```
Federal Housing Finance Board: Actions Needed to Improve Regulatory
Oversight (Chapter Report, 09/18/98, GAO/GGD-98-203).

GAO reached four primary conclusions about the Federal Housing Finance
Board's (FHFB) regulatory oversight of the nation's third-largest
government-sponsored enterprise--the Federal Home Loan Bank System.
First, FHFB did not ensure that all parts of the annual examinations GAO
reviewed met FHFB's internal standards for assessing safety and
soundness. Second, weaknesses exist in FHFB's off-site monitoring and
supervisory enforcement programs. Third, FHFB lacks policies and
procedures, outside of its reviews of the special affordable housing and
community investment programs, to determine whether or the extent to
which Federal Home Loan Banks are supporting their public mission of
housing finance. Fourth, FHFB's involvement in promoting System programs
and projects that it later evaluates for mission compliance and for
safety could complicate its primary duty as a safety and soundness
regulator and may prompt questions about FHFB's objectivity. GAO
summarized this report in testimony before Congress; see: Federal
Housing Finance Board: Actions Needed to Improve Regulatory Oversight,
by Nancy R. Kingsbury, Assistant Comptroller General for General
Government Programs, before the Subcommittee on Capital Markets,
Securities, and Government Sponsored Enterprises, House Committee on
Banking and Financial Services. GAO/T-GGD-98-185, Sept. 24 (14 pages).

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-98-203
     TITLE:  Federal Housing Finance Board: Actions Needed to Improve 
             Regulatory Oversight
      DATE:  09/18/98
   SUBJECT:  Banking regulation
             Financial management systems
             Government sponsored enterprises
             Lending institutions
             Bank examination
             Federal aid for housing
             Agency missions
             Internal controls
             Loan accounting systems
IDENTIFIER:  FHLB Affordable Housing Program
             FHLB Community Investment Program
             
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Cover
================================================================ COVER

Report to the Chairman, Subcommittee on Capital Markets, Securities
and Government-Sponsored Enterprises, Committee on Banking and
Financial Services, House of Representatives

September 1998

FEDERAL HOUSING FINANCE BOARD -
ACTIONS NEEDED TO IMPROVE
REGULATORY OVERSIGHT

GAO/GGD-98-203

Federal Housing Finance Board

(233539)

Abbreviations
=============================================================== ABBREV

  AHP - Affordable Housing Program
  CIP - Community Investment Program
  DBIMS - District Bank Information Management System
  FDIC - Federal Deposit Insurance Corporation
  FHFB - Federal Housing Finance Board
  FHLBankAct - Federal Home Loan Bank Act
  FHLBank - Federal Home Loan Bank
  FIRREA - Financial Institutions Reform, Recovery, and Enforcement
     Act
  FMP - Financial Management Policy
  FSLIC - Federal Savings and Loan Insurance Corporation
  GARP - generally accepted risk principles
  GSE - government-sponsored enterprise
  HUD - Department of Housing and Urban Development
  OF - Office of Finance
  OFHEO - Office of Federal Housing Enterprise Oversight
  OP - Office of Policy
  OS - Office of Supervision
  OTS - Office of Thrift Supervision
  REFCorp - Resolution Funding Corporation
  ROMS - Regulatory Offsite Monitoring System

Letter
=============================================================== LETTER

B-278411

September 18, 1998

The Honorable Richard H.  Baker
Chairman, Subcommittee on Capital Markets,
 Securities and Government-Sponsored Enterprises,
Committee on Banking and Financial Services
House of Representatives

Dear Mr.  Chairman: 

This report responds to your request that we review the Federal
Housing Finance Board's (FHFB) safety and soundness and mission
compliance oversight.  Our objectives were to evaluate (1) FHFB's
annual safety and soundness and mission compliance examinations of
FHLBanks, (2) other aspects of FHFB's oversight, and (3) the status
of FHFB's involvement in System business. 

We are sending copies of this report to other appropriate
congressional committees and executive branch agencies, including the
Secretary of the Treasury, the Secretary of the Department of Housing
and Urban Development, and the Acting Director of the Office of
Federal Housing Enterprise Oversight.  We will also make copies
available to others on request. 

This report was prepared under the direction of Richard J.  Hillman,
Associate Director, Financial Institutions and Markets Issues, who
may be reached on (202) 512-8678 if you or your office has any
questions.  Major contributors are listed in appendix II. 

Nancy R.  Kingsbury
Acting Assistant Comptroller General

EXECUTIVE SUMMARY
============================================================ Chapter 0

   PURPOSE
---------------------------------------------------------- Chapter 0:1

The Federal Housing Finance Board (FHFB) was established in 1989 as
the regulator of the Federal Home Loan Bank System (System), a
government-sponsored enterprise (GSE) whose mission is to support
housing finance.  The System raises funds through the issuance of
consolidated debt obligations (primarily short-term), which exceeded
$2 trillion during 1997.  At year-end 1997, about $304 billion of
consolidated debt remained outstanding.  The System's assets at
year-end 1997 totaled about $349 billion.  FHFB's primary statutory
duty is to ensure that the Federal Home Loan Banks (FHLBank) operate
in a financially safe and sound manner.  FHFB's safety and soundness
oversight function is important to taxpayers because of the size of
the financial obligation of the FHLBank System and the possibility,
given the System's public purpose, that the federal government might
provide assistance if the System became troubled. 

In addition to responsibility for FHLBanks safety and soundness, the
Federal Home Loan Bank Act (FHLB Act) assigns FHFB three other
duties, "to the extent they are consistent with its primary duty."
These are (1) supervise FHLBanks, (2) ensure that FHLBanks carry out
their housing finance mission, and (3) ensure that FHLBanks remain
adequately capitalized and able to raise funds in the capital
markets.\1 In earlier work, GAO has consistently expressed concern
that FHFB's involvement in corporate governance and System business
functions may undermine FHFB's regulatory independence and
objectivity.\2 FHFB has recognized the inherent conflict in the
combined roles of regulation and governance and is devolving to the
FHLBanks some System management and governance authorities.  This
report responds to a request from the Chairman of the Subcommittee on
Capital Markets, Securities and GSEs, House Committee on Banking and
Financial Services that GAO review FHFB's safety and soundness and
mission-related oversight of the FHLBanks. 

The specific objectives of this report are to evaluate (1) FHFB's
annual safety and soundness and mission-compliance examinations of
the FHLBanks; (2) other aspects of FHFB's oversight, including
off-site monitoring and supervisory enforcement; and (3) the status
of FHFB's involvement in System business. 

--------------------
\1 12 U.S.C.  � 1422a(3)(B). 

\2 Government-Sponsored Enterprises:  Framework for Limiting the
Government's Exposure to Risks, (GAO/GGD-91-90, May 22, 1991) and
Federal Home Loan Bank System:  Reforms Needed to Promote Its Safety,
Soundness, and Effectiveness (GAO/GGD-94-38, Dec.  8, 1993). 

   BACKGROUND
---------------------------------------------------------- Chapter 0:2

The Financial Institutions Reform, Recovery, and Enforcement Act of
1989 (FIRREA) created FHFB as an independent agency within the
executive branch, with a five-member board of directors (Board). 
FHFB is organized into 10 offices; however, the functions of 3
offices are most relevant to this report.  The primary responsibility
of the Office of Supervision (OS) is to ensure the safety and
soundness and mission-compliance of the FHLBanks; it conducts the
federally mandated annual examinations of all FHLBanks.  The Office
of Policy (OP) and Office of General Counsel provide assistance to
and share oversight responsibility with OS. 

The System consists of 12 regional FHLBanks, each with its own board
of directors and management, that are cooperatively owned and
controlled by member institutions in their districts.  However, each
FHLBank is jointly and severally liable for the System's consolidated
debt.\3 FHLBanks support housing finance by making loans, called
advances, to owner-members and eligible nonmember mortgagees on the
security of mortgages and other pledged collateral.  In addition,
FHLBanks make advances to smaller community lenders that lack diverse
funding sources.  At year-end 1997, advances accounted for 58 percent
of System assets; investments accounted for 40 percent (the remainder
was cash, buildings, etc.). 

Like other financial institutions, FHLBanks face risks from their
advances and investments.  FHLBanks use a variety of techniques to
manage these risks.  The primary risks include losses from changes in
interest rates, a borrower or counterparty failing to perform on an
obligation, and poor internal controls.  Also, FHFB and FHLBank
officials have supported legislative initiatives that would expand
the System's mission and eligible types of collateral which would
result in additional business risk for the System. 

In addition to the responsibilities discussed earlier, the FHLBank
Act explicitly gives FHFB responsibility for a number of business or
corporate-governance-type duties for the System, including issuing
the System's consolidated obligations and approving FHLBank
dividends, bylaws, the banks' initial selection of FHLBank
presidents, and the appointment of six members of each FHLBank board
including the chairs and vice chairs.  In expressing concern that
such involvement in System business compromises FHFB's regulatory
objectivity, as discussed earlier, GAO has also said that if mission
and safety and soundness oversight are combined in the same
regulatory body, the regulator should not have a role, other than
oversight, in the governance or corporate affairs of the GSE.  The
central coordination of GSE activities should be carried out by the
GSE, not by the regulator.\4

The primary responsibility of FHFB's examination function is to
assess the safety and soundness of the FHLBanks.  After determining
that FHFB's examination standards were comparable with those of other
financial regulators, GAO compared FHFB's practices with its
standards.  To do that, GAO reviewed a judgmental sample of 1996 and
1997 examination reports and supporting work papers for six FHLBanks. 
FHLBanks in the sample accounted for about 60 percent of System
assets as of year-end 1996.  GAO also compared FHFB's enforcement
policy and monitoring program with criteria previously articulated by
GAO.  Finally, GAO reviewed FHFB's effort to devolve its role in
governance activities to FHLBanks and the extent of FHFB's ongoing
involvement in System business. 

--------------------
\3 That is, should one or more FHLBank be unable to repay its
participation in the consolidated obligations, each of the other
FHLBanks could be called upon to repay a portion of such obligations. 

\4 GAO/GGD-91-90, GAO/GGD-94-38, and Government-Sponsored
Enterprises:  Advantages and Disadvantages of Creating a Single
Housing GSE Regulator (GAO/GGD-97-139, July 9, 1997). 

   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

FHFB did not ensure that the annual examinations GAO reviewed met
internal FHFB standards for assessing the safety and soundness of
FHLBanks.  While each of the 12 sampled examinations included reviews
of FHLBank policies and procedures to mitigate interest-rate and
credit risk, the examinations did not include assessments of those
areas that FHFB and others have identified as vital in evaluating an
institution's risk-management capabilities.  Further, after
identification of deficiencies in consecutive examinations of one
FHLBank (inadequate segregation of duties), examinations were not
expanded to investigate the extent of related potential problems, as
required by FHFB standards.  With regard to examining for mission
compliance, the agency acknowledges having no examination policies or
procedures outside of its reviews of the special affordable housing
and community investment programs, to determine whether or to what
extent FHLBanks were supporting housing finance.  These special
programs that were examined represented less than 1 percent of System
assets at year-end 1997.  Since 1997, FHFB has taken several steps to
develop procedures and mechanisms to better ensure mission
compliance. 

Additional weaknesses existed in off-site monitoring and supervisory
enforcement guidance.  In 1997, OS suspended monthly off-site
monitoring of FHLBank activities due to staffing constraints. 
Examiners primarily reviewed off-site information for each FHLBank's
condition and activities during their annual preexamination planning. 
Although OS and OP prepared several periodic reports that tracked
specific bank activities, they did not coordinate their activities. 
FHFB lacked clear policies and procedures regarding corrective
actions for specific FHLBank conditions and failed to specify what
actions would be taken if certain conditions existed.  In addition,
FHFB's statutory enforcement authority is not clearly enumerated
other than the authority to remove for cause a FHLBank director,
officer, employee, or agent. 

GAO found that FHFB has undertaken activities that further involve it
in System business.  In GAO's view, some of FHFB's activities may
undermine FHFB's independence as a regulator.  While FHFB began to
devolve certain authorities, within limits, to FHLBanks in 1995, FHFB
continues to promote and coordinate System activities.  For example;
(1) FHFB's strategic plan primarily focuses on and promotes changes
to enhance FHLBanks' business performance with less emphasis on its
role in providing safety and soundness oversight; (2) FHFB proposed a
plan to involve itself in developing new services, products, and
partnerships with housing advocates; and (3) the FHFB Chairman acts
as a central coordinator and participates in Systemwide meetings with
FHLBank chairs and vice chairs. 

FHFB's involvement in promoting System programs and projects that it
subsequently evaluates for mission compliance and safety and
soundness could complicate FHFB's primary duty as safety and
soundness regulator and may prompt questions about its objectivity. 
FHFB views these activities as consistent with its primary duty of
ensuring the System's safety and soundness, as well as ensuring
mission compliance.  GAO maintains its position that regulation of
the System could be done more effectively by an arm's-length
regulator (preferably one for all the housing GSEs) that is not
involved in System business. 

   PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4

      FHFB DID NOT ENSURE
      EXAMINATIONS MET FHFB'S
      STANDARDS
-------------------------------------------------------- Chapter 0:4.1

FHFB, other financial regulators, and GAO have identified the
following areas for review to be among those considered critical in
evaluating an institution's risk-management capabilities: 
assessments of board of director and management oversight,
assessments of internal control systems, and testing to determine the
reliability of internal audits upon which examiners rely in
conducting a review.  While none of the examinations GAO reviewed
fully assessed more than one of the areas, all failed to assess board
of director oversight.  These critical areas should be reviewed
during every annual examination. 

OS officials said that because OS staff resources were inadequate to
fully evaluate an FHLBank's system of internal controls, OS provided
only limited assurance of the adequacy of internal control systems. 
Further, these officials said OS often does not formally assess
oversight of boards of directors and managers or determine the
reliability of internal audits because of time and resource
constraints and the stability of the management and auditing
functions of the FHLBanks.  Rather, the examinations focus on
specific problems that arise and then determine the role of the
FHLBank board and management in relation to those problems. 

In each of the examinations GAO reviewed, more than half of the areas
of examination were not conducted in accordance with examination
procedures in FHFB's examination manual (that is, examiners did not
complete the examination program in the manual or use the manual's
examination questionnaires, or both).  FHFB examiners explained that
they did not have time to complete the procedures described in the
manual and that the manual's procedures often were not useful for
certain parts of the examination.  In addition, GAO found that
examiners did not document the examination procedures or support for
conclusions drawn from their work, as required by FHFB standards, for
most areas covered in the examination. 

In 11 of 12 examinations GAO reviewed, some planned examination
procedures were not completed during the course of the examination. 
In each of the cases, examiners indicated in the work papers that
those procedures were not completed due to time constraints.  In two
cases examiners curtailed the scope of examinations but provided no
explanation for the change in scope in the work papers.  OS officials
said that limited examination staff resources often resulted in scope
reductions, and that such reductions occurred in parts of the
examination that examiners believed involved less risk. 

Examiners also failed to expand the examination when potentially
serious problems were found.  Examiners found potentially serious
internal control problems at consecutive examinations of a FHLBank
but did not expand their review to determine whether there were
additional problems.  Both cases involved an inadequate segregation
of duties in a FHLBank's investment activities--an internal control
problem that has allowed severe problems to cause losses at other
financial institutions. 

Although FHFB was established in 1989 and is responsible for ensuring
FHLBank compliance with its housing mission, FHFB's examination
program has not assessed FHLBank compliance with its housing finance
mission.  Rather, mission compliance oversight includes examiners
reviewing FHLBanks' compliance with affordable housing program and
community investment program requirements--two programs established
by FIRREA that represented less than 1 percent of the System's total
assets in 1997; and, beginning in 1997, annual reports from FHLBanks
that describe new products, pricing, and investment partnerships. 
FHFB has taken several steps recently to better ensure mission
compliance.  For example, FHFB has (1) commissioned a study to, among
other things, assist it in developing procedures to oversee FHLBank
mission compliance; (2) tested draft examination procedures to ensure
mission compliance; and (3) issued amended regulations for FHLBank
member community support requirements as well as FHFB's oversight
activities to ensure member compliance with those requirements. 

      WEAKNESSES EXIST IN OTHER
      AREAS OF FHFB'S REGULATORY
      OVERSIGHT PROGRAM
-------------------------------------------------------- Chapter 0:4.2

Recognizing the need for timely monitoring, OS developed a regulatory
oversight and off-site monitoring system in 1996 that required
monthly reviews of FHLBank data, including minutes from the board of
directors meetings, internal audit reports, and financial data.  In
1997, monthly monitoring was suspended due to staff constraints.  GAO
found that OS examiners primarily reviewed the periodic data
submitted by the FHLBanks to FHFB as part of their preparation for
annual FHLBank examinations.  OS also prepared periodic reports on
issues, such as financial management policy compliance and
interest-rate risk exposures, financial trends, and debt-issuance
activities.  In addition to OS's reports, OP produced several
periodic reports, such as the quarterly profile report that tracks
FHLBank statistics including FHLBank membership, affordable housing
program, unsecured credit, and individual FHLBank profiles.  Both
offices shared their reports with the Board but they did not
coordinate their monitoring activities. 

The statute authorizes FHFB to "promulgate and enforce regulations
and orders," but only delineates one enforcement power for FHFB--the
authority to remove or suspend for cause FHLBank directors, officers,
employees, or agents.  FHFB officials said they believe that the
general provision in the statute enables the FHFB to take corrective
action, if necessary.  Officials said they consider examination
reports that include examination "findings" requiring corrective
action, the equivalent of an enforcement order.  GAO found that FHFB
lacked clear policies and procedures regarding the use of corrective
actions and failed to specify what actions would be taken if certain
conditions existed.  In addition, GAO believes, as it recommended in
the past for any GSE regulator, that the statute should specifically
give FHFB all enforcement authorities granted other regulators. 
Further, in past GSE work, GAO identified certain principles
necessary for effective enforcement of rules and regulations.\5
Included in these principles are that certain enforcement actions
should be mandatory when previously specified conditions are met and
should be the result of a clear and reasonable process.  FHFB needs a
well-defined mechanism in place to address serious problems if they
were to arise. 

--------------------
\5 GAO/GGD-91-90. 

      FHFB REMAINS INVOLVED IN
      SYSTEM BUSINESS
-------------------------------------------------------- Chapter 0:4.3

Consistent with its 1993 report on the System, GAO continues to find
that FHFB combines safety and soundness and System business
functions.\6 In certain instances, the FHLBank Act provides for
FHFB's involvement in System business.  For example, under the
FHLBank Act, FHFB is the legal issuer of the System's consolidated
obligations.  The act further requires that FHFB approve FHLBank
dividends, bylaws, and selection of FHLBank presidents.  In 1994,
FHFB started a project to identify and devolve certain business or
governance and management activities to the FHLBank boards.  Since
that time, numerous activities have been devolved to FHLBanks, within
specified limits.  Devolved activities include the authority to
establish presidents' salaries and incentive plans, approve
affordable housing program applications, determine the compensation
of FHLBank directors, and set FHLBank performance targets. 
Activities identified by FHFB yet to be devolved include the
authority to approve dividends, certain general administrative
matters, and credit policies. 

Also, as previously reported in 1993, GAO continues to find that FHFB
is a promoter and coordinator for the System.  That is, FHFB becomes
involved beyond the business functions assigned to it in statute. 
Although the Chairman believes that this activity is consistent with
his statutory responsibilities to ensure the System's safety and
soundness and mission compliance, GAO continues to believe that such
involvement in the System's business functions may inhibit FHFB's
ability to independently assess System activities.  Undertaking such
activities may undermine FHFB's independence and lead to questions
about its objectivity.  FHLBanks have established two groups with the
potential to provide central coordination and promotion for the
System.  Nevertheless, FHFB officials view promotion as part of
FHFB's role as a regulator.  FHFB's 5-year strategic plan illustrates
the prominence of the coordination and promotion roles in agency
operations.  Of the plan's nine objectives, one addresses the
examination function; and five address changes FHFB advocates to
enhance FHLBank performance, such as expanding the acceptable uses
for advances and eligible collateral to include small business loans. 
Of the other three objectives, two address the devolution effort; and
one deals with disseminating public information about the FHFB's
performance. 

GAO cited other examples of FHFB's promotion and coordination
activities.  For example, GAO identified the FHFB Chairman's actions
in coordinating and participating in periodic meetings with FHLBank
chairs and vice chairs including the coordination of congressional
lobbying efforts to be inappropriate for a regulator.  In particular,
GAO noted that although other regulators consult with Congress about
and testify on possible or pending legislation, the FHFB is in a
strong position to influence the FHLBank chairs and vice chairs
because it appoints them.  GAO noted that FHFB should have regulatory
authority over business functions to ensure safety and soundness and
mission compliance but emphasized that having such regulatory
authority differs from being a participant in System business on a
regular basis and from promoting a particular program or activity
over other mission-related activity.  A regulator, according to GAO,
must strike a balance between fostering mission compliance and
promoting activities it prefers. 

--------------------
\6 GAO/GGD-94-38. 

      SINGLE HOUSING REGULATOR
      WOULD HAVE ADVANTAGES OVER
      FHFB
-------------------------------------------------------- Chapter 0:4.4

GAO noted in previous work that establishing a single, independent,
arm's-length regulator for the System and the other two housing
GSEs\7 would better ensure objective regulation of the System and
create some economies, efficiencies, and valuable synergies among
regulatory staff.  GAO recommended combining safety and soundness
oversight of the three housing GSEs in a 1993 report and, in a 1997
report, identified advantages to a single regulator--one that would
also have mission oversight responsibility.\8 A single regulator
would be more independent and objective than separate agencies
because it would not be affiliated with one particular GSE, dependent
on that GSE for its continued existence, and thus subject to its
influence.  A single regulator would be more prominent in government
than FHFB is alone.  This should further enhance a single regulator's
independence and make it more competitive in attracting and retaining
staff with appropriate expertise and experience. 

--------------------
\7 The Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac) are regulated
for safety and soundness by the Office of Federal Housing Enterprise
Oversight (OFHEO), an independent regulator within the Department of
Housing and Urban Development, which oversees the GSEs' mission
compliance. 

\8 GAO/GGD-94-38 and GAO/GGD-97-139. 

   RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5

To strengthen FHFB in its primary oversight role as the safety and
soundness supervisor of the FHLBank System, GAO recommends that FHFB

(1) ensure that critical aspects of FHLBank operations are reviewed
as part of every FHFB examination;

(2) ensure that examiners follow the guidance and complete the
appropriate examination procedures described in the examination
manual;

(3) adequately document the work performed and conclusions drawn
during examinations; and

(4) more clearly articulate and document its current enforcement
mechanisms, policies, and procedures. 

   MATTERS FOR CONGRESSIONAL
   CONSIDERATION
---------------------------------------------------------- Chapter 0:6

GAO continues to support its 1994 and 1997 positions that a single
housing GSE regulator be created to oversee the safety and soundness
and mission compliance oversight of the housing GSEs.  While
considering this action, Congress may want to consider taking interim
action to redirect FHFB's attention to its primary role as the
System's safety and soundness regulator by making FHFB an
arm's-length regulator, as in the case of other GSE regulators.  This
could be achieved by ensuring that its statutory duties do not
involve FHFB in any System business.  In addition, Congress may want
to consider giving FHFB specific enforcement authorities it has
provided to other GSE regulators. 

   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 0:7

GAO requested comments on a draft of this report from FHFB, which
provided written comments that are discussed at the end of chapters 2
and 4.  In addition, FHFB's comments are printed in appendix I, as
well as GAO's response to specific comments.  FHFB disagreed with
GAO's assessment of FHFB's safety and soundness and mission oversight
performance.  Nevertheless, FHFB believed that the draft report had a
number of useful suggestions for improving the quality of its
examination process and said it would evaluate and implement them
where appropriate.  FHFB framed its disagreements with the draft
report around three major themes. 

First, FHFB stated that the scope of GAO's work, focusing primarily
on examination activities, was "very limited" and that GAO
inappropriately drew "overly broad, inaccurate and unsubstantiated
conclusions" about FHFB's performance.  FHFB maintained that GAO
assumed examinations were its "sole safety and soundness tool."
Therefore, GAO's "work cannot support any conclusions regarding the
overall effectiveness of the Finance Board's safety and soundness
oversight."

GAO believes that its scope was appropriate and consistent with the
objectives of its review.  The congressional requester also agreed to
the scope of work, which focussed not only on FHFB's examination
activities but also its off-site monitoring efforts and supervisory
enforcement program (see ch.  3).  GAO believes that regular,
comprehensive on-site examinations are the cornerstone of any
financial institution regulator's oversight program.  Without such
periodic reviews of operations, a regulator cannot be assured that an
institution has proper controls in place, is complying with relevant
laws and regulations, or that its board and management are
effectively managing risks and complying with safety and soundness
and mission-related requirements. 

GAO emphasized that off-site monitoring, fully integrated with the
examination program, is also vital to effective oversight.  Such
monitoring should be timely, focus on previously identified problems,
and identify potential problems.  Off-site monitoring between annual
examinations is especially important as the demographics of the
System change, FHLBanks undertake new activities, and economic
conditions change.  GAO stated that clear policies and procedures for
a regulatory enforcement program are essential to FHFB's ability to
deal promptly and effectively with any serious problems that might
arise.  GAO's review identified weaknesses in FHFB's examination,
off-site monitoring, and enforcement programs and recommended
improvements.  Thus, based on its review of all of these areas, GAO
concluded that FHFB's oversight of the System needs to be
strengthened to provide on-site assurance that FHLBanks are
effectively managing risk and, thus, are operating in a safe and
sound manner. 

Second, FHFB said that in reaching its conclusions GAO did not
consider the proper statutory and regulatory context that makes the
System a conservative, low-risk, and well-capitalized GSE.  FHFB
emphasized that the safety and soundness prescribed for FHLBanks in
statute, regulation, and policy are conservative and result in a high
credit rating for System obligations (without, according to FHFB,
"reference to its implied government backing"). 

GAO does not disagree that the current standards are conservative and
had already stated in its draft report that none of the FHLBanks had
ever experienced a credit loss.  GAO acknowledged that the System's
financial policies, practices, and condition may result in a high
credit rating.  GAO had noted in the draft report, and in past
reports, that the size of the System's obligations and its public
purpose make regulatory oversight especially important because of the
possibility the government might provide assistance, as it has done
in the past for other GSEs, if the System became troubled.  In
addition, GAO noted that the government has afforded a priority lien
status to FHLBank advances made to FDIC insured members.  Aside from
the need for FHFB to properly oversee compliance, as stated above,
GAO noted that the environment within which the System operates can
change due to such external factors as legislation, demand for System
products, or membership.  Although the FHLBanks may have a relatively
low-risk profile today, conditions can change; and the System needs a
well-equipped and vigilant regulator to ensure a continued low-risk
profile. 

GAO agrees with FHFB that corporate governance, annual independent
audits, and internal audits are important elements in helping ensure
the System's safety and soundness.  However, GAO noted that these
elements cannot substitute for judicious oversight in protecting the
government's interest in a GSE.  GAO emphasized that System capital,
which is based on stock purchases required of members and is not risk
based, is less suitable for absorbing losses than other forms of
capital because it is redeemable by members, under certain
circumstances. 

Third, FHFB stated that GAO mistook its authorization of certain
System activities and identification of ways for FHLBanks to fulfill
their mission as intrusions into System business.  GAO agrees that
FHFB should have regulatory authority over business functions to
ensure safety and soundness and mission compliance but emphasizes
that having such regulatory authority differs from being a
participant in System business.  A regulator, GAO believes, must
strike a balance between fostering mission compliance and promoting
activities it prefers.  In general, FHFB's comments reflect its
general disagreement with GAO's view that a regulator's role of
ensuring mission compliance should be limited to defining proper
mission related activities in regulation and then ensuring--through a
combination of on-site examinations, off-site monitoring, and other
oversight efforts--that the GSE is complying with the rules.  FHFB
characterized this as a "passive" view of its role as a mission
regulator. 

FHFB stated that its role by law is to actively foster what it sees
as appropriate System activities.  Because FHFB is ultimately
responsible for regulating the projects and programs it has promoted,
however, GAO is concerned that FHFB's strategy of "actively
encouraging" the FHLBanks' development of mission-related assets
raises questions about its independence and objectivity.  GAO
recognized the difficulty in developing a mission oversight mechanism
and acknowledged steps FHFB took recently to develop such a
regulatory mechanism.  These matters are addressed in chapters 2 and
4 of this report. 

INTRODUCTION
============================================================ Chapter 1

The Financial Institutions Reform, Recovery, and Enforcement Act of
1989 (FIRREA) created the Federal Housing Finance Board (FHFB) as an
independent agency within the executive branch with a combination of
regulatory and management responsibilities for the 12 Federal Home
Loan Banks (FHLBanks) that comprise the Federal Home Loan Bank System
(System).  FHFB's primary duty is to ensure that the FHLBanks operate
in a financially safe and sound manner.  The System is a
government-sponsored enterprise (GSE) whose mission is to support
housing finance.\1 The System provides funds to support housing
finance through the issuance of consolidated debt obligations.  This
report responds to a request from the Chairman of the Subcommittee on
Capital Markets, Securities and GSEs, House Committee on Banking and
Financial Services that we review FHFB's safety and soundness and
mission-related oversight.  Our objectives are to evaluate (1) FHFB's
annual safety and soundness and mission-compliance examinations of
the FHLBanks; (2) other aspects of FHFB's oversight, including
off-site monitoring and supervisory enforcement; and (3) the status
of FHFB's involvement in System business. 

--------------------
\1 GSEs are financial institutions chartered by Congress to achieve a
public purpose, such as facilitating the flow of funds to housing and
agriculture.  In addition to the FHLBank System, these GSEs include
the Federal National Mortgage Association (Fannie Mae), the Federal
Home Loan Mortgage Corporation (Freddie Mac), and the Farm Credit
System. 

   BACKGROUND
---------------------------------------------------------- Chapter 1:1

In 1989, Congress created FHFB following the thrift crisis in the
1980s.  At the same time, Congress abolished the Federal Home Loan
Bank Board (FHLBank Board), FHFB's predecessor, which was extensively
involved in the business operations of the Federal Home Loan Banks
(FHLBanks).  Prior to FIRREA, FHLBanks were not only wholesale
lenders to thrifts but also the regulator of thrifts.  FIRREA
maintained the FHLBanks' wholesale lender role and transferred the
regulation of the thrift industry to the newly created Office of
Thrift Supervision (OTS).  It also abolished the FHLBank Board and
transferred its other functions to FHFB, including a number of
management functions and existing FHLBank Board policies.  For
example, FHFB has the authority to approve FHLBank dividends, appoint
six directors to each of the FHLBank boards, and approve the
selection of FHLBank presidents.  Thus, FIRREA did not establish FHFB
as an arm's-length regulator and FHFB remains the only GSE regulator
that is not arm's-length from the GSE it regulates. 

In 1989, FIRREA gave FHFB the responsibility to (1) supervise
FHLBanks, (2) ensure that FHLBanks carry out their housing finance
mission, (3) ensure that FHLBanks remain adequately capitalized and
able to raise funds in the capital markets, and (4) ensure that
FHLBanks operate in a safe and sound manner.  In 1992, concerns about
the safety and soundness of the housing GSEs prompted Congress to
raise the primacy of safety and soundness oversight by making it
FHFB's primary duty.  The 1992 amendment further specified that
FHFB's other three duties were to be fulfilled, "to the extent they
are consistent" with its primary duty. 

   FHFB IS AN INDEPENDENT AGENCY
   LED BY A BOARD
---------------------------------------------------------- Chapter 1:2

FHFB is to be managed by a salaried five-member Board of Directors
(Board).  The Secretary of the Department of Housing and Urban
Development (HUD) serves as an ex officio director.  The remaining
four full-time directors are appointed by the President with the
advice and consent of the Senate for 7-year terms.  Each of the four
appointed members must have experience or training in housing finance
or commitment to providing specialized housing credit.  Not more than
three of the five members can be from the same political party.  At
least one director must come from an organization with more than a
2-year history of representing consumer or community interests in
banking services, credit needs, housing, or financial consumer
protections.  The President designates one of the four appointed
directors to serve as chairman.  Since 1990, the Board has operated
under a resolution that delegated most Board functions to the
chairman.  According to the resolution, the Board's rationale for the
delegation was "for ease of general operation."\2

FHFB has not operated with a full five-member board since 1993. 
Until March 1998, FHFB had only one vacancy.  However, in a letter
dated March 9, 1998, the President terminated a board member who had
served in a holdover capacity since February 28, 1995.\3

The term of one of the remaining three members expired February 28,
1997, but as of July 2, 1998, he continued to serve in a holdover
capacity. 

The costs of FHFB's operations are funded through assessments to the
FHLBanks.  In 1997, FHFB's assessments were about $16 million.  As of
May 31, 1998, FHFB's 114 staff members were organized into 10
offices, as illustrated in figure 1.1.\4 The number of staff assigned
to each office is shown in parentheses.  According to FHFB
regulations and office descriptions,

  -- The Office of the Managing Director is responsible for the
     day-to-day management, functioning, and organization of FHFB. 

  -- The Office of General Counsel is responsible for advising the
     Board, FHFB offices, and employees on legal interpretations. 

  -- The Office of Supervision (OS) is responsible for conducting, at
     least annually, examinations of all 12 FHLBanks, the follow-up
     and resolution of outstanding examination issues, liaison with
     each FHLBank audit committee and the review and evaluation of
     the work of each FHLBank's internal audit staff, and the
     monitoring of FHLBanks and System interest rate risk, financial
     trends, and mission-related activities. 

  -- The Office of Policy (OP) is responsible for coordinating policy
     development, providing policy advice and analyzing and reporting
     to the agency on various issues.  Its responsibilities include,
     (1) analysis and modeling of the financial performance of the
     FHLBanks, (2) preparation of the System's annual combined
     financial reports and other periodic reports, (3) collection and
     analysis of data on the housing and community and economic
     development activities of the FHLBanks, (4) analysis of the
     FHLBank's performance under the affordable housing and community
     investment programs, (5) preparation of monthly survey of rates
     and terms and conforming loans limits for Fannie Mae and Freddie
     Mac purchases and guarantees, and (6) review of FHLBank's
     quarterly dividends recommendations. 

  -- The Office of Congressional Affairs is responsible for ensuring
     effective coordination and communication between the agency,
     constituent groups, and Congress. 

  -- The Office of Public Affairs is responsible for the
     dissemination of FHFB actions, policies, and press releases and
     ensuring effective coordination and communication between the
     agency and the media. 

  -- The Office of Resource Management is responsible for human
     resources, payroll, contracting, procurement, support services,
     budget, accounting, finance, management, information systems,
     and general administrative functions in FHFB and is the chief
     advisor to FHFB on internal management and organization. 

  -- The Office of Strategic Planning is responsible for the
     planning, analysis, development, and execution of the agency's
     strategic plan, both short and long term. 

   Figure 1.1:  FHFB
   Organizational Chart

   (See figure in printed
   edition.)

   Note:  Staff, as of May 31,
   1998, shown in parentheses.

   (See figure in printed
   edition.)

   Source:  FHFB.

   (See figure in printed
   edition.)

According to FHFB regulation, OS oversees the FHLBanks, Office of
Finance (OF) and the Financing Corporation\5 to ensure that they
operate in a financially safe and sound manner, that the FHLBanks are
carrying out their housing and community and economic development
finance mission, and that they are in compliance with applicable
statutes and regulations as well as FHFB policies and orders.  OS
responsibilities include annual examinations of FHLBanks, which are
required by statute, and OF and the Financing Corporation
examinations, which are required by regulation.  The annual FHLBank
examination focuses on safety and soundness but includes some
mission-compliance oversight.  According to FHFB's annual report, the
purposes of the examinations are to review systems of internal
control to ensure the integrity of operations; assess the degree to
which assets are protected from loss; and review compliance with
statutes, regulations, and policies.  OP and the Office of General
Counsel also provide technical support to OS in performing its
duties. 

FHFB's performance in its safety and soundness oversight role is
important to taxpayers because of the size of the financial
obligations of the FHLBank System and the possibility, given the
System's public purpose, that the federal government might provide
assistance if the System became troubled.\6 The importance of
effective regulatory oversight becomes increasingly important as the
System grows and FHLBanks undertake new activities that can pose new
risks.  As we discuss later in this chapter, both of these conditions
exist. 

--------------------
\2 FHFB Resolution 90-143 (Dec.  18, 1990) delegates to the FHFB
chairman, "after consultation with the other members of the Board as
appropriate, all authorities, powers and responsibilities of the
Board necessary to effect the overall management, functioning and
organization of the Board including, without limitation, the
authority to execute documents on behalf of the Board, including
regulations, resolutions or orders duly passed by the Board, and to
appoint, remove, and direct FHFB personnel." This resolution was
superseded by FHFB Resolution 93-92 on November 17, 1993, which
reaffirmed the delegation to the chairman. 

\3 The member's termination was effective March 23, 1998.  On March
30, 1998, the member filed suit in U.  S.  District Court for the
District of Columbia to override the termination.  In July a federal
judge upheld the termination. 

\4 The Office of the Board includes the board members, their
assistants, and administrative staff.  The Office of the Inspector
General (staff of four) is not discussed in this report. 

\5 OF is a joint office of the FHLBanks responsible for issuing the
System's consolidated obligations.  The Financing Corporation is a
tax-exempt, mixed-ownership, government corporation that was
established to issue bonds for the Federal Savings and Loan Insurance
Corporation (FSLIC) and the FSLIC Resolution Fund for resolution
activities. 

\6 The government has intervened in the past to strengthen the
position of some troubled GSEs, although it has no legal obligation
to do so.  For example, the government intervened when the Farm
Credit System faced severe financial stress in the 1980s.  Congress
authorized up to $4 billion in federal assistance despite the fact
that the system's enabling legislation clearly states that its
obligations are not guaranteed by the U.S.  government as to
principal or interest.  The federal government provided less direct
support to Fannie Mae in 1982 in the form of changes to its income
tax treatment and regulatory forbearance of its troubled condition. 
See Farm Credit System:  Repayment of Federal Assistance and
Competitive Position (GAO/GGD-94-39, Mar.  10, 1994); and
Government-Sponsored Enterprises:  A Framework for Limiting the
Government's Exposure to Risks (GAO/GGD-91-90, May 22, 1991). 

   SYSTEM'S COOPERATIVE STRUCTURE
   NOT UNIQUE AMONG GSES
---------------------------------------------------------- Chapter 1:3

The FHLBank System, established in 1932, is cooperatively owned by
its members, who must buy stock in the System as a prerequisite for
borrowing.  This structure is not unique to the System:  the Farm
Credit System, a GSE created to increase the flow of funds to
agriculture, is also cooperatively structured.  At year-end 1997,\7

the System included a combination of voluntary and mandatory members. 
Voluntary members included state-chartered savings associations and
savings banks and state-insured and uninsured thrifts, commercial
banks, credit unions, and insurance companies.  Mandatory members
were federally chartered savings associations and savings banks
regulated by OTS.  Before FIRREA, membership was limited to thrifts,
savings banks insured by the Federal Deposit Insurance Corporation
(FDIC), and insurance companies.  FIRREA expanded the System's
voluntary membership to include commercial banks and credit unions. 
At year-end 1997, commercial banks dominated System membership with
69 percent of the members, thrifts were 27 percent; and the remaining
4 percent were credit unions and insurance companies (see table 1.1). 

                               Table 1.1
                
                  Annual Federal Home Loan Bank System
                Membership, Year-end 1993 through Year-
                                end 1997

Institution                       1993    1994    1995    1996    1997
------------------------------  ------  ------  ------  ------  ------
Commercial banks                2,276\   3,133   3,641   4,072  4,514\
                                     a
Thrifts                          2,177   2,067   1,969   1,874   1,742
Credit unions and insurance         \a     106     165     200    \248
 companies
Total                            4,453   5,306   5,775   6,146   6,504
----------------------------------------------------------------------
\a In 1993, FHFB combined commercial banks, credit unions, and
insurance companies. 

Source:  Federal Home Loan Bank System 1997 Financial Report, Federal
Home Loan Bank System 1996 Financial Report, Federal Home Loan Bank
System 1995 Financial Report. 

By law, members must purchase stock in their FHLBank based on the
level of their residential mortgage assets or total assets.  The
FHLBank Act also contains an advances-to-stock ratio subscription
requirement.  These stock purchases are the primary source of equity
capital for FHLBanks.  Member stock is not publicly traded.  At
year-end 1997, capital stock comprised 98 percent of the System's
equity capital, the remaining 2 percent was from retained earnings. 

The 12 FHLBanks are located in Boston, New York, Pittsburgh, Atlanta,
Cincinnati, Indianapolis, Chicago, Des Moines, Dallas, Topeka, San
Francisco, and Seattle and each serves a defined geographic region of
the country (see fig.  1.2).  At year-end 1997, the individual
FHLBanks ranged in asset size from about $15 billion to over $61
billion.  For purposes of comparison, as of year-end 1997, the 40
largest regional bank-holding companies in the United States ranged
in asset size from about $14 billion to about $89 billion. 

   Figure 1.2:  Map of the FHLBank
   System

   (See figure in printed
   edition.)

   Source:  FHFB data.

   (See figure in printed
   edition.)

Each FHLBank is governed by a board of at least 14 directors.  Six
directors are appointed by FHFB\8 and the remaining directors are
elected by members.  Appointed directors serve 4-year terms, and
elected directors serve 2-year terms.  The chair and vice chairs are
designated by FHFB and serve a 1-year term.  The chair is an
appointed director, and the vice chair is an elected director.  FHFB
approves the bylaws and the initial appointment of the FHLBank
presidents. 

--------------------
\7 Year-end means calendar year unless noted otherwise. 

\8 Of the six appointed directors, at least two must be chosen from
organizations with more than a 2-year history of representing
consumer or community interests on banking services, credit needs,
housing, or financial consumer protections. 

   FHLBANKS PROVIDE FUNDING AND
   LIQUIDITY THROUGH ADVANCES
---------------------------------------------------------- Chapter 1:4

FHLBanks' primary mechanism to support housing finance is advances,
which provide a funding source for mortgages.  Advances are made to
members and eligible nonmember mortgagees\9 on the security of
mortgages and other pledged collateral.  Advances generally are to
support mortgage originations and provide term funding for portfolio
lending.  The System also serves as a source of liquidity for its
members.  While 57 percent of the System's over 6,500 members held
advances as of December 31, 1997, 35 members held almost 50 percent
of the System's total advances. 

Like other GSEs, the System raises funds in the capital markets
partially on the strength of its ties to the federal government.  The
primary source of funds for FHLBanks is the issuance of debt
securities, known as consolidated obligations.  Consolidated
obligations, whether issued by a single FHLBank or collectively, are
the "joint and several" obligations of FHLBanks.\10 The FHLBank Act
authorizes FHFB to issue consolidated obligations, which FHFB
delegated to OF, a joint office of the FHLBanks established by
regulation.  During 1997, the System's debt issuance exceeded $2
trillion.  In the first quarter of 1998, the System's debt issuance
continued to grow and the System replaced Treasury as the largest
issuer of debt in the world.  However, most of the debt issued
consisted of short-term obligations to provide liquidity for members
and for money-market investments.  As a result, total consolidated
obligations outstanding was about $304 billion at year-end 1997.  The
FHLBanks collectively held about $349 billion in total assets at
year-end 1997, making it the third largest GSE in the nation.  See
table 1.2 for a summary of FHLBank System financial data. 

                               Table 1.2
                
                    Selected FHLBank System Summary
                Financial Data as of December 31, 1997,
                         and December 31, 1993

                         (Dollars in millions)

Financial data                                            1997    1993
------------------------------------------------------  ------  ------
Advances to members                                     $202,2  $103,1
                                                            65      31
Investments                                             140,10  72,293
                                                             6
Total assets                                            348,57  178,89
                                                             5       7
Consolidated obligations                                304,49  138,74
                                                             3       1
Capital stock                                           18,836  11,450
Retained earnings                                          342     317
Net income                                               1,492     884
Dividends paid                                           1,191     696
Return on average equity                                 8.33%   7.94%
Return on average assets                                 0.49%   0.54%
----------------------------------------------------------------------
Source:  Federal Home Loan Bank System 1997 Financial Report. 

--------------------
\9 The FHLBank Act authorizes FHLBanks to make advances to an entity
that is not a member of the FHLBank if the FHLBank certifies the
entity as a nonmember mortgagee.  12 U.S.C.� 1430b.  To be certified,
an entity must meet certain criteria, including approval by HUD as a
'mortgagee' under the National Housing Act and being subject to the
inspection and supervision of a governmental agency.  Examples of
eligible nonmember mortgagees are state housing finance agencies and
tribally designated housing entities. 

\10 With prior FHFB approval, a FHLBank may issue its own
obligations.  However, as of July 2, 1998, FHFB has not granted such
approval, and no individual FHLBank obligations are outstanding. 

   FHLBANK SYSTEM FACES A NUMBER
   OF RISKS
---------------------------------------------------------- Chapter 1:5

The primary risks inherent in the FHLBank System activities are
interest-rate risk, credit risk, and operations risk.  Interest- rate
risk is the potential for financial loss due to movements in interest
rates.  FHLBanks are exposed to interest-rate risk because they face
possible losses and changes in the value of their portfolios
resulting from changes in interest rates.  Credit risk is the
potential for financial loss from a borrower or counterparty failing
to perform on an obligation.  Finally, operations risk is the
potential for unexpected financial loss arising from inadequate
information systems, operational problems, breaches in internal
controls, or fraud.  FHLBanks use a variety of mechanisms to manage
these risks, such as credit enhancements to manage credit risks and
interest exchange agreements to manage interest-rate risk.\11 In
addition, each FHLBank's financial statement is audited annually by
an independent accounting firm. 

None of the FHLBanks has ever experienced a credit loss on an
advance.  As we noted in an earlier report, this record reflects
conservative credit standards and the use of collateral as a credit
enhancement for advances.\12 In addition, the government has afforded
a special lien status to FHLBank advances made to FDIC insured
members.  In the event of the failure of FDIC insured members (i.e.,
a bank or thrift), FHLBanks have priority in the assets of the failed
institution over most other security interests, including insured
deposits.\13 Advances represented 58 percent of total System assets
at year-end 1997; the balance (less 2 percent for other fixed assets,
such as accrued interest and bank premises and equipment) was in
investments (discussed in greater detail later in this chapter). 
Among individual FHLBanks, advances as a percent of total assets
ranged from 40 to over 80 percent. 

Like other GSEs, the FHLBank System also faces business risk--the
risk that factors largely beyond its control could lead to unexpected
changes in earnings, growth, or capital.  Examples of external
factors that pose business risk include (1) changes in legislation or
regulation governing their lines of business, (2) changes in demand
for their products, and (3) changes in membership eligibility.  For
example, voluntary members, who can leave the System with 6 months'
notice, can redeem their stock.\14 Due to legislative changes (as
noted previously, only federally chartered savings associations and
savings banks regulated by OTS are mandatory members) and thrift
industry consolidation, the percentage of voluntary members has been
increasing.  At year-end 1997, voluntary members (who represented
almost 85 percent of System membership) held about 55 percent of the
System's capital stock.  Mandatory members held the remaining 43
percent.  As we reported in our past work, the nonpermanent nature of
this capital stock makes it a less suitable buffer for absorbing
losses than other forms of capital.\15

FHLBank and System officials have supported legislation introduced
into the 105th Congress that would, among other things, potentially
expose the System to additional risk.\16 The pending legislation
would expand the collateral provisions for certain members to include
certain small business loans and rural development loans.  Such
expansion of the System's mission increases its potential risk
exposure.  However, as of August 31 these provisions were still under
consideration. 

--------------------
\11 The FHFB provides a framework for FHLBank's financial management
strategies through its "Financial Management Policy."

\12 Federal Home Loan Bank System:  Reforms Needed to Promote Its
Safety, Soundness, and Effectiveness (GAO/GGD-94-38, Dec.  8, 1993). 

\13 Another facet of FHLBanks' special lien status for advances is
the risk it poses to FDIC.  The priority of advances has the
potential to result in increased costs to FDIC in resolving a
possible bank or thrift failure.  The FDIC Chairman expressed this
opinion in a September 1995 correspondence with the Chairman of the
Subcommittee on Capital Markets, Securities and Government
Sponsored-Enterprises, Committee on Banking and Financial Services,
House of Representatives.  We concurred with the analysis and
discussed the issue in comments on proposed legislation to expand the
mission of the FHLBank System.  See Enterprise Resource Bank Act
(GAO/GGD-96-140R, June 27, 1996). 

\14 FHFB may refuse to redeem stock at par value should the member's
FHLBank be or likely be in financial difficulty. 

\15 GAO/GGD-94-38, chapter 3. 

\16 H.R.  10 "Financial Modernization," which includes provisions
relevant to the System) passed the House on May 13, 1998.  S.  1423
"FHLBank System Modernization Act of 1997" was introduced Nov.  7,
1997. 

   SYSTEM'S ACTIVITIES HAVE
   EXPANDED
---------------------------------------------------------- Chapter 1:6

Although the System's charter contains no explicit statement of the
System's purpose, the FHLBank Act identifies that purpose as
supporting housing finance.\17 Historically, the System has achieved
that purpose primarily by making loans (called advances) secured by
home mortgages, to savings and loans, cooperative banks, and thrift
institutions.  Since 1989, the System's activities have expanded to
include targeted lending, greater investments, pilot programs, and
various other activities.  In addition, pending legislation
(discussed previously) would expand eligible types of activities even
further. 

FIRREA created special affordable housing requirements.  Each FHLBank
must maintain two low- and moderate-income housing
programs--Affordable Housing Program (AHP) and Community Investment
Program (CIP).  These programs comprised less than 1 percent of
System total assets at year-end 1997. 

AHP, which began in 1990, requires the System to contribute the
greater of $100 million or 10 percent of the preceding year's net
income.\18 The funding is provided in the form of a direct subsidy. 
The FHLBank Act sets priorities for use among eligible projects.  It
also provides the grounds for FHFB to suspend an FHLBank's AHP
obligations, if such payments are contributing to financial
instability.  In 1997, about $136 million was provided to AHP
projects. 

As part of CIP, the FHLBank Act requires that each FHLBank establish
a program to make advances for members to finance the purchase or
rehabilitation of housing for eligible households and to finance
other projects benefiting residents of low- and moderate-income
neighborhoods at cost or at a special rate.  The FHLBank Act did not
specify a particular dollar goal but required these advances to be
made at a discounted price.  In 1997, over $3 billion in advances
were made through CIP, including $152 million for economic or
community development purposes. 

Beginning in the early 1990s, significant changes occurred in the
System's level of investment activities.  According to FHFB
officials, concerns about income pressures due to financial
obligations relating to the thrift crisis and the new AHP
requirements, among other concerns, led FHFB to expand FHLBanks'
investment authority.\19 The primary investments of the FHLBanks are
mortgage-backed securities, overnight and term federal funds sold,
commercial paper, and U.S.  government and agency securities. 
Between year-ends 1989 and 1997, the System's investments grew from
about $34 billion to $140 billion, a 312 percent increase.  Advances
have also increased, though not as dramatically.  Between year-ends
1989 and 1997, advances grew from about $142 billion to $202 billion,
a 42 percent increase.  Year-end 1989 investments represented almost
20 percent of System total assets, compared with almost 40 percent at
year-end 1997.  As we noted previously, the composition of assets
among the individual FHLBanks varies.  At year-end 1997, investments
as a percentage of total assets at FHLBanks ranged from a low of 17
percent to a high of 58 percent. 

According to testimony by the FHFB Chairman, FHFB began to follow a
strategy ".  .  .  to encourage the development of additional
mission-related assets.  .  .  " as an outgrowth of concerns about
nonmission-related investments.\20 As of July 2, 1998, FHFB had
approved four pilot programs that ranged in size from $25 million to
$750 million.  In general, the programs involve FHLBank funding or
financing for home ownership in new ways.  For example, in one
program, the FHLBank purchases participation interests in affordable
multifamily housing loans originated by a consortium of small banks
that are mostly FHLBank members.  Another program offers FHLBank
members a new alternative to holding loans in their portfolios or
selling them in the secondary market, for example to Fannie Mae or
Freddie Mac.  The FHLBank is to fund and retain in its portfolio the
loans originated, serviced, and credit-enhanced by members.  The
risks are to be shared between the members and the FHLBank. 

In April 1998, the Board approved a final rule to amend the
definition of residential mortgages for the purposes of determining
System membership and collateral requirements.\21 According to FHFB,
this change should provide rural banks with greater access to the
System both in terms of membership eligibility and borrowing power. 
Also in April 1998, FHFB issued a proposal that would expand existing
targeted investment opportunities.  Statute permits the FHLBanks to
establish Community Investment Cash Advance programs in addition to
AHP and CIP, which are required.  Community investment cash advance
programs are designed to target FHLBank advances to income-targeted
households and specified economic development projects.  The proposed
rule would require each FHLBank to create a strategy for providing
community investment program advances to support financing for
projects that is not otherwise available or is available at less
attractive terms. 

--------------------
\17 Section 1422a(3)(B), in part, charges FHFB with "[ensuring] that
the Federal Home Loan Banks carry out their housing finance mission."

\18 FIRREA mandated that the systemwide AHP contributions would be 5
percent of net income, or not less than $50 million, between 1990 and
1993, increasing to 6 percent of net income or not less than $75
million in 1994.  Since 1995, the systemwide contribution is the
greater of 10 percent or $100 million.  The contribution is
calculated before affordable housing program charges but after paying
Resolution Funding Corporation (REFCorp) bond obligations. 

\19 FIRREA required the FHLBanks to transfer $2.5 billion in retained
earnings to REFCorp to help pay for the cost of thrift resolutions
and make a $300 million annual payment toward interest on the REFCorp
bonds until the last bond matures in the year 2030. 

\20 Statement of Bruce Morrison, Chairman of the Federal Housing
Finance Board before the Subcommittee on Financial Institutions and
Regulatory Relief of the Committee on Banking, Housing, and Urban
Affairs, U.S.  Senate, September 24, 1997. 

\21 The law requires System members to have at least 10 percent of
their total assets in residential mortgage loans.  Previously,
residential mortgages, which a member would use for collateral on
advances, were defined as mortgages on residences whose value was at
least 50 percent of the appraised value of the whole property.  The
change, which applies only to institutions with average total assets
of $500 million or less, eliminated the 50 percent requirement and
requires the residence to be an "integral part" of the property. 
According to FHFB, this change essentially eliminates the 50 percent
test for business and farm property. 

   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:7

As agreed with our requester, the objectives of this report are to
evaluate (1) FHFB's annual safety and soundness and
mission-compliance examinations of the FHLBanks, (2) other aspects of
FHFB's oversight, and (3) the status of FHFB's involvement in System
business. 

To evaluate FHFB's annual safety and soundness and mission-compliance
review, we reviewed FHFB's examination program, including compliance
with its policies and procedures.  We reviewed FHFB's 1995 draft
examination manual that was to be used during 1996 and 1997
examinations.  We also reviewed its 1997 manual.  We compared the
topics covered by the draft and final manuals with those of other
banking and GSE regulators, such as the Federal Reserve, OTS, Office
of Federal Housing Enterprise Oversight (OFHEO), and the Farm Credit
Administration.  After determining that the topics to be reviewed by
FHFB were comparable to other regulators, we compared FHFB's
practices with its policies and procedures.  However, we did not
assess the depth or adequacy of FHFB's guidance. 

We analyzed what the FHFB examiners did compared with FHFB's
requirements along with standards stated in our previous reports,
including standards related to management and board oversight,
internal controls, and internal audits.  Several of our studies on
the regulation of banks, thrifts, and credit unions discussed the
importance of appropriate standards and described typical
deficiencies.  We have stated in the past that the regulator should
review the annual independent audit and consider the results in
examining and monitoring the institution.  We have also stated in
previous work that an adequate system of internal controls is a vital
part of assessing risk management.  In addition, we stated that to
determine the effectiveness of a bank's control systems, regulators
need to assess the adequacy of control systems, specifically they
need to identify critical control procedures, test the procedures,
and evaluate the results of these tests. 

We reviewed 1996 and 1997 examination reports for the 12 FHLBanks and
OF.  In addition, we reviewed the supporting examination work papers
for 1996 and 1997 for a judgmentally selected sample of 6 of the 12
FHLBanks.  In choosing our sample, we stratified FHLBanks into three
tiers ranked according to year-end 1996 total assets to ensure that
we reviewed FHLBanks of various sizes.  The three tiers were less
than $20 billion, between $20 and $29 billion, and over $29 billion. 
We selected two FHLBanks from each tier.  In addition we reviewed the
portfolio composition of the various FHLBanks to ensure that we
included FHLBanks of various portfolio composition.  The six FHLBanks
selected comprised 60 percent of the System's year-end 1996 total
assets. 

We met with FHFB officials and examiners to discuss our findings and
observations about the examinations reviewed.  We also reviewed
FHFB's annual examination plans and Advisory Bulletins.  We
documented the scope of the sampled examinations, the nature and
extent of the problems identified, whether the identified problems
were included as findings in the examination report and the types of
findings.  We also documented the extent to which examiners included
supplemental information in the work papers, whether the work papers
had been reviewed by a supervisor, whether examination questionnaires
in the manual were completed, and whether the examiner followed the
procedures specified in the exam manual. 

To fulfill the second objective, we reviewed FHFB's monitoring and
enforcement activities.  Monitoring is an integral part of regulatory
oversight.  We reviewed existing FHFB documents, policies,
procedures, and interviewed FHFB officials and staff from OS and OP
to gain a better understanding of FHFB's monitoring activities.  We
also drew upon criteria for monitoring outlined in our previous work
on GSEs, which, among other things, states that monitoring should be
timely, focus on previously identified problems, and enable examiners
to identify potential problems.  We reviewed relevant sections of the
examination manual and other FHFB documents, including annual
reports.  We also reviewed one sample monitoring folder to determine
the information typically reviewed and monitored.  Because monthly
monitoring was suspended in May 1997, we did not expand our sample. 

To review FHFB's enforcement program, we reviewed the relevant
sections of the FHLBank Act and compared them with the statutory
authorities granted other GSE regulators, including the Farm Credit
Administration and OFHEO.  We compared FHFB's enforcement program to
our existing principles for GSE oversight.  For example, an
enforcement program should have clear policies and procedures and
specify conditions that would result in corrective actions being
taken and what those actions would be.  We reviewed FHFB's policies
and procedures, including sections of the examination manual related
to enforcement or corrective actions.  In addition, we reviewed the
examination reports and findings memos for all 12 FHLBanks and OF for
1996 and 1997 to determine what types of findings were included in
the reports of examination.  We met with various officials from OS
and Office of General Counsel to discuss FHFB's enforcement
authority.  We also reviewed periodic reports FHFB uses to track the
status of outstanding examination findings. 

To fulfill our third objective of evaluating FHFB involvement in
System business, we reviewed actions taken by FHFB to devolve
managerial functions to FHLBanks and applied our previously
articulated criteria.  We applied criteria we developed in earlier
work that a federal regulatory structure for GSEs would need to meet
to carry out its oversight responsibilities effectively.  They
include independence and objectivity, prominence in government,
economy and efficiency, separate regulation of primary and secondary
markets, and consistency in regulation.  We reviewed various FHFB
activities considering these criteria.  Specifically, we reviewed
memorandums addressing the status of FHFB's effort to devolve certain
business functions to FHLBanks, FHFB's analysis of devolution
priorities, statutory provisions requiring FHFB involvement in System
business, and FHFB regulations.  We also reviewed FHFB's 5-year
strategic plan and its 1998 annual plan.  We reviewed agendas for
meetings with FHLBank boards' chairs and vice chairs, testimonies and
speeches of Board members, and various FHFB correspondence.  In
addition, we met with FHFB and System officials. 

Our work was done in accordance with generally accepted government
auditing standards.  We did the work underlying this report between
October 1997 and July 1998, primarily at FHFB in Washington, D.C. 

We requested comments on a draft of this report from the Chairman of
FHFB.  The full text of FHFB's comments and our additional responses
are included at the end of chapters 2 and 4 and in appendix I. 

FHFB EXAMINATIONS WE REVIEWED DID
NOT FULLY ASSESS SAFETY AND
SOUNDNESS AND MISSION COMPLIANCE
============================================================ Chapter 2

We found several weaknesses that could limit the effectiveness of
FHFB's examinations, particularly as it contemplates expanding the
activities in which the FHLBanks may engage.  While the examination
manual is FHFB's primary source of examination policy and guidance,
examiners routinely did not follow its procedures during
examinations.  Examiners did not always fully assess critical
elements of bank operations, such as internal controls, that the FHFB
examination manual, other financial industry regulators, and we have
identified as vital to evaluate risk management.  The planned scope
of examinations was reduced and examination procedures were often not
completed due to time constraints.  We also found examples where the
scope was not expanded when examiners found potentially significant
deficiencies in bank operations.  FHFB staff said limited examination
staff resources often accounted for these conditions.  FHFB has had a
statutory obligation to ensure that FHLBanks carry out their mission
to support housing finance since 1989.  Since 1997, it has taken
several steps to try to develop policies and procedures to assess
mission compliance. 

   FHFB PROCEDURES FOR ON-SITE
   SAFETY AND SOUNDNESS
   EXAMINATIONS OF THE FHLBANKS
---------------------------------------------------------- Chapter 2:1

According to FHFB's examination manual, FHFB's examination process is
to include an annual on-site examination and off-site monitoring
performed by FHFB's OS.  In 1996 and 1997, each FHLBank examination
was allotted 120 staff days and lasted about 4 weeks.  OS develops an
annual plan for examinations each year that details planned
examinations and issues to be reviewed at FHLBanks.  FHFB's off-site
monitoring activities are discussed in detail in chapter 3. 

According to FHFB's examination manual, FHFB conducts three types of
examinations:  regular examinations, follow-up examinations, and
special examinations.  Regular examinations are scheduled in the
annual plan and may include any aspect of bank operations but
generally include credit operations, financial operations, operating
performance, compliance issues, and housing finance mission. 
Follow-up examinations are designed to resolve important outstanding
issues or to review the progress and sufficiency of corrective
actions taken.  The scope of follow-up examinations is limited to the
unresolved issues or actions taken by a FHLBank under the direction
of FHFB.  Special examinations are to be conducted at the request of
the Board.  The scope of these examinations is usually to be limited
to one issue or a narrow range of issues.  In the last 2 years, FHFB
has conducted each type of examination.  In 1996 and 1997, FHFB has
also conducted preimplementation examinations prior to the initiation
of pilot programs. 

      THE EXAMINATION MANUAL
      CONTAINS EXAMINATION
      PROGRAMS FOR ALL EXAMINATION
      AREAS AND QUESTIONNAIRES FOR
      MOST
-------------------------------------------------------- Chapter 2:1.1

The FHFB examination manual describes FHFB's process for examining
the FHLBanks.  According to the manual, its purpose is to document
examination objectives and procedures in order to provide guidance to
examiners, FHLBanks, OF, and the Financing Corporation, and to
promote an effective and efficient examination process.  The manual
states that it is intended to provide a framework for the examination
process.  Examiners are to assess an institution's operations and
financial condition for safety and soundness and compliance with
applicable statutes, regulations, and policies.  Examiners are to
report their findings regarding the sufficiency of control and
compliance with law.  Where needed, examiners are to direct that
corrective actions be taken.  The manual states that the examination
process should identify existing weaknesses and cases of apparent
noncompliance as well as potential problems and emerging issues.  The
manual states that examiners may recommend practical steps to correct
such deficiencies. 

The FHFB examination manual existed in draft form until April 8,
1998, but has been FHFB's primary source of examination guidance
since 1994.  The examination manual currently contains 29 examination
programs covering different aspects of the FHLBanks' operations, such
as internal control, collateral operations, and payment systems and
funds transfer operations.  For our review of 12 FHLBank
examinations, we relied primarily on versions of the manual, compiled
in 1995 and in 1997, that contained 31 programs.  FHFB officials said
this would be appropriate for our review and that FHFB examiners are
expected to follow the examination manual when doing examinations. 
The two programs that were dropped in the final version of the
manual, AHP and equal employment opportunity, are currently under
revision and are to be added to the manual later. 

The manual presents the examination programs in eight broad
categories that include management, bank operations, financial
management, community investment operations, compliance programs, OF
and the Financing Corporation, asset review, and electronic data
processing.  In addition to an examination program, which includes
the objectives and procedures for specific parts of FHFB
examinations, there are also examination questionnaires, surveys, or
worksheets (questionnaires) that accompany 16 of the 31 examination
programs.  Examination procedures contained in the manual instruct
examiners to complete the questionnaires in areas where they are
included. 

      EXAMINERS ARE TO DETERMINE
      EXAMINATION SCOPE PRIOR TO
      COMMENCING THE EXAMINATION
-------------------------------------------------------- Chapter 2:1.2

The scope of each examination is to be based on the annual
examination plan and the preexamination analysis done by examiners
before starting an examination.  Examinations are defined according
to several scope categories.  At a minimum, all of the FHLBanks are
to be subject to a limited scope examination each year.  For regular
examinations, this is generally to entail an off-site review, which
may be combined with an on-site review of one or two risk factors or
compliance issues.  Most FHFB examinations have been moderate scope
examinations.  These examinations are to consist of an on-site review
of several risk factors or compliance issues.  OS may also perform
comprehensive scope examinations, which may be requested by the Board
and may entail an on-site examination of virtually all risk and
compliance factors.  Special examinations may be done as
comprehensive scope examinations.  FHFB did not conduct any
comprehensive examinations during the period covered by our review. 

Examination procedures are divided into two tiers.  Tier 1 procedures
represent the minimum review required to assess the adequacy of
control and compliance systems in any given area of bank operations. 
Tier 1 procedures are to focus on review of internal control, audit
reports, policies, and management compliance systems.  Tier 2
procedures are to involve more in depth reviews, and include testing
of management representations, procedures, and calculations or
transactions.  According to the examination manual, most reviews are
a combination of Tier 1 and 2 procedures. 

During the course of an examination, conditions at a FHLBank may
convince examiners that the scope of an examination should be
altered.  Guidance in the FHFB examination manual states that to
amend the examination scope, the examiner-in-charge should contact
his or her supervisor to explain why the scope must be amended,
obtain concurrence for amending the scope, and write a memo to the
supervisor documenting the amended scope that is to be included in
the examination work papers. 

      EXAMINERS ARE TO FORMULATE
      CONCLUSIONS AND PRESENT
      THEIR FINDINGS TO FHLBANK
      MANAGEMENT
-------------------------------------------------------- Chapter 2:1.3

Upon completing an examination, examiners are to develop their
findings and present those that cause supervisory concern to FHLBank
management in the form of findings memos.  Findings are categorized
according to the nature and seriousness of the issues presented in
the finding.  The categories include referral, recommendation,
compliance matter, weakness, and violation.  An additional unsafe and
unsound category is used when intensive oversight and immediate
corrective action is considered warranted.  See table 2.1 for a
description of each category. 

                               Table 2.1
                
                  FHFB Report of Examination Findings
                               Categories

Findings
Category      Description
------------  --------------------------------------------------------
Referral      A novel or unsettled legal or policy issue requiring
              guidance from or development by other FHFB staff.

Recommendati  A practice or control that should be improved to meet
on            best banking practices

Compliance    Compliance matter not warranting treatment as a
matter        violation. Examples: noncompliance with FHLBank internal
              policy, technical compliance matter resolved during or
              prior to the examination.

Weakness\a    A deficient practice that may cause losses or a lack of
              sufficient internal control to ensure that deficient
              practices or violations will be timely detected.

Violation\a   A violation of statute, regulations, or FHFB policy.

Unsafe and    Practice or control deficiencies, or patterns of
unsound       deficiencies in practices, or control that threaten or
practice or   have caused substantial losses or impairment of capital.
condition\b
----------------------------------------------------------------------
\a Finding category that requires corrective action. 

\b Finding category that requires immediate corrective action. 

Source:  FHFB Examination Manual. 

FHLBank management is to be provided with the opportunity to respond
to preliminary examination findings prior to completing the Report of
Examination and presenting it to a FHLBank's board of directors. 

      OS OFFICIALS SAID THAT
      LIMITED EXAMINATION
      RESOURCES HAVE AFFECTED
      EXAMINATIONS
-------------------------------------------------------- Chapter 2:1.4

During the period covered by our review, OS employed 8 to 10
examiners who were responsible for completing the 14 required annual
examinations of FHLBanks, OF, and the Financing Corporation as well
as special, follow-up, and preimplementation examinations.  The
examiners were also responsible for other projects and activities,
such as monitoring the FHLBanks between examinations, developing
Advisory Bulletins for the FHLBanks, and revising the examination
manual.  In addition to the eight regular examiners, most of whom had
some experience with other regulatory agencies, OS employed one
special examiner for affordable housing and one for electronic data
processing examinations.  However, OS officials said that they have
had difficulty retaining qualified examiners, particularly for
electronic data-processing examinations. 

During the period of our review, OS hired both affordable housing and
electronic data processing examiners but also lost two senior
examiners and one junior examiner.  OS officials said that staffing
constraints have hindered some of their supervisory oversight areas
and that they have plans to hire additional examiners in the near
future to be better able to handle their examination workload. 
However, as discussed later, staff retention remains a problem. 

   REVIEW OF EXAMINATIONS REVEALED
   THAT EXAMINERS OFTEN DID NOT
   FOLLOW GUIDANCE PROVIDED IN
   EXAMINATION MANUAL
---------------------------------------------------------- Chapter 2:2

In each of the examinations reviewed, we found that examiners often
did not comply with examination procedures described in FHFB's
examination manual.  In most examination areas, we could not
determine what procedures had been completed because the supporting
examination work papers did not document what had been done. 
Examiners generally did not follow examination procedures in the
examination manual nor did they complete the questionnaires designed
to assist examiners in certain areas.  In some instances, examiners
documented examination procedures in a format other than that
contained in the manual. 

      EXAMINERS GENERALLY DID NOT
      COMPLETE EXAMINATION
      QUESTIONNAIRES
-------------------------------------------------------- Chapter 2:2.1

The examinations we reviewed included an average of 11 areas for
which there were questionnaires that examiners were expected to
complete.  We found that examiners usually did not complete them. 
For example, examiners completed 3 or fewer questionnaires in 10 of
the examinations reviewed, including 2 examinations in which
examiners did not complete any questionnaires.  In the remaining two
examinations, examiners completed four questionnaires.  According to
an OS official, examiners often do not complete the questionnaires
because they view them as being unnecessary documentation. 

      EXAMINERS GENERALLY DID NOT
      DOCUMENT EXAMINATION
      PROCEDURES
-------------------------------------------------------- Chapter 2:2.2

In the 12 examinations we reviewed, we found that examiners often did
not document their examination procedures.  The examination manual
states that work papers are to document the planning and execution of
an examination and support and document the basis for the findings
reached.  We found that when examiners documented their examination
procedures, they generally documented them in any of three ways; (1)
they used the pages listing examination procedures from the
examination manual (an average of 3 times per examination), (2) they
used formats other than those that appear in the examination manual
(an average of 3 times per examination), and (3) they used the
examination questionnaires discussed previously (an average of 2
times per examination).  Some examination procedures were documented
through a combination of these techniques. 

While each of the 12 examinations we reviewed covered an average of
24 examination programs, we found that an average of only 7 programs
were documented using one or more of the three techniques.  Because
examination procedures were not documented for over two- thirds of
examination programs, we could not determine with certainty what
procedures were completed or how thoroughly some areas were reviewed. 
This sometimes resulted in inadequate documentation of conclusions
drawn in the examination. 

      FHFB EXAMINERS SAID THEY DID
      NOT FOLLOW MANUAL PROCEDURES
      BECAUSE OF TIME CONSTRAINTS
      AND QUESTIONS ABOUT THE
      USEFULNESS OF THE MANUAL
-------------------------------------------------------- Chapter 2:2.3

FHFB examination staff said that they often did not follow the
procedures in the examination manual or complete the questionnaires
because they did not have time to complete the procedures described
in the manual.  Also, they said that in their opinions, the
procedures were not often useful for certain parts of the
examination.  They explained that documentation of examination
procedures and conclusions is often not completed because of staffing
constraints.  FHFB officials said that they expected that the manual
would become more useful to examiners as it is revised over time and
that they hope to hire additional examiners to help carry out the
workload.  However, the staff turnover discussed earlier in this
chapter makes the documentation of examination procedures and
conclusions all the more important to provide an audit trail and
avoid the loss of institutional memory. 

   EXAMINERS DID NOT ALWAYS FULLY
   ASSESS CRITICAL ELEMENTS OF
   FHLBANK OPERATIONS IN
   EXAMINATIONS WE REVIEWED
---------------------------------------------------------- Chapter 2:3

Although all of the examinations we reviewed included reviews of
FHLBank policies and procedures to mitigate interest rate and credit
risk, examiners did not always fully assess critical elements of
FHLBank operations that the examination manual, other financial
industry regulators, and that we have identified as vital to evaluate
risk management and that should be reviewed as part of every annual
examination.  These elements include internal controls, board of
director oversight, management oversight, and the internal audit
function.  OS officials explained that they currently do not have
adequate staff resources to fully evaluate a FHLBank's system of
internal controls; and therefore, they provide only a limited
assurance of the adequacy of the internal control system upon the
completion of an examination.  The officials explained that they
often do not formally examine the other areas we identified because
of time and staff resource constraints and the stability of the
management and auditing functions of the FHLBanks. 

      FHFB EXAMINERS DID LIMITED
      REVIEWS OF FHLBANK INTERNAL
      CONTROLS
-------------------------------------------------------- Chapter 2:3.1

During our review of 12 examination reports and their supporting work
papers for the 6 FHLBanks sampled, we found that examiners generally
did limited reviews of internal controls.  As we have stated in
earlier work, internal controls promote safety and soundness by
preventing errors and irregularities from occurring, or by
identifying them early enough for management to take corrective
action before the bank's financial condition is significantly
damaged.  Reviewing internal controls during an examination is
important because internal controls affect all major operational
areas of banks.  Periodic comprehensive evaluations of internal
controls, including identification of significant controls and review
of individual transactions and records to determine whether controls
are functioning properly, help ensure that adequate systems are in
place to enable banks to operate safely and soundly.\1

Examiners did not perform comprehensive reviews of internal control
systems at any FHLBanks reviewed in 1996 or 1997.  Rather, examiners
generally reviewed internal controls of selected areas of FHLBank
operations, such as asset/liability management and wire transfers. 
We did not find evidence that examiners completed the internal
controls procedures in the manual or questionnaires for any of the
examinations we reviewed. 

FHFB's assessment of the FHLBanks' internal controls is found only in
the standardized language in the final reports of examination rather
than in sections of the reports that describe each FHLBank's internal
control system and the extent of examiners' review.  In September
1996, FHFB began describing its review of internal controls in the
report of examination by noting that examiners did a "limited"
review.  FHFB officials explained that this caveat was added because
they do not do the type of review to merit an affirmative endorsement
of a FHLBank's system of internal controls, and they changed the
language in the report of examination to more accurately reflect the
type of review OS examiners did.  FHFB officials estimated that to do
the work required to issue a definitive opinion of the FHLBank's
internal controls would require that the entire FHFB examination
staff work in a single FHLBank for 6 months. 

FHFB officials explained that to compensate for their limited
internal control assessments, they rely heavily on the work of
FHLBank internal auditors.  However, as we discuss later in this
chapter, FHFB examiners generally do not assess the quality of the
internal audit function before relying on the work.  We also found no
evidence that examiners verified the internal control testing done by
internal auditors or that examiners routinely tracked weaknesses
identified by internal audit. 

Because internal controls promote safety and soundness by preventing
errors and irregularities from occurring, it is important that they
operate effectively.  FHFB examiners cannot verify, based on their
reviews, that internal controls are operating effectively in FHLBanks
and, therefore, that errors and irregularities are not occurring. 

--------------------
\1 Bank Examination Quality:  FDIC Examinations Do Not Fully Assess
Bank Safety and Soundness (GAO/AFMD-93-12, Feb.  16, 1993). 

      EXAMINERS OFTEN DID NOT
      ROUTINELY ASSESS FHLBANKS'
      INTERNAL AUDIT FUNCTION
-------------------------------------------------------- Chapter 2:3.2

During our review of the 12 examinations, we found that FHFB
examiners did not routinely assess the internal audit function at the
FHLBanks.  The FHFB examination manual states that the examiner's
review and evaluation of the internal audit function is a key element
in determining the scope of the examination.  The manual states that,
based on the evaluation of relevant factors, the examiner should
assess whether the work performed by the internal auditors is
acceptable.  According to the manual, there are three main objectives
of the internal audit function:  (1) the detection of financial
irregularities; (2) the determination of compliance with a FHLBank's
policies and procedures; and (3) the appraisal of the soundness and
adequacy of accounting, operating, and administrative controls to
ensure that those controls provide for the prompt and accurate
recording of transactions and the proper safeguarding of assets.  The
manual states that examiners should consider several factors in
reviewing and evaluating FHLBank internal audit functions.  Principal
among these factors are the competence and independence of the
internal auditors and the adequacy and effectiveness of the audit
program. 

Although FHFB examiners rely heavily on the work of FHLBank internal
auditors for their internal control assessments, we found that
examiners evaluated the auditor's competence, independence, and audit
program adequacy for only 2 of 12 examinations we reviewed.  In both
cases, a new internal auditor had been hired since the last
examination.  However, the examination procedures performed were not
documented in a format found in the examination manual for either of
the examinations.  FHFB officials said that they generally do not do
a full assessment of the internal audit function unless there has
been a major change in some aspect of a FHLBank's audit function,
such as hiring a new internal auditor.  Generally, they said if there
has not been a change of the internal auditor, FHFB examiners assume
that the internal audit function is reliable. 

In four other examinations, we found that examiners evaluated only
the independence of the internal auditor.  FHFB Advisory Bulletin
96-1, issued on February 29, 1996, emphasized the importance of
maintaining the independence of the internal auditor and alerted the
FHLBanks that compliance with FHFB policy guidelines regarding
internal auditor independence would be included in the scope of all
examinations conducted in 1996.  FHFB did three of the four
assessments of internal auditor independence in 1996.  We did not
find a completed Internal Audit Questionnaire or an examination
program documenting examination steps for any of the examinations we
reviewed. 

The internal audit function is to detect financial irregularities and
inaccuracies in financial reporting; determine compliance with laws,
regulations, and FHFB and FHLBank policies and procedures; and
appraise the adequacy of internal controls.  Because FHFB examiners
did not routinely review the audit function at FHLBanks we reviewed,
they could not be certain that it was operating as it should and
serving the purpose for which it is intended. 

      EXAMINERS DID NOT REVIEW
      BOARD OF DIRECTOR OR
      MANAGEMENT OVERSIGHT
-------------------------------------------------------- Chapter 2:3.3

We did not find documentation indicating that FHFB examiners had
completely reviewed board of director or management oversight of
overall FHLBank operations during any of the 12 examinations we
reviewed.  Board of director and management oversight are the
essential elements of corporate governance of financial institutions. 
The FHFB examination manual states that the board of directors'
collective responsibility is to ensure that the FHLBank operates in a
financially safe and sound manner, that it is in compliance with law
and policy, and that it supports housing finance and community
investment.  The manual states that management oversight is also
important and that a major examination objective is the review of
FHLBank management quality and effectiveness.  The success of
operations depends on the skill, abilities, and effectiveness of
management.  Operational weaknesses are often traceable to
ineffective management. 

Principles of risk management that have been developed by various
financial industry and regulatory bodies stress the importance of
board of director and management involvement in managing the risks
undertaken by financial institutions.\2 Under these principles, an
organization's risk management strategy is to be based on a framework
of responsibilities and functions driven by the board of directors
down to operating levels, which cover all aspects of risk.  The basis
for this principle is the belief that unless the board of directors
is fully integrated in the risk management approach, the
organization's managers and employees will not be fully committed to
risk management.  To emphasize the importance of risk management, the
principles state that a risk management group composed of senior
managers is to be created.  FHFB officials stated that their
examinations are focused on risk management. 

While reviewing examination work papers, we did not find a completed
board of director oversight or management oversight questionnaire or
examination program in any of the 12 examinations.  Further, with the
exception of one examination, we did not see board of director or
management oversight explicitly discussed in any of the
preexamination analysis, scope, assignment, or findings memos or the
Report of Examination.  In the one exception, a management oversight
issue was discussed in a findings memo and in the report of
examination, but there was little additional evidence in the work
papers explaining how the area was reviewed. 

One element of FHFB's review of board of director and management
oversight is an assessment of the extent to which the FHLBank board
and management are responsive to examination findings, which were
raised during the prior year's examination and presented to the
FHLBank board and management.  OS is also required to monitor FHLBank
responses to supervisory determinations (examination findings) as
part of the FHFB's Disputed Supervisory Determinations process, which
is discussed in chapter 3.  In 6 of the examinations, we saw evidence
to indicate that examiners had reviewed board of director
responsiveness to examination findings while we found evidence that
they assessed management's responsiveness to examination findings in
each of the 12 examinations. 

FHFB officials said that they did not approach board of director and
management oversight in a top-down manner.  Instead, they said that
in cases where they identify problems in a FHLBank's operations, they
would determine how board of director or management oversight may
have contributed to the problem.  However, they generally do not
review board of director or management oversight during an
examination unless a specific problem is uncovered that they believe
warrants a review or if there have been significant changes in those
areas since the last examination. 

Board of director and management oversight are the primary factors in
the management and operating strategy of FHLBanks.  In omitting
complete reviews of these two areas, FHFB examiners risk missing the
opportunity to uncover, in a timely manner, the sources of certain
operational weaknesses, which may or may not have manifested
themselves in other aspects of FHLBank's operations. 

--------------------
\2 Principles of risk management have been developed by various
industry and regulatory bodies, including the Bank for International
Settlements, the International Organization of Securities
Commissions, Derivatives Policy Group, U.S.  bank regulators, and a
group assembled by Coopers & Lybrand.  All of the risk management
principles are broadly similar.  The principles listed in the text
are from Coopers & Lybrand, termed generally accepted risk principles
or GARP. 

   EXAMINATIONS WE REVIEWED WERE
   OFTEN CURTAILED DUE TO TIME OR
   OTHER UNKNOWN CONSTRAINTS AND
   NOT EXPANDED WHEN POTENTIALLY
   SERIOUS PROBLEMS WERE FOUND
---------------------------------------------------------- Chapter 2:4

In our review of the 12 examinations, we found that the planned
examination scope or procedures were sometimes reduced due to time
constraints or for reasons other than conditions identified at the
FHLBank, while in other cases we found that the scope was not
expanded when potentially serious problems were uncovered.  In two
examinations, we found that the planned examination scope was
curtailed without explanation in the work papers.  We also found that
examiners failed to complete some planned examination procedures
because of time constraints in 11 of the 12 examinations we reviewed. 

      EXAMINERS CURTAILED THE
      EXAMINATION SCOPE IN TWO
      EXAMINATIONS WITHOUT
      EXPLANATION
-------------------------------------------------------- Chapter 2:4.1

In 2 of the 12 examinations we reviewed, we found that examiners did
not complete the planned scope.  The examination manual indicates
that preexamination planning is important and provides an important
control on the examination scope.  The manual indicates that the
scope of the examination is to be amended in response to conditions
at the FHLBank.  Reducing the planned examination scope for reasons
other than the condition at a FHLBank is inconsistent with the
guidance in the examination manual.  Guidance in the FHFB examination
manual also states that to amend the examination scope, the
examiner-in-charge should contact his or her supervisor to explain
why the scope must be amended, obtain concurrence for amending the
scope, and write a memo to the supervisor documenting the amended
scope that is to be included in the examination work papers. 

In both of these cases the examination work papers contained no
explanation of why the areas originally included in the examination
scope had been eliminated.  OS officials said that limited
examination staff resources often require that the planned scope of
examinations be curtailed.  In these instances, OS officials stated
that examiners delete from the scope parts of the examination that
they believe involve less risk.  In the two cases where the scope was
reduced without explanation, the deleted areas included the CIP,
advances, and member applications.  The FHLBanks' CIP are a major
element of their compliance with their housing finance mission which,
as we discuss later in this chapter, is an area in which FHFB is
still working to develop examination policies and procedures. 
Therefore, in light of the importance of the areas that were dropped
from the scope of the examinations, and because it is required by the
examination manual, it would have been appropriate for examiners to
have provided an explanation for deleting these areas from the
planned scope. 

      EXAMINERS FOUND POTENTIALLY
      SERIOUS INTERNAL CONTROL
      PROBLEMS IN CONSECUTIVE
      EXAMINATIONS OF A FHLBANK
      BUT DID NOT EXPAND THE SCOPE
      TO LOOK FOR ADDITIONAL
      PROBLEMS
-------------------------------------------------------- Chapter 2:4.2

Examiners found potentially serious internal control problems during
consecutive annual examinations of a FHLBank but did not expand the
scope of either examination to determine whether additional problems
resulted from those control deficiencies.  As described earlier, the
FHFB examination manual allows for the expansion of examination scope
where conditions at a FHLBank indicate the need for enhanced review. 

Both of the cases we identified involved an inadequate segregation of
duties in the FHLBank's investment activities.  A major internal
control procedure within financial institutions is to segregate
certain duties which, if done by the same person, could allow that
person to perpetrate irregularities within the institution and to
prevent their discovery by others.  Inadequate segregation of duties
is an internal control problem that has allowed large losses to occur
at other financial institutions for an extended period of time
without detection. 

During a 1996 examination, examiners found that traders had the
ability to process transactions and make changes to a counterparty's
creditworthiness rating.  They recommended in this case that
management separate these two functions by restricting trader access
levels on the unsecured credit system to reduce the risk of a trader
engaging in unauthorized transactions.  During the same examination,
examiners noted that broker confirmation tickets for certain
transactions were sent directly to the division responsible for
conducting the trades rather than to the accounting division. 
Examiners recommended that management ensure that all broker
confirmation tickets be sent to the accounting division to reduce the
risk of a trader engaging in unauthorized transactions.  The finding
memorandum describing this situation stated that examiner concern
over this issue was mitigated by the fact that the tickets were sent
to the traders' supervisor rather than directly to traders. 

During the 1997 examination of the same bank, an examiner noted that
so called "front and back office" operations were not sufficiently
segregated in the investments area.  Staff with trading functions
(front office) were permitted to perform accounting functions (back
office) in which they accounted for the market values of investments
and off-balance sheet items.  The examiner noted in the findings memo
that if a significant difference were to arise between a securities
dealer's valuation and the FHLBank's valuation, it might not come to
the management's attention and that the reasons for any significant
discrepancies might not be discovered if one individual is
responsible for both duties.  This was presented in the report of
examination as a weakness that should be corrected. 

Examiners did not expand the scope of either the 1996 or 1997
examination to determine whether the inadequate segregation of duties
had resulted in damage to the FHLBank in the form of unauthorized
transactions or inaccurate accounting data.  In the first of the two
cases, examiners presented the problem they had identified as a
recommendation in the Report of Examination that the FHLBank correct
the situation by strengthening internal controls.  As indicated in
table 2.1, a recommendation does not require that the FHLBank correct
problems identified by FHFB examiners.  In the other case, the
problem was presented as a weakness, which is a category requiring
mandatory corrective action. 

An OS official said that OS did not expand the scope of the
examinations in these instances to identify whether any
irregularities had occurred because it believed that any problems
would have been uncovered once the duties were segregated.  The
official also said that OS was not concerned that the problems had
occurred at the same FHLBank in consecutive examinations because the
FHLBank in question had traditionally been managed in a conservative
manner.  However, because examiners did not expand their review
during either of these examinations, they could not be certain that
other problems, such as undetected transactions or losses, had not
occurred. 

   FHFB IS IN THE PROCESS OF
   DEVELOPING MISSION COMPLIANCE
   EXAMINATION PROGRAM
---------------------------------------------------------- Chapter 2:5

Although FHFB was established in 1989, FHFB has not developed
policies and procedures to ensure that FHLBanks fulfill their
statutory mission.  To ensure mission compliance, FHFB must have (1)
a clearly defined mission, (2) well defined policies that delineate
what constitutes mission compliance, and (3) methods to measure
whether or not FHLBanks have fulfilled their mission.  Without that
type of structure, it is difficult to systematically ensure mission
compliance.  FHFB appears to have recognized the shortcomings in its
existing structure and has taken several steps to develop a framework
to ensure mission compliance. 

Specifically, since 1997, FHFB has taken a number of actions to help
ensure mission achievement.  First, OS added a new
mission-achievement reporting requirement.  Second, OS tested
examination procedures aimed at mission achievement oversight. 
Third, FHFB requested public input on mission achievement and
measurement through an advance proposed rulemaking.  Fourth, FHFB
amended regulations for FHLBank member community support requirements
and related FHFB monitoring activities to ensure compliance.  Fifth,
FHFB commissioned a study to, among other things, address how to
measure and monitor the System's mission objectives.  Finally, FHFB
has been involved in reviewing System nonmission-related investments
and considering whether regulations are needed to limit the FHLBanks'
investment portfolios.  FHFB has also encouraged alternative
activities to increase mission-related investments. 

Although FHFB has not developed examination procedures to assess nor
ensure FHLBanks' compliance with the System's housing finance
mission, examiners have traditionally reviewed some of the FHLBanks'
activities to assess their consistency with specific regulations
during the annual examination.  These programs account for less than
1 percent of the System's total assets.  Also in 1997, FHFB required
that FHLBanks annually submit reports that describe new products,
pricing, and partnerships.  These reports are reviewed by OS during
the annual examination, but examiners did not independently assess
FHLBanks' overall mission compliance in the examination report. 
Instead examiners summarized FHLBanks' mission compliance reports. 

FHFB also had begun to develop and test examination procedures that
would be used during the annual examination to assess FHLBanks'
compliance with mission.  For example, draft procedures include
evaluating FHLBank policies, existing and new products, and pricing
to determine whether they are consistent with the System's housing
finance mission.  Draft procedures also include reviews of a
FHLBank's degree of market penetration and its marketing plans and
tools to create awareness of its credit products.  However, these
procedures were not final as of July 1, 1998, nor have they been
incorporated into the FHFB examination manual. 

In April 1997, FHFB issued an advance notice of proposed rulemaking
in the Federal Register to request public comment on ways the
FHLBanks can further achieve their mission and ways the FHFB, as
regulator, could measure and ensure that FHLBanks achieve their
mission.  According to the notice, FHFB believes the System's
mission--to support and promote housing finance and community
investment--is clear.  The notice also requests comments on whether
FHFB should define and measure mission fulfillment for FHLBanks
through a regulation.  In addition, it inquired about ways to measure
mission achievement and how to relay that information to the public. 
As of July 1, 1998, no additional action had been taken on this
matter. 

In May 1997, FHFB amended its regulation on community support that
establishes community support standards that FHLBank members must
meet to maintain access to long-term FHLBank advances.  The rule
restates statutory criteria that FHFB would apply in evaluating a
member's community support performance.  The criteria includes a
Community Reinvestment Act performance (based on its rating) and its
lending record to first-time home buyers.  The rule further specifies
the FHFB's monitoring process, which includes selecting approximately
one-eighth of the members in each FHLBank district for community
support review each calendar quarter.  Those members selected for the
community support review are required to submit a community support
statement to FHFB, which must act on the report within 75 calendar
days once the statement is deemed complete.  FHFB is required by
statute to notify a member and the appropriate FHLBank in writing of
its determination regarding the member's statement.  The rule also
states the conditions in which it would restrict a member's access to
long-term advances. 

In July 1997, FHFB commissioned a study to, among other things,
assist it in developing procedures to oversee FHLBank mission
compliance.  Specifically, the study was to address "methodologies to
measure performance against mission." FHFB officials said that the
study results are expected to be incorporated into examination
procedures for mission compliance.  FHFB's 1998 annual performance
plan included an objective to develop "a system for ensuring
achievement of mission." Before the end of fiscal year 1999, FHFB
expects to recommend a methodology for evaluating the extent to which
FHLBanks' assets support mission achievement and a process for
monitoring mission achievement on an ongoing basis.  As of July 1,
1998, the study had not been completed. 

Finally, during 1998, FHFB engaged in an ongoing review of the
System's investment practices and whether the System should be
required to dedicate a greater portion of its assets to
mission-related investments.  Treasury has expressed concerns about
the System's investment portfolio and a lack of its relationship to
the GSE's public purpose.  As noted in a Treasury letter dated July
27, 1998, "The System uses this portfolio to conduct extensive
arbitrage--issuing debt securities at close to the Treasury rate and
investing the proceeds in other, higher yielding securities."\3

Treasury added that most of the System's investments do nothing to
support residential mortgage lending or otherwise advance the
System's public purpose.  At year-end 1997, Systemwide investments
were almost 40 percent of total assets; individually, the percentage
ranged from a low of 17 percent to a high of 58 percent.  The FHFB
review included development of a staff paper prepared by OP and a
public hearing in which participants were asked to consider the
System's investment practices and an approach for limiting certain
nonmission related investments.  As of July 1, 1998, FHFB's review
was continuing and had not resulted in any concrete proposals.  Also
as part of FHFB's concerns about the level of nonmission-related
investments, FHFB has encouraged pilot programs as a means to test
alternative investment activities.  According to FHFB's policy
governing the approval process, among others, FHFB is to consider
mission fulfillment as one of the criteria. 

--------------------
\3 Robert Rubin, Department of Treasury letter to Alfonse M. 
D'Amato, Chairman, Committee on Banking, Housing, and Urdan Affairs,
U.S.  Senate (July 27, 1998). 

   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 2:6

FHFB had four primary comments about our findings on its safety and
soundness and mission-compliance examinations.  First, FHFB said that
we failed to evaluate FHFB's examination program in the proper
context given the stringent regulations, policies, and financial
conditions that exists.  We believe the FHFB's program should be
evaluated in this context.  In chapter 1 of the draft and final
reports, we discuss the current financial condition of the System,
the types of risks it faces, and how it manages these risks.  We also
reviewed the statutes and regulations with which FHLBanks are
required to comply that affect these risks.  We believe that regular,
comprehensive on-site examinations are the cornerstone of any
financial institution regulator's oversight program.  Without such
periodic reviews of operations, a regulator cannot be assured that an
institution has proper controls in place; is complying with laws,
regulations, and policies; or that its board and management are
effectively managing risks and complying with safety and soundness
requirements.  In addition, conditions can change and we believe
changes to the mission of the System, and the environment within
which FHLBanks operate, require FHFB to properly monitor FHLBanks and
take any steps necessary to ensure they continue to operate in a safe
and sound manner. 

Second, FHFB said that we did not consider the extent to which
examination findings addressed critical areas, most notably internal
controls.  We agree that many of the examination reports included
findings on internal control problems.  Our concern, however, is that
FHFB's review of internal controls at the FHLBanks was limited to
problems in areas that were routinely reviewed such as AHP, wire
transfers, and financial operations.  There was no overall assessment
of the internal control systems of the FHLBanks.  FHFB provided an
analysis in its comment letter that indicated that 61 percent of its
examination findings addressed internal control problems, which
indicated to us that a broader review of overall control systems may
be warranted. 

Third, FHFB said we did not consider that these areas in which the
examination scope was curtailed were relatively low-risk and that
identified internal control problems did not merit an expansion of
examination scope even though they recurred over time at the same
FHLBank.  Our concern that examination scope was curtailed is rooted
in FHFB's own standards.  Examination scope is determined through OS'
preexamination analysis of each FHLBank and, according to FHFB's
policy, the examiner-in-charge is to provide a written explanation
subject to supervisory approval for any subsequent change in the
planned scope. 

We found the scope was curtailed in 2 of the 12 examinations
reviewed, and examiners provided no explanation for the change in the
work papers.  Moreover, when we discussed these findings with OS
officials, they said that limited staff resources and time
constraints, in addition to the relative risk of the activities
involved, sometimes required curtailing the planned examination
scope.  We believe that the two internal control problems examiners
identified indicated a need to expand the scope of those
examinations.  Both of the cases involved an inadequate segregation
of duties in consecutive annual examinations at the same FHLBank. 
Although the issues involved violations of fundamental principles of
internal controls, FHFB felt that no additional review of the
FHLBank's system of internal controls was warranted. 

Finally, FHFB said that we had inappropriately based our conclusion
about whether FHFB was ensuring mission compliance on the fact that
it lacked policies and procedures.  It said that its statutory duty
is to work actively with the FHLBanks to ensure the housing finance
mission is carried out.  (We discuss this concern further in chapter
4.) While we considered whether FHFB had policies and procedures to
ensure mission compliance, we did not limit our review to that alone. 
At the onset of this review, FHFB officials told us that they did not
have a program in place to measure mission compliance but had begun
to actively remedy that situation.  In this chapter, we discuss
numerous mission-related actions taken by FHFB.  In addition, we note
that FHFB's strategic plan indicates it is in the process of
establishing its mission oversight program.  One objective in FHFB's
strategic plan is to establish "a system for ensuring mission
compliance." As a result, we make no conclusions about whether or not
FHFB is meeting its statutory duty.  We recognize the difficulty in
developing a mission oversight mechanism and acknowledge steps FHFB
has taken recently to develop such a regulatory mechanism. 

PROGRAMMATIC WEAKNESSES MAY LIMIT
THE EFFECTIVENESS OF FHFB'S
REGULATORY OVERSIGHT
============================================================ Chapter 3

In addition to the weaknesses found in the sample of FHFB
examinations we reviewed, we found two programmatic weaknesses that
may limit the effectiveness of FHFB's regulatory oversight.  First,
FHFB's off-site monitoring consists of the preparation and review of
several periodic reports prepared by OS and OP.  However, FHFB lacked
policies and procedures for off-site monitoring and there appeared to
be no correlation between the FHLBank size or scope of activities and
the level or type of off-site monitoring performed by these offices. 
Second, FHFB's supervisory enforcement program lacks clear policies
and procedures for taking enforcement actions and does not specify
what actions would be taken if certain conditions existed.  In
addition, the statute does not specifically enumerate FHFB's
enforcement authority, except its authority to suspend or remove a
director, officer, employee, or agent of the FHLBanks.  These types
of deficiencies raise concerns about FHFB's ability to compel timely
corrective action should serious problems ever occur. 

   FHFB OFF-SITE MONITORING NEEDS
   IMPROVEMENT
---------------------------------------------------------- Chapter 3:1

As stated in previous work on GSE regulation, monitoring between
annual on-site examinations is an integral part of regulatory
oversight.\1 We also stated that monitoring should be timely, focus
on previously identified problems, and identify potential problems. 
We found FHFB monitoring activities consisted of several periodic
reports that were not tailored to individual FHLBanks nor were they
structured to identify potential problems.  For example, an OS
analyst prepared several periodic reports that tracked such
activities as Financial Management Policy (FMP) compliance\2 and
interest rate risk positions and trend data.  Since 1996, FHFB has
tracked the status of outstanding examination findings.  Also in 1995
to 1996, OS established a "Regulatory Oversight Monitoring System"
(ROMS).  ROMS consisted of monthly reviews of various FHLBank
information submitted to FHFB, including FHLBank board of director
minutes, internal audit reports, and other FHLBank reports.  We
believe ROMS could also serve as a useful off-site monitoring tool
between annual examinations.  Monthly reviews under ROMS were
suspended in May 1997, those reviews are now included as part of the
annual preexamination planning. 

OP, which is also involved in off-site monitoring activities,
prepared periodic reports on various aspects of System operations. 
However, examiners generally reviewed these reports during
preexamination planning, if at all, rather than throughout the year. 
OS and OP generally do not coordinate their activities.  According to
FHFB officials, the monitoring efforts of the two offices are viewed
as serving different purposes. 

--------------------
\1 Farm Credit System:  Farm Credit Administration Effectively
Addresses Identified Problems (GAO/GGD-94-14, Jan.  7, 1994). 

\2 The Financial Management Policy establishes guidelines for FHLBank
funds not immediately required to fund credit programs or operations. 
It specifies allowable investments and contains certain limitations
on others. 

      OFFICE OF SUPERVISION
      OFF-SITE MONITORING
      ACTIVITIES
-------------------------------------------------------- Chapter 3:1.1

FHFB's regulations include off-site monitoring among the duties to be
performed by OS.\3 As we have stated in our past work, "the level of
monitoring must be sufficient to provide an adequate understanding of
the GSE's operations, financial condition, and risk to the
government.  .  .  .  Rapidly expanding business volume, entry into
new activities, and issuing or purchasing new types of debt
instruments should trigger increased regulatory monitoring."\4

Many of those conditions have existed in the System, as we noted in
chapter 1.  Regular monitoring between examinations is important
because of the changing demographics of the System, its entry into
new activities, and the issuance of new debt instruments.  These
factors reinforce the need for a fully-functioning monitoring program
that is integrated with the examination program. 

An OS analyst prepared four periodic reports for the Board. 
Examiners sometimes used these reports during annual preexamination
planning.  First, OS produced a quarterly "Regulatory and Financial
Management Policy Compliance and Interest Rate Risk Positions
Report." This report is compiled from reports FHLBanks are to submit
monthly to FHFB about their compliance with FMP.  During the course
of our review, OS officials said they were also developing a way to
independently verify FHLBank compliance with FMP.  The report also
provided the quarterly interest-rate positions of FHLBanks.  Second,
OS produced a quarterly monitoring and compliance review of System
debt issuance activity based on information provided by OF.  This
report reviews several key areas OS identified as important including
new developments, debt issuance activity, and compliance and
disclosure.  Third, OS produced a quarterly trend report that tracks
various FHLBank financial data, such as income and balance sheet
composition.  This information is also included as an appendix to
FHLBank examination reports.  Fourth, since 1996, OS has prepared
periodic reports that track the status of outstanding examination
findings (that required management to take corrective action) between
annual examinations.  Finally, in 1998, OS began monitoring unsecured
credit reports prepared by OF on a monthly basis. 

These periodic reports cover many important aspects of FHLBank
operations.  However, other valuable information supplied by FHLBanks
is not immediately reviewed by examiners when submitted to FHFB,
although such reviews were performed under ROMS prior to May 1997. 
This information includes FHLBank board of directors minutes and bank
internal audit reports.  Minutes of board meetings can provide timely
information about a bank's activities in addition to revealing
directors' and managements' level of knowledge and participation in
bank business.  Internal audit reports can provide objective
information on various facets of bank operations as well as
management's response to any weaknesses the internal auditors
identified.  Currently, examiners review board minutes, internal
audit reports, and other submitted information just prior to the
annual on-site examination. 

--------------------
\3 The regulation states that OS' responsibilities include, among
others, monitoring of bank and System interest-rate risk, financial
trends, and mission-related activities.  C.F.R.  � 900.14 (d). 

\4 Government-Sponsored Enterprises:  A Framework for Limiting the
Government's Exposure to Risks (GAO/GGD-91-90, May 22, 1991). 

      OFFICE OF SUPERVISION
      SUSPENDED ITS MONTHLY
      MONITORING SYSTEM DUE TO
      STAFFING CONSTRAINTS
-------------------------------------------------------- Chapter 3:1.2

As mentioned previously, OS suspended monthly monitoring under ROMS
due to staff constraints in May 1997.  According to FHFB documents,
ROMS was originally established in 1995 to 1996 "to track the
disposition of all examination issues and concerns, large and small."
However, OS officials said that the purpose of ROMS was to save
examiners time at the start of the annual on-site examination by
reviewing and summarizing certain information that is periodically
submitted to FHFB by the FHLBanks throughout the year on a monthly
basis.  FHFB officials said they did not consider ROMS a monitoring
tool.  However, we believe that ROMS has the added potential benefit
of allowing examiners to monitor the activities of FHLBanks between
annual examinations.  Monthly monitoring through ROMS could enhance
the standard Systemwide periodic reports prepared by OS. 

As of July 1, 1998, monthly ROMS monitoring remained suspended and
was to be completed as part of annual preexamination planning. 
Although FHLBanks are engaged in a fairly narrow range of activities,
timely monitoring provides a useful way for the regulator to keep
abreast of changes in activities between annual examinations.  Given
the recent and potential changes in the System, which we discussed in
chapter 1, it will become more important for examiners to track the
activities and condition of FHLBanks between annual examinations to
ensure that the FHLBanks are adequately managing their risks.  Unlike
the other monitoring reports produced by OS, ROMS reviews could
include a combination of historical and planned activities.  For
example, information addressed in board of director minutes may
include information about planned or proposed activities.  This type
of forward-looking information would be useful to augment the
historical data captured in its monitoring reports. 

      OP ALSO MONITORS FHLBANK
      OPERATIONS; COORDINATION
      WITH OS LACKING
-------------------------------------------------------- Chapter 3:1.3

OP monitoring consists primarily of preparing various reports that
range in frequency from monthly to annual.  The reports are produced
from information FHLBanks are required to submit periodically to FHFB
and financial data that FHFB has access to through its District Bank
Information Management System (DBIMS).\5

For example, each month, staff are to prepare a set of tables that
track membership data, including the amount of advances, capital
stock, and commitments that each member holds at the end of the
month.  In addition, OP is to annually reconcile AHP accounts to
determine whether FHLBanks have committed all the AHP funds that the
statute requires them to commit.  Other reports may include quarterly
reports on FHLBanks' advances to selected borrowers, such as state
housing finance agencies and institutions owned or controlled by
Native Americans; regular reports on AHP projects; special data
tabulations for examiners during on-site examinations of AHP; reports
on financial modeling, such as spread and growth estimates to
generate income; and monthly financial reports.  In addition, OP
prepares a quarterly profile book that provides various types of
comparative information, such as membership statistics and financial
summaries, AHP data, and data on commercial bank versus thrift
representation on boards of directors. 

Most of these reports are generated for the Board, according to FHFB
officials.  These reports provide a systemwide rather than individual
bank review.  We found that examiners may use some of these reports
during annual preexamination planning and preparation as part of
their assessment of FHLBank operations rather than as a tool to
monitor the FHLBanks' condition throughout the year.  While both OP
and OS monitor certain aspects of FHLBank activities, they generally
do not coordinate their monitoring activities.  Although officials
said the purposes for their monitoring were different, we believe OS
and OP could improve oversight of FHLBanks if their efforts were
better coordinated.  FHFB's regulations and the examination manual do
not address the monitoring role performed by OP. 

--------------------
\5 DBIMS is the means by which the FHLBanks report their financial
condition to FHFB on a monthly basis. 

   FHFB ENFORCEMENT PROGRAM LACKED
   POLICIES AND PROCEDURES
---------------------------------------------------------- Chapter 3:2

FHFB's enforcement program lacked clear policies and procedures.  In
our past work on GSE regulators and effective enforcement of rules
and regulations, we outlined certain principles that we believed
necessary for effective enforcement of GSE rules and regulations.\6
Those principles, among others, include that certain enforcement
actions (1) should be mandatory when prespecified conditions are met,
such as increasingly severe asset, earnings, or capital deterioration
and (2) should be the result of a clear and reasonable process.  The
FHLBank Act does not enumerate specific enforcement authorities for
FHFB, other than the authority to suspend or remove various parties,
including any FHLBank director, employee, or officer.  However, FHFB
officials said that the statutory power to enforce orders allows the
FHFB to issue and enforce orders requiring banks to take specified
corrective actions.  Given the lack of specificity in the statute, it
is important that FHFB have a program in place to ensure that it has
clear policies and procedures regarding what those specified actions
would be.  Currently, FHFB has no well-defined process to address
serious problems if they should ever arise. 

--------------------
\6 See GAO/GGD-91-90, May 1991. 

      FHFB LACKED CLEAR POLICIES
      AND PROCEDURES FOR ALL TYPES
      OF ENFORCEMENT MECHANISMS
-------------------------------------------------------- Chapter 3:2.1

FHFB lacked clear policies and procedures regarding the use of
enforcement actions and failed to specify what actions it would take
if certain conditions existed.  An FHFB official said that he does
not believe it is necessary to produce detailed policies and
procedures given the small size of the agency.  He also said that
enforcement decisions are made at the management level making written
policies unnecessary.  We believe that the broad statutory language
makes policies and procedures more important.  They would provide for
consistency in regulation, continuity through changes in the Board
and FHFB staff, and make FHLBanks fully aware of the repercussions of
not taking corrective action. 

We found that existing guidance, primarily the examination manual,
stated that examiners have several "supervisory methods" to (1)
encourage improved practices or to remedy violations of law, policy,
or regulation and (2) correct weaknesses or unsafe and unsound
practices or conditions.  These methods include meetings with FHLBank
management and boards, supervisory letters, follow-up examinations,
requests for voluntary management changes or reorganizations, written
voluntary agreements with an FHLBank, and supervisory
determinations\7 .  While we found that FHFB used many of these
methods, FHFB used supervisory determinations, which include certain
categories of examination findings, most frequently.  Officials said
they view supervisory determinations as equivalent to an enforcement
order because they require that a FHLBank take corrective action
within a specified time period.  See table 3.1 for a breakdown of
examination findings for 1996 and 1997.  FHLBank boards are required
to respond to examination reports within 45 days and when warranted
to include a remedial plan and timetable.  According to FHFB records,
FHLBanks were generally responsive to FHFB's examination findings. 

                               Table 3.1
                
                  Examination Findings by Category for
                   1997 and 1996 Annual Examinations

Findings Category                                         1997    1996
------------------------------------------------------  ------  ------
Referral                                                     2       2
Recommendation                                              41      61
Compliance matter                                           14       9
Weakness\a                                                  11      28
Violation\a                                                 10      19
Unsafe or unsound\ condition\b                               0       0
----------------------------------------------------------------------
Note:  Each finding category is defined in table 2.1. 

\a Denotes findings that require corrective action.  These findings
are also referred to in the chapter as supervisory determinations. 

\b Additional category used in infrequent circumstances requiring
intensive regulatory oversight and corrective action, including
measures to strengthen FHLBank management.  Immediate corrective
action is required. 

Source:  GAO analysis of 1997 and 1996 Reports of Examination for the
12 FHLBanks. 

The examination manual does not provide examiners guidance that
mandates the use of any type of action when a particular condition is
determined, such as severe asset, earnings, or capital deterioration. 
The examination manual further states that if, in the
examiner-in-charge's opinion, an FHLBank's response or planned action
will not resolve the identified issue, the matter is to be referred
to the OS director or deputy director for guidance.  Once again, the
manual does not indicate what additional actions would be taken by
management or at what point the Board would become involved in
enforcing supervisory determination.  According to one official, more
specific details were not included in the examination manual because
the manual is viewed as an examiner's tool and management would be
responsible for any additional actions that would be taken, thus
written guidelines were not considered necessary.  We believe that
FHFB could benefit from additional written guidance. 

Beginning in 1996, we found that examiners tracked FHLBank responses
to outstanding examination findings that required corrective action
(i.e., weaknesses, violations, and unsafe or unsound conditions) and
periodically prepared reports for the Board.  Based on our review of
those reports, it appears that the FHLBanks took corrective actions
that satisfied the examiners and the Board.  In addition, we
identified only a few instances in FHFB records of weaknesses or
violations that were carried forward into the subsequent year's
examination and that resulted in the supervisory determinations being
repeated.  Examiners identified no unsafe or unsound conditions
during the period of our review.  The outstanding compliance issues
generally related to CIP or AHP. 

In July 1996, FHFB established a process for the FHLBanks to resolve
examination findings that they dispute.\8 In general, FHFB encourages
FHLBank staff to maintain cooperative communication to resolve
disputes with OS staff informally.  However, if an informal
resolution is not possible, the FHLBank may file a petition with FHFB
to have the matter considered by the Board.  The FHFB's managing
director is to review the filed petitions in consultation with OS and
the chairman and promptly forward them to the Board.  The managing
director may also determine that additional information is needed
before it is to be considered by the Board.  According to FHFB
documents, FHFB tries to resolve the dispute before it goes to the
full Board and most disputes are expected to be resolved before a
petition is filed.  As of May 31, 1998, five FHLBanks had filed
petitions disputing examination findings.  Two of the petitions were
closed or abandoned by FHLBanks prior to reaching the Board.  FHFB
withdrew the supervisory determination for one petition before it was
considered by the full Board.  In another petition, the Board
approved a settlement agreement between OS and the FHLBank.  The last
petition, filed October 1997, is scheduled to be reviewed by the
Board later this year. 

--------------------
\7 As defined in Finance Board Resolution 96-96 (Dec.  18, 1996), a
supervisory determination is (1) a finding of OS requiring mandatory
action (e.g., an unsafe and unsound practice or condition, weakness,
or violation) set forth in a report of examination, order or
directive; (2) an order or directive by the OS requiring mandatory
action concerning safety and soundness or compliance matters; or (3)
a failure by the OS, within 60 days of a Bank's written request, to
acknowledge in writing that the OS will take no supervisory action
with regard to an issue or set of circumstances presented by the
institution. 

\8 FHFB Resolution No.  96-60, dated July 30, 1996, "Procedures for
the Review of Disputed Supervisory Determinations," was effective
until Oct.  31, 1996.  Resolution No.  96-74, dated Oct.  24, 1996
extended the effective date to Dec.  31, 1996.  FHFB Resolution No. 
96-96, "Revision and Adoption of Procedures for Review of Disputed
Supervisory Determinations," Dec.  18, 1996. 

      STATUTE DOES NOT
      SPECIFICALLY ENUMERATE
      FHFB'S ENFORCEMENT AUTHORITY
-------------------------------------------------------- Chapter 3:2.2

Unlike other GSE regulators, FHFB's statutory enforcement authority
is not specifically enumerated in the statute.  The FHLBank Act
authorizes FHFB to "promulgate and enforce"\9 regulations and orders;
but, with one exception, it does not delineate enforcement
authorities provided other GSE regulators, such as cease and desist
orders and civil money penalties.  These and other enforcement
authorities are typically provided by law for other GSE regulators. 
The law does, however, specifically authorize FHFB to "suspend or
remove for cause a director, officer, employee, or agent of any
Federal Home Loan Bank or joint office."\10

FHFB officials said that they believe that the general powers
provision in the statute to enforce regulations and orders would
enable them to issue and enforce orders requiring an FHLBank to take
specific actions to address a safety and soundness problem if FHFB
identified such a need.  According to FHFB officials, they would seek
court enforcement of the FHFB order if necessary.  However, we
believe that seeking this authority could take some time and thus
preclude a prompt resolution of the problem.  Further, because the
statute does not enumerate specific authorities beyond FHFB's
suspension and removal authority, an FHLBank may be inclined to
legally challenge FHFB's authority.  Therefore, having the specific
statutory authorities that other regulators have would allow FHFB to
avoid the potential for a dispute over its enforcement authority and
to encourage timely corrective action, if a serious problem should
ever arise.  We believe, as we have stated in the past for any GSE
regulator, that the statute should give FHFB enforcement authorities
that are granted other regulators.\11

--------------------
\9 12 U.S.C.  � b(a)(1)(1994). 

\10 12 U.S.C.  � b(a)(2)(1994). 

\11 Formal enforcement actions, authorized by statute, available to
other regulators include issuing cease and desist orders, assessing
civil money penalties, and entering into formal written agreements
with the institutions.  Formal enforcement actions are legally
enforceable tools that regulators can use to compel banks to take
corrective actions to address supervisory concerns. 

STATUTE AND PRACTICES STILL
INVOLVE FHFB IN SYSTEM BUSINESS
============================================================ Chapter 4

FHFB has certain System business functions assigned to it in statute
which complicate its primary duty as FHLBanks' safety and soundness
regulator.  Both FHFB and System officials agree that at least some
of those business functions should be performed by FHLBanks.  FHFB
has devolved, within certain parameters, some of those functions to
FHLBanks.  In addition to its business functions based in statute,
FHFB serves as a promoter and coordinator for the System to some
extent.  FHFB views these activities as consistent with its primary
duty of ensuring the System's safety and soundness, as well as
ensuring mission compliance.  In our view some of FHFB's activities
may undermine its independence as a regulator.  For example, FHFB has
adopted an initiative to stimulate development of new services and
products.  As the System's regulator, FHFB would be responsible for
evaluating the new products it has previously advocated with respect
to their safety and soundness.  We continue to believe that Congress
should shift FHFB's management functions to FHLBanks and their
members so that the System manages itself, as other GSEs do. 

In past work on the housing GSEs, we recommended that a single
regulator be created to assume the duties of FHFB, OFHEO, and HUD. 
Our current work at FHFB and our recent work at OFHEO and HUD have
strengthened our belief that oversight of the housing GSEs would be
more effective if combined. 

   LIKE ITS PREDECESSOR, FHFB
   REMAINS INVOLVED IN SYSTEM
   BUSINESS
---------------------------------------------------------- Chapter 4:1

When FHFB was established in 1989, the statute maintained many of the
remnants of FHFB's predecessor agency, the FHLBank Board.  The
FHLBank Board was an integral part of the System and many of the
System business functions it performed passed to the new FHFB.  Thus,
FHFB was not established as an arm's-length regulator as are other
GSE regulators, such as the Farm Credit Administration that oversees
the Farm Credit System.  As recently as September 24, 1997, the FHFB
Chairman testified before the Senate Subcommittee on Financial
Institutions and Regulatory Relief of the Senate Committee on
Banking, Housing, and Urban Affairs at the oversight hearing on FHFB
that "One of the anachronisms from the days of the Federal Home Loan
Bank Board is the degree to which the Finance Board, the regulator of
the Banks, is required to approve day-to-day operational decisions of
the Banks."\1 FHFB business functions include the authority to
approve FHLBank dividends, bylaws, the appointment of presidents,
employee benefits, the transfer of advances among FHLBanks, travel
policies, cost-of-living adjustments for retirees, and other
retirement policies.  FHFB is reviewing these approval authorities
for possible devolution. 

FHFB also has statutory authority to issue consolidated obligations
for the System.  Generally, it is GSEs that have the authority to
issue their own debt, rather than the regulator.  The Farm Credit
System, which is a cooperative system composed of banks and other
entities, issues debt through a fiscal arm established in statute for
that purpose.  Although FHFB delegated its authority to issue System
debt to OF through regulation, its statutory authority remains.  FHFB
has other ties to the office, such as appointing its three board
members, approving the appointment of a director and the budget. 
This statutory link to debt issuance could potentially expose the
federal government and ultimately taxpayers to legal risk. 

Both FHFB and FHLBank officials have recognized the need for
separation of the business and regulatory functions.  FHFB stated in
a 1993 report to Congress, "The dual role of the Finance Board is a
weakness of the current Bank System structure.  The roles of
regulation and governance residing in one entity are not compatible
and, indeed, represent a long-standing, well-understood inherent
conflict when joined.  A regulator needs the objectivity that
'distance' from decisionmaking provides; a manager cannot objectively
self-audit."\2 According to its 1994 annual report, the FHFB had
slated several of its regulations and policies for devolution.  In
response to recommendations made in a study by a committee of FHLBank
stockholders,\3 the FHFB Chairman testified in September 1997 before
a congressional committee that since 1993, FHFB had sought to devolve
"as many purely management responsibilities as it could."\4 Thus,
there has been general agreement for some time among top System
officials and FHFB that business functions should be devolved to
FHLBanks. 

Others, including us, concur.  Studies mandated by the Housing and
Community Development Act of 1992 by the Departments of Treasury and
HUD, FHFB, FHLBanks Stockholder Committee, and us said that the
management function should be separated from safety and soundness
oversight of the System.  In congressional testimony in 1994 and
1995, Treasury officials stated that the FHFB's "current
responsibilities are in conflict."\5 In discussing an Administration
bill to reform the System in 1995 Treasury explained that its
proposal to devolve FHFB's managerial responsibilities to the
FHLBanks would "remove the inherent conflicts between the Finance
Board's regulatory and managerial responsibilities, while
strengthening all members' stake in the System."\6 We also
recommended in 1995 that all FHFB governance or management functions
be devolved to the System.  We expressed concern then, and continue
to believe that combining the roles of oversight and management may
undermine the independence necessary to be an effective safety and
soundness regulator.\7

--------------------
\1 Bruce Morrison, Chairman, FHFB, testimony before the Subcommittee
on Financial Institutions and Regulatory Relief, Senate Committee on
Banking, Housing, and Urban Affairs, Sept.  24, 1997. 

\2 FHFB Report on the Structure and Role of the System, submitted by
the FHFB to Congress Apr.  28, 1993. 

\3 The Future Direction of the Federal Home Loan Bank System, report
submitted to banking committees of the House and Senate, July 1993. 
The FHLBank Stockholder Study Committee was statutorily established
by the Housing and Community Development Act of 1992 P.L.  No. 
102-550 � 1394, 106 stat.  3672, 4011 (1992).  The Committee
consisted of 24 members--two stockholders from each of the 12
FHLBanks--elected by their respective boards. 

\4 Bruce Morrison, Chairman, FHFB, testimony before the Subcommittee
on Financial Institutions and Regulatory Relief, Senate Committee on
Banking, Housing, and Urban Affairs, Sept.  24, 1997. 

\5 Statement of Frank N.  Newman, Under Secretary of the Treasury,
Senate Committee on Banking, Housing, and Urban Affairs, June 15,
1994. 

\6 Statement of Richard S.  Carnell, Assistant Secretary of the
Treasury, Subcommittee on Capital Markets, Securities, and
Government-Sponsored Enterprises, House Committee on Banking and
Financial Services, May 17, 1995. 

\7 Federal Home Loan Bank System:  Reforms Needed to Promote Its
Safety, Soundness, and Effectiveness, (GAO/T-GGD-95-244, Sept.  27,
1995). 

   FHFB HAS DEVOLVED SOME SYSTEM
   BUSINESS FUNCTIONS TO FHLBANKS
---------------------------------------------------------- Chapter 4:2

As of July 1, 1998, FHFB had devolved several responsibilities to
FHLBanks within specified limits.  These responsibilities included
the authority to (1) establish presidents' and other employees
salaries and incentive payments, (2) approve AHP applications, (3)
determine the appropriate level and structure of compensation for
FHLBank directors, (4) establish FHLBank performance targets, (5)
approve budgets and amendments, (6) approve membership applications
for FHLBanks, (7) execute and administer the System's contract for an
external audit, (8) approve charitable contributions and meetings
outside of the FHLBank districts, and (9) approve applications for
nonmember mortgagee eligibility. 

FHFB, other GSEs, and bank regulators have regulatory authority over
many aspects of the entities they regulate.  Such authority is
appropriate for ensuring that certain business decisions do not
threaten financial soundness, that certain activities are consistent
with mission, or as a tool for compelling a financial institution to
correct safety and soundness deficiencies identified by a regulator. 
For example, FHFB and other regulators have authority, under certain
conditions that could pose a threat to safety and soundness, to
remove officers or directors of the institutions they regulate. 
However, FHFB also has the authority, following the selection by the
FHLBank's board, to approve the appointment of each FHLBank's
president--a function generally left to the boards of directors of
other GSEs.  As part of its devolution project, FHFB authorized the
FHLBank boards to determine the length of the FHLBank presidents'
tenure, but retained its authority to approve the boards' initial
appointment of the president. 

FHFB explained its rationale for retaining authority to approve the
initial appointment when it issued a final rule on this matter.\8

FHFB believes that FHLBank presidents are charged with representing
and furthering not only a bank's stockholders' interest but also the
interests of the public.  Given its statutory duties, FHFB stated it
believed that retaining its initial approval authority over a
FHLBank's selection of its highest officer was necessary to carry out
its duties.  Although this approval authority may be useful to FHFB,
we note that retaining this role could appear to give FHFB an
interest in the individual's appointment and complicate FHFB's
decision to remove a president if the need arose. 

For most of the devolved activities, FHFB created guidelines and
parameters within which FHLBanks are to exercise their authority. 
For example, in 1996, FHFB approved a final rule that authorized the
FHLBank boards to establish reasonable salaries and incentive
payments for employees, other than the president.  The rule also
transferred to FHLBanks the authority to establish presidents'
salaries and incentive payments, within limits.  The rule (1)
required that FHFB set an annual base salary cap, (2) specified the
standard criteria for incentive payments that the FHLBank boards must
use for their presidents, and (3) limited the total incentive amount
to a percentage of the annual base salary cap, published by FHFB. 
According to at least one FHLBank director, some of the incentive
criteria created a conflict between the FHLBank board and FHFB
because the board wanted to encourage certain types of
mission-related activities and FHFB may want to encourage others. 
For example, one criterion FHFB specified that FHLBank boards must
use to determine FHLBank presidents' incentives was the level of
community investment programs activity.  We acknowledge that it is
appropriate for a GSE regulator, because of GSEs' special public
purposes and close ties to the government, to have some regulatory
authority over compensation levels.  For example, other GSE
regulators have the authority to ensure that compensation is not
excessive.\9 However, it is less clear whether FHFB should be
involved in setting salary limits and specifying criteria that
FHLBank boards should use to provide incentives for presidents. 
Those types of activities could be viewed as more managerial than
regulatory. 

System and FHFB officials generally agree that to completely make
FHFB arm's-length would require legislative changes.  FHFB's 1998 to
2002 strategic plan identifies the devolution of management issues
"including compensation and dividends, with safety and soundness and
mission oversight retained by the Finance Board" as part of
legislation it wants to see enacted.  In March 1998, the FHFB
Chairman said in reference to its involvement in the day-to-day
management of the FHLBanks, "Unfortunately, the Finance Board cannot
extract itself from some of these matters under current law."\10
While the devolution process may offer some interim relief, several
FHLBank officials said that they believe the devolution project is
more form than substance.  They said that most of the devolved items
are administrative in nature and those that are not, have been
devolved within such tight parameters that they leave little room for
FHLBank board discretion.  FHLBank officials also said that even with
the devolution, legislation is required because the current
devolution project could be suspended and the regulation reversed by
a FHFB Board resolution.  As stated in a previous report, other
officials said they disagree with FHFB's interpretation of the
statute on some issues and believe that the FHFB has the power to
fully delegate these business functions to the banks and should do
so.\11

--------------------
\8 Federal Register, Vol.  62, No.  1, Thursday, Jan.  2, 1997. 

\9 OFHEO has authority to prohibit its GSEs from providing
compensation to executive officers that is not reasonable and
comparable with that of similar businesses.  12 U.S.C.  � 4518
(1994).  The Farm Credit Administration has authority to monitor Farm
Credit System directors' compensation and ensure it does not exceed
levels specified in law.  12 U.S.C.  � 2209 (1994). 

\10 Statement for the record by Bruce Morrison, Chairman, FHFB,
Committee on Banking, Housing, and Urban Affairs, U.  S.  Senate
(Washington, D.C., Mar.  12, 1998). 

\11 GAO/GGD-97-139, pp.10-11. 

   FHFB'S INVOLVEMENT IN SYSTEM
   BUSINESS INCLUDES PROMOTION AND
   CENTRAL COORDINATION
---------------------------------------------------------- Chapter 4:3

Although many of the activities that involve FHFB in System business
are statutory or regulatory requirements, FHFB also continues to
function as a promoter and coordinator for certain System activities
and programs.  The FHLBanks themselves have two groups to provide
some coordination of System issues, and they have expanded their
involvement in debt issuance.  Nevertheless, the FHFB involves itself
in promoting the System and coordinates communication among and
congressional outreach by the FHLBank chairs and vice chairs.  FHFB
views these activities as consistent with ensuring the System's
safety and soundness, as well as ensuring mission compliance. 
However, consistent with our previous work, we believe that aspects
of such of participation in System business may be inappropriate for
a regulator and undermine its independence. 

      SYSTEM NEEDS CENTRAL
      COORDINATION AND HAS
      ESTABLISHED GROUPS WITH THE
      POTENTIAL TO FILL THIS ROLE
-------------------------------------------------------- Chapter 4:3.1

The 12 FHLBanks are independently owned by their individual
stockholders and governed by individual boards of directors. 
However, FHLBanks are interdependent in that they were established as
GSEs under the same statute to fulfill the same mission, and they
raise funds in the capital market through consolidated obligations
for which they are joint and severally liable.  As noted earlier,
FHLBanks and FHFB acknowledged the need for central coordination, at
least as early as 1993; and the System has made progress in trying to
undertake this role. 

Perhaps the most significant factor linking each FHLBank is the joint
issuance of System obligations.  Each FHLBank is jointly and
severally liable for the System's debt.  As noted in chapter 1, this
means that if one or more FHLBanks are unable to repay its
participation in the consolidated obligations, the other FHLBanks
could be called upon to repay a portion of such obligations.  This
obligation makes it important for each bank to be aware of debt
issuance activity, risk management, and in general the financial
condition of the other banks in the System.  In 1994 the FHLBanks
took steps to improve the flow of information about debt issuance by
creating a committee of bank presidents to work with the OF board. 
The OF board consists of two bank presidents and a private citizen,
all appointed by FHFB.  In addition, it was agreed that minutes of
board meetings and related materials would be distributed to all
FHLBank presidents. 

In a 1993 report, FHLBanks, OF, and FHFB recognized several functions
that need to be managed centrally for the System.\12 These included

  -- strategic planning,

  -- establishment of general credit policies,

  -- legislative coordination and lobbying,

  -- cultural leadership and image building, and

  -- data collection and financial modeling. 

The existing mechanisms for managing these functions, include the
Conference of Federal Home Loan Banks (President's Conference) and
the newly established Council of the FHLBanks (Council).  These
mechanisms provide for the exchange of information and present the
opportunity for the System to assume a larger role in coordinating
Systemwide interest.  The Presidents' Conference, consisting of the
presidents of the 12 FHLBanks, meets at least bimonthly to "identify,
define, and deliberate issues of strategic significance to the
Federal Home Loan Bank System and to provide a forum of the exchange
of ideas and information related to improved service and performance
of the Federal Home Loan Bank System." It works through five
committees:  steering; communication and general management; finance,
research, and planning; housing and community development; and
legislative.  The steering committee develops a strategic issues
agenda for the Conference and coordinates the study and discussion of
the issues.  For example, a task force on rural issues worked with
FHFB, the Department of Agriculture, and five FHLBanks serving
predominately rural areas in exploring increasing investments in
targeted rural areas as part of the CIP.  While the Presidents'
Conference can make recommendations to the respective FHLBank boards,
the positions and resolutions reached by the presidents are not
binding. 

In 1997, nine FHLBanks created a Council "to enhance the public's
awareness and understanding of the Federal Home Loan Bank and to
promote the role and purpose of the Federal Home Loan Banks." The
Council has broader representation than the President's Conference
because its representatives may include FHLBank board members and/or
management; each member may appoint two representatives.  A tenth
bank joined the Council in 1998; as of July 1998, the FHLBanks of
Chicago and New York had not joined.  The Council is still in its
formative stages, but it has established an office in Washington,
D.C.  and hired permanent staff including a lobbyist and executive
vice president.  The Council provides another opportunity for
FHLBanks to come together in furthering the role of the System. 

--------------------
\12 System 2000:  A Strategic Framework for the Future of the Federal
Home Loan Bank System, Aug.  1993. 

      FHFB STILL SERVES AS A
      SYSTEM PROMOTER AND
      COORDINATOR
-------------------------------------------------------- Chapter 4:3.2

Despite the existence of the President's Conference and the Council
of FHLBanks, FHFB acts as a promoter and coordinator for the System
in some respects.  Although FHFB views these activities as consistent
with its primary duty of ensuring the System's safety and soundness,
we are concerned that these activities further involve FHFB in System
business.  Undertaking these activities may undermine FHFB's
independence and lead to questions about its objectivity.  We
continue to support our 1991 position that the regulator's function
"should not be to promote a GSE over other market participants nor
should it include promotion of the economic sector served by the
GSE." The following three examples illustrate FHFB's promotional and
coordinating activities. 

First, FHFB's strategic plan provides an overview of its promotional
and coordinating activities as well as its safety and soundness
function.  Of the plan's nine objectives, one focuses on the
examination function.  Five address changes FHFB advocates "for
FHLBanks in order to enhance their performance." These changes
include seeking structural and other reforms for the System through
legislation, including expanding the acceptable uses for advances and
eligible collateral to include, for example, small business loans. 
The plan also includes conducting an ongoing "cost-benefit" study
regarding the value of the FHLBanks to provide information for
"long-term decisions about ensuring mission achievement." Two
objectives address the devolution effort; and one speaks to
disseminating information about the goals, objectives, and
achievements of the FHFB. 

The plan, approved by the Board in September 1997, notes that it is
an integral part of the budget planning process and that performance
plans for FHFB divisions will be based on it.  With so many of the
plan's objectives focused on topics other than FHLBank safety and
soundness, the official agency plan does not appear to place adequate
emphasis on its primary responsibility--safety and soundness
oversight.  Further, the lack of significance FHFB places on the
safety and soundness examination function is evident in its
allocation of fulltime staff to the examination program--OS staff
comprise 13 percent of FHFB staff resources as of May 31, 1998. 

Second, in its strategic plan, FHFB identified what it believes is a
need for a marketing clearinghouse function to collect information on
marketing methods and the demand for new System services and products
and to help the FHLBanks develop potential partnerships with housing
advocates and others.  FHFB officials acknowledged that this type of
service typically would be performed by a trade association, but FHFB
is proceeding to develop such a clearinghouse function.  According to
its 1998 annual performance plan, FHFB also will be involved in
developing new services and products that are to fulfill housing
finance needs.  By fiscal year-end 1998, FHFB plans to develop a
semiannual "best practices" report on innovative FHLBank products,
services, and marketing methods.  Although working with FHLBanks and
others to identify and share such best practices is an appropriate
undertaking for FHFB, it is less clear that developing new products
or advocating that FHLBanks undertake specific activities are
consistent with its duties as a regulator.  As the System's
regulator, FHFB would be responsible for examining any new products
or programs thus raising questions about its objectivity in
evaluating an activity it helped promote. 

Third, FHFB plays a coordination role through the chairman's regular
meetings with the FHLBank chairs and vice chairs.  According to FHFB
documents, the meetings with the chairman were initiated by the
chairs in 1996.  In 1997, meetings were held quarterly; in 1998, they
were to be held monthly.  FHFB used these meetings to further its
legislative agenda.  For example, the chairman coordinates the
congressional lobbying efforts of FHFB appointed FHLBank chairs and
vice chairs through these monthly meetings.  Agenda items addressed
at meetings included "mobilizing for passage" and "getting Congress
to adopt the legislation" that FHFB promoted.  FHFB's involvement of
chairs and vice chairs it appoints in lobbying for statutory changes
illustrates the potential FHFB has for influence over those
positions.  Also, in June 1998, FHFB coordinated the annual
conference for FHLBank directors planned by a committee of System
officials with FHFB assistance.  The purposes of the 1998 conference
were to discuss the current status and strengths of the System and
what should be changed to enhance the value of the System to its
members.  These activities illustrate concerns raised in our 1995
testimony about whether FHFB should be responsible for appointing
directors to FHLBank boards because FHFB may nominate directors who
support the regulator's views and may not reflect the views of the
public.\13

--------------------
\13 GAO/T-GGD-95-244. 

   SINGLE HOUSING REGULATOR WOULD
   HAVE ADVANTAGES OVER CURRENT
   REGULATORS
---------------------------------------------------------- Chapter 4:4

In past work on the housing GSEs, we recommended that a single
regulator be created for the three housing GSEs that would assume the
duties of (1) FHFB, (2) OFHEO, and (3) HUD, the regulators of Fannie
Mae and Freddie Mac and discussed the advantages and disadvantages of
such a regulatory scheme.\14 We have continued to monitor and
evaluate the housing GSEs and their regulators.  For example, we
issued report on OFHEO in October 1997 and on HUD's mission oversight
of Fannie Mae and Freddie Mac in July 1998.\15 We found that OFHEO
had not fully completed two important duties:  establishing
risk-based capital standards and implementing a comprehensive and
timely examination program.\16

Our work at HUD raised a number of issues about its oversight of
Fannie Mae and Freddie Mac, some of which would be eliminated or at
least mitigated if there were a single regulator for the housing
GSEs.\17 For example, HUD is required to establish goals for its
purchase of mortgages serving targeted groups and also maintain the
financial soundness because such purchases could increase credit
risk.  We found that HUD adopted a conservative approach to setting
the goals that placed a high priority on maintaining the GSEs'
financial soundness, but HUD did not consider the financial
consequences of setting higher goals.  In addition, we found that HUD
has not implemented a process to ensure that the GSEs' financial
activities are consistent with their housing mission.  For example,
HUD did not initiate efforts to determine whether the GSEs'
nonmortgage investments were consistent with their housing mission
until 1997.  A single regulator would be better able to evaluate the
trade-off between mission and safety and soundness as well as
evaluate the financial aspects of new mortgage products and
nonmortgage investments because it would combine expertise in housing
and finance. 

As a result of this work, we have found no evidence that would cause
us to alter our previous positions.  Rather, our current work at FHFB
and the recent work at OFHEO and HUD have strengthened our belief
that FHFB's, OFHEO's, and HUD's oversight of the housing GSEs would
be more effective if combined. 

A single regulator for the housing GSEs would have four important
attributes that would facilitate improvements in the safety and
soundness and mission oversight functions now mandated to FHFB. 
First, a single regulator would be more independent and objective
than separate regulatory bodies can be.  A single regulator would not
be affiliated with one particular GSE, dependent on that GSE for its
continued existence, and thus subject to their influence.  Because
the operations and interests of the System, Fannie Mae, and Freddie
Mac do not align precisely, there should be a healthy tension in the
oversight of the entities that could help prevent the regulator from
being "captured" by the GSEs.  In addition, a single regulator would
not be inclined to promote any one particular segment of the GSE
housing finance industry over another because its fate would not be
tied to the existence of one particular GSE. 

Second, a single regulator would be more prominent in government than
FHFB, OFHEO, and HUD's GSE oversight function can be alone.  This
would not only afford the regulator more "clout" in overseeing the
housing GSEs, but provide added weight to its opinions and findings
when presented to Congress, the Department of the Treasury, GSE
stockholders, and others in the public and private sectors. 

Third, some economies and efficiencies would be created with a single
regulator.  Staff could share expertise in such areas as
examinations, credit and interest-rate risk monitoring, financial
analysis, and economic research.  The examination staffing
constraints we identified at FHFB and similar staffing concerns
identified at OFHEO might be alleviated by combining FHFB, OFHEO, and
HUD resources.  Plus, an arm's-length regulator without
responsibilities for any System business functions would have more
resources to use in oversight.  As we reported in chapter 2, OS was
unable, due to staffing constraints, to perform all duties required
by its own standards.  FHFB officials acknowledged that lack of
resources was also the reason the monthly off-site monitoring effort
was suspended in 1997.  A more prominent single regulator could help
attract and retain staff with the special mix of expertise and
experience needed to examine and monitor System and the other housing
GSEs--three sophisticated financial institutions. 

OFHEO's work in setting capital standards and developing a stress
test for Fannie Mae and Freddie Mac could be useful in oversight of
the System.  We have recommended in past work that adequate capital
standards be set for all the housing GSEs based on the risks they
undertake.  Bills now pending in the Senate and House propose that
the FHLBank regulator set risk-based capital standards.  The results
of OFHEO's comprehensive financial modeling to determine how much
capital its GSEs should hold may be helpful in evaluating the risks
to the System and the adequacy of its capital. 

Fourth, a single regulator would provide consistent regulation for
the GSEs serving the same economic sector and sharing the public
purpose of providing credit for housing.  Although the System, Fannie
Mae, and Freddie Mac do not directly compete in all of their
activities, they are all participants in the residential mortgage
market.  Consolidating their regulation would enable a regulator to
take into account the competitive effects that regulatory decisions
made concerning Fannie Mae and Freddie Mac would have on the System
and vice versa.  For example, some pilot programs approved by FHFB
and undertaken by some FHLBanks involve services Fannie Mae or
Freddie Mac could or currently do provide.  In one program, an
FHLBank would fund and hold mortgages originated by its member
institutions.  FHFB found that this program would provide member
institutions a way to move mortgages off their books without having
to pay fees associated with selling mortgages to Fannie Mae or
Freddie Mac or to other secondary market participants.  OFHEO
officials said they independently assessed the competitive impact of
the pilot programs on Fannie Mae and Freddie Mac.  If a single
regulator were responsible for all three housing GSEs, a single
assessment could have combined consideration of all competitive
effects and ensured regulatory consistency of oversight. 

--------------------
\14 GAO/GGD-94-38 and GAO/GGD-97-139. 

\15 The Federal Housing Enterprises Financial Safety and Soundness
Act of 1992 established OFHEO to oversee the safety and soundness of
Fannie Mae and Freddie Mac.  Other than safety and soundness and
certain other matters that the 1992 Act specifies as exclusive to
OFHEO, the 1992 Act gives general regulatory power over Fannie Mae
and Freddie Mac to the Secretary of HUD. 

\16 See Federal Housing Enterprises:  OFHEO Faces Challenges In
Implementing a Comprehensive Oversight Program (GAO/GGD-98-6, Oct. 
22, 1997). 

\17 Federal Housing Enterprises:  HUD's Mission Oversight Needs to Be
Strengthened (GAO/GGD-98-173, July 28, 1998). 

   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 4:5

FHFB generally disagreed with our analysis in this chapter, including
our assessment of its allocation of staff resources, analysis of its
strategic plan, and assessment of FHFB's coordination and mission
promotion activities.  FHFB stated that ensuring the safety and
soundness and that FHLBanks "carry out their housing finance
mission," are the primary duties of its entire staff.  We evaluated
the function and size of staff resources and overall responsibilities
of staff offices on the basis of regulatory definitions and other
published descriptions of FHFB operations.  For example, FHFB's 1997
Annual Report states that

     "The Office of Supervision (OS) is responsible for the Finance
     Board's two most important functions:  ensuring that the
     FHLBanks operate safely and soundly, and ensuring that public
     mission standards for the FHLBank System are being met.  OS
     performs these functions through on-site examinations and
     off-site monitoring."

FHFB regulations support this description, and we note that none of
the other offices have similar language in the regulations describing
their responsibilities.  Using full-time staff equivalents, as
discussed in this chapter of the draft and final reports, we
determined that OS, the office FHFB describes as "responsible for the
Finance Board's two most important functions" comprised 13 percent of
FHFB staff resources.  In addition, FHFB officials' own statements to
us that they curtailed some examination work, did not expand other
examination work, and suspended some of their off-site monitoring
performed between examinations, led us to question the adequacy of
the resources allocated to the oversight of FHLBank safety and
soundness, specifically OS.  Although FHFB said that we failed to
consider that "most of the goals listed in its strategic plan focus
on safety and soundness and compliance issues," we reviewed and
evaluated FHFB's strategic plan in the context of its regulatory
mission.  We found that most of the plan's objectives, in our
opinion, did not have a "strong" safety and soundness and compliance
component.  Instead, we concluded that they focused on changes FHFB
advocated to enhance their performance. 

FHFB strongly disagreed with our conclusions about its approach to
mission compliance oversight.  FHFB also characterized our view of
mission regulation as "passive" and "inconsistent with the plain
language of the Bank Act." It also stated that FHFB's strategy of
fulfilling its statutory mandate to ensure that the FHLBanks carry
out their housing finance mission by "actively encouraging" the
development of mission-related activities by the FHLBanks is entirely
consistent with its statutory charge.  We recognize and understand
the difficulty in regulating mission compliance, as stated in this
chapter and chapter 2.  However, we make a distinction between
mission regulation and mission promotion.  Because FHFB is ultimately
responsible for regulating the projects and programs it has promoted,
we are concerned that FHFB's strategy of "actively encouraging"
FHLBanks' development of mission-related assets could raise questions
about its independence and objectivity.  We believe an arm's-length
regulator should have all the regulatory authority it needs to ensure
mission compliance, but this should not include involvement in the
day-to-day operations of the regulated entities. 

Although FHFB contends that our conclusions about mission oversight
are based on a "lack of understanding," we instead believe this
represents a simple disagreement about what activities constitute
mission regulation.  FHFB considers its promotion activities to be a
form of regulation.  In chapter 2 of the draft and final reports, we
discuss three elements that we consider essential to mission
oversight:  "(1) a clearly defined mission, (2) well defined policies
that delineate what constitutes mission compliance, and (3) methods
to measure whether or not FHLBanks have fulfilled their mission." In
comparison, in its comments, FHFB cited three strategies a regulator
should follow, (1) measure what is being accomplished, (2) authorize
or refuse to authorize activities, subject to safety and soundness,
but also (3) define public needs that FHLBanks should meet and
mechanisms and procedures to achieve them.  We agree with FHFB's
first two strategies and view them as similar to ours.  However, we
believe Congress should define "public needs," not the regulator, as
FHFB suggests. 

Finally, we view the development of policies and procedures and a
systematic way to view FHLBank activities as an active and
appropriate means of ensuring that FHLBanks fulfill their public
purposes.  It is our view that a regulator's role is to ensure
mission compliance by defining proper mission-related activities in
regulation and then ensuring--through a combination of on-site
examinations, off-site monitoring, and other oversight efforts--that
the GSE is complying with the rules.  Contrary to FHFB's stated
emphasis on laws, regulations, and policies for "ensuring" safety and
soundness, FHFB does not subscribe to this approach for "ensuring"
mission compliance.  FHFB stated that its role is to actively foster
what it sees as appropriate System activities.  Instead, we would
encourage FHFB to develop a regulatory framework for viewing FHLBank
activities and ensure that FHLBanks comply with it. 

CONCLUSIONS AND RECOMMENDATIONS
============================================================ Chapter 5

In their 65 year history, no FHLBank has experienced a credit loss. 
However, the System of 1932 is not the System of today.  In the last
10 years, the System has undergone substantial change.  The System no
longer makes advances only to thrifts for home mortgages.  It
provides funding and liquidity to new groups of members--commercial
banks and credit unions--and to all members for more diverse
purposes, such as community development and lending to targeted
groups.  FHFB has encouraged FHLBanks to create alternative
mission-related investments in response to growing concerns about the
System's large investment portfolio.  In addition, Congress is
considering whether System activities should be expanded further to
accept additional types of collateral that could expose the System to
additional risk. 

Due to the System's expanding activities and changing business
environment, FHFB's safety and soundness regulation is increasingly
important to protect taxpayer interests.  Recognizing the importance
of safety and soundness, Congress made ensuring that the FHLBanks
"operate in a financially safe and sound manner" FHFB's primary duty
in 1992.  FHFB has established quidelines for FHLBanks to follow in
implementing financial management strategies through its "Financial
Management Policy." However, FHFB's operations do not reflect the
same prominence given its safety and soundness duty in statute.  FHFB
allocated 13 percent of its staff resources to OS.  While it shares
oversight responsibility with OP and the Office of General Counsel,
OS has the sole responsibility for doing on-site examinations to
ensure safety and soundness and mission compliance of the FHLBanks. 

FHFB examiners focused on interest-rate and credit risk, which was
generally appropriate, given the activities and risks of the
FHLBanks.  However, the 120 staff-day allocation per FHLBank was
generally not sufficient for the staff assigned to conduct the
planned analysis of the FHLBanks' operations.  As a result, examiners
often reduced the planned examination scope or eliminated examination
procedures to finish examinations on time.  Examiners also routinely
excluded elements, such as oversight by board and management,
internal control systems, and internal and external audits, which we,
FHFB, and other regulators have deemed critical to evaluate risk
management.  Rather than evaluating FHLBanks' overall systems to
review these critical areas, examiners looked for problems that had
already occurred and tracked the sources of those problems.  FHFB's
"bottom-up" approach may be useful to track known problems, but it
does not allow examiners to identify weaknesses in control systems or
other potential problems early enough for management to take
corrective action. 

FHFB's examiners generally did not follow examination procedures or
document their examinations as required by FHFB's examination manual. 
FHFB officials explained that procedures are not followed and
documented because examiners often do not have time to complete all
of the procedures described in the manual or to adequately document
their procedures or conclusions.  In addition, they suggested that
some of the examination programs contained in the manual are not well
suited to their examinations.  Especially given staff turnover, it is
important that examiners have useful guidance and adequately document
the work performed and conclusions reached during examinations. 

Mission compliance is also part of FHFB's annual examination process. 
However, FHFB acknowledged having no examination policies or
procedures outside of its reviews of the special affordable housing
and community investment programs to determine whether or the extent
to which FHLBanks were supporting housing finance.  In 1997, FHFB
began the process of determining whether it should promulgate
regulations to define and measure mission fulfillment.  Prior to
1997, mission compliance focused primarily on the AHP and CIP, two
programs that account for less than 1 percent of the System's total
assets.  FHFB also relies on the percentage of advances outstanding
to qualified thrift lenders as evidence of mission compliance.  Other
funds are invested.  FHFB's efforts to establish parameters for
nonmission investments could help ensure that a majority of System
assets are dedicated to the System's mission.  Currently, individual
FHLBank investment portfolios (including mortgage-backed securities)
ranged from 17 percent to 58 percent of total assets. 

We recognize the difficulty in developing a mission compliance
oversight mechanism because it is difficult to track how advances are
used once the funds are dispersed to System members.  FHFB has taken
several steps to develop a regulatory mechanism that would provide
procedures for determining the extent to which an FHLBank complies
with the System's mission, including hiring a consultant to study the
issue, requiring FHLBanks to self-report about their mission
compliance activities, and issuing new community support regulations. 

We identified additional weaknesses in FHFB monitoring and
enforcement programs that raised concerns about FHFB's regulatory
effectiveness.  FHFB lacks a coordinated off-site monitoring system,
which is an important part of effective safety and soundness
regulation because it can provide an early warning of potential
problems.  OS and OP produce a variety of reports that track many
aspects of the FHLBanks.  However, they do not coordinate their
monitoring activities.  Monitoring should be timely, focus on
previously identified problems, and identify potential problems. 
ROMS was not viewed as a monitoring tool, which limited its potential
benefit to examiners.  Although OS' other periodic reports tracked
useful information, OS could also benefit from the timely monitoring
under ROMS, which could allow examiners to identify problems early. 
The periodic reports prepared by OS and OP provide some monitoring
benefits; however, they are geared toward keeping the Board informed
about FHLBanks rather than keeping examiners apprised of the
condition and current activities of FHLBanks. 

Another element of effective regulation is an adequate enforcement
mechanism.  Although FHFB believes that it has adequate authority
under the statute, FHFB lacks policies and procedures that clearly
delineate its program of corrective action.  The examination manual
lists several informal methods that FHFB can take to encourage
corrective action, it primarily uses categories of examination
findings to articulate whether the FHLBank needs to take corrective
action.  This type of approach may not be sufficient were a serious
issue to develop at one of the FHLBanks.  The statute governing FHFB
gave it the authority to promulgate and enforce regulations and one
specific enforcement authority, to remove or suspend FHLBank
directors, officers, employees, or agents.  FHFB officials said they
believed the general provision would allow them to take any necessary
action through the courts.  However, we believe FHFB would be better
prepared and assured of its ability to take forceful action if its
statute enumerated the authorities granted other GSE regulators, such
as cease and desist and civil money penalties. 

Unlike other GSE regulators, FHFB does not function as an
arm's-length regulator.  In addition to its oversight
responsibilities, FHFB has an ongoing role in the System's business. 
While many of its statutory and regulatory functions are
administrative, they open the door for FHFB's involvement and
participation in System business, which it has ultimate
responsibility to oversee.  FHFB has recognized this as inappropriate
and begun to delegate several of these functions to FHLBanks.  While
we believe this is a positive step toward more arm's-length
regulation of the System, achieving arm's-length regulation will
require legislation to remove all governance functions assigned to
FHFB in statute.  Such a statutory change would not preclude FHFB's
oversight of System business; rather, it would preclude FHFB's
involvement in System business. 

FHFB is also involved in the process of developing and promoting
certain activities that it must ultimately regulate.  FHFB views this
role as consistent with ensuring the System's safety and soundness
and its mission compliance.  However, we believe that such
involvement in System business raises concerns about FHFB's
independence and objectivity because FHFB is ultimately responsible
for regulating the projects and programs it has promoted.  In
addition, because it regulates only one GSE, FHFB may have a vested
interest in the survival of the System which contributes to its
willingness to act as an advocate of the System. 

The deficiencies we identified in FHFB's examination and monitoring
programs and FHFB officials' own acknowledgement of the lack of
resources for these vital functions leads to our conclusion that
FHFB's oversight of the System needs to be strengthened to provide
on-site assurance that FHLBanks are effectively managing risk and,
thus, are operating in a safe and sound manner.  The quality,
frequency, and coordination of off-site monitoring also needs to be
improved so that problems can be detected sooner and on-site
examinations can be carried out more effectively and efficiently. 
Since 1997, FHFB has taken a number of actions to help ensure mission
achievement.  However, FHFB is not yet in a position to ensure that
the FHLBanks are carrying out their housing finance mission given
that FHFB does not yet have policies or procedures, other than for
special targeted-lending programs and self-reporting, to make such a
judgment. 

FHFB's limitations as a regulator need to be viewed against the
backdrop of its continuing role, provided in statute, in System
business, as well as its innovation and promotion of System programs. 
This lack of arm's-length status--unique among GSE regulators--raises
additional questions about whether this regulatory agency is
structured for effective oversight of the safety and soundness and
mission compliance of the nation's third largest GSE. 

As noted in previous reports, we continue to believe the best way to
address many of our concerns would be to create an arm's-length
regulator.  A single regulator for the housing GSEs would help
address many of the deficiencies we found at FHFB, HUD, and OFHEO.  A
single regulator would be more independent and objective, have more
prominence than all agencies individually, create potential economies
and efficiencies, and provide consistent regulation for the three
largest GSEs. 

   RECOMMENDATION
---------------------------------------------------------- Chapter 5:1

To strengthen FHFB in its primary oversight role as the safety and
soundness supervisor of the System, we recommend that FHFB

(1) ensure that critical aspects of FHLBank operations are reviewed
as part of every FHFB examination;

(2) ensure that examiners follow the guidance and complete the
appropriate examination procedures described in the examination
manual;

(3) adequately document the work performed and conclusions drawn
during examinations; and

(4) more clearly articulate and document its current enforcement
mechanisms, policies, and procedures. 

   MATTER FOR CONGRESSIONAL
   CONSIDERATION
---------------------------------------------------------- Chapter 5:2

GAO continues to support its 1994 and 1997 positions that a single
housing GSE regulator be created to oversee the safety and soundness
and mission compliance oversight of the housing GSEs.  While
considering this action, at a minimum, Congress may want to consider
taking interim action to redirect FHFB's attention to its primary
role as the System's safety and soundness regulator by making FHFB an
arm's-length regulator, as in the case of other GSE regulators.  This
could be achieved by ensuring that its statutory duties do not
involve FHFB in any System business.  In addition, Congress may want
to consider giving FHFB specific enforcement authorities it has
provided to other GSE regulators. 

(See figure in printed edition.)Appendix I
COMMENTS FROM FHFB
============================================================ Chapter 5

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pp.  12-13 and p.  51. 

(See figure in printed edition.)

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(See figure in printed edition.)

   GAO COMMENTS
---------------------------------------------------------- Chapter 5:3

1.  FHFB stated in its comment letter that during examinations it
reviews critical risk areas such as financial management,
interest-rate risk compliance and modeling, FMP compliance, and the
integrity of internal controls over various banking operations.  In
addition, it stated that when operational issues suggest weaknesses
in management or board oversight, such weaknesses are pursued.  Our
review of FHFB's examinations of the FHLBanks indicated that FHFB
examiners routinely reviewed the elements of the FHLBank operations
discussed in their comment letter.  Thus, we noted in the draft that
"all of the examinations we reviewed included reviews of FHLBank
policies and procedures to mitigate interest rate and credit risk."
However, we are concerned that OS examiners did not routinely assess
other aspects of FHLBank operations that we and other financial
industry regulators have identified as vital to evaluate risk
management.  That is, because of the growth in the size and
complexity of the FHLBanks and the additional activities in which
they have become involved, it has become increasingly important for
FHFB to evaluate the overall oversight, management, and internal
control systems of FHLBanks to assure that the institution's
management has adequate, accurate information about their operations
and that they use the information to manage the FHLBank in a safe and
sound manner.  Making such a determination can allow FHFB to
anticipate problems that may emerge from an assessment of FHLBank
management before problems develop and thereby lower its operations
risk.  We also noted in the draft that FHFB officials stated that
although they do not assess board of director and management
oversight in a top-down manner, they would attempt to determine how
those functions contributed to any problems they identify during an
examination. 

In its comment letter, FHFB stated that examiners routinely review
board minutes and other materials including internal audit materials
in the course of planning and executing each examination.  Our review
of examination work papers indicated in some cases that OS examiners
reviewed board of director minutes and internal audit reports. 
However, we did not see any indication, nor did we receive any from
the OS officials we interviewed, that the review of these materials
led to a conclusion on the part of OS examiners as to the role played
by the board of directors in overseeing the institution or, with the
exception of 2 of the 12 examinations we reviewed, of the overall
quality or reliability of the internal audit function. 

2.  In its comment letter, FHFB described how examination findings
constitute "supervisory determinations," with which FHLBank
management must comply.  FHFB also described its enforcement
authorities and pointed out that there has never been an
unimplemented directive from the Board.  We also noted in our draft
that while we found no evidence of instances in which FHFB was unable
to achieve FHLBank compliance with examination findings, we remained
concerned that FHFB would not have procedures in place if serious
problems ever were to occur. 

We described two key principles that we believe are necessary for
effective enforcement of GSE rules and regulations.  First, certain
enforcement actions should be mandatory when prespecified conditions
are met.  Second, such actions should be the result of a clear and
reasonable process.  We found that FHFB did not have policies or
procedures consistent with the two key principles.  We therefore
believe that FHFB should more clearly articulate and document its
current enforcement mechanisms, policies, and procedures. 

3.  FHFB commented that to ensure that FHLBanks fulfill their
mission, it "must actively foster the maximizing of public benefit
from the activities of the FHLBanks." We do not disagree that
maximizing public benefit may be part of FHFB's role, but we also
believe that regulation requires a regulatory framework.  We do not
consider "mission promotion" the same as "mission regulation." While
a regulator must take certain actions to ensure mission compliance,
we believe that unless FHFB develops regulations and policies to
establish boundaries for what is and is not mission-related, it will
be difficult to ensure whether a FHLBank is fulfilling the System's
mission. 

4.  FHFB commented that examinations are not its sole mission
compliance tool.  We would agree that examinations are not the only
tool available to ensure mission compliance, nor should they be. 
Further, we agree that statute, regulations, and policies should
establish a framework for mission compliance.  However, aside from
AHP and community support requirements, we are unaware of other
regulations that have been issued by FHFB on this issue.  We address
some of FHFB's proposed regulations and activities in chapters 1 and
2.  We also discuss FHFB's involvement in the development of new
products and services in chapter 4. 

5.  FHFB said that our report demonstrates a "total lack of
understanding of what effective mission regulation entails." We
believe that our differences in views are based on fundamental
philosophical differences.  As stated previously, we realize that
active involvement by the regulator is needed.  However, we view FHFB
establising policies and procedures for oversight, measuring mission
compliance, and taking action to ensure that FHLBanks fulfill their
mission, as active appropriate involvement. 

6.  FHFB said that it is impossible for an effective mission and
safety and soundness regulator not to be involved with System
business.  We believe that a regulator should be arm's-length from
the institutions it regulates.  In chapter 4 we discussed the
statutory requirements that involve FHFB in System business and the
fact that FHFB has devolved some of those requirements to FHLBank
boards.  However, we view some of FHFB's involvement in System
business as beyond its statutory requirements and continue to believe
that a regulator should not be involved in the business of its
regulated entities, as discussed in chapter 4. 

7.  FHFB said that "Part of the draft's confusion stems from failing
to analyze the inherent conflict between safety and soundness and
mission accomplishment." We discuss the trade-off between mission and
safety and soundness in chapter 4.  We also cite previous work we
performed that specifically focused on the advantages and
disadvantages of having a single safety and soundness and
mission-compliance regulator for the three housing-related GSEs,
including the healthy tension created between mission and safety and
soundness oversight. 

8.  FHFB said that the "fact that an agency authorizes an activity
does not mean that the agency cannot then effectively examine and
supervise the activity for safety and soundness." FHFB expressed its
opinion that although the Office of the Comptroller of the Currency
(OCC) and OTS charter financial institutions, they do not have
difficulty regulating them.  We have no reason to believe that
chartering an institution would preclude regulatory objectivity. 
However, when a regulator is actively involved in the development and
promotion of certain activities, as described by FHFB in its
comments, at a minimum, it creates the appearance of a conflict of
interest.  We do not disagree that a regulator should "exhort"
regulated entities to comply with statutory, regulatory, and policy
requirements and that doing so does not preclude the agency from
examining and supervising the regulated entity.  We are also aware
that OCC and OTS "advocate" Community Reinvestment Act compliance
through "written regulations to guide and facilitate that
compliance." We agree that we have not suggested that these agencies
not engage in developing "written regulations to guide and
facilitate" compliance.  In fact, we encourage FHFB to do the same
concerning FHLBanks' compliance with their housing finance mission. 

MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Thomas J.  McCool, Director
Richard J.  Hillman, Associate Director
M.  Kay Harris, Project Director
Orice M.  Williams, Project Manager
Thomas L.  Conahan, Senior Evaluator
Marion L.  Pitts, Senior Evaluator
Desiree W.  Whipple, Communications Analyst

OFFICE OF GENERAL COUNSEL,
WASHINGTON D.C. 

Rachael DeMarcus, Assistant General Counsel
Rosemary Healy, Attorney

*** End of document. ***
```