming

to be. This is one of the reasons, again, why it is better not to have

a static statutory number there and to allow the regulator to adjust

capital over time, with various products and their complexities and

risks to adjust the capital so that FGA can better assure adequate

capital. And it is true that Farmer Mac exceeds the current capital

requirements. But to date, it is not totally clear, and it hasn’t been

demonstrated that it is adequate to withstand a severe economic

downturn. And so what we have recommended is that Farmer Mac

do come up with a capital adequacy plan. We have asked the Farm

Credit Administration to adjust how it stresses the risk-based capital. And all of that was kind of pointed at this fundamental problem with the capital requirements. And it is interesting that Farmer Mac points out in each one of its 10-Ks how much more it could

increase its program assets because it exceeds its capital requirements by so much rather than saying we really think we have adequate capital to cover our risks. It is an interesting contrast in perspective.

Mr. DOOLEY. Ms. Pellett, did you want to comment on this, I

mean, in terms of the FCA’s approach to this in terms of evaluating the potential risk that is emerging because of the standby

agreements?

Ms. PELLETT. Mr. McKenzie, please.

Mr. MCKENZIE. Thank you, Congressman.

Capital is always a very, very important issue to a regulator.

And when we are talking about, again, the secondary market capital structure that is relatively highly leveraged compared to other

lenders, it makes it doubly important.

First of all, let us recognize what we are talking about as far as

the standby required capital level. They are similar to the AMBSs

that would be sold. In particular, they would be treated the same

for under the statutory minimum capital requirement, which is

three-quarters of 1 percent capital required. Currently, that is the

amount that Farmer Mac would have to hold for any of the standbys that it would be providing or guaranteeing on the loan

amounts, because the risk-based capital, which you also referred to,

is substantially predicting less capital than the statutory required

levels in total. So whether 0.75 percent capital required for agricultural credit is sufficient in the statute, I think, we fully support

GAO’s recommendation that the regulator be given greater flexibility to address those capital issues.

17

Furthermore, I might add that in response to not only the GAO

recommendation but our own initiative to review the risk-based

capital regulatory requirements that are required by statute that

we are aggressively looking into those issues recommended by GAO

as well as our own issues, some of which were caused by the longterm standby. And, we hope to have before the FCA board a proposed rule with some revisions later this year to address them.

The CHAIRMAN. I thank the gentleman.

The gentleman from Michigan, Mr. Smith.

Mr. SMITH. Thank you, Mr. Chairman.

With your leave, I would like to briefly introduce my new agriculture LA, and that is Lee Van Aken. Lee did his undergraduate

and his masters at the University of Wisconsin, got his doctor’s degree in Montana State, worked for a year as a science fellow with

Representative Gutknecht, so Lee, welcome.

I guess it seems to me that our goal is to have credit availability

to farmers and ranchers. I mean, that is the goal. That is why, in

1987, we made this decision to expand the secondary market in

hopes of facilitating that goal. And I guess my first question would

be if there wasn’t any Farmer Mac and you were advising this committee today whether or not we should establish a Farmer Mac,

would you recommend that we establish a Farmer Mac? In other

words, is credit availability otherwise provided by other institutions adequate today without Farmer Mac? And I guess I would go

to you, Ms. Pellett, for, maybe, your first reaction.

Ms. PELLETT. Thank you, Congressman.

Each entity that services rural agriculture, the farmers and

ranchers that make it up, has its own place. And that is true for

the commercial independent bankers, Farmer Mac, as well as the

Farm Credit System. Farmer Mac has made it possible for a steady

flow of credit from the institutions that use it to the farmers and

ranchers. And for that reason, I would say that there is a place for

each one of them, and yes; I would recommend it.

Mr. SMITH. So you are saying that credit availability today for

farmers and ranchers is such that without Farmer Mac, it would

be lacking? Is that what you are saying?

Ms. PELLETT. No, no. It just makes it smoother and makes it

more available. No, it would not be lacking.

Mr. SMITH. Help me understand. With the other efforts for farm

loans in FSA, in our rural development both in USDA, what is the

involvement of Farmer Mac now in terms of underwriting some of

the FSA farm loans? Do they take a very small portion or a significant portion of that underwriting? Do you know that, or shall I

save that for the next panel?

Ms. PELLETT. I think that Mr. McKenzie probably does.

Mr. MCKENZIE. I don’t have the precise number, Congressman,

but they have, indeed, a special program for these loans. They have

two programs. One is Farmer Mac I and the second is Farmer Mac

II. And Farmer Mac II is devoted exclusively to USDA guaranteed

loans. It is my recollection, and you could ask Farmer Mac the precise numbers in the later discussion with them, but I believe they

have somewhere in the neighborhood of $750 million, three-quarters of a billion dollars under Farmer Mac II out of the $5.8 billion

total. So it would be somewhere around 10 to 12 percent, if you

18

look at overall program activity. That is to the best of my recollection.

Mr. SMITH. Thank you.

And a question to GAO. In your report, you concentrated somewhat on the Farmer Mac’s board structure. And maybe in 1987, the

makeup of that board structure might have been adequate. Would

you recommend a change in how the board is made up, such as

possible presidential nominees, especially when the class C stockholders don’t seem to have board representation now?

Ms. D’AGOSTINO. Yes, Congressman. We recommended that the

Congress restructure the board to take both feet and put them

squarely either into a cooperative structure with the class A and

class B stockholders electing the board of directors and not issuing

any class C stock, don’t have it a publicly-traded company, or place

both feet squarely in the publicly-traded, investor-owned corporation world, which is now governed by Sarbanes-Oxley Act, and by

NYSE listing standards. And at this time, the structure that is set

in the statute is seemingly misaligned with today’s market environment and other statute and principles in corporate governance that

prevail today.

Mr. SMITH. Secretary Zerzan, or maybe anybody, do we know, is

there somehow an accounting or record keeping of how much rural,

farm, or ranch loans are underwritten or have a secondary market

from Freddie Mac or Fannie Mae or other underwriting secondary

institutions? Do we know how much they are doing?

Mr. ZERZAN. Thank you, Congressman Smith.

I don’t know that information off of the top of my head, but I will

be sure to see if we can find that and get it to you after this hearing.

[Mr. Zerzan responded for the record:]

Fannie Mae and Freddie Mac do not purchase loans like farm and ranch loans.

They do buy and guarantee rural housing loans. The Department of Housing and

Urban Development tracks this measure as part of collecting data on Fannie Mae’s

and Freddie Mac’s housing goals. According to HUD’s proposed rule on the GSE’s

housing goals (69 FR 24228), Fannie Mae and Freddie Mac purchased 1.2 million

mortgages for single family homes in ‘‘non-metropolitan’’ counties in 2002, see attached table B.11 of proposed rule. HUD derived this number from loan level data

provided by the GSE’s using 2000 census data assuming metropolitan statistical

area (MSA) boundaries used prior to June 2003.

19

20

Mr. SMITH. Mr. Chairman, I don’t have any other questions, except I would like to compliment GAO on that kind of effort that allows us to review the service of this organization.

Thank you.

The CHAIRMAN. I thank the gentleman.

The gentleman from Oklahoma, Mr. Lucas.

Mr. LUCAS. Thank you, Mr. Chairman.

My first question goes to our GAO friends. I can see, obviously,

where the long-term standby commitment program is a benefit to

the Farm Credit System since each institution has a guarantee on

a sizable amount of its assets, and they are able to maintain less

capital in that portfolio. But is there a particular reason or a series

of reasons as to why the rest of the commercial banking companies

or other agricultural lenders have not used this program, that you

could tell or determine?

Ms. D’AGOSTINO. Yes, sir. We attempted to address this in our

work that we did in the 2003 report. What we found was that between 1996 and the end of 2002, commercial banks participation in

Farmer Mac I dropped from 80 percent to 22 percent. It is quite

precipitous, and it is quite large. Also, the commercial lenders that

do do business with Farmer Mac are very few and very concentrated in between two and four commercial lenders.

In the meantime, the FCS institutions participation went from 2

percent to more than 55 percent. So as you can see, whereas I

think the vision was the commercial lenders would really use the

Farmer Mac facility and then free up a lot of commercial lending

credit availability, what has happened is fewer commercial lenders

are using it and more FCS institutions are using it, who already

have GSE status. It was difficult for us to find a reason why this

was happening, why commercial lenders weren’t using Farmer

Mac’s facility more. And Farmer Mac’s latest 10-K‘, points out that

historically the commercial lenders have preferred to keep their agricultural mortgage loans in their portfolio rather than use the secondary market for these loans. I have no further explanation, just

noting the trends that have occurred. We did try to find out, but

it is very hard to get at something like that from our perspective.

Mr. LUCAS. Any opinions from the rest of the panel, perhaps, on

this issue?

Mr. MCKENZIE. I think that would be a good question, again,

that you may want to ask Farmer Mac, but from our perspective,

we would note that the Farm Credit System obviously is a source

of mortgages and a primary source of mortgages, which is a legitimate source of business for Farmer Mac. Ms. D’Agostino mentioned

disclosure and SEC filings. I think also reported there is Farmer

Mac’s recognition that the commercial banks and lenders have adequate liquidity present and have adequate cash funds on hand.

And, so there is a difference between availability of secondary market demand during high demand periods and low deposit periods.

So, I think that may have contributed as well.

Mr. LUCAS. And before I would direct my last question to the

panel, I would note that there have been several comments made

about the challenges in the early 1980’s. And having lived through

that period, also, it is kind of unique in my part of Oklahoma in

that we faced both the collapse of agricultural prices, the collapse

21

of energy prices, high inflation, and a deregulated interest market

for the first time since the 1930’s. So the early 1980’s can only be

compared to the deepest, darkest part of the early 1930’s. And if

we gauge everything by that absolute worst case scenario, well,

that is a challenge.

So let me ask my last question. Based on the comments and testimony and written testimony of everyone on the panel, on this

first panel, is it fair to say that there are no major immediate

short-term problems with Farmer Mac? Is that a fair statement to

say in the immediate short-term nature? Major problems? And

whoever would care to be brave enough to answer that.

Ms. FRANZEL. OK. I hate to go first on this. That is a very good

question. Our report did point out areas of risk. We did make a

number of recommendations of areas that we thought needed to be

addressed now in good times and difficult public policy issues that

are easier to consider in good times rather than in bad times. And

we did point out some limitations of the credit modeling at Farmer

Mac as well as liquidity planning, again, which are very important

to address, because even if we don’t get to an early 1980’s scenario,

some depressed conditions in the agricultural economy could put a

strain on Farmer Mac in terms of credit losses as well as liquidity

needs. So we do see those as issues that should be addressed now

rather than later.

Ms. PELLETT. Excuse me. I can not comment on specific issues

as far as examination is concerned, but what I would like to say

is that we continue to work with the Farmer Mac Board and executive management as they address their risk profile, as they continue to grow. Also, we do not see any immediate threat to the financial condition of Farmer Mac to its viability or to its access to

the GSE debt market.

Mr. ZERZAN. Thank you, Congressman.

As Treasury does not regulate Farmer Mac, I would defer to the

FCA’s opinion on this.

Mr. LUCAS. So the barn doors may be a little creaky and the roof

may need some patching, but it is not on fire yet, I believe, Mr.

Chairman.

Thank you.

The CHAIRMAN. I thank the gentleman.

The gentleman from Colorado is departing, so we will turn, then,

to the gentleman from Minnesota, Mr. Gutknecht.

Mr. GUTKNECHT. Thank you, Mr. Chairman, and thank you for

having this hearing.

And I come at this issue maybe different than most people. I

have spent a lot of time in Mr. Lucas’ District back in the 1980’s

as an auctioneer and a real estate broker, and we sold an awful

lot of real estate. And who would have guessed 50,000 people in the

State of Oklahoma turned the keys to their houses back to their

lenders, because everything went upside down. Now Ms. Franzel,

you come from a little farm. You grew up on a farm between

Owatonna and Bigsby, Minnesota.

Ms. FRANZEL. That is correct.

Mr. GUTKNECHT. And let me just ask you, having grown up on

that farm, a little bit about farm values. And I want to go back and

visit, because I think we are setting ourselves up for the same kind

22

of problem we had in the 1980’s. And the reason I say that is I

think the fundamental problem was we were involved in assetbased lending, OK, not cash flow based lending, which everybody

said now we are going to move to cash flow based lending. Is there

any way that you can afford to pay $3,000 an acre for land in

southern Steele County, Minnesota and make it work, even at $8

beans?

Ms. FRANZEL. I am not up on all of the cash flows on farming,

but certainly if the loan goes upside down, so, for instance, the

farmer has more debt on the land than the land is even worth, and

usually that happens when farm prices are low, you have got a

very bad scenario on your hands. I would defer to Farm Credit Administration and Farmer Mac to discuss underwriting standards,

which are key up front to helping ensure that quality loans are

made.

Mr. GUTKNECHT. Well, I want to just come back to the point.

Maybe I am wrong, but I don’t see any way in the world that you

can make it work. Now Ms. Pellett, you are from Iowa. What county are you from?

Ms. PELLETT. Cass County, southwest Iowa.

Mr. GUTKNECHT. OK. I don’t know what land values are down

there, but I mean, how did land values get so high?

Ms. PELLETT. Congressman, they are rising, and——

Mr. GUTKNECHT. But no, I understand they are rising, but how

did they start rising? What is driving the price up?

Ms. PELLETT. I, in my opinion, this is not an official FCA opinion,

but I——

Mr. GUTKNECHT. Well, if people can’t get a loan, how can they

possibly buy land for $3,000 an acre?

Ms. PELLETT. There are several factors. One is that there are

very nice government subsidies, and they are making that land

rise. And they are——

Mr. GUTKNECHT. But even with government subsidies, you can’t

make those numbers work.

Ms. PELLETT. Interest rates, again, are very low. Congressman,

as we go about examining the institutions that we regulate, we

look very closely at those risk management factors and rising

land——

Mr. GUTKNECHT. But are you doing cash flow analysis of some

of these deals? I mean, somebody ought to be paying attention.

Here is the deal. Here is what happened in the 1980’s. Who took

the haircut at the end of the day in the 1980’s? It was the American taxpayer that took the haircut, and it was to the tune of billions of dollars. And I am not blaming Farm Credit System or

Farmer Mac or any of those things. I mean, it was all of those Federal guarantee programs, and basically it was the American taxpayer who lost billions and billions and billions of dollars, because

people were making loans that they probably shouldn’t have made

because liquidity. Gee, if we don’t make the loan, somebody else

will. And that is what is happening again today. I mean, I do not

see that much difference between today and 1982.

Ms. PELLETT. Congressman, I would agree. The indicators are

there. As we go into these institutions that we regulate and we examine them once every 18 months, we are looking at just the

23

things that you are talking about. They have to have and we have

to ensure that their risk management practices are in place so that

they can weather this and that they have done appropriate measures now during the good times to keep from happening what happened in the 1980’s. Their underwriting standards are very conservative.

Mr. GUTKNECHT. How can you say that? I mean, how can you say when they are loaning money for $3,000 for an acre of land, how

can you say they are conservative?

Mr. MCKENZIE. Congressman, are you referring to Farmer Mac

or lenders in general?

Mr. GUTKNECHT. Well, ultimately, you buy those loans. I mean,

they make the loan, they are off of the hook, right?

Mr. MCKENZIE. The lenders?

Mr. GUTKNECHT. Right. If they sell the loan to you, how much

skin have they got in the game now?

Mr. MCKENZIE. Certainly, with lenders and cash flow, I will go

back to what Chairman Pellett said in our examination of institutions we do the examination and ensure that there is not

collateralized lending as you indicated there. We want to make

sure that the risk management systems in all institutions that we

regulate, and Farmer Mac in particular with its capital structure,

are adequate. I will let Farmer Mac address its underwriting

standards. It does have an underwriting standard program. It does

do due diligence on all loans that it buys. And those factors are

factored into even the risk-based capital model that the statute requires us to address. From the examination perspective, I would

share with you that we do do a thorough analysis of risk and cash

flow. I personally share with you some of the concerns about agricultural prices in general. I grew up on a small farm myself, and

the market is driving the prices. And there are a lot of investors.

And obviously farmers that are buying it is doing that.

Mr. GUTKNECHT. But none of that could happen if you didn’t

have pretty loose credit.

Mr. MCKENZIE. And I would say to you, in FCA, we are looking

for good examiners. And you might be a good source. I would appreciate any help that we could have from you.

Mr. GUTKNECHT. Well, I may be an auctioneer back in a couple

of years, and I don’t want to see that happen again. But I think

we are setting ourselves up for the same situation, because we

have got land values way ahead of what they could possibly cash

flow. And the greatest farm economist that ever lived is a guy by

the name of Johnny Cash. And he said it best when he said, ‘‘Everything changes as well it should. The bad ain’t forever, and the

good ain’t for good.’’ And I just think we are set up, once again,

with land values that can not be cash flowed, and sooner or later,

when the market begins to turn, we are going to wind up with a

whole lot of that coming back, and then the auctioneers will reset

the values of that, and it will be set at what people can really afford to pay for it. And it will be a lot lower than it is today. And

everybody loses. And I just think we are not doing enough today

to make certain that that doesn’t happen.

I yield back.

Ms. Pellett?

24

Ms. PELLETT. Congressman, we appreciate your comments and

respect them. And may I assure you that we are taking means to

keep these things from happening and will continue to. Thank you.

The CHAIRMAN. I thank the gentleman.

Before we turn to the gentleman from Nebraska, I yield to the

gentleman from Texas for a brief comment.

Mr. STENHOLM. Yes. The gentleman from Wisconsin was asking

some very good questions as it pertained to current and future

questions, but I think the inference was left that the taxpayers

took a haircut in the 1980’s as a result of the appreciation of land

values. I believe, if you examine the record, taxpayers have not

been out one penny to the Farm Credit System. We provided in the

legislation of 1987 loans that have been paid back, capital is adequate today in the Farm Credit System to pay back in its entirety,

should they choose to do so, pay back that which was lent to the

Farm Credit System. We also created an insurance system that is

self-financed. Now there were some haircuts, as the gentleman

said, that were taken, but it was usually with stockholders and

various PCAs and land banks, et cetera, all part of the system that,

for various mismanagement or misjudgment, as the gentleman is

correctly pointing out the question how can you pay this much,

these are legitimate questions. But I did not want the record to

show that the taxpayers of America have been out any money on

the Farm Credit System thanks to good management taking the

legislation that was passed in 1987 and doing with it what Congress intended, we have a system today that in today’s terms are

in good financial condition. Not to say that the gentleman from

Wisconsin’s questions are not ones that all of us in agriculture need

to be looking at. And also, from the standpoint of GAO and on the

risk management of Farmer Mac, et cetera, these are all things

that we have got to pay a little bit more attention to. But the folks

that gave the taxpayers the haircut, as it was termed, was the savings and loans. And that was some of the most gross mismanagement that you could possibly see. And the taxpayer was out a

bunch. But the taxpayer was not out one penny on the Farm Credit

System.

The CHAIRMAN. I thank the gentleman. And I am sure the gentleman from Minnesota appreciates those comments, but I also appreciate the observations from the gentleman from Minnesota.

There are some concerns here that need be addressed.

The gentleman from Nebraska, Mr. Osborne.

Mr. OSBORNE. Thank you, Mr. Chairman.

I have a question for Ms. D’Agostino. And I read in your testimony you said that government does not guarantee Farmer Mac

obligations and that the perception in the agricultural community

is that the government does guarantee those obligations. And I

think the fact that this perception is out there, you also said in

your testimony, allows Farmer Mac to have some advantages in

terms of rates and ability to borrow. Now it seems to me that this

isn’t quite consistent with a fair way of doing business if, in fact,

all we are dealing with here is a perception and, in reality, the government does not stand behind these loans. It would seem that

maybe we should have some specific language where either it does

or it doesn’t. And also whether we should put these people in a poVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
25

sition where they can achieve lower interest rates than the banks

and other people who are in a lending situation. I just would appreciate your comment on that and your willingness to flesh out your

original testimony.

Ms. D’AGOSTINO. Sure. I think, to clarify one thing, what we

have said is that not that they don’t have the Treasury line of credit, but that the Treasury line of credit, according to Treasury’s

view, is extendible only in cases where the guarantees aren’t running to Farmer Mac itself, in other words where Farmer Mac has

kept its own securities in its own portfolio. Where Farmer Mac has

securitized and sold to investors the capital markets, then that

guarantee would run, I believe, under the Treasury position. And

of course, this is a disputed issue between Treasury and Farmer

Mac whose outside counsel totally disagrees that Treasury’s line of

credit could apply only in certain given instances, that it would

apply in all instances. So what we pointed out was this dispute is

ongoing. And the lack of certainty and the lack of clarity about this

point does allow a perception to continue, as you pointed out, in the

markets that everything of Farmer Mac’s has the full faith and

credit guarantee backing of the U.S. Government; whereas the

Treasury line of credit is $1.5 billion and there is this question out

there about to what it covers, not under what conditions, but what

it covers.

Mr. OSBORNE. I am assuming that it would be advisable to get

this clarified, is that correct?

Ms. D’AGOSTINO. That is one of the options that Congress

has——

Mr. OSBORNE. All right.

Ms. D’AGOSTINO [continuing]. is providing more clarity to the line

of credit. And I think the Treasury witness also welcomed that.

Mr. OSBORNE. Well, let me press on with one other question for

you. You also stated that legislation is not specific and it does not

provide mission-related criteria that allows for a meaningful assessment of Farmer Mac’s progress in meeting policy goals. I am

thinking about where does this committee come in. And it seems

to me that that is somewhat in our area of jurisdiction to provide

specific language. And again, I guess what you are saying is that

the language isn’t tight enough, because it is not clear enough, and

therefore, your job of assessing is difficult.

Ms. D’AGOSTINO. It was very difficult. And I think Treasury’s

statement amplified the difficulty even further of trying to go from

the broad statutory mission statement to figure out what Farmer

Mac really is contributing in terms of interest rates, in terms of

coverage, in terms of the agricultural real estate market as a

whole. This is true particularly given the concentration and the

number and the location of lenders that use Farmer Mac. It would

seem that to be fulfilling a public purpose, you would want a very

broad and nicely spread out benefit from Farmer Mac to the Nation

as a whole. And we would be happy to work with the committee

on trying to improve the language. Some of the things that we have

thought about include being informed by what the housing GSEs

have in terms of their goals. There may be targeted populations

you want to cover. I know in the FCS statute, there are provisions

for young beginning and small farmers to get some attention from

26

the institutions. I think there are a lot of options for you to consider and paths that you can take.

Mr. OSBORNE. Thank you. And my time has expired. I yield back,

Mr. Chairman.

Mr. LUCAS [presiding]. Thank you.

Mr. King.

Mr. KING. Thank you, Mr. Chairman, and I would like to thank

the chairman for the hearing here today and the testimony of all

of you.

As I listen to this, most of the questions have been answered,

and I think they have been good questions and good answers. The

three questions, really, that stand out about this hearing for me

are the question about capitalization, the question then about the

board structure, and then the third question is about the mission

statement and is the mission being fulfilled. I would look back on

a couple of things. The long litany of things that were wrong in

1982 given by the gentleman from Minnesota is really right on the

mark. I would say there is a little bit of a difference between today

and then, though. And the exception that I would point out is that

today we have markets. Today, at least in our part of the country,

we have gotten some rain, and I am grateful for that. And so that

makes a big difference to have markets have productivity and some

rain to support that. And I hope that comes to the western part of

the country as well. So that is a distinction.

But I would also point out that the taxpayers did take a haircut in the 1980’s. And I remember a headline that said $26 billion

dumped into the farm program. That came out of the taxpayers,

and that was specifically to bring agriculture out of the toughest

hit that it had taken at least since the 1930’s. It was part of all

of the things that Mr. Stenholm pointed out and Mr. Gutknecht

and a number of others, but we also, as taxpayers, did take a hit.

And so what is interesting to me is Chairman Goodlatte’s initial

question intrigued me from the beginning and that was replay the

scenario of the 1980’s and advise the committee on what that impact might be if we went back to that scenario again. And that has

recurred from Mr. Lucas and Mr. Gutknecht. And so it was also interesting to me that that question asked of Ms. D’Agostino that

was passed off to Ms. Franzel. It is interesting to know that you

are from Minnesota and your water runs down to us, and you had

a prepared answer to that question, which boiled down to we don’t

know. I understand that, but don’t we have any kind of model that

can look at this capitalization? I mean, don’t we know that underlying all of these loans are land values and cash flows together, not

exclusive from each other, but together? And can’t we do some kind

of analysis of that so that we can better predict what condition we

are in here, because that is the central question here? The very

purpose of setting up Farmer Mac was in reaction to the farm crisis in the 1980’s. So why don’t we know more? And can we find out

more? And I direct that, then, to Ms. D’Agostino.

Ms. D’AGOSTINO. OK. You have really hit this right on the money

in that, and this is one of what we feel is a major and important

issue to address now. It was to address the modeling problems that

we found at Farmer Mac and some at Farm Credit. Basically, the

models that Farmer Mac uses are using old loans from FCB Texas.

27

They are using old loans and assumptions that don’t bear any resemblance to the loans currently in portfolio. There are different

conditions. There are different prepayment risks and terms. And

what we recommended was to include current data on farm loan,

payment delinquency, and valuation, one of the issues you pointed

out, for the loans included in the estimation models so that this

process reflects current loan and economic conditions. We had several other recommendations. I won’t bore you and read them to

you, but not being a modeler, we had modelers looking at their

models, and this is where our recommendations came from. The

modeling has serious limitations and weaknesses, and that is why

we can’t answer your question. Their model has major problems.

Mr. KING. But does anyone have a model that lays this all out?

I mean, I envision an interrelational spreadsheet that plays with

some of these scenarios, which is part of our land values are

prompted by the farm program, some by low interest rates, some

by strong markets, some because it is in good hands and we have

people that have their farms paid for and they can afford to pay

a high dollar for 80 acres. But can we plug that into our loans and

play with those scenarios that maybe see land values drop by 10

percent? And then what does that do to the cash flow capitalization

and——

Ms. D’AGOSTINO. You should be able to, but this model that they

have doesn’t do that.

Mr. KING. Can you put that together?

Ms. D’AGOSTINO. No, we normally don’t. I mean, are you willing

to augment our appropriations?

Mr. KING. I mean, you are making recommendations here, and

I’m giving an opinion, so I am suggesting that it needs to be far

more important.

Ms. D’AGOSTINO. No, I agree. Really, we don’t see it as our job

to create the model for them. We have recommended that they do

so. There are other models out there that they could use to inform

themselves to adjust and make the correct type of model that

would adequately consider changes in land values and interest

rates. It would be relatively awkward for GAO to offer to create the

model for them and then go review it the next time you ask us.

Mr. KING. So in summary, you can either endorse or offer recommendations?

Ms. D’AGOSTINO. Yes.

Mr. KING. And I will accept that answer, and I would ask the

chairman for unanimous consent for an extra couple of minutes,

please.

Mr. LUCAS. Seeing no objection.

Mr. KING. Thank you, Mr. Chairman. And I would just pass the

question that question along to Ms. Pellett or Mr. McKenzie. With

regard to models, I think the modeling part of this may be the way

this question gets answered for us. Would you care to speak to

that?

Ms. PELLETT. OSMO has been working on this, and I will pass

to Mr. McKenzie.

Mr. MCKENZIE. Congressman, I think you have gone to the core

of the issue. I would respond this way. There is a multitude of people out there in risk management that are attempting to do exactly

28

what you are requesting. I will say this—this is one reason that the

regulator we support the recommendation to have greater flexibility so that we can adjust over time. Indeed, the statute prescribes

a certain risk model now. This is the regulatory minimum riskbased capital stress test, that it is known as, that it tries to predict

just what you said. But the model and the data availability has

limitations. So you end up with a multitude of assumptions that

build into those issues. And whether your assumption is correct or

the regulator is correct, or the Congressman from Minnesota’s predictions are correct is all a matter of opinion. And it is very difficult to have one model that addresses the minimum capital levels

of financial institutions. For example, in our regulation of Farm

Credit institutions, we have at least four minimum capital levels

that we address by regulation. Most of the financial institutions

regulators have multiple ratios that they look at and capital. They

look at it from different ways. And we do support the additional

flexibility. I will assure you that we are looking at the existing

statutory provisions and the existing risk-based model to improve

the existing regulatory requirements for Farmer Mac.

Mr. KING. Would it, Mr. McKenzie, be a reasonable statement

that if this Congress is to provide for any changes in the capitalization structure of Farmer Mac or Farm Credit Administration in its

entirety that we have the opportunity to hear from the people who

are managing the models so that we can listen to those types of

scenarios that you described?

Mr. MCKENZIE. Correct. Actually, we prescribe the regulation

that Farmer Mac actually submit quarterly submissions of its riskbased model result, and we will be reviewing those as a matter of

off-site processes and as a part of our examination. And as I have

indicated, also, we have a regulatory project that will be looking at

revisions for the regulatory provisions as well.

Mr. KING. And I would be interested at some point if there is a

red line scenario there to get a sense of where that might be. I

think that would be an operative question.

I want to thank you for your responses to these questions, and

I thank the chairman for the additional time.

Mr. LUCAS. Thank you.

Mr. Peterson.

Mr. PETERSON. Thank you, Mr. Chairman. And I missed part of

this hearing, because I had an Intelligence committee meeting. I

hope this hasn’t been addressed. In the GAO testimony, risk control and management are one of their underlying concerns. And

Farmer Mac, I guess, argued that the hypothetical situation that

they have raised is too implausible that something like what they

are looking at would never happen. And I guess I am kind of wondering, we have got a couple of things going on. One is that the

people are continually taking shots at us and talking about eliminating government programs and supports in the future. We are in

the middle of the round where we are trying to give away all of

our support for agriculture.

I am not sure that that is going to happen, but say that it did

happen. Say that we pulled out the supports completely either because of the trade agreements or because the Congress decided

they finally wanted to balance the budget, what would happen? It

29

seems to me that the farm bill that we passed had a significant effect of increasing land values. And the land values are going up.

I think the main reason is because of the farm bill, at least in my

part of the world. So what would happen if we accomplish these

things and all of a sudden the support wasn’t there and that land

values fell in half, for example? What kind of a situation does that

put you in?

Ms. PELLETT. I would like to respond to that, Congressman. That

would be a very, very challenging time for both the institutions

that we regulate and for all lending institutions that give agricultural credit. That is why during these very good times in agriculture we are doing everything possible to see that our institutions are safe and sound and that the risk management tools are

in place to handle a time that is not as good as we are experiencing

right now.

Mr. PETERSON. And so you have those tools in place so that if

we saw a 50 percent collapse in land values you wouldn’t have a

problem?

Ms. PELLETT. It would be very challenging, Congressman, but we

are working to see that they are in place in the institutions that

we regulate.

Mr. PETERSON. From 1998 to 2001 we put in $26 billion of additional assistance. What would have happened during that period of

time if we wouldn’t have done that? Have you looked at that?

Ms. PELLETT. Congressman, I am a farmer, and I lived during

those times, and they were very difficult times for all entities involved: the farmers, the lenders, and now, as I am looking at it

from the regulator standpoint, it would have been a very difficult

time for the regulator. And like I said, we are working hard and

diligently every day to make sure that those risk management tools

are in place.

Mr. PETERSON. Yes, maybe I just don’t have enough background

in this area, but I am a CPA and I get involved and am somewhat

used to in my practice that I had the Fannie Mae and those folks

up talking to me because of the spotlight that has been put on

them. And I have to tell you, after talking to them for 2 hours trying to understand what in the heck this is about, I still couldn’t

figure it out. You get into all of these derivatives and all of this

other stuff that supposedly is risk management is mystifying to

me. I hear what you are saying that you are trying to do something

about this, but I come away from this conversation like I did with

that one with those other agencies and that is that I don’t quite

get it. So maybe if there is some way you could put this into some

simpler language that an old farm boy CPA could understand, it

would be helpful.

Ms. PELLETT. Congressman, we would be pleased to do that, and

our staff would be pleased to put something in writing and/or meet

with you personally.

Mr. LUCAS. Thank you, Mr. Peterson.

Mr. Ose.

Mr. OSE. Thank you, Mr. Chairman.

My understanding of the GAO report is that there are standby commitments of $3.1 billion.

Ms. D’AGOSTINO. Standby and similar agreements.

30

Mr. OSE. Is Farmer Mac compensated for taking those standby

positions?

Ms. D’AGOSTINO. Yes, they generate fee income for Farmer Mac.

Mr. OSE. What does the fee income equate to, in terms of basis

points?

Ms. D’AGOSTINO. We have the balance sheet.

Ms. FRANZEL. The guarantee and commitment fees for 2003 were $20.7 million. They have been growing steadily each year as the

amount of these commitments increased. For instance, in 2001, the

amount of guarantee and commitment fees was $15.8 million.

Mr. OSE. Now I also understand that Farmer Mac’s total portfolio is around $4.5 billion.

Ms. D’AGOSTINO. It is $5.8 billion, including on and off balance

sheet assests and guarantees.

Mr. OSE. And if I read your report correctly, the income for the

period ending December 31, 2003 for Farmer Mac was $27.3 million? It is on page eight of your report.

Ms. FRANZEL. Yes, net income before cumulative changes of accounting principles would be $27.2 million.

Mr. OSE. So if I take the $27.3 million and I subtract the $20.7

million, I come up with $6.6 million of income from continuing operations under GAAP?

Ms. FRANZEL. That is correct. You would also want to calculate

in the tax effect, so the effect would not be that dramatic, but your

point is that those guarantee and commitment fees are making up

a large part of the bottom line.

Mr. OSE. Well, my point is that the margin between profit and loss on the underlying $5.8 billion portfolio is one basis point, essentially? $6.6 million on $5.8 billion?

Ms. FRANZEL. That is approximate, yes.

Mr. OSE. Is it supposed to be run on a basis of a break-even status? Is that what the statute calls for?

Ms. FRANZEL. No, but there is a number of components of income. You can also segregate out the income on their retained securities, which is also very significant.

Mr. OSE. Well, I notice that the mortgage-backed security thing

has not been effectively marketed or marketized.

Ms. FRANZEL. Right.

Mr. OSE. Marketized? Is that a word?

Ms. D’AGOSTINO. It hasn’t been put out——

Mr. OSE. Securitized, but it hasn’t been marketized?

Ms. D’AGOSTINO. Right.

Mr. OSE. That is a new word.

Ms. D’AGOSTINO. That is a good one.

Mr. OSE. We make a lot of things up around here. So I am curious whether you have any information as to whether or not those

mortgage-backed securities would trade at face value, at a premium, or a discount?

Ms. D’AGOSTINO. That is the big, unanswered question.

Mr. OSE. So you have an organization running a margin on a year-to-year basis of about one basis point, owning $5.8 billion

worth of mortgages with an in-house traded, mortgage-backed security portfolio of—I am unclear on what that amount is, some

amount, with over $3 billion of contentious liabilities and what can

31

only be called a special purpose entity under GAAP’s provisions.

Am I correct on that?

Ms. FRANZEL. That is correct. Yes. And that is really the heart

of the mission and non-mission question here. Our Farmer Mac is

holding a number of investments, which are kicking off a fair

amount of income, which contributes to the bottom line, and a

number of——

Mr. OSE. But the liabilities associated with that income are not

reflected on their balance sheet?

Ms. FRANZEL. Correct, although that would be part of the program assets. Yes, the underlying assets are off balance sheet, because Farmer Mac does not own them, however, Farmer Mac does

have potential future obligations, and Farmer Mac does collect annual income related to those standby agreements. So it is very complicated.

Mr. OSE. In your study, if Farmer Mac, on a continuing operation

basis, is operating on a margin of one basis point, how does that

compare with, say, Fannie Mae or Freddie Mac? Do you have any

information about that?

Ms. FRANZEL. We do have, in our October report, some comparisons of Farmer Mac’s net income or return on assets to the other

institutions. I don’t have that at my fingertips, but we can certainly

get back to you with that. We have some analysis on that.

Mr. OSE. But what I am interested in is if you take out the special purpose entity income and you come down to what is

euphemistically called as income from continuing operations. I

would like to compare that as a function and basis point margin

with that of, say, Fannie Mae or Freddie Mac.

Ms. FRANZEL. Yes, we could slice and dice the income for you and

give you some analysis, if you would like.

Mr. OSE. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Mr. Ose.

A couple of questions from the Chair. Chairman Pellett, your

statement is a very straightforward accounting of your regulatory

program overseeing Farmer Mac and provides a great deal of very

useful information. And I noted on page five in the last full paragraph, you discuss the increased regulatory presence over Farmer

Mac. You do mention the GAO report as being an impetus for stepping up these examinations, however, what role did the allegations

that Farmer Mac may be operating in an unsafe manner have in

your increased activity?

Ms. PELLETT. The increased activity was a result of the rapid

growth that Farmer Mac had experienced. And there was a very

steep rise after 1999. And that raised their whole risk profile, and

that triggered our increased examination, which has taken place

over the last couple of years.

Mr. LUCAS. You also mention that FCA staff is looking at a requirement for Farmer Mac to obtain a credit rating. Does FCA

have sufficient authority to require Farmer Mac to get a credit rating?

Ms. PELLETT. That may be questionable, however, we are studying to see how the other regulators have gone about seeing that the

institutions that they regulate have gotten credit ratings. A credit

32

rating is usually driven by the marketplace. But we are doing that

study, and we may have some findings from that very soon.

Mr. LUCAS. OK.

The Chair turns to the ranking member, Mr. Stenholm.

Mr. STENHOLM. Thank you. I thank the panel for your input

today in this Farmer Mac hearing. And again, going back to 1987

and remembering how we got there, it is fascinating to me. And

Ms. D’Agostino, you said you couldn’t answer the question, but one

of the questions that I have in my mind that I hope someone will

be able to answer for this committee’s satisfaction soon is when we

passed this in 1987, we had strong support from the banking community, but we had almost downright opposition from the Farm

Credit System. And today, we find that the Farm Credit System is

using it, but we have seen a decline in the bankers in using it. And

that is the question. Why? What is it that is happening today that

is causing that, because the whole purpose of Farmer Mac was to

provide agricultural borrowers with the cheapest interest that we

could, compared to Fannie Mae, et cetera? And the theory still

works, but for some reason, we have not been able to fully utilize

it to this point. Well, admitting that Farmer Mac is a baby in this

area, I think that that perhaps is part of the answer, but I think

that there are some other questions that you can’t answer and I

think, perhaps, even Farmer Mac can’t answer, but it is something

that I hope, Mr. Chairman, this committee will continue to pursue,

because I think that is a valid question.

Just regarding the haircut, and my friend from Iowa pointed out the $26 billion. That was disaster assistance. That was trying to

bail out agriculture. And of course lenders get bailed out when you

bail out producers. But I remember very distinctly, because it is

still today, the Rolling Plains Production Credit Association that

was my original financier and still is. They have changed names

about three times now as they have adjusted to meet the challenges of modern day agriculture, but they refused, during the

1980’s when so many experts in agriculture were recommending leverage: ‘‘Take whatever dollars you have, borrow, buy land. It is

never going down again.’’ Well, the folks that did lost big. I also

observed with great sadness many producers who received SBA disaster loans at 3 percent interest and didn’t use that to pay off their

debt but used that to leverage into continuing to enlarge their operations and ended up losing everything.

The questions that you have been asked by many of my colleagues today regarding standards and how we look at this whole

question of agriculture, the question Mr. Peterson asked regarding

WTO and regarding the constant pressure to eliminate agricultural

subsidies, if we were to do that, there will be an adjustment that

will affect lenders of all shapes, sizes, and proportions. I can’t help

but remember when we were doing the hearings on what became

the 2002 farm bill. We had 10 hearings, 20 witnesses at each hearing, 200 witnesses, 1 of which suggested the total elimination of all

subsidies and doing it immediately, because that would be the best

way to get us to the adjustment that sooner or later we are going

to be at anyway. 199 said, ‘‘No, that is not the best suggestion and

solution for us.’’ But the questions that you have been asked today

and your answers and the emphasis on risk is something that we

33

have to continue to look at and continue to do so in a way that is

complementary to the industry in which we serve and you have

been here today to testify on behalf of one element, Farmer Mac,

which I still believe, as I did in 1987, has a significant role to play

in the future of agriculture.

Thank you very much for your attendance today. We may have

some additional questions to submit to you in writing for the

record.

The CHAIRMAN. I thank the gentleman.

Yes, we do have some additional questions we will submit in

writing for the record, and I want to thank you for your very extensive and very helpful testimony. The committee has some valuable

information and some good recommendations that we need to look

at very closely and see where we go from here. And we also look

forward to hearing from the representatives of Farmer Mac on the

next panel. So we thank you all and move on to them.

We will invite our second panel to the table: the Honorable Frederick Dailey, Chairman of the Federal Agricultural Mortgage Corporation of Washington, DC; and Mr. Henry Edelman, president

and chief executive officer of the Federal Agricultural Mortgage

Corporation.

Mr. Dailey, we welcome you and advise you that your full statement will be made a part of the record and ask that you limit your

comments to 5 minutes. And you may proceed.

STATEMENT OF FREDERICK L. DAILEY, CHAIRMAN, FEDERAL

AGRICULTURAL MORTGAGE CORPORATION

Mr. DAILEY. Thank you, Mr. Chairman and members of the committee. My name is Fred Dailey. I am Chairman of the Federal Agricultural Mortgage Corporation. I also happen to be a farmer, and,

in another lifetime, also the director of the Ohio Department of Agriculture.

I appreciate the opportunity you have given us today to appear

before you and to speak about our mission successes, our safety

and soundness, and our corporate governance policies. As the chairman of Farmer Mac, I feel a great sense of duty to exercise my

shared responsibilities in such a manner as to ensure the fulfillment of our congressional mission in a safe and sound way for the

benefit of farmers, ranchers, home owners, the lenders who serve

them, and the stockholders who have capitalized this enterprise.

By statute, as you have heard, Farmer Mac is made up of five

appointees of the President of the United States, five representatives of the Farm Credit System, and five representatives of commercial banks, insurance companies, and other financial institutions. Our board works together as an alliance that is unique in agricultural finance to accomplish Farmer Mac’s important congressional mission.

Every day, Farmer Mac seeks new ways to fulfill the important

socioeconomic mission Congress has given us in a safe and sound

manner and to create ongoing value for our stockholders. As you

are aware, agriculture has become a very capital-intensive industry, and Farmer Mac has made great strides in accomplishing its

congressional mission of increasing the availability of long-term

mortgage credit to farmers and ranchers at stable interest rates by

34

providing greater liquidity and lending capacity to agricultural

lenders in our role as a secondary market for agricultural mortgages.

Since the 1996 revision to our charter, we have helped farmers,

ranchers, and rural homeowners throughout all 50 states by acquiring or committing to acquire over 33,500 loans. Here is a fact

that encapsulates why we were created and how we are fulfilling

our mission. On average, interest rates offered by lenders using the

Farmer Mac I program are almost a full percentage point lower, actually 85 basis points lower, than rates on comparable loans as reported to U.S. Federal Reserve banks by member banks in agricultural lending states. We also, through our Farmer Mac II program,

are reaching out to help small and family farmers who would not

otherwise be able to obtain financing and to help finance the development of business and infrastructure in the Nation’s rural communities.

I am especially proud of the strides we have made in corporate

governance. At my very first board meeting in October of 2002, we

instituted a policy of executive sessions at all board and committee

meetings. Farmer Mac’s board and committee membership meet

the independence requirements of the SEC rules and the New York

Stock Exchange listing requirements. In distinction to other secondary market GSEs and most other private sector corporations,

Farmer Mac has a board of directors composed entirely of outside

directors. No members of management serve on the board. The

chairman of the Farmer Mac Board is not the chief executive officer as its president serves in that latter capacity. Since the fall of

last year, Farmer Mac’s board has adopted a code of business conduct and ethics. We have adopted new board committee charters.

We participated in director training, hired an outside, nationally

recognized consultant for corporate governance. And we have also

brought our board in for one day of special training put on by the

National Association of Corporate Directors. We have also revised

our committee structure by eliminating the executive committee

and transferring those responsibilities to our corporate governance

committee. And we have a split our program development committee in to a credit committee and marketing committee to avoid any

appearance of conflict of interest.

Farmer Mac is operating safely and soundly and in full compliance with current corporate governance standards. Since the inception of its business, Farmer Mac has been required to comply with

the rules and regulations of both the FCA, SEC, and New York

Stock Exchange listing rules. Farmer Mac has been an SEC reporting company for security law purposes since its initial public offering of stock in 1988 and publicly offered Farmer Mac guaranteed

agricultural mortgage-backed securities have always been required

to be registered with the SEC. Farmer Mac files quarterly call reports with the FCA as well as periodic financial reports and quarterly reports on form 10-Q and annual reports on 10-K with the

SEC. Farmer Mac continues to build its capital strength through

efficient and profitable operations, linited credit losses, and retention of earnings.

Farmer Mac is receptive and responsive to comments and recommendations from Congress and GAO and its regulators, such as

35

FCA and the SEC, agricultural lenders, capital market debt, equity

investors, and most importantly, farmers, ranchers, and rural

homeowners. We at Farmer Mac welcome this hearing as an opportunity to explain how we attempt to satisfy each of these constituencies.

Thank you, Mr. Chairman, and members of the committee, for

your attention and for your support of Farmer Mac.

[The prepared statement of Mr. Dailey appears at the conclusion

of the hearing.]

The CHAIRMAN. Thank you, Mr. Dailey.

Mr. Edelman, welcome.

STATEMENT OF HENRY D. EDELMAN, PRESIDENT AND CHIEF

EXECUTIVE OFFICER, FEDERAL AGRICULTURAL MORTGAGE

CORPORATION

Mr. EDELMAN. Thank you, Mr. Chairman.

Mr. Chairman, distinguished members of the committee, my

name is Henry Edelman. I am president of Farmer Mac, and I am

pleased to be here today reporting to your committee on Farmer

Mac’s progress and the fulfillment of its congressional mission. I

share Chairman Dailey’s appreciation for the opportunity you have

given us to appear before you today.

Having been at Farmer Mac since it started business in 1989, I

am proud of the advances we have made, and I look forward to the

opportunities that stand before us to benefit rural America. Most

of our recent progress has been through the development of the

well-considered changes you have made to our statute in 1996. Our

guarantees and commitments on securities and agricultural loans

held by lenders enable those lenders to make more loans without

increasing their equity. Farmer Mac’s guarantee or commitment

decreases to one-fifth the amount of equity the lenders must maintain in support for those loans. This provides lenders with five

times as much capacity to make loans based on the same equity.

Farmer Mac has purchased or provided guarantees and commit- ments on $10.7 billion of agricultural mortgage loans to farmers,

ranchers, and rural homeowners throughout America. In addition,

Farmer Mac purchases loans to recharge lenders’ funding. This creates new liquidity and gives them the ability to make additional

loans. As a secondary market, Farmer Mac maintains a ready and

consistent daily offer to purchase or guarantee loans that conform

to Farmer Mac standards based on our access to the capital markets.

A credit delivery system that relies solely upon primary lenders,

whose funding may ebb and flow according to economic cycles or

other factors, would put rural borrowers at risk of uncertain funding availability. Farmer Mac, as a capital market based secondary

market, has demonstrated its ability to provide a consistent and reliable source of funding for rural America. This is evidenced by

Farmer Mac’s purchases of $4.5 billion of agricultural loans to date.

Farmer Mac is operating safely and soundly, consistent with its

enabling legislation. As disclosed in our quarterly SEC filings,

Farmer Mac administers its risks conservatively. Our regulatory

capital is almost six times the level required by the statutory riskbased capital test. And its regulatory capital is 12⁄3 times the reVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
36

quired statutory minimum capital level. Farmer Mac’s 90-day delinquencies at the end of 2003 had trended down to 0.6 percent,

lower than the average experience of comparable agricultural mortgage lenders. This represented a reduction from $58 million at the

end of the preceding year to $30 million during the preceding year.

As an SEC reporting company, our reserve for losses meets

GAAP requirements. I will just mention on losses, when you consider that we have done $9.2 billion of business in Farmer Mac I

and our total losses have been approximately $11 million on loans

while we continue to be profitable on our bottom line, that represents a 13 basis point historical loss over the life of Farmer Mac’s

business.

Farmer Mac’s assets and liabilities are closely matched with the

low sensitivity to shifts and interest, which enables us to hold

AMBS on our books with little risk, and there is no requirement

in the statute that we sell AMBS. We have certainly done so. We

have sold $940 million of AMBS. We have sold them as recently as

last month at a profit, and we consistently, over time, on a hedge

basis sold at a profit, so I am really appalled to hear people talking

about the risk vetted in those AMBS when they are helping farmers and ranchers.

While Farmer Mac is similar to other secondary market GSEs,

it has been able to succeed with many qualifications on its ability

to do business that distinguish it from Fannie Mae and Freddie

Mac. And while we have made great progress, we have always recognized that growth is going to bring new challenges. We are ready

to meet those challenges. We have taken many steps consistent

with the findings and recommendations in the GAO report to enhance our risk management practices, and we have specified those

in our testimony. And contrary to the GAO testimony, we have

completed many of those.

These and other enhancements have strengthened Farmer Mac

so that, in summary, we believe we have made great progress in

the safe and sound accomplishment of the very important congressional mission you have given us for the benefit of the Nation’s

farmers and ranchers. A great deal of work certainly lies ahead,

but so do also many promising opportunities. We are confident that

Farmer Mac will make an ever-greater difference for rural America. We look forward to working with this committee in bringing

our potential to fruition.

Thank you, sir.

[The information appears at the conclusion of the hearing.]

The CHAIRMAN. Thank you very much.

At the outset, I said that I would give you the opportunity to answer the same question I asked the first panel, and that is, with

Farmer Mac’s sizable loan portfolio, how confident are you that the

company could withstand a downturn in the agricultural economy

that was seen in the mid–1980’s?

Mr. EDELMAN. Thank you, sir.

The CHAIRMAN. Are you confident that Farmer Mac can maintain

the liquidity to sustain itself through such a recession?

Mr. EDELMAN. Yes, we are very confident. Let me describe a few

things. First of all, Farmer Mac’s underwriting standards, in response to a question that Mr. Gutknecht raised, are based not only

37

on collateral, but also on cash flow. And therefore, when we look

at cash flow, that includes the income from farming that is earned

by a farmer. And when you consider that and also further consider

the fact that our appraisal standards include the income method,

that gives due consideration to the present value of the future economic flows from the highest and best agricultural use of the property, and when the example was made about a $3,000 per acre

farm, we would probably only see a $1,500 per acre loan on that

farm. Now if you put this into the context of the 1980’s, the statutory risk-based capital model that was devised by Congress for

Farmer Mac and developed by the FCA actually was implemented

by FCA at approximately a 50 percent higher level than was required by the statute. This is because they used worst case data

from Texas in the Farm Credit Bank in the mid–1980’s, and that

would have resulted in a 2.73 percent loss rate for the two worst

years in the mid–1980’s. They then looked at the loss severity in

other States, Iowa, Illinois, Minnesota, and raised the number from

2.73 to 4.18 percent. So they went beyond any historical information about a specific time and place in formulating that risk-based

capital model. Having done so, they generated a model, which was

designed and validated by outside experts at the University of Illinois Urbana, and that model showed that Farmer Mac needed different amounts of equity at different times. Currently, Farmer

Mac’s equity is, for modeling purposes—which includes reserves—

approximately $245 million, and that is more than five times the

risk-based capital requirement. So if you use data from the mid–

1980’s, you see that Farmer Mac, based upon a model, which contrary to GAO’s testimony about their uncertainties, was, indeed,

based not only on loans from the mid–1980’s, but loans that were

specifically selected out of the total database for their conformity

to Farmer Mac’s underwriting standards, appraisal standards, and

documentation standards that were submitted to this committee for

review on September 13, 1989.

And when you consider those factors, I think that Farmer Mac

could easily withstand a similar cataclysm to what was seen in the

1980’s because of our underwriting standards, because of the effectiveness of the risk-based capital model, and because of our careful

administration of loans.

The CHAIRMAN. Mr. Dailey, anything you want to add to that?

Mr. DAILEY. The only thing I want to add to that is that that was

during a very stressful time. We have tried to take the worst case

scenarios and use to underwrite our risk assessment programs. We

have been encouraged by GAO and by FCA to use more of our own

data, our own historical data, but it comes from a good time in agriculture. If we use our own historical data, it requires us to have

less reserves instead of more reserves, but we operate very conservatively.

The CHAIRMAN. OK. Let me ask another question to you, Mr.

Edelman. You currently hold a sizable portion of the agricultural

mortgage-backed securities in your portfolio even though the GAO

reported in March of 1998 that you expected, within 2 to 3 years,

your presence in the capital markets would be well established and

AMBS would be a marketable asset. Do you have a view as to why

38

the market interest in Farmer Mac securities has not worked out

as anticipated?

Mr. EDELMAN. I would say that was a mistatement, sir. There is

a lot of interest in Farmer Mac securities. We have, nevertheless,

retained AMBS while we have sold Farmer Mac debt. Since 1998,

that is a very important date, the collapse of long-term capital resulted in a widening of spreads throughout the bond market such

that the profitability of retaining AMBS in portfolio, very closely

and carefully funded under Farmer Mac’s asset and liability management standards, which are very high standards, as reflected in

the half-month duration gap, has proven to be a benefit to farmers

and ranchers, because we have been able to use lower rates and

been able to deliver the 85 basis point advantage for farmers and

ranchers in their potential borrowing from Farmer Mac lenders.

At the same time, we have recently sold AMBS at a profit, and

we see no impediment to selling AMBS at a profit. However, we

question the real wisdom of doing so when retention of these on our

books with the carefully managed ALM that we have engaged in

also creates a diversification of our sources of income so that, in

other words, part of our income is from spread on those assets.

Asset and liability management can produce a positive spread, and

that is another source beyond the assumption of credit risk, so that

the combination of those two sources makes Farmer Mac safer and

sounder and, at the same time, provides a benefit to farmers. There

is nothing in the Farmer Mac statute that requires us to sell

AMBS into the secondary market. It says make a secondary market for agricultural mortgages. We make a vibrant secondary market for agricultural mortgages and, to the extent that it benefits

farmers and ranchers, we will sell AMBS, but if it benefits them

better for us to hold AMBS on the books, we would expect to do

that as long as it was safe and sound.

The CHAIRMAN. Well, now it has been reported that Farmer Mac,

just within the last few days, may have sold AMBS to an outside

investor or investors. Is this correct?

Mr. EDELMAN. That is correct.

The CHAIRMAN. And if that is the case, please describe that sale

and include the amount of AMBS sold and the number of investors

involved.

Mr. EDELMAN. Mr. Chairman, we would be happy to submit that

to you in writing, but inasmuch as it is not public information, and

we are a publicly traded company, we would prefer not to do so in

a public forum.

The CHAIRMAN. All right. Well, we will accept that.

Mr. Dailey, when are the normally scheduled meetings of the

Farmer Mac Board, and how often do you meet without the managing officers?

Mr. DAILEY. Mr. Chairman, members of the committee, we meet

at least six times a year. During the last year, we probably met

about eight or nine times. We are changing our meeting schedule,

having meetings on a quarterly basis with two additional meetings,

this is so that we can track our quarterly reports better that we

will be implementing that new schedule next year. We will still

have six meetings, but there will be four meetings corresponding

with the end of each quarter.

39

The CHAIRMAN. And how often do you meet without the managing officers?

Mr. DAILEY. We have met—as I indicated, we have executive sessions at every meeting.

The CHAIRMAN. Are the managing officers excluded from the executive sessions?

Mr. DAILEY. They are. They are. It is strictly board members.

The CHAIRMAN. What number of board members constitutes a

quorum? And do all board members attend regularly scheduled

board meetings?

Mr. DAILEY. The quorum, I believe, is 10. Is that right? It is

eight, but very seldom do we have anybody miss one of our board

meetings. Our attendance is usually the total 15. Occasionally, we

will lose one or two.

The CHAIRMAN. Good. Thank you very much.

The gentleman from Texas, Mr. Stenholm.

Mr. STENHOLM. Welcome, gentlemen.

A question that I want to ask you is what we have talked about

here, and that is I remember when legislation passed in 1987. We

had strong support from the independent banking area and, if not

opposition, reluctance from the Farm Credit System. Today, we

find the Farm Credit System participating at a growing rate and

a declining rate of participation from independent banking.

Mr. EDELMAN. That was the manipulation of numbers, sir. What

in fact has happened is not that there has been a decline in volume

but rather a decline in share. That is, when people referred to the

participation of bankers falling from 80 to 22 percent, that is simply what size of the pie their volume represented at Farmer Mac.

Mr. STENHOLM. It is still a decline.

Mr. EDELMAN. That is only because of the corresponding growth

of the Farm Credit System. The bankers didn’t pull away so much

as the Farm Credit System came in, which made the volume that

the bankers were doing with us look like a smaller percentage of

the total. But the Farm Credit System sort of went from 0 to 60

in 3 years, sir. What happened is that the Farm Credit System did

more and more business with Farmer Mac and became approximately 50 percent of our total book of business, and so there wasn’t

so much a decline and a rise as simply a normalization of what you

probably expected, in 1987, which is that there has been more or

less equal use by the Farm Credit System and the bankers. So

those moving percentages belie the actual dollars, which show consistent growth and more or less equilibration of Farm Credit and

the bankers’ use of Farmer Mac.

Mr. STENHOLM. On a similar light, then, Farmer Mac’s LongTerm Standby Commitment to Purchase program has been used

exclusively by institutions of the Farm Credit System. Why haven’t

commercial bankers used the LTSCP program?

Mr. EDELMAN. There are several reasons, sir. First of all, there

is some notion out there that long-term standby is something mysterious and different, and nothing could be farther from the truth.

Long-term standby is simply a pure mutation of a swap. And that

is in a swap transaction, Farmer Mac acquires mortgages from a

lending institution and gives them back a mortgage-backed security backed by the same mortgages with Farmer Mac’s guarantee.

40

And we have done that type of business with a number of banks

throughout the United States, and insurance companies as well, I

should add. And a standby is a slightly different arrangement

where we provide Farmer Mac credit enhancement to a designated

pool of mortgages on the books of a Farm Credit institution. And

it is a closed pool that gets the same credit underwriting and appraisal review that the loans going into a swap would get. And in

turn, we stand ready to absorb the losses in the same manner, that

is to buy the loans out of the pool, whether it is a pool backing a

mortgage-backed security or a standby. The specific reason that the

Farm Credit System uses standby is because they prefer to hold assets on their books for two important reasons. One, as another

GSE, their funding is very comparable to Farmer Mac’s, and so

coming to Farmer Mac for the funding is not very important to

them. However, as a co-op, they have limited access to new equity,

and what Farmer Mac does is it provides its guarantee for a select

sub-group of loans on their portfolio that allows them more lending

capacity as intended by the statute.

The other consideration for those Farm Credit institutions, I beg

your indulgence, is the fact that statutory borrower rights are a

very important consideration for Farm Credit institutions, and

those are not provided for customers at commercial banks and insurance companies. In order for us to allow Farm Credit institutions to interact with their borrowers consistent with the borrower

rights, what Farmer Mac has done is left the loans on the books

of the Farm Credit institution for the benefit of those borrowers,

and at the same time, assumed the credit risk so that the Farm

Credit institutions could have more lending capacity and be more

competitive in their lending area.

Mr. STENHOLM. It is that practice that GAO warned, or had real

concerns about your policy as you have just described it. And in

fact, there is a little—I have got a little—let me ask it this way.

The last page of your own testimony regarding the forward-looking

statements appears to have been copied from SEC 10-K filing. It

lists a number of uncertainties. For example, substantial changes

in interest rates of the general economy could materially alter

Farmer Mac’s expectations and actual results. Yet on page 12 of

your own testimony, you dismiss GAO’s concern as too implausible

to deserve serious consideration. Please explain why you believe

GAO’s concerns are too implausible and therefore unwarranted.

Mr. EDELMAN. Yes, sir. First of all, I would note that you are correct that this forward-looking statement warning is taken from our

10-K. Other factors that are included in that disclosure, for the

sake of completeness, are changes in the weather and possible establishment of another secondary market and the rate and direction of the market itself. So I think that there are many different

issues that have to be taken into account in full and fair disclosure

to investors. Turning, however, to the assumptions that were made

by GAO in their report, in my testimony I noted the fact that in

order to get to the conclusion that they got to, they made several

leaping assumptions.

First, they assumed defaults far beyond the 13.8 percent default

rate peak that was reached in the 1980’s for all agricultural loans,

including non-mortgage loans and mortgage loans that didn’t meet

41

Farmer Mac standards, in other words, uncollateralized loans and

sub-standard loans all generated a 13.8 percent default rate. Nevertheless, GAO went beyond that for these loans which had to meet

the underwriting standards that were reviewed by Congress in

1989. The made a completely fallacious assumption that the default

rate in a mid–1980’s scenario on the loans that we are talking

about at Farmer Mac would be worse than the entire gamut of

loans out there.

The second error in their analysis was they disregarded the loanto-value ratio of the portfolio at Farmer Mac. The loan-to-value

ratio at origination on a weighted average basis at Farmer Mac is

under 50 percent. And again, Congressman Gutknecht mentioned

the losses in Iowa. Iowa was the worst state in the mid–1980’s, in

terms of losses of land values, and those were 50 percent. And

Farmer Mac does not assume that the entire United States would

suffer a 50 percent loss. However, when you consider the fact that

on a weighted average basis, 50 percent of our portfolio of mortgages represents only borrower equity and less than 50 percent

represents Farmer Mac’s mortgage exposure—or rather our portfolio of real estate backed by mortgages, we have a very high level

of support.

Another inconsistency in the GAO’s analysis was their concern

that even in this case, which I dismiss as being farfetched, that

Farmer Mac would have to buy back those mortgages. Those mortgages represent a balance of approximately $2.5 billion on Farmer

Mac’s books. Farmer Mac currently issues approximately $100 billion a year in debt securities. For us to absorb another $2.5 billion

of issuance is a relatively minor consideration. And so I think that

when I look at all of the different considerations that they had to

get through in order to reach the conclusion that they did, I think

they went beyond reason.

The CHAIRMAN. Thank you.

We do have some votes. The gentleman from Minnesota, I think,

can get some questions in. We will come back after the votes,

though and——

Mr. GUTKNECHT. Well, Mr. Chairman, I thank you, and I will be

very brief, because, Mr. Edelman, you have shared something here

that I apologize, I did not understand. That $3,000 land that is

selling in my District, you are only loaning, or not you, but ultimately Farmer Mac is only taking loans for $1,500, and it is a 50

percent equity deal?

Mr. EDELMAN. Let me elucidate on that, if I may. I know you——

Mr. GUTKNECHT. Well, I would prefer just a yes or a no.

Mr. EDELMAN. The answer is maybe, sir.

Mr. GUTKNECHT. OK.

Mr. EDELMAN. Because sometimes it could be $1,500, sometimes

it could be less or more. It depends on the cash flow.

Mr. GUTKNECHT. Well, I am not concerned about the less. I am

concerned about the more.

Mr. EDELMAN. It depends on cash flow.

Mr. GUTKNECHT. Right.

Mr. EDELMAN. And Farmer Mac looks at the present value of the

future profit stream from the highest and best agricultural use of

that land. So to the extent that the price was bid up, speculatively,

42

that would not necessarily cover the income. So first of all, we are

capped at 70 percent LTV in our lending programs normally, so

you would normally see a maximum of $2,100 an acre on that land.

But even below that maximum, we look to see the property cash

flow, because under the underwriting standards at Farmer Mac, we

expect to see it cash flow, and we expect to see a surplus above

what is necessary to meet the mortgage on a 1.25 times what is

necessary to meet the mortgage. So on that basis, I would find it

very remarkable to see the loan above $1,500 unless you told me

that it was a very profitable and efficient operation.

Mr. GUTKNECHT. Thank you.

The CHAIRMAN. We have five votes, and so rather than keep you

all waiting while we do that, we will recess the committee until one

o’clock or as soon thereafter as the votes are completed, that way

if you want to go downstairs to the cafeteria and get something to

eat or something, we can assure you that we won’t start without

you, at least not until one o’clock.

Mr. EDELMAN. Thank you.

Mr. DAILEY. Thank you.

[Recess.]

The CHAIRMAN. The committee will reconvene.

And at this time, it is the Chair’s pleasure to recognize the gentleman from California, Mr. Ose.

Mr. OSE. Thank you, Mr. Chairman.

Mr. Dailey, I want to understand something here. If I am correctly informed, the way I understand Farmer Mac to work is that

Farmer Mac buys pools of loans from its member or correspondent

banks across the country that are based in agriculture. In other

words, some bank out here might make a loan, and then they will

turn to Farmer Mac and, either in the form of a pool or with the

standby guarantee, basically ensure that that loan is liquidatable,

that is not the right word, but you can liquidate that loan if circumstances require it. Am I correct in that understanding?

Mr. DAILEY. Yes, sir.

Mr. EDELMAN. Yes, you are.

Mr. OSE. OK. So now the loans come from different areas of the

country?

Mr. EDELMAN. Yes.

Mr. OSE. So is there a geographic concentration, or do you spread

your risk, in a sense, by only buying X percent from each region?

Mr. EDELMAN. We limit our risks in several ways. First, we buy

loans, and I think we should more broadly talk about Farmer Mac

assumes credit risk, because whether we purchase a mortgage and

put it into a security or whether we guarantee a security or whether we issue a standby commitment, we are still assuming the credit

risk. So I think that if you look at Farmer Mac’s total book of business, you should look at a consolidated book of credit risks that we

assume through different transaction types.

Mr. OSE. And you and I had a brief conversation about the characteristics of the loans that are either directly purchased or otherwise existent under the standby situation.

Mr. EDELMAN. Yes.

Mr. OSE. And if I recall correctly, your comment to me was that

the credit characteristics, whether it is in this pool or that, whether

43

it is the actual loan itself or the standby commitment, the credit

characteristics underlying each loan are the same?

Mr. EDELMAN. Yes, the credit standards for whether we accept

the loan or not would be the same.

Mr. OSE. So when these pools of loans are put to you or offered

to you, more accurately, if there are loans—let us say someone offers to sell or asks Farmer Mac to liquidate from this third party’s

portfolio a group of ten loans, do you go through each of those loans

and examine their credit?

Mr. EDELMAN. We do.

Mr. OSE. All right.

Mr. EDELMAN. What happens is, if I may, there are three different types of transactions that put us in a position where we

have assumed credit risk. First of all, if we purchase mortgages

and then securitize them, that is form a pool of mortgages and create a mortgage-backed security backed by that pool of mortgages,

we can either hold that security on our books or sell it into the capital markets. But in any event, if we guarantee the AMBS, we have

assumed the credit risk.

The second type of transaction is a swap transaction. And in a

swap, what we do is we exchange Farmer Mac guaranteed mortgage-backed securities for mortgages. And of course, those mortgage-backed securities are backed by the same mortgages that were

proffered in the transaction. There again, the result is a mortgagebacked security, called an AMBS, Agricultural Mortgage-Backed

Security with a Farmer Mac guarantee on it.

The third type of transaction is a long-term standby commitment

where someone comes to us with a group of mortgages and instead

of asking us to purchase them, they ask us to assume the credit

risk by performing the same due diligence we would perform in

evaluating the loans for inclusion in the pool that we would have

used for an AMBS, but in this case, we evaluate them and consent

to their being placed in a closed pool at that lending institution.

And they pay us a commitment fee, which is of the same magnitude as the guarantee fee, and we assume the same credit risk.

That is we would buy a defaulted mortgage out of an AMBS the

same way we would buy it out of a long-term standby closed pool.

And the economic risk to Farmer Mac is statistically the same because we perform the same due diligence. We get the same fees,

whether it is a guarantee fee or a commitment fee, and at the end

of the day, we have assumed the same credit risk, because we have

underwritten to the same credit underwriting and appraisal standards.

Mr. OSE. Are you saying you comb through those loans offered

to you and sort out the ones that do meet your standards and the

ones that don’t meet your standards?

Mr. EDELMAN. That is correct.

Mr. OSE. And you force the tenderer to replace the ones that

don’t meet your standards?

Mr. EDELMAN. We would give them the choice of either replacing

them with loans that did meet our standards or doing a smaller

pool.

44

Mr. OSE. OK. Now, on the—Mr. Chairman, I see my red light is

blinking. May I have—if it would be satisfactory to you and the

ranking member, may I have some extra time?

The CHAIRMAN. Without objection, the gentleman may proceed.

Mr. OSE. All right. If I understand correctly, you have sold $940 million worth of

mortgage-backed securities to date?

Mr. EDELMAN. That is correct.

Mr. OSE. OK. Now you have retained an additional amount of

mortgage-backed securities?

Mr. EDELMAN. Yes.

Mr. OSE. And I think your testimony regarding the $940 million

was that you had sold them profitably?

Mr. EDELMAN. Yes.

Mr. OSE. Most recently, last month?

Mr. EDELMAN. Yes.

Mr. OSE. On those loans that have been securitized, do you offer

the buyer the same guarantee that would come in the form of a

standby commitment to purchase back anything that might default?

Mr. EDELMAN. Yes, it is embedded in the security. Yes.

Mr. OSE. OK. So there is little, if any, risk of a buyer of a mortgage-backed security from Farmer Mac?

Mr. EDELMAN. If I could phrase it another way, sir. There is no

difference in risk to the buyer of an AMBS than to the holder of

a standby commitment. It is the same risk. That is, Farmer Mac’s

credit, our equity, and the Treasury backstop.

Mr. OSE. All right. Now would you characterize United States’

farm economy today as in good shape, in medium shape, in bad

shape? How would you characterize it?

Mr. EDELMAN. I think the farm economy is in good shape.

Mr. OSE. All right. I had a conversation with the lady from the

GAO, and you were kind enough to come up here and tell me that

my numbers were a little bit wrong, and I appreciate that. I want

to step through the calculation that I did that mistakenly said the

margin was one basis point. We have a $5.8 billion portfolio. We

have annual income reported as of December 31 of 2003 of $27.3

million, and we have $20.6 million of that, according to the testimony from GAO, attributable to the standby fees on the off balance

sheet commitments you have.

Mr. EDELMAN. I don’t believe that that is a correct number.

Mr. OSE. OK. Then we need to correct that, for the record.

Mr. EDELMAN. In fact, sir, GAO was incorrect. If you were to look

at our financials, you would see guarantee and commitment fees,

that is all guarantee fees on that $5.8 billion and all commitment

fees added up to $20.7 million. And so it was not on just the standbys. It is on all guarantees.

Mr. OSE. OK. Do you break that out between the standbys versus

balance?

Mr. EDELMAN. Between what, I am sorry?

Mr. OSE. You have income from standby commitment fees and

then you have income from the loans you actually——

Mr. EDELMAN. Yes. And part of the income from the loans held

on our books is, in fact, guarantee fees.

45

Mr. OSE. OK. How much from the $20.7 comes from the fees on

your books, the loans on your books?

Mr. EDELMAN. On books?

Mr. OSE. Yes.

Mr. EDELMAN. That would be approximately 50 times $4.5 billion

times one-half, $11.25 million.

Mr. OSE. So it would be 50 basis points times $4.5 billion?

Mr. EDELMAN. Partly. It works out to $11.25 million.

Mr. OSE. OK. So you have got about $9 million in fees from

standby situations?

Mr. EDELMAN. Well, it is about 11 from standby. The thing that

complicates this is that under financial accounting statement 140,

if you put mortgages or mortgage-backed securities on your books

post April 1, 2001, the guarantee fee income has to be treated as

interest income for financial statement purposes so that the guarantee fees on that are somewhat understated in the vernacular, because it includes that.

Mr. OSE. The $20.7 million is an understatement?

Mr. EDELMAN. It is an understatement of what we are receiving

for assuming credit risk, because there is a recharacterization

under FAS–140 of guarantee fee income into interest income for

new on books assets after April 1, 2001.

Mr. OSE. For the purposes of the committee, in terms of basis

points, contrary to what GAO might have testified, on the $5.8 billion portfolio, you are making about $11 million in standby fees?

Mr. EDELMAN. That is about correct, yes.

Mr. OSE. Which is, by my math, about 20 basis points?

Mr. EDELMAN. Approximately.

Mr. OSE. OK. Now there is one other thing on here that I didn’t

understand. I have the semi-annual report dated December 31,

2003. And on page 13, there is a chart. Now the testimony has

been, from previous witnesses, that there are about $3.1 billion

worth of off balance sheet commitments or obligations. And I must

be missing something. But I look at page 13 on this chart put together by Farm Credit Administration, so it is not your chart, it

shows on balance sheet assets, as of December 31, of $4.3 billion

and plus off balance sheet program assets and obligations of about

$5.8 billion, which is $1.5 billion.

Mr. EDELMAN. Part of the on balance sheet assets, Congressman,

include our non-program investments of approximately $1.5 billion.

So if you back the $1.5 billion out of the $4.3 billion, you get back

down into the ballpark.

Mr. OSE. I am trying to find the difference between the $3.1 billion that has been testified to by GAO and the $1.5 billion that is

reflected in this chart. That is the thing I don’t quite understand

right now.

Mr. EDELMAN. I don’t understand the question very well without

the chart in front of me. However, there is one point I would make,

sir, which is the number you were referring to as a margin of one

basis point is, in fact, 47 basis points. That is, when you take our

net income and divide it by guarantees and commitments, what

you see is a 47 basis point margin.

Mr. OSE. That would be the $27.3 million number?

46

Mr. EDELMAN. Yes. Correct. When I look at the document here,

what I see in the FCA table is they show on balance sheet assets

of $4.3 billion, and of that $4.3 billion, approximately $1.5 billion

is investments. So if you back that out, that is $2.8 of on books program assets as opposed to non-program.

Mr. OSE. OK. So then you add the $2.8 plus the $3.1 and you come up with that $5.8-odd that is in that chart?

Mr. EDELMAN. That is right.

Mr. OSE. OK. I misread that. All right. That makes it consistent.

All right. So the mortgage-backed securities that you have sold

again have the buyer’s protection have been able to put back a loan

or default to you. In other words, they are protected from any decline in principal?

Mr. EDELMAN. Yes, sir.

Mr. OSE. The mortgage-backed securities that Farmer Mac has

put to market contain provisions to protect the buyer from a default or a loss of principal by basically protecting the income

stream in such a case. And the way Farmer Mac has protected

itself on those cases is that the quality of the loans within those

pools have met the standards that are otherwise laid out by the organization as a whole?

Mr. EDELMAN. That is correct.

Mr. OSE. All right.

Mr. EDELMAN. In particular, those standards include the fact

that every single loan has to meet a property debt coverage ratio.

Mr. OSE. 1.25. Actually, that is the cash flow.

Mr. EDELMAN. That is the total debt coverage, TDC, of 1.25.

Mr. OSE. Which is an 80 percent loan-to-value ratio.

Mr. EDELMAN. And a one-to-one coverage ratio for property itself.

So where the property is less than the total package of debt on a

farm. So——

Mr. OSE. Run through that again.

Mr. EDELMAN. Sure.

Mr. OSE. Start at the 1.25 again, please.

Mr. EDELMAN. OK. 1.25 is total debt coverage. One-to-one is

property debt coverage, so if there is a farm that has multiple parcels, incremental parcels can be added at one-to-one, however, the

total debt coverage of the enterprise must be 1.25 to 1, because it

is conceded that certain parcels may be less profitable than others,

but the aggregate for a borrower has to be 1.25.

Mr. OSE. Let me reverse that to you. Are you saying that the

loan-to-value ratio in the aggregate for the enterprise——

Mr. EDELMAN. OK. This is not loan-to-value ratio, sir. This is the

cash flow coverage. That is the ability——

Mr. OSE. I understand. I understand what that is, too. That was

my next question.

Mr. EDELMAN. Right.

Mr. OSE. All right. So the cash flow in the aggregate from the

enterprise must be 125 percent of the debt service under any of the

loans that you are otherwise holding or financing?

Mr. EDELMAN. That is right.

Mr. OSE. OK.

Mr. EDELMAN. The loan-to-value ratio is statutorily capped at 80

percent, but, in fact, operationally, we have capped it at 70 percent

47

for full-time farm loans. And as a practical matter, the loan-tovalue percentage at origination on a weighted average basis is only

49 percent in our total exposure.

Mr. OSE. Loan-to-value ratio is 49 percent?

Mr. EDELMAN. Weighted average at origination. Yes. So in other words, a $490,000 loan on $1 million property creates a 49 percent

loan-to-value.

Mr. OSE. Why do you have the caveat at—I don’t understand the

at origination caveat.

Mr. EDELMAN. We can’t track it on an ongoing basis without conducting new appraisals each year.

Mr. OSE. All right.

Mr. EDELMAN. So there are two countervailing forces. One is amortization of the debt, because each payment of principal reduces

debt outstanding, also appreciation in land values decreases LTV.

Conversely, the other force is depreciation of land values would increase the LTV.

Mr. OSE. Mr. Chairman, I thank you for your indulgence on this

line of questioning.

The CHAIRMAN. I thank the gentleman.

We will have another round.

Mr. Edelman, earlier when you were commenting on the ability

to cover your loans during a very difficult situation like the mid–

1980’s that we have all talked about, you commented on the conservative nature of your underwriting standards, which you again

reiterated with Mr. Ose. Does that apply to purchasing loans

through your cash window or when packaging loans for the LongTerm Standby Program? I understand that there are exceptions

made to those underwriting standards.

Mr. EDELMAN. The answer to your first question is no. The answer to your second question is also no.

The CHAIRMAN. You never have any exceptions to the underwriting standards?

Mr. EDELMAN. Let me clarify that, sir. We have several underwriting standards. I believe there are nine or ten of them in all.

One of them is what we refer to as standard nine, which says that

a loan that does not meet all of the ratios in the preceding standards, but which is, nevertheless, a loan that is of high quality because of compensating strengths, that is being stronger on one particular ratio would compensate for a certain amount of weakness

in another, but not loan-to-value. We don’t let loan-to-value be compensated. And in the instance there is a loan that still meets our

underwriting standards it simply meets them through standard

nine instead of through other ratios because of compensating

strength. And statistically, we have shown that those loans have

consistently performed as well as or better than loans that met the

list of ratios, because indeed they are loans made to borrowers who

had a profile, although it didn’t meet the one-size-fits-all profile of

ratios, nevertheless were loans to farmers who represented the profile of a strong borrower in their segment of agriculture.

The CHAIRMAN. So are you saying that there are no loans

through the cash window or the guarantee program that are purchased even though the loans do not meet Farmer Mac’s loan underwriting standards?

48

Mr. EDELMAN. Including standard nine, that is correct.

The CHAIRMAN. And standard nine is the ratio?

Mr. EDELMAN. Standard nine is the compensating strengths.

The CHAIRMAN. Well, but how would one looking at that evaluate

that? Is that documented in such a way that someone can evaluate

those compensating strengths when they are giving up something

else on the other standards?

Mr. EDELMAN. Yes. We have internal documentation that acts as

a guideline for that, and we keep internal documentation of how

we reach the conclusions and also how the loans perform.

The CHAIRMAN. In the March 1998 report, the GAO indicates

your debt issuance and retained portfolio strategy would make

funds available to recruit new mortgage originators to the Farmer

Mac program. How many originators now participate, and how

many have been added to your operation since 1998?

Mr. EDELMAN. I would have to provide you with the exact numbers in writing after the hearing, Mr. Chairman, however, if I could

give you a rough estimate, we have about 300 or 400, closer to 400,

lenders. However, that number is not entirely illuminating, because that would include a community bank that had, say, one office, and it would also include a large, multi-state bank that had

500 lending branches in many states. So to count the number of

institutions does not necessarily give you a fair sense of how many

outlets there are offering loans that would go into Farmer Mac

guaranteed securities. You were asking, also, how many have been

added since 1998. I would estimate about on-third, but again, I

would like to provide you with detailed information.

The CHAIRMAN. Please, we would like to have that.

Could you describe how a group of loans are pooled and

securitized?

Mr. EDELMAN. Yes.

[Mr. Edelman responded for the record as follows:]

There are a total of 948 lenders participating in Farmer Mac’s programs, including 160 Farmer Mac I approved sellers; 667 Farmer Mac II participants to date, and

121 lenders who have participated indirectly through two networks established by

larger approved sellers.

As of December 31, 1998 (the closing date of the referenced GAO Report), there

were 6,261enders participating in Farmer Mac’s programs, with a similar break-out

as above; thus, the number of participating lenders has increased by 322 or 51 percent since the referenced GAO Report.

The CHAIRMAN. What are the pieces of this information, and how

much does each piece cost Farmer Mac?

Mr. EDELMAN. Let me see if I can answer that. First, the pooling

process, let me give you a hypothetical. It is probably easier to answer your question. If a lending institution came to us with a pool

of $120 million worth of loans and asked us if we would purchase

those loans so that we could place them in a security. What we

would do is have a group of underwriters from Farmer Mac review

each of the loan files and also review, in that process, the credit

underwriting, the original application, the appraisal, the documentation to ascertain that the loans met our underwriting and appraisal standards and documentation standards. In addition, we

obtain a database printout from the lender containing the relevant

ratios on each loan in the pool, and they represent and warrant to

us, legally, that the data in the loan files conforms to the database.

49

We analyze all of those loans, and using both the database and actual file review, determine which loans meet our underwriting, appraisal, and documentation standards. Based on that, we might exclude, in my hypothetical, $20 million worth of loans, so it became

a $100 million portfolio. We would purchase the $100 million of

loans and place that into a trust and issue a mortgage-backed security backed by that trust, which we would either hold or sell, or in

some cases, deliver back to the lender, if it were a swap. The costs

of that will vary, depending on the travel costs, the time involved,

the complexity of the loans. And those are our up front fixed costs.

In addition, if we sell into the capital markets, we will pay SEC

registration fees on the AMBS. We will also pay attorney fees

working on the registration statement for that offering. And in any

event, we will pay attorney fees in connection with the formation

of the trust and the documentation of the security even if we hold

it on our books or swap it. And then the ongoing costs involved are

ongoing monitoring of the credit quality of the underlying mortgages from year to year. And again, that will be a function of how

the mortgages perform, because if they all perform well, it is relatively less expensive. We also contract out to central servicers,

who perform the billing and collection function, and to field

servicers, who perform the local monitoring function and borrower

contact function. And we also pay fees to an agent, who is the

transfer agent on the securities, and we, in addition, incur costs

that are regulatory costs, because those are really associated with

those securities.

I hope I have answered your question.

The CHAIRMAN. Yes, well, I have a follow-up.

Mr. EDELMAN. Please.

The CHAIRMAN. What if you would compare that arrangement,

which I suppose could be described as your usual business, compare that arrangement in terms of its costs versus benefits with

the Long-Term Standby Commitment to Purchase and the swap

programs.

Mr. EDELMAN. It is substantially the same, except for the SEC

fees and the securitization costs, because we don’t have to form a

mortgage-backed security in the case study of standby commitment. Even though we have taken the same economic risk and we

have contracted to receive the same economic benefits through a

commitment fee instead of a guarantee fee, at the end of the day,

the only difference between the two is the fact that when you form

a security, there are a few more costs associated with securitization

and SEC registration if we sell, but otherwise, the costs are substantially the same because of the due diligence and the monitoring.

The CHAIRMAN. Would you describe the AgVantage program and

provide us with some insight as to why that program has not been

attractive to lenders?

Mr. EDELMAN. Well, that program was instituted at the specific

request of the ICBA a number of years ago. That program, to describe it very simply, is a program in which we purchase securities

backed by mortgages, which are debt instruments issued by lending institutions and collateralized by Farmer Mac conforming mortgages on their books. And the effective rate is comparable to rates

50

that those entities might have achieved with residential mortgages

and with the debt securities they would issue to the home loan

banks. In fact, we have patterned our documentation after home

loan bank documentation.

The CHAIRMAN. And how have you marketed this program compared with the Long-Term Standby Commitment to Purchase program?

Mr. EDELMAN. We have sent out mailings, and we have sent out

people as salespeople to call on individual lending institutions and

to make presentations at lender conventions and other meetings to

promote that program.

The CHAIRMAN. And I think Mr. Stenholm asked this in a little

different way earlier, but in your view, why haven’t commercial

bankers used the LTSCP?

Mr. EDELMAN. Well, because, first of all, they could easily do

swaps, which would give them a liquid security that would be

pledgable at the Fed, and if I ran a community bank, for example,

I would much prefer to do a swap, which is essentially the same

as a standby, if I were not impeded by borrower rights consideration statutory that are unique to the Farm Credit System. So

under those circumstances, getting a pledgable security is a liquidity advantage for a small institution that is not a requirement for

a Farm Credit institution that can fund itself through the Farm

Credit Funding Corporation.

The CHAIRMAN. And what is your view of the Treasury Department’s position on the $1.5 billion line of credit?

Mr. EDELMAN. Well, I think that your question is their concern

about the question of Farmer Mac being able to invoke the Treasury backstop as to a security held on its own books.

The CHAIRMAN. Right.

Mr. EDELMAN. The law of guaranty specifically provides, as our

counsel has advised us, that a guarantor who acquires his own

paper might potentially lose the guarantee, however, in the event

that it is the subsidiary corporation that acquires the guaranteed

security, it is not extinguished. And based upon that, we believe

that we have a reasoned legal opinion from outside counsel that

supports our interpretation, and as much as we respect the United

States Treasury and all of the importance they have for Farmer

Mac, I have yet to hear of or see one page of reasoned legal opinion,

but rather I have heard a lot of polemic.

Now turning, if I may, to the polemic, it is a question of how

many angels could dance on the head of a pin. It is all well and

good to talk about whether Farmer Mac would have access to the

Treasury backstop as to securities that are held on its books, but

as a practical matter, if Farmer Mac were under pressure—let me

give you an example, if I may. If we had $2.5 billion of mortgagebacked securities on our books and we had $2.5 billion of debt, the

logical thing for us to do would be—to get more liquidity if we

needed it to pay on guarantees—to sell those mortgage-backed securities into the capital markets to investors whose recourse to

Treasury backstop of our guarantee is unassailable. We would do

that for liquidity reasons long before it came down to a crunch

where we had to go to Treasury. There is no earthly reason that

Farmer Mac would want to hold those securities and have valuable

51

assets on its books as well as matching liabilities and go to the

Treasury and concede the authority over its business to Treasury

at a time when it had liquid assets. So Farmer Mac would sell

those assets. Once we sold the assets, this legal quibble about

whether the guarantee is backed by Treasury or not becomes irrelevant. And therefore, although I think it is a fascinating topic and

I would love to see Treasury’s legal opinion on it, in the end, as

a practical matter, no one would get to use either of our legal opinions.

The CHAIRMAN. Do you think the Congress should clarify this

matter?

Mr. EDELMAN. I think that Farmer Mac works at a certain disadvantage to the other GSEs, and you have to decide whether you

want to perpetuate that disadvantage, sir. The disadvantage is that

Fannie Mae and Freddie Mac are covered by the Treasury backstop

for all of their securities, both their mortgage-backed securities and

their debt securities. This gives them a certain amount of latitude

in how they operate and how they provide value to residential borrowers. Farmer Mac, on the other hand, is limited, and by the way,

I want to emphasize the fact that all of our debt securities are emblazoned with the statement that there is no Treasury support behind them. And if Farmer Mac is going to operate at a disadvantage such as this, I would like to see Congress consider clarifying

for Treasury the fact that the backstop should apply to guaranteed

securities on our books or alternatively give Farmer Mac the same

status as Fannie and Freddie, that is, to extend the Treasury backstop to include our debt securities, however, tha latter would put

us on a more equal footing with the residential market. But to not

do the latter and to question the backstop on our on books assets

would create an economic disadvantage even beyond that which we

now endure.

The CHAIRMAN. Thank you.

I have got some questions for Mr. Dailey. Perhaps Mr. Stenholm

wants to ask some questions before I do that.

Mr. STENHOLM. Thank you, Mr. Chairman.

No, I will submit additional questions in writing. Thank you very

much.

The CHAIRMAN. All right.

Mr. Dailey, as you probably know, the GAO has observed that

Farmer Mac and, by extension, its board have characteristics of a

cooperative in that banks and other financial institutions and the

Farm Credit System are required to own shares and have a legally

mandated membership. What benefits does this structure bring to

the Farmer Mac Board, or conversely, what liabilities?

Mr. DAILEY. Well, Mr. Chairman, I believe the advantage that

you have there is that you have people on the board working with

the agricultural credit system, and it is an opportunity for them to

learn more about our programs, learn more about marketing opportunities. I don’t see the conflict of interest if we have one institution that sells a lot of product. The determination will be made

whether they are independent or not. So I see advantages to that

simply by tying us closer, letting those banks, financial institutions, and insurance companies, know more about our programs

and have some degree of representation on our board.

52

The CHAIRMAN. Well, does that explain the concentration of your

business? I mean, would you agree or disagree with this statement

as it pertains to Farmer Mac? Farmer Mac is a relatively small

company doing a relatively substantial business with a very few

business partners that are concentrated geographically.

Mr. DAILEY. Well, once again, the concentration, as was mentioned earlier, is with some banks that have many, many branches.

The concentration that I have been more concerned about, quite

frankly, has been geographical concentration. We have talked a lot

today about risk. We have talked about the agricultural economy

and where it stands. Quite frankly, even though the agricultural

economy, generally, is considered to be good today, there are always segments of the agricultural economy that are stressed. The

areas that we focused a lot of attention in the past year or so has

been the apple industry up in Washington. So one of the concerns

I have is more geographical distribution of the loans that we have.

As the company was set up——

The CHAIRMAN. Is there a history of these loans being geographically concentrated in other parts of the country?

Mr. DAILEY. Well, we probably have more concentration on the

northwest and the southwest. Part of that is because——

The CHAIRMAN. Right, but I mean, I think that has historically

been true, has it not?

Mr. DAILEY. It has historically been true, but——

The CHAIRMAN. How would you explain why you are not loaning

in my part of the country or in the Midwest and——

Mr. DAILEY. Well, we are loaning in those parts of the country,

we are just not doing as much. And coming from the Midwest myself, it is an area of particular concern to me.

The CHAIRMAN. OK. But what would be your explanation for why

that is occurring?

Mr. DAILEY. Well, part of that has to do with unit banking laws

that some states, such as Iowa, might have that encourages banks

to hold more of their portfolio themselves rather than to sell it.

Part of it, I think, is the nature of the industry. You have smaller

family farmers. We don’t have agriculture capitalized to such the

extent that you might see in some other areas. And but once again,

I think there is opportunities for us to provide more penetration

into that Midwest market. And we are going to focus more of our

attention there.

Mr. EDELMAN. Mr. Chairman, may I add to that?

The CHAIRMAN. Sure. Sure.

Mr. EDELMAN. The concentration, which is somewhat of a concentration, in the western United States, is attributable to several

things. First of all, the higher value of land in that part of the

country on a per acre basis tends to make each loan a higher dollar

amount. And therefore, when Farmer Mac thinks about its congressional mission of serving borrowers, we try to look at this on a per

capita basis. How many borrowers are we serving, not how much

is the value of their particular farm? Overall, the average amount

of a Farmer Mac loan is $275,000, and 75 percent of the loans are

under $300,000. But nevertheless, what that means is that there

are a number of farmers in the western United States, which already produces one-third of the value of agricultural output who

53

have more expensive farms, and therefore taking one loan from one

of them gives us a higher number than a loan from one farmer in,

say, Virginia.

The CHAIRMAN. So how would the dollar distribution occur, then,

between different regions of the country? You are saying that the

number of farms served is not as disparate.

Mr. EDELMAN. That is correct.

The CHAIRMAN. But what about the dollar amount?

Mr. EDELMAN. The dollars, clearly, are concentrated more in the

western United States where two factors are at work: the higher

value of land and the greater level of competition among agricultural lenders.

The CHAIRMAN. All right.

Mr. Dailey, should class C stockholders, which do not now enjoy

voting rights in the company, have a voice in the operations of

Farmer Mac?

Mr. DAILEY. Mr. Chairman, that was a recommendation that

GAO wanted Congress to take a look at. I don’t have a strong opinion on that. We don’t want anybody to be disenfranchised.

The CHAIRMAN. Well, that is my next question. If we were to do

it, how would we reconstitute the board to allow for doing it?

Mr. DAILEY. Well, that is a decision that you, in Congress, would

have to make.

The CHAIRMAN. Do you have any advice for us?

Mr. DAILEY. Well, I know from——

The CHAIRMAN. You are there every day every time you meet.

The board a little better than I do.

Mr. DAILEY. Well, we will have our annual board meeting tomorrow, and there will be an opportunity for all of the class C stockholders to make any kind of statements that they would like to at

that meeting.

The CHAIRMAN. Do they traditionally do that?

Mr. DAILEY. They occasionally do it. But let me say something

about the presidential appointments, because I think maybe you

are going there as well. And that is that we don’t come in with as

strong a financial background as our president has or the other 10

Board members. Yet we do come to the board with a strong and

abiding interest in America’s agricultural industry. We are ranchers and farmers. Our focus is agriculture. You have heard me talk

about the concentration. It is easy and natural to pick the lowhanging fruit first, but our focus is going to be on the mission,

whether we are accomplishing the mission, whether we are making

Farmer Mac succeed, whether we are providing more competitive

advantages for our farmers. And if we look to the future, where we

may see more financial stress, it is all the more important in a capital-intensive industry, such as agriculture, to be as competitive as

we can and lower the costs that farmers have for borrowing money.

The CHAIRMAN. Thank you. Your statement indicates that the

Farmer Mac Board meets all of the New York Stock Exchange listing requirements, but your 2004 proxy statement indicates that

two board members will be replaced. I wonder if you could explain

that.

Mr. DAILEY. Mr. Chairman, as Sarbanes-Oxley was passed and

implemented, we worked with our outside counsel and others to deVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00056 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
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termine whether our board members were independent. As a result

of some of the business that two of the board members did, they

were determined not to be independent, which meant that they

could still serve on the board, but they couldn’t serve on the audit

committee, the compensation committee, or the corporate governance committee. In one particular case, the board member decided

to not seek renomination to the board. In another case, the board

member is still with us, but doesn’t serve on those committees and

is making very useful contributions to our organization.

The CHAIRMAN. When you say they were determined to be not

independent, that means they have a substantial amount of dealings with——

Mr. DAILEY. That means not that they personally do, but the

banks or the financial institution, the Farm Credit System institution with which they are affiliated is selling loans to us, and that

is what makes the determination of whether they are independent

or not. When it reaches a certain threshold, I think it is 2 percent

of their income.

The CHAIRMAN. And what about the percentage of Farmer Mac’s

transactions? Is that a measure as well?

Mr. DAILEY. Of the amount of transactions that we do with

them?

The CHAIRMAN. Right.

Mr. DAILEY. I think it is based more on the 2 percent rule, but

I would defer to Mr. Edelman.

Mr. EDELMAN. It is not. Their independence is based on the

amount of their revenue they derive from us.

The CHAIRMAN. All right. And do you have a figure of the total

amount of the transactions of Farmer Mac that are done with

board members? What percentage of your overall business? Of the

institutions represented by board members, put it that way.

Mr. EDELMAN. Mr. Chairman, that is set forth in our proxy statement in great detail. I would be happy to provide you with a copy

of the proxy statement.

The CHAIRMAN. I believe we already have that.

Mr. EDELMAN. The related party activity, as of December 31,

2003, included transactions with Zions National Bank, which is no

longer represented on our board. And there are a variety of different types of transactions there. We purchased loans from them

of about $75 million, representing 38 percent of the volume in that

particular segment of our program. We purchased six USDA guaranteed portions from them for $1.7 million. We sold approximately

$75.8 million of Farmer Mac guaranteed securities to them. We entered into interest rate swap transactions with Zions with an aggregate notional principal amount of $28.6 million. All interest rate

swaps between Farmer Mac and Zions added to $307.6 million.

Farmer Mac received approximately $1.4 million in guarantee fees

on Farmer Mac guaranteed securities from Zions. Farmer Mac paid

Zions $48,000 in underwriting and loan file review fees. Zions received approximately $1.3 million in servicing fees for acting as a

central servicer. In addition, they received $225,500 in fees for acting as an agent with respect to $154.7 million of Farmer Mac medium-term notes. And they received approximately $18,000 in commissions for acting as a dealer in $189 million of Farmer Mac disVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00057 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
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count notes. We also had transactions with AgFirst Farm Credit

Bank, which is a major holder of class B voting stock. We purchased four loans with an aggregate principal amount of $900,000

from them, representing one-half of 1 percent of that program’s volume for the year. We extended standby commitments on 1,016

loans with an aggregate principal amount of $172.5 million to

AgFirst. We guaranteed approximately $393 million of Farmer Mac

guaranteed securities backed by rural housing loans under which

Farmer Mac is a second loss guarantor. Farmer Mac received

$400,000 in guarantee fees from AgFirst and approximately $2.1

million in commitment fees on standbys. AgFirst received approximately $107,000 in servicing fees for acting as a central servicer.

And as of December 31, 2003, Farmer Mac owned $88 million of

preferred stock of AgFirst. In addition, Farm Credit West, which is

also represented on our board, did business with us so that we extended standbys on 287,000 loans.

The CHAIRMAN. Let me interrupt for a second. Are these the two

directors that are referenced on the proxy statement?

Mr. EDELMAN. The two directors referenced on the proxy statement, Mr. Chairman, the first one was from Zions Bank.

The CHAIRMAN. Right.

Mr. EDELMAN. The second one——

The CHAIRMAN. But you just listed in there—is the second one

you are about to——

Mr. EDELMAN. No, it is not. The second one who resigned from

our board was the former vice chairman of Greenpoint Savings

Bank. The member of our board referenced in respect to AgFirst

Farm Credit was not previously mentioned. And the member who

I was just about to describe at Farm Credit West was the second

of the two who were deemed not independent for SEC purposes.

And the reason in that case, Farm Credit West, was that the percent of their revenues was slightly over 2 percent. I think it was

approaching 3 percent.

The CHAIRMAN. I see. But in terms of the overall percentage of

the transactions or dollar value of the transactions of your organization, you do not have a figure of what percentage of that is undertaken by institutions that are represented on your board?

Mr. EDELMAN. There are many different types of transactions,

sir. There are mortgage-backed securities. There is discount

note——

The CHAIRMAN. Certainly, but you could break those down into

each category.

Mr. EDELMAN. I could certainly break all of those down. I would

be happy to provide you with that information.

[Mr. Edelman responded for the record as follows:]

Farmer Mac’s business with related parties during 2003 was as follows:

a. 54.9 percent of Farmer Mac I and II program volume in 2003 was transacted

with related parties

i. 39.1 percent, or $75 million, of Farmer Mac I loan purchases in 2003 were

from related parties in 2003, with the preponderance of that volume coming from

one entity (no longer represented on the Farmer Mac Board as of June 3, 2004) that

networks more than 100 unrelated lenders.

ii. 77.1 percent of Farmer Mac Long- Term Standby Purchase Commitments

were with related parties in 2003. That percentage reflects the facts that the LTSPC

structure was established at the request of the Farm Credit System and, by statute,

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that the FCS has five seats on the Farmer Mac Board that have been distributed

among the five district banks.

iii. 3.8 percent of Farmer Mac II guaranteed portion purchases were from related parties in 2003.

b. With respect to debt transactions: i. 0.26 percent, or $189 million, of the discount notes Farmer Mac issued in

2003 were issued through a related party . ii. 42 percent, or $155 million, of the medium-term notes Farmer Mac issued

in 2003 were issued through a related party .

c. With respect to hedging transactions: i. 10.6 percent, or $29 million notional amount, of the long-term interest rate

swaps Farmer Mac entered into in 2003 were entered into with a related party. ii. 62 percent, or $553 million notional amount, of the short-term hedging

transaction volume Farmer Mac conducted in 2003 was conducted with a related

party .

The CHAIRMAN. We would appreciate it if you would do that. Let

me ask you one more thing. Do you have enough employees to

carry out the complex business that you operate?

Mr. EDELMAN. I believe that we do, sir.

The CHAIRMAN. Has the Farm Credit Administration made any

recommendations about those levels?

Mr. EDELMAN. They have made recommendations to us about

various functions, and although I am not at liberty to describe all

of the details of the FCA examination report, I would say that

Farmer Mac is very receptive to their recommendations. And we

take them seriously, and we always try to carry them out to the

extent that we can.

The CHAIRMAN. But at this point, you have not carried them out?

Mr. EDELMAN. Oh, we have. We have added a number of employees over the last year, both at our own instance and at that of the

FCA.

The CHAIRMAN. Great. Thank you.

Well, gentlemen, I thank you very much. You have handled a

great many detailed questions. And I will ask the gentleman from

California if he has anything else he wants to ask.

Mr. OSE. Mr. Chairman, I just want to make sure I convey this.

We have spent a lot of time. Members of Congress serve on a number of different committees, and the chairman serves on Judiciary.

I serve on Financial Services. And the thing that just gives me

pause, Mr. Chairman, is the off balance sheet obligation. And if I

could convey one very real concern of Members collectively, Mr.

Dailey and Mr. Edelman, it would be that those off balance sheet

commitments will get an undue amount of attention from those of

us in Congress. It is not that your credit quality standards aren’t

satisfactory. It is that we have had to deal with all sorts of ‘‘special

purpose entities’’ to the detriment of the economy and at significant

loss to the American public. So I would just urge you, to any degree

you can, to go in a direction other than off balance commitments,

regardless of the protections you set in place. They are just a red

flag.

Mr. EDELMAN. May I make one brief comment on that?

Mr. OSE. Certainly.

Mr. EDELMAN. I respect what you are saying completely. There

is a little bit of a tension here that I want to just highlight, if I

might. That is we have been asked, at times, to sell our AMBS. If

we took all of our existing AMBS and sold them into the capital

markets, they would be off balance sheet liabilities.

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Mr. OSE. Because of the guarantees.

Mr. EDELMAN. That is right. The same as long-term standbys

today. Conversely, if we sold no AMBS and went to all of the institutions with whom we had standbys and persuaded them, somehow, to sell us the underlying mortgages so that we could create

AMBS and put them on our books, then we would have no off balance sheet liabilities. So it is all a question of where Congress

wants us to go. We want to be responsive, but there is an inconsistency between telling us to sell AMBS and move these assets into

the status of off balance sheet liabilities and telling us to get rid

of off balance sheet liabilities and hold them on the books and then

not sell AMBS. And whatever guidance you could give us, I would

be grateful.

Mr. OSE. One of the things we struggle with here is that oftentimes the people we deal with immediately are exceptional

operatives. They know what they are doing and how to do it and

how to protect themselves, but next week, they might be gone. And

I haven’t figured out how to solve that. I just reiterate my concern

about off balance sheet issues as they relate to government-sponsored enterprises. This is a hornet’s nest that, in my judgment,

holds more risk than reward.

Mr. DAILEY. Mr. Chairman, thank you for this opportunity.

The CHAIRMAN. I thank you, Mr. Dailey. I thank you, Mr.

Edelman.

Mr. EDELMAN. We appreciate it.

The CHAIRMAN. I thank all of the members of our audience, who

I understand includes a number of members of the board of your

organization, and we welcome their presence as well. I thank the

gentleman from California.

Without objection, the record of today’s hearing will remain open

for 10 days to receive additional material and supplementary written responses from witnesses to any question posed by a member

of the panel. This hearing of the House Committee on Agriculture

is adjourned.

[Whereupon, at 2:13 p.m., the committee was adjourned.]

[Material submitted for inclusion in the record follows:]

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GAO ANSWERS TO SUBMITTED QUESTIONS

The GAO report encourages Congress to consider the make up of the

Farmer Mac Board structure by either making it a true cooperative entity

and rescind Farmer Mac’s authority to issue class C stock, or by amending

its board structure to ensure its independence and including a one share,

one vote principle to its class C common stock. I’m curious to know what

you found in your review of Farmer Mac’s board structure for making this

recommendation. For example, did you find conflict of interest issues because class A and class B board members do business with Farmer Mac?

Our recommendation was made in the context of comparing Farmer Mac’s statutory board structure to sound corporate governance practices found in today’s business environment. Under this board structure, Farmer Mac resembles a cooperative

that is owned and controlled by the institutions that use its services. At the same

time, Farmer Mac is also a publicly traded company and therefore subject to requirements of the market on corporate governance, which requires an independent

board and fully independent key committees such as the Audit Committee, Nominating Committee and Compensation Committee. However, because two-thirds of

Farmer Mac’s board of directors are elected by class A and class B shareholders who

do business with Farmer Mac, the board may give the appearance that it lacks independence and that the directors will be protecting or pursuing the interests of those

shareholders with respect to Farmer Mac. For example, conflict of interest could

arise where Farmer Mac ends up serving the most influential shareholders instead

of carrying out its broader public mission. During our 2003 review, we were concerned that some of Farmer Mac’s board members may not meet the independence

standards. In 2003, Farmer Mac board’s corporate governance consultant opined

that 3 out of the 15 directors were not ‘‘independent’’. Similarly, in its 2004 proxy,

Farmer Mac noted that one class A board member did not meet the standards by

virtue of his executive management positions at the financial institution that does

business with Farmer Mac and a class B board member exceeded the material relationship (dollar standards) requirements for independence. With this board structure, it may become more and more difficult each year to fill these key committees

with independent class A and class B directors as these entities’ business with

Farmer Mac could exceed the dollar limits. In addition, good corporate governance

dictates that the interests and loyalties of directors of publicly traded companies

should be clearly focused on serving the interests of all shareholders. Without voting

rights, holders of class C stock cannot voice their opinion on governance and management issues.

Are you satisfied that Farmer Mac is making progress regarding recommendations made in the GAO report especially those dealing with lowering its risk profile?

As mentioned in our statement, Farmer Mac has demonstrated that it is taking

steps to implement our recommendations, including those intended to lower its risk

profile. However, in many cases, it is too early for us to assess the actions taken.

In response to our recommendation, Farmer Mac staff are developing a loan classification system that will be completed in 2005 that is based on Farmer Mac’s loan

loss experience. Staff are also now documenting the supporting underwriting decisions for loans that Farmer Mac management approved by overriding one or more

specific criteria based on the compensating strengths of those loans. Farmer Mac

management told us that they are developing a capital adequacy model and they

are working with an outside consultant to develop a prepayment model to ensure

accurate interest rate risk measurements. Farmer Mac has also adopted a formal

contingency funding and liquidity plan but this plan does not address our concerns

about providing for liquidity if a large amount of standby and similar agreement

loans were put to Farmer Mac unexpectedly.

Based on your review do you believe Farmer Mac has achieved its statutory mission of creating a secondary market for agricultural real estate

mortgages?

Farmer Mac’s enabling legislation contains a broad mission statement that refers

to Farmer Mac providing a secondary marketing arrangement for agricultural real

estate mortgages that would generally improve the credit availability to farmers and

ranchers. The lack of specific or measurable mission-related criteria in the legislation does not allow for a meaningful assessment of whether Farmer Mac had

achieved its public policy goals. Nevertheless, we evaluated Farmer Mac’s contribution to the secondary market in four ways. First, we tried to assess whether Farmer

Mac has made long-term credit available to farmers and ranchers at stable interest

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rates. We found that from 2001 to 2002, its long-term fixed interest rates on Farmer

Mac I loans were similar to the rates offered by commercial banks and FCS institutions but whether the terms and condition were improved was difficult to determine.

Second, we considered whether Farmer Mac has contributed to the development of

a secondary market in agricultural real estate mortgages through the sale of agricultural mortgage backed securities (AMBS) to outside investors. We found that

Farmer Mac has been operating under a retained portfolio strategy; therefore, the

depth and liquidity of the AMBS market is unknown. Third, we compared lending

institutions’ market share in the agricultural real estate market with their percentage of participation in Farmer Mac’s programs. We found that FCS institutions accounted for more than 55 percent of Farmer Mac I loans in December 2002, a significant increase from 2 percent in 1996. In contrast, commercial banks participation rate has dropped from 80 percent in 1996 to 22 percent as of December 2002.

As of 2002, FCS institutions held 36 percent and commercial banks held 32 percent

of nationwide farm-related real estate debt. It is interesting to note that while commercial banks’ relative share of Farmer Mac’s business has been falling, bank-held

farm mortgage volume has doubled since Farmer Mac was created—a time when

commercial banks viewed Farmer Mac as a new source of competitively priced funding. It remains questionable whether Farmer Mac has truly developed a secondary

market and whether a need exists for such a market if (1) it is only meeting the

needs of FCS institutions and (2) other financial institutions such as commercial

banks are not using its programs and services. Finally, we analyzed Farmer Mac’s

nonmission investment portfolio in relation to Farmer Mac’s business needs. Although we found that the proportion of nonmission investments has declined, we

still have concerns about the composition and potential growth of this portfolio.

Holding relatively high proportions of nonmission investments could potentially lead

to charges that Farmer Mac is misusing its status as a GSE to generate arbitrage

profits.

Based on your analysis, do you believe the Farm Credit Administration

(FCA) is fulfilling its regulatory role in regard to Farmer Mac?

As discussed in our report and testimony, in the past two years, FCA has continued to strengthen its oversight of Farmer Mac by doing a more comprehensive safety and soundness examination and undertaking initiatives to expand its regulatory

framework. However, we found that FCA continued to face challenges in sustaining

and improving its oversight and more remained to be done to improve its off-site

monitoring, assessment of risk-based capital, and mission oversight.

The GAO report made a number of recommendations directed at FCA to

improve its oversight role. How has FCA responded to those recommendations?

Since our 2003 report, FCA has continued to further enhance its oversight of

Farmer Mac, including implementing our recommendations, but again, it is too

early for us to assess their actions. FCA staff have drafted regulatory revisions to

the risk-based capital model that covers a range of issues in addition to our recommended changes. They plan to present a proposed rule to the FCA board for consideration in the fall of 2004. In response to our recommendation, FCA has made

some revisions to the Farmer Mac quarterly call reports. FCA is also undertaking

a number of projects to address our recommendations about (1) capital arbitrage

within the Farm Credit System, (2) requiring Farmer Mac to obtain a credit rating,

and (3) assessing the impact Farmer Mac’s activities have on the agricultural real

estate lending market.

Do you believe FCA’s role as regulator for both the Farm Credit System

and Farmer Mac impairs its ability to effectively and fairly fulfill its oversight responsibility?

In our report, we pointed out that because the FCS institutions and Farmer Mac

are subject to oversight by the same FCA board and reviewed by some of the same

FCA examiners and analysts, FCA could be subject to potential conflicts of interest.

In our discussions with FCA officials, they said they were aware of the need to

maintain the proper balance in their oversight roles to avoid such potential conflicts.

Conversely, we have recently observed that this arrangement could enhance FCA’s

ability to effectively oversee both the FCS institutions and Farmer Mac. For example, FCA has recently issued an information memorandum to the FCS institutions

suggesting that their boards consider whether the institutions should engage in

transactions only with counterparties that have been assigned one of the highest

two credit ratings. Since some of the FCS institutions conduct business with Farmer

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Mac, this could be one way for FCA to provide an incentive for Farmer Mac to obtain a credit rating.

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JOINT STATEMENT OF FRED L. DAILEY AND HENRY D. EDELMAN

Mr. Chairman, distinguished members of the committee, our names are Fred

Dailey and Henry Edelman; we are, respectively, the Chairman of the Board and

the president and CEO of Farmer Mac, the Federal Agricultural Mortgage Corporation. We appreciate the opportunity you have given Farmer Mac to appear before

you today to review the business and corporate activities and financial products of

Farmer Mac, particularly as reflected in the October 2003 Government Accounting

Office report on Farmer Mac (GAO–04–116).

It has been some time since Farmer Mac last testified before this Committee, and

we are pleased to be here today to update you on the forward strides this Corporation has taken in the accomplishment of its mission in a safe and sound manner

since Congress expanded its authorities in the Farm Credit Reform Act of 1996.

OVERVIEW

Farmer Mac is accomplishing its congressional mission of increasing the availability of long-term mortgage credit to farmers and ranchers at stable interest rates by

providing greater liquidity and lending capacity to agricultural lenders through a

secondary marketing arrangement for qualified mortgages. Since the 1996 revision

to its charter, Farmer Mac’s $10.7billion of credit enhancements and purchases have

covered more than 33,500 loans that have helped farmers, ranchers and rural homeowners throughout all 50 states. On average, interest rates offered by lenders

through the Farmer Mac I program are almost a full percentage point lower than

rates on comparable loans, as reported to U.S. Federal Reserve Banks by member

banks in agricultural lending states. Through its Farmer Mac II program, Farmer

Mac is reaching out to help small and family farmers who would not otherwise be

able to obtain financing, and to help finance development of businesses and infrastructure in the Nation’s rural communities.

Farmer Mac is operating safely and soundly, consistent with its enabling legislation and in full compliance with current corporate governance standards. Since the

inception of its business, Farmer Mac has been required to comply with the rules

and regulations of both the Farm Credit Administration (FCA) and the U.S. Securities and Exchange Commission (SEC). Farmer Mac has been a reporting company

for Securities Exchange Act purposes since its initial public offering of stock in 1988,

and publicly offered Farmer Mac-guaranteed agricultural mortgage-backed securities (AMBS) have always been required to be registered with the SEC. Farmer Mac

files quarterly call reports with the FCA, as well as periodic financial statements

in quarterly reports on Form 10-Q and annual reports on Form 10-K with the SEC.

The United States Treasury backstop line of credit that supports Farmer Mac’s mission-related activities is limited to support of Farmer Mac’s guarantees of AMBS

and does not extend to the Corporation’s debt.

By conventional measures of financial management, Farmer Mac administers its

risks conservatively:

• As of March 31, 2004, Farmer Mac’s regulatory capital of $245.7 million was

almost six times the level required by the Congressionally mandated risk-based capital stress test, and its regulatory core capital was one and two-thirds times the required statutory minimum capital level.

• As of March 31, 2004, Farmer Mac’s 90day delinquencies have trended down

to 1.17 percent of the principal balance of all post–1996 Act Farmer Mac I program

loans, slightly lower than the average experience of agricultural mortgage lenders

for 2003, as reported by the USDA.

• Farmer Mac’s reserve for losses meets the accounting requirement under U.S.

Generally Accepted Accounting Principles (GAAP) of a provision for ‘‘probable and

reasonably estimable losses.’’

• The Corporation’s assets and liabilities were closely matched, with a low sensitivity to shifts in interest rates. Farmer Mac has maintained effective internal controls and conservative risk management, while always working to improve and enhance its risk management practices and tools. Accordingly, as will be explained in

detail later in this testimony, the Corporation has generally adopted the recommendations contained in the GAO Report.

While Farmer Mac is similar to other secondary market GSEs, many qualifications upon its ability to do business distinguish Farmer Mac from them. Unlike

Fannie Mae and Freddie Mac, public offerings of Farmer Mac guaranteed securities

must be registered with the Securities and Exchange Commission; every loan

brought into the Farmer Mac program must meet various statutorily mandated

credit underwriting and collateral appraisal requirements; and Farmer Mac must

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comply with numerous other requirements that have distinguished its operating

structure from those of the other GSEs.

In further distinction to other secondary market GSEs and most other private sector corporations, Farmer Mac has a Board of Directors composed entirely of outside

directors; no member of management serves on the Board. Likewise, the Chairman

of the Farmer Mac Board is not the chief executive officer of the Corporation; its

president serves in that latter capacity. The Corporation’s board and committee

membership meet the independence requirements of the SEC rules and NYSE Listing Requirements.

DISCUSSION

Background. The need for Farmer Mac is best explained in the context of the circumstances that gave rise to the creation of this secondary market. In 1987, the

U.S. agricultural lending community had just gone through its most serious financial credit crisis since the Great Depression of the 1930’s. This prompted concern

in Congress that farmers, ranchers and rural homeowners might someday be without stable sources of long-term credit. At the end of 1987, in response to those concerns, Congress passed legislation to facilitate the creation of a secondary market

for mortgages backed by agricultural real estate and rural housing that meet rigorous underwriting standards. In the preamble to Farmer Mac’s charter, Congress

stated its purposes in creating the new secondary market:

• to increase the availability of long-term credit at stable interest rates;

• to provide greater liquidity and lending capacity to lenders who extend credit

to farmers and ranchers; and

• to provide for new long-term lending to agriculture with new sources of funding

provided through the capital markets, including at fixed rates of interest.

Farmer Mac thus became one of a small group of congressionally chartered institutions owned by private-sector investors but charged with carrying out specific public policy objectives, subject to Congressional oversight and Federal agency regulation and contingently backed by the Federal Government. Farmer Mac was capitalized initially through the sale of $21 million of common stock, primarily to commercial banks, insurance companies and institutions of the Farm Credit System. No

Federal funds were invested in Farmer Mac and no Federal funds have ever been

provided to Farmer Mac to support the Corporation’s operations. In fact, Farmer

Mac has paid increasingly-sizable annual assessments to the FCA to cover the entire cost to the government of regulating and supervising the Corporation for safety

and soundness, an assessment currently equal to one-third of Farmer Mac’s total

personnel costs.

To relieve structural impediments that had limited Farmer Mac’s ability to function efficiently, Congress passed the Farm Credit System Reform Act of 1996 (the

1996 Act), which significantly revised Farmer Mac’s statutory authority and significantly improved Farmer Mac’s ability to serve rural America. Among other things,

the 1996 Act allowed Farmer Mac to: (1) purchase agricultural mortgage loans directly from lenders, pool the loans, and create securities that are backed by these

pools, for retention or sale; and (2) eliminate the mandatory requirement for loan

originators and poolers to retain ten percent, first-loss subordinated interests in

each securitized loan pool.

ACCOMPLISHMENTS IN FULFILLMENT OF CONGRESSIONAL MISSION UNDER THE

REVISED CHARTER.

Since the 1996 revision to Farmer Mac’s charter, the Corporation has maintained

a ready and consistent daily offer to provide agricultural lenders with a variety of

credit enhancements based on capital markets rates and terms. Through those activities, Farmer Mac has provided credit enhancements on agricultural mortgages

for farmers, ranchers and rural homeowners throughout America aggregating $9.2

billion through its Farmer Mac I program and an additional $1.5 billion through its

Farmer Mac II program. This market presence, in turn, has created new liquidity

and lending capacity for participating lenders. As of March 31, 2004, Farmer Mac’s

total guarantees and standby commitments outstanding were $5.7 billion, resulting

in at least $5.0 billion of new lending capacity for agricultural lenders. As of that

the same date, Farmer Mac’s outstanding purchases of agricultural mortgages stood

at $3.3 billion, reflecting an increase in agricultural lenders’ liquidity of a like

amount.

Through the sale of AMBS or the issuance of its debt, Farmer Mac has used the

capital markets as a funding source and as the basis for the interest rates and

terms in its loan purchases, guarantees and commitments. Those funding sources

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afford Farmer Mac the ability to further its mission of providing a secondary market

for agricultural mortgage loans.

Farmer Mac’s programs have influenced lenders to offer more attractive loan rates

and terms when they use Farmer Mac I, as reflected in comparisons of interest

rates offered by lenders through the Farmer Mac I program to rates on comparable

loans, as reported to U.S. Federal Reserve Banks by member banks in agricultural

lending states. It is further evidenced by analyses of rates and spreads in Farmer

Mac II loans compared to rates and spreads on U.S. Department of Agriculture

(USDA)-guaranteed loans made before the advent of Farmer Mac II. Farmer Mac’s

programs have also had a positive influence on agricultural mortgage lending

through the standardization of agricultural mortgage loan terms offered by lenders

across the country, which has contributed to prospective liquidity for the lenders,

whether they currently use Farmer Mac or not.

FARMER MAC’S PROGRAMS

Farmer Mac loan programs are divided into two main groups referred to as Farmer Mac I and Farmer Mac II. Farmer Mac I consists of agricultural and rural housing mortgage loans that do not contain federally provided primary mortgage insurance. For loans underlying pre–1996 Act Farmer Mac I AMBS, ten percent first-loss

subordinated interests mitigate Farmer Mac’s credit risk exposure. Before Farmer

Mac incurs a credit loss on those AMBS, losses are first absorbed by the poolers’

or originators’ subordinated interest. As of March 31, 2004, Farmer Mac had not experienced any credit losses related to the pre–1996 Act Farmer Mac I AMBS, and

the first-loss subordinated interests are expected to exceed the estimated credit

losses on those loans. Current risks in Farmer Mac’s loan and guarantee portfolio,

such as those discussed later in this testimony, are generated primarily by post–

1996 guaranteed securities and loans. Farmer Mac receives an annual guarantee fee

from the third party or trust involved based on the outstanding balance of the

Farmer Mac I post–1996 AMBS.

With particular regard to the availability of long-term credit, Farmer Mac has,

since 1996, operated a ‘‘cash window’’ program in which it offers daily rate locks on

long-term mortgage loans, including fixed rates. Through the cash window, Farmer

Mac purchases mortgages directly from lenders for cash and purchases mortgagebacked bonds from agricultural lenders. Periodically, Farmer Mac transfers its purchased loans into trusts that it uses as vehicles for the securitization of those loans.

Securitization is the transfer of assets (in this case, loans) to a third party or trust.

In turn, the third party or trust issues certificates to investors. Farmer Mac refers

to such certificates as ‘‘guaranteed securities’’ or as agricultural mortgage-backed securities (AMBS). The cash flow from the transferred loans supports repayment of

the AMBS. Farmer Mac guarantees timely payments to investors holding the certificates, regardless of whether the trust has actually received such scheduled loan payments.

Farmer Mac’s long-term standby purchase commitments (standby agreements), introduced in 1999, represent a commitment by Farmer Mac to purchase eligible loans

from financial institutions at an undetermined future date if a specific event occurs.

The specific events or circumstances that would require Farmer Mac to purchase

loans under a standby agreement include when: (1) an institution determines to sell

at mark-to-market prices some or all of the loans that are not then more than 120

days delinquent under the agreement to Farmer Mac; or (2) a borrower fails to

make installment payments for 120 days on a loan covered by a standby agreement.

Upon entering into a standby agreement with Farmer Mac, financial institutions effectively transfer the credit risk on the loans covered by a standby agreement to

Farmer Mac over the life of the agreement. Consequently, these institutions’ regulatory capital requirements and loss reserve requirements would then be reduced.

To date, Farm Credit System (FCS) institutions have been the only participants in

standby agreements, though they are available to all agricultural lenders. In exchange for Farmer Mac’s commitment under the standby agreement, Farmer Mac

receives an annual commitment fee from institutions entering into these agreements, based on the outstanding balance of the loans covered by the standby agreement. Any standby agreement party may, at any time, require that Farmer Mac

issue to it, in exchange for the loans covered by the standby, a guaranteed security

backed by those loans.

Farmer Mac II is Farmer Mac’s program for acquisition of USDA-guaranteed portions of farm ownership, farm operating, business and industry and community facilities loans to enable lenders to fund more of those loans at lower rates. Those

USDA-guaranteed loans are backed by the full faith and credit of the United States.

Similar to the pre–1996 Act securities, Farmer Mac has experienced no credit losses

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in the Farmer Mac II program and does not expect to incur any such losses in the

future.

Farmer Mac is the single largest purchaser of USDA-guaranteed loans. Since the

inception of the Farmer Mac II program in 1991, Farmer Mac has purchased approximately $1.5 billion in guaranteed portions, representing over 6,500 loans to

small and family farmers and rural businesses and communities, of which $723 million were outstanding as of March 31, 2004 (reflecting an annual growth rate of 13

percent). As of March 31, 2004, 660 sellers from 45 states had participated in the

Farmer Mac II program. The core group of active sellers (defined as sellers who

have sold loans into the Farmer Mac II program since January 1, 2002) total 217

USDA-guaranteed loan originators (selling 1,718 loans totaling $491 million), most

of which are small to mid-size community banks; the group also includes mortgage

companies and credit unions, as well as FCS institutions.

• Farmer Mac II program volume in 2003 was a record-setting $271 million, compared to $173 million in the prior year. This growth represented a $98 million or

56 percent increase, in which:

• 78 percent (or $210 million) of 2003 Farmer Mac II volume was from the purchase of USDA- guaranteed farmer program loans.

• 22 percent (or $61 million) of 2003 Farmer Mac II volume was from the purchase of USDA- guaranteed community facility and business and industry loans.

BENEFITS TO AGRICULTURAL BORROWERS

Rates available on real estate loans purchased in the Farmer Mac I program are

typically 85/100ths of a percentage point lower than the average rate on such loans

made by commercial banks, as published by the Federal Reserve. According to the

United States Department of Agriculture, there is approximately $111 billion of agricultural real estate debt outstanding today, of which we estimate about $45 billion

is eligible for Farmer Mac loans. Farmer Mac currently provides credit enhancement

and, in many cases, funding for approximately 20,800 loans to borrowers in all 50

states. Today, Farmer Mac’s guarantees and commitments outstanding equal $5.7

billion, nearly 13 percent penetration of the eligible market. On the basis of the current Farmer Mac-eligible market, the current potential savings to agricultural borrowers from Farmer Mac can be estimated between $25 million and $60 million per

annum, depending on the extent to which portfolio lenders pass back to borrowers

the advantages of past transactions with Farmer Mac in their future lending activities. If half of the eligible market were covered by Farmer Mac guarantees, analogous to the market penetration of other secondary market GSEs, the savings to

farmers could be as great as $225 million per year.

In addition to those monetary savings, Farmer Mac is a primary source of fixedrate mortgage financing that offers the advantage of stable rates that do not fluctuate with short-term interest rates. This stability is of particular importance to agricultural borrowers when farmers stand to profit from higher commodity prices in

an inflationary economy. Affected borrowers with short-term adjustable interest rate

loans may give up a significant portion of those profits in higher interest payments.

A viable entity such as Farmer Mac can provide stable, long-term fixed rates of interest when rates rise under inflationary pressures, resulting in a consistently available benefit to agriculture.

In its Farmer Mac I program, Farmer Mac is reaching small and family farmers,

as reflected by the average loan size of $275,000 in that program, with 75 percent

of the loans under $300,000.

Of the $210 million of USDA-guaranteed farmer program loans purchased in

Farmer Mac II in 2003, $177 million were made to borrowers who locked in

intermediate- or long-term (5- to 25-year) fixed interest rates. Furthermore, 40 percent (or $84 million) of that farmer program loan volume was specifically tied to the

5-year reset Farmer Mac II Cost of Funds Index. During 2003, Farmer Mac II allowed lenders to offer borrowers fixed rates of interest on intermediate term loans

at historically low levels, less than one point above the prevailing Prime Rate typically used for short-term floating rate loans.

Through its Farmer Mac II program, Farmer Mac works closely with not only the

lenders in our selling group, but also with state and county USDA field offices. The

Farm Service Agency’s farmer program guaranteed loans are available only to small

and family farmers and ranchers who cannot obtain direct commercial credit from

a local agricultural lender. USDA business and industry loans, which do not have

a test for credit, encourage the financing of rural businesses, thereby creating and

saving rural jobs as well as improving the economic climate of rural communities.

With both of these important USDA programs, Farmer Mac adds significant value

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agement for participating lenders. As previously mentioned, Farmer Mac has assisted in the financing of more than 6,500 USDA guaranteed loans to date, totaling

approximately $1.5 billion.

BENEFITS TO AGRICULTURAL LENDERS

In the preamble to Farmer Mac’s statutory charter, it is stated that the Corporation was formed to: increase the availability of long-term credit to farmers and

ranchers at stable interest rates; and provide greater liquidity and lending capacity

in extending credit to farmers and ranchers through a secondary marketing arrangement for qualified mortgages with new sources of funding provided through

the capital markets.

a. Liquidity—Loan purchases by Farmer Mac recharge the lenders’ funds available to make additional loans, thereby creating new liquidity. Farmer Mac has always maintained a ready and consistent daily offer to purchase or guarantee loans

conforming to Farmer Mac’s credit and appraisal standards, based on the Corporation’s access to the capital markets. Farmer Mac has purchased $4.5 billion of agricultural loans in Farmer Mac I and Farmer Mac II to date; the balance of loans

purchased as of March 31, 2004 was $3.3 billion.

b. Lending Capacity—In addition to its loan purchases, Farmer Mac’s guarantees

and commitments on securities and agricultural loans held by lenders enable those

lenders to make more loans without increasing their equity. The Farmer Mac guarantee or commitment decreases to one-fifth the amount of equity that lenders must

maintain to support those loans, giving them five times as much capacity to make

loans based on the same equity. Since the 1996 revision to Farmer Mac’s charter,

Farmer Mac has purchased or provided guarantees and commitments on $10.7 billion of agricultural mortgage loans to farmers, ranchers and rural homeowners

throughout America. As of March 31, 2004, the balance of loans purchased, guarantees and commitments outstanding was $5.7 billion.

Farmer Mac’s Congressional mission clearly states the legislative intent that it

should increase lending capacity, i.e., enable lenders to make more loans without

increasing their equity, as we have described. The justification for the resulting

higher leverage is the higher quality of the loans which, as required by Farmer

Mac’s charter, must be first mortgages on agricultural real property that meet appraisal, underwriting and documentation standards established by Farmer Mac’s

Board of Directors. Federal banking regulators and FCA set uniform regulatory capital levels for primary lenders that encompass not only first mortgage loans (except

residential loans), but also a wide spectrum of riskier loans, including second mortgage loans, personal property loans, signature loans, and credit card receivables.

Only agricultural first mortgage loans that meet Farmer Mac’s standards are eligible for a Farmer Mac guarantee or commitment.

Critics of Farmer Mac have claimed that its secondary market activities undermine capital support of mortgage loans on the books of regulated entities. Those

critics use the term ‘‘capital arbitrage’’ to disparage the legitimate process by which

Congress enabled lenders to make more agricultural mortgage loans without increasing the regulatory capital they hold to support those mortgages. This is accomplished through the regulatory assignment of a lower capital requirement (risk

weight) to mortgages supported by a Farmer Mac guarantee or commitment. Criticism of that process of increasing the lending capacity of agricultural lenders

through the judicious use of Farmer Mac as a secondary market GSE is inconsistent

with the intent of Congress expressed in the preamble to Farmer Mac’s charter.

Nothing else could have been meant by the phrase ‘‘provide greater. . . lending capacity’’ in 12 U.S.C. a2279aa (note)(3)(B). The 20 percent regulatory risk weight assigned to mortgages and AMBS that are credit enhanced by Farmer Mac is consistent with the intent of Congress that Farmer Mac should, by increasing the lending

capacity of agricultural lenders, generate sizable economic benefits for the farmers,

ranchers and rural homeowners of this Nation.

ADEQUACY OF FARMER MAC’S CAPITAL

Farmer Mac’s core capital as of March 31, 2004 totaled $223.7 million and exceeded its statutory minimum capital requirement of $132.2 million by $91.5 million.

Farmer Mac is also required to meet the capital standards of the risk-based capital

stress test promulgated by FCA (RBC test). The RBC test is a worst-case scenario

based on industry loan loss data from the experience of the Farm Credit Bank of

Texas in the mid–1980’s (FCBT data). The RBC test determines the amount of regulatory capital Farmer Mac would need to maintain a positive capital position during

a ten-year stress period of extraordinary credit losses and interest rate volatility.

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The RBC test then increases the capital requirement by an additional thirty percent

to cover operational risks.

As of March 31, 2004, the RBC test generated a capital requirement of $42.0 million. Farmer Mac’s regulatory capital of $245.7 million exceeded that capital requirement by $203.7 million.

Credit. As of March 31, 2004, Farmer Mac’s 90day delinquencies were trending

downward at $57.4 million, or 1.17 percent of the outstanding portfolio, slightly

lower than the average experience of agricultural mortgage lenders for 2003, as reported by the USDA. This also compared favorably to Farmer Mac’s 90day delinquencies of $76.2 million (1.58 percent) a year earlier.

As part of the loss mitigation process, Farmer Mac may acquire the real estate

securing its loans. When a property is acquired in the loss mitigation process, Farmer Mac develops a liquidation strategy that results in either an immediate sale or

retention pending later sale. Farmer Mac evaluates these and other alternatives

based upon the economics of the transactions and the requirements of local law. As

of March 31, 2004, Farmer Mac owned $12.3 million of such collateral, compared

to $15.5 million as of December 31, 2003 and $8.2 million as of March 31, 2003.

Since its inception, Farmer Mac I has accepted the credit risk on $9.2 billion of

agricultural mortgage loans and has incurred an aggregate of just $11.8 million of

credit losses, about one-eighth of one percent. Coupled with the recent downward

trend in delinquencies, Farmer Mac believes that this history evidences its prudent

credit risk management practices. Additionally, Farmer Mac provides an allowance

for losses in conformity with GAAP as a reserve to cover ‘‘probable and reasonably

estimable losses’’ as required by Statement of Financial Accounting Standards No.

5, Accounting for Contingencies. As of March 31, 2004, that represented a reserve

for further losses of $22.2 million.

Interest Rate Risk. Farmer Mac measures its interest rate risk through several

tests, including the sensitivity of its Market Value of Equity (MVE) and Net Interest

Income (NII) to uniform or ‘‘parallel’’ yield curve shocks. As of March 31, 2004, a

parallel increase of 100 basis points across the entire U.S. Treasury yield curve

would have increased MVE by 0.5 percent, while a parallel decrease of 100 basis

points would have decreased MVE by 0.8 percent. As of March 31, 2004, a parallel

increase of 100 basis points would have increased Farmer Mac’s NII, a shorter-term

measure of interest rate risk, by 2.8 percent, while a parallel decrease of 100 basis

points would have decreased NII by 4.3 percent. Farmer Mac’s duration gap, another measure of interest rate risk, was only minus 0.5 months as of March 31,

2004.

The goal of Farmer Mac’s interest rate risk management is to create and maintain

a portfolio that generates stable earnings and value across a variety of interest rate

environments. Farmer Mac’s primary strategy for managing interest rate risk is to

fund asset purchases with liabilities that have similar durations so that they will

perform similarly as interest rates change. To achieve this match, Farmer Mac

issues discount notes and both callable and non-callable medium-term notes across

a spectrum of maturities. Farmer Mac issues callable debt to offset the prepayment

risk associated with its mortgage assets. By using a blend of liabilities that includes

callable debt, the interest rate sensitivities of the liabilities tend to increase or decrease as interest rates change in a manner similar to changes in the interest rate

sensitivities of the assets.

Taking into consideration the prepayment provisions and the default probabilities

associated with its mortgage assets, Farmer Mac uses prepayment models to project

and value cash flows associated with these assets. Because borrowers’ behavior in

various interest rate environments may change over time, Farmer Mac periodically

evaluates the effectiveness of these models compared to actual prepayment experience and adjusts and refines the models as necessary to improve the precision of

subsequent prepayment forecasts. In addition, Farmer Mac consults with independent prepayment experts as part of the model evaluation process. Regular back-testing of existing proxy prepayment models (comparing forecast to actual prepayment

experience) has consistently demonstrated the predictive accuracy of existing models

for prepayment experience in Farmer Mac’s portfolio of program assets, thereby ensuring accurate interest rate risk measurement.

Farmer Mac also uses financial derivatives to alter the duration of its assets and

liabilities to better match their durations, thereby further reducing overall interest

rate sensitivity. Farmer Mac uses those instruments solely for hedging risk, not for

speculative purposes. All of Farmer Mac’s financial derivative transactions are conducted through standard, collateralized agreements that limit Farmer Mac’s potential credit exposure to any counterparty. As of March 31, 2004, Farmer Mac had

no uncollateralized net exposure to any counterparty.

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Comments on GAO Report. Farmer Mac has previously received and reviewed the

October 16, 2003 General Accounting Office (GAO) Report on Farmer Mac (No.

GAO–04–116) titled, Farmer Mac: Some Progress Made, but Greater Attention to

Risk Management, Mission and Corporate Governance Needed, addressing topics in

the June 2002 request letter from the Senate Committee on Agriculture, Nutrition

and Forestry to GAO. It was gratifying to note that, after the third examination and

review of Farmer Mac by GAO over the course of the past six years, no serious deficiencies in the implementation of Farmer Mac’s programs or mission were identified; recommendations were made for enhancing risk management procedures in

light of the Corporation’s continuing growth; and a number of positive findings were

made about the safety and soundness of Farmer Mac’s operations and about its

progress in establishing the secondary market for agricultural mortgages.

In its previous report on Farmer Mac, dated May 21, 1999, GAO had concluded

that ‘‘Farmer Mac’s future viability depends on its growth potential in the secondary

market for agricultural mortgages and the prospects for realizing that potential are

unclear. . . . if FCS institutions or other lenders increase participation in Farmer

Mac programs, Farmer Mac’s financial condition could improve.’’ Working with agricultural lenders throughout the Nation, Farmer Mac’s Board and management have

resolved favorably the uncertainties raised in that earlier report, reflected in dramatic increases in participation in Farmer Mac’s programs. Thus, Farmer Mac is

pleased with the most recent Report’s recognition of Farmer Mac’s progress in the

four intervening years, in terms of both its financial strength and the growth of its

mission-related activities. At the same time, Farmer Mac shares GAO’s view, expressed in the Report, that Farmer Mac should continue to enhance its risk management, because the efficiency of our operations will be a key factor in the accomplishment of our mission and the overall success of Farmer Mac. Farmer Mac has

already implemented several enhancements to risk management procedures since

the issuance of GAO Report, and is in the process of implementing others, as will

be explained later in this testimony.

The chairman and ranking member of the United States Senate Committee on

Agriculture, Nutrition, and Forestry, in their letter request of June 26, 2002, sought

GAO’s assistance ‘‘to ensure that Farmer Mac’s mission continues to be met in a

financially sound manner.’’ As to the six specific topics GAO was asked to address

in that letter, the GAO Report: found no current financial instability at Farmer

Mac, noting that: independent accountants issued Farmer Mac a ‘‘clean, unqualified

audit opinion; an outside forensic accounting firm concurred with Farmer Mac’s

methodology for estimating loan loss allowance under GAAP; Farmer Mac effectively

managed its interest rate risk through asset/liability matching and yield maintenance protection against prepayment risk; and Farmer Mac’s controls over credit

risks were generally sound, but could be improved in light of recent and expected

future growth. Since the date of the GAO Report, Farmer Mac’s independent accountants issued Farmer Mac a clean, unqualified audit opinion on the Corporation’s 2003 financial statements.

Found no significant shortcomings in corporate governance; acknowledged that

Farmer Mac was taking actions to ensure that it complies with recent SarbanesOxley Act and NYSE listing requirements, as they become effective; and noted areas

in which Farmer Mac (like other private sector corporations) might have to update

its corporate governance, including expanded director training. Since the date of the

GAO Report: Farmer Mac’s Board adopted a Code of Business Conduct and Ethics;

adopted new Board committee charters; participated in director training with outside counsel and the National Association of Corporate Directors; received advice of

outside counsel that it is in full compliance with Sarbanes-Oxley requirements currently in effect; nominated a certified public accountant from a firm not associated

with the Corporation for election as a director at the 2004 Annual Meeting of Stockholders; revised its committee structure to eliminate its Executive Committee,

transferring those responsibilities to the Corporate Governance Committee; and will

tomorrow bifurcate its Program Development Committee into separate Credit and

Marketing Committees.

Found executive compensation was in line with the recommendations of two independent consultants, but recommended that the timing of vesting of stock options

be extended, which the Farmer Mac Board has done. Since the date of the GAO Report, the Compensation Committee directed its outside consultant to perform a zerobased analysis of executive compensation and to advise on incentive compensation

alternatives to stock options for directors and officers.

Found no irregularities in Farmer Mac’s investment practices or strategy and that

non-mission investments have been reduced as a percentage of mission-related assets. recommended that Congress reconsider the non-voting status of Farmer Mac

class C common stock.

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Noted that Farmer Mac has increased its congressional mission-related activities

(loan purchases, guarantees and commitments) since GAO’s 1999 report, and recommended that Congress consider establishing more specific criteria for measurement of Farmer Mac’s mission accomplishment. Since the date of the GAO Report,

the Public Policy Committee has adopted a requirement for regular monitoring of

mission accomplishment.

In addition, the Report raised several hypothetical or problematic issues. For simplicity, those issues are paraphrased in italics below, with Farmer Mac’s observations following them.

As Farmer Mac’s Long-Term Standby Purchase Commitments (LTSPCs) continue

to grow, if risks were not closely managed and there were massive defaults on those

loans far beyond the worst levels experienced in U.S. agricultural economic history,

the Corporation could be required to acquire a high proportion of the outstanding

loans covered by LTSPCs, resulting in a possible future funding risk. This hypothetical relies upon words ‘‘if,’’ ‘‘and,’’ ‘‘far beyond, ’’could,’’ and ‘‘possible’’ to such a

degree as to render its premise too implausible to deserve serious consideration. To

hypothesize circumstances in which Farmer Mac would face a ‘‘possible future funding risk,’’ the GAO Report had to posit: (1) unchecked mismanagement of risks at

Farmer Mac (despite close management, Board, FCA monitoring and securities law

disclosure of the components of those risks); (2) loan defaults far beyond the 13.8

percent default rate peak for all agricultural loans (including non-mortgage loans)

within a concentrated geographic region in the Farm Credit System in 1986, the

worst period in recorded U.S. agricultural economic history; (3) significant impairment of the value of the collateral behind those loans, for which the weighted average loan-to-value ratio at origination was less than 50 percent; (4) nearly simultaneous default among a group of thousands of Farmer Mac loans diversified by commodity and geography, and (5) an inability on Farmer Mac’s part to issue $2.5 billion of new short-term debt, a small amount relative to its current annual issuance

rate of over $100 billion of such instruments. Without discussing Farmer Mac’s 90-

day delinquency rate on the LTSPCs referenced in the GAO Report at 0.1 percent,

Farmer Mac notes that, while the hypothetical is incredibly remote, the additional

funding required would not be inconsistent with Farmer Mac’s demonstrated level

of access to the capital markets.

With respect to guaranteed AMBS held by Farmer Mac, the U.S. Treasury has

questioned whether it would be required to allow Farmer Mac to draw upon its

Treasury line of credit to support those guarantees.

No issue has been raised as to the availability of Farmer Mac’s statutory Treasury

line of credit relative to AMBS held by parties other than Farmer Mac and, if Farmer Mac were coming under pressure to fund its guarantee obligations, it would sell

to third parties any AMBS it held long before it needed to access the Farmer Mac

Treasury line of credit.

Farmer Mac recognizes that there are a number of areas in its business that will

continue to evolve and need attention. Independent of, but consistent with the findings and recommendations in the GAO Report, Farmer Mac has taken a number

of steps to enhance its risk management practices. With respect to the recommendations for Farmer Mac itemized on pages 57 and 58 of the GAO Report, the Corporation has taken the following actions:

The GAO Report cites the conclusion of a prominent agricultural economic consultant to Farmer Mac’s Federal regulator, the FCA, that the FCBT data was the

‘‘best available’’ data for the purpose of building a model to estimate Farmer Mac’s

credit risk, but it nevertheless concludes that it would be better if Farmer Mac were

using its own historical data. Since the date of the GAO Report, Farmer Mac has

taken great strides toward the development of a model based on its own historical

data to estimate the credit risk in its portfolio and ultimately establish loss reserves. Farmer Mac is currently testing that model and expects to migrate to the

model by 2005, and will continue to use the FCBT data in a manner consistent with

GAAP until that migration is completed. Farmer Mac has enhanced its loan classification system as a critical step in the process of migrating our loss allowance and

reserve process to a methodology based on Farmer Mac’s loan loss experience rather

than the FCBT data. Farmer Mac also uses its loan classification system as the

basis for its internally developed capital adequacy model. Farmer Mac measures its

capital adequacy against this model, in addition to the statutory minimum capital

levels established by Congress and risk-based capital levels established by FCA.

Farmer Mac has continued to gather documentation supporting underwriting decisions based on compensating strengths of loans to be used in supporting future underwriting decisions and considered in the enhancement of Farmer Mac’s loan classification system. With respect to loans resulting from those underwriting decisions,

the Corporation has enhanced its documentation procedures; its tracking of the subVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00091 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
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sequent performance of those loans; and conformed its loan loss reserve methodology

and procedures.

During 2004, Farmer Mac has marketed and sold on-books AMBS at prices similar to those of comparable GSE securities. The Corporation will continue to market

and sell AMBS on a periodic basis in the future.

Farmer Mac has formalized a contingency funding plan. Farmer Mac has formalized the Corporation’s long-standing liquidity contingency funding plan, with Board

action confirming the new plan, adopted in August 2003. Farmer Mac completed two

significant floating rate medium-term note (MTN) issuances totaling $280 million

during first quarter 2004 to enhance its balance sheet liquidity and reduce its exposure to discount refunding needs. The Corporation has conducted regular fixed-rate

MTN issuances, in lieu of floating-to-fixed interest rate swaps, according to its MTN

needs supporting program purchases. During 2003 and 2004 to-date, Farmer Mac

issued a total of $749 million of MTNs at rates similar to those of comparable GSE

securities. A comprehensive analysis of Farmer Mac liquidity needs is has been performed, based on the Sound Practices for Managing Liquidity in Banking Organizations issued by the Basel committee on Banking and Supervision in 2000. Farmer

Mac maintained an average of 92 days’ liquidity during first quarter 2004. Farmer

Mac’s Board adopted a new liquidity policy in April 2004, with a 60-day minimum

liquidity requirement and a 90-day liquidity target.

Farmer Mac has been consulting with a nationally-recognized prepayment expert

to ensure the continued accuracy of its current prepayment model and to develop

a proprietary prepayment model based on its own portfolio agricultural mortgage

prepayment data. The prepayment models used by Farmer Mac to date have been

consistent with models used by other agricultural mortgage lenders. Since no publicly available agricultural mortgage prepayment database exists, Farmer Mac has

used several residential prepayment models, adjusted to reflect the differences in

the behavior of agricultural and residential mortgage borrowers, with validation by

a recognized outside expert on prepayment modeling; and the accuracy of Farmer

Mac’s model has been confirmed through ‘‘back-testing,’’ i.e., verifying model forecasts against actual outcomes. Regular back-testing of adjusted proxy prepayment

models has consistently demonstrated the predictive accuracy of those models for

prepayment experience in Farmer Mac’s portfolio of program assets, thereby ensuring accurate interest rate risk measurement. Since the date of the GAO Report the

design of a prototype Farmer Mac agricultural mortgage prepayment model has

been completed by the prepayment consultant and is expected to be available for

Farmer Mac’s use in its interest rate risk management during the latter part of

2004.

Independent of its statutory and regulatory capital requirements, Farmer Mac has

developed a capital adequacy model for internal use in its capital planning.

Farmer Mac’s Board has extended the vesting period of new grants of stock options on Farmer Mac’s class C non-voting common stock, effective January 2004.

Farmer Mac is working with its corporate governance advisors to assure that the

Board nomination process continues to comply with all applicable laws and regulations. Farmer Mac’s Board has reviewed, and confirmed by unanimous resolution,

that all of its members understand the nomination process and they consider it to

be ‘‘transparent.’’ Moreover, Farmer Mac and its counsel believe the nomination

process is fully and fairly disclosed in its Proxy Statement issued in connection with

its 2004 Annual Meeting of Stockholders.

Farmer Mac’s Board formalized the Corporation’s management succession plan in

June 2003, and will do so annually each year at its June meeting. Farmer Mac has

initiated a formal training program for its Board of Directors, including consultation

and participation with the National Association of Corporate Directors. In fact, in

December 2003, in conjunction with the Board’s meeting, the members participated

in an eight hour training program on Director Professionalism presented by the

NACD. The Board intends to participate in at least one ‘‘outsider provided’’ training

program each year, generally in conjunction with its December meeting and receives

more detailed briefings on specific Farmer Mac-related subjects on a regular basis

from the Farm Credit Administration and management. Three examples of management briefings included reviews of: (1) Farmer Mac debt issuance and investment

strategy; (2) Farmer Mac interest rate risks and asset and liability management

strategy; and (3) Farmer Mac’s use of derivatives and the advantages and disadvantages of such instruments.

Farmer Mac has fully considered GAO’s recommendations and is continuing to enhance its operations consistent with them. These and other enhancements have further strengthened Farmer Mac as it continues to carry out its mission in a safe and

sound manner for the benefit of the Nation’s farmers and ranchers.

90

The Board of Directors of Farmer Mac statutorily mandated to be composed of five

appointees of the President of the United States, five representatives of Farm Credit

System institutions and five representatives of commercial banks, insurance companies and other financial institutions works together as an alliance unique in agricultural finance to accomplish Farmer Mac’s important Congressional mission. Farmer

Mac is receptive and responsive to criticism and recommendations from Congress

and GAO as its investigative arm, regulators such as FCA and the SEC, agricultural lenders, capital markets debt and equity investors, and, most important, farmers, ranchers and rural homeowners. Every day, Farmer Mac seeks new ways to satisfy all of those important constituencies in furtherance of its Congressional mission,

safe and sound operation, and creation of stockholder value. Farmer Mac welcomes

this hearing as an opportunity to explain how we attempt to satisfy each of those

interests.

Thank you for the opportunity you have generously provided Farmer Mac to give

testimony on this matter of great importance to American agriculture. We would be

pleased to answer any questions you may have at this time.

NOTE ON FORWARD LOOKING STATEMENTS

In addition to historical information, this testimony includes forward-looking

statements that reflect management’s current expectations for Farmer Mac’s future

financial results, business prospects and business developments. Management’s expectations for Farmer Mac’s future necessarily involve a number of assumptions and

estimates and the evaluation of risks and uncertainties. Various factors could cause

Farmer Mac’s actual results or events to differ materially from the expectations as

expressed or implied by the forward-looking statements, including uncertainties regarding: (1) the rate and direction of development of the secondary market for agricultural mortgage loans; (2) the possible establishment of additional statutory or

regulatory restrictions or constraints on Farmer Mac that could hamper its growth

or diminish its profitability; (3) legislative or regulatory developments or interpretations of Farmer Mac’s statutory charter that could adversely affect Farmer Mac or

the ability or motivation of certain lenders to participate in its programs or the

terms of any such participation, or increase the cost of regulation and related corporate activities; (4) possible reaction in the financial markets to events involving

government-sponsored enterprises other than Farmer Mac; (5) Farmer Mac’s access

to the debt markets at favorable rates and terms; (6) the possible effect of the riskbased capital requirement, which could, under certain circumstances, be in excess

of the statutory minimum capital requirement; (7) the rate of growth in agricultural

mortgage indebtedness; (8) lender interest in Farmer Mac credit products and the

Farmer Mac secondary market; (9) borrower preferences for fixed-rate agricultural

mortgage indebtedness; (10) competitive pressures in the purchase of agricultural

mortgage loans and the sale of agricultural mortgage backed and debt securities;

(11) substantial changes in interest rates, agricultural land values, commodity

prices, export demand for U.S. agricultural products and the general economy; (12)

protracted adverse weather, market or other conditions affecting particular geographic regions or particular commodities related to agricultural mortgage loans

backing Farmer Mac I Guaranteed Securities or under LTSPCs; (13) the willingness

of investors to invest in agricultural mortgage-backed securities; or (14) the effects

on the agricultural economy or the value of agricultural real estate of any changes

in Federal assistance for agriculture. Other factors are discussed in Farmer Mac’s

Annual Report on Form 10-K for the year ended December 31, 2003, as filed with

the SEC on March 15, 2004, and its Quarterly Report on Form 10-Q for the quarter

ended March 31, 2004, as filed with the SEC on May 10, 2004. The forward-looking

statements contained in this testimony represent management’s expectations as of

the date of this testimony. Farmer Mac undertakes no obligation to release publicly

the results of revisions to any forward-looking statements included in this testimony

to reflect any future events or circumstances, except as otherwise mandated by the

SEC. Both of the referenced filings are available on Farmer Mac’s website at

www.farmermac.com.

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STATEMENT OF WILLIAM (BILL) R. CLAYTON

AgFirst Farm Credit Bank (AgFirst) provides service to over 85,000 borrowers

through twenty-three local cooperative associations whose members include full-time

and part-time farmers as well as rural homeowners in fifteen states and Puerto

Rico. As one of five Farm Credit System Banks, AgFirst is located in Columbia,

South Carolina.

AgFirst and its affiliated associations, each of which is locally owned and operated, serve a broad mission. This mission is to help maintain the quality of life in

rural America and on the farm through a constant commitment to competitive lending, expert financial services and advice, and a feeling of partnership with our customers.

As one of the largest financial cooperatives in the country, our key goal is to reward our borrowing entities with value added through patronage dividends and

other returns on capital invested. In fact, our institutions have distributed to our

owner/users nearly $1.9 billion in the past 15 years.

In continuing to meet our mission goals, we likewise look to partner with other

entities whose missions are compatible. The Federal Agricultural Mortgage Corporation (Farmer Mac) is one of the institutions with which we are proudly associated.

Our partnership with Farmer Mac has provided AgFirst with certain statutory authorities which assists us in the delivery of value to our stockholders as well as providing the member associations a secondary market for certain agricultural and

rural home loans.

The mission of Farmer Mac has evolved over its history as it has adapted itself

to the changing needs of U.S. farmers and the financial institutions that serve them.

This ability was enhanced when Congress passed the Farm Credit Reform Act of

1996 (the 1996 Act), which revised Farmer Mac’s statutory authority resulting in

an improved ability to fulfill its public policy mission to serve rural America.

From our perspective, as both a stockholder of Farmer Mac and a customer, we

strongly believe it is fulfilling its mission, while likewise, helping us fulfill our own.

For example, Farm Credit System institutions, geographically constrained by regulation, build up natural credit concentrations in certain crop or livestock enterprises. Farmer Mac, by purchasing loans or guaranteeing credits, enables those FCS

institutions to transfer credit risks on loans that meet its conservative underwriting

standards to an external, nationwide pool, and so allows them to continue to expand

their service to local farm borrowers without undue concentration concern. The additional benefit achieved is the supplement to capital brought to the retail lending institutions servicing their respective territories. The 20 percent risk weight of loans

under Farmer Mac credit enhancement (Long Term Standby Purchase Commitments) allows a potential five-times increase in our associations’ service to agricultural mortgage borrowers, with the risk transferred largely from our farmer-stockholders to the private sector investors who have capitalized Farmer Mac.

In this latter regard, we note that there has been some criticism of the so-called

capital arbitrage created by Farmer Mac, referencing the lower capital requirements

for loans covered by it guarantees and commitments compared to other loans. We

believe it was part of the intent of Congress in creating and revising Farmer Mac’s

authorities that it should provide agricultural mortgage lenders the benefits of a

GSE secondary market, particularly more efficient use of capital through safe

leveraging. This is accomplished through the regulatory assignment of a lower capital requirement (risk weight) to mortgages supported by a Farmer Mac guarantee

or commitment, and is particularly important for Farm Credit Institutions, whose

access to equity is only through borrower stock purchases and retention of earnings.

We think the prudent use of Farmer Mac as a secondary market GSE is consistent

with the intent of Congress in the preamble to Farmer Mac’s charter, seeking to create an entity that would provide greater. . . lending capacity in 12 U.S.C. §2279aa

(note)(3)(B).

The resulting benefits for the farmers, ranchers and rural homeowners of this Nation have already been proven, not least by our own affiliated associations’ having

placed over $400 million under Farmer Mac’s stand-by in portfolio guarantees,

working through AgFirst, which services these loans on a centralized basis.

Our conclusion is that Farmer Mac is meeting its congressionally mandated mission. It is vital to our meeting and expanding our current and future stockholders’

expectations for a competitive return on their investment in AgFirst.

Likewise, our view of Farmer Mac’s risk management is that our equity investment is well protected. Farmer Mac’s underwriting standards, appraisal guidelines,

and other risk assessment and control factors involved in lending decisions are conservative and market tested. The company’s comparatively low historical credit loss

rate attests to this, as reported in Farmer Mac’s 2003 annual report.

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In its service to rural America, Farmer Mac plays a critical role in the financing

of qualified rural residences. Through its programs, it purchases or guarantees loans

on homes to rural homeowners or part-time farmers. In the U.S., over 55 million

people live in communities of less than 2500 population or unincorporated areas.

Many of these in the areas served are minorities, elderly, and/or young, small or

beginning farmers whose family needs include adequate, affordable housing.

AgFirst and many associations and Farmer Mac, in tandem, serve this growing

market. The local associations through their loan originations and Farmer Mac

through its guarantees on single family home loans are fulfilling a growing need

often not filled by traditional residential mortgage lenders. Interest rates on these

long-term mortgage loans are competitive nationally through the pooling of credit

risk and efficiencies created by the secondary mortgage market program. Rate benefits are passed through to the borrower giving them advantages not only of availability of credit but also access to conventional home mortgage rates as well.

Farmer Mac has supported territorial service objectives of Farm Credit System institutions in serving the part-time farmer needs with over $375 million in part-time

farm loans. Of these, over $150 million in part-time farm loans are serviced by

AgFirst.

Of the GSEs serving agriculture and rural America, Farmer Mac is unique in that

its shares are publicly traded. Its governance and management policies and practices are open to public scrutiny. Its regulation by the Farm Credit Administration,

should be progressive and market oriented, not burdensome, as the changing financial regulatory landscape is viewed today.

The House Committee on Agriculture has an important responsibility for oversight of GSE’s serving agriculture and rural America. This is to assure a regulatory

regime is in place to balance financial safety and soundness on one hand and the

public policy mission fulfillment on the other.

Farmer Mac is important to AgFirst. AgFirst became a Farmer Mac lender/

servicer in 1992 to take advantage of Title VIII lending authority. This authority

afforded the bank the opportunity to establish a nationwide program to enhance residential financing in rural America. This authority gives us the ability to purchase

qualified residential mortgage loans from any Farm Credit System association or

Non-Farm Credit System mortgage lender. Non-Farm Credit System mortgage lenders include small rural community banks and traditional residential mortgage companies. We at AgFirst are servicing 11,750 loans which total $1.56 billion. Without

Farmer Mac, this rural housing program would be significantly curtailed. AgFirst

is proud to be known nationally as the rural housing expert. AgFirst and Farmer

Mac are accomplishing the public policy mission mandated by Congress.

AgFirst is grateful to have an opportunity to express to the House Committee on

Agriculture our views on the positive and continuing contributions of Farmer Mac

to the people of rural America and to the Nation’s food and fiber production.

Representing the member/stockholders of the AgFirst district within the Farm

Credit System, we are grateful to Congress for the establishment of Farmer Mac

and the significant revisions to its statutory authority via the 1996 Act. Farmer Mac

is accomplishing its mission by providing liquidity, lending capacity and stable mortgage rates to the loan markets serving agriculture and rural America.

STATEMENT OF JOHN EVANS, JR.

Thank you Chairman Goodlatte and Ranking Member Stenholm for holding this

hearing on Farmer Mac and for the opportunity to provide this statement for the

record. I am John Evans, Jr., CEO of D.L. Evans Bank in Burley, ID and also the

chairman of ICBA’s Agriculture-Rural America Committee.

ICBA represents the largest constituency of community banks in the Nation and

is dedicated exclusively to protecting the interests of the community banking industry. Seventy-five percent of ICBA’s members are located in communities with a population of 20,000 or less and our members are heavily involved in financing agriculture and rural development across the country. Commercial banks continue to

provide approximately 40 percent of the financing for farmers and ranchers, more

than any other lender group.

We appreciate the Committee holding this hearing. As you know, Farmer Mac is

a government- sponsored enterprise (GSE) within the Farm Credit System (FCS)

with a mission to provide a secondary market for agricultural mortgages. Although

the purpose of this oversight hearing is to review the recent General Accounting Office (GAO) report on Farmer Mac, we would also like to offer our suggestions for

additional oversight activities by the Committee pertaining to GSE’s.

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As you know, the housing GSE’s have been under considerable scrutiny by their

Congressional Committees of jurisdiction and the Administration in recent months.

We believe the larger agricultural GSE, the FCS, should not be exempt from close

scrutiny. We are particularly concerned about the FCA’s board structure and the

FCA’s predilection to facilitate the FCS’s expansion agenda through regulatory

changes. Therefore, we believe additional hearings would provide the opportunity to

build upon the Committee’s oversight function by focusing attention on the broader

GSE, the FCS, in addition to just looking at Farmer Mac.

Furthermore, as the numbers show, the use of the Farmer Mac I program by commercial banks has decreased significantly over time. In light of this, we believe

there is a need for further program enhancements that would improve the usefulness of Farmer Mac for community banks. The use of the Farmer Mac II program

by banks continues to be significant.

We have several recommendations for improving the Farmer Mac I program that

we believe would allow banks to more fully utilize this secondary market for agricultural real estate loans.

GREATER GSE OVERSIGHT

The Senate Banking, Housing, and Urban Affairs Committee has held seven hearings on GSE’s in the 108th Congress and the House Financial Services Committee

has held three such hearings this Congress. Given that Farmer Mac is part of the

FCS, a GSE, and the Administration’s recent concerns over the housing GSE’s and

its efforts to enact new legislation establishing a stronger regulator, we believe it

would be appropriate for the Committee to hold a hearing focusing on the role the

FCA plays as the regulator of the FCS, of which Farmer Mac is an independent entity.

Even though the FCS is regulated by the FCA, which is charged with regulating

and examining all FCS institutions, it is important to point out that the FCA board

has no mandated participation by members that are objectively and primarily concerned about protecting the general public’s interests. It is possible, for example, for

all three members of the FCA board to have previously been employed by the FCS

and/or have direct ties to the FCS.

Here are some recent examples of the FCS expansionist agenda, which are described in more detail below.

• Allowance of illegal activities by institutions if using excess capacity in good

faith.

• Scope and Eligibility proposal that would allow unlimited lending to anyone for

non-agricultural purposes even if the borrower has only a tangential involvement

in agriculture.

• Development of broad new lending programs under the guise of investment authorities.

Illegal Activities. The FCA allows FCS institutions to engage in illegal activities

if it is proven that the institution is operating with so-called ‘‘excess capacity and

good faith’’. This has the effect of encouraging more FCS institutions to seek the

same exemptions for illegal activities and to build up excess capacity for this purpose. We believe such decisions have dubious legal underpinnings and should cause

the Committee major concerns given the FCA’s role as a regulator to prohibit any

illegal activities by FCS institutions. The fact that a regulator would continuously

allow illegal activities to take place under the guise of ‘‘excess capacity and good

faith’’ certainly calls into question its objectivity and the level of independence the

regulatory agency and its general counsel has regarding the industry it is mandated

to regulate.

Scope and Eligibility

This proposal would allow the FCS to go far beyond its traditional GSE mission

of serving bona fide farmers as required by statute and allow the System to make

an unlimited amount of loans virtually unrelated to agriculture to borrowers that

have little or no real involvement in farming. This proposal is currently pending

within the FCA.

INVESTMENTS AS LOANS

The FCA board recently directed staff to prepare a proposed rule allowing FCS

institutions to offer retail lending for business and consumer loans for items completely unrelated to agriculture. This Farmers Notes proposal would allow the FCA

to take a minor statutory authority to regulate FCS investments and turn it into

broad retail and consumer-lending programs. We believe this is an abuse of FCA’s

authorities and was never envisioned by Congress.

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It is important to point out that such actions by the FCA have a direct bearing,

not only on FCS institutions, but also on all lenders involved in the rural credit

markets, including thousands of community banks across the country. According to

the Federal Reserve, there were 2,600 agricultural banks as of June 30, 2002 and

thousands of other banks lend in rural areas. Further expansion of what is supposed

to be a limited purpose GSE to one that competes against the private sector by providing retail lending products and services to all rural residents will diminish the

ability of community banks to serve agriculture and rural communities, resulting in

fewer credit choices for rural residents.

To begin addressing some of these issues, we offer the following recommendations:

• Increase the FCA board from 3 members to 5 members, adding board members

who are objective and required to be principally concerned with protecting the public

interest. This would help diminish criticism of the FCA as an advocate for the FCS

and allow it to be considered an arms-length, objective, world-class regulator, on par

with the housing GSE regulator that the Senate Banking Committee and House

Committee on Financial Services are working to establish. • Prohibit the FCA from using the so-called excess capacity and good faith loophole and require the FCA to publish all instances of illegal activities by FCS institutions. • Prohibit the FCS from using their so-called investment authority as a facade

for expanded lending activities. • Require the FCA to monitor and report on below-market, predatory pricing practices of FCS lenders. • Reduce or eliminate FCA’s exemptions under the Freedom of Information Act,

as it appears the agency is creating a lack of transparency and accountability to the

public, by using closed board meetings to consider important policy matters.

Banks Use of Farmer Mac I. Community banks were a strong advocate for the

creation of a secondary market for agricultural real estate loans when Farmer Mac

was chartered in 1987. However, the participation of banks in the Farmer Mac I

program has decreased from 80 percent of program loans in 1996 to 22 percent in

2002, according to the 2003 GAO report on Farmer Mac. The FCS now accounts for

about 55 percent of Farmer Mac I loans. For comparison, commercial banks held

34 percent of the nationwide agricultural real estate debt in 2003, while the FCS

held 36 percent. As can be seen from these numbers, commercial banks have not

been able to utilize the Farmer Mac I program on a level comparable with their agricultural real estate lending volume because the program has not been user friendly for community banks and small lenders.

To give a personal perspective, my bank was the 6th largest originator of Farmer

Mac I loans in 1999 and this year we haven’t originated a single loan with Farmer

Mac. We have dropped from originating $11–12 million in loans four years ago to

$0 this year in the Farmer Mac I program. This tells me there are some issues that

need to be resolved so that community banks can resume the level of activity that

once existed.

NEW FARMER MAC PRODUCTS

In 1999, Farmer Mac introduced a long-term standby purchase commitment

(LTSPC) product, which is a commitment by Farmer Mac to purchase eligible loans

from financial institutions at a future date if the loan deteriorates or the holder

chooses to sell the loan. This program allows lenders to transfer the credit risk of

loans to Farmer Mac, while maintaining the loan in their portfolio. In exchange for

this agreement, the lender must pay Farmer Mac an annual commitment fee based

on the outstanding balance of the loans covered by the LTSPC. Commercial banks

have not participated in the LTSPC program to date; only FCS institutions have

been participants in the LTSPC, which now represents approximately 40 percent of

Farmer Mac’s loan and guarantee portfolio. As of year-end 2003, there were $2.3

billion of LTSPC with Farmer Mac.

We will be exploring the LTSPC program further with commercial bank lenders

to ascertain whether Farmer Mac is marketing the program equally aggressively to

banks as to FCS associations.

In a positive move, Farmer Mac is planning to eliminate some of the pre-payment

penalties on their products, which should be a help for lenders who have not used

Farmer Mac because of the potential costs of such penalties if borrowers decide to

pay off the loan earlier than anticipated.

RECOMMENDATIONS FOR FARMER MAC

The GAO report on Farmer Mac in 2003, ‘‘Some Progress Made, but Greater Attention to Risk Management, Mission, and Corporate Governance is Needed’’ outVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00116 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
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lines a number of recommendations for Farmer Mac and its board to undertake as

well as recommendations for the FCA and Congress. GAO urged the FCA to assess

and report on the impact Farmer Mac activities have on the agricultural real estate

lending market.

But, Farmer Mac also needs to focus on further developing and enhancing its offerings to the thousands of community banks in rural America. There may be some

external issues that have contributed to the reduced level of participation by community banks in Farmer Mac programs. However, we believe there are significant

internal issues that need to be addressed that would allow banks to better utilize

the Farmer Mac I program. We would recommend the following: • Offer more competitive interest rate options so Farmer Mac loans are competitive with the FCS. • Ensure consistency in the application of underwriting standards across loans.

• Provide for electronic submission of loan packages and ensure an efficient approval process (days, not weeks or months as has been the case). • Ensure all users of Farmer Mac, both large and small, are treated equally.

• Greater outreach and communications by Farmer Mac to community banks and

promote products without bias to the types and size of lenders. • Require Farmer Mac to engage in four to six well-publicized listening sessions

with agricultural lenders in different regions of the U.S. to gather input and ideas

on how to streamline and enhance their products. • Consider eventually altering the makeup of the Farmer Mac board by reducing

the board size. This would include reducing the number of seats allotted to the FCS

representatives, since this is supposed to be an independent entity within FCS, and

placing a cap on the total number at eleven members instead of the fifteen members

now on the board.

FARMER MAC II

While commercial banks’ use of the Farmer Mac I program has been on the decrease, the smaller Farmer Mac II program, which buys the guaranteed portion of

USDA loans, continues to be used primarily by banks. In 2003, 650 lenders participated in the Farmer Mac II program, about 95 percent of which were commercial

banks. The 2003 loan volume was approximately $270 million with a total loan portfolio of $1.5 billion.

In short, Farmer Mac was to provide a simple mechanism for lenders to securitize

pools of long-term agricultural real estate loans at a low overhead cost, freeing up

additional capital to lend to farmers. At this point, we believe Farmer Mac still has

room for improvement if it is to reach the expectations that were envisioned when

it was created. In particular, if Farmer Mac is to ever achieve the success once envisioned, it must offer a better array of competitively priced products tailored to the

needs of community banks. It does not now offer products that allow community

banks to compete with FCS lenders. This reality is inconsistent with lowering the

cost of credit to farmers. Congress should ask ‘‘Why’’? Why are the Farmer Mac interest rates uncompetitive with those of the FCS? And, why is its cost of funds in

the AgVantage program uncompetitive with the other sources of funds?

Again, we thank the Committee for holding this hearing and for the opportunity

to provide this input. We urge the Committee to hold additional hearings in the future on the impact of both agriculturally oriented GSE’s. If the housing GSE’s and

their regulatory structure are going to receive intense scrutiny by Congress, the Agriculture Committees would be remiss to avoid similar scrutiny over the GSE’s

under their oversight particularly the Farm Credit System.

ICBA would welcome the opportunity to assist in the implementation of any recommendations that will improve Farmer Mac programs in a way that is beneficial

to community banks.

STATEMENT OF NANCY C. PELLETT

Mr. Chairman, members of the committee, I am Nancy C. Pellett, Chairman and

Chief Executive Officer of the Farm Credit Administration (FCA or agency). On behalf of my colleagues on the FCA Board, Doug Flory and Michael Reyna, I am

pleased to be here this morning to discuss FCA’s oversight of the Federal Agricultural Mortgage Corporation, often referred to as Farmer Mac. Farmer Mac is one

of two government-sponsored enterprises (or GSEs), which the FCA regulates, examines, and supervises.

Farmer Mac and the Farm Credit banks and associations are devoted to providing

credit and financial services to agriculture and rural America. Our mission at FCA,

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through these two GSEs, is to ensure that a safe, sound and dependable source of

credit is readily available at all times for farmers, ranchers, farmer-owned cooperatives, rural homeowners, and rural America.

This morning I would like to share with you information about FCA and, specifically, its role in the oversight and supervision of Farmer Mac. I will provide you

with a brief overview of the organizations, Farmer Mac’s current financial condition

and risk profile,and recent regulatory and oversight activity affecting Farmer Mac.

THE FARM CREDIT SYSTEM

To add perspective on our regulatory oversight of Farmer Mac, I would like to

give you a very brief overview of our role overseeing the Farm Credit System banks

and associations (FCS or System). The System has played a prominent role in financing American agriculture and rural America since Congress created the System’s first part, the Federal Land Banks, in 1916. The System is the oldest financial

GSE in America, and is the only GSE that engages in retail lending. The 108 institutions of the FCS serve all 50 states and the Commonwealth of Puerto Rico. As

of December 31, 2003, the System consisted of four Farm Credit Banks and one agricultural credit bank, 97 association lenders, and six subsidiary service corporations. The FCS banks also provide credit to 29 non-System financing institutions,

known as OFIs, which include commercial and community banks and their affiliates. At year-end 2003, FCS banks and associations provided services to nearly

450,000 borrowers and held assets of just under $117 billion.

FARMER MAC

Our focus today, however, is on FCA’s oversight role of Farmer Mac. Farmer Mac

is regulated by FCA through the Office of Secondary Market Oversight (OSMO),

which was established in 1992 as required by the Farm Credit Act, as amended.

OSMO provides for the examination and general supervision of Farmer Mac’s safe

and sound performance of its powers, functions, and duties prescribed by the statute. The statute requires that OSMO constitute a separate office within the agency,

reporting to the FCA Board and that its activities, to the extent practicable, be carried out by individuals not responsible for the supervision of the banks and associations of the System.

Farmer Mac was created in response to the farm credit crisis of the mid–1980’s

and subsequent calls from commercial rural bankers for a liquidity source similar

to that provided for residential mortgages by the so-called housing GSEs, Fannie

Mae and Freddie Mac. Amendments in 1996 to Farmer Mac’s authorizing legislation

have allowed this GSE to grow its business and achieve economic viability, which

was by no means certain in the first few years of its operation. To illustrate that

point, the new authorities provided in the Farm Credit System Reform Act of 1996

(1996 Act), helped launch Farmer Mac’s first year of positive earnings in that year,

when net income was $777,000. Net income generally has risen as rapidly as program growth since then andreached $25 million at year-end 2003, representing a

5-year average annual growth rate of 35 percent while program growth averaged 37

percent over the same period.

Farmer Mac is a stockholder-owned, federally chartered GSE established by Congress to provide a secondary market for agricultural real estate and rural home

mortgages. Farmer Mac operates through a network of agricultural lenders, originators, and sellers, among them commercial banks, FCS banks and associations, life

insurance companies and mortgage companies. Farmer Mac conducts its business

primarily through two core programs, known as Farmer Mac I and Farmer Mac II.

Under Farmer Mac I, FarmerMac purchases, or commits to purchase, qualified

loans, or obligations backed by qualified loans, that are not guaranteed by any instrumentality or agency of the United States. Under Farmer Mac II, Farmer Mac

purchases the guaranteed portions of farm ownership and farm operating loans,

rural business and community development loans, and certain other loans guaranteed by USDA.

Farmer Mac has three classes of common stock: class A Voting Common Stock

which may only be held by banks, insurance companies, and other financial institutions that are not institutions of the FCS. By statute, no owner of class A stock may

hold more than 33 percent of the outstanding shares of class A stock. At year-end

2003, one class A stockholder, Zions Bancorporation, held over 31 percent (2 percentage points under the statutory limit). There are just over one million shares of

class A common stock outstanding.

2. Class B Voting Common Stock which may only be held by institutions of the

FCS and are not exchange-traded. There are no restrictions on the maximum purchase or holdings of class B stock. Major class B common stockholders of the FCS

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include: AgriBank, FCB, St. Paul, MN, (40 percent); U.S. AgBank, FCB, Wichita,

KS, (20 percent), and AgFirst Farm Credit Bank, Columbia, SC, (17 percent). There

are just over 500,000 class B shares issued and outstanding.

3. Class C Non-Voting Common Stock which has no ownership restrictions. The

top holders of class C non-voting stock is Zions Bancorporation (14.6 percent) as of

April 9, 2004, the record date for Farmer Mac’s most recent notice of annual meeting. Together, all Farmer Mac directors and executive officers owned 26.9 percent

of class C shares. Outstanding shares of class C common stock were just over 10.5

million at year-end.

Class A and class C common stock are traded on the New York Stock Exchange

(NYSE) under the symbols ‘‘AGMa’’ for class A and ‘‘AGM’’ for class C shares.

The Farmer Mac Board of Directors (Board) is comprised of 15 members according

to the statute. Five are elected by class A common stock shareholders. Five are

elected by holders of class B common stock. The President of the United States appoints the remaining five, and one of these is appointed by the President as chairman. The Board has organized several standing committees and appoints other adhoc committees, which oversee Farmer Mac’s management and operations.

The recent General Accounting Office (GAO) report noted the potential

difficultyFarmer Mac could have complying with the independence requirements in

NYSE listingstandards. Notably, in response to this, the Farmer Mac Board and,

in particular, the Audit Committee have increased their activity in the areas of

independent review and reporting processes in recent months.

Farmer Mac’s daily operations are led by its President and Chief Executive Officer

(CEO) and a core team of five vice-presidents made up of the Chief Financial Officer, General Counsel, Controller, Vice President of Agricultural Finance (primarily

a marketing/business development position), and the recently created position of

Vice-President of Mortgage Servicing. The Corporation employs 36 people and all

but one are located at the Washington, D.C. headquarters.

FINANCIAL HIGHLIGHTS

For the year ended December 31, 2003, Farmer Mac’s net worth increased 16 per- cent to $213 million, up from $183.5 million at year-end 2002. Capital available to

meet minimum and regulatory requirements were well above levels prescribed by

the statute and FCA regulations. The minimum core capital required by statute was

$142 million. Core capital available to meet this requirement was $216 million.

Risk-based regulatory capital required at year-end 2003 was $39 million. Regulatory

capital available to meet this requirement was $238 million.

Operations and Program Portfolio. Net income for the year was $25 million, an

18 percent increase over 2002. However, core earnings were relatively flat.

Loan purchase and credit guarantee activity grew just under 5 percent to $5.8 billion from $5.5 billion at year-end 2002. Liquidity investments were $1.7 billion, up

nearly 9 percent from a year earlier.

Farmer Mac’s Long-term Standby Purchase Commitment (Standby) program has

become a significant part of its operations. Standby’s essentially are a guarantee of

loans that are not purchased by Farmer Mac unless a specific event, such as a default of the loans, trigger such a response. Standby volume outstanding totaled $2.3

billion at the end of December 2003 and now represents over 40 percent of all (offand on-balance sheet) Farmer Mac program activity.

PORTFOLIO RISK

Nonperforming asset volume at year-end 2003 amounted to 1.39 percent of post–

1996 program volume outstanding, compared to 1.56 percent at December 31, 2002.

These assets are measured against post–1996 activity because of the negligible risk

in loans underlying assets acquired before the 1996 legislative changes. The downward trend in nonperforming loans and delinquencies appears to be continuing in

2004.

The allowance for losses, the first buffer to Farmer Mac’s capital from loan losses,

was $22.1 million at year-end 2003, compared to $20.0 million as of December

31,2002. Charge-offs on loans and real estate-owned during 2003 were $5.2 million,

up from $4.1 million in 2002 and $2.2 million in 2001. In contrast, there were no

charge-offs in 2000. Working with Farmer Mac and Farmer Mac’s outside accounting firm, FCA monitors charge-off activity.

REGULATORY ACTIVITY

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gram, the agency requires Farmer Mac to report quarterly on financial performance

consistent with regulatory requirements that are similar to the quarterly Call Reports required by other Federal financial regulators. The agency promulgates regulations, examines all books and records, and ensures safe and sound operations of

Farmer Mac through regulatory enforcement powers that are comparable with other

Federal financial regulators, though somewhat broader in the area of receivership

authority than that of our counterpart, the Office of Federal Housing Enterprise

Oversight (OFHEO). FCA, in contrast to OFHEO, has clear statutory authority to

establish receivership regulations for the institutions it regulates, including Farmer

Mac. The FCA has had receivership regulations in place for Farmer Mac since 1997.

The statute provides the FCA Board broad enforcement powers.These powers are

comparable to other Federal financial regulators such as the Comptroller of the Currency and the Federal Deposit Insurance Corporation.

Unlike Fannie Mae and Freddie Mac, by statute, Farmer Mac must register with

the Securities and Exchange Commission (SEC) and as a publicly traded corporation, also must comply with NYSE listing standards and requirements. As a publicly

traded entity and SEC registrant, regulatory reporting and disclosure requirements

are significant matters demanding constant vigilance for compliance by Farmer

Mac’s compliance officer, executive management, and Board.

EXAMINATION AND SUPERVISION

The statute requires FCA to examine Farmer Mac’s operations once each year. In

practice, FCA monitors activities and requires reports from all institutions it regulates on an on-going basis, including Farmer Mac. We combine our offsite review

and follow-up activities with onsite testing and verification procedures and produce

an annual report of examination. OSMO and FCA examiners regularly meet with

the Farmer Mac Board and executive management to discuss and resolve examination findings and recommendations and to ensure required regulatory reporting is

accurate and appropriate.

Consistent with past practice and for safety and soundness reasons, FCA does not

make public (1) institution-specific examination findings and recommendations, nor

(2) enforcement actions taken against institutions it supervises. Therefore, I may

not be able to fully address certain questions in open session that would pertain to

examination findings or FCA’s supervisory activities resulting from the examination.

Ongoing monitoring and oversight activities resulting from examination findings

and recommendations are conducted through OSMO and are independent and separate from the oversight activities affecting other institutions of the Farm Credit System.

The FCA has increased examination and oversight activities of Farmer Mac over

the past 2 years. Numerous meetings and follow-up discussions have occurred with

the Farmer Mac Board and management during 2003 as results from the 2002 examination were being addressed and as the 2003 examination was conducted. Examination scopes, both breadth and depth, were expanded significantly. Examiner

resources applied to Farmer Mac’s oversight more than tripled from FY 2001 to

those used during FY 2003. Use of outside consultants to assist OSMO in the examination and oversight of Farmer Mac also increased, including securing an outside

accounting firm to advise and assist FCA examiners as the 2003 examination was

completed.

Throughout 2003, agency offsite monitoring and follow-up activities with Farmer

Mac’s Board and management increased significantly over prior years. FCA’s increased examination and oversight activities respond specifically to the GAO report

recommendations. Additional permanent budgeted resources also were increased for

OSMO. In October 2002, a full-time Senior Policy Analyst was added to OSMO’s

staff, and an Associate Director for Examination and Supervision is planned for FY

2004.

The most recent examination was concluded in December 2003. The examination

was comprehensive, risk-based, and focused on what is referred to by Federal financial regulators as a ‘‘CAMELS’’ assessment. A CAMELS assessment includes an indepth analysis of the institution’s Capital, Assets, Management, Earnings, Liquidity, and Sensitivity to market risks. The 2003 examination also included an in-depth

evaluation of Farmer Mac’s information technology, internal controls, and accounting treatmentfor nonperforming loans and real estate owned. We presented the

agency’s 2003 Report of Examination to the Farmer Mac Board at its February 2004

meeting and OSMO actively continues to follow-up with the Board, the Board’s

Audit Committee,and executive management.

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CHALLENGES FOR THE FUTURE

The GAO Report issued in October 2003 included five recommendations for enhanced oversight of Farmer Mac by FCA. In addition to activities that were already

underway while the GAO was conducting their study, the agency has taken action

on several fronts in response to the GAO report, among which are the following:

Non-Program Investment and Liquidity Proposed Rule. This proposed rule was

approved by the FCA Board on April 22, 2004. Publication in the Federal Register

is expected in June with a comment period of 90 days. The proposed rule would set

limits, both minimum and maximum, on the amount and type of non-program liquidity investments that Farmer Mac would be permitted to hold. While GAO had

no specific recommendations for FCA regarding Farmer Mac’s liquidity, we believe

the proposed rule will help address the issues raised in the report with regard to

liquidity planning and mission focus by Farmer Mac.

2. Revised Risk-Based Capital Standards. We have a workgroup actively engaged

in the development of a second proposed rule, which we expect will revise numerous

aspects of the Risk-based Capital (RBC) Stress Test. The RBC stress test is required

by statute and is used to calculate the amount of minimum regulatory capital required by Farmer Mac. By this fall, we expect the workgroup to provide recommendations to the FCA Board regarding any additional regulatory requirements

for Farmer Mac to consider in the application of the RBC test and capital adequacy

planning. I would also note that we are giving full consideration to the recommendations by GAO for the RBC stress test.

3. Offsite Monitoring and Reporting Requirements Initial revisions to the Farmer

Mac quarterly call reports (Call Reports) were implemented in March 2004,including

conversion from hardcopy to electronic submission format, as well as numerous adjustments to Call Report schedules, some of which were specifically recommended

by GAO in their comments regarding offsite monitoring of Farmer Mac. We are also

evaluating the need for additional revisions or expansion of schedules, which will

be implemented in 2005. Other reporting requirements have been implemented also.

For example, OSMO recently required a detailed position-level report on Farmer

Mac’s debt issuances, derivatives, and liquidity investments that are received on a

more frequent schedule than the quarterly Call Reports. We believe these enhanced

reporting requirements are necessary for the on-going oversight of Farmer Mac’s operations and go beyond the recommendations provided by the GAO report.

4. Credit Rating Requirement for Farmer Mac. FCA has initiated work and committed resources for an analysis and evaluation of different approachesused by other

GSE regulators that require their regulated entities to obtain credit ratings. We

have asked staff to present options and recommendations to the FCA Board regarding GAO’s recommendation on this matter. We have alsorequested staff to consider

other activities currently underway at the agencyand at Farmer Mac that may affect the need for the agency to promulgate formalrules in this area.

5. Assessment of Farmer Mac’s Impact on the Real Estate Market. The GAO report recommended we conduct an assessment of Farmer Mac’s impact on the agricultural real estate market. The GAO report also suggested Congress clarify the

statute with regard to Farmer Mac’s mission. Staff has begun planning for this recommendation and will consider different approaches for conducting this assessment.

Meanwhile, OSMO is developing a special ‘‘Mission Call Report’’to help track Farmer Mac’s success in achieving its mission as currently defined in statute.

I would like to note that FCA supports the suggestions to Congress made in the

GAO report. In particular, we support greater flexibility for the regulator to design

and set minimum and regulatory capital standards in addition to those established

by the Risk-Based Capital Stress Test. This would be consistent with authority

granted to other financial institution regulators and our own authority to regulate

capital needed by the Farm Credit System banks and associations.

Farmer Mac has made progress since the 1996 legislative changes. Capital has

increased to $213 million at year-end 2003 from $47 million at year-end 1996. Program growth has been robust impacting Farmer Mac’s risk profile and challenging

management, operational systems, and internal controls. Both Farmer Mac and

FCA are actively working to ensure these challenges are met.

In conclusion, Mr. Chairman, let me say that we are committed to Farmer Mac’s

success and the achievement of its statutory purpose as a Congressionally-chartered

GSE serving agriculture and rural America. It must be safe and sound at all times

to do so. FCA continues to enhance its regulatory oversight of Farmer Mac, and I

believe we are well positioned to address any challenges to ensure Farmer Mac has

the capability to remain successful in the future. We remain committed to that goal

and the achievement of our mission, ‘‘to ensure a safe, sound and dependable source

of credit for agriculture and rural America.’’

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Thank you for the opportunity to be here today and for your continued support

of FCA and our mission of service to agriculture and rural America. I will be pleased

at this time to answer any questions.

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STATEMENT OF GREG ZERZAN

Thank you Chairman Goodlatte, Ranking Member Stenholm and members of the

Committee for this opportunity to testify today on the Federal Agricultural Mortgage Corporation (commonly know as Farmer Mac). Our Nation’s interest in maintaining strong agricultural credit markets that serve the needs of farmers and

ranchers remains strong. The Federal Government has established a number of programs or entities that seek to supplement the private sector’s efforts in meeting the

credit needs of Rural America. Farmer Mac is one such entity, a government sponsored enterprise (GSE) established by Congress in 1987 to address perceived inefficiencies in the allocation of mortgage credit to agricultural real estate. Publicly traded GSEs such as Farmer Mac are not backed by the full faith and credit of the

United States, nor do they receive funding from the United States. However, such

GSEs do enjoy a limited set of benefits not generally available to other financial institutions.

Farmer Mac was created in the aftermath of the farm financial crisis of the mid–

1980’s, which many observers linked to the predominance of variable rate mortgages. Farmer Mac was envisioned to operate along the lines of the successful secondary markets for residential mortgages and improve the opportunities for farmers

and ranchers to obtain long-term fixed rate mortgages. The idea was that farm real

estate mortgages would be originated by participating lenders, pooled by third party

financial institutions, guaranteed by Farmer Mac, and sold to investors in the form

of securities. Originators would use the proceeds from the sale of loans to make new

loans, enhancing the competitiveness of agricultural real estate mortgage markets,

and expanding the supply of long-term credit available for farmers and ranchers.

The initial structure of Farmer Mac, however, proved unsuccessful and by 1995

Farmer Mac had low business volume, its capital was depleted, and the anticipated

secondary market in agricultural real estate mortgages had not developed. Congress

decided to act the following year to significantly alter Farmer Mac’s structure with

the Farm Credit System Reform Act of 1996 (the 1996 Act). The 1996 Act permitted

Farmer Mac to directly act as pooler of agricultural real estate mortgages and it

eliminated the requirement that loan originators and poolers retain a 10 percent

subordinated participation interest in each securitized loan pool.

Since 1996, Farmer Mac’s business operations have improved. Total assets have

increased from $512 million at the end of 1995 to $4.3 billion at the end of 2003.

Farmer Mac had its first profitable year in 1996, and Farmer Mac’s net income totaled $27 million in 2003.

Despite Farmer Mac’s improving financial results, as the General Accounting Office (GAO) noted in its November 2003 report, Farmer Mac poses a number of questions for policy makers to consider. In particular, today I would like to focus on

three such issues: Farmer Mac’s mission achievement; regulatory issues associated

with Farmer Mac, including the perception of the Treasury Department’s oversight

role; and the Treasury Department’s perspective on Farmer Mac’s line of credit.

FARMER MAC’S MISSION ACHIEVEMENT

To evaluate the mission of a GSE like Farmer Mac, it is important to understand

the reason why Congress created such an entity and what powers Congress provided

the entity to accomplish its purpose. Unlike some of the other GSEs, Farmer Mac’s

enabling legislation does not contain an explicit, prescriptive mission; instead, its

broad mission statement refers to Farmer Mac providing a secondary marketing arrangement for agricultural real estate mortgages that would generally improve the

credit availability to farmers and ranchers.

One useful way to evaluate Farmer Mac’s broad statutory purpose is to consider

whether Farmer Mac has contributed to the development of an active secondary

market in agricultural real estate mortgages, much like the secondary market that

exists for residential housing mortgages. The secondary market for residential housing mortgages is characterized by a wide array of investors who on any given day

are buyers and sellers of mortgage-backed securities. GSEs such as Fannie Mae,

Freddie Mac, and the Federal Home Loan Bank System have roles in this market,

as does a wholly-owned government corporation, Ginnie Mae; but other institutions,

such as commercial banks, thrifts, credit unions, mutual funds, insurance companies, and pension funds also have significant investments in mortgage-backed securities.

Similarly liquid markets for agricultural mortgage backed securities (AMBS) do

not yet exist. Farmer Mac operates two main AMBS programs. Under the Farmer

Mac I program, Farmer Mac purchases agricultural mortgages that meet Farmer

Mac’s underwriting, appraisal, and documentation standards. Then Farmer Mac

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issues and guarantees the timely payment of principal and interest on AMBS

backed by such mortgages. Under the Farmer Mac II program, Farmer Mac purchases the guaranteed portions of loans guaranteed by the United States Department of Agriculture and guarantees the AMBS backed by those USDA-guaranteed

portions. Farmer Mac may retain its guaranteed securities in its portfolio or sell

them to third parties.

The amount of AMBS held by outside investors fell dramatically between 1998 and 2002 from about $600 million to about $367 million. As a portion of total AMBS

outstanding, the amount of AMBS held by outside investors declined from 52 percent in 1998 to 19 percent in 2002. As noted by GAO, because Farmer Mac holds

so much of its own guaranteed securities as investments, no active secondary market has developed. In 2003, the amount of AMBS held by outside investors did increase to about $1 billion, or 40 percent of all Farmer Mac AMBS outstanding; however, this increase was due to a loan participation swap that Farmer Mac entered

into with a Farm Credit System institution in 2003. Under this loan participation

swap, Farmer Mac replaces loans guaranteed under its Long Term Standby Purchase Commitment (LTSPC) program with an AMBS. Thus, while the participation

swap transaction increased AMBS held by outside investors, it did not increase the

outstanding credit guarantees of Farmer Mac. Even with this substantial increase

in AMBS outstanding, Farmer Mac continues to hold more than twice as many

loans and AMBS in portfolio as it sells to investors. Absent a more aggressive effort

by Farmer Mac to sell its AMBS to outside investors, it is difficult to perceive of

an active secondary market for AMBS developing.

Another way to consider Farmer Mac’s mission achievement is to determine if it

is broadly providing support for agricultural credit that is not being provided by

other credit providers. There are many providers of credit to farmers and ranchers,

including commercial banks, insurance companies, the Farm Credit System, and

specialized agricultural credit providers. Farmer Mac supplements these institutions’ activities by issuing debt in capital markets and purchasing agricultural real

estate mortgages or AMBS. In that sense, Farmer Mac is providing a secondary

market outlet for lenders to dispose of loans, much the same way that other financial institutions would purchase or participate in agricultural real estate mortgage

loans from one another. If the goal of creating Farmer Mac was to create another

specialized agricultural lender, as opposed to developing a viable secondary market

for AMBS, then Farmer Mac has been more successful in achieving its mission.

Whether such an activity constitutes a meaningful public mission is one that Congress should carefully consider.

Another mission evaluation issue is Farmer Mac’s investments in non-mission-related assets (i.e., non-agricultural assets). Farmer Mac continues to maintain the

highest percentage of non-mission investments among all the GSEs. As of year-end

2003, Farmer Mac’s investment portfolio accounted for 25 percent of Farmer Mac’s

total assets with the majority of Farmer Mac’s remaining assets being its own

AMBS. Farmer Mac’s investment portfolio has increased from $150 million as of

year-end 1996 to $1.7 billion as of year-end 2003. In 2003, 22 percent of Farmer

Mac’s interest income was generated from its investment portfolio.

Holding relatively high proportions of non-mission investments invites speculation

that GSE status is being used to generate what amount to arbitrage profits. Farmer

Mac initially justified its build-up of investments in the latter part of 1990’s on the

grounds that the corresponding increase in debt issuance would improve capital

market recognition of Farmer Mac and the pricing of its securities. It was then argued that improved pricing on Farmer Mac debt securities would be passed on to

farmers in the form of lower mortgage rates. Non-mission investments have also

been viewed by some as providing a source of liquidity. All financial institutions

should maintain a prudent amount of liquidity. The question of how much non-mission investments are necessary for Farmer Mac’s liquidity purposes has been the

source of debate over several years. We understand that the Farm Credit Administration is about to issue a proposed rule on this issue, and we look forward to following the progress of that rulemaking.

REGULATORY OVERSIGHT OF FARMER MAC

The Farm Credit Administration (FCA) is the regulator of Farmer Mac. The

Treasury Department does not have any direct regulatory oversight responsibilities

with respect to Farmer Mac. However, on December 22, 1995, the House and Senate

Agriculture Committees asked the Treasury to jointly monitor Farmer Mac’s financial condition with FCA throughout the capital deferral period and beyond if necessary. The capital deferral period was established as part of the Farm Credit System Reform Act of 1996 and effectively prohibited FCA from implementing a riskVerDate 11-SEP-98 10:45 Jul 23, 2004 Jkt 094704 PO 00000 Frm 00133 Fmt 6633 Sfmt 6633 F:\DOCS\10831 HAGRI PsN: HAGRI
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based capital rule for Farmer Mac prior to February 10, 1999. The FCA Board approved a final Farmer Mac risk-based capital rule on February 21, 2001, the final

rule became effective on May 23, 2001, and Farmer Mac was required to be in compliance after a 1-year trial period that ended on May 23, 2002.

Treasury’s role under the joint monitoring request has consisted of reviewing the

semi-annual report that FCA sends to Congress, periodically discussing Farmer

Mac’s progress with FCA officials, and on a few occasions submitting comments to

FCA that focused on broader policy issues associated with Farmer Mac. We have

appreciated the close working relationship we have had with FCA in conducting the

joint monitoring requested by Congress, but at this time, with the capital deferral

period long over, there will be no continued formal relationship with FCA on the

joint monitoring of Farmer Mac. FCA has developed a useful semi-annual report,

which, as we understand, it will continue to provide to Congress. It would be useful

for Treasury also to receive a copy of the final report. However, having FCA provide

an advance copy of the report for Treasury to review, or having Farmer Mac or FCA

continue to reference a joint monitoring arrangement with Treasury, may inadvertently provide the false impression that Treasury exercises some form of oversight

of, or responsibility for, Farmer Mac. Treasury plays no such role.

While Treasury does not have any regulatory supervision responsibilities with respect to Farmer Mac, just as Treasury does not have with the other financial institutions (including the other GSEs), Treasury has an interest in monitoring the activities of Farmer Mac and the FCA. An issue that has periodically come up in FCA

rulemaking, which the GAO report raised and we have also raised in the past, is

Farmer Mac’s relationship under certain transactions with members of the Farm

Credit System. In particular, under the LTSPC program, Farmer Mac effectively

acts as an insurer of mortgages held by Farm Credit System institutions. LTSPC

transactions create regulatory capital arbitrage opportunities for Farm Credit institutions. Under this arrangement, a Farm Credit institution can carry its agricultural mortgages at a 20 percent risk weight, rather than 100 percent, which in turn

lowers its regulatory capital requirement for these loans from 7 percent to 1.4 percent. Farmer Mac must hold 0.75 percent in capital against these loans under its

minimum capital requirement (which appears to be the binding requirement at this

time). Thus, the combined regulatory capital for these loans is just over 2 percent

compared to the Farm Credit institution’s 7 percent capital requirement on these

loans prior to the transaction. This may raise some particular concerns because

Farmer Mac is partially owned by Farm Credit institutions.

Outstanding LTSPC guarantees have increased from $575 million as of year-end

1999 to $2.3 billion as year-end 2003. The GAO also noted concerns with the LTSPC

program regarding Farmer Mac’s liquidity and concentration risk. Over the last few

years, FCA Board members have indicated an awareness of the potential for capital

arbitrage with the LTSPC program and they have taken some recent actions to address concentration risk within the Farm Credit System.

FARMER MAC’S LINE OF CREDIT WITH TREASURY

As noted by GAO, there appears to be some confusion over how and under what

terms Farmer Mac would have access to its line of credit with Treasury. This issue

was brought to the forefront in 1997 when Treasury submitted comments to FCA

on a proposed regulation that would govern any future conservatorship or receivership for Farmer Mac. That letter described Treasury’s position regarding Farmer

Mac’s line of credit as follows:

The Farm Credit Act specifies the circumstances allowing Farmer Mac to request

the Treasury Secretary to purchase Farmer Mac obligations. Farmer Mac must certify that the proceeds from issuing obligations to the Treasury are necessary to fulfill Farmer Mac’s guarantee obligations, and it must have exhausted its reserves.

Treasury’s obligation extends to Farmer Mac only in the prescribed circumstances,

and is not a blanket guarantee protecting Farmer Mac’s guaranteed securities holders from loss. Nor is the purpose of the Treasury’s obligation to protect Farmer Mac

shareholders or general creditors. Thus, we have serious questions as to whether the

Treasury would be obligated to make advances to Farmer Mac to allow it to perform

on its guarantee with respect to the securities held in its own portfolio—that is,

where Farmer Mac’s guarantee essentially runs to Farmer Mac itself. Indeed, Farmer Mac’s guaranteed securities must, by statute, carry a disclaimer stating that

these securities are not guaranteed by the Federal Government.

Treasury has not changed its position on this issue. Investors in Farmer Mac securities should rely on the underlying credit quality of Farmer Mac when making

investment decisions, not on any potential access to a line of credit with the Treasury.

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Our Nation’s interest in maintaining strong agricultural credit markets that serve

the needs of farmers and ranchers remains strong. Farmer Mac has improved its

business prospects since it was granted new powers by Congress in 1996, and its

capital position has improved over the years. FCA completed its implementation of

Farmer Mac’s risk-based capital standards and has been considering other issues

associated with risk concentration within the Farm Credit System and Farmer

Mac’s non-mission investments. While Farmer Mac’s role in agricultural mortgage

markets has increased, whether Farmer Mac’s increased business activity contributes to achieving a significant public purpose remains an issue that Congress should

continue to evaluate.

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