    Government-Sponsored Enterprises: Federal Oversight Needed for
    Nonmortgage Investments (Letter Report, 03/11/98, GAO/GGD-98-48).

    Pursuant to a congressional request, GAO reviewed the nonmortgage
    investment activities at 3 government-sponsored enterprises (GSEs)-- the
    Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal
    National Mortgage Association (Fannie Mae), and the Federal Agricultural
    Mortgage Corporation (Farmer Mac)--focusing on the: (1) enterprises'
    legal authority for making nonmortgage investments and federal
    regulatory oversight of that activity; (2) relationship between
    nonmortgage investment policies and practices and missions of the
    enterprises; and (3) extent to which the enterprises have undertaken
    nonmortgage investments for arbitrage profits--using the funding
    advantage from government sponsorship to purchase nonmortgage
    investments that generate profits.

    GAO noted that: (1) legally, the enterprises have broad investment
    authority; (2) to date, regulatory oversight activities for the three
    enterprises have focused on whether nonmortgage investments are safe and
    sound and not on whether the nonmortgage investment policies and
    practices are mission-related; (3) the Department of Housing and Urban
    Development has not developed criteria to determine if nonmortgage
    investments are consistent with enterprise charter purposes; (4) in
    October 1997, the Farm Credit Administration (FCA) indicated that it did
    not have concerns that Farmer Mac's nonmortgage investment activity is
    inconsistent with its charter mission, but FCA also stated that the debt
    issuance strategy associated with the investments is intended to be
    temporary and to develop over a reasonable period of time; (5)
    therefore, according to FCA, its position could change if over time
    evidence does not show that such investments play a role in helping
    Farmer Mac achieve its mission; (6) enterprises have invested in
    nonmortgage assets to varying degrees with somewhat different rationales
    for how these investments further their charter purposes; (7) each
    enterprise has an investment policy that specifies permissible credit
    ratings, maturities, and concentration limits and describes the
    relationship of investments to earnings and to achievement of the
    enterprise's mission; (8) Freddie Mac officials indicated that its
    nonmortgage investments have been held for cash management purposes and
    as an investment vehicle, which could make capital available to help
    fund future anticipated demand for residential mortgages; (9) the
    relationship between longer term nonmortgage investments and the
    enterprises' mission goals is not always clear, because long term
    nonmortgage investments may not facilitate liquidity in the residential
    mortgage market as well as short-term investments; (10) however, it is
    clear that nonmortgage investments generate arbitrage profits; (11) in
    its analysis, GAO found that the various nonmortgage investments fall
    along a continuum representing the degree to which they facilitate
    liquidity in the residential mortgage market and thus are more clearly
    related to the enterprises' missions; and (12) GAO's review of
    compensation practices and board member responsibilities at the
    enterprises suggests that individual incentives to generate corporate
    profits are structured in a manner that is fairly typical of major
    corporations and financial institutions without federal charters
    limiting their activities.

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  GGD-98-48
         TITLE:  Government-Sponsored Enterprises: Federal Oversight Needed
                 for Nonmortgage Investments
          DATE:  03/11/98
       SUBJECT:  Government sponsored enterprises
                 Mortgage programs
                 Financial management
                 Arbitrage
                 Securities
                 Investments
                 Federal corporations
                 Agency missions
    IDENTIFIER:  Farm Credit System

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

    Report to the Chairman, Committee on Banking and Financial Services,
    House of Representatives

    March 1998

    GOVERNMENT-SPONSORED ENTERPRISES -
    FEDERAL OVERSIGHT NEEDED FOR
    NONMORTGAGE INVESTMENTS

    GAO/GGD-98-48

    Enterprise Nonmortgage Investments

    (233519)

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

      ABS - asset-backed securities
      AMBS - agricultural mortgage-backed securities
      FCA - Farm Credit Administration
      GSE - government-sponsored enterprise
      HUD - Department of Housing and Urban Development
      MBS - mortgage-backed securities
      MPP - mortgage protection plan
      OFHEO - Office of Federal Housing Enterprise Oversight
      OSMO - Office of Secondary Market Oversight
      SEC - Securities and Exchange Commission
      S&P - Standard and Poor's

    Letter
    =============================================================== LETTER

    B-277819

    March 11, 1998

    The Honorable James A.  Leach
    Chairman, Committee on Banking
     and Financial Services
    House of Representatives

    Dear Mr.  Chairman:

    This report responds to your request dated April 10, 1997, and
    supplemented on May 13, 1997, that we gather and analyze information
    on nonmortgage investment activities at three government-sponsored
    enterprises (GSEs):  the Federal Home Loan Mortgage Corporation
    (Freddie Mac), the Federal National Mortgage Association (Fannie
    Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac)
    (called enterprises in this report).\1 In your request, you expressed
    concerns that these enterprises may be using their benefits in
    financial markets resulting from their government ties to make
    investments that may not serve the public purposes as expressed in
    their federal charters.\2 Specifically, you requested that we examine
    (1) the enterprises' legal authority for making nonmortgage
    investments and federal regulatory oversight of that activity, (2)
    the relationship between nonmortgage investment policies and
    practices and missions of the enterprises, and (3) the extent to
    which the enterprises have undertaken nonmortgage investments for
    arbitrage profits--using the funding advantage from government
    sponsorship to purchase nonmortgage investments that generate
    profits.  In relation to the third objective, you also asked us to
    provide information on the enterprises' compensation structures for
    directors and senior managers and whether these structures create
    incentives for making nonmortgage investments.

    --------------------
    \1 At Farmer Mac, nonmortgage investments are defined as investments
    other than those in agricultural mortgages (also referred to as
    nonagricultural-mortgage investments in this report).

    \2 We provided the preliminary results of our work on Freddie Mac and
    Fannie Mae in our letter to you, Housing Enterprises:  Investment
    Authority, Policies, and Practices (GAO/GGD-97-137R, June 27, 1997).

       BACKGROUND
    ------------------------------------------------------------ Letter :1

    Congress created GSEs to help make credit available to certain
    sectors of the economy, such as housing and agriculture, in which the
    private market was perceived as not effectively meeting credit needs.
    GSEs receive benefits from their federal charters that help them
    fulfill their missions.  Freddie Mac and Fannie Mae (the housing
    enterprises) have federal charters granting each of them explicit
    benefits, which include (1) exemption from registering their
    securities with the Securities and Exchange Commission (SEC), (2)
    exemption from state and local corporate income taxes, and (3) use of
    the Federal Reserve as a transfer agent.  Farmer Mac is subject to
    SEC registration requirements, but it uses the Federal Reserve as a
    transfer agent, and Farmer Mac officials told us that it is exempt
    from state income taxes in most states.  The most important benefit
    that all three enterprises receive is an implicit one stemming from
    investors' perception that the federal government would not allow the
    enterprises to default on their obligations.  Due to this perception,
    investors do not demand yields on investments in enterprise debt and
    mortgage-backed securities that are as high as those on comparable
    financial instruments issued by corporations without government
    sponsorship.  One result of government sponsorship, therefore, is a
    reduction in debt costs compared with debt costs in similar
    corporations without government sponsorship.

    Freddie Mac and Fannie Mae were chartered by Congress to enhance the
    availability of residential mortgage credit across the nation.  The
    housing enterprises accomplish this mission by purchasing residential
    mortgages from lenders.  The housing enterprises retain some of the
    mortgages they purchase in their own portfolios, but a majority of
    the mortgages are pooled into mortgage-backed securities (MBS) that
    are sold to investors in the secondary residential mortgage market.
    As of December 1996, Freddie Mac had about $463 billion in MBS
    obligations and $156 billion in debt obligations outstanding.  The
    corresponding figures for Fannie Mae were about $548 billion and $331
    billion, respectively.  Therefore, combined MBS and debt obligations
    of these housing enterprises totaled about $1.5 trillion.

    Farmer Mac was chartered by Congress to enhance the availability of
    agricultural mortgage credit across the nation.  Farmer Mac is making
    efforts to establish a secondary mortgage market for agricultural
    mortgages along the lines the housing enterprises have established
    for residential mortgages.  Farmer Mac issues, and guarantees payment
    on, agricultural mortgage-backed securities (AMBS).  One type of
    AMBS, called Farmer Mac I securities, is backed by agricultural
    mortgages not containing federally provided primary mortgage
    insurance.  The other type of AMBS, called Farmer Mac II securities,
    is backed by agricultural mortgages containing primary mortgage
    insurance provided by the Department of Agriculture.  Farmer Mac is a
    small financial institution in comparison to the housing enterprises.
    As of December 31, 1996, Farmer Mac had about $642 million in AMBS
    (of which about $226 million were owned by others, and about $416
    million were held by Farmer Mac) and about $546 million in debt
    obligations outstanding.  Therefore, combined AMBS owned by others
    and debt obligations of Farmer Mac totaled about $772 million.

    The housing enterprises pass along, at least in part, the benefits
    they receive from government sponsorship, such as lower debt costs,
    to residential borrowers.  In a previous study, we estimated that
    interest rates on single-family, fixed-rate, conforming mortgages
    were probably 15 to 35 basis points lower than they would have been
    without government sponsorship of the enterprises.\3 Limiting the
    activities of the housing enterprises primarily to funding conforming
    residential mortgages helps create a mechanism for the benefits they
    receive, such as lower debt costs, to be passed through to borrowers.
    Such limitations are consistent with the special purpose charters
    imposed by Congress.  Congress gave the Department of Housing and
    Urban Development (HUD) general regulatory authority over the housing
    enterprises so that HUD can ensure that the missions of these
    enterprises as stated in their respective charter acts are being
    fulfilled.  HUD also has regulatory authority to approve new mortgage
    programs proposed by the housing enterprises.  In consideration of
    the potential risks to taxpayers from an enterprise default on its
    financial obligations, Congress created safety and soundness
    regulators for the enterprises.  HUD's Office of Federal Housing
    Enterprise Oversight (OFHEO) is the safety and soundness regulator of
    the housing enterprises.  The Farm Credit Administration (FCA),
    through its Office of Secondary Market Oversight (OSMO), has
    regulatory responsibility with respect to Farmer Mac, including
    specific authority over safety and soundness matters.

    --------------------
    \3 Housing Enterprises:  Potential Impacts of Severing Government
    Sponsorship (GAO/GGD-96-120, May 13, 1996).  A single-family housing
    unit is defined as a housing unit in a structure with four or fewer
    total units.  The housing enterprises are restricted in statute to
    purchasing residential mortgages below the conforming loan limit; in
    1997, this limit was $214,600 on single-unit residences.  A basis
    point is one one-hundredth of a percentage point.

       RESULTS IN BRIEF
    ------------------------------------------------------------ Letter :2

    Legally, the enterprises have broad investment authority.  To date,
    regulatory oversight activities for the three enterprises have
    focused on whether nonmortgage investments are safe and sound and not
    on whether the nonmortgage investment policies and practices are
    mission related.  OFHEO and OSMO have determined that the
    enterprises' nonmortgage investment portfolios do not raise safety
    and soundness concerns.

    To ensure that the enterprises use their government-provided benefits
    to achieve a public purpose, Congress gave HUD and FCA mission
    regulatory authority.  Recently, this oversight has become especially
    important because Farmer Mac has substantially increased its holdings
    of nonagricultural-mortgage investments and the housing enterprises
    have proposed new types of nonmortgage investments.  As of June 30,
    1997, nonmortgage investments constituted about 15 percent of
    on-balance sheet assets at Fannie Mae and 10 percent at Freddie Mac;
    66 percent of Farmer Mac's assets were in nonagricultural-mortgage
    investments.

    HUD has not developed criteria to determine if nonmortgage
    investments are consistent with enterprise charter purposes.  In
    August 1997, HUD indicated its plan to promulgate regulations
    addressing the housing enterprises' nonmortgage investment activities
    and their relation to the housing enterprise mission.  The advance
    notice of proposed rulemaking was published in December 1997.

    In October 1997, FCA indicated that, for now, it did not have
    concerns that Farmer Mac's nonmortgage investment activity is
    inconsistent with its charter mission.  However, FCA also stated that
    the debt issuance strategy associated with the investments is
    intended to be temporary and to develop over a reasonable period of
    time.  Therefore, according to FCA, its position could change if over
    time evidence does not show that such investments play a role in
    helping Farmer Mac achieve its mission.

    Enterprises have invested in nonmortgage assets to varying degrees
    with somewhat different rationales for how these investments further
    their charter purposes.  Each enterprise has an investment policy\4
    that specifies permissible credit ratings, maturities, and
    concentration limits and describes the relationship of investments to
    earnings and to achievement of the enterprise's mission.\5 As of June
    30, 1997, nonmortgage investments constituted about 15 percent of
    on-balance sheet assets at Fannie Mae and 10 percent at Freddie Mac;
    66 percent of Farmer Mac's assets were in nonagricultural-mortgage
    investments.  The housing enterprises' nonmortgage investments, as
    reported, included cash and cash equivalents, asset-backed securities
    (ABS),\6 private corporate securities, and state and municipal bonds.
    Farmer Mac's nonagricultural-mortgage investments expanded in
    calendar year 1997 from $155 million to $931 million and now consist
    primarily of other government agency securities and corporate debt
    issues.

    Freddie Mac officials indicated that its nonmortgage investments have
    been held for cash management purposes and as an investment vehicle,
    which could make capital available (i.e., employ capital) to help
    fund future anticipated demand for residential mortgages.  This year,
    Freddie Mac created an investment fund to contain nonmortgage
    investments with maturities exceeding 5 years to make capital
    available to help fund future unexpected demand for residential
    mortgages.  Fannie Mae officials indicated that nonmortgage
    investments are held for cash management purposes and as an
    investment vehicle to employ capital not currently needed to fund
    mortgages.  In contrast, according to officials of Farmer Mac, its
    nonagricultural-mortgage investments are part of a debt issuance
    strategy designed to lower funding costs.  By lowering funding costs,
    officials said that Farmer Mac will be able to better price its AMBS
    products in the secondary market, which these officials expect to
    trigger greater product demand and, thus, enable Farmer Mac to better
    meet its mission.

    The relationship between longer term nonmortgage investments and the
    enterprises' mission goals is not always clear, because long term
    nonmortgage investments may not facilitate liquidity in the
    residential mortgage market as well as short-term investments.\7

    However, it is clear that nonmortgage investments generate arbitrage
    profits.  In this report, we are defining the term "arbitrage" to
    mean using the funding advantage from government sponsorship to raise
    funds for making nonmortgage investments (see app.  I).  In our
    analysis, we found that the various nonmortgage investments fall
    along a continuum representing the degree to which they facilitate
    liquidity in the residential mortgage market and thus are more
    clearly related to the enterprises' missions.  On one end are short
    term nonmortgage investments, such as term federal funds, which
    facilitate liquidity although they might also generate arbitrage
    profits.  On the other end are long-term investments that generate
    arbitrage profits but whose relationship to the mission in
    facilitating liquidity is less clear.  Although arbitrage profits on
    nonmortgage investments are relatively small in percentage terms at
    the housing enterprises, such profits presently are a primary income
    source at Farmer Mac.

    Our review of compensation practices and board member
    responsibilities at the enterprises suggests that individual
    incentives to generate corporate profits are structured in a manner
    that is fairly typical of major corporations and financial
    institutions without federal charters limiting their activities (see
    app.  II).  These incentives, by their close tie to corporate
    earnings, can create tensions between increasing shareholder value
    and fulfilling the public mission.  It is this tension that
    highlights the importance of mission oversight.  Without effective
    mission oversight, the incentives to use the benefits of government
    sponsorship to increase shareholder value could, over time, erode the
    public mission.  If this were to occur, long term nonmortgage
    investments could become an increasing part of the housing
    enterprises' portfolios and Farmer Mac's temporary approach could
    become a permanent strategy even if it does not enhance Farmer Mac's
    ability to purchase agricultural mortgages.

    --------------------
    \4 We do not report specific details of these investment policies
    because of the proprietary nature of such enterprise information.

    \5 Credit rating agencies such as Standard and Poor's give securities
    ratings related to the credit risk associated with the investment.
    Concentration limits place a cap on the maximum share of assets that
    can be accounted for by investments in a single company's securities.

    \6 ABS are similar to MBS but are backed by nonmortgage assets, such
    as receivables on car loans and credit cards.

    \7 A market is more liquid if investors can buy and sell large
    amounts of holdings without affecting the prices of traded
    securities.  Liquidity allows the housing enterprises to fund
    residential mortgages during different market conditions.  Longer
    term nonmortgage investments are less liquid than shorter term
    investments in the sense that their market values are subject to
    larger fluctuations with changes in interest rates.

       SCOPE AND METHODOLOGY
    ------------------------------------------------------------ Letter :3

    We reviewed the enterprises' charters and relevant statutes to
    examine the enterprises' legal authority for making nonmortgage
    investments and regulatory oversight of that activity.  We obtained
    and analyzed publicly available and proprietary information on the
    enterprises' investment policies, practices, and justification of
    those policies and practices to examine the relationship between
    nonmortgage investment policies and practices and missions.  We
    reviewed literature on the role of the housing enterprises in the
    residential mortgage market to examine the extent to which the
    enterprises have undertaken nonmortgage investments for arbitrage
    profits.  We also interviewed officials at the enterprises, HUD,
    OFHEO, and FCA; and we received written responses to questions
    submitted to the Department of the Treasury.

    We obtained and analyzed information the enterprises considered to be
    proprietary that included information packages prepared for board
    members of the enterprises; detailed information on nonmortgage
    investments, their yields, and maturity; yield and other
    characteristics of enterprise debt issued to fund the nonmortgage
    investments; and compensation policies for senior officers and board
    members.  We do not report specific details of the enterprises'
    investment policies and practices or compensation policies because of
    the proprietary nature of such enterprise information.

    Our interviews with officials at OFHEO and FCA on their regulatory
    oversight of nonmortgage investments included discussion of
    proprietary information relied upon by the regulators in making their
    safety and soundness determinations regarding nonmortgage
    investments.  We did not verify their findings leading to the safety
    and soundness determinations.  Generally, the financial practices
    that the housing enterprises used to limit the interest rate and
    credit risks of their nonmortgage investments were fairly
    straightforward.  From the data we collected at the housing
    enterprises and interviews with housing enterprise and OFHEO
    officials, we obtained a general understanding of OFHEO's
    determinations.  In contrast, the financial practices that Farmer Mac
    used to limit the interest rate risk of its nonagricultural-mortgage
    investments were not as straightforward and were not fully captured
    by the specific data we collected from Farmer Mac.  Therefore, we
    were not able to obtain as complete an understanding of FCA's
    determinations.

    We obtained written comments on a draft of this report from each of
    the three enterprises, HUD, OFHEO, FCA, and Treasury.  Their comments
    are discussed near the end of this report and are reprinted in
    appendixes III through IX.  We conducted our work in Washington,
    D.C., from April 1997 through October 1997 in accordance with
    generally accepted government auditing standards.

       EACH ENTERPRISE HAS BROAD
       INVESTMENT AUTHORITY BUT IS
       SUBJECT TO REGULATORY OVERSIGHT
    ------------------------------------------------------------ Letter :4

    The charters of all three enterprises provide them with broad
    investment powers.  OFHEO has clear authority to regulate investments
    by the housing enterprises if such investments pose a safety and
    soundness concern.  HUD has general regulatory authority over the
    housing enterprises and is charged with making such rules and
    regulations as shall be necessary and proper to ensure that the
    purposes of the respective charter acts are accomplished.  In
    addition to general regulatory authority, HUD also has authority to
    approve new mortgage programs that could contain nonmortgage
    investment components.  FCA, through OSMO, has safety and soundness
    and general regulatory authority with respect to Farmer Mac.

          THE ENTERPRISES HAVE BROAD
          LEGAL AUTHORITY TO MAKE
          INVESTMENTS
    ---------------------------------------------------------- Letter :4.1

    Each enterprise has broad investment powers in its charter.  The
    Freddie Mac charter act provides that the funds of the corporation
    "may be invested in such investments as the Board of Directors may
    prescribe."\8 The Fannie Mae charter act empowers the corporation,
    among other things,

         "to enter into and perform contracts, leases .  .  .  or other
         transactions, on such terms as it may deem appropriate .  .  .
         to lease, purchase, or acquire any property, real personal or
         mixed .  .  .  and to sell, for cash or credit, lease, or
         otherwise dispose of the same, at such time and in such manner
         as and to the extent that it may deem necessary or appropriate,
         .  .  .  and to do all things as are necessary or incidental to
         the proper management of its affairs and the proper conduct of
         its business."\9

    The Farmer Mac charter act empowers it to, among other things, " .  .
    .  purchase or sell any securities or obligations .  .  .  necessary
    and convenient to the business of the Corporation."\10

    One general rule of law is that a corporation's powers can be no
    broader than the purposes for which the corporation is organized.
    This rule is particularly relevant where, as in the case of the
    enterprises, the corporation is organized for special, as opposed to
    general, purposes.  Thus, even though the enterprises have broad
    investment powers, the exercise of those powers should not be
    unrelated to the accomplishment of the special purposes for which the
    enterprises were created.  Under general corporate law, this
    relationship has been described as the logical relation of the
    activity to the corporate purpose expressed in the charter.

    --------------------
    \8 12 U.S.C.  � 1452(d).

    \9 12 U.S.C.  � 1723a(a).

    \10 12 U.S.C.  � 2279aa-3 (c) (12).  For the purpose of this report,
    we take no position as to whether Farmer Mac's investment authority
    is limited pursuant to 12 U.S.C.  � 2279aa-6(e)(2), which states as
    follows:  "The Corporation (and affiliates) may issue debt
    obligations solely for the purpose of obtaining amounts for the
    purchase of any securities (guaranteed by Farmer Mac and backed by
    pools of qualified loans), for the purchase of qualified loans .  .
    .  and for maintaining reasonable amounts for business operations
    (including adequate liquidity) relating to activities under this
    subsection .  .  .  ." FCA officials explained to us their view that
    the provision has a specific purpose and does not limit Farmer Mac's
    investment authority.

          OFHEO AND FCA HAVE CLEAR
          AUTHORITIES TO LIMIT
          NONMORTGAGE INVESTMENTS FOR
          SAFETY AND SOUNDNESS REASONS
    ---------------------------------------------------------- Letter :4.2

    OFHEO, as safety and soundness regulator, is charged with ensuring
    that the housing enterprises are adequately capitalized and operate
    safely and in accordance with the Federal Housing Enterprises
    Financial Safety and Soundness Act of 1992 (the 1992 Act).\11

    OFHEO has regulatory and enforcement authority, without the review or
    approval of HUD, with respect to matters generally related to
    enterprise safety and soundness and to a few specific matters,
    including certain capital distributions and executive compensation at
    the enterprises.\12 Therefore, OFHEO has authority to supervise an
    enterprise investment that affects the enterprise's safety and
    soundness without consultation with HUD.  Actions taken by OFHEO with
    respect to other matters not specified in the 1992 Act as exclusive
    to OFHEO are subject to the review and approval of the Secretary of
    HUD.

    FCA, through OSMO, has regulatory responsibility for Farmer Mac.
    Among other things, OSMO is responsible for ensuring that Farmer Mac
    holds adequate capital for the activities it performs and operates in
    a safe and sound manner.  OSMO is also responsible for supervising
    the safety and soundness of Farmer Mac's program and investment
    activities.

    --------------------
    \11 P.  L.  No.  102-550, Title XIII, codified at 12 U.S.C.  ��
    4501-4641.

    \12 See 12 U.S.C.  � 4513(b).

             THE ENTERPRISES'
             NONMORTGAGE INVESTMENTS
             HAVE NOT CREATED A SAFETY
             AND SOUNDNESS CONCERN
    -------------------------------------------------------- Letter :4.2.1

    OFHEO has concluded that each housing enterprise's nonmortgage
    investment policies and practices have not constituted a safety and
    soundness concern.  Its conclusion was largely based on how each
    enterprise matched the maturities (and related characteristics) of
    its debt obligations used to finance its nonmortgage investments with
    those investments and the high credit standards and generally short
    maturities of the nonmortgage investments.

    As of April 1997, OSMO concluded that Farmer Mac's
    nonagricultural-mortgage investment activities had not raised a
    safety and soundness concern.  OSMO found that the size of Farmer
    Mac's investment portfolio was not unsafe and unsound relative to the
    statutory capital requirement, and the composition of the portfolio
    was not unsafe or unsound.

          REGULATORS HAVE NOT FOCUSED
          ON NONMORTGAGE INVESTMENTS
          AND THEIR RELATIONSHIP TO
          CHARTER MISSIONS
    ---------------------------------------------------------- Letter :4.3

    Although OFHEO and FCA have examined safety and soundness
    implications of nonmortgage investments, HUD and FCA told us that
    prior to mid-April 1997 they had not focused on nonmortgage
    investment policies and practices in carrying out their general
    regulatory authority with respect to the enterprises' charter
    missions.  The scope of HUD's general regulatory authority as it
    relates to nonmortgage investments is not clearly defined in statute.
    However, as discussed later in this report (see p.  11), HUD has
    initiated action to determine how it should implement this authority.
    FCA has general regulatory authority that would allow oversight of
    Farmer Mac's investment activities.  However, FCA said it has no
    activities under way that are expected to culminate in regulation of
    Farmer Mac's investments.

             HUD HAS GENERAL
             REGULATORY AUTHORITY
    -------------------------------------------------------- Letter :4.3.1

    Section 1321 of the 1992 Act provides that except for the specific
    powers granted OFHEO, HUD has "general regulatory power" over each
    housing enterprise.\13 HUD also is charged with making "such rules
    and regulations as shall be necessary and proper to ensure" that the
    provisions of the 1992 Act concerning new mortgage programs and
    housing goals and the purposes of the respective charter acts are
    accomplished.\14

    The scope of HUD's authority under this section is not defined.  With
    respect to investments, the statute does not set forth any criteria
    other than the charter acts themselves as a basis for HUD's exercise
    of its general regulatory power and rulemaking authority.  As
    discussed previously, the charter acts provide Fannie Mae and Freddie
    Mac with broad authority to make investments.  This raises a question
    about the extent to which HUD has authority to regulate nonmortgage
    investments by the housing enterprises.

    Fannie Mae expressed the legal opinion, as supported by an opinion
    letter from legal counsel, that HUD may not "prospectively regulate"
    Fannie Mae's investment discretion.  Fannie Mae based its opinion on,
    among other things, the legislative history of provisions formerly
    contained in the Fannie Mae and Freddie Mac charter acts.  With
    respect to HUD's general regulatory authority, these provisions
    contained language substantially identical to that set forth in the
    1992 Act.\15 The Committee reports accompanying these provisions
    stated as follows:

         "It is the intent of the committee that the regulatory powers of
         the Secretary will not extend to (the enterprise's) internal
         affairs, such as personnel, salary, and other usual corporate
         matters, except where the exercise of such powers is necessary
         to protect the financial interests of the Federal Government or
         as otherwise necessary to assure that the purposes of the
         (charter act) are carried out."\16

    Fannie Mae asserted that its investment practices are internal
    corporate affairs subject to its broad discretion.  Thus, according
    to the enterprise, the above-quoted legislative history and other
    Congressional statements indicate Congress' intention that HUD should
    not exercise its general regulatory authority with respect to Fannie
    Mae's investment activities except in the "extreme situation" where
    those activities endanger its statutory mission.

    It is unclear that Congress intended to limit HUD's authority with
    respect to nonmortgage investments, particularly in light of the
    special purposes of the housing enterprise charters and the broad
    statutory language establishing the Secretary's general regulatory
    power and rulemaking authority.  But even if, as Fannie Mae contends,
    nonmortgage investments are usual corporate matters, HUD could take
    regulatory action, such as requiring reports of nonmortgage
    investment activities, in cases where HUD appropriately determines
    the action is necessary to ensure the accomplishment of the
    enterprises' charter acts.

    --------------------
    \13 12 U.S.C.  � 4541.

    \14 Id.

    \15 See 12 U.S.C.  � 1452(b) (1991 Supp.) (Freddie Mac); 12 U.S.C.  �
    1723a(h) (1988) (Fannie Mae).

    \16 See S.  Rep.  No.  1123, 90th Cong., 2d Sess.  82 (1968); H.R.
    Rep.  No.  1585, 90th Cong., 2d Sess.  71 (1968); H.R.  Rep.  No 54,
    pt.  3, 101st Cong.  1st Sess.  2 (1989).

             HUD HAS BEGUN A
             RULEMAKING EFFORT
    -------------------------------------------------------- Letter :4.3.2

    Since April 1997, HUD has been evaluating the scope of its authority
    with respect to the mission-relatedness of enterprise investments.
    HUD officials said they are considering a range of possible
    regulatory standards for enterprise investments that could be
    appropriate and within the scope of HUD's statutory authority.  On
    the one end of the range being considered is a narrower standard
    based on an enterprise activity being reasonably related to the
    enterprise's mission; and on the other end is a broader standard
    based on an activity not conflicting with the enterprise's mission.

    HUD's mission regulation actions since the passage of the 1992 Act
    have focused on developing numeric goals governing enterprise
    purchase of mortgages serving very-low-, low-, and moderate-income
    households and other underserved borrowers; promulgating rules
    containing numeric goals; and enforcing the numeric standards.  HUD
    officials told us that the activities of HUD's Office of Government
    Sponsored Enterprises Oversight have continued to focus on the
    numeric goals and fair lending issues.

    HUD officials said that they had not focused attention on nonmortgage
    investment practices at the enterprises prior to the mid-April 1997
    public disclosure of and publicity surrounding Freddie Mac's
    nonmortgage investment in long-term Phillip Morris bonds.  At that
    time, HUD requested information from Freddie Mac on its nonmortgage
    investments and received a reply from Freddie Mac on April 28.  In
    our August 1997 discussion with HUD, officials told us they have
    decided to use their general regulatory authority to request reports
    from the housing enterprises on their investment policies and
    practices.  HUD's plan is to monitor investment trends so that it can
    determine if the investments are consistent with the enterprises'
    missions and purposes as defined in their charters.  On November 13,
    1997, HUD's Director of Government Sponsored Enterprises Oversight
    made her first request for a report on nonmortgage investment
    activity from the housing enterprises.

    In August 1997, HUD told us it had reached the decision to begin a
    rulemaking effort by publishing an advance notice of proposed
    rulemaking soliciting comments on how HUD should carry out its
    general regulatory authorities with respect to nonmortgage
    investments by the housing enterprises.  HUD received executive
    branch approval and published the advance notice on December 30,
    1997.

             FCA HAS GENERAL
             REGULATORY AUTHORITY
    -------------------------------------------------------- Letter :4.3.3

    FCA has general regulatory authority over Farmer Mac.  Under the Farm
    Credit Act of 1971, FCA has general regulatory authority over
    institutions in the Farm Credit System,\17

    one of which is Farmer Mac.\18 FCA officials told us that the agency
    implements this authority through OSMO.  As required by statute, the
    Director of OSMO is selected by and reports to the FCA Board.\19
    Moreover, the statute charges FCA with ensuring that OSMO is
    adequately staffed to supervise Farmer Mac's secondary market
    activities, although, to the extent practicable, the personnel
    responsible for supervising the corporation should not also be
    responsible for supervising the banks and associations of the Farm
    Credit System.  This regulatory structure provides for a degree of
    separation between FCA's general regulatory responsibilities and its
    safety and soundness responsibilities with respect to Farmer Mac.
    However, the structure does not appear to limit FCA's general
    regulatory authority.\20

    During our review, we conducted three interviews with FCA and OSMO
    officials that included discussion of general regulatory authorities
    as they apply to nonagricultural-mortgage investments.  Over the
    course of these interviews, we observed an evolution in their
    thinking on this topic.  At the beginning of our review, the OSMO
    director told us that its focus in examining nonagricultural-mortgage
    investments had been on matters pertaining to safety and soundness.
    Toward the end of our review, it appeared to us that FCA and OSMO
    officials began to focus some attention on the relationship between
    nonagricultural-mortgage investments and mission achievement.

    In October 1997, FCA indicated that, for now, it did not have
    concerns that Farmer Mac's nonmortgage investment activity is
    inconsistent with its charter mission.  However, FCA also stated that
    the debt issuance strategy associated with the investments is
    intended to be temporary and to develop over a reasonable period of
    time.  Therefore, according to FCA, its position could change if over
    time evidence does not show that such investments play a role in
    helping Farmer Mac achieve its mission.

    --------------------
    \17 FCA is charged with providing "for the examination of the
    condition of, and general regulation of the performance of the
    powers, functions, and duties vested in, each institution of the Farm
    Credit System" and has general rulemaking authority and incidental
    powers to carry out the purposes of the Farm Credit Act of 1971.  12
    U.S.C.  �� 2243, 2252.

    \18 12 U.S.C.  � 2279aa-1(a)(2).

    \19 12 USC 2279aa-11(a)(3)(c).

    \20 FCA's regulatory role with respect to Farmer Mac raises a concern
    about regulatory conflict of interest.  The Farm Credit System is a
    major portion of the primary market for agricultural mortgage loans,
    and Farmer Mac is the secondary market for these loans.  As regulator
    of both markets, FCA may be subject to conflicts of interest.  See
    H.R.  Rep.  No.  102-210, pt.  2, at 17-19, pt.  1 at 5-6;
    Government-Sponsored Enterprises--Federal Agricultural Mortgage
    Corporation (GAO/T-GGD-91-62, July 24,1991), before the Subcommittee
    on Policy, Research, and Insurance of the House Committee on Banking,
    Finance, and Urban Affairs.  OSMO's role is intended to address this
    potential conflict of interest.

          HUD APPROVED FANNIE MAE'S
          PROPOSED MORTGAGE PROTECTION
          PLAN UNDER ITS NEW MORTGAGE
          PROGRAM AUTHORITY
    ---------------------------------------------------------- Letter :4.4

    The enterprises may at times propose new mortgage programs that
    contain nonmortgage investment components.  In addition to its
    general regulatory authority, HUD also has regulatory authority to
    approve new mortgage programs proposed by the housing enterprises.
    HUD used this authority to review Fannie Mae's proposed mortgage
    protection plan (MPP),\21 which it approved on June 23, 1997.  On
    that date, OFHEO's acting director provided the Secretary of HUD a
    letter with his determination that MPP would not create a "risk of
    significant deterioration of the financial condition" of Fannie Mae;
    this determination is required for the Secretary of HUD's approval.
    Under the proposed program, Fannie Mae would purchase a cash value
    life insurance policy--essentially a nonmortgage investment\22 --on a
    first-time homebuyer after the selected borrower's residential
    mortgage was purchased by Fannie Mae and the borrower agreed to
    accept such coverage.  The policy would protect Fannie Mae and the
    homebuyer against the risk that the mortgage would not be paid due to
    the borrower's death.  The policy also would offer limited protection
    against default and foreclosure due to disability and job loss.  Due
    in part to potential tax benefits available under current tax law
    when HUD approved MPP, and in part to Fannie Mae's relatively low
    cost of capital, Fannie Mae expected that MPP would be profitable.
    Since HUD's approval, however, a new tax bill was signed into law
    that, according to Treasury, substantially reduced the tax benefits
    that were available to Fannie Mae under the MPP.  Fannie Mae
    officials told us that Fannie Mae has decided not to go forward with
    the program.

    In commenting on a draft of this report, HUD stated that it did not
    possess detailed knowledge of the intricacies of the life insurance
    industry at the time MPP was submitted for review.  We did not see
    evidence that HUD provided Fannie Mae's MPP proposal to anyone with
    experience in evaluating cash value life insurance.  HUD determined
    that although it would have been helpful, detailed industry expertise
    was not necessary to HUD's review and understanding of MPP's
    potential benefits to borrowers and its related costs.  A Treasury
    attorney with expertise in life insurance provided basic information
    about life insurance products to HUD.  However, according to HUD
    officials, HUD determined that providing information on MPP to
    Treasury was not necessary as it had obtained sufficient information
    and analysis to complete its work.  In its written response to us,
    Treasury said:  "Since HUD has the statutory responsibility to rule
    on Fannie Mae's request to undertake the MPP, and since HUD did not
    ask for the Treasury's assistance in making its determination
    regarding the MPP, the Treasury did not seek to obtain additional
    information from Fannie Mae."

    HUD's new mortgage program review authority states that the Secretary
    can disapprove a new mortgage program if he finds that the program is
    not in the public interest.  HUD did not include tax revenue losses
    in its analysis for the public interest determination.  In commenting
    on a draft of this report, HUD stated its belief that tax issues were
    within the scope of the MPP review but that in making its public
    interest determination, HUD would find it difficult to conclude that
    a practice that is permissible under current tax law was nevertheless
    against the public interest.  Consequently, in its legal analysis,
    HUD took the position that as long as the MPP program is permissible
    under the current laws, MPP should not be regarded as against the
    public interest solely on the basis of a potential adverse impact on
    federal revenues or the concomitant favorable impact on Fannie Mae's
    tax position.

    Because tax consequences were a major factor in Fannie Mae's MPP
    proposal, we asked Treasury whether it was concerned that HUD's
    public interest determination left out tax policy considerations.
    Treasury's written response stated:  "The Treasury defers to HUD's
    interpretation of its statutory authority and responsibilities." The
    response also stated:

         "The Treasury has long been concerned about the revenue loss
         from the favorable tax treatment of cash value life insurance
         with business policyholders or beneficiaries, and the MPP
         highlighted these concerns.  However, this tax policy concern
         was not limited to the MPP.  In August, Congress passed and the
         President signed a tax bill that dealt with some of the
         principal tax policy concerns associated with the MPP."

    --------------------
    \21 Fannie Mae disagreed with HUD's characterization of MPP as a new
    mortgage program.  Fannie Mae argued that MPP was a logical extension
    of its existing mortgage products.

    \22 Cash value life insurance is a nonmortgage investment because
    Fannie Mae would pay premiums to a life insurance company and would
    receive a tax-deferred or tax-exempt return, part of which would be
    guaranteed and part of which might not be guaranteed, based in part
    on the yields on the assets held by the life insurance company.
    Unless Fannie Mae contractually specified that its premiums be
    invested solely in mortgages, the premiums it paid to the life
    insurance company generally would be invested in a wide range of
    securities.

       THE RELATIONSHIP OF THE
       ENTERPRISES' NONMORTGAGE
       INVESTMENTS TO EARNINGS AND
       MISSION
    ------------------------------------------------------------ Letter :5

    Nonmortgage investments constituted 10 to 15 percent of on-balance
    sheet assets at the housing enterprises at June 30, 1997, and most of
    these investments are short term (i.e., maturities of less than 5
    years).  Freddie Mac, however, created an investment fund in 1997
    authorized to contain up to $10 billion in nonmortgage investments
    with maturities of over 5 years.  Farmer Mac embarked on a debt
    issuance strategy in 1997 in which the debt largely finances
    nonagricultural-mortgage investments; such investments grew during
    the first half of 1997 to about 66 percent of Farmer Mac's assets.
    The housing enterprises stated that they hold nonmortgage investments
    primarily for cash management purposes and to employ capital not
    currently needed to fund mortgages.  Farmer Mac officials stated that
    Farmer Mac makes nonagricultural-mortgage investments primarily to
    invest funds from debt issuance that exceed purchases of agricultural
    mortgages.

          OVERVIEW OF ENTERPRISE
          NONMORTGAGE INVESTMENTS
    ---------------------------------------------------------- Letter :5.1

    Nonmortgage investments constituted about 15 percent of on-balance
    sheet assets at Fannie Mae and 9 percent at Freddie Mac as of
    year-end 1996.  Table 1 shows selected statistics on mortgage assets
    and stockholders' equity (i.e., capital) to provide further
    perspective.  For example, nonmortgage investments were about 2.6
    percent of Freddie Mac's and about 6.3 percent of Fannie Mae's total
    mortgage servicing portfolio.  Nonmortgage investments were more than
    double Freddie Mac's capital and more than four times Fannie Mae's
    capital.  At Farmer Mac, nonagricultural-mortgage investments were
    about one-fourth of on-balance sheet assets and over three times
    capital.

    As shown in table 1, over 65 percent of Freddie Mac's nonmortgage
    investments and over 40 percent of Fannie Mae's were short-term
    investments in cash, cash equivalents, term federal funds, and
    eurodollar deposits.  Freddie Mac's and Fannie Mae's 1996 annual
    reports also showed overall nonmortgage investments by contractual
    maturity.\23 About 78 percent of Freddie Mac's nonmortgage
    investments had maturities under 1 year, and about 93 percent had
    maturities under 5 years.  The corresponding figures for Fannie Mae
    were 68 and 75 percent.  According to housing enterprise officials,
    all of their nonmortgage investments were investment-grade.\24
    According to the data provided on sales of holdings, neither housing
    enterprise appears to have actively engaged in frequent selling of
    its nonmortgage investments.

                                    Table 1

                        Selected Financial Data for the
                      Enterprises as of December 31, 1996

                             (Dollars in millions)

                                             Freddie     Fannie     Farmer
                                                 Mac        Mae        Mac
    -------------------------------------  ---------  ---------  ---------
    Total assets                            $173,866   $351,041       $603
    Stockholders' equity                       6,731     12,773         47
    Mortgage servicing portfolio             610,820    835,225        643
    Nonmortgage investments\a
     --Cash and equivalents                    9,141        850         69
     --Term federal funds and                  1,330     21,734         --
     eurodollar deposits
     --Asset-backed securities                 2,086     12,792         --
     --Mortgage-backed securities\a               --         --         79
     --State/municipal bonds                   2,009         \b         --
     --Commercial paper                           \b      6,192         --
     --Corporate debt                            819         \b         --
     --Agency debt                                --         --          2
     --Auction rate preferred stock              392         \b         --
     --Other                                     243     11,239          5
     --Accrued interest receivable                64         \b         --
     Total nonmortgage investments           $16,084    $52,807       $155
    ----------------------------------------------------------------------
    Note:  The mortgage servicing portfolio includes mortgages purchased
    and held as on-balance sheet assets in retained portfolio plus
    mortgages purchased and pooled as off-balance sheet assets to back
    mortgage-backed securities.  Housing enterprise repurchase agreements
    were excluded from nonmortgage investments based on our understanding
    that such agreements are mortgage related.  Freddie Mac
    mortgage-related securities held for trading were also excluded.
    Definitions used by the enterprises for classifying individual data
    elements, such as cash equivalents and term federal funds, may not be
    strictly comparable.

    \a For purposes of this report, Farmer Mac nonmortgage investments
    denote nonagricultural-mortgage investments and include residential
    MBS.

    \b These data elements are not individually reported.

    Source:  1996 annual reports of Freddie Mac, Fannie Mae, and Farmer
    Mac; and information supplied by OFHEO and Fannie Mae.

    Between the end of 1996 and the end of the second quarter of 1997
    (June 30, 1997), the two housing enterprises' total assets grew (see
    table 2).  Freddie Mac's assets grew about 5.8 percent, and Fannie
    Mae's assets grew about 4.3 percent.  Both enterprises' nonmortgage
    investments remained relatively stable at about 10 percent of assets
    for Freddie Mac and at about 15 percent of assets for Fannie Mae.

    Farmer Mac's assets more than doubled from $603 million at year-end
    1996 to about $1.4 billion at June 30, 1997; its
    nonagricultural-mortgage investments grew about sixfold--from $155
    million to $931 million--and accounted for virtually the entire
    increase in total assets.  At June 30, 1997, these investments
    totaled about 66 percent of its total on-balance sheet assets.

                                    Table 2

                       Enterprise Assets at June 30, 1997

                             (Dollars in millions)

                                             Freddie     Fannie     Farmer
    Assets                                       Mac        Mae        Mac
    -------------------------------------  ---------  ---------  ---------
    Total assets                            $184,003   $365,997     $1,408
    Total nonmortgage investments             18,325     53,960        931
    Nonmortgage investments as a                9.96      14.74      66.12
     percentage of total assets
    ----------------------------------------------------------------------
    Source:  Second quarter financial statements and information supplied
    by Fannie Mae.

    The housing enterprises undertake nonmortgage long-term investments,
    and Farmer Mac undertakes nonagricultural-mortgage long-term
    investments.  These longer term investments (i.e., more than 5 years)
    include fixed-rate debt and variable-rate asset-backed securities
    (ABS).\25 The three enterprises fund these investments by issuing
    debt and undertaking different strategies, which are incorporated in
    their investment policies, to limit interest rate risks.\26
    Generally, the housing enterprises (1) match fund their fixed-rate
    nonmortgage investments--they issue debt of the same maturity as the
    investment; and (2) fund their variable-rate ABS with either
    short-term debt with the maturity of that debt matching the reset
    provision (i.e., the time period between the dates when the interest
    rate adjusts) in the ABS or with variable-rate debt.  Enterprise
    officials told us that to the extent interest rate risks still exist
    after they use the above-mentioned practices, they use hedging
    strategies to lessen or eliminate such risks.

    --------------------
    \23 Fannie Mae does not report its financial statistics in as much
    detail as Freddie Mac does.  Therefore, the statistics are not
    directly comparable.  For example, we understand that for Fannie Mae
    the "other" category includes corporate debt, auction rate preferred
    stock, and state and municipal bonds.  In addition, the Freddie Mac
    and Fannie Mae data on maturities are not directly comparable.  For
    example, Fannie Mae's annual report does not indicate the maturities
    of asset-backed securities.  The percentages we report include
    asset-backed securities in total nonmortgage investments.  Since we
    cannot determine the value of asset-backed securities that have
    short-term maturities, the percentages we report may understate the
    short-term maturity shares for Fannie Mae.

    \24 Credit rating agencies such as Standard and Poor's rate bond
    issuers with ratings ranging from AAA for the highest credit rating
    to CC for highly speculative.  Investment grade normally means bonds
    that have a credit rating of BBB or above.

    \25 Farmer Mac's longer term nonagricultural-mortgage investments
    included residential MBS.

    \26 A risk that a financial institution faces is the risk that the
    interest rates will change in ways that reduce the value of the
    institution's portfolio.

          HOUSING ENTERPRISES SAY THAT
          THEY HOLD NONMORTGAGE
          INVESTMENTS FOR CASH
          MANAGEMENT AND TO MAKE
          CAPITAL AVAILABLE TO HELP
          FUND MORTGAGE PURCHASES
    ---------------------------------------------------------- Letter :5.2

    Freddie Mac officials told us that the primary purposes for holding
    nonmortgage investments with maturities of under 5 years is for cash
    management and to meet future anticipated demands for funding
    residential mortgages.  About 7 percent of Freddie Mac's nonmortgage
    investments, as of December 31, 1996, had stated maturities exceeding
    5 years.  However, according to Freddie Mac officials, these
    investments with longer stated maturities included asset-backed
    securities that are expected to be paid off, and thereby terminate,
    prior to their stated maturity dates.

    In March 1997, Freddie Mac created a nonmortgage investment fund to
    hold securities with maturities exceeding 5 years to be generally
    funded by matched maturity noncallable debt.  Freddie Mac officials
    told us that the primary purpose of this new fund, which is
    authorized to contain up to $10 billion, is to meet future
    unanticipated demands for funding residential mortgages.  Freddie Mac
    officials told us that the amount of its other nonmortgage investment
    funds, which generally have maturities under 5 years, would decline.
    In addition, they also made the following five points about the
    longer maturity investments in the newly created fund:

      -- Freddie Mac would not likely sell these longer maturity
         nonmortgage securities, because the fund is meant to provide a
         source for funding those mortgages whose demand is
         unanticipated.

      -- If unanticipated demands for funding mortgages did occur,
         capital to help support mortgage purchases could be made
         available by selling the nonmortgage assets, which would be
         quicker than raising additional capital.

      -- Longer maturity nonmortgage investments do not exhibit the
         prepayment risks (i.e., the risk that borrowers would pay off
         their mortgages early, thus terminating payment streams)
         associated with mortgages.

      -- Match funding these investments (i.e., issuing debt with the
         same maturity of the investment) would allow Freddie Mac to
         access the noncallable bond market without generating interest
         rate risk.

      -- The longer-term nonmortgage investment portfolio would help
         stabilize income when necessary to counteract adverse earnings'
         impact from other forces.

    Fannie Mae officials told us that the primary purposes for holding
    nonmortgage investments are for cash management, as an investment
    vehicle to employ capital\27 not currently needed to fund mortgages
    that is intrinsically appropriate for a financial corporation of its
    size, and to maintain a capital cushion in excess of minimum capital
    requirements.  They told us that such a capital cushion enables them
    to respond to capital markets and fund residential mortgages.  Fannie
    Mae officials told us that nonmortgage investments with maturities
    exceeding 5 years are a relatively small portion of its total
    business.  They told us that most of these securities are
    asset-backed securities with variable interest rates and that the
    variable rate characteristic reduces the interest rate risk
    associated with fixed-rate long-term bonds and, thus, is important to
    its overall safety and soundness.

    --------------------
    \27 Here, as earlier in this report, an investment vehicle, which
    could make capital available is defined as an investment vehicle to
    employ capital.

          FARMER MAC MAKES
          NONAGRICULTURAL-MORTGAGE
          INVESTMENTS PRIMARILY TO
          INVEST FUNDS FROM DEBT
          ISSUANCE THAT EXCEED ITS
          PURCHASES OF AGRICULTURAL
          MORTGAGES
    ---------------------------------------------------------- Letter :5.3

    In February 1997 Farmer Mac's board changed its investment policies
    in order to increase Farmer Mac's presence in the capital markets,
    particularly the debt markets, to help attract investors to its
    securities and thereby reduce its borrowing and securitization costs.
    The board and management believe that increasing Farmer Mac's
    presence in the debt markets will improve the pricing of its
    agricultural mortgage-backed securities and thereby enhance the
    attractiveness of the products it offers through its programs for the
    benefit of agricultural lenders and borrowers.  Farmer Mac officials
    said that although the ultimate objective of Farmer Mac's increased
    debt issuance strategy is to invest the proceeds in loans qualifying
    for inclusion in its securitization and guarantee programs, during
    the initial period in which Farmer Mac is increasing its debt
    issuances it will be investing those proceeds in interest-earning
    nonagricultural-mortgage investment assets.  In commenting on a draft
    of this report, Farmer Mac proposed that 2 to 3 years could serve as
    a reasonable time frame within which the anticipated increased market
    interest in its AMBS will occur.

    FCA and OSMO officials said that Farmer Mac's rationale for its debt
    issuance strategy for enhancing the secondary market in AMBS is
    plausible at this point in time.  However, FCA and OSMO officials
    noted that the extensive nonagricultural-mortgage asset holdings are
    supposed to be temporary until Farmer Mac's debt and AMBS costs
    decline to levels comparable to those for the housing enterprises.
    Should Farmer Mac's strategy prove unsuccessful, then FCA and OSMO
    may revisit the appropriateness of the existing Farmer Mac
    nonagricultural-mortgage investment portfolio policy and practices.
    In the interim, FCA, through OSMO, is monitoring the Farmer Mac
    strategy.  FCA and OSMO officials said they have set no time frame
    for assessing the success of the debt issuance strategy.

       NONMORTGAGE INVESTMENTS DIFFER
       IN THE DEGREE TO WHICH THEY
       GENERATE ARBITRAGE PROFITS AND
       RELATE TO MISSION
    ------------------------------------------------------------ Letter :6

    Enterprise officers and board members have incentives to increase
    shareholder value, just as the officers and board members of private
    corporations do.  However, unlike private corporations, the
    enterprises also have public missions stated in their charters.
    Thus, these enterprise incentives can create tensions between
    increasing shareholder value and fulfilling the public mission.  In
    addition, the enterprises have opportunities to generate arbitrage
    profits that can increase shareholder value and that are not
    available to private corporations.  Financial analysts generally
    define arbitrage as profiting from differences in price when the same
    security is traded on two or more markets.  However, arbitrage can
    also arise if securities have different yields by virtue of
    differences in government-provided benefits between those securities.
    We are using this latter definition of arbitrage in considering
    enterprise nonmortgage investments.\28 Under this definition, at
    least some enterprise nonmortgage investments generate arbitrage
    profits.  In addition to generating arbitrage profits, nonmortgage
    investments can contribute to achieving the enterprises' missions,
    although shorter maturity nonmortgage investments more clearly relate
    to mission than do longer maturity nonmortgage investments.  Because
    the enterprises can generate arbitrage profits and because of the
    tension between shareholder interests and mission achievement, it is
    important for the mission regulators, HUD and FCA, to ensure that the
    missions of these enterprises as stated in their respective charter
    acts are accomplished.

    --------------------
    \28 Our definition of arbitrage is similar to the definition of an
    arbitrage bond defined in a section of the U.S.  tax code.  26 U.S.C.
    � 148.  In this section of the tax code, the definition is in
    reference to state and local governments whose funding costs are
    lowered by virtue of the federal income tax exemption for interest on
    state and local bonds.  In section 148, an arbitrage bond "means any
    bond issued as part of an issue any portion of the proceeds of which
    are reasonably expected (at the time of the issuance of the bond) to
    be used directly or indirectly (1) to acquire higher yielding
    investments, or (2) to replace funds which were used directly or
    indirectly to acquire higher yielding investments."

          ENTERPRISE OFFICERS AND
          BOARD MEMBERS HAVE
          INCENTIVES TO INCREASE
          SHAREHOLDER VALUE
    ---------------------------------------------------------- Letter :6.1

    According to enterprise officials, the competitiveness of today's
    marketplace literally demands that the enterprises recruit and
    maintain the caliber of executive officers and board members that
    will help ensure that their corporations remain among the
    top-performing organizations.  Such action includes the construction
    of compensation packages that will attract top performers and that
    contain incentives that will promote the achievement of corporate
    objectives in addition to satisfying shareholder interests.  To
    ensure that they are in line with current trends, the enterprises
    have used consulting firms to review and compare the pay structure of
    their officers and board members with the pay structure of comparable
    positions in similar private sector financial institutions and other
    enterprises.  Our review of published literature and other
    information on executive and board compensation the enterprises and
    OFHEO provided us suggests that in today's world, more companies are
    including stock-based compensation for their directors and officers
    to help create an economic alignment of director and shareholder
    interests.  Like their competitors, the enterprises award stock-based
    compensation to their board members and senior officers with the
    intention of helping them to focus on the long-term success of their
    corporations.

    In establishing statutory authority, Congress set the tone for the
    governance structure of all three enterprises--Freddie Mac, Fannie
    Mae, and Farmer Mac.  Each of these shareholder-owned corporations,
    which also have a public mission, is governed by a board consisting
    of shareholder-elected directors and appointed directors.  Statutory
    authority provides that the total number of directors elected by
    shareholders include 13 at Freddie Mac, 13 at Fannie Mae, and 10 at
    Farmer Mac; each of the enterprises must have 5 directors appointed
    by the president.  According to enterprise officials, the directors
    have the same or similar duties and obligations as directors of other
    private corporations, including fiduciary responsibilities to
    shareholders and the establishment of general operation policies that
    govern the companies.  All directors, whether elected or appointed,
    share the same duties and obligations, which are primarily carried
    out through participation in and preparation for board and committee
    meetings.  All directors of the housing enterprises serve 1-year
    terms unless reelected or reappointed.  Appointed directors of Farmer
    Mac serve at the pleasure of the president, the elected directors
    serve 1-year terms.

    In keeping with statutory requirements, the housing enterprises'
    compensation structure is built upon a philosophy of comparability\29
    (i.e., compensation is reasonable and comparable to that of similar
    businesses) and pay for performance, which includes the achievement
    of individual as well as corporate-level objectives.  All three
    enterprises have committees that set policy and make recommendations
    concerning compensation.  Annual evaluations allow for salary
    adjustments based on merit performance and the need to maintain
    market competitiveness.  Board members of all three enterprises
    receive cash compensation in the form of an annual retainer and
    stipulated fees for attending board and committee meetings.  In
    addition to the cash, board members receive long-term compensation in
    the form of stock and stock options (see table 3).  Similarly, in
    addition to their base salaries, senior managers of the enterprises
    receive bonuses (which are to recognize their individual
    contributions to the success of corporate goals), as well as stock
    and stock options designed to ensure sustained corporate success.
    (See app.  II for more detailed information on the enterprises'
    compensation structures.)

                                         Table 3

                          Compensation Structure for Enterprise
                                      Board Members

            Board members\a          Cash compensation       Long-term compensation
        ------------------------  ------------------------  ------------------------
    En
    te
    rp
    ri
    se                                                                   Stock
    s       Elected    Appointed  Retainer     Fees         Stock        options
    --  -----------  -----------  -----------  -----------  -----------  -----------
    Fr           13            5  yes          yes          yes          yes
    ed
    di
    e
    Ma
    c

    Fa           13            5  yes          yes          yes          yes
    nn
    ie
    Ma
    e

    Fa           10            5  yes          yes          no           yes
    rm
    er
    Ma
    c
    --------------------------------------------------------------------------------
    \a Freddie Mac and Fannie Mae have three and two employee directors,
    respectively.  These directors are compensated in their positions as
    executive officers.  All of Farmer Mac's board members are outside
    directors.

    Source:  Developed from information provided by the enterprises.

    --------------------
    \29 Through its authority to prohibit excessive compensation at the
    housing enterprises, OFHEO is responsible for monitoring compensation
    to ensure that this philosophy of reasonable and comparable
    compensation is carried out.

          TENSION BETWEEN INCREASING
          SHAREHOLDER VALUE AND
          ACHIEVING MISSION
    ---------------------------------------------------------- Letter :6.2

    Private corporations without government sponsorship provide
    incentives to their senior management and board members to take
    actions that will increase profits and shareholder value.  The
    enterprises have instituted compensation packages that conform
    closely to those of private corporations, including financial
    institutions, with which they compete for individuals with specific
    skills.  These compensation packages include stock-based compensation
    strategies that have the intent of aligning the economic interests of
    managers and directors with shareholder interests.\30 The
    compensation packages that board members at the enterprises receive
    do not differ according to whether the board member is shareholder
    elected, presidentially appointed, or chosen by another method.  The
    enterprises told us that the orientation and training activities they
    provide new board members do not differ according to how the board
    member is selected.  The enterprises also told us that board members
    are instructed to advocate corporate activities that enhance
    shareholder value while supporting the enterprise's charter purposes.
    From our analysis, it appears to us that compensation incentives
    available to enterprise senior management and board members,
    including stock-based compensation, reinforce the tension between
    increasing shareholder value and achieving mission.  At a minimum,
    stock-based compensation can affect how broadly board members and
    senior managers interpret whether the corporate activities they
    advocate contribute to fulfillment of mission.

    Freddie Mac officials disagreed with our view that a tension exists
    between increasing shareholder value and achieving mission.  They
    told us that the two goals were compatible and codependent.  They
    stated that Congress wanted a private company to fill a public
    purpose.  With this role, they noted that if one were to ignore the
    entity of the shareholder, the public mission cannot be fulfilled.
    We note that short of ignoring the interests of the shareholder, a
    tension exists.  It is this tension that hightlights the importance
    of mission oversight.  Without effective mission oversight, the
    incentives to use the benefits of government sponsorship to increase
    shareholder value could, over time, erode the public mission.  If
    this were to occur, long term nonmortgage investments could become an
    increasing part of the housing enterprises' portfolios and Farmer
    Mac's temporary approach could become a permanent strategy even it it
    does not enhance Farmer Mac's ability to purchase agricultural
    mortgages.

    --------------------
    \30 Fannie Mae officials emphasized the inclusion of public purpose
    goals in the compensation of some senior management officials.  For
    example, they told us that Fannie Mae's chief executive officer's
    compensation is based, in part, on Fannie Mae's progress in meeting
    its $1 trillion commitment for mortgage purchases serving low-income
    and underserved borrowers.  Freddie Mac officials also indicated that
    compensation of some senior managers is partially tied to achievement
    of mission requirements.

          ARBITRAGE CAN ARISE IF
          SECURITIES HAVE DIFFERENT
          YIELDS BY VIRTUE OF
          DIFFERENCES IN GOVERNMENT
          PROVIDED BENEFITS
    ---------------------------------------------------------- Letter :6.3

    In a previous report about the housing enterprises, we concluded that
    the greatest benefit to the enterprises from government sponsorship
    flows from the market perception of an implied guarantee on
    enterprise obligations, because this perception generates a funding
    advantage--a reduction in yields on enterprise debt.\31 In that
    report, we indicated that the funding advantage could be in the range
    of 30 to 106 basis points.  This range took into account the
    long-term nature of residential mortgage investments, and it assumed
    that the housing enterprises would receive a credit rating between a
    high of AAA and a low of A if their government sponsorship were
    eliminated.  Findings from our analysis of housing enterprise
    financial data are consistent with this estimated funding advantage
    range and with a credit rating between AA and A.\32 Appendix I
    contains a more detailed discussion of our analysis.

    In the previous report about the housing enterprises,\33 we indicated
    that government sponsorship of the housing enterprises lowered
    interest rates on single-family, fixed-rate, conforming mortgages.
    Although the benefits of government sponsorship reduce certain
    mortgage interest rates, there is no similar effect on the yields of
    nonmortgage investments, because the enterprises are not a
    significant source of funding outside the residential mortgage
    market.  Thus, there is an additional incentive for the enterprises
    to issue debt, whose yield is lower by virtue of government
    sponsorship, to invest in nonmortgage investments, whose market
    yields will be relatively higher because they are not affected by
    government sponsorship.

    Farmer Mac is a government-sponsored enterprise that also benefits
    from the market perception of an implied guarantee on enterprise
    obligations.  It is, however, a much smaller and less established
    corporation than either of the housing enterprises.  As a result, it
    is difficult to estimate Farmer Mac's funding advantage.  For
    example, we do not know whether it could remain in business without
    government sponsorship or what its credit rating would be if it
    became a going concern as a private corporation without government
    sponsorship.  If its credit rating without government sponsorship
    would be less than A, its funding advantage from government
    sponsorship could be greater than the advantage for the housing
    enterprises.  However, Farmer Mac's securities may be currently
    perceived by market participants as more risky than housing
    enterprise securities.  Farmer Mac documents provided to us in July
    1997 indicated that yields on Farmer Mac debt had been between 1 and
    10 basis points higher than yields on equivalent housing enterprise
    debt prior to Farmer Mac's new debt issuance strategy, and these
    yield differences had not yet been eliminated by Farmer Mac's debt
    issuance strategy.\34

    Of the specific nonmortgage investments made by the enterprises,
    public information is available on one investment that generated
    arbitrage profits; this investment was in Phillip Morris bonds
    purchased by Freddie Mac.  The Phillip Morris bonds, which had an A
    rating, were purchased by Freddie Mac and were funded by Freddie Mac
    bonds with the same maturity.  The yield difference was slightly over
    60 basis points.  Freddie Mac officials told us that its nonmortgage
    investment fund holding securities with maturities exceeding 5 years
    is authorized to contain up to $10 billion.\35 Applying, as an
    example, an interest rate differential of 60 basis points, a $10
    billion fund could generate as much as $60 million annually in
    arbitrage profits.  If a similar 60-basis-point differential were
    applied to Farmer Mac nonagricultural-mortgage investments with
    maturities exceeding 5 years, arbitrage profits would represent about
    $3.2 million.\36

    We did not make an overall estimate of arbitrage profits, in part
    because of difficulties in estimating the funding advantage.  For the
    housing enterprises, we have good estimates for the funding advantage
    on longer term investments in fixed-rate debt that are match funded.
    These enterprises hold nonmortgage investments in variable-rate ABS
    with stated maturities of over 5 years.  The enterprises told us that
    many of these securities have expected maturities of less than 5
    years due to borrower prepayments, and we do not have good estimates
    for the funding advantage on these investments.  We also do not have
    good estimates for the funding advantage on short-term investments.
    From our review of variable-rate ABS and short-term investments made
    by the housing enterprises, however, it appears that the funding
    advantage associated with government sponsorship is lower for these
    investments than for longer term, fixed-rate nonmortgage investments.

    --------------------
    \31 Housing Enterprises:  Potential Impacts of Severing Government
    Sponsorship (GAO/GGD-96-120, May 13, 1996).

    \32 An AA rating is higher, signifying less credit risk, than an A
    rating; an AA rated corporation has lower debt costs than an A rated
    corporation.  Therefore, the yield difference (i.e., the funding
    advantage) measure between an AA corporation and the housing
    enterprises is smaller than between an A corporation and the housing
    enterprises.  Likewise, an AAA rated corporation has lower debt costs
    than an AA rated corporation.

    \33 GAO/GGD-96-120, May 13, 1996.

    \34 In response to our inquiry, Farmer Mac's Wall Street traders, at
    Farmer Mac's direction, prepared estimates of yield spreads between
    Farmer Mac and housing enterprise debt.  The estimated yield spreads
    generally were between 1 and 10 basis points.

    \35 Freddie Mac officials told us that its forecasted level for
    year-end 1997 holdings in the fund is $2 billion.

    \36 As of June 30, 1997, Farmer Mac held $536 million in longer term,
    variable-rate, nonagricultural-mortgage investments.

          SHORTER TERM INVESTMENTS
          RELATE TO THE HOUSING
          ENTERPRISES' MISSIONS
    ---------------------------------------------------------- Letter :6.4

    The public purposes of the housing enterprises, as specified in their
    respective federal charters, include providing stability in the
    secondary market for residential mortgages and responding
    appropriately to the private capital market.  Enterprise purchases of
    residential mortgages directly contribute to mission achievement.  As
    a general matter, the housing enterprises said they also take actions
    they think position them to serve their respective markets under
    different financial market conditions as well as different conditions
    affecting the residential mortgage market.  The housing enterprises
    state that their nonmortgage investment holdings allow them to
    respond appropriately to capital markets and fund residential
    mortgages during different market conditions.  They also emphasize
    that the yields on their nonmortgage investments are lower than the
    yields on their mortgage investments.

    Our analysis of the housing enterprises' nonmortgage investments
    indicated that overall, the yields on such investments are lower than
    on their mortgage investments.  For example, in 1996 Freddie Mac's
    average interest rate on cash and nonmortgage investments was 5.55
    percent, and on mortgages it was 7.46 percent.  The respective
    interest rates for Fannie Mae in 1996 were 5.68 percent on
    nonmortgage investments and cash equivalents and 7.71 percent on
    mortgages.  The general preponderance of short-term investments in
    the enterprises' nonmortgage investments accounts for the lower
    overall yield on these investments compared to mortgage investments.
    Our analysis of these short-term nonmortgage investments, such as
    term federal funds, indicates that they have a clear relationship to
    mission in enhancing liquidity, thereby allowing the enterprises to
    fund residential mortgages during different market conditions.  In
    addition, even though they might also generate arbitrage profits,
    they are not the primary vehicle through which the housing
    enterprises would attempt to generate arbitrage profits.  Likewise,
    since the yields from these investments are low relative to long-term
    nonmortgage investments, it is not likely that the volume of
    short-term nonmortgage investments would be substantially affected by
    the tension between increasing shareholder value and achieving
    mission, because these investments have lower yields than mortgage
    investments.

          LONG-TERM, FIXED-RATE
          NONMORTGAGE INVESTMENTS BY
          THE HOUSING ENTERPRISES
          GENERATE ARBITRAGE PROFITS,
          AND THEIR RELATIONSHIP TO
          MISSION IS LESS CLEAR
    ---------------------------------------------------------- Letter :6.5

    Freddie Mac officials indicated that nonmortgage investments are an
    integral tool for carrying out its housing finance mission and are
    held for three principal reasons:  (1) cash management purposes; (2)
    as an investment vehicle that could make capital available (i.e., to
    employ capital) to help fund future anticipated demand to fund
    residential mortgages; and (3) as an investment vehicle to employ
    capital for future unexpected demand to fund residential mortgages.
    Freddie Mac created a fund in March 1997, which it calls its core
    fund, to invest in securities with maturities exceeding 5 years to be
    funded by matched maturity noncallable debt.  The main stated purpose
    for the core fund is to have capital employed in case it becomes
    necessary to fund unexpected mortgage demand.  Although Freddie Mac
    does not expect to liquidate core fund investments, Freddie Mac
    officials told us that liquidation could occur to fund purchases of
    residential mortgages if a decline in interest rates triggered a
    substantial increase in mortgage prepayments or if a major mortgage
    dealer or investor failed.  The officials also said that raising
    capital to fund unexpected mortgage demand could take up to 4 months,
    and therefore it was important to have capital employed in
    investments that could quickly be liquidated in case such funds
    became necessary.

    Our analysis focused on alternative mechanisms available to Freddie
    Mac for funding unexpected mortgage demand.  We asked Freddie Mac
    officials if they were able to supply the necessary liquidity in
    1993, when declining mortgage interest rates caused the highest level
    of mortgage prepayments in history, by using financing techniques
    that did not rely on liquidation of long-term investments.  The
    officials told us that the enterprises were able to serve the market
    by funding purchases of residential mortgages, but this particular
    experience was not a guarantee for the future.  It is worth noting
    that mortgage prepayments reduce the level of the enterprises'
    outstanding MBS held by investors; therefore, investment funds to
    fund newly refinanced mortgages are made available from investors who
    purchase housing enterprise MBS.  Thus, in this situation MBS
    issuance could provide necessary liquidity without reliance on
    liquidation of core fund investments.

    We agree that the potential failure of a major mortgage dealer or
    investor could bring about a need for additional liquidity in the
    mortgage market.  However, Freddie Mac has a number of vehicles to
    provide liquidity, such as use of proceeds from maturing short-term
    nonmortgage investments to purchase residential mortgages, which in
    turn can be funded by issuance of MBS.  Freddie Mac could also issue
    MBS backed by on-balance sheet holdings of residential mortgages,
    thereby reducing required capital to support its mortgage servicing
    portfolio.  Such an action would make a capital cushion available to
    support funding of the unexpected mortgage demand, because the
    enterprises do not have to hold as much capital to finance
    off-balance sheet compared to on-balance sheet mortgage assets.\37

    Fannie Mae officials indicated that nonmortgage investments are held
    for three principal reasons:  (1) cash management purposes, (2) as an
    investment vehicle to employ capital that is intrinsically
    appropriate for a financial corporation of its size, and (3) to
    maintain a capital cushion in excess of minimum capital requirements.
    Fannie Mae's nonmortgage investments with maturities exceeding 5
    years are mostly asset-backed securities (ABS) with variable interest
    rates.  The market value of the longer term ABS does not fluctuate as
    much as the market value of long-term fixed-rate securities, because
    most of the ABS have variable interest rates.\38 Therefore, at times
    Fannie Mae has sold ABS to finance mortgage purchases.  This activity
    is consistent with how Fannie Mae employs its short-term nonmortgage
    investments.  In addition, according to our review of variable-rate
    ABS investments by all three enterprises, it appears that the funding
    advantage associated with government sponsorship is lower for these
    instruments compared to long-term, fixed-rate nonmortgage
    investments.  Nonetheless, some arbitrage profits are generated from
    these investments.  Therefore, the ABS investments appear to have
    characteristics that differ somewhat from other nonmortgage
    investments in two dimensions.  First, they appear to be somewhat
    related to mission, because they are more liquid than fixed-rate
    long-term investments but less liquid than short-term nonmortgage
    investments.  However, fluctuations in the market value of ABS, in
    relation to short-term nonmortgage investments, can reduce their
    effectiveness in providing liquidity.  Second, they appear to
    generate arbitrage profits, although at a lower level than other
    fixed-rate long-term nonmortgage investments.

    --------------------
    \37 Currently, the housing enterprises are subject to minimum capital
    standards that are computed on the basis of capital ratios.  The two
    capital ratios relevant to this discussion are (1) 2.50 percent of
    aggregate on-balance sheet assets and (2) 0.45 percent of the unpaid
    principal balance of outstanding MBS.

    \38 The market value of the longer term ABS, however, may fluctuate
    more than the market value of short-term nonmortgage investments.

          ARBITRAGE PROFITS COULD
          REPRESENT A POTENTIAL SOURCE
          OF FUNDS FOR TARGETED
          HOUSING MORTGAGE PROGRAMS
    ---------------------------------------------------------- Letter :6.6

    In addition to the contribution to mission goals and the generation
    of arbitrage profits already presented, there is an additional
    potential mission-related rationale for holding nonmortgage
    investments where the investment merely provides a potential source
    of resources that can be used to fund targeted housing mortgage
    programs.

    Such a rationale appears to be consistent with one offered by HUD in
    its analysis of the housing enterprises' retained mortgage
    portfolios.  HUD's report on privatization\39

    concluded:  "Full privatization would reduce the GSEs' portfolio
    operations.  This would not have a major impact on the mortgage
    market because the MBS market is now well-developed and is an
    effective mechanism for allocating interest rate risk." HUD also
    concluded, however:  "Most GSE earnings come from their portfolio
    operations.  Without the cushion of a highly profitable portfolio,
    the fully privatized GSEs would reduce their funding of the more
    risky affordable loans, unless these loans started carrying much
    higher interest rates."\40

    --------------------
    \39 HUD, Privatization of Fannie Mae and Freddie Mac:  Desirability
    and Feasibility (July 1996), page 15.

    \40 Ibid.  p.  105.

          FARMER MAC'S
          NONAGRICULTURAL-MORTGAGE
          INVESTMENTS GENERATE
          ARBITRAGE PROFITS:
          RELATIONSHIP TO MISSION IS
          UNCERTAIN
    ---------------------------------------------------------- Letter :6.7

    Farmer Mac's first year with positive net income was 1996.  Net
    income has grown during the first two quarters of 1997 as Farmer Mac
    initiated its debt issuance strategy.  Currently, over half of its
    on-balance sheet asset holdings are in investments other than
    agricultural mortgages.  Government sponsorship of Farmer Mac lowers
    its debt costs, generating arbitrage profits from such investments.
    In its semiannual report to the House and Senate Agriculture
    Committees transmitted in April 1997, FCA notes that Farmer Mac can
    operate at a profit even if its core business does not expand, as
    long as it can borrow funds at lower rates than it can earn on
    investments.  Farmer Mac's strategy appears to be unique, not at all
    similar to the strategies followed by the housing enterprises over
    the course of their development, which makes it more difficult to
    determine whether the debt issuance policy will help Farmer Mac
    achieve its mission.

    It appeared to us that Farmer Mac's debt issuance strategy would
    logically operate by allowing Farmer Mac to profitably price
    agricultural mortgage purchases so that originators would expect
    higher returns by selling rather than retaining mortgages in their
    own portfolios.  For example, if the debt issuance strategy lowered
    funding costs for Farmer Mac on its AMBS, Farmer Mac might be able to
    pay mortgage originators higher prices for agricultural mortgages and
    remain profitable.  Farmer Mac officials also told us that their
    investments in agricultural mortgages have higher returns than those
    for its nonagricultural-mortgage investments.  Based on this
    observation by the Farmer Mac officials, it appeared to us that
    Farmer Mac may be able to pay mortgage originators higher prices than
    it currently does for agricultural mortgages and remain profitable in
    this mission-related segment of its business.  We asked the Farmer
    Mac officials why Farmer Mac does not, therefore, price its
    agricultural mortgage purchases more favorably for mortgage
    originators to help this mission-related business expand.  Farmer Mac
    officials stressed other strategies it is pursuing, such as outreach
    efforts with agricultural mortgage originators.  We are uncertain as
    to whether Farmer Mac's debt issuance strategy will contribute to
    mission achievement, because Farmer Mac's debt issuance strategy
    intends to lower funding costs to purchase agricultural mortgages and
    issue AMBS.  Farmer Mac might become better able to spend funds to
    recruit mortgage originators and pay mortgage originators higher
    prices for agricultural mortgages while remaining profitable in its
    mission-related business if its AMBS costs declined.  However, Farmer
    Mac already appears to have the ability to spend more funds for such
    purposes than it does currently.

       CONCLUSIONS
    ------------------------------------------------------------ Letter :7

    Our analysis indicates that in establishing GSEs, Congress has
    followed the rationale of focusing GSE activity on specific sectors
    of the economy.  Freddie Mac, Fannie Mae, and Farmer Mac have federal
    charters that specify the purposes of each enterprise and provide the
    enterprises with broad authorities as private corporations to manage
    their day-to-day business operations, including their investment
    policies.

    The enterprises' charters also direct them to fulfill specific public
    missions.  The enterprises have mission regulators with general
    regulatory authorities that are charged with ensuring that the
    missions of these enterprises are being fulfilled.  We agree with a
    recent HUD evaluation that it could use its general regulatory
    authority to potentially limit nonmortgage investments.  HUD has
    begun a rulemaking effort intended to develop regulations governing
    nonmortgage investments by the housing enterprises to help ensure
    that such investments are related in some fashion to mission
    achievement.  We agree that this effort can help HUD develop criteria
    to determine the extent to which various nonmortgage investments are
    mission related.  Although FCA could use its general regulatory
    authority over nonagricultural-mortgage investments by Farmer Mac to
    help ensure that such investments are related in some fashion to
    Farmer Mac's mission achievement, it has not established a procedure
    for doing so.  To date, neither HUD nor FCA has developed specific
    criteria to determine whether enterprise nonmortgage investments are
    consistent with mission achievement.

    The enterprises have investment policies that specify permissible
    credit ratings, maturities, and concentration limits and describe the
    relationship of investments to earnings and to achievement of
    mission.  The enterprises have incentives as private corporations to
    increase shareholder value; these incentives create a tension with
    achievement of the missions stated in the federal charters of the
    enterprises.  It is this tension that hightlights the importance of
    mission oversight.  Without effective mission oversight, the
    incentives to use the benefits of government sponsorship to increase
    shareholder value could, over time, erode the public mission.  If
    this were to occur, long term nonmortgage investments could become an
    increasing part of the housing enterprises' portfolios and Farmer
    Mac's temporary approach could become a permanent strategy even if it
    does not enhance Farmer Mac's ability to purchase agricultural
    mortgages.

    Government sponsorship of the enterprises lowers their debt costs,
    and they can therefore generate arbitrage profits (i.e., profits
    resulting from their funding advantage) by investing in nonmortgage
    assets.  The various nonmortgage investments appear to fall along a
    continuum representing the degree to which they relate to the housing
    enterprises' missions.  On one end are short-term nonmortgage
    investments, such as term federal funds, which facilitate liquidity
    although they might also generate arbitrage profits.  On the other
    end are longer term investments that generate arbitrage profits, but
    they are less clearly related to the enterprises' missions in
    facilitating liquidity in the secondary market, because fluctuations
    in their market value reduce their usefulness in responding to
    changes in capital and mortgage products.

    At this time, it is not clear whether Farmer Mac's debt issuance
    strategy will eventually help it expand purchases of agricultural
    mortgages in fulfillment of its mission.  Given the uncertainty of
    when, or if, the Farmer Mac strategy will be successful, FCA has the
    responsibility to monitor Farmer Mac's strategy to help ensure that
    the nonagricultural-mortgage investments, which are a primary source
    of its earnings, are related in some fashion to Farmer Mac's mission
    achievement.  Farmer Mac's strategy appears to be unique, not at all
    similar to the strategies followed by the housing enterprises over
    the course of their development.  In presenting this strategy, Farmer
    Mac officials told us that the strategy's contribution to mission
    achievement should develop over a reasonable period of time.

       RECOMMENDATIONS
    ------------------------------------------------------------ Letter :8

    To provide more focused oversight of the housing enterprises'
    nonmortgage investments, we recommend that the Secretary of HUD
    promptly implement HUD's stated intention to develop criteria through
    appropriate rulemaking processes to help ensure that the housing
    enterprises' nonmortgage investments are consistent with the purposes
    expressed in their charter acts.  We also recommend that the Chairman
    of the FCA Board direct OSMO to develop the requisite criteria and
    report periodically, such as through its semiannual reports to the
    House and Senate Agriculture Committees, on the relationship of
    Farmer Mac's debt issuance strategy to the achievement of Farmer
    Mac's mission.

       MATTERS FOR CONGRESSIONAL
       CONSIDERATION
    ------------------------------------------------------------ Letter :9

    To help ensure that the enterprises' nonmortgage investments
    appropriately support their public missions, the appropriate
    congressional committees may wish to monitor HUD and FCA actions to
    establish criteria and procedures for carrying out their general
    regulatory authorities.  Such oversight is important to help ensure
    that corporate incentives to increase shareholder value do not erode
    the enterprises' public mission.  If adequate progress is not made in
    a timely way, Congress may wish to consider providing further
    guidance to the regulatory agencies.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ----------------------------------------------------------- Letter :10

    We received comments on a draft of this report from each of the three
    enterprises, HUD, OFHEO, FCA, and Treasury (see apps.  III through
    IX).  Appendixes III, IV, V, VI, and VIII also contain additional
    responses to specific comments by Freddie Mac, Fannie Mae, Farmer
    Mac, HUD, and FCA.  Farmer Mac, OFHEO, FCA, and Treasury provided
    technical comments that were incorporated in the report where
    appropriate.

    The three enterprises agreed with our finding that the enterprises
    have broad investment authority and noted our acknowledgement that
    the safety and soundness regulators have determined that the
    enterprises' nonmortgage investment portfolios do not raise safety
    and soundness concerns.  However, the enterprises raised a number of
    concerns and disagreed with some of our major findings pertaining to
    the relationship of nonmortgage investments to mission achievement,
    arbitrage profits, and the tension between increasing shareholder
    value and achieving mission.  Based on Freddie Mac's disagreement
    with our findings, it did not concur with our recommendation to HUD.
    Although Farmer Mac disagreed with some of these findings, it agreed
    with our recommendation to FCA.  HUD, OFHEO, FCA, and Treasury also
    provided comments, some of which focused on the three major issues
    raised by the enterprises.

          RELATIONSHIP OF NONMORTGAGE
          INVESTMENTS TO MISSION
    --------------------------------------------------------- Letter :10.1

    Concerning the relationship of nonmortgage investments to mission
    achievement, Freddie Mac said (see app.  III) that our draft report
    made the erroneous assertion that long-term nonmortgage investments
    are fairly illiquid, and this assertion provided the basis for our
    questioning the role of nonmortgage investments in mission
    achievement.  As shown in appendix IV, Fannie Mae raised the concern
    that we had a "brief and somewhat unclear presentation of how Fannie
    Mae views the role of nonmortgage investments in capital management."

    In response to Freddie Mac's comments, we clarified our discussion of
    the role of the various nonmortgage investments in facilitating
    liquidity in the secondary market for residential mortgages.  Many of
    the housing enterprises' intermediate and longer term nonmortgage
    investments have broad and deep markets that make them readily
    marketable or liquid in the sense that they can be sold without
    substantial loss in market value.  However, longer term investments
    are less liquid than shorter term investments in the sense that their
    market values are subject to larger fluctuations with changes in
    interest rates.  These fluctuations can reduce their usefulness in
    responding to changes in capital and mortgage markets and
    facilitating liquidity in the residential mortgage market at a
    particular point in time, because their market values can be less
    than their original values when liquidation may be warranted.
    Therefore, we did not change our conclusion that the relationship
    between longer term nonmortgage investments and mission achievement
    is less clear than that for short-term nonmortgage investments.

    In response to Fannie Mae's comments, we supplemented our discussion
    of Fannie Mae's primary purposes for holding nonmortgage investments
    to include maintaining a capital cushion in excess of minimum capital
    requirements.  We note, however, that this purpose overlaps with the
    other purposes we cite in our report--cash management and providing a
    capital cushion to respond to capital markets and fund residential
    mortgages (thus facilitating liquidity).  Beyond these purposes,
    Fannie Mae appears to emphasize the role of nonmortgage investments
    in Fannie Mae's earnings and capital management as well as attention
    to safety and soundness concerns.  This emphasis is consistent with
    Fannie Mae's purposes for its investment portfolio as stated in its
    annual report,\41 which are to contribute to corporate profitability,
    serve as a source of liquidity, and provide a return on the excess
    capital of the corporation.  This argument by Fannie Mae, however,
    does not demonstrate a relationship between nonmortgage investments
    and mission achievement beyond the relationship already established
    in our report.

    Concerning the relationship of nonmortgage investments to mission
    achievement and regulatory oversight, HUD said (see app.  VI) that
    our report fairly characterizes the issues, constraints, and
    ambiguities involved in overseeing the housing enterprises'
    nonmortgage investment activities.  HUD agreed with, and said it has
    begun to implement, our recommendation to the Secretary of HUD.
    OFHEO (see app.  VII) stated that it is appropriate for Congress to
    monitor nonmortgage investments at the enterprises and that Congress
    may wish to provide more specific guidance to the regulatory agencies
    regarding the appropriate range of investment activities.

    Farmer Mac (see app.  V) agreed with our finding that FCA has the
    responsibility to monitor Farmer Mac's strategy to help ensure that
    the nonagricultural-mortgage investments are related in some fashion
    to Farmer Mac's mission achievement and our recommendation to the
    Chairman of the FCA Board containing an FCA reporting requirement.
    However, Farmer Mac took issue with our finding that its debt
    issuance strategy and related investment activities may not be
    mission related.  In particular, Farmer Mac stated that we implied
    that its debt issuance strategy will not work because we stated that
    the strategy is unique.  Farmer Mac also stated that this strategy,
    by lowering funding costs, can make funds available to recruit new
    mortgage originators.  In addition, Farmer Mac provided a detailed
    description of its debt issuance policy, how it is expected to lower
    funding costs, and how the corporation sees the policy as linked to
    achievement of its mission.

    In response to Farmer Mac's comments, we made revisions to clarify
    Farmer Mac's position on its debt issuance strategy to include the
    potential for making more funds available to recruit new mortgage
    originators.  We also added clarifying language to indicate that our
    characterization of Farmer Mac's debt issuance strategy as unique was
    included as one of several reasons why it is hard to determine
    whether the debt issuance policy will be effective in helping Farmer
    Mac achieve its mission.\42

    FCA said (see app.  VIII) that our draft report contains a fair
    representation of Farmer Mac's investment activity and FCA's views
    with respect to that activity.  FCA appears to show some support for
    our recommendation to the Chairman of the FCA Board to report on the
    relationship of Farmer Mac's debt issuance strategy to the
    achievement of Farmer Mac's mission.  However, it is not clear
    whether this willingness to report is limited to reporting on safety
    and soundness matters or includes issues of mission regulation.  In
    addition, FCA said that it does not currently have any activities
    under way that are expected to culminate in regulation of the
    investment portfolio.  In response to FCA's comments, we revised our
    recommendation to the Chairman of the FCA Board to state that
    requisite criteria should be developed to assess and report on the
    relationship of Farmer Mac's debt issuance strategy to the
    achievement of Farmer Mac's mission.

    Treasury said (see app.  IX) that we identified some of the important
    policy issues raised by the investment practices of the enterprises.
    Treasury stated that it agrees with our recommendation that the
    enterprises' mission regulators should use their general regulatory
    authority to limit the enterprises' nonmortgage investment activity.
    We note, however, that our recommendation calls for the mission
    regulators to develop criteria to help ensure that nonmortgage
    investments are consistent with the purposes expressed in the
    enterprises' charter acts.

    --------------------
    \41 1996 Fannie Mae Annual Report, page 30.

    \42 Here we note that in Farmer Mac's third quarter 1997 SEC filing,
    Farmer Mac reported:  "Loan volume has not been increasing as rapidly
    as management anticipated following the enactment of its revised
    legislative authorities due, in part, to the longer than expected
    lead-time between marketing initiatives and the realization of
    results."

          ARBITRAGE PROFITS
    --------------------------------------------------------- Letter :10.2

    The second issue relates to our position that the purchase of
    nonmortgage investments generates arbitrage profits.  In commenting
    on our draft report, Freddie Mac took issue with our definition of
    arbitrage and asserted that we created a new definition of arbitrage
    to be responsive to the requester's instructions that we report on
    the extent to which the enterprises have undertaken nonmortgage
    investments for arbitrage profits.  Freddie Mac also asserted that
    under our definition, any profitable investment Freddie Mac makes
    would be considered arbitrage, and therefore we have a circular
    argument.  Freddie Mac states the general definition of arbitrage
    used by financial analysts that is also stated in our report.  This
    general definition, however, does not consider differences in
    government-provided benefits among debt issuers.  Therefore, we
    adopted a definition of arbitrage that is similar to the definition
    of an arbitrage bond defined in a section of the U.S.  tax code.  The
    definition is in reference to state and local governments whose
    funding costs are lowered by virtue of the federal income tax
    exemption for interest on state and local bonds; this definition
    explicitly accounts for differences in government-provided benefits.
    Freddie Mac's assertion that anything profitable would be arbitrage
    according to our definition is not correct.  We note that in an
    integrated national financial market there would be little if any
    opportunity for profit from borrowing and lending for the same time
    period with no risk if no funding advantage were present.  Under our
    definition of arbitrage, arbitrage profit is the amount of profit on
    nonmortgage investments associated with the funding advantage from
    government sponsorship and not the profit resulting from either
    risk-taking or good business judgement.

    Treasury agreed with our conclusion that the enterprises' long term
    nonmortgage investments generate arbitrage profits and that some of
    the enterprises' short-term investments may also generate arbitrage
    profits.

          TENSION BETWEEN INCREASING
          SHAREHOLDER VALUE AND
          ACHIEVING MISSION
    --------------------------------------------------------- Letter :10.3

    All three enterprises took issue with our conclusion that a tension
    exists between increasing shareholder value and achieving mission.
    Freddie Mac said our draft report suggests that there is an inherent
    conflict between private ownership and Freddie Mac's public mission,
    which is at odds with legislative intent and Freddie Mac's
    demonstrated record of achievement.  Fannie Mae said that although we
    provided a good review of the policies underpinning its executive
    compensation policy, our "tension" construct implies a conflict that
    is theoretical at best.  Fannie Mae offered a construct where senior
    management is required to achieve multiple objectives.  Fannie Mae
    adds:  "What is unique to the enterprises is that our mission is
    elevated by the Charter and enforced through oversight, regulation
    and potential legal sanction.  The seriousness of our mission
    obligations are very clearly understood by managers, Directors and
    shareholders alike." Farmer Mac believes that there is a convergence
    of, rather than a tension between, the interests of Farmer Mac's
    shareholders and mission achievement through expanded volume, because
    of Farmer Mac's early stage of development.

    In our report, our finding of a tension between increasing
    shareholder value and mission fulfillment points to the role of
    mission regulation in helping to ensure that the purposes of the
    charter acts are achieved.  We recognize that Congress granted the
    housing enterprises federal charters to direct them to bring private
    sector operating efficiencies to fulfill a public purpose in the
    secondary mortgage market.  Congress also granted regulatory
    authorities to OFHEO to help ensure that the housing enterprises
    operate in a safe and sound manner and to HUD to ensure that the
    purposes of the respective charter acts are accomplished.  Therefore,
    it appears that Congress intended regulatory oversight to address
    situations in which the private and public interests may not be
    aligned.  Government sponsorship of the housing enterprises has
    created a mechanism for the government-provided benefits to be passed
    through, at least in part, in the form of lower mortgage interest
    rates.  Because this mechanism is not present for nonmortgage
    investments, at least some of these investments could be more
    profitable on a risk-adjusted basis than mortgage investments.  To
    the extent that profits from some nonmortgage investments are less
    clearly related to mission, reasonable questions can be raised about
    whether government benefits are supporting shareholder interests at
    the expense of the public mission.  Fannie Mae's view explicitly
    acknowledges charter restrictions, regulatory oversight, and multiple
    corporate goals.  Therefore, it is difficult to distinguish its view
    from ours, except that Fannie Mae appears to believe that the mission
    has been integrated into its corporate culture.  Rather than relying
    solely on corporate culture, however, Congress established HUD as a
    regulator to ensure that mission objectives are achieved.  Farmer
    Mac's debt issuance strategy has expanded the volume of
    nonagricultural-mortgage investments.  Although it is clear that
    these investments are profitable and affect executive compensation,
    it is not yet clear whether they contribute to mission achievement.

    --------------------------------------------------------- Letter :10.4

    As arranged with your office, unless you publicly announce the
    contents of this letter report earlier, we plan no further
    distribution until 14 days after its issue date.  At that time, we
    will send copies to HUD; OFHEO; FCA; Treasury; the enterprises; the
    Ranking Minority Member of your Committee; the Chairman and Ranking
    Minority Member of the Subcommittee on Capital Markets, Securities
    and Government Sponsored Enterprises; and the Chairman and Ranking
    Minority Member of the Senate Committee on Banking, Housing, and
    Urban Affairs.  We will also make copies available to others on
    request.

    Major contributors to this report are listed in appendix X.  Please
    contact me or Bill Shear, Assistant Director, at (202) 512-8678 if
    you or your staff have any questions.

    Sincerely yours,

    Thomas J.  McCool
    Director, Financial Institutions
     and Markets Issues

    MEASURING ARBITRAGE PROFITS
    =========================================================== Appendix I

    We are defining the term arbitrage to mean using the funding
    advantage from government sponsorship to raise funds for making
    nonmortgage investments.  In a previous report about the housing
    enterprises, we concluded that the largest enterprise benefit from
    government sponsorship flows from the market perception of an implied
    guarantee on enterprise obligations, because this perception
    generates a funding advantage--a reduction in yields on enterprise
    debt.\43 In that report, we indicated that the funding advantage
    could be in the range of 30 to 106 basis points.  This range
    accounted for the long-term nature of residential mortgage
    investments, and it assumed that the housing enterprises would
    receive a credit rating between a high of AAA and a low of A if their
    government sponsorship were eliminated.

    Our definition of arbitrage does not require the enterprise to match
    fund its nonmortgage investments.  However, our measurement of the
    yield differences used to estimate arbitrage profits is based on a
    comparison of debt securities with similar maturity and risk.  Under
    this method, if the debt securities being compared had different
    maturities, the yield difference (i.e., yield spread) would reflect
    both the impact of government sponsorship and the difference in
    interest rate risk between the debt securities.  Alternatively, if
    the debt securities being compared had similar maturities and risks
    but differed by virtue of government sponsorship, the yield
    difference would reflect the impact of government sponsorship.  For
    this reason, matched maturity debt provides the best measure of
    arbitrage, even though arbitrage is also present when nonmortgage
    investments are funded by enterprise debt with different maturities
    and risks.

    In addition to relying on yield differences between enterprise
    nonmortgage investments in corporate bonds and matched maturity
    enterprise debt used to finance such investments as a measure of
    arbitrage, another possible approach to measuring arbitrage is to use
    statistical techniques to adjust yield differences between corporate
    and enterprise debt for differences in maturity and risk.  Such an
    approach was used in a study commissioned by the Department of
    Housing and Urban Development to evaluate the implications of
    severing government sponsorship of the housing enterprises on the
    enterprises' debt costs.\44 The study included analysis of yield
    differences between housing enterprise debt and debt issued by
    different groups of corporations (i.e., the benchmark groups) with A,
    AA, and AAA credit ratings.  The benchmark groups were chosen on the
    assumption that the housing enterprises would have credit ratings in
    this range if their federal charters were revoked.  The analysis was
    complex, because bond characteristics differ between bonds issued by
    the enterprises and other issuers.  Ambrose and Warga recognized how
    difficult their research task was and qualified their results on the
    basis of the statistical complexities.

    We relied on the Ambrose and Warga study results for the period 1991
    through 1994, in part, in making our estimate that the housing
    enterprises' funding advantage from government sponsorship could be
    in the range of 30 to 106 basis points.  Due to the statistical
    complexities of their analysis, we concluded that their estimates
    lacked precision.  Therefore, we used this broad range for the
    funding advantage on debt.

    Recently, the Standard and Poor's (S&P) credit rating agency rated
    each housing enterprise for its government risk rating, which is
    based on the probability that the federal government would be called
    upon in the event of an enterprise default on its obligations.  Each
    enterprise received an AA minus rating.  S&P indicated that the
    rating for each enterprise still accounted for some benefits, namely
    liquidity of enterprise obligations, due to government sponsorship.
    If the enterprises were privatized, S&P said that each would likely
    have to raise additional equity capital to maintain an AA minus
    rating.

    The housing enterprises fund their nonmortgage investments with
    noncallable debt.  Generally, the Ambrose and Warga yield spread
    estimates were smaller for noncallable than for callable debt.  On
    the basis of the S&P credit ratings and the way the enterprises fund
    their nonmortgage investments, we have concluded that the Ambrose and
    Warga estimated yield spreads based on the A and AA credit ratings
    for issuance of noncallable debt are most relevant for measuring
    arbitrage profits.  For the 1991 through 1994 period, the range of
    estimated yield spreads on noncallable debt between the AA-rated
    companies and the housing enterprises was 39 to 46 basis points; when
    the A-rated companies were used as the benchmark, the range was 65 to
    72 basis points.  We continue to support the Ambrose and Warga
    estimates and our estimated range of 30 to 106 basis points for the
    funding advantage; findings from our analysis of housing enterprise
    financial data are consistent with these estimates.

    As indicated in the body of this report, we could not estimate the
    funding advantage resulting from government sponsorship for Farmer
    Mac.  However, we indicated qualitatively how Farmer Mac's funding
    advantage could compare to the funding advantage of the housing
    enterprises.

    --------------------
    \43 GAO/GGD-96-120, May 13, 1996.

    \44 Brent W.  Ambrose and Arthur Warga, "Implications of
    Privatization:  The Costs to Fannie Mae and Freddie Mac," in HUD,
    Studies on Privatizing Fannie Mae and Freddie Mac (May 1996), pp.
    169-204.

    COMPENSATION STRUCTURE FOR BOARD
    MEMBERS AND SENIOR MANAGERS
    ========================================================== Appendix II

    The enterprises' management and boards of directors have implemented
    compensation policies designed to attract and retain individuals from
    various disciplines who have the talent and motivation needed to
    accomplish the corporations' objectives.  The enterprises seek to
    closely link pay with performance and provide compensation that is
    reasonable and comparable with compensation for employment in other
    similar businesses involving similar duties and responsibilities.\45
    Through committees, the enterprises' boards of directors develop
    policies and administer compensation programs that are meant to
    conform to the congressional mandate.

    Freddie Mac's overall compensation package consists of both direct
    compensation (i.e., cash and stock incentives) and noncash employee
    benefit programs.  A base salary, an annual cash bonus, and long-term
    stock incentives are included in the direct compensation package.
    Base salaries are determined primarily by position and individual
    skills and are targeted to match the median (i.e., 50th percentile)
    level of the market as determined by data obtained from comparator
    groups (e.g., companies identified as being in a similar line of
    business) and market surveys.  Annual cash bonuses, which function as
    short-term incentives, are based on a combination of individual and
    corporate performance and increase as a percentage of base salary at
    successively higher levels of responsibility and accountability.
    Long-term stock incentives are awarded to officers and director-level
    employees (i.e., employees who report directly to officers or are
    senior-level technical and professional employees, but not members of
    Freddie Mac's Board of Directors).  For officers, long-term stock
    incentives are awarded as a percentage of base salary and increase as
    a percentage of base salary at successively higher levels of
    responsibility.  The director-level employee is awarded long-term
    stock incentives as a percentage of the director-level salary grade
    midpoint.  Freddie Mac's long-term stock incentives include
    restricted stock, which is awarded to the corporation's executive
    officers, and stock options.  Examples of noncash employee benefits
    offered to all regular employees include an individually structured
    benefits package (i.e., health care, life insurance, etc.); a pension
    plan; and an employee stock purchase plan.

    Fannie Mae's compensation package consists of a base salary, employee
    benefits, annual incentives, and long-term incentives.  The salary is
    based on individual skills, experience, performance, etc; benefits
    include such provisions as insurance coverage, vacation pay, sick
    leave, and retirement.  Annual incentives reward employees for
    reaching specific objectives or completing projects that enhance the
    corporation's success for that year, and long-term incentives
    generally reward executives for shareholder gains and the achievement
    of specific corporate objectives.

    Today, Farmer Mac's salaries and other compensation components are
    based on surveys of pay structures at other enterprises and other
    financial institutions; however, this was not always the case.
    Although its salary compensation policies were generally competitive,
    Farmer Mac officials told us that other aspects of its compensation
    were not.  In 1995, assisted by a compensation consultant, Farmer Mac
    recognized the need to revise its compensation policies to emphasize
    the creation of a greater management equity stake in Farmer Mac's
    future.  Consequently, the consultant helped Farmer Mac to establish
    a baseline compensation package for its staff that now includes an
    annual salary, annual bonus to award current-year contributions to
    Farmer Mac's success, and long-term compensation (stocks and options)
    to ensure that directors and senior managers hold an equity interest
    in the corporation to provide the incentive to ensure the long-term
    survival of Farmer Mac.  Officers and employees are also provided
    certain benefits, such as health and life insurance and a pension
    plan.

    As of December 31, 1996, Farmer Mac had 21 employees.  The proportion
    of Farmer Mac's total compensation package representing incentive
    compensation for the 1995-96 plan year was 26 percent for the Chief
    Executive Officer and ranged between 13 percent and 19 percent for
    other senior management personnel.  As recommended by a consultant, a
    portion of incentive compensation ranging from 67 percent to 88
    percent represented stock grants and stock option awards.  Incentive
    compensation was linked to the evaluation of each individual's
    performance, based on standards that included professional
    competence, motivation, and effectiveness, as well as the
    individual's contribution to the implementation of strategies
    designed to achieve the objectives set forth in Farmer Mac's business
    plan for the 1995-96 plan year.

    The purpose of Farmer Mac's stock option plans is to encourage stock
    ownership by directors, officers, and other key employees to provide
    an incentive for such individuals to expand and improve the business
    of the corporation and to assist Farmer Mac in attracting and
    retaining key personnel.  As with the other enterprises, the use of
    stock options is an attempt to align the long-term interests of
    employees more closely with those of Farmer Mac's stockholders by
    providing employees with the opportunity to acquire an equity
    interest in Farmer Mac.

    (See figure in printed edition.)Appendix III

    --------------------
    \45 For the housing GSEs, these considerations are set forth at 12
    U.S.C.  �� 1452 (c), (h)(2) (Freddie Mac), 12 U.S.C.  �� 1723a
    (d)(2), (3)(B) (Fannie Mae).  There are no similar statutory
    provisions covering compensation at Farmer Mac, but Farmer Mac
    officials told us that such factors are included in determining
    officer and director compensation levels.

    COMMENTS FROM FREDDIE MAC
    ========================================================== Appendix II

    See comment 1.

    (See figure in printed edition.)

    See pp.  5, 31,
    and 32.

    See p.  35.

    See pp.  36-37.

    (See figure in printed edition.)

    See pp.  5, 31
    and 32.

    Now on p.  5,
    fn.  7.

    Now on p.  5.

    Now on p.  26.

    Now on pp.  15
    and 16.

    (See figure in printed edition.)

    (See figure in printed edition.)

    See p.  35.

    See comment 2.

    Now on p.  27.

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    The following comments represent our response to specific comments
    made on a draft of this report on January 12, 1998, by the Chairman
    and Chief Executive Officer of Freddie Mac.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:1

    1.  Freddie Mac said that we calculate nonmortgage assets as a
    percentage of on-balance sheet assets and that this exaggerates the
    size of nonmortgage investments in relation to Freddie Mac's total
    mortgage-related activities.  We calculate nonmortgage investments as
    a percentage of (1) on-balance sheet assets; (2) total mortgage
    servicing portfolio; and (3) capital (i.e., corporate equity).  The
    second measure captures Freddie Mac's total mortgage-related
    activities.  The second measure is relevant if the sole purpose of
    the nonmortgage investments is, by definition, to support the total
    mortgage servicing portfolio.  However, we provide the first and
    third measures because of their relevance in cases where the
    relationship of nonmortgage investments to mission is not clear.  For
    example, both measures are relevant for comparisons among different
    corporations competing in the financial services industry.

    2.  Freddie Mac stated that its debt and MBS markets are not immune
    from disruption and states the example, ".  .  .  should secondary
    market investors begin to sell large amounts of long-term
    mortgage-backed securities, the `spreads' on these securities against
    Treasury bond benchmarks would widen (.  .  .  perhaps
    significantly)." Freddie Mac added that it could only make matters
    worse in this environment by issuing new MBS.  Freddie Mac does not
    specify the economic conditions that would cause investors to sell
    large amounts of MBS so that the value of MBS relative to Treasury
    securities would fall, while at the same time there would be such an
    unexpected surge in mortgage demand that would require liquidation of
    core fund investments.  During the course of our assignment, we asked
    Freddie Mac to provide analyses indicating the economic conditions
    that would require sales of nonmortgage investments from the core
    portfolio to purchase mortgages.  With respect to the examples
    Freddie Mac provided, in our report we analyzed alternative
    mechanisms available to Freddie Mac for funding unexpected mortgage
    demand.  These alternatives have been successfully employed by the
    housing enterprises in the past to meet their charter
    responsibilities.  (See pp.  26-27.)

    3.  Freddie Mac takes issue with our definition of arbitrage, which
    is similiar to the definition of an arbitrage bond in the U.S.  tax
    code.  It said:  "In the municipal bond context, however, Congress
    disapproved what it viewed as the inappropriate conversion of federal
    Treasury securities into municipal bonds, the proceeds of which were
    never applied for any legitimate governmental purposes.  Freddie
    Mac's nonmortgage investments, in contrast, directly serve our
    statutory purposes of providing liquidity and stability to the
    mortgage market." Here, we again note that the relationship between
    the various nonmortgage investments and mission achievement is less
    clear for the longer term than the shorter term nonmortgage
    investments.  Therefore, we have concluded that the analogy to
    municipal bonds in defining arbitrage is appropriate.

    4.  Freddie Mac disagrees with our use of the range of 30 to 106
    basis points to represent the housing enterprises' funding advantage
    on debt.  Freddie Mac's comments and our response appear in the
    previous GAO report establishing this range.\46 In its comment letter
    in this report, it cited its analysis of the yield spread on 5-year
    bullet debt between housing enterprise debt and debt of A and AA
    rated companies to illustrate Freddie Mac's disagreement with our
    range.  Freddie Mac also noted that the data upon which this range
    was established are from the 1991 to 1994 time period.  We first
    became aware of the Freddie Mac analysis when it was submitted for
    the record at congressional hearings on July 31, 1996, after we
    completed our previous (i.e., privatization) study identifying the
    30- to 106-basis-point range.  Although we have not thoroughly
    analyzed the methodology (including its emphasis on 5-year debt
    rather than debt issues with longer maturities) or data relied upon
    in the Freddie Mac analysis, we note that the findings on yield
    spreads from the Freddie Mac analysis are in the vicinity of the
    bottom of our range (see reference to the 36-basis-point average
    cited by Freddie Mac).  In addition, our findings from our analysis
    of housing enterprise financial data during this assignment are
    consistent with the estimated funding advantage range we established
    in our previous report and rely upon in this report.  The housing
    enterprise financial data and the Standard and Poor's credit ratings
    we relied upon for our analysis during the course of this assignment
    are more recent than the data relied upon in the Freddie Mac
    analysis.

    5.  Freddie Mac disagreed with our "draft report's estimates of
    potential arbitrage profits based on an assumed portfolio that is
    nearly 17 times larger than Freddie Mac's current longer-term
    nonmortgage investments." We provide this estimate as an example of
    how much a $10 billion fund, the authorized level for Freddie Mac's
    core fund, can generate in arbitrage profits.  We also make reference
    to the $2 billion forecasted level for year-end 1997 holdings in the
    core fund.

    (See figure in printed edition.)Appendix IV

    --------------------
    \46 GAO/GGD-96-120, May 13, 1996, pages 49-53.

    COMMENTS FROM FANNIE MAE
    ========================================================== Appendix II

    (See figure in printed edition.)

    See pp.  32 and 33.

    See comment 1.

    (See figure in printed edition.)

    See pp.  36 and 37.

    (See figure in printed edition.)

    See comment 2.

    (See figure in printed edition.)

    Now on p.  2.

    Now on p.  10.

    Now on p.  16.

    The following comments represent our response to specific comments
    made on a draft of this report on January 12, 1998, by the Vice
    President for Regulatory Activities at Fannie Mae.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:2

    1.  Fannie Mae stated that the yield on the longer term investments
    is less than that of mortgage investments.  This simple yield
    comparison does not take into account the risks, in particular
    interest rate and prepayment risks, that accompany residential
    mortgage investments.  Our report states that government sponsorship
    of the housing enterprises lowers yields on single-family,
    fixed-rate, conforming mortgages.  This mechanism is not present for
    nonmortgage investments.  Therefore, we conclude that on a
    risk-adjusted basis, some nonmortgage investments are more profitable
    than mortgage investments.

    2.  Fannie Mae said that we should amplify "the degree to which the
    corporation incents and holds management accountable for meeting
    mission obligations." We did not review contracts of individual
    managers and members of Fannie Mae's Board.  Because of the
    proprietary nature of the information, we could not have provided
    concrete examples to make such an amplification.

    (See figure in printed edition.)Appendix V
    COMMENTS FROM FARMER MAC
    ========================================================== Appendix II

    (See figure in printed edition.)

    See comment 1.

    (See figure in printed edition.)

    Now on pp.  29 and 31.

    See p.  25, fn.  36.

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    See comment 2.

    (See figure in printed edition.)

    Now on p.  29.

    See comment 3.

    Now on p.  31.

    See comment 4.

    (See figure in printed edition.)

    Now on p.  4.

    Now on p.  5.

    See p.  31.

    See comment 5.

    Now on pp.  45-47.

    Now on p.  31.

    (See figure in printed edition.)

    GAO note:
    We did not
    reproduce
    the
    appendix

    The following comments represent our response to specific comments
    made on a draft of this report on January 12, 1998, by the President
    and Chief Executive Office of Farmer Mac.

       GAO COMMENTS
    -------------------------------------------------------- Appendix II:3

    1.  Farmer Mac stated that long-term investments with short-term
    interest rate resets are generally considered to have short-term
    liquidity.  We have concluded from our analysis that Farmer Mac's
    longer term, variable-rate, nonagricultural-mortgage investments are
    subject to greater market value fluctuations with changes in interest
    rates than short-term investments.  As a result, they are less useful
    in facilitating liquidity in the agricultural mortgage market than
    short-term investments.

    2.  Farmer Mac suggested that a reasonable time frame for reaching
    the final stage of its debt issuance strategy could be 2 to 3 years
    following adoption of the strategy.  As far as we know, this is the
    first time a time frame has been suggested as a reasonable period of
    time for the debt issuance policy to contribute to mission.

    3.  Farmer Mac took issue with our observation that Farmer Mac's debt
    issuance strategy, which intends to lower the funding costs to
    purchase agricultural mortgages and issue AMBS, appears to us to
    contradict, at least in part, our observation that Farmer Mac has not
    offered higher prices for agricultural mortgages.  Farmer Mac states
    that the agricultural mortgage origination market is currently very
    inefficient, and therefore Farmer Mac is directing funds made
    available by the debt issuance strategy toward expanded efforts to
    recruit new mortgage originators.  We revised our discussion (see
    page 29) and, rather than referring to a possible contradiction, we
    now directly relate these observations to the uncertainty associated
    with the effectiveness of Farmer Mac's debt issuance strategy on
    mission achievement.

    4.  Farmer Mac said that it agrees with our recommendation to the FCA
    Board to report on the relationship of Farmer Mac's debt issuance
    strategy to the achievement of Farmer Mac's mission.  Its letter
    added that FCA already monitors Farmer Mac's investment activity.  We
    note, as indicated in our report, that FCA's monitoring of Farmer
    Mac's investment activity has focused on matters of safety and
    soundness.  Our recommendation is specific to FCA's mission oversight
    responsibilities.

    5.  Farmer Mac said that for the quarter ended June 30, 1997, Farmer
    Mac's net income from nonprogram investments represented about 38
    percent of total net income.  In response, we made revisions (see pp.
    5 and 31) and now state that nonagricultural-mortgage investments are
    a primary source of income rather than the principal source or
    majority of income.

    (See figure in printed edition.)Appendix VI
    COMMENTS FROM THE DEPARTMENT OF
    HOUSING AND URBAN DEVELOPMENT
    ========================================================== Appendix II

    comment
    supplementing those in the
    report text appears at the end of this appendix.

    (See figure in printed edition.)

    See comment 1.

    Now on p.  14.

    See p.  14.

    (See figure in printed edition.)

    See pp.  14 and 15.

    Now on p.  14.

    Now on p.  14.

    Now on p.  11.

    (See figure in printed edition.)

    Now on p.  11.

    GAO note:
    We did not
    reproduce the
    enclosure.

    The following comment represents our response to a specific comment
    made on a draft of this report on January 16, 1998, by the Assistant
    Secretary for Housing-Federal Housing Commissioner at HUD.

       GAO COMMENT
    -------------------------------------------------------- Appendix II:4

    1.  HUD took exception to our characterization of the expertise issue
    in HUD's approval of MPP.  In particular, HUD's comment letter stated
    that some statements in our draft report appear to be based on
    misunderstandings of statements made by HUD staff.  HUD stated that
    HUD did not possess detailed knowledge of the intricacies of the life
    insurance industry at the time MPP was submitted for review.
    However, HUD also stated that it concluded it was unnecessary to
    provide MPP materials to Treasury because HUD had obtained sufficient
    information and analysis to complete its work.  HUD said that this
    conclusion, rather than a HUD determination that it could not share
    the contents of the MPP proposal due to a potential conflict of
    interest within Treasury, formed the basis for not providing MPP
    materials to Treasury.  We made revisions to our report (see pages
    13-15) and state HUD's position as described in its comment letter.

    (See figure in printed edition.)Appendix VII
    COMMENTS FROM THE OFFICE OF
    FEDERAL HOUSING ENTERPRISE
    OVERSIGHT
    ========================================================== Appendix II

    (See figure in printed edition.)

    (See figure in printed edition.)Appendix VIII
    COMMENTS FROM THE FARM CREDIT
    ADMINISTRATION
    ========================================================== Appendix II

    comment
    supplementing those in the
    report text appears at the end of this appendix.

    Now on pp.  9-13.

    See comment 1.

    See pp.  9
    and 30.

    The following comment represents our response to a specific comment
    made on a draft of this report on January 6, 1998, by the Chairman
    and Chief Executive Officer of the FCA Board.

       GAO COMMENT
    -------------------------------------------------------- Appendix II:5

    1.  FCA stated that discussion on pages 9 through 13 of our draft
    report indicated a misunderstanding of its past and current thinking
    and position, namely that FCA has clear safety and soundness
    authority and has concluded that no safety and soundness concerns
    exist at Farmer Mac.  These FCA positions had been expressed in a
    previous section of the draft report dealing with safety and
    soundness oversight.  The section FCA discusses relates to FCA's
    general regulatory authority.  In response to FCA's comment, we added
    some clarifying language to our discussion on FCA's general
    regulatory authority.

    (See figure in printed edition.)Appendix IX
    COMMENTS FROM THE DEPARTMENT OF
    THE TREASURY
    ========================================================== Appendix II

    (See figure in printed edition.)

    MAJOR CONTRIBUTORS TO THIS REPORT
    =========================================================== Appendix X

       GENERAL GOVERNMENT DIVISION
    --------------------------------------------------------- Appendix X:1

    William B.  Shear, Assistant Director
    Marion L.  Pitts, Evaluator-in-Charge
    James R.  Black, Senior Evaluator
    Edward S.  Wroblewski, Senior Evaluator

       OFFICE OF THE GENERAL COUNSEL
    --------------------------------------------------------- Appendix X:2

    Paul G.  Thompson, Senior Attorney

    *** End of document. ***