Farmer Mac: Greater Attention to Risk Management, Mission, Public
Purpose, and Corporate Governance Is Needed (02-JUN-04, 	 
GAO-04-827T).							 
                                                                 
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).		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-827T					        
    ACCNO:   A10327						        
  TITLE:     Farmer Mac: Greater Attention to Risk Management,	      
Mission, Public Purpose, and Corporate Governance Is Needed	 
     DATE:   06/02/2004 
  SUBJECT:   Agency missions					 
	     Agricultural programs				 
	     Farm credit					 
	     Financial analysis 				 
	     Financial institutions				 
	     Government sponsored enterprises			 
	     Mortgage loans					 
	     Mortgage-backed securities 			 
	     Risk management					 
	     Rural areas					 

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GAO-04-827T

United States General Accounting Office

GAO Testimony

Before the Committee on Agriculture,

House of Representatives

For Release on Delivery

Expected at 10:00 a.m. EDT FARMER MAC

Wednesday, June 2, 2004

  Greater Attention to Risk Management, Mission, Public Purpose, and Corporate
                              Governance Is Needed

Statement of Davi M. D'Agostino
Director, Financial Markets and
Community Investment

Jeanette Franzel
Director, Financial Management
and Assurance

GAO-04-827T

Highlights of GAO-04-827T, a testimony to the Committee on Agriculture,
House of Representatives

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-04116). 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, missionrelated activities, board structure, and
oversight, which is provided by the Farm Credit Administration (FCA).

GAO's 2003 report found that Farmer Mac, FCA, and Congress could all take
actions to help improve Farmer Mac's safety and soundness and ability to
carry out its public policy mission. GAO recommended that Farmer Mac
strengthen its risk management and corporate governance and reevaluate
some operational strategies. GAO also recommended that FCA enhance its
oversight tools for Farmer Mac and that Congress consider establishing
measurable goals to help FCA assess how well Farmer Mac is

meeting its mission.

June 2, 2004

FARMER MAC

Greater Attention to Risk Management, Mission, Public Purpose, and Corporate
Governance Is Needed

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.

www.gao.gov/cgi-bin/getrpt?GAO-04-827T.

To view the full product, including the scope and methodology, click on
the link above. For more information, contact Davi M. D'Agostino at (202)
512-8678 or [email protected].

Mr. Chairman, Mr. Ranking Member, and Members of the Committee:

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, GAO04-116
(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 GSE1 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

1As used in this testimony, a GSE is a federally chartered, privately
owned corporation established by Congress to provide a continuing source
of credit nationwide to a specific economic sector.

securitizes these loans into guaranteed securities or agricultural
mortgagebacked 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 agreements2
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 onbalance 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

2During third quarter 2003, at the request of Farm Credit West, A.C.A., of
which one of Farmer Mac's directors is President, Farmer Mac converted a
$722.3 million standby agreements that had been established prior to
January 1, 2003 into a Farmer Mac I Guaranteed Security. To achieve this
result, the program participant transferred a pool of agricultural loans
to Farmer Mac, Farmer Mac transferred the loans to a trust, and the trust
issued Farmer Mac I Guaranteed Securities that were transferred by Farmer
Mac to the program participant. Because Farmer Mac received no proceeds
other than the beneficial interests in the transferred assets, the
transfer between Farmer Mac and the trust does not qualify as either a
sale or a financing; therefore, no gain or loss was recognized in Farmer
Mac's financial statements. Additionally, because the trust is a special
purpose entity, it was not included in Farmer Mac's financial statements.

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.

Figure 1: Percentage of Outstanding Balance of Loans, AMBS and Standby
Agreements of December 31, 2003

Note:

aThese are loans purchased by Farmer Mac prior to the change in its
statutory charter in 1996.

bFarmer Mac loan programs are divided into two main groups, Farmer Mac I
and Farmer Mac II. Farmer Mac I consists of agricultural and rural housing
mortgage loans that do not have federally provided primary mortgage
insurance. Farmer Mac II consists of agricultural mortgage loans with
primary mortgage insurance provided by the U.S. Department of Agriculture.

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 1999.3 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

3U.S. General Accounting Office, Farmer Mac: Revised Charter Enhances
Secondary Market Activity, but Growth Depends on Various Factors,
GAO/GGD-99-85 (Washington, D.C.: May 21, 1999).

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 nonmission
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.

Farmer Mac Provides a Secondary Market for Agricultural Real Estate but
Entails Certain Risks

Farmer Mac is a government-sponsored enterprise or GSE that was chartered
by Congress in 1987.4 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.5 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 a Farmer Mac faces potential losses primarily from four
sources:

Variety of Risks

o  	Credit risk, or the possibility of financial loss resulting from
default by borrowers on farming assets that have lost value;

4Pub.L. No. 100-233. The Farm Credit Act of 1971, as amended by the
Agricultural Credit Act of 1987 (the 1987 Act).

5Id.

o  	Liquidity risk, or the chance that Farmer Mac will be unable to meet
its obligations as they come due;

o  	Interest rate risk, or possible fluctuations in interest rates that
negatively impact earnings or the balance sheet; and

o  	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 Size and Composition
                           of Farmer Mac's Portfolio

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 Income and Risk Levels Have Increased

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.

Disagreements about the Extent of Coverage of Treasury's Line of Credit
Could Generate Uncertainty

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.6 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

6Both Treasury and Farmer Mac are in agreement that the authority of
Treasury to purchase obligations to enable Farmer Mac to fulfill its
guarantee obligations does not extend to the standby agreements because
they do not involve Farmer Mac's guarantee liabilities.

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.7 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),8 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

712 U.S.C.2279aa-13.

8Letter dated April 13, 1997, from then-Under Secretary for Domestic
Finance, John D. Hawke, Jr., to Marsha P. Martin, then-Chairman of the
Farm Credit Administration.

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.

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.

  Mission-related Activities Have Increased, but the Impact of Activities on
  Agricultural Real Estate Market Is Unclear

Farmer Mac's Strategy of Retaining AMBS Has Limited the Development of a
Liquid Secondary Market for AMBS

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.

Standby Agreements Reduced Total Capital Required To Be Held in FCS

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.

Figure 2: Impact of Standby and Similar Agreements on Total Required
Capital Of Farm Credit System and Farmer Mac

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.

  Farmer Mac's Board of Directors May Not Reflect All Shareholder Interests, Be
  Fully Independent, or Use Clear and Transparent Processes

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. 9 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

9SEC approved NYSE listing standards SEC on November 4, 2003.

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.

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.

  FCA Has Continued to Take Steps to Enhance Its Oversight of Farmer Mac

FCA Has Taken Steps to Enhance Oversight of Farmer Mac, but Faces
Challenges That Could Limit the Effectiveness of Its Oversight

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

Conclusions

GAO Contacts and Staff Acknowledgements

(250174)

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.

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.

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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