Farmer Mac: Greater Attention to Risk Management, Mission, Public Purpose, and Corporate Governance Is Needed
Published: 2004-06-02T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony is based on GAO's October 2003 report, Farmer Mac: Some Progress Made, but Greater Attention to Risk Management, Mission, and Corporate Governance Is Needed (GAO-04-116). GAO's testimony presents a brief overview of Farmer Mac and discusses issues raised in its 2003 report, including Farmer Mac's risk management practices and line of credit with Treasury, mission related activities, board structure, and oversight, which is provided by the Farm Credit Administration (FCA).
section_title: What GAO Found
paragraphs: Farmer Mac, a government-sponsored enterprise (GSE), was established to provide a secondary market for agricultural real estate and rural housing loans and to increase agricultural mortgage credit. In 2003, GAO reported that several aspects of Farmer Mac's financial risk management practices had not kept pace with its increasing risk profile. First, Farmer Mac had $3.1 billion in off-balance-sheet commitments and other agreements that could obligate it to buy the underlying loans or cover related losses under certain conditions. Farmer Mac and the Farm Credit System institutions that participate in the agreements are required to hold far less capital than is otherwise required. Because Farmer Mac's loan activities are concentrated in a small number of financial institutions and in the West, the risk is not reduced while less capital is required to be held. Under stressful agricultural economic conditions, Farmer Mac could be required to purchase large amounts of impaired or defaulted loans if large amounts of the commitments were exercised. Second, the coverage of Farmer Mac's $1.5 billion line of credit with the U.S. Treasury was controversial, as the entities disagreed on whether the securities it has issued and kept in its portfolio would be eligible. Third, GAO reported that while Farmer Mac had increased its mission-related activities since its 1999 report, their impact on the agricultural real estate market was unclear. The effects were difficult to measure partly because Farmer Mac's statute lacks specific mission goals. For this and other reasons, GAO concluded that the public benefits derived from Farmer Mac's activities are not clear. Finally, for profitability reasons, Farmer Mac had a strategy of holding securities it issued in its portfolio instead of selling them to investors in the capital markets. As a result, the depth and liquidity of the market for Farmer Mac's securities is unknown. Farmer Mac's board structure, set in federal law, may make it difficult to ensure that the board fully represents the interests of all shareholders and meets independence and other requirements. The board structure contains elements of both a cooperative and an investor-owned publicly traded company. For example, two-thirds of the board members do business with Farmer Mac and hold the only voting stock, while the common stock holders have no vote. GAO also identified challenges FCA faced in its oversight of Farmer Mac, including a lack of specific criteria for measuring how well it was achieving its mission. Although FCA had taken steps to improve its safety and soundness oversight, more needs to be done to improve its offsite monitoring and assessment of risk-based capital. Farmer Mac and FCA have efforts underway to address many of GAO's recommendations and it was too early to assess them.

section_title: Letter
paragraphs: We are pleased to be here today to discuss the results of GAO’s work on  the Federal Agricultural Mortgage Corporation, commonly referred to as  Farmer Mac. Our testimony is based on the report we issued on October  16, 2003, at the request of the Senate Committee on Agriculture, Nutrition,  and Forestry: Farmer Mac: Some Progress Made, but Greater Attention to  Risk Management, Mission, and Corporate Governance Is Needed, GAO- 04-116 (Washington, D.C.: October16, 2003). Our overall objective today is  to provide the committee with information and perspectives to consider as  it continues to oversee Farmer Mac. My remarks are divided into two  sections. First, I will provide an overview of Farmer Mac, its mission and  portfolio, and potential risks to taxpayers. Second, I will provide our  report findings on a variety of items associated with Farmer Mac,  including its risk management practices and its line of credit with  Treasury, mission-related activities, board structure, and oversight  provided by the Farm Credit Administration (FCA). Throughout my  statement, I will comment on Farmer Mac’s and FCA’s responses to the  findings and recommendations in our report. Information discussed in our  report was gathered from August 2002 to May 2003 from reviews of  documents and interviews we had with representatives from Farmer Mac,  FCA, other market participants, and individuals with expertise in the  agricultural real estate market. We also reviewed FCA’s examinations of  Farmer Mac and consultants’ studies related to Farmer Mac. To update our  report for this testimony, we obtained more recent financial data on  Farmer Mac and Farmer Mac’s and FCA’s responses to our  recommendations. We conducted our work in accordance with generally  accepted government auditing standards.
In summary, I will first give a brief overview of Farmer Mac. Farmer Mac is  a government-sponsored enterprise or GSE established by Congress to  create a secondary market in agricultural real estate and rural housing  loans, and to improve the availability of agricultural mortgage credit. FCA,  through its Office of Secondary Market Oversight (OSMO), regulates  Farmer Mac. In extreme circumstances, Farmer Mac may borrow up to  $1.5 billion from the U.S. Treasury. Among its program activities, Farmer  Mac purchases agricultural mortgages from lenders and periodically  securitizes these loans into guaranteed securities or agricultural mortgage- backed securities (AMBS). During the last 2 years, Farmer Mac sold AMBS  principally to related parties.
Farmer Mac also issues long-term standby purchase commitments or  standby agreements for eligible loans. To date, all of these commitments  are with institutions in the Farm Credit System (FCS), which is also a GSE.  As of December 31, 2003, loans underlying standby and similar  agreements totaled $3.1 billion and represent 53 percent of the book value  of total loans included in Farmer Mac’s programs (see fig. 1). These  agreements are held off balance sheet because Farmer Mac does not own  the loans underlying these agreements and is conditionally obligated to  purchase them. In the case of the $722.3 million of standby agreements  that was converted into a Farmer Mac I Guaranteed Security, Farmer Mac  may, at its discretion, repurchase the defaulted loans or choose to pay the  associated losses under the guarantee without purchasing the loan.  Although the underlying loans have been performing better than its on- balance sheet loans, the standby agreements include provisions that  commit Farmer Mac to purchasing the loans under specific conditions— for example, when they become 120-day delinquent.
Farmer Mac also faces potential liquidity risk as a result of these standby  and similar agreements, which can create unexpected demands for  additional funding. In other words, at a time when either the agricultural  sector is severely depressed or interest rates are falling, Farmer Mac could  be required to purchase large amounts of impaired or defaulted loans  under the agreements, thus subjecting Farmer Mac to increased funding  liquidity risks and the potential for reduced earnings. Notwithstanding the  risk these standby and similar agreements could generate for Farmer Mac  under stressful economic conditions, their off-balance sheet status allows  Farmer Mac to hold less capital against the loans placed under them  compared with its own on-balance sheet loans. These agreements also  allow the FCS institutions to hold less capital against the loans placed  under them. Further, the amount of capital that Farmer Mac would be  required to hold against these underlying loans if required to buy them is  less than what the FCS institutions are required to hold against the loans.  The result of Farmer Mac’s $3.1 billion in standby and similar agreements  is to significantly reduce the amount of capital held against these loans in  the FCS as a whole without correspondingly reducing risk because of its  geographic and lender concentration.
Second, we looked at a number of issues associated with Farmer Mac. For  instance, our findings showed that Farmer Mac’s income had increased  since 1999 and that its capital continued to exceed required levels. At the  same time, however, the rapid growth in Farmer Mac’s standby  agreements presents additional risk. We also identified trends indicating  certain aspects of Farmer Mac’s risk management systems have not kept  pace with its increasingly complex portfolio. We made recommendations  to Farmer Mac to enhance its risk management practices. Our study also  pointed out that Farmer Mac faces some uncertainty involving its $1.5  billion line of credit with the U.S. Treasury (Treasury). In particular, while  the legal opinion of Farmer Mac’s outside counsel disagrees, Treasury has  taken the position that it is not obligated to cover losses on the AMBS held  in Farmer Mac’s portfolio because the Treasury line of credit is not for the  purpose of protecting Farmer Mac shareholders or general creditors.  AMBS totaled $1.5 billion and made up 35 percent of Farmer Mac’s total  assets as of December 31, 2003.
We found that Farmer Mac has increased its mission-related activities  since we last reported on them in 1999. However, Farmer Mac’s statute  lacks specific or measurable mission goals beyond providing a secondary  market and stable long-term financing. Without specific mission goals, it is  difficult to meaningfully assess whether the increased activities are having  the desired impact on the agricultural real estate market. In addition,  Farmer Mac’s loan activities have been largely concentrated in a small  number of financial institutions—during 2003, 80.8 percent of Farmer Mac  I loan activities were with ten institutions—and its loan portfolio is  concentrated in the West. Therefore, we concluded that Farmer Mac has  increased its mission-related activities, but the public benefits derived  from these activities are not clear. We suggested that Congress consider  legislative changes to establish clearer mission goals for Farmer Mac.  Further, because Farmer Mac has elected to retain nearly all its AMBS in  its portfolio instead of selling them to investors in the capital markets, we  could not ascertain the depth and liquidity of the secondary market for  AMBS, which is unknown even in good market conditions. We made  recommendations to Farmer Mac to reevaluate its current strategy of  holding AMBS in its portfolio and issuing debt to obtain funding.
Next, we found that Farmer Mac’s board structure may make it difficult to  ensure that the board fully represents the interests of all shareholders and  could hamper Farmer Mac’s efforts to comply with the independence  requirements of the New York Stock Exchange’s (NYSE) listing standards.  As a GSE, Farmer Mac has a board set by statute that contains elements of  both a cooperative and an investor-owned publicly traded company. In  most respects, Farmer Mac’s board policies and processes appear  reasonable, but we found that some processes could be further developed  and formalized and made recommendations to Farmer Mac to make them  more transparent and consistent. We further suggested that Congress  consider legislative changes to amend the structure of the Farmer Mac  board and the structure of Farmer Mac’s Class C nonvoting common  stock.
Finally, we found that FCA had improved its oversight of Farmer Mac and  strengthened its examination approach but that more needs to be done to  enhance the assessment of risk-based capital and Farmer Mac’s  accomplishment of its mission. This enhanced focus is especially  important given Farmer Mac’s increasing risk profile, its concentration of  business with few business partners in the West, and its holdings of non- mission related assets. Since the law does not include any measurable  goals or requirements to assess Farmer Mac’s progress in furthering its  mission, FCA lacks criteria and procedures to effectively oversee this  aspect of Farmer Mac. We made several recommendations to FCA to  enhance the effectiveness of its oversight. To further assist FCA’s with its  oversight effort, we also suggested that Congress consider a legislative  change to allow FCA more flexibility in setting minimum capital  requirements for Farmer Mac.
To update our information for this testimony, we met with representatives  from Farmer Mac and FCA to discuss the status of our recommendations.  We found that Farmer Mac has either taken actions to address or is in the  process of implementing most of our recommendations. FCA is also  engaged in efforts to address and implement our recommendations. FCA  staff told us they considered and decided not to adopt certain elements of  our recommendation to enhance the risk-based capital model for Farmer  Mac, including a “run-off” approach, the effect of yield maintenance  penalties, and the use of land value declines as the independent variable in  loan loss regression. Since most of the actions undertaken by Farmer Mac  and FCA will not be fully completed for some time, it is too early for us to  evaluate their effectiveness.
subsections: section_title: Farmer Mac Provides a Secondary Market for Agricultural Real Estate but Entails Certain Risks
paragraphs: Farmer Mac is a government-sponsored enterprise or GSE that was  chartered by Congress in 1987. It is a federally chartered and privately  operated corporation that is publicly traded on the New York Stock  Exchange. Farmer Mac is also an independent entity within the Farm  Credit System or FCS, which is another GSE. As an FCS institution,  Farmer Mac is subject to FCA’s regulatory authority. FCA, through OSMO,  has general regulatory and enforcement authority over Farmer Mac.  According to the 1987 Act, Farmer Mac, in extreme circumstances, may  borrow up to $1.5 billion from the U.S. Treasury to guarantee timely  payment of any guarantee obligations of the corporation. Congress  established Farmer Mac with a mission to create a secondary market—a  financial market for buying and selling loans, individually or by  securitizing them—in agricultural real estate and rural housing loans, and  improve the availability of agricultural mortgage credit. When loans are  securitized, they are repackaged into a “pool” by a trust in order to be sold  to investors in the capital markets to generate liquidity. Generally, to carry  out its mission, Farmer Mac purchases mortgages or bonds directly from  lenders using cash generated by issuing debt obligations. It also issues  standby agreements for eligible loans whereby Farmer Mac is committed  to purchase eligible loans from financial institutions at an undetermined  future date when a specific event occurs. The intent for these activities is  to provide real estate credit to farmers at rates or conditions more  favorable than those that would be available in the absence of Farmer  Mac. Farmer Mac also securitizes the mortgages it purchases and issues  AMBS and guarantees the timely payment of interest and principal on  these securities. However, instead of selling the AMBS in the capital  markets to generate cash, Farmer Mac holds most of the AMBS that it  issues in its retained portfolio.
subsections: section_title: Farmer Mac Faces a Variety of Risks
paragraphs: Farmer Mac faces potential losses primarily from four sources:    Credit risk, or the possibility of financial loss resulting from default by  borrowers on farming assets that have lost value;   Liquidity risk, or the chance that Farmer Mac will be unable to meet its  obligations as they come due; Interest rate risk, or possible fluctuations in interest rates that negatively  impact earnings or the balance sheet; and   Operations risk, or the potential that inadequate or failed internal  processes, people and systems, or external events will affect financial  condition.
Although the federal government explicitly does not guarantee Farmer  Mac’s obligations, it is generally assumed in financial markets that the  government will not allow the GSE to default on its debt and AMBS  obligations. In fact, during the 1980s the federal government provided  financial assistance to both Fannie Mae and the Farm Credit System when  they experienced difficulties due to sharply rising interest rates and  declining agricultural land values, respectively. Because the markets  perceive that there is an implied federal guarantee on Farmer Mac’s  obligations, Farmer Mac can borrow money at interest rates that are lower  than those generally available to comparably creditworthy private  corporations and thus can extend credit and other forms of liquidity to  financial institutions at favorable rates.
section_title: The Size and Composition of Farmer Mac’s Portfolio
paragraphs: The assets associated with Farmer Mac’s activities can generally be  divided into program assets and nonmission investments. Program assets  are agricultural mortgage loans held by Farmer Mac, the guaranteed  securities backed by agricultural loans, and loans underlying Farmer Mac’s  standby agreements. As of December 31, 2003, Farmer Mac’s loan and  guarantee portfolio and standby agreements totaled about $5.8 billion. Of  that total, nearly $3.1 billion was in off-balance sheet standby and similar  agreements. Standby agreements represent a potential obligation of  Farmer Mac that does not have to be funded until such time as Farmer  Mac is required to purchase a loan. As such, these commitments are not on  Farmer Mac’s balance sheet and are subject to a statutory minimum  requirement of 0.75 percent capital instead of 2.75 percent for on-balance  sheet assets. Let me point out that whenever Farmer Mac is obligated  under a standby agreement to purchase a delinquent loan, it must also  increase the capital held against the loan from 0.75 to 2.75 percent, nearly  a 270 percent increase. Farmer Mac funds its loan purchases and other  activities primarily by issuing debt obligations of various maturities. As of  December 31, 2003, Farmer Mac had $2.8 billion of payable notes due  within one year and $1.1billion of payable notes due after one year  outstanding. At the same time, Farmer Mac held approximately $1.1 billion  in nonmission investments.
section_title: Farmer Mac’s Income and Risk Levels Have Increased
paragraphs: Farmer Mac’s net income increased from $4.6 million in 1997 to $27.3  million in 2003, for a total increase of 493 percent. Farmer Mac’s two  primary revenue sources are (1) interest income earned on its loan  portfolio, guaranteed securities, and nonmission investments, and (2)  commitment fees earned on standby agreements. In recent years, Farmer  Mac’s earnings growth has principally been driven by fees generated by its  off-balance sheet standby and similar agreements, which grew rapidly  from zero in 1998 to $3.1 billion as of December 31, 2003.
Farmer Mac’s risk levels have increased along with its income. First,  increased risk is apparent in the growing number of impaired loans, real  estate owned, and write-offs of bad loans, as well as in the rapid growth in  its on- and off-balance sheet loans, guarantees, and standby agreements.  Impaired loans totaled $69.96 million at December 31, 2003, compared to  zero at December 31, 1997. Part of our concern about the increased credit  risk involves Farmer Mac’s loan loss model, which is based on loans that  differ from those held in the corporation’s own portfolios and those  covered under its standby agreements in terms of geographic distribution  and interest rate terms. This lack of comparability and other limitations of  the model may affect the reasonableness and accuracy of Farmer Mac’s  estimated losses from credit risk either upward or downward. A  complicating factor is that notwithstanding the quality of the loans  underlying standby agreements, which have been performing better than  the loans on Farmer Mac’s balance sheet, Farmer Mac lacks the historical  experience with standby agreements that is needed to accurately estimate  the type and amount of loans it may ultimately be obligated to purchase  and any associated losses.
Farmer Mac also faces potential liquidity risk as a result of these standby  and similar agreements, which can create unexpected demands for  additional funding. In other words, at a time when either the agricultural  sector is severely depressed or interest rates are falling, Farmer Mac could  be required to purchase large amounts of impaired or defaulted loans  under the agreements, thus subjecting Farmer Mac to increased funding  liquidity risks and the potential for reduced earnings. Although our study  found that Farmer Mac has maintained sufficient liquidity to support its  loan purchase and guarantee activity, Farmer Mac’s liquidity may not be  adequate to cover its obligations under its standby or similar agreements.  We did not have the necessary historical information to project the  number of covered loans that Farmer Mac might need to purchase in the  future. Thus, we could not determine the extent of the liquidity risk  Farmer Mac might face. At the same time, Farmer Mac management did  not have the quantitative data it needed to make accurate risk  management and other operating decisions.
As noted earlier, we made recommendations to Farmer Mac to enhance its  risk management practices. We would like to report that Farmer Mac has  responded to our recommendations but it is too early for us to assess the  actions taken to implement them. Farmer Mac management recently  showed us a loan classification system that will be completed in 2005 that  is based on Farmer Mac’s loan loss experience. Staff are also now  documenting the supporting underwriting decisions for loans that Farmer  Mac management approved by overriding one or more specific criteria  based on the compensating strengths of those loans. Farmer Mac has also  adopted a formal contingency funding and liquidity plan but this plan does  not address our concerns about providing for liquidity if a large amount of  standby and similar agreement loans were put to Farmer Mac  unexpectedly. Farmer Mac representatives told us they are also developing  a capital adequacy model. In addition, Farmer Mac management said that  they are working with an outside consultant to develop a prepayment  model to ensure accurate interest rate risk measurements.
subsections: section_title: Disagreements about the Extent of Coverage of Treasury’s Line of Credit Could Generate Uncertainty
paragraphs: Now I want to focus on an issue involving Farmer Mac’s $1.5 billion line of  credit with Treasury that could impact the corporation’s long-term  financial condition. This issue is significant because it centers around the  AMBS in Farmer Mac’s retained portfolio, which as we have seen, makes  up 35 percent of its total on-balance sheet assets of $4.3 billion and 26%  percent of Farmer Mac’s total program assets of $5.8 billion—including  off-balance sheet loans underlying the standby and other agreements.  Treasury has expressed serious questions about whether it is required to  purchase Farmer Mac obligations to meet Farmer Mac-guaranteed  liabilities on AMBS that Farmer Mac or its affiliates hold. On the other  hand, a legal opinion from Farmer Mac’s outside counsel states that  Treasury would be required to purchase the debt obligations whether the  obligations are held by a subsidiary of Farmer Mac or by an unrelated third  party. This disagreement could create uncertainty as to whether Treasury  would purchase obligations held in Farmer Mac’s portfolio in times of  economic stress. This uncertainty also relates to statements made by  Farmer Mac to investors concerning Treasury’s obligation to Farmer Mac,  which in turn, could affect Farmer Mac’s ability to issue debt at favorable  rates. Ultimately, this uncertainty could impact its long-term financial  condition.
Farmer Mac’s subsidiary, Farmer Mac Mortgage Securities Corporation,  holds the majority of AMBS that Farmer Mac issued. Farmer Mac’s charter  (the 1987 Act) gives it the authority to issue obligations to the Secretary of  the Treasury to fulfill its guarantee obligations. According to the 1987 Act,  the Secretary of the Treasury may purchase Farmer Mac’s obligations only  if Farmer Mac certifies that (1) its reserves against losses arising out of its  guarantee activities have been exhausted and (2) the proceeds of the  obligations are needed to fulfill Farmer Mac’s obligations under any of its  guarantees. In addition, Treasury is required to purchase obligations  issued by Farmer Mac in an amount determined by Farmer Mac to be  sufficient to meet its guarantee liabilities not later than 10 business days  after receipt of the certification. However, Treasury has indicated that the  requirement to purchase Farmer Mac obligations may extend only to those  obligations issued and sold to outside investors.
In a comment letter dated June 13, 1997, and submitted to FCA in  connection with a proposed regulation on conservatorship and  receivership for Farmer Mac (1997 Treasury letter), Treasury stated “…we  have ‘serious questions’ as to whether the Treasury would be obligated to  make advances to Farmer Mac to allow it to perform on its guarantee with  respect to securities held in its own portfolio—-that is, where the Farmer  Mac guarantee essentially runs to Farmer Mac itself.” The 1997 Treasury  letter indicated that if the purchase of obligations extended to guaranteed  securities held by Farmer Mac this would belie the fact that the securities  are not backed by the full faith and credit of the United States, since a loan  to Farmer Mac to fulfill the guarantee would benefit holders of Farmer  Mac’s general debt obligations. The 1997 Treasury letter stated “Treasury’s  obligation extends to Farmer Mac only in the prescribed circumstances,  and is not a blanket guarantee protecting Farmer Mac’s guaranteed  securities holders from loss. Nor is the purpose of the Treasury’s  obligation to protect Farmer Mac shareholders or general creditors.”  According to Treasury, the 1997 letter remains its position concerning  Farmer Mac’s line of credit.
Meanwhile, the legal opinion of Farmer Mac’s outside counsel is that the  guarantee is enforceable whether AMBS are held by a subsidiary of  Farmer Mac or by an unrelated third party. Farmer Mac’s legal opinion  also states that Treasury could not decline to purchase the debt  obligations issued by Farmer Mac merely because the proceeds of the  obligations are to be used to satisfy Farmer Mac’s guarantee with respect  to AMBS held by a subsidiary. According to Farmer Mac, if the conditions  set forth in the 1987 Act are met—required certification and a limitation on  the amount of obligations of $1.5 billion—then there is no exception in the  1997 Act that authorizes Treasury to decline to purchase the obligations.  Farmer Mac states that discriminating among Farmer Mac guaranteed  securities based on the identity of the holder in determining whether  Farmer Mac could fulfill its guarantee obligations would lead to an  anomalous situation in the marketplace and thereby hinder the  achievement of Congress’ mandate to establish a secondary market for  agricultural loans.
section_title: Mission-related Activities Have Increased, but the Impact of Activities on Agricultural Real Estate Market Is Unclear
paragraphs: Before I go into whether Farmer Mac’s activities have had an impact on  the agricultural real estate loan market, I want to point out that the  enabling legislation contains only broad statements of the corporation’s  mission and purpose. The legislation is not specific and does not provide  measurable mission-related criteria that would allow for a meaningful  assessment of Farmer Mac’s progress in meeting its public policy goals.  Our attempt to determine the extent to which Farmer Mac had met its  public policy mission led us to conclude that although Farmer Mac has  increased its mission-related activities since our previous review, the  public benefits derived from these activities are not clear.
subsections: section_title: Farmer Mac’s Strategy of Retaining AMBS Has Limited the Development of a Liquid Secondary Market for AMBS
paragraphs: In trying to assess whether Farmer Mac had made long-term credit  available to farmers and ranchers at stable interest rates, we found that  from 2001 to 2002, its long-term fixed interest rates on Farmer Mac I loans  were similar to the rates offered by commercial banks and FCS  institutions. We also found that since 1998, Farmer Mac had been  operating under a strategy of retaining the loans it purchased and  securitized as AMBS in its portfolio. Farmer Mac stated that this strategy  would lower funding costs and increase profitability but as a result, the  depth and liquidity of the secondary market for AMBS is unknown. In our  report, we recommended that Farmer Mac reevaluate this strategy.  Recently, Farmer Mac management said that the corporation had  reevaluated its strategy for holding AMBS but determined to continue  holding them for economic reasons. However, Farmer Mac management  also indicated that the corporation was committed to selling newly issued  AMBS periodically, when the conditions of the capital markets and the  size of loan pool made such transactions efficient.
section_title: Standby Agreements Reduced Total Capital Required To Be Held in FCS
paragraphs: As I mentioned earlier, Farmer Mac has increased its mission-related  activities, primarily by developing the standby agreement program. As of  December 31, 2003, all of Farmer Mac’s standby agreements are with FCS  institutions and 3 FCS institutions represented 51 percent of the standby  agreement program. While standby agreements provide greater lending  capacity for those institutions, they also lower the amount of capital  lending institutions are required to hold against their loans. Fig. 2 shows  the effect of standby agreements on the total capital required to be held  against the underlying loans in the entire FCS.
Our concern is that standby and similar agreements reduce the sum of  capital required to be held by the Farm Credit System and Farmer Mac.  Generally, institutions can help mitigate the risks associated with lower  capital by maintaining a relatively large number of participating lenders  and a geographically diverse portfolio. However, Farmer Mac’s business  activities are concentrated among a small number of business partners and  its portfolio is concentrated largely in the western United States.
section_title: Farmer Mac’s Board of Directors May Not Reflect All Shareholder Interests, Be Fully Independent, or Use Clear and Transparent Processes
paragraphs: Before discussing governance issues at Farmer Mac, I want to describe  how Farmer Mac’s board of directors is structured in federal law. Farmer  Mac’s 15-member board of directors includes 5 members elected by Class  A stockholders, which include banks, insurance companies, and other  financial institutions that do business with Farmer Mac; 5 members  elected by Class B stockholders, which are FCS institutions that do  business with Farmer Mac; and 5 members appointed by the President of  the United States. Farmer Mac also issues nonvoting Class C stock to the  general public. Class A and Class B shareholders are concerned with the  use of Farmer Mac services, while Class C shareholders are generally  investors concerned with maximizing their profits.
According to statements made at the time Farmer Mac’s enabling  legislation was being considered, this structure was intended to protect  the interests of both FCS and commercial lenders by providing for equal  representation by FCS, commercial lenders, and the public sector. Under  this structure, Farmer Mac resembles a cooperative. At the same time,  however, it is a publicly traded company, because its Class A and C stock  are traded on the NYSE. But unlike most other publicly traded  corporations, Farmer Mac is controlled by institutions with which it has a  business relationship. For this reason, the board may face difficulties  representing the interests of all shareholders. Good corporate governance  requires that the incentives and loyalties of the board of directors of  publicly traded companies reflect the fact that the directors are to serve  the interests of all the shareholders. However, we found that the statutory  structure of Farmer Mac’s board and the voting structure of its common  stock hamper Farmer Mac’s ability to have such a focus.
Farmer Mac is subject to NYSE listing standards on corporate governance,  as well as statutory and regulatory requirements such as the Sarbanes- Oxley Act of 2002. Collectively, these standards and provisions require that  a majority of the board be independent and that key committees (audit,  nominating or corporate governance, and compensation) consist entirely  of independent directors. During our review, the listing standards were  being revised and criteria for independence had not been finalized.  Based  on the proposed standards, our assessment was that business  relationships between Farmer Mac and the directors of its board may have  prevented these individuals from meeting the standards of independence  under NYSE rules. In updating our information for this testimony, we  noted that Farmer Mac’s 2004 annual proxy statements had identified 2 of  15 directors as not meeting the independence standards. One of the 2  directors is not a nominee for re-election. The other director has decided  to withdraw as a member of the corporate governance committee if  elected as a director at 2004 annual meeting.
We found that Farmer Mac’s board nomination process, director training,  and management succession planning were not as concise, formal, or well  documented as best practices would suggest. We also found that Farmer  Mac’s stock option vesting program appears generous compared to  general industry practices. We made recommendations to Farmer Mac’s  board to improve the transparency and disclosure of these processes and  to reevaluate stock option levels and vesting period. Since our 2003 report,  according to Farmer Mac management, the board has reviewed and  confirmed that all board members fully understand the nomination  process and that it has established a formal executive management  succession plan. Further, the board has initiated a formal training program  for its members that included external training and briefings on subjects  relevant to the operations of Farmer Mac. Finally, the board had extended  the vesting period of the corporation’s stock options.
section_title: FCA Has Continued to Take Steps to Enhance Its Oversight of Farmer Mac
paragraphs: The final area of our 2003 review involved regulatory oversight of Farmer  Mac. We reported that since 2002 FCA had taken several steps to enhance  supervisory oversight of Farmer Mac but it faced significant challenges  that could limit its regulatory effectiveness. We made several  recommendations to FCA designed to enhance the risk-based capital  model, improve off-site monitoring of Farmer Mac, and help assess and  report how well Farmer Mac is achieving its mission. In updating our  information for this testimony, we found that FCA had taken or planned to  take a number of actions to further address many of our concerns and  recommendations.
subsections: section_title: FCA Has Taken Steps to Enhance Oversight of Farmer Mac, but Faces Challenges That Could Limit the Effectiveness of Its Oversight
paragraphs: During our 2003 review, we noted that FCA had begun strengthening its  oversight of Farmer Mac by doing a more comprehensive safety and  soundness examination and undertaking initiatives to expand its  regulatory framework. These initiatives included developing regulations to  limit the level and quality of Farmer Mac’s nonmission investments and  issue specific liquidity standards, and studying the implications of  regulatory capital arbitrage between FCS institutions and Farmer Mac.  However, we found that FCA continued to face significant challenges in  sustaining and improving its oversight and more remained to be done to  improve its off-site monitoring, assessment of risk-based capital, and  mission oversight. For example, FCA had not been updating and  reformatting Farmer Mac’s call report schedules and corresponding  instructions to fully conform to FCA regulations and to reflect recent  accounting changes. We also identified a number of issues related to the  data used in and structure of FCA’s risk-based capital model, but the  overall impact these issues have on the estimate of risk-based capital for  Farmer Mac’s credit risk is uncertain. Some concerns, such as the  potential undercounting of loans which experienced credit losses, or  greater prepayment of the loans in the database used to build FCA’s credit  risk model relative to the kinds of loans that Farmer Mac now purchases,  may result in the FCA credit risk model underestimating the credit risk  capital requirement. Other issues, such as lacking a variable to track land  price changes for any but the year with the most economic stresses, may  cause the model to overestimate the credit risk capital requirement.  Augmented data and more analysis could better determine the relative  magnitudes of these effects.
Our study found that FCA’s oversight of Farmer Mac had typically focused  on safety and soundness and that FCA lacked criteria and procedures to  effectively oversee how well Farmer Mac achieves its mission. At the same  time, Farmer Mac’s enabling legislation is broadly stated and does not  include any measurable goals or requirements to assess progress toward  meeting its mission. More explicit mission goals or requirements would  help FCA in improving its oversight of Farmer Mac.
Since our 2003 report, FCA has continued to make a concerted effort to  further enhance its oversight of Farmer Mac. First, FCA staff are drafting  regulatory revisions to the risk-based capital model that covers a range of  issues. They plan to present a proposed rule to the FCA board for  consideration in the fall of 2004. According to FCA officials, they are  engaged in efforts to address the issues related to the risk-based model  raised in our report but there are certain elements of our recommendation  they have considered and decided not to adopt, including a “run-off”  approach, the effect of yield maintenance penalties, and the use of land  value declines as the independent variable in loan loss regression. Second,  FCA has made some revisions to the Farmer Mac quarterly call reports,  and is in process of making additional revisions. These initial revisions  included adjustments to call report schedules that were identified during  our 2003 review. FCA has a number of capital-related projects in progress  that, taken collectively, may address the issue of capital arbitrage within  the Farm Credit System. In addition, FCA has a number of ongoing  projects that may address our recommendation related to requiring  Farmer Mac to obtain a credit rating. Finally, FCA has begun planning for  a project that will consider different approaches for assessing the impact  Farmer Mac’s activities have on the agricultural real estate lending market.
section_title: Conclusions
paragraphs: Our 2003 review showed that Farmer Mac’s income, mission-related  activities and risks have all increased since we last reported in 1999. At the  same time, we found that Farmer Mac, FCA, and Congress could each take  actions to ensure that Farmer Mac operates in a safe and sound manner  while fulfilling its public policy mission. We recommended in our report  that Farmer Mac strengthen its risk management and corporate  governance practices and reevaluate its strategies to carry out its mission.  Our report also recommended that FCA make several enhancements to its  oversight tools to more effectively oversee both the safety and soundness  and mission of Farmer Mac. Farmer Mac and FCA agreed with several of  our report’s findings and conclusions. During our recent discussions with  Farmer Mac and FCA, both entities demonstrated that they are taking  steps to implement many of our recommendations. Finally, our report  suggested that Congress consider making legislative changes to ensure  that Farmer Mac’s public benefits can be measured and FCA has the  necessary flexibilities to carry out its oversight responsibilities.
Mr. Chairman, this concludes our prepared statement. We would be happy  to respond to any questions you or other members of the Committee may  have at this time.
section_title: GAO Contacts and Staff Acknowledgements
paragraphs: For information about this testimony, contact Davi D’Agostino, Director,  Financial Markets and Community Investment, at (202) 512-8678, or  Jeanette Franzel, Director at (202) 512-9471. In addition to the individuals  named above, Rachel DeMarcus, Debra Johnson, Austin Kelly, Paul  Kinney, Bettye Massenburg, Kimberley McGatlin, John Treanor, and Karen  Tremba made key contributions to this testimony.
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