Government-Sponsored Enterprises: Federal Oversight Needed for Nonmortgage Investments
Published: 1998-03-11T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO reviewed the nonmortgage investment activities at 3 government-sponsored enterprises (GSEs)--the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac)--focusing on the: (1) enterprises' legal authority for making nonmortgage investments and federal regulatory oversight of that activity; (2) relationship between nonmortgage investment policies and practices and missions of the enterprises; and (3) extent to which the enterprises have undertaken nonmortgage investments for arbitrage profits--using the funding advantage from government sponsorship to purchase nonmortgage investments that generate profits.
section_title: What GAO Found
paragraphs: GAO noted that: (1) legally, the enterprises have broad investment authority; (2) to date, regulatory oversight activities for the three enterprises have focused on whether nonmortgage investments are safe and sound and not on whether the nonmortgage investment policies and practices are mission-related; (3) the Department of Housing and Urban Development (HUD) has not developed criteria to determine if nonmortgage investments are consistent with enterprise charter purposes; (4) in October 1997, the Farm Credit Administration (FCA) indicated that it did not have concerns that Farmer Mac's nonmortgage investment activity is inconsistent with its charter mission, but FCA also stated that the debt issuance strategy associated with the investments is intended to be temporary and to develop over a reasonable period of time; (5) therefore, according to FCA, its position could change if over time evidence does not show that such investments play a role in helping Farmer Mac achieve its mission; (6) enterprises have invested in nonmortgage assets to varying degrees with somewhat different rationales for how these investments further their charter purposes; (7) each enterprise has an investment policy that specifies permissible credit ratings, maturities, and concentration limits and describes the relationship of investments to earnings and to achievement of the enterprise's mission; (8) Freddie Mac officials indicated that its nonmortgage investments have been held for cash management purposes and as an investment vehicle, which could make capital available to help fund future anticipated demand for residential mortgages; (9) the relationship between longer term nonmortgage investments and the enterprises' mission goals is not always clear, because long-term nonmortgage investments may not facilitate liquidity in the residential mortgage market as well as short-term investments; (10) however, it is clear that nonmortgage investments generate arbitrage profits; (11) in its analysis, GAO found that the various nonmortgage investments fall along a continuum representing the degree to which they facilitate liquidity in the residential mortgage market and thus are more clearly related to the enterprises' missions; and (12) GAO's review of compensation practices and board member responsibilities at the enterprises suggests that individual incentives to generate corporate profits are structured in a manner that is fairly typical of major corporations and financial institutions without federal charters limiting their activities.

section_title: Letter
paragraphs: This report responds to your request dated April 10, 1997, and supplemented on May 13, 1997, that we gather and analyze information on nonmortgage investment activities at three government-sponsored enterprises (GSEs): the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac) (called enterprises in this report). In your request, you expressed concerns that these enterprises may be using their benefits in financial markets resulting from their government ties to make investments that may not serve the public purposes as expressed in their federal charters. Specifically, you requested that we examine (1) the enterprises’ legal authority for making nonmortgage investments and federal regulatory oversight of that activity, (2) the relationship between nonmortgage investment policies and practices and missions of the enterprises, and (3) the extent to which the enterprises have undertaken nonmortgage investments for arbitrage profits—using the funding advantage from government sponsorship to purchase nonmortgage investments that generate profits. In relation to the third objective, you also asked us to provide information on the enterprises’ compensation structures for directors and senior managers and whether these structures create incentives for making nonmortgage investments.
subsections: section_title: Background
paragraphs: Congress created GSEs to help make credit available to certain sectors of the economy, such as housing and agriculture, in which the private market was perceived as not effectively meeting credit needs. GSEs receive benefits from their federal charters that help them fulfill their missions. Freddie Mac and Fannie Mae (the housing enterprises) have federal charters granting each of them explicit benefits, which include (1) exemption from registering their securities with the Securities and Exchange Commission (SEC), (2) exemption from state and local corporate income taxes, and (3) use of the Federal Reserve as a transfer agent. Farmer Mac is subject to SEC registration requirements, but it uses the Federal Reserve as a transfer agent, and Farmer Mac officials told us that it is exempt from state income taxes in most states. The most important benefit that all three enterprises receive is an implicit one stemming from investors’ perception that the federal government would not allow the enterprises to default on their obligations. Due to this perception, investors do not demand yields on investments in enterprise debt and mortgage-backed securities that are as high as those on comparable financial instruments issued by corporations without government sponsorship. One result of government sponsorship, therefore, is a reduction in debt costs compared with debt costs in similar corporations without government sponsorship.
Freddie Mac and Fannie Mae were chartered by Congress to enhance the availability of residential mortgage credit across the nation. The housing enterprises accomplish this mission by purchasing residential mortgages from lenders. The housing enterprises retain some of the mortgages they purchase in their own portfolios, but a majority of the mortgages are pooled into mortgage-backed securities (MBS) that are sold to investors in the secondary residential mortgage market. As of December 1996, Freddie Mac had about $463 billion in MBS obligations and $156 billion in debt obligations outstanding. The corresponding figures for Fannie Mae were about $548 billion and $331 billion, respectively. Therefore, combined MBS and debt obligations of these housing enterprises totaled about $1.5 trillion.
Farmer Mac was chartered by Congress to enhance the availability of agricultural mortgage credit across the nation. Farmer Mac is making efforts to establish a secondary mortgage market for agricultural mortgages along the lines the housing enterprises have established for residential mortgages. Farmer Mac issues, and guarantees payment on, agricultural mortgage-backed securities (AMBS). One type of AMBS, called Farmer Mac I securities, is backed by agricultural mortgages not containing federally provided primary mortgage insurance. The other type of AMBS, called Farmer Mac II securities, is backed by agricultural mortgages containing primary mortgage insurance provided by the Department of Agriculture. Farmer Mac is a small financial institution in comparison to the housing enterprises. As of December 31, 1996, Farmer Mac had about $642 million in AMBS (of which about $226 million were owned by others, and about $416 million were held by Farmer Mac) and about $546 million in debt obligations outstanding. Therefore, combined AMBS owned by others and debt obligations of Farmer Mac totaled about $772 million.
The housing enterprises pass along, at least in part, the benefits they receive from government sponsorship, such as lower debt costs, to residential borrowers. In a previous study, we estimated that interest rates on single-family, fixed-rate, conforming mortgages were probably 15 to 35 basis points lower than they would have been without government sponsorship of the enterprises. Limiting the activities of the housing enterprises primarily to funding conforming residential mortgages helps create a mechanism for the benefits they receive, such as lower debt costs, to be passed through to borrowers. Such limitations are consistent with the special purpose charters imposed by Congress. Congress gave the Department of Housing and Urban Development (HUD) general regulatory authority over the housing enterprises so that HUD can ensure that the missions of these enterprises as stated in their respective charter acts are being fulfilled. HUD also has regulatory authority to approve new mortgage programs proposed by the housing enterprises. In consideration of the potential risks to taxpayers from an enterprise default on its financial obligations, Congress created safety and soundness regulators for the enterprises. HUD’s Office of Federal Housing Enterprise Oversight (OFHEO) is the safety and soundness regulator of the housing enterprises. The Farm Credit Administration (FCA), through its Office of Secondary Market Oversight (OSMO), has regulatory responsibility with respect to Farmer Mac, including specific authority over safety and soundness matters.
section_title: Scope and Methodology
paragraphs: We reviewed the enterprises’ charters and relevant statutes to examine the enterprises’ legal authority for making nonmortgage investments and regulatory oversight of that activity. We obtained and analyzed publicly available and proprietary information on the enterprises’ investment policies, practices, and justification of those policies and practices to examine the relationship between nonmortgage investment policies and practices and missions. We reviewed literature on the role of the housing enterprises in the residential mortgage market to examine the extent to which the enterprises have undertaken nonmortgage investments for arbitrage profits. We also interviewed officials at the enterprises, HUD, OFHEO, and FCA; and we received written responses to questions submitted to the Department of the Treasury.
We obtained and analyzed information the enterprises considered to be proprietary that included information packages prepared for board members of the enterprises; detailed information on nonmortgage investments, their yields, and maturity; yield and other characteristics of enterprise debt issued to fund the nonmortgage investments; and compensation policies for senior officers and board members. We do not report specific details of the enterprises’ investment policies and practices or compensation policies because of the proprietary nature of such enterprise information.
Our interviews with officials at OFHEO and FCA on their regulatory oversight of nonmortgage investments included discussion of proprietary information relied upon by the regulators in making their safety and soundness determinations regarding nonmortgage investments. We did not verify their findings leading to the safety and soundness determinations. Generally, the financial practices that the housing enterprises used to limit the interest rate and credit risks of their nonmortgage investments were fairly straightforward. From the data we collected at the housing enterprises and interviews with housing enterprise and OFHEO officials, we obtained a general understanding of OFHEO’s determinations. In contrast, the financial practices that Farmer Mac used to limit the interest rate risk of its nonagricultural-mortgage investments were not as straightforward and were not fully captured by the specific data we collected from Farmer Mac. Therefore, we were not able to obtain as complete an understanding of FCA’s determinations.
We obtained written comments on a draft of this report from each of the three enterprises, HUD, OFHEO, FCA, and Treasury. Their comments are discussed near the end of this report and are reprinted in appendixes III through IX. We conducted our work in Washington, D.C., from April 1997 through October 1997 in accordance with generally accepted government auditing standards.
section_title: Each Enterprise Has Broad Investment Authority but Is Subject to Regulatory Oversight
paragraphs: The charters of all three enterprises provide them with broad investment powers. OFHEO has clear authority to regulate investments by the housing enterprises if such investments pose a safety and soundness concern. HUD has general regulatory authority over the housing enterprises and is charged with making such rules and regulations as shall be necessary and proper to ensure that the purposes of the respective charter acts are accomplished. In addition to general regulatory authority, HUD also has authority to approve new mortgage programs that could contain nonmortgage investment components. FCA, through OSMO, has safety and soundness and general regulatory authority with respect to Farmer Mac.
subsections: section_title: The Enterprises Have Broad Legal Authority to Make Investments
paragraphs: “to enter into and perform contracts, leases . . . or other transactions, on such terms as it may deem appropriate . . . to lease, purchase, or acquire any property, real personal or mixed . . . and to sell, for cash or credit, lease, or otherwise dispose of the same, at such time and in such manner as and to the extent that it may deem necessary or appropriate, . . . and to do all things as are necessary or incidental to the proper management of its affairs and the proper conduct of its business.”
The Farmer Mac charter act empowers it to, among other things, “ . . . purchase or sell any securities or obligations . . . necessary and convenient to the business of the Corporation.”
One general rule of law is that a corporation’s powers can be no broader than the purposes for which the corporation is organized. This rule is particularly relevant where, as in the case of the enterprises, the corporation is organized for special, as opposed to general, purposes. Thus, even though the enterprises have broad investment powers, the exercise of those powers should not be unrelated to the accomplishment of the special purposes for which the enterprises were created. Under general corporate law, this relationship has been described as the logical relation of the activity to the corporate purpose expressed in the charter.
section_title: OFHEO and FCA Have Clear Authorities to Limit Nonmortgage Investments for Safety and Soundness Reasons
paragraphs: OFHEO, as safety and soundness regulator, is charged with ensuring that the housing enterprises are adequately capitalized and operate safely and in accordance with the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the 1992 Act). OFHEO has regulatory and enforcement authority, without the review or approval of HUD, with respect to matters generally related to enterprise safety and soundness and to a few specific matters, including certain capital distributions and executive compensation at the enterprises. Therefore, OFHEO has authority to supervise an enterprise investment that affects the enterprise’s safety and soundness without consultation with HUD. Actions taken by OFHEO with respect to other matters not specified in the 1992 Act as exclusive to OFHEO are subject to the review and approval of the Secretary of HUD.
FCA, through OSMO, has regulatory responsibility for Farmer Mac. Among other things, OSMO is responsible for ensuring that Farmer Mac holds adequate capital for the activities it performs and operates in a safe and sound manner. OSMO is also responsible for supervising the safety and soundness of Farmer Mac’s program and investment activities.
subsections: section_title: The Enterprises’ Nonmortgage Investments Have Not Created a Safety and Soundness Concern
paragraphs: OFHEO has concluded that each housing enterprise’s nonmortgage investment policies and practices have not constituted a safety and soundness concern. Its conclusion was largely based on how each enterprise matched the maturities (and related characteristics) of its debt obligations used to finance its nonmortgage investments with those investments and the high credit standards and generally short maturities of the nonmortgage investments.
As of April 1997, OSMO concluded that Farmer Mac’s nonagricultural-mortgage investment activities had not raised a safety and soundness concern. OSMO found that the size of Farmer Mac’s investment portfolio was not unsafe and unsound relative to the statutory capital requirement, and the composition of the portfolio was not unsafe or unsound.
section_title: Regulators Have Not Focused on Nonmortgage Investments and Their Relationship to Charter Missions
paragraphs: Although OFHEO and FCA have examined safety and soundness implications of nonmortgage investments, HUD and FCA told us that prior to mid-April 1997 they had not focused on nonmortgage investment policies and practices in carrying out their general regulatory authority with respect to the enterprises’ charter missions. The scope of HUD’s general regulatory authority as it relates to nonmortgage investments is not clearly defined in statute. However, as discussed later in this report (see p. 11), HUD has initiated action to determine how it should implement this authority. FCA has general regulatory authority that would allow oversight of Farmer Mac’s investment activities. However, FCA said it has no activities under way that are expected to culminate in regulation of Farmer Mac’s investments.
subsections: section_title: HUD Has General Regulatory Authority
paragraphs: Section 1321 of the 1992 Act provides that except for the specific powers granted OFHEO, HUD has “general regulatory power” over each housing enterprise. HUD also is charged with making “such rules and regulations as shall be necessary and proper to ensure” that the provisions of the 1992 Act concerning new mortgage programs and housing goals and the purposes of the respective charter acts are accomplished.
The scope of HUD’s authority under this section is not defined. With respect to investments, the statute does not set forth any criteria other than the charter acts themselves as a basis for HUD’s exercise of its general regulatory power and rulemaking authority. As discussed previously, the charter acts provide Fannie Mae and Freddie Mac with broad authority to make investments. This raises a question about the extent to which HUD has authority to regulate nonmortgage investments by the housing enterprises. “It is the intent of the committee that the regulatory powers of the Secretary will not extend to (the enterprise’s) internal affairs, such as personnel, salary, and other usual corporate matters, except where the exercise of such powers is necessary to protect the financial interests of the Federal Government or as otherwise necessary to assure that the purposes of the (charter act) are carried out.”
Fannie Mae asserted that its investment practices are internal corporate affairs subject to its broad discretion. Thus, according to the enterprise, the above-quoted legislative history and other Congressional statements indicate Congress’ intention that HUD should not exercise its general regulatory authority with respect to Fannie Mae’s investment activities except in the “extreme situation” where those activities endanger its statutory mission.
It is unclear that Congress intended to limit HUD’s authority with respect to nonmortgage investments, particularly in light of the special purposes of the housing enterprise charters and the broad statutory language establishing the Secretary’s general regulatory power and rulemaking authority. But even if, as Fannie Mae contends, nonmortgage investments are usual corporate matters, HUD could take regulatory action, such as requiring reports of nonmortgage investment activities, in cases where HUD appropriately determines the action is necessary to ensure the accomplishment of the enterprises’ charter acts.
section_title: HUD Has Begun a Rulemaking Effort
paragraphs: Since April 1997, HUD has been evaluating the scope of its authority with respect to the mission-relatedness of enterprise investments. HUD officials said they are considering a range of possible regulatory standards for enterprise investments that could be appropriate and within the scope of HUD’s statutory authority. On the one end of the range being considered is a narrower standard based on an enterprise activity being reasonably related to the enterprise’s mission; and on the other end is a broader standard based on an activity not conflicting with the enterprise’s mission.
HUD’s mission regulation actions since the passage of the 1992 Act have focused on developing numeric goals governing enterprise purchase of mortgages serving very-low-, low-, and moderate-income households and other underserved borrowers; promulgating rules containing numeric goals; and enforcing the numeric standards. HUD officials told us that the activities of HUD’s Office of Government Sponsored Enterprises Oversight have continued to focus on the numeric goals and fair lending issues.
HUD officials said that they had not focused attention on nonmortgage investment practices at the enterprises prior to the mid-April 1997 public disclosure of and publicity surrounding Freddie Mac’s nonmortgage investment in long-term Phillip Morris bonds. At that time, HUD requested information from Freddie Mac on its nonmortgage investments and received a reply from Freddie Mac on April 28. In our August 1997 discussion with HUD, officials told us they have decided to use their general regulatory authority to request reports from the housing enterprises on their investment policies and practices. HUD’s plan is to monitor investment trends so that it can determine if the investments are consistent with the enterprises’ missions and purposes as defined in their charters. On November 13, 1997, HUD’s Director of Government Sponsored Enterprises Oversight made her first request for a report on nonmortgage investment activity from the housing enterprises.
In August 1997, HUD told us it had reached the decision to begin a rulemaking effort by publishing an advance notice of proposed rulemaking soliciting comments on how HUD should carry out its general regulatory authorities with respect to nonmortgage investments by the housing enterprises. HUD received executive branch approval and published the advance notice on December 30, 1997.
section_title: FCA Has General Regulatory Authority
paragraphs: FCA has general regulatory authority over Farmer Mac. Under the Farm Credit Act of 1971, FCA has general regulatory authority over institutions in the Farm Credit System, one of which is Farmer Mac. FCA officials told us that the agency implements this authority through OSMO. As required by statute, the Director of OSMO is selected by and reports to the FCA Board.Moreover, the statute charges FCA with ensuring that OSMO is adequately staffed to supervise Farmer Mac’s secondary market activities, although, to the extent practicable, the personnel responsible for supervising the corporation should not also be responsible for supervising the banks and associations of the Farm Credit System. This regulatory structure provides for a degree of separation between FCA’s general regulatory responsibilities and its safety and soundness responsibilities with respect to Farmer Mac. However, the structure does not appear to limit FCA’s general regulatory authority.
During our review, we conducted three interviews with FCA and OSMO officials that included discussion of general regulatory authorities as they apply to nonagricultural-mortgage investments. Over the course of these interviews, we observed an evolution in their thinking on this topic. At the beginning of our review, the OSMO director told us that its focus in examining nonagricultural-mortgage investments had been on matters pertaining to safety and soundness. Toward the end of our review, it appeared to us that FCA and OSMO officials began to focus some attention on the relationship between nonagricultural-mortgage investments and mission achievement.
In October 1997, FCA indicated that, for now, it did not have concerns that Farmer Mac’s nonmortgage investment activity is inconsistent with its charter mission. However, FCA also stated that the debt issuance strategy associated with the investments is intended to be temporary and to develop over a reasonable period of time. Therefore, according to FCA, its position could change if over time evidence does not show that such investments play a role in helping Farmer Mac achieve its mission.
section_title: HUD Approved Fannie Mae’s Proposed Mortgage Protection Plan Under Its New Mortgage Program Authority
paragraphs: The enterprises may at times propose new mortgage programs that contain nonmortgage investment components. In addition to its general regulatory authority, HUD also has regulatory authority to approve new mortgage programs proposed by the housing enterprises. HUD used this authority to review Fannie Mae’s proposed mortgage protection plan (MPP), which it approved on June 23, 1997. On that date, OFHEO’s acting director provided the Secretary of HUD a letter with his determination that MPP would not create a “risk of significant deterioration of the financial condition” of Fannie Mae; this determination is required for the Secretary of HUD’s approval. Under the proposed program, Fannie Mae would purchase a cash value life insurance policy—essentially a nonmortgage investment—on a first-time homebuyer after the selected borrower’s residential mortgage was purchased by Fannie Mae and the borrower agreed to accept such coverage. The policy would protect Fannie Mae and the homebuyer against the risk that the mortgage would not be paid due to the borrower’s death. The policy also would offer limited protection against default and foreclosure due to disability and job loss. Due in part to potential tax benefits available under current tax law when HUD approved MPP, and in part to Fannie Mae’s relatively low cost of capital, Fannie Mae expected that MPP would be profitable. Since HUD’s approval, however, a new tax bill was signed into law that, according to Treasury, substantially reduced the tax benefits that were available to Fannie Mae under the MPP. Fannie Mae officials told us that Fannie Mae has decided not to go forward with the program.
In commenting on a draft of this report, HUD stated that it did not possess detailed knowledge of the intricacies of the life insurance industry at the time MPP was submitted for review. We did not see evidence that HUD provided Fannie Mae’s MPP proposal to anyone with experience in evaluating cash value life insurance. HUD determined that although it would have been helpful, detailed industry expertise was not necessary to HUD’s review and understanding of MPP’s potential benefits to borrowers and its related costs. A Treasury attorney with expertise in life insurance provided basic information about life insurance products to HUD. However, according to HUD officials, HUD determined that providing information on MPP to Treasury was not necessary as it had obtained sufficient information and analysis to complete its work. In its written response to us, Treasury said: “Since HUD has the statutory responsibility to rule on Fannie Mae’s request to undertake the MPP, and since HUD did not ask for the Treasury’s assistance in making its determination regarding the MPP, the Treasury did not seek to obtain additional information from Fannie Mae.”
HUD’s new mortgage program review authority states that the Secretary can disapprove a new mortgage program if he finds that the program is not in the public interest. HUD did not include tax revenue losses in its analysis for the public interest determination. In commenting on a draft of this report, HUD stated its belief that tax issues were within the scope of the MPP review but that in making its public interest determination, HUD would find it difficult to conclude that a practice that is permissible under current tax law was nevertheless against the public interest. Consequently, in its legal analysis, HUD took the position that as long as the MPP program is permissible under the current laws, MPP should not be regarded as against the public interest solely on the basis of a potential adverse impact on federal revenues or the concomitant favorable impact on Fannie Mae’s tax position. “The Treasury has long been concerned about the revenue loss from the favorable tax treatment of cash value life insurance with business policyholders or beneficiaries, and the MPP highlighted these concerns. However, this tax policy concern was not limited to the MPP. In August, Congress passed and the President signed a tax bill that dealt with some of the principal tax policy concerns associated with the MPP.”
section_title: The Relationship of the Enterprises’ Nonmortgage Investments to Earnings and Mission
paragraphs: Nonmortgage investments constituted 10 to 15 percent of on-balance sheet assets at the housing enterprises at June 30, 1997, and most of these investments are short term (i.e., maturities of less than 5 years). Freddie Mac, however, created an investment fund in 1997 authorized to contain up to $10 billion in nonmortgage investments with maturities of over 5 years. Farmer Mac embarked on a debt issuance strategy in 1997 in which the debt largely finances nonagricultural-mortgage investments; such investments grew during the first half of 1997 to about 66 percent of Farmer Mac’s assets. The housing enterprises stated that they hold nonmortgage investments primarily for cash management purposes and to employ capital not currently needed to fund mortgages. Farmer Mac officials stated that Farmer Mac makes nonagricultural-mortgage investments primarily to invest funds from debt issuance that exceed purchases of agricultural mortgages.
subsections: section_title: Overview of Enterprise Nonmortgage Investments
paragraphs: Nonmortgage investments constituted about 15 percent of on-balance sheet assets at Fannie Mae and 9 percent at Freddie Mac as of year-end 1996. Table 1 shows selected statistics on mortgage assets and stockholders’ equity (i.e., capital) to provide further perspective. For example, nonmortgage investments were about 2.6 percent of Freddie Mac’s and about 6.3 percent of Fannie Mae’s total mortgage servicing portfolio. Nonmortgage investments were more than double Freddie Mac’s capital and more than four times Fannie Mae’s capital. At Farmer Mac, nonagricultural-mortgage investments were about one-fourth of on-balance sheet assets and over three times capital.
As shown in table 1, over 65 percent of Freddie Mac’s nonmortgage investments and over 40 percent of Fannie Mae’s were short-term investments in cash, cash equivalents, term federal funds, and eurodollar deposits. Freddie Mac’s and Fannie Mae’s 1996 annual reports also showed overall nonmortgage investments by contractual maturity. About 78 percent of Freddie Mac’s nonmortgage investments had maturities under 1 year, and about 93 percent had maturities under 5 years. The corresponding figures for Fannie Mae were 68 and 75 percent. According to housing enterprise officials, all of their nonmortgage investments were investment-grade. According to the data provided on sales of holdings, neither housing enterprise appears to have actively engaged in frequent selling of its nonmortgage investments.
Between the end of 1996 and the end of the second quarter of 1997 (June 30, 1997), the two housing enterprises’ total assets grew (see table 2). Freddie Mac’s assets grew about 5.8 percent, and Fannie Mae’s assets grew about 4.3 percent. Both enterprises’ nonmortgage investments remained relatively stable at about 10 percent of assets for Freddie Mac and at about 15 percent of assets for Fannie Mae.
Farmer Mac’s assets more than doubled from $603 million at year-end 1996 to about $1.4 billion at June 30, 1997; its nonagricultural-mortgage investments grew about sixfold—from $155 million to $931 million—and accounted for virtually the entire increase in total assets. At June 30, 1997, these investments totaled about 66 percent of its total on-balance sheet assets.
The housing enterprises undertake nonmortgage long-term investments, and Farmer Mac undertakes nonagricultural-mortgage long-term investments. These longer term investments (i.e., more than 5 years) include fixed-rate debt and variable-rate asset-backed securities (ABS).The three enterprises fund these investments by issuing debt and undertaking different strategies, which are incorporated in their investment policies, to limit interest rate risks. Generally, the housing enterprises (1) match fund their fixed-rate nonmortgage investments—they issue debt of the same maturity as the investment; and (2) fund their variable-rate ABS with either short-term debt with the maturity of that debt matching the reset provision (i.e., the time period between the dates when the interest rate adjusts) in the ABS or with variable-rate debt. Enterprise officials told us that to the extent interest rate risks still exist after they use the above-mentioned practices, they use hedging strategies to lessen or eliminate such risks.
section_title: Housing Enterprises Say That They Hold Nonmortgage Investments for Cash Management and to Make Capital Available to Help Fund Mortgage Purchases
paragraphs: Freddie Mac officials told us that the primary purposes for holding nonmortgage investments with maturities of under 5 years is for cash management and to meet future anticipated demands for funding residential mortgages. About 7 percent of Freddie Mac’s nonmortgage investments, as of December 31, 1996, had stated maturities exceeding 5 years. However, according to Freddie Mac officials, these investments with longer stated maturities included asset-backed securities that are expected to be paid off, and thereby terminate, prior to their stated maturity dates.
In March 1997, Freddie Mac created a nonmortgage investment fund to hold securities with maturities exceeding 5 years to be generally funded by matched maturity noncallable debt. Freddie Mac officials told us that the primary purpose of this new fund, which is authorized to contain up to $10 billion, is to meet future unanticipated demands for funding residential mortgages. Freddie Mac officials told us that the amount of its other nonmortgage investment funds, which generally have maturities under 5 years, would decline. In addition, they also made the following five points about the longer maturity investments in the newly created fund:
Freddie Mac would not likely sell these longer maturity nonmortgage securities, because the fund is meant to provide a source for funding those mortgages whose demand is unanticipated. If unanticipated demands for funding mortgages did occur, capital to help support mortgage purchases could be made available by selling the nonmortgage assets, which would be quicker than raising additional capital.
Longer maturity nonmortgage investments do not exhibit the prepayment risks (i.e., the risk that borrowers would pay off their mortgages early, thus terminating payment streams) associated with mortgages.
Match funding these investments (i.e., issuing debt with the same maturity of the investment) would allow Freddie Mac to access the noncallable bond market without generating interest rate risk.
The longer-term nonmortgage investment portfolio would help stabilize income when necessary to counteract adverse earnings’ impact from other forces.
Fannie Mae officials told us that the primary purposes for holding nonmortgage investments are for cash management, as an investment vehicle to employ capital not currently needed to fund mortgages that is intrinsically appropriate for a financial corporation of its size, and to maintain a capital cushion in excess of minimum capital requirements. They told us that such a capital cushion enables them to respond to capital markets and fund residential mortgages. Fannie Mae officials told us that nonmortgage investments with maturities exceeding 5 years are a relatively small portion of its total business. They told us that most of these securities are asset-backed securities with variable interest rates and that the variable rate characteristic reduces the interest rate risk associated with fixed-rate long-term bonds and, thus, is important to its overall safety and soundness.
section_title: Farmer Mac Makes Nonagricultural-Mortgage Investments Primarily to Invest Funds From Debt Issuance That Exceed Its Purchases of Agricultural Mortgages
paragraphs: In February 1997 Farmer Mac’s board changed its investment policies in order to increase Farmer Mac’s presence in the capital markets, particularly the debt markets, to help attract investors to its securities and thereby reduce its borrowing and securitization costs. The board and management believe that increasing Farmer Mac’s presence in the debt markets will improve the pricing of its agricultural mortgage-backed securities and thereby enhance the attractiveness of the products it offers through its programs for the benefit of agricultural lenders and borrowers. Farmer Mac officials said that although the ultimate objective of Farmer Mac’s increased debt issuance strategy is to invest the proceeds in loans qualifying for inclusion in its securitization and guarantee programs, during the initial period in which Farmer Mac is increasing its debt issuances it will be investing those proceeds in interest-earning nonagricultural-mortgage investment assets. In commenting on a draft of this report, Farmer Mac proposed that 2 to 3 years could serve as a reasonable time frame within which the anticipated increased market interest in its AMBS will occur.
FCA and OSMO officials said that Farmer Mac’s rationale for its debt issuance strategy for enhancing the secondary market in AMBS is plausible at this point in time. However, FCA and OSMO officials noted that the extensive nonagricultural-mortgage asset holdings are supposed to be temporary until Farmer Mac’s debt and AMBS costs decline to levels comparable to those for the housing enterprises. Should Farmer Mac’s strategy prove unsuccessful, then FCA and OSMO may revisit the appropriateness of the existing Farmer Mac nonagricultural-mortgage investment portfolio policy and practices. In the interim, FCA, through OSMO, is monitoring the Farmer Mac strategy. FCA and OSMO officials said they have set no time frame for assessing the success of the debt issuance strategy.
section_title: Nonmortgage Investments Differ in the Degree to Which They Generate Arbitrage Profits and Relate to Mission
paragraphs: Enterprise officers and board members have incentives to increase shareholder value, just as the officers and board members of private corporations do. However, unlike private corporations, the enterprises also have public missions stated in their charters. Thus, these enterprise incentives can create tensions between increasing shareholder value and fulfilling the public mission. In addition, the enterprises have opportunities to generate arbitrage profits that can increase shareholder value and that are not available to private corporations. Financial analysts generally define arbitrage as profiting from differences in price when the same security is traded on two or more markets. However, arbitrage can also arise if securities have different yields by virtue of differences in government-provided benefits between those securities. We are using this latter definition of arbitrage in considering enterprise nonmortgage investments. Under this definition, at least some enterprise nonmortgage investments generate arbitrage profits. In addition to generating arbitrage profits, nonmortgage investments can contribute to achieving the enterprises’ missions, although shorter maturity nonmortgage investments more clearly relate to mission than do longer maturity nonmortgage investments. Because the enterprises can generate arbitrage profits and because of the tension between shareholder interests and mission achievement, it is important for the mission regulators, HUD and FCA, to ensure that the missions of these enterprises as stated in their respective charter acts are accomplished.
subsections: section_title: Enterprise Officers and Board Members Have Incentives to Increase Shareholder Value
paragraphs: According to enterprise officials, the competitiveness of today’s marketplace literally demands that the enterprises recruit and maintain the caliber of executive officers and board members that will help ensure that their corporations remain among the top-performing organizations. Such action includes the construction of compensation packages that will attract top performers and that contain incentives that will promote the achievement of corporate objectives in addition to satisfying shareholder interests. To ensure that they are in line with current trends, the enterprises have used consulting firms to review and compare the pay structure of their officers and board members with the pay structure of comparable positions in similar private sector financial institutions and other enterprises. Our review of published literature and other information on executive and board compensation the enterprises and OFHEO provided us suggests that in today’s world, more companies are including stock-based compensation for their directors and officers to help create an economic alignment of director and shareholder interests. Like their competitors, the enterprises award stock-based compensation to their board members and senior officers with the intention of helping them to focus on the long-term success of their corporations.
In establishing statutory authority, Congress set the tone for the governance structure of all three enterprises—Freddie Mac, Fannie Mae, and Farmer Mac. Each of these shareholder-owned corporations, which also have a public mission, is governed by a board consisting of shareholder-elected directors and appointed directors. Statutory authority provides that the total number of directors elected by shareholders include 13 at Freddie Mac, 13 at Fannie Mae, and 10 at Farmer Mac; each of the enterprises must have 5 directors appointed by the president. According to enterprise officials, the directors have the same or similar duties and obligations as directors of other private corporations, including fiduciary responsibilities to shareholders and the establishment of general operation policies that govern the companies. All directors, whether elected or appointed, share the same duties and obligations, which are primarily carried out through participation in and preparation for board and committee meetings. All directors of the housing enterprises serve 1-year terms unless reelected or reappointed. Appointed directors of Farmer Mac serve at the pleasure of the president, the elected directors serve 1-year terms.
In keeping with statutory requirements, the housing enterprises’ compensation structure is built upon a philosophy of comparability (i.e., compensation is reasonable and comparable to that of similar businesses) and pay for performance, which includes the achievement of individual as well as corporate-level objectives. All three enterprises have committees that set policy and make recommendations concerning compensation. Annual evaluations allow for salary adjustments based on merit performance and the need to maintain market competitiveness.  Board members of all three enterprises receive cash compensation in the form of an annual retainer and stipulated fees for attending board and committee meetings. In addition to the cash, board members receive long-term compensation in the form of stock and stock options (see table 3). Similarly, in addition to their base salaries, senior managers of the enterprises receive bonuses (which are to recognize their individual contributions to the success of corporate goals), as well as stock and stock options designed to ensure sustained corporate success.  (See app. II for more detailed information on the enterprises’ compensation structures.)
section_title: Tension Between Increasing Shareholder Value and Achieving Mission
paragraphs: Private corporations without government sponsorship provide incentives to their senior management and board members to take actions that will increase profits and shareholder value. The enterprises have instituted compensation packages that conform closely to those of private corporations, including financial institutions, with which they compete for individuals with specific skills. These compensation packages include stock-based compensation strategies that have the intent of aligning the economic interests of managers and directors with shareholder interests.The compensation packages that board members at the enterprises receive do not differ according to whether the board member is shareholder elected, presidentially appointed, or chosen by another method. The enterprises told us that the orientation and training activities they provide new board members do not differ according to how the board member is selected. The enterprises also told us that board members are instructed to advocate corporate activities that enhance shareholder value while supporting the enterprise’s charter purposes. From our analysis, it appears to us that compensation incentives available to enterprise senior management and board members, including stock-based compensation, reinforce the tension between increasing shareholder value and achieving mission. At a minimum, stock-based compensation can affect how broadly board members and senior managers interpret whether the corporate activities they advocate contribute to fulfillment of mission.
Freddie Mac officials disagreed with our view that a tension exists between increasing shareholder value and achieving mission. They told us that the two goals were compatible and codependent. They stated that Congress wanted a private company to fill a public purpose. With this role, they noted that if one were to ignore the entity of the shareholder, the public mission cannot be fulfilled. We note that short of ignoring the interests of the shareholder, a tension exists. It is this tension that hightlights the importance of mission oversight. Without effective mission oversight, the incentives to use the benefits of government sponsorship to increase shareholder value could, over time, erode the public mission. If this were to occur, long term nonmortgage investments could become an increasing part of the housing enterprises’ portfolios and Farmer Mac’s temporary approach could become a permanent strategy even it it does not enhance Farmer Mac’s ability to purchase agricultural mortgages.
section_title: Arbitrage Can Arise If Securities Have Different Yields by Virtue of Differences in Government Provided Benefits
paragraphs: In a previous report about the housing enterprises, we concluded that the greatest benefit to the enterprises from government sponsorship flows from the market perception of an implied guarantee on enterprise obligations, because this perception generates a funding advantage—a reduction in yields on enterprise debt. In that report, we indicated that the funding advantage could be in the range of 30 to 106 basis points. This range took into account the long-term nature of residential mortgage investments, and it assumed that the housing enterprises would receive a credit rating between a high of AAA and a low of A if their government sponsorship were eliminated. Findings from our analysis of housing enterprise financial data are consistent with this estimated funding advantage range and with a credit rating between AA and A. Appendix I contains a more detailed discussion of our analysis.
In the previous report about the housing enterprises, we indicated that government sponsorship of the housing enterprises lowered interest rates on single-family, fixed-rate, conforming mortgages. Although the benefits of government sponsorship reduce certain mortgage interest rates, there is no similar effect on the yields of nonmortgage investments, because the enterprises are not a significant source of funding outside the residential mortgage market. Thus, there is an additional incentive for the enterprises to issue debt, whose yield is lower by virtue of government sponsorship, to invest in nonmortgage investments, whose market yields will be relatively higher because they are not affected by government sponsorship.
Farmer Mac is a government-sponsored enterprise that also benefits from the market perception of an implied guarantee on enterprise obligations. It is, however, a much smaller and less established corporation than either of the housing enterprises. As a result, it is difficult to estimate Farmer Mac’s funding advantage. For example, we do not know whether it could remain in business without government sponsorship or what its credit rating would be if it became a going concern as a private corporation without government sponsorship. If its credit rating without government sponsorship would be less than A, its funding advantage from government sponsorship could be greater than the advantage for the housing enterprises. However, Farmer Mac’s securities may be currently perceived by market participants as more risky than housing enterprise securities. Farmer Mac documents provided to us in July 1997 indicated that yields on Farmer Mac debt had been between 1 and 10 basis points higher than yields on equivalent housing enterprise debt prior to Farmer Mac’s new debt issuance strategy, and these yield differences had not yet been eliminated by Farmer Mac’s debt issuance strategy.
Of the specific nonmortgage investments made by the enterprises, public information is available on one investment that generated arbitrage profits; this investment was in Phillip Morris bonds purchased by Freddie Mac. The Phillip Morris bonds, which had an A rating, were purchased by Freddie Mac and were funded by Freddie Mac bonds with the same maturity. The yield difference was slightly over 60 basis points. Freddie Mac officials told us that its nonmortgage investment fund holding securities with maturities exceeding 5 years is authorized to contain up to $10 billion. Applying, as an example, an interest rate differential of 60 basis points, a $10 billion fund could generate as much as $60 million annually in arbitrage profits. If a similar 60-basis-point differential were applied to Farmer Mac nonagricultural-mortgage investments with maturities exceeding 5 years, arbitrage profits would represent about $3.2 million.
We did not make an overall estimate of arbitrage profits, in part because of difficulties in estimating the funding advantage. For the housing enterprises, we have good estimates for the funding advantage on longer term investments in fixed-rate debt that are match funded. These enterprises hold nonmortgage investments in variable-rate ABS with stated maturities of over 5 years. The enterprises told us that many of these securities have expected maturities of less than 5 years due to borrower prepayments, and we do not have good estimates for the funding advantage on these investments. We also do not have good estimates for the funding advantage on short-term investments. From our review of variable-rate ABS and short-term investments made by the housing enterprises, however, it appears that the funding advantage associated with government sponsorship is lower for these investments than for longer term, fixed-rate nonmortgage investments.
section_title: Shorter Term Investments Relate to the Housing Enterprises’ Missions
paragraphs: The public purposes of the housing enterprises, as specified in their respective federal charters, include providing stability in the secondary market for residential mortgages and responding appropriately to the private capital market. Enterprise purchases of residential mortgages directly contribute to mission achievement. As a general matter, the housing enterprises said they also take actions they think position them to serve their respective markets under different financial market conditions as well as different conditions affecting the residential mortgage market. The housing enterprises state that their nonmortgage investment holdings allow them to respond appropriately to capital markets and fund residential mortgages during different market conditions. They also emphasize that the yields on their nonmortgage investments are lower than the yields on their mortgage investments.
Our analysis of the housing enterprises’ nonmortgage investments indicated that overall, the yields on such investments are lower than on their mortgage investments. For example, in 1996 Freddie Mac’s average interest rate on cash and nonmortgage investments was 5.55 percent, and on mortgages it was 7.46 percent. The respective interest rates for Fannie Mae in 1996 were 5.68 percent on nonmortgage investments and cash equivalents and 7.71 percent on mortgages. The general preponderance of short-term investments in the enterprises’ nonmortgage investments accounts for the lower overall yield on these investments compared to mortgage investments. Our analysis of these short-term nonmortgage investments, such as term federal funds, indicates that they have a clear relationship to mission in enhancing liquidity, thereby allowing the enterprises to fund residential mortgages during different market conditions. In addition, even though they might also generate arbitrage profits, they are not the primary vehicle through which the housing enterprises would attempt to generate arbitrage profits. Likewise, since the yields from these investments are low relative to long-term nonmortgage investments, it is not likely that the volume of short-term nonmortgage investments would be substantially affected by the tension between increasing shareholder value and achieving mission, because these investments have lower yields than mortgage investments.
section_title: Long-Term, Fixed-Rate Nonmortgage Investments by the Housing Enterprises Generate Arbitrage Profits, and Their Relationship to Mission Is Less Clear
paragraphs: Freddie Mac officials indicated that nonmortgage investments are an integral tool for carrying out its housing finance mission and are held for three principal reasons: (1) cash management purposes; (2) as an investment vehicle that could make capital available (i.e., to employ capital) to help fund future anticipated demand to fund residential mortgages; and (3) as an investment vehicle to employ capital for future unexpected demand to fund residential mortgages. Freddie Mac created a fund in March 1997, which it calls its core fund, to invest in securities with maturities exceeding 5 years to be funded by matched maturity noncallable debt. The main stated purpose for the core fund is to have capital employed in case it becomes necessary to fund unexpected mortgage demand. Although Freddie Mac does not expect to liquidate core fund investments, Freddie Mac officials told us that liquidation could occur to fund purchases of residential mortgages if a decline in interest rates triggered a substantial increase in mortgage prepayments or if a major mortgage dealer or investor failed. The officials also said that raising capital to fund unexpected mortgage demand could take up to 4 months, and therefore it was important to have capital employed in investments that could quickly be liquidated in case such funds became necessary.
Our analysis focused on alternative mechanisms available to Freddie Mac for funding unexpected mortgage demand. We asked Freddie Mac officials if they were able to supply the necessary liquidity in 1993, when declining mortgage interest rates caused the highest level of mortgage prepayments in history, by using financing techniques that did not rely on liquidation of long-term investments. The officials told us that the enterprises were able to serve the market by funding purchases of residential mortgages, but this particular experience was not a guarantee for the future. It is worth noting that mortgage prepayments reduce the level of the enterprises’ outstanding MBS held by investors; therefore, investment funds to fund newly refinanced mortgages are made available from investors who purchase housing enterprise MBS. Thus, in this situation MBS issuance could provide necessary liquidity without reliance on liquidation of core fund investments.
We agree that the potential failure of a major mortgage dealer or investor could bring about a need for additional liquidity in the mortgage market. However, Freddie Mac has a number of vehicles to provide liquidity, such as use of proceeds from maturing short-term nonmortgage investments to purchase residential mortgages, which in turn can be funded by issuance of MBS. Freddie Mac could also issue MBS backed by on-balance sheet holdings of residential mortgages, thereby reducing required capital to support its mortgage servicing portfolio. Such an action would make a capital cushion available to support funding of the unexpected mortgage demand, because the enterprises do not have to hold as much capital to finance off-balance sheet compared to on-balance sheet mortgage assets.
Fannie Mae officials indicated that nonmortgage investments are held for three principal reasons: (1) cash management purposes, (2) as an investment vehicle to employ capital that is intrinsically appropriate for a financial corporation of its size, and (3) to maintain a capital cushion in excess of minimum capital requirements. Fannie Mae’s nonmortgage investments with maturities exceeding 5 years are mostly asset-backed securities (ABS) with variable interest rates. The market value of the longer term ABS does not fluctuate as much as the market value of long-term fixed-rate securities, because most of the ABS have variable interest rates.
Therefore, at times Fannie Mae has sold ABS to finance mortgage purchases. This activity is consistent with how Fannie Mae employs its short-term nonmortgage investments. In addition, according to our review of variable-rate ABS investments by all three enterprises, it appears that the funding advantage associated with government sponsorship is lower for these instruments compared to long-term, fixed-rate nonmortgage investments. Nonetheless, some arbitrage profits are generated from these investments. Therefore, the ABS investments appear to have characteristics that differ somewhat from other nonmortgage investments in two dimensions. First, they appear to be somewhat related to mission, because they are more liquid than fixed-rate long-term investments but less liquid than short-term nonmortgage investments. However, fluctuations in the market value of ABS, in relation to short-term nonmortgage investments, can reduce their effectiveness in providing liquidity. Second, they appear to generate arbitrage profits, although at a lower level than other fixed-rate long-term nonmortgage investments.
section_title: Arbitrage Profits Could Represent a Potential Source of Funds for Targeted Housing Mortgage Programs
paragraphs: In addition to the contribution to mission goals and the generation of arbitrage profits already presented, there is an additional potential mission-related rationale for holding nonmortgage investments where the investment merely provides a potential source of resources that can be used to fund targeted housing mortgage programs.
Such a rationale appears to be consistent with one offered by HUD in its analysis of the housing enterprises’ retained mortgage portfolios. HUD’s report on privatization concluded: “Full privatization would reduce the GSEs’ portfolio operations. This would not have a major impact on the mortgage market because the MBS market is now well-developed and is an effective mechanism for allocating interest rate risk.” HUD also concluded, however: “Most GSE earnings come from their portfolio operations. Without the cushion of a highly profitable portfolio, the fully privatized GSEs would reduce their funding of the more risky affordable loans, unless these loans started carrying much higher interest rates.”
section_title: Farmer Mac’s Nonagricultural-Mortgage Investments Generate Arbitrage Profits: Relationship to Mission Is Uncertain
paragraphs: Farmer Mac’s first year with positive net income was 1996. Net income has grown during the first two quarters of 1997 as Farmer Mac initiated its debt issuance strategy. Currently, over half of its on-balance sheet asset holdings are in investments other than agricultural mortgages. Government sponsorship of Farmer Mac lowers its debt costs, generating arbitrage profits from such investments. In its semiannual report to the House and Senate Agriculture Committees transmitted in April 1997, FCA notes that Farmer Mac can operate at a profit even if its core business does not expand, as long as it can borrow funds at lower rates than it can earn on investments. Farmer Mac’s strategy appears to be unique, not at all similar to the strategies followed by the housing enterprises over the course of their development, which makes it more difficult to determine whether the debt issuance policy will help Farmer Mac achieve its mission.
It appeared to us that Farmer Mac’s debt issuance strategy would logically operate by allowing Farmer Mac to profitably price agricultural mortgage purchases so that originators would expect higher returns by selling rather than retaining mortgages in their own portfolios. For example, if the debt issuance strategy lowered funding costs for Farmer Mac on its AMBS, Farmer Mac might be able to pay mortgage originators higher prices for agricultural mortgages and remain profitable. Farmer Mac officials also told us that their investments in agricultural mortgages have higher returns than those for its nonagricultural-mortgage investments. Based on this observation by the Farmer Mac officials, it appeared to us that Farmer Mac may be able to pay mortgage originators higher prices than it currently does for agricultural mortgages and remain profitable in this mission-related segment of its business. We asked the Farmer Mac officials why Farmer Mac does not, therefore, price its agricultural mortgage purchases more favorably for mortgage originators to help this mission-related business expand. Farmer Mac officials stressed other strategies it is pursuing, such as outreach efforts with agricultural mortgage originators. We are uncertain as to whether Farmer Mac’s debt issuance strategy will contribute to mission achievement, because Farmer Mac’s debt issuance strategy intends to lower funding costs to purchase agricultural mortgages and issue AMBS. Farmer Mac might become better able to spend funds to recruit mortgage originators and pay mortgage originators higher prices for agricultural mortgages while remaining profitable in its mission-related business if its AMBS costs declined. However, Farmer Mac already appears to have the ability to spend more funds for such purposes than it does currently.
section_title: Conclusions
paragraphs: Our analysis indicates that in establishing GSEs, Congress has followed the rationale of focusing GSE activity on specific sectors of the economy. Freddie Mac, Fannie Mae, and Farmer Mac have federal charters that specify the purposes of each enterprise and provide the enterprises with broad authorities as private corporations to manage their day-to-day business operations, including their investment policies.
The enterprises’ charters also direct them to fulfill specific public missions. The enterprises have mission regulators with general regulatory authorities that are charged with ensuring that the missions of these enterprises are being fulfilled. We agree with a recent HUD evaluation that it could use its general regulatory authority to potentially limit nonmortgage investments. HUD has begun a rulemaking effort intended to develop regulations governing nonmortgage investments by the housing enterprises to help ensure that such investments are related in some fashion to mission achievement. We agree that this effort can help HUD develop criteria to determine the extent to which various nonmortgage investments are mission related. Although FCA could use its general regulatory authority over nonagricultural-mortgage investments by Farmer Mac to help ensure that such investments are related in some fashion to Farmer Mac’s mission achievement, it has not established a procedure for doing so. To date, neither HUD nor FCA has developed specific criteria to determine whether enterprise nonmortgage investments are consistent with mission achievement.
The enterprises have investment policies that specify permissible credit ratings, maturities, and concentration limits and describe the relationship of investments to earnings and to achievement of mission. The enterprises have incentives as private corporations to increase shareholder value; these incentives create a tension with achievement of the missions stated in the federal charters of the enterprises. It is this tension that hightlights the importance of mission oversight. Without effective mission oversight, the incentives to use the benefits of government sponsorship to increase shareholder value could, over time, erode the public mission. If this were to occur, long term nonmortgage investments could become an increasing part of the housing enterprises’ portfolios and Farmer Mac’s temporary approach could become a permanent strategy even if it does not enhance Farmer Mac’s ability to purchase agricultural mortgages.
Government sponsorship of the enterprises lowers their debt costs, and they can therefore generate arbitrage profits (i.e., profits resulting from their funding advantage) by investing in nonmortgage assets. The various nonmortgage investments appear to fall along a continuum representing the degree to which they relate to the housing enterprises’ missions. On one end are short-term nonmortgage investments, such as term federal funds, which facilitate liquidity although they might also generate arbitrage profits. On the other end are longer term investments that generate arbitrage profits, but they are less clearly related to the enterprises’ missions in facilitating liquidity in the secondary market, because fluctuations in their market value reduce their usefulness in responding to changes in capital and mortgage products.
At this time, it is not clear whether Farmer Mac’s debt issuance strategy will eventually help it expand purchases of agricultural mortgages in fulfillment of its mission. Given the uncertainty of when, or if, the Farmer Mac strategy will be successful, FCA has the responsibility to monitor Farmer Mac’s strategy to help ensure that the nonagricultural-mortgage investments, which are a primary source of its earnings, are related in some fashion to Farmer Mac’s mission achievement. Farmer Mac’s strategy appears to be unique, not at all similar to the strategies followed by the housing enterprises over the course of their development. In presenting this strategy, Farmer Mac officials told us that the strategy’s contribution to mission achievement should develop over a reasonable period of time.
section_title: Recommendations
paragraphs: To provide more focused oversight of the housing enterprises’ nonmortgage investments, we recommend that the Secretary of HUD promptly implement HUD’s stated intention to develop criteria through appropriate rulemaking processes to help ensure that the housing enterprises’ nonmortgage investments are consistent with the purposes expressed in their charter acts. We also recommend that the Chairman of the FCA Board direct OSMO to develop the requisite criteria and report periodically, such as through its semiannual reports to the House and Senate Agriculture Committees, on the relationship of Farmer Mac’s debt issuance strategy to the achievement of Farmer Mac’s mission.
section_title: Matters for Congressional Consideration
paragraphs: To help ensure that the enterprises’ nonmortgage investments appropriately support their public missions, the appropriate congressional committees may wish to monitor HUD and FCA actions to establish criteria and procedures for carrying out their general regulatory authorities. Such oversight is important to help ensure that corporate incentives to increase shareholder value do not erode the enterprises’ public mission. If adequate progress is not made in a timely way, Congress may wish to consider providing further guidance to the regulatory agencies.
section_title: Agency Comments and Our Evaluation
paragraphs: We received comments on a draft of this report from each of the three enterprises, HUD, OFHEO, FCA, and Treasury (see apps. III through IX). Appendixes III, IV, V, VI, and VIII also contain additional responses to specific comments by Freddie Mac, Fannie Mae, Farmer Mac, HUD, and FCA. Farmer Mac, OFHEO, FCA, and Treasury provided technical comments that were incorporated in the report where appropriate.
The three enterprises agreed with our finding that the enterprises have broad investment authority and noted our acknowledgement that the safety and soundness regulators have determined that the enterprises’ nonmortgage investment portfolios do not raise safety and soundness concerns. However, the enterprises raised a number of concerns and disagreed with some of our major findings pertaining to the relationship of nonmortgage investments to mission achievement, arbitrage profits, and the tension between increasing shareholder value and achieving mission. Based on Freddie Mac’s disagreement with our findings, it did not concur with our recommendation to HUD. Although Farmer Mac disagreed with some of these findings, it agreed with our recommendation to FCA. HUD, OFHEO, FCA, and Treasury also provided comments, some of which focused on the three major issues raised by the enterprises.
subsections: section_title: Relationship of Nonmortgage Investments to Mission
paragraphs: Concerning the relationship of nonmortgage investments to mission achievement, Freddie Mac said (see app. III) that our draft report made the erroneous assertion that long-term nonmortgage investments are fairly illiquid, and this assertion provided the basis for our questioning the role of nonmortgage investments in mission achievement. As shown in appendix IV, Fannie Mae raised the concern that we had a “brief and somewhat unclear presentation of how Fannie Mae views the role of nonmortgage investments in capital management.”
In response to Freddie Mac’s comments, we clarified our discussion of the role of the various nonmortgage investments in facilitating liquidity in the secondary market for residential mortgages. Many of the housing enterprises’ intermediate and longer term nonmortgage investments have broad and deep markets that make them readily marketable or liquid in the sense that they can be sold without substantial loss in market value. However, longer term investments are less liquid than shorter term investments in the sense that their market values are subject to larger fluctuations with changes in interest rates. These fluctuations can reduce their usefulness in responding to changes in capital and mortgage markets and facilitating liquidity in the residential mortgage market at a particular point in time, because their market values can be less than their original values when liquidation may be warranted. Therefore, we did not change our conclusion that the relationship between longer term nonmortgage investments and mission achievement is less clear than that for short-term nonmortgage investments.
In response to Fannie Mae’s comments, we supplemented our discussion of Fannie Mae’s primary purposes for holding nonmortgage investments to include maintaining a capital cushion in excess of minimum capital requirements. We note, however, that this purpose overlaps with the other purposes we cite in our report—cash management and providing a capital cushion to respond to capital markets and fund residential mortgages (thus facilitating liquidity). Beyond these purposes, Fannie Mae appears to emphasize the role of nonmortgage investments in Fannie Mae’s earnings and capital management as well as attention to safety and soundness concerns. This emphasis is consistent with Fannie Mae’s purposes for its investment portfolio as stated in its annual report, which are to contribute to corporate profitability, serve as a source of liquidity, and provide a return on the excess capital of the corporation. This argument by Fannie Mae, however, does not demonstrate a relationship between nonmortgage investments and mission achievement beyond the relationship already established in our report.
Concerning the relationship of nonmortgage investments to mission achievement and regulatory oversight, HUD said (see app. VI) that our report fairly characterizes the issues, constraints, and ambiguities involved in overseeing the housing enterprises’ nonmortgage investment activities. HUD agreed with, and said it has begun to implement, our recommendation to the Secretary of HUD. OFHEO (see app. VII) stated that it is appropriate for Congress to monitor nonmortgage investments at the enterprises and that Congress may wish to provide more specific guidance to the regulatory agencies regarding the appropriate range of investment activities.
Farmer Mac (see app. V) agreed with our finding that FCA has the responsibility to monitor Farmer Mac’s strategy to help ensure that the nonagricultural-mortgage investments are related in some fashion to Farmer Mac’s mission achievement and our recommendation to the Chairman of the FCA Board containing an FCA reporting requirement. However, Farmer Mac took issue with our finding that its debt issuance strategy and related investment activities may not be mission related. In particular, Farmer Mac stated that we implied that its debt issuance strategy will not work because we stated that the strategy is unique. Farmer Mac also stated that this strategy, by lowering funding costs, can make funds available to recruit new mortgage originators. In addition, Farmer Mac provided a detailed description of its debt issuance policy, how it is expected to lower funding costs, and how the corporation sees the policy as linked to achievement of its mission.
In response to Farmer Mac’s comments, we made revisions to clarify Farmer Mac’s position on its debt issuance strategy to include the potential for making more funds available to recruit new mortgage originators. We also added clarifying language to indicate that our characterization of Farmer Mac’s debt issuance strategy as unique was included as one of several reasons why it is hard to determine whether the debt issuance policy will be effective in helping Farmer Mac achieve its mission.
FCA said (see app. VIII) that our draft report contains a fair representation of Farmer Mac’s investment activity and FCA’s views with respect to that activity. FCA appears to show some support for our recommendation to the Chairman of the FCA Board to report on the relationship of Farmer Mac’s debt issuance strategy to the achievement of Farmer Mac’s mission. However, it is not clear whether this willingness to report is limited to reporting on safety and soundness matters or includes issues of mission regulation. In addition, FCA said that it does not currently have any activities under way that are expected to culminate in regulation of the investment portfolio. In response to FCA’s comments, we revised our recommendation to the Chairman of the FCA Board to state that requisite criteria should be developed to assess and report on the relationship of Farmer Mac’s debt issuance strategy to the achievement of Farmer Mac’s mission.
Treasury said (see app. IX) that we identified some of the important policy issues raised by the investment practices of the enterprises. Treasury stated that it agrees with our recommendation that the enterprises’ mission regulators should use their general regulatory authority to limit the enterprises’ nonmortgage investment activity. We note, however, that our recommendation calls for the mission regulators to develop criteria to help ensure that nonmortgage investments are consistent with the purposes expressed in the enterprises’ charter acts.
section_title: Arbitrage Profits
paragraphs: The second issue relates to our position that the purchase of nonmortgage investments generates arbitrage profits. In commenting on our draft report, Freddie Mac took issue with our definition of arbitrage and asserted that we created a new definition of arbitrage to be responsive to the requester’s instructions that we report on the extent to which the enterprises have undertaken nonmortgage investments for arbitrage profits. Freddie Mac also asserted that under our definition, any profitable investment Freddie Mac makes would be considered arbitrage, and therefore we have a circular argument. Freddie Mac states the general definition of arbitrage used by financial analysts that is also stated in our report. This general definition, however, does not consider differences in government-provided benefits among debt issuers. Therefore, we adopted a definition of arbitrage that is similar to the definition of an arbitrage bond defined in a section of the U.S. tax code. The definition is in reference to state and local governments whose funding costs are lowered by virtue of the federal income tax exemption for interest on state and local bonds; this definition explicitly accounts for differences in government-provided benefits. Freddie Mac’s assertion that anything profitable would be arbitrage according to our definition is not correct. We note that in an integrated national financial market there would be little if any opportunity for profit from borrowing and lending for the same time period with no risk if no funding advantage were present. Under our definition of arbitrage, arbitrage profit is the amount of profit on nonmortgage investments associated with the funding advantage from government sponsorship and not the profit resulting from either risk-taking or good business judgement.
Treasury agreed with our conclusion that the enterprises’ long term nonmortgage investments generate arbitrage profits and that some of the enterprises’ short-term investments may also generate arbitrage profits.
section_title: Tension Between Increasing Shareholder Value and Achieving Mission
paragraphs: All three enterprises took issue with our conclusion that a tension exists between increasing shareholder value and achieving mission. Freddie Mac said our draft report suggests that there is an inherent conflict between private ownership and Freddie Mac’s public mission, which is at odds with legislative intent and Freddie Mac’s demonstrated record of achievement. Fannie Mae said that although we provided a good review of the policies underpinning its executive compensation policy, our “tension” construct implies a conflict that is theoretical at best. Fannie Mae offered a construct where senior management is required to achieve multiple objectives. Fannie Mae adds: “What is unique to the enterprises is that our mission is elevated by the Charter and enforced through oversight, regulation and potential legal sanction. The seriousness of our mission obligations are very clearly understood by managers, Directors and shareholders alike.” Farmer Mac believes that there is a convergence of, rather than a tension between, the interests of Farmer Mac’s shareholders and mission achievement through expanded volume, because of Farmer Mac’s early stage of development.
In our report, our finding of a tension between increasing shareholder value and mission fulfillment points to the role of mission regulation in helping to ensure that the purposes of the charter acts are achieved. We recognize that Congress granted the housing enterprises federal charters to direct them to bring private sector operating efficiencies to fulfill a public purpose in the secondary mortgage market. Congress also granted regulatory authorities to OFHEO to help ensure that the housing enterprises operate in a safe and sound manner and to HUD to ensure that the purposes of the respective charter acts are accomplished. Therefore, it appears that Congress intended regulatory oversight to address situations in which the private and public interests may not be aligned. Government sponsorship of the housing enterprises has created a mechanism for the government-provided benefits to be passed through, at least in part, in the form of lower mortgage interest rates. Because this mechanism is not present for nonmortgage investments, at least some of these investments could be more profitable on a risk-adjusted basis than mortgage investments. To the extent that profits from some nonmortgage investments are less clearly related to mission, reasonable questions can be raised about whether government benefits are supporting shareholder interests at the expense of the public mission. Fannie Mae’s view explicitly acknowledges charter restrictions, regulatory oversight, and multiple corporate goals. Therefore, it is difficult to distinguish its view from ours, except that Fannie Mae appears to believe that the mission has been integrated into its corporate culture. Rather than relying solely on corporate culture, however, Congress established HUD as a regulator to ensure that mission objectives are achieved. Farmer Mac’s debt issuance strategy has expanded the volume of nonagricultural-mortgage investments. Although it is clear that these investments are profitable and affect executive compensation, it is not yet clear whether they contribute to mission achievement.
As arranged with your office, unless you publicly announce the contents of this letter report earlier, we plan no further distribution until 14 days after its issue date. At that time, we will send copies to HUD; OFHEO; FCA; Treasury; the enterprises; the Ranking Minority Member of your Committee; the Chairman and Ranking Minority Member of the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises; and the Chairman and Ranking Minority Member of the Senate Committee on Banking, Housing, and Urban Affairs. We will also make copies available to others on request.
Major contributors to this report are listed in appendix X. Please contact me or Bill Shear, Assistant Director, at (202) 512-8678 if you or your staff have any questions.
section_title: Measuring Arbitrage Profits
paragraphs: We are defining the term arbitrage to mean using the funding advantage from government sponsorship to raise funds for making nonmortgage investments. In a previous report about the housing enterprises, we concluded that the largest enterprise benefit from government sponsorship flows from the market perception of an implied guarantee on enterprise obligations, because this perception generates a funding advantage—a reduction in yields on enterprise debt. In that report, we indicated that the funding advantage could be in the range of 30 to 106 basis points. This range accounted for the long-term nature of residential mortgage investments, and it assumed that the housing enterprises would receive a credit rating between a high of AAA and a low of A if their government sponsorship were eliminated.
Our definition of arbitrage does not require the enterprise to match fund its nonmortgage investments. However, our measurement of the yield differences used to estimate arbitrage profits is based on a comparison of debt securities with similar maturity and risk. Under this method, if the debt securities being compared had different maturities, the yield difference (i.e., yield spread) would reflect both the impact of government sponsorship and the difference in interest rate risk between the debt securities. Alternatively, if the debt securities being compared had similar maturities and risks but differed by virtue of government sponsorship, the yield difference would reflect the impact of government sponsorship. For this reason, matched maturity debt provides the best measure of arbitrage, even though arbitrage is also present when nonmortgage investments are funded by enterprise debt with different maturities and risks.
In addition to relying on yield differences between enterprise nonmortgage investments in corporate bonds and matched maturity enterprise debt used to finance such investments as a measure of arbitrage, another possible approach to measuring arbitrage is to use statistical techniques to adjust yield differences between corporate and enterprise debt for differences in maturity and risk. Such an approach was used in a study commissioned by the Department of Housing and Urban Development to evaluate the implications of severing government sponsorship of the housing enterprises on the enterprises’ debt costs. The study included analysis of yield differences between housing enterprise debt and debt issued by different groups of corporations (i.e., the benchmark groups) with A, AA, and AAA credit ratings. The benchmark groups were chosen on the assumption that the housing enterprises would have credit ratings in this range if their federal charters were revoked. The analysis was complex, because bond characteristics differ between bonds issued by the enterprises and other issuers. Ambrose and Warga recognized how difficult their research task was and qualified their results on the basis of the statistical complexities.
We relied on the Ambrose and Warga study results for the period 1991 through 1994, in part, in making our estimate that the housing enterprises’ funding advantage from government sponsorship could be in the range of 30 to 106 basis points. Due to the statistical complexities of their analysis, we concluded that their estimates lacked precision. Therefore, we used this broad range for the funding advantage on debt.
Recently, the Standard and Poor’s (S&P) credit rating agency rated each housing enterprise for its government risk rating, which is based on the probability that the federal government would be called upon in the event of an enterprise default on its obligations. Each enterprise received an AA minus rating. S&P indicated that the rating for each enterprise still accounted for some benefits, namely liquidity of enterprise obligations, due to government sponsorship. If the enterprises were privatized, S&P said that each would likely have to raise additional equity capital to maintain an AA minus rating.
The housing enterprises fund their nonmortgage investments with noncallable debt. Generally, the Ambrose and Warga yield spread estimates were smaller for noncallable than for callable debt. On the basis of the S&P credit ratings and the way the enterprises fund their nonmortgage investments, we have concluded that the Ambrose and Warga estimated yield spreads based on the A and AA credit ratings for issuance of noncallable debt are most relevant for measuring arbitrage profits. For the 1991 through 1994 period, the range of estimated yield spreads on noncallable debt between the AA-rated companies and the housing enterprises was 39 to 46 basis points; when the A-rated companies were used as the benchmark, the range was 65 to 72 basis points. We continue to support the Ambrose and Warga estimates and our estimated range of 30 to 106 basis points for the funding advantage; findings from our analysis of housing enterprise financial data are consistent with these estimates.
As indicated in the body of this report, we could not estimate the funding advantage resulting from government sponsorship for Farmer Mac.
However, we indicated qualitatively how Farmer Mac’s funding advantage could compare to the funding advantage of the housing enterprises.
section_title: Compensation Structure for Board Members and Senior Managers
paragraphs: The enterprises’ management and boards of directors have implemented compensation policies designed to attract and retain individuals from various disciplines who have the talent and motivation needed to accomplish the corporations’ objectives. The enterprises seek to closely link pay with performance and provide compensation that is reasonable and comparable with compensation for employment in other similar businesses involving similar duties and responsibilities. Through committees, the enterprises’ boards of directors develop policies and administer compensation programs that are meant to conform to the congressional mandate.
Freddie Mac’s overall compensation package consists of both direct compensation (i.e., cash and stock incentives) and noncash employee benefit programs. A base salary, an annual cash bonus, and long-term stock incentives are included in the direct compensation package. Base salaries are determined primarily by position and individual skills and are targeted to match the median (i.e., 50th percentile) level of the market as determined by data obtained from comparator groups (e.g., companies identified as being in a similar line of business) and market surveys. Annual cash bonuses, which function as short-term incentives, are based on a combination of individual and corporate performance and increase as a percentage of base salary at successively higher levels of responsibility and accountability. Long-term stock incentives are awarded to officers and director-level employees (i.e., employees who report directly to officers or are senior-level technical and professional employees, but not members of Freddie Mac’s Board of Directors). For officers, long-term stock incentives are awarded as a percentage of base salary and increase as a percentage of base salary at successively higher levels of responsibility. The director-level employee is awarded long-term stock incentives as a percentage of the director-level salary grade midpoint. Freddie Mac’s long-term stock incentives include restricted stock, which is awarded to the corporation’s executive officers, and stock options. Examples of noncash employee benefits offered to all regular employees include an individually structured benefits package (i.e., health care, life insurance, etc.); a pension plan; and an employee stock purchase plan.
Fannie Mae’s compensation package consists of a base salary, employee benefits, annual incentives, and long-term incentives. The salary is based on individual skills, experience, performance, etc; benefits include such provisions as insurance coverage, vacation pay, sick leave, and retirement. Annual incentives reward employees for reaching specific objectives or completing projects that enhance the corporation’s success for that year, and long-term incentives generally reward executives for shareholder gains and the achievement of specific corporate objectives.
Today, Farmer Mac’s salaries and other compensation components are based on surveys of pay structures at other enterprises and other financial institutions; however, this was not always the case. Although its salary compensation policies were generally competitive, Farmer Mac officials told us that other aspects of its compensation were not. In 1995, assisted by a compensation consultant, Farmer Mac recognized the need to revise its compensation policies to emphasize the creation of a greater management equity stake in Farmer Mac’s future. Consequently, the consultant helped Farmer Mac to establish a baseline compensation package for its staff that now includes an annual salary, annual bonus to award current-year contributions to Farmer Mac’s success, and long-term compensation (stocks and options) to ensure that directors and senior managers hold an equity interest in the corporation to provide the incentive to ensure the long-term survival of Farmer Mac. Officers and employees are also provided certain benefits, such as health and life insurance and a pension plan.
As of December 31, 1996, Farmer Mac had 21 employees. The proportion of Farmer Mac’s total compensation package representing incentive compensation for the 1995-96 plan year was 26 percent for the Chief Executive Officer and ranged between 13 percent and 19 percent for other senior management personnel. As recommended by a consultant, a portion of incentive compensation ranging from 67 percent to 88 percent represented stock grants and stock option awards. Incentive compensation was linked to the evaluation of each individual’s performance, based on standards that included professional competence, motivation, and effectiveness, as well as the individual’s contribution to the implementation of strategies designed to achieve the objectives set forth in Farmer Mac’s business plan for the 1995-96 plan year.
The purpose of Farmer Mac’s stock option plans is to encourage stock ownership by directors, officers, and other key employees to provide an incentive for such individuals to expand and improve the business of the corporation and to assist Farmer Mac in attracting and retaining key personnel. As with the other enterprises, the use of stock options is an attempt to align the long-term interests of employees more closely with those of Farmer Mac’s stockholders by providing employees with the opportunity to acquire an equity interest in Farmer Mac.
section_title: Comments From Freddie Mac
paragraphs: The following comments represent our response to specific comments made on a draft of this report on January 12, 1998, by the Chairman and Chief Executive Officer of Freddie Mac.
subsections: section_title: GAO Comments
paragraphs: 1. Freddie Mac said that we calculate nonmortgage assets as a percentage of on-balance sheet assets and that this exaggerates the size of nonmortgage investments in relation to Freddie Mac’s total mortgage-related activities. We calculate nonmortgage investments as a percentage of (1) on-balance sheet assets; (2) total mortgage servicing portfolio; and (3) capital (i.e., corporate equity). The second measure captures Freddie Mac’s total mortgage-related activities. The second measure is relevant if the sole purpose of the nonmortgage investments is, by definition, to support the total mortgage servicing portfolio. However, we provide the first and third measures because of their relevance in cases where the relationship of nonmortgage investments to mission is not clear. For example, both measures are relevant for comparisons among different corporations competing in the financial services industry. 2. Freddie Mac stated that its debt and MBS markets are not immune from disruption and states the example, “. . . should secondary market investors begin to sell large amounts of long-term mortgage-backed securities, the ‘spreads’ on these securities against Treasury bond benchmarks would widen (. . . perhaps significantly).” Freddie Mac added that it could only make matters worse in this environment by issuing new MBS. Freddie Mac does not specify the economic conditions that would cause investors to sell large amounts of MBS so that the value of MBS relative to Treasury securities would fall, while at the same time there would be such an unexpected surge in mortgage demand that would require liquidation of core fund investments. During the course of our assignment, we asked Freddie Mac to provide analyses indicating the economic conditions that would require sales of nonmortgage investments from the core portfolio to purchase mortgages. With respect to the examples Freddie Mac provided, in our report we analyzed alternative mechanisms available to Freddie Mac for funding unexpected mortgage demand. These alternatives have been successfully employed by the housing enterprises in the past to meet their charter responsibilities. (See pp. 26-27.) 3. Freddie Mac takes issue with our definition of arbitrage, which is similiar to the definition of an arbitrage bond in the U.S. tax code. It said: “In the municipal bond context, however, Congress disapproved what it viewed as the inappropriate conversion of federal Treasury securities into municipal bonds, the proceeds of which were never applied for any legitimate governmental purposes. Freddie Mac’s nonmortgage investments, in contrast, directly serve our statutory purposes of providing liquidity and stability to the mortgage market.” Here, we again note that the relationship between the various nonmortgage investments and mission achievement is less clear for the longer term than the shorter term nonmortgage investments. Therefore, we have concluded that the analogy to municipal bonds in defining arbitrage is appropriate. 4. Freddie Mac disagrees with our use of the range of 30 to 106 basis points to represent the housing enterprises’ funding advantage on debt. Freddie Mac’s comments and our response appear in the previous GAO report establishing this range. In its comment letter in this report, it cited its analysis of the yield spread on 5-year bullet debt between housing enterprise debt and debt of A and AA rated companies to illustrate Freddie Mac’s disagreement with our range. Freddie Mac also noted that the data upon which this range was established are from the 1991 to 1994 time period. We first became aware of the Freddie Mac analysis when it was submitted for the record at congressional hearings on July 31, 1996, after we completed our previous (i.e., privatization) study identifying the 30- to 106-basis-point range. Although we have not thoroughly analyzed the methodology (including its emphasis on 5-year debt rather than debt issues with longer maturities) or data relied upon in the Freddie Mac analysis, we note that the findings on yield spreads from the Freddie Mac analysis are in the vicinity of the bottom of our range (see reference to the 36-basis-point average cited by Freddie Mac). In addition, our findings from our analysis of housing enterprise financial data during this assignment are consistent with the estimated funding advantage range we established in our previous report and rely upon in this report. The housing enterprise financial data and the Standard and Poor’s credit ratings we relied upon for our analysis during the course of this assignment are more recent than the data relied upon in the Freddie Mac analysis. 5. Freddie Mac disagreed with our “draft report’s estimates of potential arbitrage profits based on an assumed portfolio that is nearly 17 times larger than Freddie Mac’s current longer-term nonmortgage investments.” We provide this estimate as an example of how much a $10 billion fund, the authorized level for Freddie Mac’s core fund, can generate in arbitrage profits. We also make reference to the $2 billion forecasted level for year-end 1997 holdings in the core fund.
section_title: Comments From Fannie Mae
paragraphs: The following comments represent our response to specific comments made on a draft of this report on January 12, 1998, by the Vice President for Regulatory Activities at Fannie Mae.
subsections: section_title: GAO Comments
paragraphs: 1. Fannie Mae stated that the yield on the longer term investments is less than that of mortgage investments. This simple yield comparison does not take into account the risks, in particular interest rate and prepayment risks, that accompany residential mortgage investments. Our report states that government sponsorship of the housing enterprises lowers yields on single-family, fixed-rate, conforming mortgages. This mechanism is not present for nonmortgage investments. Therefore, we conclude that on a risk-adjusted basis, some nonmortgage investments are more profitable than mortgage investments. 2. Fannie Mae said that we should amplify “the degree to which the corporation incents and holds management accountable for meeting mission obligations.” We did not review contracts of individual managers and members of Fannie Mae’s Board. Because of the proprietary nature of the information, we could not have provided concrete examples to make such an amplification.
section_title: Comments From Farmer Mac
paragraphs: The following comments represent our response to specific comments made on a draft of this report on January 12, 1998, by the President and Chief Executive Office of Farmer Mac.
subsections: section_title: GAO Comments
paragraphs: 1. Farmer Mac stated that long-term investments with short-term interest rate resets are generally considered to have short-term liquidity. We have concluded from our analysis that Farmer Mac’s longer term, variable-rate, nonagricultural-mortgage investments are subject to greater market value fluctuations with changes in interest rates than short-term investments. As a result, they are less useful in facilitating liquidity in the agricultural mortgage market than short-term investments. 2. Farmer Mac suggested that a reasonable time frame for reaching the final stage of its debt issuance strategy could be 2 to 3 years following adoption of the strategy. As far as we know, this is the first time a time frame has been suggested as a reasonable period of time for the debt issuance policy to contribute to mission. 3. Farmer Mac took issue with our observation that Farmer Mac’s debt issuance strategy, which intends to lower the funding costs to purchase agricultural mortgages and issue AMBS, appears to us to contradict, at least in part, our observation that Farmer Mac has not offered higher prices for agricultural mortgages. Farmer Mac states that the agricultural mortgage origination market is currently very inefficient, and therefore Farmer Mac is directing funds made available by the debt issuance strategy toward expanded efforts to recruit new mortgage originators. We revised our discussion (see page 29) and, rather than referring to a possible contradiction, we now directly relate these observations to the uncertainty associated with the effectiveness of Farmer Mac’s debt issuance strategy on mission achievement. 4. Farmer Mac said that it agrees with our recommendation to the FCA Board to report on the relationship of Farmer Mac’s debt issuance strategy to the achievement of Farmer Mac’s mission. Its letter added that FCA already monitors Farmer Mac’s investment activity. We note, as indicated in our report, that FCA’s monitoring of Farmer Mac’s investment activity has focused on matters of safety and soundness. Our recommendation is specific to FCA’s mission oversight responsibilities. 5. Farmer Mac said that for the quarter ended June 30, 1997, Farmer Mac’s net income from nonprogram investments represented about 38 percent of total net income. In response, we made revisions (see pp. 5 and 31) and now state that nonagricultural-mortgage investments are a primary source of income rather than the principal source or majority of income.
section_title: Comments From the Department of Housing and Urban Development
paragraphs: The following comment represents our response to a specific comment made on a draft of this report on January 16, 1998, by the Assistant Secretary for Housing-Federal Housing Commissioner at HUD.
subsections: section_title: GAO Comment
paragraphs: 1. HUD took exception to our characterization of the expertise issue in HUD’s approval of MPP. In particular, HUD’s comment letter stated that some statements in our draft report appear to be based on misunderstandings of statements made by HUD staff. HUD stated that HUD did not possess detailed knowledge of the intricacies of the life insurance industry at the time MPP was submitted for review. However, HUD also stated that it concluded it was unnecessary to provide MPP materials to Treasury because HUD had obtained sufficient information and analysis to complete its work. HUD said that this conclusion, rather than a HUD determination that it could not share the contents of the MPP proposal due to a potential conflict of interest within Treasury, formed the basis for not providing MPP materials to Treasury. We made revisions to our report (see pages 13-15) and state HUD’s position as described in its comment letter.
section_title: Comments From the Office of Federal Housing Enterprise Oversight
section_title: Comments From the Farm Credit Administration
paragraphs: The following comment represents our response to a specific comment made on a draft of this report on January 6, 1998, by the Chairman and Chief Executive Officer of the FCA Board.
subsections: section_title: GAO Comment
paragraphs: 1. FCA stated that discussion on pages 9 through 13 of our draft report indicated a misunderstanding of its past and current thinking and position, namely that FCA has clear safety and soundness authority and has concluded that no safety and soundness concerns exist at Farmer Mac. These FCA positions had been expressed in a previous section of the draft report dealing with safety and soundness oversight. The section FCA discusses relates to FCA’s general regulatory authority. In response to FCA’s comment, we added some clarifying language to our discussion on FCA’s general regulatory authority.
section_title: Comments From the Department of the Treasury
section_title: Major Contributors to This Report
subsections: section_title: General Government Division
section_title: Office of the General Counsel
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