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.  ï¿½ 1452(d). 

\9 12 U.S.C.  ï¿½ 1723a(a). 

\10 12 U.S.C.  ï¿½ 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.  ï¿½ 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.  ï¿½ï¿½
4501-4641. 

\12 See 12 U.S.C.  ï¿½ 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.  ï¿½ 4541. 

\14 Id. 

\15 See 12 U.S.C.  ï¿½ 1452(b) (1991 Supp.) (Freddie Mac); 12 U.S.C.  ï¿½
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.  ï¿½ï¿½ 2243, 2252. 

\18 12 U.S.C.  ï¿½ 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. 
ï¿½ 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.  ï¿½ï¿½ 1452 (c), (h)(2) (Freddie Mac), 12 U.S.C.  ï¿½ï¿½ 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. ***