-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO/T-GGD-98-185		

TITLE:     Federal Housing Finance Board: Actions Needed to Improve 
Regulatory Oversight

DATE:   09/24/1998 
				                                                                         
----------------------------------------------------------------- 

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Cover
================================================================ COVER


Before the Subcommittee on Capital Markets, Securities,
and Government Sponsored Enterprises, Committee on
Banking and Financial Services
House of Representatives

For Release on Delivery
Expected at
11:00 a.m., EDT
on Thursday
September 24, 1998

FEDERAL HOUSING FINANCE BOARD -
ACTIONS NEEDED TO IMPROVE
REGULATORY OVERSIGHT

Statement of Nancy R.  Kingsbury
Assistant Comptroller General
General Government Programs

GAO/T-GGD-98-185

GAO/GGD-98-185T


(233586)


Abbreviations
=============================================================== ABBREV

  FHFB - x
  GAO - x
  GSE - x
  OFHEO - x
  HUD - x

FEDERAL HOUSING FINANCE BOARD: 
ACTIONS NEEDED TO IMPROVE
REGULATORY OVERSIGHT
====================================================== Chapter SUMMARY

GAO's testimony, based on its recent report,\1 discusses weaknesses
found and actions needed to improve the Federal Housing Finance
Board's (FHFB) regulatory oversight of the Federal Home Loan Bank
System (System).  Four primary conclusions were reached about FHFB's
oversight.  First, FHFB's examination function did not ensure that
annual examinations met FHFB's internal examination standards,
including adequate documentation for work performed.  The
examinations included reviews of interest-rate and credit risk, two
of the primary types of risk faced by the Federal Home Loan Banks
(Banks).  However, the examinations did not fully assess other areas
that FHFB and others have identified as vital in evaluating an
institution's risk-management capabilities, such as management and
board of directors oversight, internal control systems, and internal
audit function. 

Second, weaknesses existed in FHFB's off-site monitoring and
supervisory enforcement programs.  FHFB lacks a coordinated off-site
monitoring system, which is an important part of effective safety and
soundness oversight, because it can provide an early warning of
potential problems.  FHFB also lacks an enforcement program that
clearly articulates policies and procedures for taking corrective
action.  The situation is further aggravated because the statute
grants only general authority to enforce the statute and make orders. 
The only authority delineated in the statute is the authority to
remove or suspend Bank employees, directors, officers, or agents for
cause. 

Third, FHFB does not have policies or procedures, outside of its
reviews of the special affordable housing and community investment
programs, to determine whether or the extent to which Banks are
supporting housing finance.  FHFB recognized this omission and has
begun to take steps to establish such a program, but no final actions
have been taken to establish a regulatory framework to ensure mission
compliance. 

Fourth, FHFB continues to be involved in System business.  Many of
the authorities that involve FHFB in System business are specified in
statute or are carryover regulations from its predecessor agency. 
FHFB began to devolve many of the functions in 1994, but it still
plays a role in coordination and promotion of Banks.  GAO continues
to believe that such involvement in the System's business functions
may undermine FHFB's independence and lead to questions about its
objectivity. 

GAO makes recommendations to strengthen FHFB's primary oversight role
as safety and soundness regulator of the System.  GAO also continues
to support its position that a single housing regulator be created to
oversee the safety and soundness and mission compliance of the
housing government-sponsored enterprises. 


--------------------
\1 Federal Housing Finance Board:  Actions Needed to Improve
Regulatory Oversight (GAO/GGD-98-203, Sept.  18, 1998). 


FEDERAL HOUSING FINANCE BOARD: 
ACTIONS NEEDED TO IMPROVE
REGULATORY OVERSIGHT
==================================================== Chapter STATEMENT

Mr.  Chairman and Members of the Subcommittee: 

We are pleased to be here today to discuss the Federal Housing
Finance Board's (FHFB) regulatory oversight of the nation's third
largest government-sponsored enterprise (GSE), the Federal Home Loan
Bank System (System).  At your request, we recently issued a report
on FHFB's oversight.\1 The specific objectives of our review were to
evaluate (1) FHFB's annual safety and soundness and mission
compliance examinations of the Federal Home Loan Banks (Banks), (2)
other aspects of FHFB's oversight, and (3) the status of FHFB's
involvement in System business. 

We reached four primary conclusions about FHFB's oversight which I
will discuss today.  First, FHFB did not ensure that all parts of the
annual examinations we reviewed met their internal standards for
assessing safety and soundness.  Second, weaknesses exist in FHFB's
off-site monitoring and supervisory enforcement programs.  Third,
FHFB does not have policies or procedures, outside of its reviews of
the special affordable housing and community investment programs, to
determine whether or the extent to which Banks are supporting their
public mission of housing finance.  Fourth, FHFB's involvement in
promoting System programs and projects that it subsequently evaluates
for mission compliance and safety and soundness could complicate its
primary duty as safety and soundness regulator and may prompt
questions about FHFB's objectivity. 

In addition, I will discuss the concept of a single regulator for all
the housing GSEs.  We have suggested in past work that Congress
consider creating one regulator to oversee the safety and soundness
and mission compliance of the three largest GSEs.  Our recent work at
FHFB and the other GSE regulators has strengthened our belief that
this single-regulator concept would be more effective than the
existing regulatory structure. 

As you know, FHFB is the safety and soundness and mission compliance
regulator of the 12 Banks that, along with the Office of Finance,
comprise the System.  However, FHFB is more than just the System's
regulator, it is also involved in various aspects of System business,
including management decisionmaking.  This type of regulator-manager
structure is unique among GSE regulators.  That is, while other GSE
regulators may be responsible for mission and safety and soundness
oversight, FHFB is the only regulator that remains involved in the
business of the System it regulates.  In certain instances, the
Federal Home Loan Bank Act (Bank Act) provides for FHFB's involvement
in System business.  FHFB has devolved some business or governance
and management activities to the Bank boards.  However, FHFB
continues to function as a promoter and coordinator for the System. 

To complete our objectives, we reviewed FHFB's examination function
and other relevant oversight activities, such as off-site monitoring
and enforcement.  This included a review of Bank examination reports
and selected supporting work papers.  We also reviewed off-site
monitoring reports and related documents, as well as documents
relevant to FHFB's enforcement activities.  Finally, we reviewed
information relevant to FHFB's managerial functions and the status of
its devolution project. 


--------------------
\1 Federal Housing Finance Board:  Actions Needed to Improve
Regulatory Oversight (GAO/GGD-98-203, Sept.  18, 1998). 


      FHFB DID NOT ENSURE
      EXAMINATIONS MET ITS
      STANDARDS
------------------------------------------------ Chapter STATEMENT:0.1

As part of our evaluation of FHFB's examination program, we reviewed
the 1996 and 1997 examinations and supporting work papers for a
stratified, judgmental sample of six Banks whose assets represented
60 percent of System assets at year-end 1996.  We found that
examiners performed required examinations but failed to follow all
the policies and procedures specified in their examination manual. 
Most notably, examiners did not always fully assess critical elements
of Bank operations--such as internal controls, board of director and
management oversight, and the reliability of internal audits--that
FHFB, other financial regulators, and we have identified as vital in
evaluating an institution's risk-management capabilities.  None of
the examinations we reviewed fully assessed more than one of the
areas.  All failed to assess board of director oversight.  While
examiners generally assessed management of interest-rate and credit
risk, the critical elements just mentioned should be reviewed during
every on-site examination to ensure that operations risk is being
adequately managed.  Operations risk poses the potential for
unexpected financial loss due to such problems as inadequate internal
controls or fraud. 

Unlike other regulators, FHFB does not perform a top-down assessment
of Bank operations.  In contrast, we found, and FHFB officials
confirmed, that examiners focus on identifying problems and then
determining the causes of the problems.  Such an approach may not
identify weaknesses in control and management systems that could be
identified through a broader assessment of Bank operations.  Office
of Supervision officials--the FHFB office whose primary
responsibility is the examination function--said that, due to limited
staff resources in their office, they were unable to take a top-down
examination approach.  In addition, we found that examiners relied on
the work of Bank internal auditors without any regular assessment of
the adequacy of their work. 

In each of the 12 examinations we reviewed, more than half of the
work in each area specified in FHFB's examination manual was not
conducted in accordance with the manual's procedures.  That is,
examiners did not complete the examination program in the manual or
use the manual's examination questionnaires.  The examiners explained
that they often did not have time to complete the procedures
described in the manual and that the manual's procedures often were
not useful for certain parts of the examination.  In addition, we
found that, for most areas covered in the examination, examiners did
not document examination procedures or provide support for their
conclusions, as required by FHFB standards. 

In all but 1 of the 12 examinations reviewed, some planned
examination procedures were not completed during the course of the
examination.  In each of the cases, examiners indicated in the work
papers that those procedures were not completed because of time
constraints.  In 2 of the 12 examinations, examiners curtailed the
scope but provided no explanation for the change in the work papers. 
OS officials told us that limited examination staff resources
sometimes resulted in scope reductions, and that such reductions
occurred in parts of the examination that examiners believed involved
less risk. 

Examiners also failed to expand the examination scope when
potentially serious problems were found.  Examiners found potentially
serious internal control problems at one Bank in consecutive
examinations but did not expand their reviews to determine whether
there were additional related problems.  FHFB did not view those
internal control weaknesses as significant.  Both cases involved an
inadequate segregation of duties in a Bank's investment activities
and were weaknesses that recurred at the same Bank.  In spite of the
fact that adequate segregation of duties involves a violation of
fundamental principles of internal controls, FHFB did not believe it
was necessary to expand its review to the Bank's system of internal
controls. 

Based on these findings, we recommended that FHFB strengthen its
primary oversight role as the safety and soundness supervisor of the
System by (1) ensuring that critical aspects of Bank operations are
reviewed as part of every FHFB examination, (2) ensuring that
examiners follow the guidance and complete the appropriate
examination procedures described in the examination manual, and, (3)
adequately documenting the work performed and conclusions drawn
during examinations. 


      FHFB IS NOW DEVELOPING A
      MISSION COMPLIANCE
      EXAMINATION PROGRAM
------------------------------------------------ Chapter STATEMENT:0.2

In its almost 10 years of operation, FHFB has not developed a
compliance program to ensure mission compliance, one of its statutory
duties.  Historically, mission compliance oversight included
reviewing the Banks' compliance with affordable housing program and
community investment program requirements--two programs mandated by
law in 1989 that represented less than 1 percent of the System's
total assets in 1997.  More recently, FHFB's mission compliance
efforts have included promoting certain mission-related activities;
however, FHFB continues to lack policies and procedures that lay out
how it will effectively regulate mission.  Recently, FHFB has taken a
number of steps to try to better ensure and assess mission
compliance.  Specifically, FHFB has (1) required that Banks submit
annual reports that describe their new products, pricing, and
investment partnerships; (2) commissioned a study to, among other
purposes, assist in developing procedures to oversee Bank mission
compliance; (3) tested draft examination procedures to ensure mission
compliance; and (4) amended regulations for Bank member community
support requirements, as well as FHFB's oversight activities, to
ensure member compliance with those requirements.  FHFB has also
begun to study the System's investment activities and is considering
whether it should limit non-mission related investments.  We view
these as positive steps because a high level of non-mission related
investments would raise questions about how Banks are fulfilling
their mission.  Investments at the individual Banks ranged from 17 to
58 percent of assets at year-end 1997. 

We encourage FHFB to continue its efforts to develop a regulatory
framework for a mission compliance oversight program.  To be
effective we believe such a program must be based on well-defined
policies that delineate what constitutes mission compliance and
prescribe the methods to be used to measure whether Banks have
fulfilled their mission. 


      WEAKNESSES EXIST IN OTHER
      AREAS OF FHFB'S REGULATORY
      OVERSIGHT PROGRAM
------------------------------------------------ Chapter STATEMENT:0.3

We found additional weaknesses in FHFB's off-site monitoring and
enforcement programs that raise concerns about its regulatory
effectiveness.  Both functions are vital to ensure that any problems
are identified promptly and that corrective action is taken when
needed. 

Recognizing the need for timely monitoring, the Office of Supervision
developed a regulatory oversight and off-site monitoring system in
1996 that required monthly reviews of Bank data, including minutes of
board of directors meetings, internal audit reports, and financial
data.  In 1997, the Office of Supervision suspended its monthly
off-site monitoring due to staff constraints.  We found that
examiners primarily reviewed the periodic data submitted by the Banks
to FHFB as part of their annual preparation for examinations.  The
Office of Supervision also prepared several periodic reports on
financial management policy compliance and interest-rate risk
exposures, financial trends, and debt-issuance activities.  In
addition, the Office of Policy produced several periodic monitoring
reports, such as a quarterly profile report that tracks Bank
statistics (including Bank membership), the affordable housing
program, and unsecured credit.  Both offices shared their reports
with the board of directors but they generally did not coordinate
their monitoring activities, which are viewed as having different
purposes.  FHFB lacked policies and procedures for off-site
monitoring, and there appeared to be no correlation between Bank size
or scope of activities and the level or type of off-site monitoring
performed by these offices. 

We found that FHFB's supervisory enforcement program lacks clear
policies and procedures for taking enforcement actions and does not
specify what actions would be taken if certain conditions existed. 
We recommended that FHFB clearly articulate and document its current
enforcement mechanism, policies, and procedures.  The Bank Act
authorizes FHFB to "promulgate and enforce" regulations and orders
but only delineates one enforcement power for FHFB--the authority to
remove or suspend for cause any Bank director, officer, employee, or
agent.  FHFB officials told us that they believe that the general
provision in the statute enables them to take corrective action, if
necessary.  The officials stated that they consider examination
reports that include "findings" requiring corrective action the
equivalent of an enforcement order.  We did not find instances when
FHFB had been unable to obtain Bank compliance with its findings. 
However, we believe, as we have recommended in past work for any GSE
regulator, that the statute should specifically give FHFB all
enforcement authorities granted other regulators.  Further, in past
GSE work, we identified certain principles necessary for effective
enforcement of rules and regulations.\2 Two of these principles are
that certain enforcement actions should be mandatory when previously
specified conditions are met and should be the result of a clear and
reasonable process.  We believe FHFB would be better prepared and
assured of its ability to take forceful action if its statute
enumerated the authorities granted other GSE regulators, such as
cease and desist and civil money penalty powers.  Therefore, we
suggest that Congress consider granting FHFB the specific enforcement
authority provided other GSE regulators. 


--------------------
\2 Government-Sponsored Enterprises:  A Framework for Limiting the
Government's Exposure to Risks (GAO/GGD-91-90, May 22, 1991). 


      FHFB REMAINS INVOLVED IN
      SYSTEM BUSINESS
------------------------------------------------ Chapter STATEMENT:0.4

Mr.  Chairman, our review of FHFB oversight would not be complete
without a consideration of its unique role in some aspects of System
business.  We remain concerned, as we have noted in the past, that
combining the roles of oversight and involvement in System business
may undermine the independence necessary for FHFB to be an effective
safety and soundness and mission regulator.\3 We recognize that the
responsibility for FHFB's involvement in System business is, in part,
due to statutory authorities carried over from FHFB's predecessor,
the Bank Board.  For example, the Bank Act gives FHFB authority to
issue the System's consolidated obligations and requires that FHFB
approve Bank dividends and bylaws.  FHFB and System officials agree
that a regulator should not be involved in the day-to-day operations
of Banks, but the degree and type of involvement they consider
appropriate varies.  Since 1994, FHFB has identified and devolved
certain business or governance and management activities, within
specified limits, to Banks' boards.  These activities include the
authority to establish presidents' salaries and incentive plans,
approve affordable housing program applications, determine the
compensation of Bank directors, and set Bank performance targets. 
Management activities identified by as yet to be devolved include the
authority to approve dividends, certain general administrative
matters, and setting credit policies.  Although FHFB has delegated
some of these functions to the bank boards, we suggest that Congress
consider ensuring, through legislation, that FHFB not be involved in
the business of the System.  We are aware of and support the
provisions of the legislation pending in the House and Senate that
would begin to correct some of our concerns about FHFB's involvement
in System business. 

In 1993, we expressed concerns about FHFB acting as a promoter and
coordinator for the System.  On the basis of our latest review, we
are still concerned with the degree to which FHFB remains involved in
System business.  Undertaking promotion and coordination activities
may undermine FHFB's independence and raise questions about its
objectivity as a regulator.  The Banks have organized two central
groups with the potential to provide central coordination and
promotion for the System.  Nevertheless, FHFB officials view
promotion as part of FHFB's role as a regulator.  Its 5-year
strategic plan, which FHFB says is integral to its budget and
performance planning, illustrates the prominence of the promotion and
coordination roles in agency operations.  Of the plan's nine
objectives, one addresses the examination function, and five address
changes FHFB advocates to enhance Bank performance, such as expanding
the acceptable uses for advances and expanding acceptable collateral
on advances to include small business loans.  Of the other three
objectives, two address the devolution effort, and one deals with
disseminating public information about FHFB's performance. 

We identified other examples of the FHFB's promotion and coordination
activities during our review.  For example, the FHFB chairman
coordinates and participates in periodic meetings with Bank chairs
and vice chairs that include coordinating congressional lobbying
efforts.  FHFB's involvement with these bank officials--whom it
appoints--in lobbying for statutory changes illustrates the potential
FHFB has for influence over these positions.  We believe FHFB should
have regulatory authority over business functions to ensure safety
and soundness and mission compliance, but we emphasize that having
such regulatory authority differs from being a participant in System
business on a regular basis and from promoting a particular program
or activity over other mission-related activities.  Further, mission
promotion is not a substitute for mission regulation, which has to be
built on measurable and enforceable regulations and policies. 


--------------------
\3 FHLBank System:  Reforms Needed to Promote Its Safety, Soundness,
and Effectiveness (GAO/T-GGD-95-244, Sept.  27, 1995). 


      A SINGLE HOUSING REGULATOR
      WOULD HAVE ADVANTAGES OVER
      FHFB
------------------------------------------------ Chapter STATEMENT:0.5

The last issue I want to address today is our suggestion that
Congress consider creating a single regulator to oversee the safety
and soundness and mission compliance of the three housing GSEs.  In
addition to the System, these include the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac), which are regulated for safety and
soundness by the Office of Federal Housing Enterprise Oversight
(OFHEO), an independent regulator within the Department of Housing
and Urban Development (HUD), and HUD itself, which has general
regulatory authority and oversees Fannie Mae's and Freddie Mac's
mission compliance. 

In past work on the housing GSEs, we discussed the advantages and
disadvantages of creating a single housing GSE regulator.\4 Since
then, we have continued to monitor and evaluate the housing GSEs and
their regulators.  For example, we issued a report on OFHEO in
October 1997 and updated that work in July 1998.  We also reported on
HUD's mission oversight of Fannie Mae and Freddie Mac in July 1998.\5

We found that OFHEO had not fully completed two important duties: 
establishing risk-based capital standards and implementing a
comprehensive and timely examination program.  At your request, Mr. 
Chairman, we provided new information to this subcommittee in July
regarding OFHEO's progress in implementing a comprehensive oversight
program.  We reported that OFHEO had made some progress but still
faced challenges in completing those two important duties.\6

Our work at HUD raised a number of issues about its oversight of
Fannie Mae and Freddie Mac, some of which would be eliminated or at
least mitigated if there were a single regulator for the housing
GSEs.  For example, HUD is required to establish goals for its GSEs'
purchase of mortgages serving targeted groups and also maintain the
GSEs financial soundness because such purchases could increase credit
risk.  We found that HUD had adopted a conservative approach to
setting the goals that placed a high priority on maintaining the
GSEs' financial soundness, but that HUD had not fully analyzed the
financial consequences of setting higher goals. 

As a result of our work at OFHEO and HUD, we found no evidence that
would cause us to alter our previous position regarding a single
regulator.  In addition, our current work at FHFB has strengthened
our conclusion that FHFB's, OFHEO's, and HUD's oversight of the
housing GSEs would be more effective if combined.  Thus, we continue
to support our 1994 and 1997 positions that a single housing GSE
regulator be created to oversee the safety and soundness and mission
compliance oversight of the housing GSEs. 

A single regulator would be better able to evaluate the trade-off
between mission and safety and soundness as well as evaluate the
financial aspects of new mortgage products and other GSE activities,
such as nonmission investments, because it would combine expertise in
housing and finance.  A single regulator would be more independent
and objective than separate agencies, because it would not be
affiliated with one particular GSE, or dependent on that GSE for its
continued existence and thus subject to its influence.  A single
regulator would be more prominent in government than either FHFB or
OFHEO is alone.  This should further enhance the single regulator's
independence and make it more competitive in attracting and retaining
staff with appropriate expertise and experience.  In addition, a
single regulator could capitalize on sharing staff expertise in such
areas as examinations, risk monitoring, financial analysis, and
economic research.  The examinations staffing constraints we
identified at FHFB and similar staffing concerns identified at OFHEO
might be alleviated by combining FHFB, OFHEO, and HUD resources. 
Similarly, OFHEO's work in setting capital standards and developing a
stress test could be useful in oversight of the System. 


--------------------
\4 Federal Home Loan Bank System:  Reforms Needed to Promote Its
Safety, Soundness, and Effectiveness (GAO/GGD-94-38, Dec.  8, 1993)
and Government-Sponsored Enterprises:  Advantages and Disadvantages
of Creating a Single Housing GSE Regulator (GAO/GGD-97-139, July 19,
1997). 

\5 Federal Housing Enterprises:  OFHEO Faces Challenges In
Implementing a Comprehensive Oversight Program (GAO/GGD-98-6, Oct. 
22, 1997) and Federal Housing Enterprises:  HUD's Mission Oversight
Needs to Be Strengthened (GAO/GGD-98-173, July 28, 1998). 

\6 OFHEO's Progress in Implementing a Comprehensive Oversight Program
for Fannie Mae and Freddie Mac (GAO/GGD-98-182R, July 29, 1998). 


------------------------------------------------ Chapter STATEMENT:0.6

This concludes my prepared statement, Mr.  Chairman.  My colleagues
and I would be pleased to answer any questions. 


*** End of document. ***