Congress has a long-standing concern that the safety and soundness of the two largest government-sponsored enterprises, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), be maintained so that they can meet their intended purposes and that their financial activities do not pose risks to taxpayers. Consequently, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the act), which established the Office of Federal Housing Enterprise Oversight (OFHEO) within the Department of Housing and Urban Development (HUD) as an independent financial safety and soundness regulator of Fannie Mae and Freddie Mac (the enterprises). For reasons relating to the federal charters and structures of the enterprises—which had combined financial obligations of $1.5 trillion at year-end 1996—investors and rating agencies perceive the enterprises’ securities as implicitly guaranteed by the federal government, despite there being no such statutory obligation. We have been mandated by the Department of Veterans Affairs (VA)/HUD Appropriations Act of 1997 to assess OFHEO’s fulfillment of its safety and soundness mission. Based on discussions with congressional staff, our major objectives were to (1) identify why OFHEO has not finalized risk-based capital standards for the enterprises even though there was a December 1, 1994, deadline for doing so and (2) assess OFHEO’s implementation of its enterprises’ safety and soundness examination responsibility. We are also providing information on OFHEO’s implementation of key mission support functions and participation in a U.S. government initiative to assist Mexico in developing a secondary mortgage loan market. The enterprises help ensure that mortgage funds are available to home buyers by buying mortgages from mortgage originators, such as commercial banks, thrifts, and mortgage bankers. In turn, the originators use the funds supplied by the enterprises to make additional mortgage loans thereby helping ensure a continuous supply of mortgage credit nationwide during both good and bad economic periods. The enterprises hold some of the mortgages they purchase in portfolio as direct investments on their books and issue debt and equity securities to finance these holdings. However, a majority of mortgages that the enterprises buy from mortgage originators are “securitized”—that is, the enterprises package them into mortgage pools to support mortgage-backed securities (MBS). These mortgage pools receive interest and principal payments from the mortgages in the pools and pass them on to the investors who purchased MBS. The enterprises guarantee the timely payment of principal and interest on MBS held by investors, administer the payments, and charge “guarantee fees” for providing these services. The enterprises may also repurchase MBS and hold the securities in their mortgage portfolios. The enterprises are government-sponsored in that they operate under federal charters that convey certain benefits, impose certain restrictions, and permit the enterprises to earn a profit while serving public policy purposes, such as providing liquidity to mortgage markets. In 1992, Congress expanded the enterprises’ public purpose by requiring annual goals for the purchase of mortgages on housing serving very-low, low-, and moderate-income and other households that are underserved by the residential mortgage market. These goals are to be set, monitored, and enforced by HUD. The charters restrict the enterprises to buying mortgages that do not exceed a set dollar amount, known as the conforming loan limit. A major factor that enhances the enterprises’ profitability is the financial markets’ perception that there exists an implied federal guarantee of their debt and MBS obligations. Investors perceive that this implied guarantee decreases the risk of default on the enterprises’ financial obligations. Consequently, this perception reduces the enterprises’ borrowing costs because investors are willing to accept lower expected returns on enterprise debt than they would for similar private firms without government ties. Likewise, interest rates on MBS are lowered by this perception. Their lower funding costs allow the enterprises to increase their purchases and give them a cost advantage over their potential competitors. This perception of a federal guarantee remains, even though laws chartering the enterprises contain explicit language stating that there is no such guarantee. The market perception of the implied federal guarantee is based on, among other things, federal ties to the enterprises, including government-sponsored status, each enterprise’s $2.25 billion conditional line of credit with the Department of the Treasury, and their exemptions from state and local income taxes and securities registration fees imposed by the Securities and Exchange Commission. In 1996, we estimated that the financial benefits that accrue to the enterprises from their federal sponsorship ranged from about $2.2 billion to $8.3 billion on a pretax basis and from about $1.6 billion to $5.9 billion on an aftertax basis in 1995. We also reported that approximately 80 percent to 95 percent of these estimated benefits were derived from the lower funding costs that the enterprises accrue as a result of the perception of a federal guarantee. It is widely accepted that the enterprises’ activities have generated benefits to mortgage borrowers, such as lower mortgage interest rates. For example, in our 1996 report, we estimated that the activities of the enterprises resulted in a savings on single-family fixed-rate home mortgages below the conforming loan limit of about 15 to 35 basis points.Thus, a borrower with a $100,000 thirty-year, fixed-rate mortgage saves about $10 to $25 a month on mortgage payments as a result of the enterprises’ activities. For the approximately $2 trillion in outstanding conventional conforming fixed-rate mortgages in 1995, we estimated that the aggregate annual savings in mortgage payments were in the range of $3 billion to $7 billion. Other benefits of the enterprises are that they have reduced regional disparities in interest rates and mortgage availability, and spurred the development of new technologies that facilitate the home financing process. However, the potential also exists that, in the event of a financial emergency, the federal government would choose to intervene and assist either Fannie Mae or Freddie Mac or both in meeting their debt and MBS obligations, which stood at a combined $1.5 trillion at year-end 1996 (see table 1.1), potentially exposing the taxpayers to losses. In fact, during the early 1980s when short-term interest rates rose dramatically, Fannie Mae experienced substantial financial difficulties because the enterprise had funded its mortgage portfolio with short-term debt. As rates increased, Fannie Mae had to issue new short-term debt at higher rates to replace existing short-term debt that came due. Because interest earned on the old mortgages in portfolio was less than interest expenses on new debt, Fannie Mae experienced total losses of about $277 million between 1981 and 1984. (The type of risk Fannie Mae faced in the early 1980s is referred to as interest rate risk.) In response, the federal government provided limited tax relief and regulatory forbearance in the form of relaxed capital requirements. Similarly, in 1987, Congress authorized $4 billion to support the Farm Credit System—another government-sponsored enterprise—when it experienced financial difficulties. Recognizing the potentially large financial costs that Fannie Mae and Freddie Mac posed to taxpayers, in 1992, Congress passed the act, which established OFHEO as an independent regulator within HUD whose mission is to help ensure the enterprises’ safety and soundness. One of OFHEO’s most important means of helping to ensure the enterprises’ financial soundness is to establish capital requirements that are related to potential risks that the enterprises face. Further, the act gave OFHEO broad authority to examine the activities of the enterprises, such as the requirement that OFHEO conduct annual on-site examinations of the enterprises to assess their financial condition. During fiscal year 1997, OFHEO had a budget of about $15.5 million and a total staff—full-time staff, temporary staff, contract employees, and detailees from bank regulatory agencies—of 85 individuals as of March 31, 1997, to carry out its safety and soundness responsibilities and to perform administrative support functions. The act established OFHEO as an independent office within HUD with respect to safety and soundness matters, and reserved for the Secretary of HUD the responsibility to oversee the enterprises’ efforts to meet the housing goals as well as general regulatory power over the enterprises. However, the act also clarified that the duty to ensure that Fannie Mae and Freddie Mac are adequately capitalized and operate in a safe and sound manner belongs to OFHEO exclusively. OFHEO was intended to operate separately from HUD as a safety and soundness regulator and to be staffed with experts in financial analysis or financial institution oversight. OFHEO is under the management of a presidentially appointed and Senate-confirmed director. The act provided the director with numerous exclusive authorities (i.e., without the review and approval of the Secretary of HUD), such as powers to examine the operations of the enterprises, determine capital adequacy, and take enforcement actions. The act also gave the director exclusive authority to manage OFHEO, which includes preparing annual budgets and hiring personnel. Thus, the director leads and directs OFHEO’s activities by setting internal and external policies, managing overall operations, and serving as the chief spokesperson for the organization. OFHEO’s first director was appointed on June 1, 1993, and resigned on February 13, 1997, to become the Administrator of the Small Business Administration. As of June 1997, OFHEO was headed by the acting director, while the President and Congress considered potential candidates for the organization’s new director. OFHEO is organized into six offices, which report to the director and deputy director. Figure 1.1 illustrates OFHEO’s organizational structure. The Office of the General Counsel (OGC) has responsibility for preparing regulations required by the act and advising the director on legal issues, including financial institutions regulatory issues, applicable corporate law principles, and general legal matters.