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. 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. 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. 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. 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.