Government-Sponsored Enterprises: A Framework for Strengthening GSE Governance and Oversight
Published: 2004-02-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Congress established government sponsored enterprises (GSE)-- such as Fannie Mae, Freddie Mac, the FHLBank System, and the Farm Credit System--to facilitate the development of mortgage and agricultural lending in the United States. Although the federal government does not explicitly guarantee the GSEs' approximately $4.4 trillion in financial obligations, the potential exists that the government would provide financial assistance in an emergency as it has done in the past. Recent financial reporting problems at Freddie Mac have raised concerns about the quality of the GSEs' corporate governance and regulatory oversight. To assist Congress in reviewing the adequacy of GSE oversight, this testimony provides information on GSE corporate governance, regulatory oversight, and mission compliance measures.
section_title: What GAO Found
paragraphs: GSEs should lead by example in connection with governance, accountability, integrity, and public trust issues. GSEs should strive to achieve model corporate governance structure, provide reasonable transparency of financial and performance activities, and adopt compensation arrangements that focus on both long-term and short-term results. However, GSE corporate governance has not always reflected best practices. For example, currently, the Chief Executive Officers (CEO) of Freddie Mac and Fannie Mae also serve as the chairmen of their respective GSE boards, which is not consistent with model governance standards that call for officers to work for an independent board. GAO notes that as part of its regulatory agreement, Freddie Mac has agreed to separate the position of CEO and the position of chairman within a reasonable period of time. However, Fannie Mae has yet to take this step. With respect to compensation arrangements, Freddie Mac's focus on short-term financial results as performance targets appears to have contributed to the GSE's recent financial reporting problems. GSE regulators must be capable, credible, strong, and independent. However, the regulatory structure for the housing GSEs--Fannie Mae, Freddie Mac, and the FHLBank System--is fragmented with safety and soundness and mission oversight responsibilities divided among three regulators. A single housing GSE regulator offers many advantages over this fragmented structure including prominence in government, the sharing of technical expertise, and the ability to assess trade-offs between safety and soundness considerations and certain mission compliance activities, such as affordable housing initiatives. Although there are advantages of a single director model for the new housing GSE regulator, GAO believes on balance that a board or a hybrid board and director might make the most sense to oversee the GSEs' safety and soundness and mission oversight. To be effective, the single GSE regulator must also have all the regulatory oversight and enforcement powers necessary to carry out its critical responsibilities. Because of a lack of clear measures, it is difficult for Congress, accountability organizations, and the public to determine whether the benefits provided by the GSEs' activities are in the public interest and outweigh their financial risks. Available evidence and data indicate that the housing GSEs have made, in some cases, progress in benefiting homebuyers. For example, it is generally agreed that Fannie Mae and Freddie Mac's activities have lowered mortgage interest rates, although there is debate over the degree of these benefits. However, it is not clear that the housing GSEs' large holdings of mortgage-backed securities benefit borrowers. There is also limited information as to the extent to which the FHLBank System's more than $500 billion in outstanding loans to financial institutions have facilitated mortgage lending.

section_title: Letter
paragraphs: I appreciate the opportunity to participate in today’s hearing to discuss  oversight of the government-sponsored enterprises (GSE), namely Fannie  Mae, Freddie Mac, the Federal Home Loan Banks (FHLBanks), the Farm  Credit System (FCS), and the Federal Agricultural Mortgage Corporation  (Farmer Mac). I note that the GSEs had combined obligations, including  mortgage-backed securities (MBS) and other debt obligations, of $4.4  trillion as of September 30, 2003, and, as I will explain in detail later, the  potential exists that the federal government may choose to provide  financial assistance to the GSEs in an emergency. Accounting and  financial reporting problems related to earnings disclosed by Freddie Mac  last year have raised several concerns about the company’s management  and board of directors as well as the effectiveness of regulatory oversight  that is designed to protect taxpayers from the risks associated with the  GSEs. Recently reported investment losses at the FHLBanks have also  served to raise public concerns regarding the well-being of GSEs. These  events prompted Congress to consider the need for meaningful reforms to  help strengthen the oversight of GSEs. In my view, our past experience in  the savings and loan industry, the recent accountability breakdowns in the  private sector, and the importance of gaining public trust for regulatory  agencies that oversee our financial institutions and our capital markets is  directly relevant to the ongoing debate on appropriate regulatory oversight  of GSEs.
It is clear that many parties have different views on what needs to be fixed  and how to do it. My comments today are intended to frame GSE oversight  issues broadly and provide our views on some of the questions and  options that must be addressed to better oversee the GSEs going forward.  Although my comments will largely focus on the housing GSEs—Fannie  Mae, Freddie Mac, and the FHLBank System—-given the themes of our  discussion today, I will also use examples from the other GSEs to illustrate  my points. We look forward to working with Congress to provide  assistance in defining these issues, exploring various options, and  identifying their implications in order to address any weaknesses that  could serve to threaten confidence in our financial markets and that  inhibit improvements in the current regulatory structure.
My testimony today is divided into two sections. In the first part, I will  provide an overview of the GSEs and their missions, discuss the risks they  pose to taxpayers and financial markets, and then I will lay out principles  to help ensure effective governance and oversight of the GSEs. Second, I  will provide our views regarding the extent to which GSE governance and  oversight structures are consistent with these important principles.
In summary, to ensure that the GSEs operate in a safe and sound manner,  it is essential that effective governance, reasonable transparency, and  effective oversight systems are established and maintained. In particular,  the GSEs should lead by example in the area of corporate governance;  GSE regulators must be strong, independent, and have necessary  expertise; and GSE mission definitions and benefit measures need to be  established. However, our work found that GSE corporate governance  does not always reflect best practices; for example, Fannie Mae’s Chief  Executive Officer (CEO) serves as chairman and its Chief Operating  Officer (COO) and Chief Financial Officer (CFO) both serve as vice  chairmen of the board, which is not consistent with model governance  theory that calls for an independent board and chair. I note that Freddie  Mac’s CEO is also the chairman of that company’s board but Freddie Mac  has agreed to split these functions in the future. Furthermore, the  regulatory structure for the housing GSEs is fragmented and serious  questions exist as to the capacity of GSE regulators to fulfill their  responsibilities. In each of these areas, I will summarize steps that  Congress, GSEs, and regulators can take to improve GSE governance and  oversight. In particular, I believe that Congress should establish a single  housing GSE regulator that would be governed by a board or a hybrid  board and director and provided with the authorities necessary to carry  out its mission.
To prepare for this testimony, we relied heavily on a substantial amount of  work that we had done on GSEs and their regulatory oversight in the past,  but we also reviewed our historical positions in light of the current  regulatory structure and GSE activities. The attachment lists reports  representing this body of work. In addition to reviewing our past work, we  solicited views of officials from the Office of Federal Housing Enterprises  Oversight (OFHEO), the Department of Housing and Urban Development  (HUD), and the Federal Housing Finance Board (FHFB). We also reviewed  financial data on the GSEs, best practices standards for corporate  governance, and regulatory reports on such issues as the GSEs’ effects on  financial market stability. We conducted our work in Washington, D.C.,  between November 2003 and January 2004 in accordance with generally  accepted government auditing standards.
subsections: section_title: Overview of GSEs, Their Risks, and Principles for Effective Governance and Oversight
paragraphs: I would like to begin by summarizing the roles and responsibilities of the  GSEs, describing their potential risks to taxpayers and the financial  markets, and offering certain principles on governance and oversight to  help ensure that the GSEs’ activities are safe, sound, and consistent with  their public missions.
subsections: section_title: What are the GSEs and How Do They Carry Out Their Missions?
paragraphs: Over the past century, Congress established GSEs to address concerns  that private financial institutions were not adequately meeting the credit  needs of homebuyers and agricultural interests (see table 1). The GSEs are  government-sponsored, privately owned and operated corporations whose  public missions are to enhance the availability of mortgage and  agricultural credit across the United States. It is also generally understood  that the housing GSEs’ public missions include the obligation to meet the  needs of targeted groups of borrowers. The GSEs generally carry out their  missions by (1) borrowing funds in the capital markets and purchasing  assets from financial institutions or making loans to the institutions or (2)  securitizing assets and providing a credit guarantee to security holders.  These activities may provide mortgage or real estate credit to homebuyers,  businesses, or farmers at rates or conditions more favorable than those  that would be available in the absence of these GSEs. It is important to  note that the GSEs’ debt and security offerings are not explicitly  guaranteed or insured by the U.S. government.
Let me now briefly discuss the missions and activities of each of the GSEs:    Fannie Mae and Freddie Mac’s mission is to enhance the availability of  mortgage credit across the nation during both good and bad economic  times by purchasing mortgages from lenders (banks, thrifts, and  mortgage lenders) that use the proceeds to make additional mortgages  available to homebuyers. Most mortgages purchased by Fannie Mae  and Freddie Mac are conventional mortgages, which have no federal  insurance or guarantee. The companies’ mortgage purchases are  subject to a conforming loan limit that currently stands at $333,700 for  a single-family home in most states. Although Fannie Mae and Freddie  Mac hold some mortgages in their portfolios that they purchased, most  mortgages are placed in mortgage pools to support MBS. Fannie Mae  and Freddie Mac issued MBS are either sold to investors (off-balance  sheet obligations) or held in their retained portfolios (on-balance sheet  obligations). Fannie Mae and Freddie Mac guarantee the timely  payment of interest and principal on MBS that they issue.
The 12 FHLBanks traditionally made loans—also known as advances— to their members (typically banks or thrifts) to facilitate housing  finance and community economic development. FHLBank members  are required to collateralize advances with high quality assets such as  single-family mortgages. More recently, the FHLBanks initiated  programs to purchase mortgages directly from their members and hold  them in their retained portfolios. This process is similar to Fannie Mae  and Freddie Mac’s traditional business activities, although the  FHLBanks do not currently have the authority to securitize mortgages.
FCS, of which Farmer Mac is an independent institution, is a  nationwide network of borrower-owned financial institutions and  specialized service organizations. FCS consists of six Farm Credit  Banks and one Agricultural Credit Bank, which provide funding and  affiliated services to locally owned Farm Credit associations and  numerous cooperatives nationwide. Among other activities, FCS  provides credit and related services to farmers, ranchers, producers,  and rural homeowners.
Farmer Mac’s mission is to provide for a secondary marketing  arrangement for agricultural real estate and rural housing loans subject  to its underwriting standards. Farmer Mac purchases mortgages  directly from lenders for cash and purchases bonds from agricultural  lenders. Farmer Mac securitizes mortgages and issues AMBS and, like  Fannie Mae and Freddie Mac, guarantees the timely payment of  interest and principal on these securities. Farmer Mac holds most of  the AMBS that it issues in its retained portfolio.
section_title: What are the Risks of the GSEs?
paragraphs: As a result of their activities, the GSEs’ outstanding debt and off-balance  sheet financial obligations are large. The GSEs’ financial obligations were  $4.4 trillion as of September 30, 2003. By comparison, the U.S. Treasury  had $6.8 trillion in total obligations for the same date. The GSEs face the  risk of losses primarily from credit risk, interest rate risk, and operational  risks. Although the federal government explicitly does not guarantee the  obligations of the GSEs, it is generally assumed on Wall Street that  assistance would be provided in a financial emergency. In fact, during the  1980s the federal government provided financial assistance to both Fannie  Mae and FCS when they experienced difficulties due to sharply rising  interest rates and declining agricultural land values, respectively. The  potential exists that Congress and the Executive Branch would determine  that such assistance was again necessary in the event that one or more of  the GSEs experienced severe financial difficulties. Because the markets  perceive that there is an implied federal guarantee on the GSEs’  obligations, the GSEs are able to borrow at interest rates below that of  private corporations, which—as I discussed earlier—allows them to  extend credit to financial institutions at favorable rates.
The GSEs also pose potential risks to the stability of the U.S. financial  system. In particular, if Fannie Mae, Freddie Mac, or the FHLBank System  were unable to meet their financial obligations, other financial market  participants depending on payments from these GSEs, may in turn become  unable to meet their financial obligations. This risk, called systemic risk, is  often associated with the housing GSEs because of the sheer size of their  financial obligations. For example, as discussed in OFHEO’s 2003 report  on systemic risk, if either Fannie Mae or Freddie Mac were to become  insolvent, financial institutions holding the enterprise’s MBS could be put  into a situation where they could no longer rely on those securities as a  ready source of liquidity. Depending on the response of the federal  government, the financial health of the banking segment of the financial  services industry could decline rapidly, possibly leading to a decline in  economic activity. As another example, derivatives counterparties holding  contracts with a financially troubled GSE could realize large losses if the  GSE were no longer able to meet its obligations. If such a hypothetical  event were to occur, widespread defaults could occur in derivatives  markets.
section_title: How Can GSE Risks Be Mitigated?
paragraphs: To prevent the need for the federal government ever to have to provide  financial support to a GSE and to minimize the risks of financial  instability, it is critical to ensure that proper corporate governance,  reasonable transparency, and effective oversight systems are in place.  There are several lines of defense to ensure that GSEs’ activities are  conducted in a safe and sound manner including management, boards of  directors, auditors, and regulators. As we have seen in recent private  sector instances such as Enron and Worldcom, these critical lines of  defense can and do fail. Consequently, the private sector, Congress, and  regulators have initiated actions—such as the passage and implementation  of the Sarbanes-Oxley Act—to ensure that the risk of such failures of  governance and oversight are minimized. In my view, it is all the more  important that strong safeguards are established for the GSEs because  such institutions are not subject to the same degree of market discipline as  other privately run businesses. As a result of the perception of an implied  guarantee of GSE obligations, customers and creditors may be less willing  to monitor the companies’ risk-taking, which could encourage managers to  take on excessive risks.
subsections: section_title: The GSEs Should Lead by Example in Terms of Corporate Governance and Accountability
paragraphs: Not only should GSEs be sensitive to good governance but it is all the  more important they lead by example in connection with accountability,  integrity, and public trust. In particular, GSEs should strive to have a truly  independent board, compensation arrangements consistent with their  public mission and private shareholder obligations, and appropriate  transparency of their financial activities. Under model governance theory,  the board of directors works in the best interest of the shareholders and  the CEO works for the board. Board members should be independent and  be able to provide strategic advice to management in order to help  maximize shareholder value. The board should also help manage risk to  shareholders and have a clear responsibility to hold management  accountable for results both currently and over time. I note that in the  context of the GSEs, boards could also have a responsibility to ensure that  the GSEs’ activities fulfill their public missions. In some cases, there can  be a tension between maximizing shareholder value and fulfilling public  missions. GSE boards and executives must have the requisite commitment  and talent to respond to this challenge.
To adhere to model governance theory, it is also important for the board  to ensure that overall executive compensation is aligned with  achievements related to the company’s long-term strategic objectives and  less on short-term accomplishments such as quarterly or annual earnings.  Further, it is not just the total amount of compensation but the form and  structure of executive compensation arrangements that is important as  well. Finally, transparency through timely and reliable financial and  performance information and reasonable disclosures is necessary to  enable capital markets and investors to understand related values and  risks associated with the GSEs. Market discipline works best when firms  fully and publicly disclose their financial obligations and activities.
section_title: The GSEs Require a Strong, Independent, and Capable Regulatory System
paragraphs: A regulatory system of GSE oversight must have the necessary strength,  independence, and capability to protect against the significant risks and  potential costs to taxpayers posed by the GSEs. We have consistently  supported and continue to believe in the need for the creation of a single  regulator to oversee both safety and soundness and mission of the housing  GSEs, which, as I will describe later, are currently divided among OFHEO,  HUD, and FHFB. A single regulator could be more independent and  objective than separate regulatory bodies and could be more prominent  than either one alone. Although the housing GSEs operate differently, the  risks they manage and their missions are similar. We believe that valuable  synergies could be achieved and expertise in evaluating GSE risk  management could be shared more easily within one agency. In addition,  we believe that a single regulator would be better positioned to oversee  the GSEs’ compliance with mission activities, such as special housing  goals and any new programs or initiatives any of the GSEs might  undertake. This single regulator should be better able to assess these  activities’ competitive effects on all three housing GSEs and better able to  ensure consistency of regulation for GSEs that operate in similar markets.
Further, a single regulator would be better positioned to consider potential  trade-offs between mission requirements and safety and soundness  considerations, because such a regulator would develop a fuller  understanding of the operations of these large and complex financial  institutions. Some critics of combining safety and soundness and mission  have voiced concerns that doing so could create regulatory conflict for the  regulator. However, we believe that a healthy tension would be created  that could lead to improved oversight. The trade-offs between safety and  soundness and compliance with mission requirements could be best  understood and accounted for by having a single regulator that has  complete knowledge of the GSEs’ financial condition, regulates the  mission goals Congress sets, and assesses efforts to fulfill them.
To be effective, the single regulator must have all the powers, authorities,  and technical expertise necessary to oversee the GSEs’ operations and  compliance with their missions.
section_title: Measures Must Be Established to Help Ensure That the GSEs’ Benefits Outweigh the Financial Risks That Their Activities Pose to Taxpayers
paragraphs: Without clearly defined measures of the GSEs’ benefits, it is not possible  for Congress, accountability organizations, and the public to determine  whether the federal government should be subject to the financial risks  associated with the GSEs’ activities. I acknowledge that developing such  measures may prove challenging for several reasons. First, isolating the  GSEs’ effects on mortgage and agricultural credit markets is a complex  and technical undertaking. Second, the GSEs’ financial activities have  evolved over the years and become increasingly sophisticated, which  further complicates any analysis of the GSEs’ benefits and costs. Third, in  some cases, there is a lack of measurable mission-related criteria that  would allow for a meaningful assessment of the GSEs’ mission  achievement or whether the GSEs’ activities are consistent with their  charters. Nevertheless, past actions by Congress and regulators  demonstrate that developing such quantifiable measures is possible. For  example, in 1992, Congress required HUD to set numeric housing goals for  Fannie Mae and Freddie Mac to help ensure that their mortgage purchases  served the needs of low-income households as well as other targeted  groups.
section_title: The GSEs’ Corporate Governance, Regulatory Oversight, and Mission Compliance Reporting Can Be Strengthened
paragraphs: Now that I have laid out the risks associated with the GSEs and principles  for effective governance and oversight, I would like to turn my attention to  how the current system compares with those principles. While there is  some positive information to report about the GSEs, there are also  weaknesses in the areas of corporate governance, regulatory oversight,  and mission compliance reporting. In each of these areas, there are steps  we believe Congress, the regulators, or GSEs can take to address  weaknesses in GSE governance and oversight that we have identified.
subsections: section_title: GSE Corporate Governance Practices Can Be Improved
paragraphs: The GSEs’ corporate governance practices are not fully consistent with the  principles that I previously mentioned. The first principle I discussed is  independence of the board and the role of the board of directors. There  are instances where the GSEs can further their efforts in ensuring board  independence. To illustrate:    Like CEOs at many other publicly traded companies, the CEO of  Fannie Mae and the CEO of Freddie Mac currently serve as chairman of  their respective boards of directors. In addition, Fannie Mae’s COO and  CFO both serve as vice chairmen of the board. All too frequently, such  individuals will have significant influence over who is asked to join the  board and who is asked to leave it. OFHEO, in its special examination  of Freddie Mac (OFHEO report), recommended that Freddie Mac  should separate the functions of the CEO and the board chairman to  improve the effectiveness of the board of directors and Freddie Mac  has agreed to do so. I also note that OFHEO recently submitted  proposed corporate governance reforms to the Office of Management  and Budget that would require the GSEs to separate the CEO and chair  positions; and   A recent FHFB study on board governance of the FHLBanks found that  the selection process for board and committee chairpersons and  assignment of committee memberships at some FHLBanks lacked  transparency or inclusiveness. The study concluded that committee  selection processes relying on only one person or the  recommendations of senior management may diminish the  independence of directors. FHFB recommended the FHLBanks  strengthen their boards of directors by using a transparent and  inclusive selection process.
In practice, GSE boards may face difficulties in complying with modern  governance standards because of statutory and regulatory requirements  regarding the structure, selection, and composition of such boards. For  example,    Fannie Mae and Freddie Mac’s boards include five seats that are  appointed annually by the President, serve one-year terms, and  represent various interests including the real estate industry, the  mortgage lending industry, and consumer interests. Treasury has  proposed eliminating the presidentially appointed directors at Fannie  Mae and Freddie Mac because the perceived roles of these directors  contradict best practices of corporate governance. OFHEO agrees with  Treasury’s position because it has found that the appointed members  do not play meaningful roles on the GSEs’ boards. While there may be  reasons to eliminate these positions, should Congress decide to retain  them, it should consider (1) lengthening the terms of the appointed  directors so that they have sufficient time to understand the GSEs’  complex activities, (2) establishing criteria to ensure that qualified  individuals serve on the boards who have expertise in financial  activities and understand the GSEs’ mission responsibilities, and (3)  establishing fiduciary responsibilities to serve the special public  purpose of the GSE.
I would also like to point out that FHFB appoints at least 6 directors,  known as public interest directors, to serve on the board of the  FHLBanks, whose boards each consist of at least 14 members. We  believe that a selection process that uses a regulator to select the  directors of the regulated entities could jeopardize the independence of  those directors as well as FHFB.
As another example, our recent study of Farmer Mac provides an  illustration of how congressionally established board structure can  complicate a GSE’s compliance with board independence  requirements. We noted that the statutory structure of the Farmer Mac  board requires a majority of the directors to come from institutions  that utilize Farmer Mac’s services. This raises questions as to the  independence of that board.
In the area of compensation, there are indications that the structure of  executive compensation arrangements and the process of determining  compensation levels at the GSEs are not in line with best practices for  corporate governance. As examples,    According to the OFHEO report, approximately 54 percent of the total  cash compensation (salaries, bonuses, and other compensation) paid  by Freddie Mac to executive officers for performance in 2001 was  based on corporate performance for that year. The study found that the  compensation of senior executives, in particular, the size of the bonus  pool, was tied, in part, to meeting or exceeding annual specified  earnings per share targets. OFHEO concluded that the importance of  achieving such targets contributed, in part, to the improper accounting  and management practices of the GSE. As such, OFHEO recommended  that Freddie Mac should develop financial incentives for executives  and employees based on long-term goals.
Our study at Farmer Mac also identified an aggressive stock option  vesting plan whereby stock options for employees and directors were  fully vested within 2 years. By comparison, companies have average  vesting periods of 4 to 5 years. Farmer Mac has since changed its  vesting program to be more aligned with those of other companies.
Finally, in my view, adequate transparency is important because the  housing GSEs engage in complex transactions, such as securitizations,  guarantees, and hedging of risk which introduce many financial reporting  complexities. With the exception of Farmer Mac, GSEs are exempt from  the securities laws, and are not required to file disclosure documents with  the Securities Exchange Commission (SEC) with respect to their  securities issuances. Nevertheless, in October 2000, Fannie Mae and  Freddie Mac adopted six voluntary commitments aimed at increasing their  financial disclosures. More recently, Fannie Mae has registered its stock  with SEC on a voluntary basis and Freddie Mac has stated its intention to  do the same. Although financial disclosure may improve transparency, its  impact on the GSEs and their customers or funding parties may be limited  if the GSEs are perceived to have implicit government backing. For this  reason, while market discipline can play a role in curbing risky behavior  by GSEs, it also has its limitations. Effective oversight thus takes on more  importance as a means for limiting inappropriate risk-taking behavior by  the GSEs. Now let me move on to the last line of defense, that is, oversight  by regulators.
section_title: Housing GSE Regulatory Structure Does Not Ensure Effective Oversight
paragraphs: Unfortunately, the current housing GSE regulatory structure is  fragmented, which limits the federal government’s ability to oversee the  GSE’s activities. Congress now has the opportunity to rationalize the  current GSE regulatory structure through the creation of a single regulator  that would oversee the housing GSEs’ safety and soundness and mission  activities. Congress should also ensure that the new GSE regulator has the  authorities necessary to carry out its critical responsibilities.
subsections: section_title: GSE Regulatory Structure Can Be Consolidated
paragraphs: Although the housing GSEs share similar risks and missions, there are  three regulators overseeing either their safety and soundness, their  missions, or both. Currently, OFHEO regulates Fannie Mae and Freddie  Mac on matters of safety and soundness, while HUD is the mission  regulator. FHFB serves as the safety and soundness and mission regulator  of the FHLBanks. Available evidence raises questions about the capacity  of the current regulatory structure to effectively monitor the GSEs’ safety  and soundness and mission compliance. To illustrate:    OFHEO did not identify the substantial financial accounting problems  at Freddie Mac at an early stage. In fact, OFHEO’s 2001 and 2002  examinations of Freddie Mac gave high marks to the GSE in such  relevant areas as corporate governance and internal controls, despite  the widespread deficiencies later identified in these areas. OFHEO’s  current director has stated that the agency plans to strengthen its  examination program, create an office of the chief accountant, and  elevate the important area of corporate accounting into its oversight  process.
As of July 2002, FHFB employed just 10 examiners to review the  increased risks and complexity of the 12 FHLBanks and the agency’s  reviews of key activities—such as internal controls—were limited.  Although FHFB has initiated a program to triple the number of  examiners to 30 by the end of FY 2004 and has revised its examination  program, it is too soon to judge the effectiveness of FHFB’s initiatives.  For example, as FHFB continues the process of developing a sufficient  and capable force of examiners, it must cope with the fact that several  FHLBanks reported losses or weak financial results in late FY 2003 and  some FHLBanks continue to expand their mortgage purchase  programs.
HUD officials we contacted said that the department lacks sufficient  staff and resources necessary to carry out its GSE mission oversight  responsibilities. HUD officials said that although the GSEs’ assets have  increased nearly six-fold since 1992, HUD’s staffing has declined by  4,200 positions and GSE oversight—which now consists of about 13  full-time positions—must compete with other department priorities for  the limited resources available. The President’s 2005 budget includes a  proposal that would allow HUD to assess Fannie Mae and Freddie Mac  for the cost of its mission oversight. I also note that HUD (1) has not  proposed a rule to ensure that the GSEs’ nonmortgage investments  (such as long-term corporate debt) are consistent with their housing  mission as the department committed to do in response to a 1998 GAO  report and (2) it is not clear that HUD has the expertise necessary to  review sophisticated financial products and issues, which are  associated with nonmortgage investments and new program  applications.
As I stated previously, a single GSE regulator offers many advantages over  the fragmented structure that exists today including prominence in  government, the sharing of technical expertise, and the ability to assess  trade-offs between safety and soundness considerations and certain  mission compliance activities.
In determining the appropriate structure for a new GSE regulator, we note  that Congress has authorized two different structures for governing  financial regulatory agencies: a single director and board. Among financial  regulators, single directors head the Office of the Comptroller of the  Currency (OCC), the Office of Thrift Supervision (OTS) and OFHEO while  boards or commissions run FHFB, SEC, and the Board of Governors of the  Federal Reserve System, among others. The single director model has  advantages over a board or commission; for example, the director can  make decisions without the potential hindrance of having to consult with  or obtain the approval of other board members.
In our previous work, however, we have stated that a “stand-alone” agency  with a board of directors would better ensure the independence and  prominence of the regulator and allow it to act independently of the  influence of the housing GSEs, which are large and politically influential. A  governing board may offer the advantage of allowing different  perspectives, providing stability, and bringing prestige to the regulator.  Moreover, if the board included the secretaries of Treasury and HUD or  their designees, the potential exists that safety and soundness and housing  mission compliance concerns would both be represented. We are mindful,  though, based on recently completed work, of some of the disadvantages  of a stand-alone agency with a board of directors that is divided along  party lines. Tensions and conflicts between board members potentially  diminish some of these benefits.
I would note that in other regulatory sectors—besides financial  regulation—Congress has established alternative board structures that  could be considered as potential models for the new GSE regulator. One  such alternative structure would be to have a presidentially appointed and  Senate confirmed director, and a board of directors comprised of the  secretaries from relevant executive branch agencies, such as Treasury and  HUD. Board members being from the same political party could lessen  some of the tensions and conflicts observed at boards purposefully  structured to have a split in membership along party lines. A board  comprised of members all from the same political party may, though, not  benefit from different perspectives to the same extent as a board with  members from different political parties. Therefore, an advisory  committee to the regulator could be formed, to include representatives of  financial markets, housing, and the general public. This advisory  committee could also be required to have some reasonable representation  from different political parties.
I would now like to comment on issues surrounding the potential funding  arrangements for a new housing GSE regulator. Similar to FHFB, OCC,  and OTS, OFHEO funds its operations through assessments on its  regulated entities, Fannie Mae and Freddie Mac. However, unlike these  agencies that are exempt from the appropriations process, OFHEO can  only collect the assessments when approved by an appropriations bill and  at a level set by its appropriators. While testifying on GSE regulatory  reform, the director of OFHEO noted that the appropriations process has  placed severe constraint on OFHEO’s operations and has hindered its  ability to hire additional resources it needs to strengthen its oversight.
Exempting the new GSE regulator from the appropriations process would  provide the agency the financial independence necessary to carry out its  responsibilities. More importantly, without the timing constraints of the  appropriations process, the regulator could more quickly respond to  budgetary needs created by any crisis at the GSEs. However, being outside  the appropriations process can create trade-offs. First, while the regulator  will have more control over its own budget and funding level, it will lose  the checks and balances provided by the federal budget and  appropriations processes or the potential reliance on increased  appropriations during revenue shortfalls. As a result, the regulator would  need to establish a system of budgetary controls to ensure fiscal restraint.  Second, removing the regulator from the appropriations process could  diminish congressional oversight of the agency’s operations. This trade-off  could be mitigated through increased oversight by the regulator’s  congressional authorizing committees, such as a process of regular  congressional hearings on the new GSE regulator’s operations and  activities.
section_title: Congress Should Ensure That the New Housing GSE Regulator Has Adequate Enforcement Authorities
paragraphs: The new GSE regulator must have adequate powers and authorities to  address unsafe and unsound practices, respond to financial emergencies,  and ensure that the GSEs comply with their public missions. In our  previous work, we have stated that each GSE housing regulator  administers its own statutory scheme and these schemes contain various  types of powers and authorities, which although similar, are not identical.  Further, the GSE housing regulators’ powers and authorities differ from  that of banking regulators in key areas. The following describes some of  these differences, which Congress may wish to consider in determining  the appropriate authorities for a new GSE housing regulator:    Unlike bank regulators and FHFB, OFHEO’s (1) authority to issue  Cease and Desist Orders does not specifically list an unsafe and  unsound practice as grounds for issuance and (2) powers do not  include the same direct removal and prohibition authorities applicable  to officers and directors;    Bank regulators have prompt corrective authorities that are arguably  more robust and proactive than those of OFHEO and FHFB. These  authorities require that bank regulators take specific supervisory  actions when bank capital levels fall to specific levels or provide the  regulators with the option of taking other actions when other specified  unsafe and unsound actions occur. Although OFHEO has statutory  authority to take certain actions when Fannie Mae or Freddie Mac  capital falls to predetermined levels, the authorities are not as  proactive or broad as those of the bank regulators. OFHEO has also  established regulations requiring specified supervisory actions when  unsafe developments are identified that do not include capital, but  OFHEO’s statute does not specifically mention these actions. FHFB’s  statute does not establish prompt corrective action scheme, but FHFB  officials believe they have all the authority necessary to carry out their  safety and soundness responsibilities; and   Unlike bank regulators—-which can place insolvent banks into  receivership—-and FHFB, which can take actions to liquidate an  FHLBank, OFHEO is limited to placing Fannie Mae or Freddie Mac into  a conservatorship. I note that should Congress decide to grant the  new GSE regulator receivership authority, it should task the regulator  to develop rules and procedures that would reduce the adverse impacts  that a GSE liquidation could have on housing finance and the stability  of financial markets.
In summary, I believe Congress can review the regulatory authorities at  OFHEO, FHFB, and bank regulators and, where appropriate, ensure that  the new regulator has sufficient authorities to carry out its critical  responsibilities.
section_title: Measures Have Not Been Established to Determine Whether the GSEs’ Benefits Outweigh Their Risks
paragraphs: In important cases, it is clear that the GSEs have fulfilled the public  missions for which they were initially created. Since the establishment of  Fannie Mae and the FHLBank System in the 1930s, for example, the  nation’s mortgage finance market has progressed from a regionally based  system characterized by periodic credit shortages to a nationwide and  liquid system. Furthermore, it is generally agreed that Fannie Mae and  Freddie Mac’s mortgage purchase activities have lowered the interest rates  on qualifying mortgages below what they otherwise would be. In a 1996  report, we estimated that Fannie Mae and Freddie Mac’s activities lowered  the rate on qualifying mortgages by about 15 to 35 basis points or a  monthly savings of between $10 and $25 on a typical mortgage of  $100,000. Subsequently, federal agencies and researchers, academics, and  the GSEs have initiated studies that have estimated the extent of the  benefits provided by the GSEs’ activities and the recipients of such  benefits (i.e., homebuyers vs. investors and management), which have  reached differing conclusions. Additional studies may be needed to more  precisely estimate the extent to which the GSEs’ activities benefit  homebuyers.
In other areas, however, there is substantially greater uncertainty  regarding the benefits of the GSEs’ activities and more research is needed  to clarify these issues. Although the GSEs have expanded rapidly and  become more complex in recent years, for example, it is not always clear  how the GSEs’ growth and complexity have enhanced their public  missions. For instance, at year-end 2002, Fannie Mae and Freddie Mac held  a combined $1.4 trillion of mortgage assets in their retained portfolios,  including MBS, while the FHLBanks hold about a combined $100 billion of  MBS. Although holding mortgage assets in their portfolios may enhance  the profitability of the GSEs, it also exposes them to interest rate risk,  which requires the use of sophisticated financial strategies—such as the  use of hedging which includes the use of derivatives—to manage  effectively. In addition, derivatives may also be used by financial  institutions to take positions on interest rate movements, which can  enhance their profitability but which is also inherently risky. Over the  years, questions have been raised as to whether the GSEs’ portfolio  investments in MBS generate benefits to borrowers.
Additionally, the lines that initially existed between Fannie Mae and  Freddie Mac on the one hand and the FHLBank System on the other have  blurred. In addition to making advances to their members, for example,  FHLBanks have now purchased about $108 billion in mortgages directly  from their members, which is essentially Fannie Mae and Freddie Mac’s  traditional business. Although the FHLBanks’ mortgage purchases may  enhance competition in the market for secondary mortgage purchases,  they can just as easily raise questions as to whether there is a need for an  additional GSE performing essentially the same mission and incurring  similar risks.
In some cases, the absence of specific criteria and guidance complicates  efforts to assess the benefits of the GSEs’ activities. Our recent work  concluded that Farmer Mac’s statute contains broad mission purpose  statements and lacks specific or measurable criteria that would help  determine whether the GSE is meeting its policy goals. Farmer Mac’s  nonmission-related assets—such as long-term corporate bonds—declined  from 66 percent of assets in 1997 to 37 percent in 2002. However, the  composition and criteria for nonmission investments could potentially  lead to investments that are excessive in relation to Farmer Mac’s financial  operating needs or otherwise would be inappropriate to the statutory  purpose of Farmer Mac. We suggested that Congress should consider  establishing clearer mission goals for Farmer Mac with respect to the  agricultural and real estate market to allow a determination as to whether  Farmer Mac had achieved its public policy goals.
Finally, I would also like to point out that there are other limitations in the  evidence and research on the benefits provided by the GSEs’ activities.  The following are some examples that we have identified:    There is limited information as to the extent to which the FHLBank  System’s more than $500 billion in outstanding advances, as of mid- year 2003, have facilitated mortgage availability. Although anecdotal  information is available on the benefits of FHLBank advances, studies  using quantitative analysis to assess the impacts of FHLBank advances  on housing and community development have not been produced.
There is limited information available on the extent to which Fannie  Mae and Freddie Mac’s investments in nonmortgage assets—such as  long-term corporate bonds—serve their public missions. As I described  earlier, HUD has not acted on its general regulatory authority to review  the appropriateness of the GSEs’ nonmortgage investments as it  committed to do in response to a 1998 GAO report. Given that HUD has  not acted in this area for the past 6 years, we again recommend that  Congress legislate nonmortgage investment criteria for HUD or any  new GSE regulator that may be established through legislation.
There is virtually no information available as to whether Farmer Mac’s  activities have benefited agricultural real estate markets. For example,  the depth and liquidity of the demand for AMBS in the current market  is unknown.
Without quantifiable measures and reliable data, Congress and the public  cannot judge the effectiveness of the GSEs in meeting their missions or  whether the benefits provided by the GSEs’ various activities are in the  public interest and outweigh their financial risks. To improve the quality of  information about the GSEs’ activities, I believe that the GSEs, the new  housing GSE regulator, and FCA—the regulator of Farmer Mac and FCS— should research the areas that we have identified as well as others and  periodically report their findings to the public.
Mr. Chairman, this concludes my statement. In summary, I believe that the  following steps can be taken to strengthen GSE governance and oversight:    Fannie Mae and Freddie Mac should ensure that their executives report  to independent boards; FHLBank directors should be chosen through  transparent and inclusive processes; and GSE compensation packages  should include short and long-term performance measures;   Congress should create a single housing GSE regulator that is governed  by a board or a hybrid board and director and has adequate authorities  to fulfill its safety and soundness and mission compliance oversight  responsibilities; and    Congress should provide clearer direction to the GSEs in fulfilling their  missions—such as in the case of the GSEs’ nonmortgage investments— and the GSEs, the new GSE regulator, and FCA should research certain  aspects of the GSEs’ financial activities and periodically report to the  public as to how these activities are consistent with mission  requirements.
I would now be happy to respond to any questions that you or other  members of the Committee may have.
section_title: Staff Contacts and Acknowledgements
paragraphs: For further information regarding this testimony, please contact Thomas J.  McCool at (202) 512-8678 or William B. Shear at (202) 512-4325. Individuals  making contributions to this testimony include Diane Brooks, M’Baye  Diagne, Rachel DeMarcus, Andrew Pauline, Wesley M. Phillips, Mitchell  Rachlis, and Karen Tremba.
section_title: GAO Government-Sponsored Enterprise Related Reports
paragraphs: Farmer Mac: Some Progress Made, but Greater Attention to Risk  Management, Mission, and Corporate Governance Is Needed.   GAO-04-116. Washington, D.C.: October 16, 2003  Federal Home Loan Bank System: Key Loan Pricing Terms Can Differ  Significantly. GAO-03-973. Washington, D.C.: September 8, 2003.
Financial Regulation: Review of Selected Operations of the Federal  Housing Finance Board. GAO-03-364. Washington, D.C.: February 28,  2003.
OFHEO’s Risk Based Capital Stress Test: Incorporating New Business Is  Not Advisable. GAO-02-521. Washington, D.C.: June 28, 2002.
Farm Credit Administration: Oversight of Special Mission to Serve,  Young, Beginning, and Small Farmers Needs to Be Improved.   GAO-02-304. Washington, D.C.: March 8, 2002.
Federal Home Loan Bank System: Establishment of a New Capital  Structure. GAO-01-873. Washington, D.C.: July 20, 2001.
Comparison of Financial Institution Regulators’ Enforcement and  Prompt Corrective Action Authorities. GAO-01-322R. Washington, D.C.:  January 31, 2001.
Capital Structure of the Federal Home Loan Bank System  . GAO/GGD-99- 177R. Washington, D.C.: August 31, 1999.
Farmer Mac: Revised Charter Enhances Secondary Market Activity, but  Growth Depends on Various Factors. GAO/GGD-99-85. Washington, D.C.:  May 21, 1999.
Federal Housing Finance Board: Actions Needed to Improve Regulatory  Oversight. GAO/GGD-98-203. Washington, D.C.: September 18, 1998.
Federal Housing Enterprises: HUD’s Mission Oversight Needs to Be  Strengthened. GAO/GGD-98-173. Washington, D.C.: July 28, 1998.
Risk-Based Capital: Regulatory and Industry Approaches to Capital and  Risk. GAO/GGD-98-153. Washington, D.C.: July 20, 1998.
Government-Sponsored Enterprises: Federal Oversight Needed for  Nonmortgage Investments. GAO/GGD-98-48. Washington, D.C.: March 11,  1998.
Federal Housing Enterprises: OFHEO Faces Challenges in Implementing  a Comprehensive Oversight Program. GAO/GGD-98-6. Washington, D.C.:  October 22, 1997.
Government-Sponsored Enterprises: Advantages and Disadvantages of  Creating a Single Housing GSE Regulator. GAO/GGD-97-139.  Washington, D.C.: July 9, 1997.
Housing Enterprises: Investment, Authority, Policies, and Practices.  GAO/GGD-91-137R. Washington, D.C.: June 27, 1997.
Comments on “The Enterprise Resource Bank Act of 1996.”   GAO/GGD-96-140R. Washington, D.C.: June 27, 1996.
Housing Enterprises: Potential Impacts of Severing Government  Sponsorship. GAO/GGD-96-120. Washington, D.C.: May 13, 1996.
Letter from James L. Bothwell, Director, Financial Institutions and  Markets Issues, GAO, to the Honorable James A. Leach, Chairman,  Committee on Banking and Financial Services, U.S. House of  Representatives, Re: GAO’s views on the “Federal Home Loan Bank  System Modernization Act of 1995.” B-260498. Washington, D.C.: October  11, 1995.
FHLBank System: Reforms Needed to Promote Its Safety, Soundness,  and Effectiveness. GAO/T-GGD-95-244. Washington, D.C.: September 27,  1995.
Housing Finance: Improving the Federal Home Loan Bank System’s  Affordable Housing Program. GAO/RCED-95-82. Washington, D.C.: June  9, 1995.
Government-Sponsored Enterprises: Development of the Federal Housing  Enterprise Financial Regulator. GAO/GGD-95-123. Washington, D.C.: May  30, 1995.
Farm Credit System: Repayment of Federal Assistance and Competitive  Position. GAO/GGD-94-39. Washington, D.C.: March 10, 1994.
Farm Credit System: Farm Credit Administration Effectively Addresses  Identified Problems. GAO/GGD-94-14. Washington, D.C.: January 7, 1994.
Federal Home Loan Bank System: Reforms Needed to Promote Its Safety,  Soundness, and Effectiveness. GAO/GGD-94-38. Washington, D.C.:  December 8, 1993.
Improved Regulatory Structure and Minimum Capital Standards are  Needed for Government-Sponsored Enterprises. GAO/T-GGD-91-41.  Washington, D.C.: June 11, 1991.
Government-Sponsored Enterprises: A Framework for Limiting the  Government’s Exposure to Risks. GAO/GGD-91-90. Washington, D.C.: May  22, 1991.
Government-Sponsored Enterprises: The Government’s Exposure to  Risks. GAO/GGD-90-97. Washington, D.C.: August 15, 1990.
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