Farmer Mac: Revised Charter Enhances Secondary Market Activity, but
Growth Depends on Various Factors (Letter Report, 05/21/99,
GAO/GGD-99-85).

Pursuant to a congressional request, GAO reviewed the progress that the
Federal Agricultural Mortgage Corporation (Farmer Mac) has made in
achieving its statutory mission and examined its future viability,
focusing on: (1) actions taken by Farmer Mac to promote the development
of a secondary market, including the introduction of new programs and
products; the standardization of loan processes, including loan
documents and underwriting standards; and the use of risk management
techniques to facilitate safe and sound secondary market activities; and
(2) Farmer Mac's future viability and the potential benefits and costs
of a government-sponsored secondary market for agricultural mortgages.

GAO noted that: (1) in an attempt to make the secondary market in
agricultural mortgages an attractive alternative for lenders, Farmer Mac
has: (a) used its enhanced charter authorities to develop new programs
and products and streamlined the process for buying loans; (b)
standardized certain aspects of the loan processes, such as
underwriting; and (c) developed risk management techniques to facilitate
safe and sound secondary market activities; (2) while these efforts have
increased secondary market activity, Farmer Mac's share of the overall
agricultural mortgage market remains small, about 1.2 percent; (3) since
its 1996 restructuring, Farmer Mac has introduced programs to directly
purchase agricultural mortgages from lenders and to exchange
agricultural mortgage-backed securities for mortgage loans held by
lenders; (4) Farmer Mac also recently introduced a program (called
AgVantage) through which it provides to agricultural lenders loans that
are based on agricultural mortgage collateral; (5) Farmer Mac has
standardized some aspects of secondary market transactions by requiring
participating lenders to attest that their loans meet Farmer Mac
underwriting standards; (6) Farmer Mac has not developed standardized
loan documents because it believes the cost would be prohibitive given
the state-by-state variability of laws governing agricultural mortgages;
(7) Farmer Mac purchased futures and options to help manage the
interest-rate risk of those loans it held in its portfolio, and its risk
management techniques appeared to be generally consistent with industry
risk management principles; (8) it appears that Farmer Mac could
continue to be viable if: (a) its recent rate of expansion is
maintained; (b) it continues to experience rates of return that are
comparable to current levels; and (c) economic conditions in the
national and agricultural economies remain stable; (9) events such as a
less favorable interest-rate environment or declines in the credit
quality of agricultural mortgages could reduce Farmer Mac's future
profitability; (10) one important determinant of the net benefits
generated by Farmer Mac is the extent to which its activities compete
with or complement those of other government sponsored enterprises
(GSE); and (11) because there is potential for mission overlap among
Farmer Mac, Farm Credit System (FCS), and the Federal Home Loan Bank
(FHLBank) System, new or expanded activities by one of these entities
can affect the benefits generated by the other two.

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

 REPORTNUM:  GGD-99-85
     TITLE:  Farmer Mac: Revised Charter Enhances Secondary Market
	     Activity, but Growth Depends on Various Factors
      DATE:  05/21/99
   SUBJECT:  Government sponsored enterprises
	     Mortgage programs
	     Risk management
	     Redundancy
	     Agricultural programs
	     Mortgage loans
	     Government guaranteed loans
	     Mortgage-backed securities
	     Lending institutions
	     Farm credit
IDENTIFIER:  Farmer Mac AgVantage Program
	     Farmer Mac Cash Window Program

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Farmer Mac Revised CharterEnhances Secondary

Market Activity, butGrowth Depends on Various Factors

United States General Accounting OfficeGAO Report to the Chairman,
Subcommittee on Capital Markets, Securities andGovernment-
Sponsored Enterprises, Committee on Banking and FinancialServices,
House of Representatives

May 1999

GAO/GGD-99-85

United StatesGeneral Accounting Office Washington, D.C.  20548

General Government Division

B-280648

Page 1 GAO/GGD-99-85 Enhancing AgMortgage Liquidity

GAO

May 21, 1999 The Honorable Richard H. BakerChairman, Subcommittee
on Capital Markets,    Securities and Government-Sponsored
EnterprisesCommittee on Banking and Financial Services House of
Representatives Dear Mr. Chairman: The Federal Agricultural
Mortgage Corporation (Farmer Mac) is agovernment-sponsored
enterprise (GSE) that was established in 1988 with a statutory
mission to create a secondary market in agricultural
mortgages,thus improving the availability of agricultural mortgage
credit. By 1996, it was evident that Farmer Mac was having
difficulties fulfilling its statutorymission. To relieve
structural impediments that had limited Farmer Mac's ability to
function efficiently, Congress passed the Farm Credit SystemReform
Act of 1996 (the 1996 Act), which significantly revised Farmer
Mac's statutory authorities. You asked us to review the progress
that Farmer Mac has made inachieving its statutory mission and
examine its future viability. Our objectives were to (1) examine
actions taken by Farmer Mac to promotethe development of a
secondary market, including the introduction of new programs and
products; the standardization of loan processes, includingloan
documents and underwriting standards; and the use of risk
management techniques to facilitate safe and sound secondary
marketactivities, and (2) analyze Farmer Mac's future viability
and discuss the potential benefits and costs of a government-
sponsored secondary marketfor agricultural mortgages.

In an attempt to make the secondary market in agricultural
mortgages anattractive alternative for lenders, Farmer Mac has (1)
used its enhanced charter authorities to develop new programs and
products and streamlinedthe process for buying loans; (2)
standardized certain aspects of the loan processes, such as
underwriting; and (3) developed risk managementtechniques to
facilitate safe and sound secondary market activities. While these
efforts have increased secondary market activity, Farmer
Mac'sshare of the overall agricultural mortgage market remains
small, about 1.2 percent. Since its 1996 restructuring, Farmer Mac
has introduced programs todirectly purchase agricultural mortgages
from lenders and to exchange

Results in Brief

B-280648

Page 2 GAO/GGD-99-85 Enhancing AgMortgage Liquidity agricultural
mortgage-backed securities (AMBS) for mortgage loans heldby
lenders. Farmer Mac also has recently introduced a program (called
AgVantage) through which it, in effect, provides to agricultural
lendersloans that are based on agricultural mortgage collateral.
Farmer Mac has standardized some aspects of secondary market
transactions by requiringparticipating lenders to attest that
their loans meet Farmer Mac underwriting standards. However,
Farmer Mac has not developedstandardized loan documents because it
believes the cost would be prohibitive given the state-by-state
variability of laws governingagricultural mortgages. Farmer Mac
has also modified its loan underwriting standards by, for example,
requiring larger down payments toaddress its increased exposure to
credit risk allowed under the 1996 Act. Farmer Mac purchased
futures and options to help manage the interest-rate risk of those
loans it held in its portfolio, and its risk management techniques
appeared to be generally consistent with industry riskmanagement
principles.

On the basis of our analysis, it appears that Farmer Mac could
continue tobe viable if (1) its recent rate of expansion is
maintained, (2) it continues to experience rates of return that
are comparable to current levels, and (3)economic conditions in
the national and agricultural economies remain stable. For our
analysis, we defined viability as the ability of Farmer Macto
generate sufficient profit from its core business operations in
the secondary market in agricultural mortgages to provide a
reasonable returnto its investors.

There are trends (such as those previously cited) and events that
couldimprove or worsen Farmer Mac's financial condition. If Farmer
Mac develops new programs and products that are attractive to
lenders or ifFarm Credit System (FCS) institutions or other
lenders increase participation in Farmer Mac programs, Farmer
Mac's financial conditioncould improve. However, events such as a
less favorable interest-rate environment or declines in the credit
quality of agricultural mortgagescould reduce Farmer Mac's future
profitability.

Even if Farmer Mac is viable under its current operating
structure, themore fundamental public policy issue is whether the
public benefits it generates are greater than the potential public
costs it imposes. Oneimportant determinant of the net benefits
generated by Farmer Mac is the extent to which its activities
compete with or complement those of otherGSEs. Because there is
potential for mission overlap among Farmer Mac, FCS, and the
Federal Home Loan Bank (FHLBank) System, new orexpanded activities
by one of these entities can affect the benefits

B-280648 Page 3 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
generated by the other two. In judging Farmer Mac's overall level
of publicbenefit, Congress may want to consider how Farmer Mac
interacts with these other GSEs. The Agricultural Credit Act of
1987 (the 1987 Act) authorized Farmer Macto promote the
development of a secondary market for agricultural real estate and
rural housing loans. As a GSE, Farmer Mac is a federallychartered,
privately owned and operated corporation that operates as a
special purpose corporation. Farmer Mac is also an independent
entitywithin FCS, which is another GSE.

1 When Congress passed the 1987 Act,

some observers stated that a Farmer Mac-sponsored nationwide
secondarymarket would develop quickly and be widely used. Others
stated that

Farmer Mac would serve more as a safety valve for the agricultural
sectorif FCS encountered difficulties.

A secondary market is a financial market for buying and selling
loans,either individually or in the form of securities backed by
cash flows from groups or "pools" of loans. By authorizing Farmer
Mac to promote thedevelopment of an agricultural secondary market,
Congress intended to (1) increase the availability of long-term
financing to creditworthy farmersand ranchers at stable interest
rates and (2) provide greater liquidity

2 in

agricultural financing. Ideally, such a market would provide
agriculturallenders with access to national capital markets,
which, by returning cash

to such lenders in exchange for the mortgages, would generate
additionalfunds for them to lend and enhance their ability to
manage credit and interest-rate risks. Under Farmer Mac's
originating statute, the 1987 Act, it was only to certifycertain
agricultural lenders and other financial institutions to act as
thirdparty "poolers"*that is, financial institutions that would
buy qualifiedloans from other lenders or "originators," assemble
or "pool" the loans, and issue and sell securities that are backed
by these pools to investors.Farmer Mac guarantees the timely
payment of principal and interest to investors who purchase these
mortgage-backed securities. The originalstatute did not permit
Farmer Mac to buy and hold agricultural loans. The 1987 Act also
required either originators/poolers to maintain a cash reserveto
cover at least the first 10 percent of losses arising from
defaults on the pools of loans backing Farmer Mac-guaranteed
securities or holders ofsubordinated participation interests (SPI)
to absorb these losses before
1In this report, we treat Farmer Mac and FCS as two distinct GSEs.

2A market is more liquid if investors can buy and sell large
amounts of holdings without affecting the prices of the traded
securities.

Background

B-280648

Page 4 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Farmer Mac's
guarantee could be exercised.3 The purpose of the
reserverequirement was to minimize risks to Farmer Mac and the
federal government by requiring originators, poolers, and
investors to hold most ofthe loan's credit risk.

4

Risk-based capital requirements for banks and FCS institutions
requiredthem to hold capital against the full amount of the sold
loan, not just the 10 percent retained by the lender. Regulators
of primary market lenders (e.g.,banks and FCS institutions) viewed
the retained SPI as the source of substantially all of the loan's
credit risk and, therefore, obtaining FarmerMac's guarantee did
not reduce the amount of capital the lender was required to hold.
As a result, the incentive for banks and FCS institutions*major
agricultural mortgage lenders*to sell loans intoFarmer Mac-
guaranteed loan pools was reduced. Further, the 1987 Act

required certain diversification standards to be met--that is,
each pool wasto be made up of loans secured by properties from
different geographic locations that produce different agricultural
commodities. The necessity to operate through third-party poolers
and establish themandatory cash reserve or SPI increased the
complexity and expense of secondary market transactions to both
Farmer Mac and lenders. Under itsoriginal operating structure,
Farmer Mac was unable to achieve a profit, and its prospects for
survival were dim. Eight years after its creation, Farmer Mac
faced possible financial failureand was ineffective in creating a
successful agricultural secondary market.

5

Farmer Mac requested and Congress granted new statutory
authorities inthe 1996 Act to improve Farmer Mac's ability to
fulfill its statutory mission.

Among other things, the revised charter allowed Farmer Mac to
(1)purchase agricultural mortgage loans directly from lenders and
serve as a pooler, (2) eliminate the mandatory 10-percent minimum
cash reserve andSPI required with each loan pool and also
eliminate the loan diversification

3SPIs represent the right to receive a portion of the principal
and interest payments on a loan or poolof loans, but only after
investors in the Farmer Mac-guaranteed securities backed by these
pools had

received all payments due to them. Originators could have retained
SPIs in the loans they sold toFarmer Mac or they could have sold
SPIs to a pooler.

4The required 10-percent loss reserve generally exceeded
historical worst-case scenarios by a wide margin. 5According to
our prior work, some factors that contributed to the slow
development of the agricultural secondary market included: strong
liquidity of agricultural lenders, stringent regulatorycapital
requirements for banks and FCS institutions originating
agricultural mortgages, and weak loan

demand*especially for long-term, fixed rate loans.  See Federal
Agricultural Mortgage Corporation:Secondary Market Development
Slow and Future Uncertain (GAO/RCED-91-181, Sept. 10, 1991).

B-280648 Page 5 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
standards, (3) have its securities accorded full "agency status"
in thefinancial markets,

6 and (4) relax and delay the implementation of

regulatory capital standards for Farmer Mac. The first three
revisionsmade Farmer Mac's operating structure essentially the
same as Freddie

Mac's and Fannie Mae's*the GSE facilitators of the secondary
markets forresidential mortgage loans.

Primary market lenders, secondary market entities, and investors
insecurities backed by cash flows from loan pools face credit,
interest-rate, prepayment, management, and business risks. Farmer
Mac faces credit risk*that is, the possibility of financial loss
resulting from default byborrowers on farming assets that have
lost value and/or other parties'

failing to meet their obligations. This risk occurs when Farmer
Mac holdsmortgages in portfolio and when it guarantees principal
and interest payments to investors in AMBS it issues. Farmer Mac's
interest-rate risk7can result from the possibility of an increase
in interest rates in the national economy that is not matched by
an increase in interest rates paidby borrowers to Farmer Mac for
loans that are held in portfolio by Farmer Mac. Farmer Mac's
prepayment risk can result from the possibility of adecline in
interest rates, which can cause borrowers to prepay their
mortgages.8 Farmer Mac faces management risk from the possibility
offinancial loss resulting from a management mistake that can
threaten the company's viability. Finally, Farmer Mac faces
business risk from thepossibility of financial loss due to
conditions within the agricultural sector that affect loan
performance. The risk characteristics of agricultural mortgage
loans are different fromthose of conventional single-family
residential mortgage loans.

9

Agricultural mortgages are commercial loans that fund a wide
variety ofagricultural activities (e.g., poultry farms or orange
groves), while single

family mortgages fund a fairly homogeneous asset. As a result, in
the eventof loan foreclosure, farm properties can be harder to
appraise and more

6Agency status results from regulatory exemptions and trading
preferences of GSEs' securities. The

1996 Act requires (rather than allows) Federal Reserve Banks to
act as Farmer Mac's depositories andfiscal agents.

7Interest-rate risk is the possibility that a fixed-rate debt
instrument will decline in value as a result of a rise in interest
rates. 8Prepayment risk is the potential loss of anticipated
future income that results from borrowers' paying off their loans
earlier than expected. 9The common definition of a single-family
residential mortgage is a loan for purchase or refinance of a
housing unit in a one- to four-unit structure. A conventional
mortgage loan is one without federalmortgage insurance.

B-280648 Page 6 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
difficult to liquidate than a single-family residence. In
addition, thefinancial and business skills of farm operators can
affect the value of their collateral since their income comes
largely from the mortgaged property,rather than from independent
employment or investment income. As a result, assessing the risks
of cash flows from agricultural loan pools can bemore difficult
than such an assessment for single-family residential mortgages.
To some extent, agricultural mortgage loans are more
likemultifamily loans than single-family loans because multifamily
loans are commercial loans in which income is derived largely from
rental of themortgaged property.

Farmer Mac strives to fulfill its statutory mission mainly by
purchasingagricultural mortgages from lenders. Lenders who
participate in the primary market for such agricultural mortgages
include federally insureddepository institutions, insurance
companies, and FCS institutions. Once purchased by Farmer Mac, the
mortgages can be held directly in portfolioor pooled to back newly
issued AMBS. Farmer Mac, in turn, can hold some AMBS in portfolio
and sell some AMBS to investors in national financialmarkets.

10 About $1.1 billion in total AMBS were outstanding as of year-
end

1998; slightly more than half of the value was held by investors
other thanFarmer Mac. Farmer Mac guarantees timely payment of
principal and

interest to investors in its AMBS. Farmer Mac conducts its
operations through two broadly definedprograms. The Farmer Mac I
Program consists of agricultural and rural housing mortgage loans
that do not contain federally provided primarymortgage insurance.
The Farmer Mac II Program consists of agricultural mortgage loans
containing primary mortgage insurance provided by theU.S.
Department of Agriculture (USDA). Farmer Mac was authorized in the
Food, Agriculture, Conservation, and Trade Act of 1990 (the 1990
Act) tofacilitate the creation of a secondary market for USDA-
guaranteed agricultural loans. Under Farmer Mac II, Farmer Mac can
purchase*or have others purchase*the guaranteed portions of USDA
loans, assemblethem into pools, and hold them in portfolio or sell
them as securities to

investors. At year-end 1998, Farmer Mac held $306.8 million of
Farmer MacII AMBS in portfolio and other investors held $30.1
million.

10Farmer Mac also purchases rural residential mortgage loans and
either holds them in portfolio or

pools them to back newly issued AMBS.

B-280648 Page 7 GAO/GGD-99-85 Enhancing AgMortgage Liquidity We
focused our attention on the secondary market in
agriculturalmortgages under the Farmer Mac I Program because it is
the primary program through which Farmer Mac conducts its
secondary marketactivity. However, we included Farmer Mac II
Program activity in our analysis of Farmer Mac's future viability.
To address our objectives overall,we reviewed relevant literature,
congressional testimony, Securities and Exchange Commission public
filings, and relevant Internet World WideWeb sites. We also held
numerous discussions with Farmer Mac executives and interviewed
representatives of the American BankersAssociation, Independent
Bankers Association of America, and the Farm Credit Council. To
gain a better understanding of the agricultural mortgage market
and itsprospects for future growth, we met with financial and
agricultural economists from USDA's Economic Research Service.
Additionally, toobtain a regulatory perspective on Farmer Mac
activities, we met with officials from the Farm Credit
Administration (FCA), the Director of FCA'sOffice of Secondary
Market Oversight, and the Department of the Treasury's Director of
GSE Policy. In our analysis of the agriculturalmortgage market, we
did not undertake detailed analyses of competing FCS or FHLBank
System products. We also did not analyze the USDA loanguarantee
programs.

To determine Farmer Mac's risk management practices and exposure
toeach type of risk, we (1) obtained Farmer Mac's written and oral
responses to questions on interest-rate, prepayment, credit,
business, andmanagement risks; (2) reviewed corporate policies and
standards, including Farmer Mac's Seller/Servicer Guide (Farmer
Mac guide), whichspecifies lender requirements for participation
in Farmer Mac programs; (3) obtained data on Farmer Mac's current
financial condition andoperating results, such as delinquency
rates and profit margins; (4) reviewed methodologies for
determining capital adequacy, pricing,sensitivity to interest-rate
changes, sensitivity to economic stress, and management
information systems; and (5) examined copies of externalauditors'
reports and management letters. We also reviewed FCA's March 1998
regulatory examination report and discussed the report with
FCAofficials.

To help determine the potential market benefits from a government-
sponsored secondary market for agricultural loans, we conducted a
mail survey of approved Farmer Mac sellers and nonparticipants.11
Using two
11An approved seller is a financial institution that has completed
a seller application (supported by

financial information, proof of sufficient insurance, and evidence
of Farmer Mac stock ownership) and

Scope andMethodology

B-280648

Page 8 GAO/GGD-99-85 Enhancing AgMortgage Liquidity mail
questionnaires, we conducted the survey in late 1998 and early
1999and telephoned selected nonrespondents in 1999. We obtained
information on the background of the financial institutions,
questioned theirknowledge of and participation in Farmer Mac
programs, and sought their views on Farmer Mac and the secondary
agricultural mortgage market.Survey participants were chosen from
lists provided by Farmer Mac. The 263 institutions*commercial
banks, thrifts, mortgage bankers, trust companies, and FCS
institutions*on Farmer Mac's approved sellers list(as of Oct.
1998) and the 331 financial institutions of various sizes with

over $100 million in assets on Farmer Mac's nonparticipants list
(as of Oct.1998) were sent the respective surveys.

12 To the list of 331 nonparticipants,

we added 3 large insurance companies that are agricultural
mortgagelenders that were not on Farmer Mac's list. Our survey
results are not

generalizable to the universe of agricultural lenders, but the
results aregeneralizable to the unique groups identified by Farmer
Mac and us. We did not examine the impact of Farmer Mac on
agricultural mortgageinterest rates or the availability of
agricultural mortgage credit. See appendixes I and II for a more
detailed description of our surveymethodology and survey results,
respectively.

We constructed financial scenarios using various assumptions to
helpillustrate Farmer Mac's ability to sustain mission viability
as described in appendix III. We defined mission viability as the
ability of Farmer Mac togenerate a profit from its core business
of operating a secondary market in agricultural mortgages and to
provide a reasonable rate of return to itsequity investors. Our
purpose was to construct scenarios to illustrate conditions that
could affect Farmer Mac's future viability. These scenariosdo not
represent forecasts of the future. We were limited by our reliance
on publicly available data in presenting our scenarios. We
reviewed the legislative history and statutory authorities
governingFarmer Mac. We also reviewed legal opinions written by
and on behalf of Farmer Mac, FCA, and the Farm Credit Council. The
legal opinionsaddressed whether Farmer Mac has the authority to
undertake the AgVantage Program, which is discussed in more detail
in the next sectionof this report. The opinions also focused on
the statutory language of the Farm Credit Act of 1971 (the 1971
Act), as amended, defining the
had it approved by Farmer Mac. A nonparticipant is a financial
institution that has not been approvedby Farmer Mac to participate
in Farmer Mac's programs.

12By using a Farmer Mac-provided nonparticipants' list of
commercial banks meeting certain Farmer Mac-determined thresholds,
we eliminated from our survey many agricultural banks having
$100million or less in assets.

B-280648 Page 9 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
authorities of Farmer Mac as well as the legislative history of
the 1971 Actand Farmer Mac's mission. We also discussed the legal
opinions with officials from these three entities. To provide a
perspective on secondary market servicing guidelines
andprocedures, in addition to reviewing the Farmer Mac guide, we
reviewed two Fannie Mae guides for servicing single-family and
multifamilyresidential mortgages.

We did not independently verify the information supplied by Farmer
Macor others. We conducted our work in Washington, D.C., between
July 1998 and April1999 in accordance with generally accepted
government auditing standards. We obtained written comments on a
draft of this report fromthe President and Chief Executive Officer
of Farmer Mac. His written comments are discussed at the end of
this letter and are reprinted inappendix IV.

Farmer Mac has developed new programs and products in an attempt
toprovide an alternative source of funding for agricultural
lenders. Farmer Mac also has used its new charter authorities to
streamline the process forbuying loans, including some
standardization, and developed a program to market its products to
agricultural lenders. The market's reception ofFarmer Mac's
products thus far has been limited, and Farmer Mac's loan purchase
volumes have remained small in relation to the primary market.For
example, the share of agricultural mortgages sold to Farmer Mac
has shown some growth since the 1996 restructuring, but its market
sharerepresented about 1.2 percent of the agricultural mortgage
debt outstanding as of the third-quarter of 1998.  In addition to
its loan purchaseprograms, Farmer Mac, in 1998, initiated its
AgVantage Program in which Farmer Mac in effect provides loans to
agricultural lenders with thelenders' using agricultural mortgages
as collateral. Activity under this program has been of relatively
small volume to date. In an attempt to facilitate an efficient
secondary market, Farmer Mac hasstreamlined the process for buying
loans and standardized some aspects of a secondary market
transaction, including underwriting guidelines, but itbelieves
that standardized loan documents, such as those used in the
secondary market for residential mortgages, would be cost
prohibitive.13
13Standardization refers to the application of established and
industrywide loan documentation

procedures in connection with loan originations.

Farmer Mac's ActionsTaken to Promote Secondary MarketGrowth

B-280648

Page 10 GAO/GGD-99-85 Enhancing AgMortgage Liquidity To mitigate
its exposure to risks, Farmer Mac uses risk managementtechniques
to help it conduct secondary market activities in a safe and sound
manner. In its effort to stimulate greater secondary market
activity, since 1996Farmer Mac has developed several new programs
and loan products that were designed to increase participation by
traditional (e.g., rural banks) aswell as nontraditional (e.g.,
mortgage banks) agricultural mortgage lenders. Through workshops
and various marketing initiatives, FarmerMac has increased the
number and types of sellers approved to sell loans to Farmer Mac,
established new programs, and expanded its product line.Farmer Mac
expected these initiatives to enhance market reception to Farmer
Mac, thereby increasing the volume of agricultural mortgages
soldin the secondary market.

Secondary market activity is likely to be greater when the
secondarymarket creates products that help lenders and investors
manage various risks at low cost. For example, interest-rate risk
associated with long-term,fixed-rate loans can often be managed at
lower cost by secondary market investors (e.g., AMBS investors,
including Farmer Mac) with access tolong-term bond financing
relative to primary market financial institutions that rely on
deposit bases. Secondary market entities, such as Farmer Mac,can
also use their nationwide operations to obtain geographic
diversification of their loan purchases to help manage credit
risk. Whilestandards for underwriting, appraisal, and loan
servicing are used to help manage credit risk, secondary market
entities have relatively less abilitythan lenders to rely on
borrower relationships to assess credit risk.  Thus, from the pool
of loans meeting their underwriting standards, secondarymarket
entities increase their risk of purchasing loans with high credit
risk from less creditworthy borrowers. By establishing a training
program, Farmer Mac sought to educate andattract lenders by
increasing their interest in and improving their understanding of
Farmer Mac and the secondary market for agriculturalmortgages. In
1997, over 800 lenders attended the more than 20 seller/servicer
workshops that Farmer Mac conducted across the nation toinform
lenders of Farmer Mac's new authorities and programs and of the
benefits of participating in the agricultural secondary market.
Marketinginitiatives have resulted in Farmer Mac's approving
several nationally known, large commercial banks and mortgage
banks as approved sellersfrom which it could buy loans, which has
increased the potential for lender diversity.  The initiatives
also expanded the number of outlets throughwhich Farmer Mac
products can be marketed to customers. Lenders

New Programs andProducts Have Been Introduced

B-280648

Page 11 GAO/GGD-99-85 Enhancing AgMortgage Liquidity approved to
submit loans for possible sale to the Farmer Mac I Programtotaled
286 as of December 1998.

14 At its peak under the old charter,

Farmer Mac had nine approved sellers (at that time known as
poolers).

The mechanism that Farmer Mac established to purchase
mortgagesdirectly from lenders for cash and provide loans to
agricultural lenders (i.e., the AgVantage Program) is called its
Cash Window Program. Thisprogram grew out of the 1996 legislation
that granted Farmer Mac greater flexibility in its business
dealings with agricultural lenders. The 1996 Actauthorized Farmer
Mac to purchase loans directly from originating lenders. Before
this act, lenders could only participate in the secondarymarket by
selling agricultural real estate loans to qualified Farmer Mac
poolers. Additionally, the Cash Window Program was designed to
(1)provide lenders with new product terms and competitive interest
rates for agricultural real estate loans and (2) provide a
responsive process forbetter servicing the credit needs of
lenders' borrowers.  The Cash Window Program began in July 1996
and by December 1998, $732 million in loanswere sold to Farmer
Mac.

In late 1997, Farmer Mac introduced its Part-Time Farm Program,
whichcovered farms with substantial off-farm income. This program
offers a fixed-rate, 30-year home mortgage product for farms on at
least five acresof land or farms generating at least $5,000 in
gross farm sales from agricultural crops or livestock. The value
of the home must represent atleast 30 percent of the total
appraised value of the property. Farmer Mac sought to facilitate
the use of this program by making the origination andservicing
requirements simple and using familiar documents and procedures.
For example, standard conforming residential secondarymarket
origination forms are used in this program.

15

In February 1998, as an expansion of the Cash Window Program,
FarmerMac established the AgVantage Program, which allows Farmer
Mac to fund eligible lenders by providing cash advances. The
primary differencebetween the AgVantage Program and existing
Farmer Mac programs is that, in this program, the lender does not
sell its loans to Farmer Mac butinstead issues a bond backed by
eligible loans and other collateral. To
14Farmer Mac had 265 approved sellers as of October 1998, which
was our cutoff date for including

institutions in our survey. Forty-six percent (91 of 196) of those
approved sellers responding to oursurvey reported actually
completing transactions with Farmer Mac for the period January
1997 through

September 1998. Of those institutions selling, pledging, or
swapping loans, the average dollar amounttransacted by an
institution during that period was $6.1 million.

15Conforming mortgages are residential mortgages that meet Fannie
Mae and Freddie Mac underwriting standards and are within the
current 1999 conforming limit of $240,000.

B-280648 Page 12 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
facilitate access to this program, Farmer Mac has provided
standarddocumentation, including a standard form for the bond.
Farmer Mac guarantees the bond and purchases it.16 This
transaction allows the lenderto keep the loans and associated
credit risk, while increasing its debt and liquidity positions.
Farmer Mac is to receive low-risk income from thebond and
guarantee fees. This program was designed to meet the demand for
long-term loans by being attractive to lenders with excess
collateral,but inadequate liquidity.

Since the program's February 1998 inception through December 1998,
16AgVantage bond transactions had been consummated with 10
AgVantage issuers, resulting in Farmer Mac guarantees for $143.6
million ofAgVantage bonds. Due to the short-term nature of the
obligations that had been issued, only $10.8 million of the $143.6
million remained outstandingat year-end 1998.

In addition to the Cash Window, Part-Time Farm, and
AgVantagePrograms, Farmer Mac can purchase loans through a Swap
Program (introduced in early 1997). A swap is a transaction in
which lendersexchange one or more eligible loans for Farmer Mac-
guaranteed securities, rather than cash.17 Unlike Cash Window
transactions, which generallyinvolve loans with Farmer Mac-
specified terms, Farmer Mac is to negotiate these swap
transactions with the lender and is to acquire loans withpayment,
maturity, and interest-rate characteristics that Farmer Mac would
not purchase through its Cash Window Program. In January
1999,Farmer Mac reported that it had committed to enter into a
$408 million long-term, standby purchase commitment that operates
similarly to a swapin agricultural mortgages.

18 As of January 1999, Farmer Mac had

16Farmer Mac purchases general bond obligations issued by
qualified lenders that are collateralized by

Farmer Mac I- or Farmer Mac II-qualified farm mortgages, rather
than purchasing the loans outrightfrom lenders and then selling
AMBS to investors. In April 1998, FCA concluded that the AgVantage

Program was within Farmer Mac's statutory authority. In reaching
her conclusion, FCA's GeneralCounsel found that the AgVantage
bonds are securities guaranteed by Farmer Mac, issued by certified
facilities, and represent obligations backed by pools of qualified
loans. 17Many qualified loans should be eligible for swap
transactions on the basis of their conformity to Farmer Mac's
"existing loan" criteria, which require that the loans be
outstanding for at least 5 yearsand have low (60 percent or less)
loan-to-value ratios and other indications of performance.
Qualified

loans outstanding for less than 5 years are eligible for swap
transactions only on the basis of theirconformity to Farmer Mac's
more stringent credit ratios as of the date of their origination
and are to be subject to other performance analyses. 18According
to a Farmer Mac press release, the recipient of the standby
commitment segregates the loans on its books and pays Farmer Mac
an annual fee approximating its usual guarantee fee on
theoutstanding balance of the loans, in return for Farmer Mac's
assumption of the credit risk on those

loans. This structure permits the lender to retain the loans while
reducing its credit risk andconcentration exposures and,
consequently, its capital requirements.

B-280648 Page 13 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
consummated four Farmer Mac I swap transactions totaling
approximately$493 million (includes the previously mentioned $408
million transaction). In 1997 and early 1998, complementary to its
existing product lines,Farmer Mac developed new loan products that
included a refined 1-year adjustable rate mortgage (ARM) and a new
3-year ARM with flexibleborrower prepayment terms. These two loan
products can be converted to a long-term, fixed-rate loan after a
certain time period has elapsed. FarmerMac also developed a 10-
year, fixed-rate mortgage. See table 1 for a list of Farmer Mac's
programs and their descriptions and features, in addition tothe
various loan products offered.

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Page 14 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Program
Program description Product feature Farmer Mac Ia   Cash Window
Program Sellers receive cash by selling 100 percentof qualifying
first mortgage agricultural real

estate loans directly to Farmer Mac.

Terms and rates are described below under the Full-TimeFarm, Part-
Time Farm, and AgVantage Programs.

Full-Time Farm        Program Designed for borrowers who live
onagricultural properties and derive a

significant portion of their income from farmemployment.

Types of agricultural loans offered include:* 15-year fixed rate,
15-year maturity with 15- or 25-year    amortization and partial
open prepayment (annual,   semiannual, or monthly payments);

* 10-year fixed rate and 10-year maturity fully amortizing
(semiannual or monthly payments);

*  5-year reset loan with a 5-, 10-, or 15-year term; 5-, 10-,
15-, or 25-year amortization and open prepayment without
penalty (annual, semiannual, or monthly payments);* 1- and 3-year
ARMs, 15-year maturity, 15- or 25-year    amortization, and open
prepayment (semiannual   payments); and

* facility loans, 10- or 15-year fixed rate maturity, and fully
amortized.      Part-Time Farm        Program Designed for
borrowers who live onagricultural properties with a valuable

residence and derive a significant portionof their income from
off-farm employment.

Farmer Mac offers a 30-year fixed rate residential mortgage,which
is a fully amortizing loan with monthly principal and interest
payments and no prepayment limitations.      AgVantage Program
Allows sellers to retain qualified mortgagesin portfolio and sell
securities backed by

those mortgages to Farmer Mac.

AgVantage bonds may range in maturity from short-term to15 years
and have low fixed or variable rates of interest.

Swap Program Agricultural lenders receive mortgage-backed
securities in return for qualifying

agricultural real estate mortgages.

Security terms, rates, etc., are negotiated with the seller onthe
basis of the characteristics of the loan.

Farmer Mac IIb   Cash Window Program Lenders receive cash by
selling 100 percentof the guaranteed portion of USDA loans

directly to Farmer Mac.

* 7-year fixed rate and 15-year fixed rate based on full
amortization;

* 5- or 10-year fixed rate based on full amortization with 5- or
10-year rate reset periods--which are tied to the Farmer    Mac 5-
or 10-year Reset Cost of Funds Index Net Yield;   and

* floating rate is tied to Farmer Mac 3-month Cost of Funds
Index's "Net Yield" with calendar quarter rate adjustments    or
The Wall Street Journal's Prime Rate.  Swap Program Lenders
receive Farmer Mac-guaranteed securities in return for the
guaranteedportion of USDA loans. Security terms, rates, etc., are
negotiated with the seller onthe basis of the characteristics of
the loan.

aFarmer Mac I operates as a secondary mortgage market for high-
quality agricultural real estate and rural home mortgages.
Participation is limited to financially healthy farmers as
established in theAgricultural Credit Act of 1987.

bIn the 1990 Act, Farmer Mac was authorized to serve as the pooler
for secondary sales of agricultural and rural development loans
that are guaranteed by USDA. This program benefits borrowers who
areunable to get commercial credit at affordable rates because of
financial problems.

Sources: Farmer Mac and FCA.

Table 1:  Farmer Mac programs and products

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Page 15 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Increased
authority granted to Farmer Mac by the 1996 Act, which allowedits
operating structure to parallel that of Fannie Mae and Freddie
Mac, has provided it with flexibility to develop programs.
However, this expandedoperational authority does not mean that
program success will be guaranteed or that expected outcomes will
be achieved. Although FarmerMac has expanded its seller base and
provided lenders with streamlined procedures, including some
standardization, to access the secondarymarket, Farmer Mac
acknowledges that it cannot be certain whether the new products it
offers will generate a sufficient volume of loans that wouldallow
Farmer Mac to continuously function as a profitable corporation.

One key factor that could hinder lenders' use of Farmer Mac
programswould be their lack of knowledge about these programs. Our
survey results showed that familiarity with Farmer Mac programs
varied widely,with the majority of the nonparticipating
respondents being unfamiliar with the programs*52 percent and 62
percent were unfamiliar withFarmer Macs I and II Cash Window
Programs, respectively. With other programs, familiarity was even
lower*70 percent of the respondents wereunfamiliar with the
AgVantage Program, and over 87 percent were unfamiliar with the
Swap Programs under Farmer Macs I and II. Evenamong approved
sellers, familiarity with some Farmer Mac programs was low. For
example, 31 percent of the respondents were unfamiliar with
theAgVantage Program; 75 percent and 78 percent were unfamiliar
with the Swap Programs under Farmer Macs I and II, respectively.
The AgVantage Program's volume has been relatively small to date,
butnevertheless, Farmer Mac officials consider the program to be
beneficial because it encourages lenders to do business with
Farmer Mac and it isconsidered to be competitive with advances
offered by the FHLBank System.19 Furthermore, Farmer Mac officials
believe that the AgVantageProgram is more advantageous to lenders
than FHLBank System advances considering that AgVantage loans can
be sold to Farmer Mac at a later timewithout the need for any
additional paperwork requirements.

On the basis of our survey, 23 percent of the approved sellers
surveyedsaid they are "likely" or "very likely" to participate in
the AgVantage Program in the next 3 years; among nonparticipants,
this proportion was12 percent. The extent to which these lender
inclinations result in increased secondary market activity for
Farmer Mac has yet to bedetermined.

19FHLBanks make loans, called advances, on the security of
mortgages and other collateral, to lenders

who are owner-members of the FHLBank System.

B-280648 Page 16 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Standardization, such as the development of standardized loan
documents,can help streamline the process for buying loans.  Thus,
standardization has the potential to help lower transaction costs
and increase theefficiency of the secondary market. Farmer Mac had
standardized some aspects of the secondary market transaction by
requiring its agriculturalmortgage lenders to make representations
and warranties

20 that the loans

they are selling meet Farmer Mac underwriting standards. Farmer
Macofficials told us that standardized loan documents have not
been

developed because of the prohibitive cost associated with
standardizationgiven that state laws governing agricultural
mortgage loans and agricultural lending practices vary from state-
to-state. Farmer Mac hadestablished lender requirements in its
Farmer Mac guide that provides various levels of standardization
for different lender practices. Although its statute is silent on
loan document standardization, FarmerMac has, to some extent,
taken steps to standardize loan documentation for the agricultural
secondary market. Standardization of loan originationdocuments is
common in the secondary market for residential mortgages. In the
secondary market for residential mortgages, Fannie Mae andFreddie
Mac have increased efficiency through greater standardization of
mortgage products and processes.21 Standardized documents can
reducethe cost and effort necessary to evaluate the quality of
asset pools because inspection or review of each lending
arrangement can be replaced withverification that adherence to the
predetermined industrywide standards for loan origination has been
maintained. Farmer Mac officials stated that early in Farmer Mac's
existence, it soughtto standardize loan documents but was not able
to achieve a level of standardization approaching that achieved by
Fannie Mae and FreddieMac. These Farmer Mac officials attributed
this inability to differences in agricultural real estate state
laws that differ greatly from state-to-state.Residential real
estate state laws are more uniform. These officials also stated
that, with the diversity of agricultural lender practices and
theheterogeneous characteristics of agricultural loans, developing
nationwide documents would be difficult and costly.

20A representation is any statement, or any attempt to give an
impression about a state of facts, that

was done to convince another person to make a contract. A warranty
is a statement, either written orimplied, that assertions made in
completion of a contract are true.

21See Housing Enterprises: Potential Impacts of Severing
Government Sponsorship (GAO/GGD-96-120, May 13, 1996), pp. 4 and
54.

Farmer Mac HasStandardized Some Loan Processes

Loan Documentation WasStandardized to Some Extent

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Page 17 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Farmer Mac
generally allows agricultural lenders the option of usingFarmer
Mac forms, their own forms, or an off-the-shelf commercial loan
package. According to Farmer Mac's Chief Executive Officer and
GeneralCounsel, the vendor of the off-the-shelf package is to
guarantee Farmer Mac that each loan package meets the legal
requirements of all stateswhere the loans were originated. These
officials also stated that Farmer Mac forms do not meet the legal
requirements of all states.  Farmer Macprovides loan origination
forms on a disk for use by lenders, but it only requires that
participants use the loan summary and environmental surveyforms.
As long as other forms used by the lenders present information in
substantially the same format as Farmer Mac forms, the use of
FarmerMac's forms is not required. These Farmer Mac officials
noted that small lenders, rather than large lenders, are more apt
to use the off-the-shelfcommercial product because small lenders
often lack in-house legal departments. The Chief Executive Officer
and General Counsel of Farmer Mac statedthat regardless of whether
the loan documents used are the lender's own or those of the
commercial vendor, the documents must include legallyenforceable
standard Farmer Mac representations, warranties, and provisions to
ensure that the loans conform to Farmer Mac's loanunderwriting and
appraisal standards. These officials also stated that since the
initial use of representations and warranties in 1991, they
haveencountered no problems enforcing the terms of the loan
agreements. The Farmer Mac guide states that Farmer Mac is to
verify, via examination ofloan files, that the documents submitted
by lenders conform to Farmer Mac's underwriting standards and
other loan origination requirements.Also, as stated in the Farmer
Mac guide, Farmer Mac's verification of loan files does not
relieve lenders of their obligations under the representationsand
warranties provided to Farmer Mac.

For its part-time farm loans*essentially, residential mortgage
loans*Farmer Mac uses the standard, conforming residential
mortgageloan application and documentation forms used in the
residential mortgage

secondary market. Also, to improve the consistency of
informationincluded in the closing/settlement statements for all
loans sold to Farmer Mac, lenders are required to use the standard
Department of Housing andUrban Development closing/settlement
statement, which is commonly known as the HUD-1.  This document
provides an itemized listing of thefunds that are payable at
closing, such as loan fees and real estate commissions.

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Page 18 GAO/GGD-99-85 Enhancing AgMortgage Liquidity When
submitting a loan for sale to Farmer Mac, sellers are to follow
thefollowing general steps:

*  Meet with the customer and prepare a preliminary approval loan
package.*

Submit the package to Farmer Mac for preliminary approval.*
Following approval and lock in of interest rate, complete the
appraisal andtitle work.

*  Close and fund the loan.*

Deliver executed legal documents to Farmer Mac for final
approval.*   After being notified of final approval, submit a
Notice of Purchase Requestat least 2 days before the desired
purchase date. (Farmer Mac wires

purchase funds on the basis of the seller's instructions.) If the
loan documents are properly completed and submitted inaccordance
with Farmer Mac guidelines, the entire loan process from
submission to completion is expected to take about 8 business
days. Farmer Mac officials expressed no concerns with their
current approachof using lender or commercial off-the-shelf loan
documents. They felt that the legal protections afforded by the
inclusion of the Farmer Mac standardrepresentations, warranties,
and provisions were more important than the standardization of the
forms. They also noted that the use of lenderdocuments better
supported the Swap Program since forms do not have to be redone.
Also, the officials said that the current costs to Farmer Mac
ofachieving further standardization of loan documents exceed the
benefits.

The Farmer Mac guide specifies requirements for lender
participation inFarmer Mac programs.  The Farmer Mac guide
requires participating lenders to follow certain standardized
practices.  For example, FarmerMac requires inclusion of
standardized representations and warranties (e.g., the seller is
authorized to do business and loan informationsubmitted to Farmer
Mac is true and correct).  In addition, the Farmer Mac guide
specifies requirements for underwriting, collection of
mortgagepayments, administration of escrow accounts, and
initiation of foreclosure proceedings. The guide includes nine
underwriting standards, includingthose pertaining to obtaining a
credit report and financial statements, the borrowers' debt-to-
asset ratio, and the loan-to-value (LTV) ratio for thefinanced
agricultural property. The Farmer Mac guide provides some
underwriting flexibility to recognize differences and variances in
financialreporting of agricultural borrowers. It also provides
flexibility for special loan-servicing practices associated with
specific agricultural activities,such as livestock operations and
properties with irrigation systems. The

Farmer Mac Had DevelopedStandardized Lender Guidelines

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Page 19 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Farmer Mac
guide includes sections on loan-making, -selling, and-servicing as
well as seller requirements for participation in Farmer Mac
programs. Individual chapters of the guide include credit and
appraisalstandards for various programs and guidelines for
managing loan delinquencies. To provide perspective to the Farmer
Mac guide, we compared it with thetwo previously mentioned Fannie
Mae guides for servicing residential mortgages*the single-family
guide and the multifamily guide.22 The FannieMae guides differ
from the Farmer Mac guide due to differences in the types of
industry served and loan programs. For example, single-
familyresidential mortgages generally are not commercial loans
(i.e., most finance owner-occupied housing), while multifamily
residential andagricultural mortgages are commercial mortgages.
Fannie Mae's multifamily guide includes separate sections for its
delegated underwritingprogram and negotiated transactions. Under
its delegated underwriting program, Fannie Mae delegates its
authority to underwrite and determinethe creditworthiness of a
loan to the originating lender and agrees to purchase the loan
without prior review. In return for this autonomy, thelender is to
assume a percentage of the risk of default on the loan. In
contrast, Farmer Mac generally takes on the full credit risk of
backingAMBS.  This practice conforms most closely to Fannie Mae's
negotiated transactions program.  In this program, Fannie Mae,
similar to FarmerMac, provides some underwriting flexibility to
recognize differences among multifamily properties in specifying
lender obligations intransaction documents.

The Fannie Mae and Farmer Mac guides share some similarities in
thetopics that they cover. For example, Fannie Mae's single-family
guide and the Farmer Mac guide, have sections on lender
relationships, mortgage andproperty insurance, special mortgage
programs, delinquent mortgages, and mortgage foreclosures.
However, the Fannie Mae guides address eachservicer requirement
and guideline in greater specificity than the Farmer Mac guide
does.  Farmer Mac officials told us that they continuously workon
further developing Farmer Mac's guide as the corporation grows.

22We also reviewed Fannie Mae's Forms Guide, which contains
required Fannie Mae standardized

forms to be used by lenders.

B-280648 Page 20 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Farmer Mac is expected to fulfill its public policy purpose and
earn a profitby taking prudent risks. Like any other private
financial firm, Farmer Mac faces risks from changes in market
interest rates; loan defaults and othercredit problems; external
business factors, such as natural disasters or industry
competition; and poor management decisions that may
adverselyaffect its profitability. Farmer Mac uses risk management
procedures in its operations to help ensure that its secondary
market operations areconducted in a safe and sound manner. Farmer
Mac has mechanisms in place to measure, monitor, and take actions
to control, its exposure tothese risks.

On the basis of (1) unverified information provided by senior
officers ofFarmer Mac and its federal regulator and (2) reports
and analyses done by third parties, such as external auditors and
consultants, it appears thatFarmer Mac generally manages its
operations in ways that are consistent with industry risk
management principles. For example, Farmer Macstrives to limit
interest-rate risk by issuing AMBS in the capital markets and
attempts to control losses from other risks, such as credit
risk,through the monitoring of seller/servicer financial condition
and servicing performance. Principles of risk management that have
been developed by variousfinancial industry and regulatory bodies
stress the importance of board of directors and management
involvement in managing the risks undertakenby financial
institutions.

23 Under these principles, an organization's risk

management strategy is to be based on a framework of
responsibilities andfunctions, driven by the board of directors
down to operating levels, which

are to cover all aspects of risk. The basis for this principle is
the belief thatunless the board of directors is fully integrated
into the risk management approach, the organization's managers and
employees will not be fullycommitted to risk management. To
emphasize the importance of risk management, these principles
state that a risk management group made upof senior managers is to
be created. Farmer Mac's risk management function is overseen by
the Asset Liability Committee, which is made up ofsenior managers,
and its Board of Directors' Finance Committee.

23Principles of risk management have been developed by various
industry and regulatory bodies,

including the Bank for International Settlements, the
International Organization of SecuritiesCommissions, the
Derivatives Policy Group, U.S. bank regulators, and a group
assembled by Coopers &

Lybrand. All of these risk management principles are broadly
similar. The principles listed in thisreport are termed generally
accepted risk principles and were developed by Coopers & Lybrand.

Farmer Mac Uses RiskManagement Techniques to Help Ensure Safe
andSound Operations

B-280648

Page 21 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Like other
portfolio lenders,24 Farmer Mac is exposed to interest-rate
risk(the possibility of an increase in interest rates in the
national economy that is not matched by an increase in interest
rates paid by borrowers whoseloans are held in portfolio by Farmer
Mac). Farmer Mac employs several techniques to control interest-
rate risk. Farmer Mac measures its exposureto interest-rate risk.
Farmer Mac's management and Board of Directors are to ensure
compliance with its interest-rate risk policy limits.  FarmerMac
also purchases financial instruments to help manage part of its
exposure to interest-rate risk. Constant monitoring and adjustment
of thecontrol techniques are necessary to avoid increases in
Farmer Mac's exposure to interest-rate risk, which changes over
time as the economyand its portfolio change.

Farmer Mac is exposed to interest-rate risk on its portfolio of
guaranteedsecurities and other investments and on loans purchased
through the Cash Window Program. Measurement of interest-rate
risk. The following two techniques areemployed by Farmer Mac to
measure interest-rate risk: duration gaps and market value of
equity sensitivity. Duration gaps measure the average economic
life of a whole portfolio,rather than the time to final payment
for each asset or liability. The difference between a firm's asset
and liability durations is called itsduration gap.

The duration gap measures the overall interest-rate risk exposure
ofFarmer Mac. The larger the gap in absolute value, the greater
Farmer Mac's exposure to interest-rate risk. For example, if
Farmer Mac's averageeconomic life of its assets is 1.5 years
greater than the average economic life of its liabilities, then it
has a duration gap of 1.5 years. Should interestrates rise, Farmer
Mac's net interest income would fall because interest expenses
would rise sooner than interest income. Farmer Mac tries tomanage
interest-rate risk by managing its portfolio to keep the duration
gap within a certain parameter. Another technique that Farmer Mac
uses in measuring interest-rate risk isto estimate the sensitivity
of its market value net worth to various changes in interest
rates. Market value net worth provides a measure of FarmerMac's
ability to absorb losses. Financial firms report their income

24A portfolio lender purchases loans to hold in portfolio or makes
loans, or does both of these activities,

and in the process can earn net interest income.

Interest-Rate Risk

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Page 22 GAO/GGD-99-85 Enhancing AgMortgage Liquidity statements
and balance sheets according to generally accepted
accountingprinciples (GAAP).

25 GAAP relies primarily on the historical (book) value

of the financial assets and liabilities, rather than on their
current marketvalue. The market value of such assets and
liabilities is affected by current

interest rates, but the market value also can change if the
likelihood ofprepayment or repayment changes. The market value of
assets minus the market value of liabilities provides the market
value of net worth. For example, Farmer Mac carries a 10-year, 8-
percent loan at the amountof unpaid principal over the life of the
loan. If interest rates decrease, the market value of the loan
increases because the loan earns a higher yieldthan the yield on a
new loan. Likewise, the market value declines if interest rates
rise because the yield would be greater on a new loan. One method
ofmonitoring a firm's exposure to interest-rate risk is to
regularly determine the market value of the firm's assets and
liabilities (marking-to-market)and project how market value would
change for assumed changes in interest rates. Management of
interest-rate risk. Once its interest-rate risk exposure
ismeasured, Farmer Mac managers can change Farmer Mac's exposure
by various actions that lengthen or shorten the expected maturity
of assetsand liabilities so that payment streams on assets and
liabilities behave similarly. The managers may issue liabilities
with variable maturity terms or call features*callable debt allows
Farmer Mac to repay its bonds aftera specified time frame, which
is a useful option if interest rates were to

decline*or levy prepayment penalties on borrowers who prepay
theirmortgages when interest rates fall. This is known as
prepayment risk. Prepayment penalties allow Farmer Mac to offer
competitive interest ratesto farmers and ranchers and entice
investors to accept lower rates of return on their investment in
Farmer Mac-guaranteed securities. However,as indicated by
agricultural lenders' responses to our survey, prepayment
penalties reduce the competitive attractiveness of Farmer Mac
products ascompared with agricultural loan products offered by FCS
and other agricultural lenders without prepayment penalties.
Management of interest-rate risk is important at Farmer Mac
because of itsinvestment portfolio and pipeline operations (loans
submitted to Farmer Mac for approval and loans approved but not
yet committed forpurchase--i.e., locked in interest rate). Farmer
Mac controls interest-rate risk associated with portfolio lending
by striving to closely match the
25GAAP is a set of accounting rules and conventions defining
acceptable practices in preparing financial

statements. GAAP's aim is to provide conformity in financial
statements reporting.

B-280648 Page 23 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
interest-rate sensitivity of its assets and liabilities and by
requiring a yieldmaintenance provision

26 for loans that are paid off earlier than their

scheduled payoff date. In addition, interest-rate risk can be
avoided byissuing and selling AMBS and shifting the interest-rate
risk to investors. In

its role as financial guarantor of AMBS, Farmer Mac does not
directlyundertake interest-rate risk. Also, through the use of
sophisticated hedging techniques, such as futures contracts,
Farmer Mac attempts to align theduration of its assets and
liabilities, thereby minimizing interest-rate risk.

Farmer Mac monitors interest-rate risk exposure through duration
gapsand market value equity sensitivity reports that identify
interest-rate mismatches. These two reports are provided to Farmer
Mac's Board ofDirectors on a regular basis.

Credit risk is the possibility of financial loss resulting from
default byborrowers on farming assets that have lost value and/or
other parties' failing to meet their obligations. Credit risk is
inherent in the dailyoperations of all financial firms, including
Farmer Mac. Like other financial firms, Farmer Mac's underwriting
standards represent a major tool inlimiting credit risk. Farmer
Mac uses several techniques to measure and manage its credit risk
exposure. Measures of credit risk. Farmer Mac uses the two
following basicmeasures of credit risk: (1) the volume of loans or
bonds that are not performing according to the contractual
agreement and (2) the dollarlosses to Farmer Mac resulting from
such nonperforming loans or bonds.

Typically, when a borrower fails to make a scheduled payment, the
loan istermed delinquent. Delinquency rates are an early indicator
of credit problems. After a period of continuing delinquency, the
loan servicer orFarmer Mac may act to recover the loan principal
by foreclosing

27 on the

property and filing a claim with any party that insured or
guaranteed theloan. At the time of foreclosure, the loan is said
to have defaulted.

Generally, only a small fraction of delinquent loans default.
Farmer Macsaid it monitors delinquency rates on a monthly basis,
and its delinquency rates over the last 2 years have generally
been less than 1 percent.

26A yield maintenance provision is an agreement designed to
discourage prepayment and to

compensate lenders for reinvestment costs during periods of
falling interest rates. 27Foreclosure is a legal proceeding
initiated by a creditor to take possession of collateral securing
a defaulted loan.

Credit Risk

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Page 24 GAO/GGD-99-85 Enhancing AgMortgage Liquidity The financial
losses from defaults include any principal of the loan or bondnot
repaid, interest not paid, and expenses to foreclose or
restructure,

28

adjusted by recoveries from collateral sales and insurance.
Defaults andloss rates can be predicted by Farmer Mac when it has
historical default

and loss data for similar types of loans in various economic
circumstances.With new types of products, defaults and losses are
difficult to predict accurately, and product performance must be
monitored carefully tocontrol credit risk. Farmer Mac only has a
limited history of loan performance data, so it uses the
historical loan loss data of a FCSinstitution to construct
hypothetical loan pools to estimate losses on loan pools. The
result is to be used to determine the level of guarantee fees
thatFarmer Mac needs for a pool of loans to generate sufficient
income to provide an adequate return and maintain a minimum level
of capital. Methods to manage credit risk. Farmer Mac manages
credit risk by tryingto control the number of defaults and
minimize the losses that result from defaults. Farmer Mac controls
defaults through credit underwriting,appraisal standards, and
geographic and commodity diversification standards that provide a
quality control over the credit risks it takes andhelp it to
prevent defaults. To minimize losses from any defaults that do
occur, Farmer Mac uses techniques called credit enhancements
(e.g.,USDA guarantees or collateral requirement) that should allow
Farmer Mac to recover portions of its potential losses from
collateral or from thirdparties, such as lenders, loan insurers,
or loan guarantors.

Underwriting standards. Farmer Mac has underwriting standards
todetermine which mortgages it will buy, that it could then hold
as investments or place into mortgage pools. Underwriting is the
process ofidentifying the potential risks of loss associated with
financial activities to determine loan eligibility, and
underwriting also aids in the pricing of suchrisks. Underwriting
is an integral part of business and financial transactions that
occur daily throughout the private and public sectors ofthe
economy and involve the transfer and pricing of risk. Underwriting
standards provide guidelines that are used to (1) limit the type
and amountof risk of loss permitted in a financial portfolio and
(2) establish methods to control such risks. Farmer Mac's
underwriting standards are discussedin appendix V.

28A loan restructuring occurs when a lender grants a concession to
a borrower in financial difficulty.

For example, the lender negotiates a workout agreement with the
borrower to modify the originalcredit terms, rather than initiate
foreclosure proceedings against the delinquent borrower.

B-280648 Page 25 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Before Farmer Mac purchases a loan or bond or guarantees a
security,certain underwriting standards are to be met.
Underwriting standards cover numerous borrower and property
characteristics that help FarmerMac evaluate the likelihood of
defaults and the severity of related losses. For example, as
stated in the Farmer Mac guide, Farmer Mac hasunderwriting
standards that indicate (1) whether a borrower has sufficient
income to make the scheduled payments and a credit history
suggestingthat the borrower has met past obligations in an
acceptable manner and (2) the maximum LTV ratio, which measures
the borrower's equity (downpayment) in the property. Experience
has shown that borrowers with low amounts of equity in the
property, and thus high LTV ratios, are more likelyto default than
borrowers with high amounts of equity. Farmer Mac has also
established appraisal standards to estimate the value of the
propertyserving as collateral for the mortgage and geographic and
commodity diversification standards to mitigate Farmer Mac's
exposure to a particularagricultural region or commodity product.

Because Farmer Mac does not make loans directly, standards are
also tobe used to qualify other parties to participate in its
credit activities. For example, Farmer Mac has established
standards for lenders, CentralServicers, and Contract
Underwriters.

29 Such standards include measures

of financial strength, past performance indicators, and
managementquality. Lenders, Central Servicers, and Contract
Underwriters expose

Farmer Mac to risks of default to the extent that they fail to
followstandards adequately when making the loan or fail to collect
payments diligently. Farmer Mac has also established audit and
quality controlprocedures to monitor the performance of lenders,
Central Servicers, and Contract Underwriters. Farmer Mac also sets
standards for firms withwhich they share financial risk. For
example, when Farmer Mac enters a transaction to exchange cash
flows as a means to limit its interest-raterisk, there is credit
risk that the other party may fail to meet its obligation (i.e.,
counterparty risk). To mitigate such risk, Farmer Mac sets
minimumstandards of financial strength for such parties.

Farmer Mac said it contracts out certain functions to take
advantage of theexperience and efficiency of outside resources.
Two key functions that are contracted out are Farmer Mac's loan-
servicing function and credit loan-underwriting function.  As
discussed below, Farmer Mac is to mitigate the risks of
contracting by performing annual on-site inspections of the third-
parties' operations for compliance with the terms of their
agreements.

29Central Servicers and Contract Underwritiers are firms that
Farmer Mac has contracted with to

provide loan-servicing and loan underwriting services,
respectively.

B-280648 Page 26 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
Farmer Mac divides the loan servicing into two functions, the
CentralServicer and the Field Servicer. The Central Servicer has
entered into a contract with Farmer Mac to provide general
servicing for certain FarmerMac I loans and is responsible for
directing the Field Servicer in the performance of such servicer's
duties. The duties of the Field Servicerinclude things such as
maintaining borrower relationships, servicing the loans, annually
inspecting the mortgaged property to detect any adversetrend in
the property's condition and preparing a report related to such
inspection, and monitoring for current hazard insurance policy and
tax andassessment payments. The Field Servicer is also to assist
the Central Servicer in resolving delinquent loans. The Central
Servicer is alsoresponsible for establishing, maintaining, and
monitoring delinquent loans. Farmer Mac annually performs an on-
site review of the Central Servicer tomake certain that it is in
compliance with the terms of the contract agreement. In addition,
the Central Servicer is required to have itsindependent public
accountants review its servicing operations for compliance with
Farmer Mac requirements. Contract Underwriters are entities that
have entered into contracts withFarmer Mac to perform the function
of underwriting loans in accordance with Farmer Mac's underwriting
and appraisal standards. ContractUnderwriters are required to
review appraisals to ensure compliance with the requirements set
forth in the Farmer Mac guide. Farmer Mac annuallyperforms on-site
due diligence of the Contract Underwriter and checks for
compliance with Farmer Mac requirements. Farmer Mac made
modifications to address increased credit risk sincepassage of the
1996 Act. Before changes in Farmer Mac's operating structure
authorized by the 1996 Act, Farmer Mac was responsible for aloan's
credit loss in excess of 10 percent of outstanding loan principal.
The 10-percent cash reserve or SPI required for every loan pool
formed andsecuritized covered the first 10 percent in losses.

As a result of its new legislative authority granted in 1996, to
purchaseagricultural mortgage loans directly from lenders and to
issue and guarantee 100 percent of the securities backed by such
loans without alender cash reserve or SPI requirement, Farmer Mac
is subject to a first loss position.30 To mitigate its increased
credit risk position, Farmer Mactook the following steps

30The first loss position refers to the first 10 percent of losses
arising from defaults on the pools of

loans backing Farmer Mac-guaranteed securities.

B-280648 Page 27 GAO/GGD-99-85 Enhancing AgMortgage Liquidity

*  Farmer Mac lowered its loan underwriting standard LTV ratio for
aqualified loan from 75 percent to 70 percent for loans up to $2.3
million.

This change requires borrowers to increase their down payment or
risksharing in the loan, thereby decreasing the chance that
borrowers will default on their loans because of their larger
equity stake. The LTV ratio isimportant in determining the
probability of default and the magnitude of loss.

*  Farmer Mac increased the annual pool fee rate it normally
charges lendersfor providing loan pool guarantees from 25 to 50
basis points

31--the

maximum allowed by statute--of the initial principal loan amount.
Aportion of this fee is required by law to be set aside by Farmer
Mac in a

segregated account as a reserve against losses arising from its
guaranteeactivities. Among other things, full recourse must be
taken against such reserve before Farmer Mac may be authorized to
draw upon its $1.5 billionline of credit with the Department of
Treasury to satisfy its guarantee obligations.

*  Farmer Mac established new loan loss reserves for Farmer Mac I
loanssecuritized after 1996 (i.e., AMBS). Loan loss reserves
represent the

estimated amount necessary to cover anticipated credit losses in
the loanportfolio. Farmer Mac I loans securitized before1996 had
to be supported by the 10-percent cash reserve or SPI requirement.
To mitigate the credit risk from new products, Farmer Mac requires
thefollowing:

*   AgVantage bonds, which are general obligations of the issuer,
are to beover-collateralized continuously by eligible collateral
in an amount ranging

from 120 percent to 150 percent of the bonds' outstanding
principalamount, depending on the financial status of the
borrower. Eligible collateral includes qualified loans, cash, U.S.
treasury securities, orsecurities guaranteed by an agency or
instrumentality of the federal government.

*  The eligibility for part-time farm loans, which are generally
residentialloans, is to be determined on the basis of lenders'
compliance with the

underwriting standards that are used for conforming
residentialmortgages. Part-time farm loans are underwritten to
conforming residential ratios*a 28-percent inside ratio (monthly
housing expense togross monthly income) and a 36-percent outside
ratio (total monthly debt
31A basis point is one one-hundredth of a percentage point.

B-280648 Page 28 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
expense to gross monthly income). Income may come from farming
ornonfarming sources. Farmer Mac currently uses a credit-scoring
model32 to monitor the creditquality of loans in pools to
determine the financial performance of approved sellers and to
determine if loan loss reserves are adequate. Inaddition, Farmer
Mac stated that it uses credit scoring in connection with its
credit approval process, but not as a determinative factor for
creditapproval.

We defined business risk as the possibility of financial loss due
toconditions within the agricultural sector that affect loan
performance. For example, Farmer Mac has business risk associated
with being limited tooperating in the agricultural and rural
housing lines of business. Business risk cannot be easily
measured, and many business risk factors aredifficult to
anticipate and control.

Farmer Mac is limited in its ability to manage its business risk
exposure bylegislation that requires it to serve a specific public
mission. Farmer Mac's charter requires that its activities be
concentrated in the buying and sellingof agricultural and rural
housing loans across the nation and in good and bad economic
conditions. This requirement prohibits Farmer Mac fromseeking
alternative business opportunities to supplement, diversify, or
replace current business when economic conditions or the promise
ofhigher returns would lead a private firm into other lines of
business. However, Farmer Mac can shift assets into new products
and investmentswithin its given line of business.

Even though diversification standards were eliminated by the 1996
Act,Farmer Mac requires its loan pools to be diversified both
geographically and, with respect to agricultural commodities
(products), to help it toavoid large exposure to regional economic
shocks. Farmer Mac has established a standard for the maximum
percentage that a region orcommodity product can make up of the
portfolio, which Farmer Mac said it periodically monitors for
compliance. Management and operations risk (subsequently referred
to as managementrisk) is the possibility of financial loss
resulting from a management mistake that can threaten the
company's viability. In many respects,management risk encompasses
all of the risks faced by Farmer Mac,

32A credit-scoring model uses statistical analysis to identify and
weigh (or score) the characteristics of

borrowers who have been most likely to make loan payments.

Business Risk Management Risk

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Page 29 GAO/GGD-99-85 Enhancing AgMortgage Liquidity including
interest-rate, credit, prepayment, and business risks. Forexample,
since Farmer Mac's management establishes loan standards and
financing policies, its decisions determine Farmer Mac's exposure
to creditand interest-rate risk. Generally, the managers can
expose Farmer Mac to losses through incompetence, inadequate
planning, poor internal controls,risky business strategies, fraud,
and negligence. Management risk is not easily quantified, but its
control is crucial to the firm's successfuloperation.

Farmer Mac generally controls its exposure to management risk
throughpersonnel administration, strategic and operational
planning, its policymaking process, internal controls systems,
management informationsystems, and board of directors and
management oversight of firm operations. The dollar value of
Farmer Mac's loan purchases and the size of thesecondary market
have both increased since passage of the 1996 Act. Both trends
represent positive indicators of progress in fostering
secondarymarket developments. Even with this expansion, Farmer
Mac-guaranteed securities and individual mortgage holdings
accounted for about 1.2percent of the agricultural mortgage debt
outstanding as of the thirdquarter of 1998. This compares to the
approximately 16 percent ofmultifamily residential mortgage loans
accounted for by the housing enterprises (Fannie Mae and Freddie
Mac) as of year-end 1997. Our analysis shows that Farmer Mac is
currently viable in its agriculturalmortgage mission activities.
However, Farmer Mac's future viability depends on its growth
potential in the secondary market for agriculturalmortgages and
the prospects for realizing that potential are unclear. There are
trends and events that could improve or worsen Farmer Mac's
financialcondition.  If Farmer Mac develops new products that are
attractive to lenders or if FCS institutions or other lenders
increase participation inFarmer Mac programs, Farmer Mac's
financial condition could improve. However, events such as a less
favorable interest-rate environment ordeclines in the credit
quality of agricultural mortgage could reduce Farmer Mac's future
profitability. Even if Farmer Mac continued to beeconomically
viable under its current operating structure, it is difficult to
determine whether the public benefits created justifies
continuedgovernment sponsorship. These public benefits could
affect and be affected by the activities of two other GSEs*FCS and
the FHLBankSystem.  These benefits and costs are difficult to
quantify.

Indicators of FarmerMac's Mission Achievement andFuture Viability

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Page 30 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Since the
1996 restructuring, two key measures show that Farmer Mac hasmade
some progress in fulfilling its statutory mission by fostering
secondary market development. Specifically, the dollar amounts of
FarmerMac's loan purchases and issued securities have both
increased since passage of the 1996 legislation. To foster
development of a secondary market, Farmer Mac must be able
tosustain growth in the purchase of loans over time. Loan purchase
data provided by Farmer Mac are shown in table 2. Loan purchases
havecontinued to grow in both of the Farmer Macs I and II
Programs. Of particular importance is (1) the sustained growth in
the Farmer Mac IProgram and (2) data showing that the upward trend
in this program has been greater than the growth of the Farmer Mac
II Program. Total loanpurchase dollar volumes have increased since
the 1996 Act.

Dollars in millions Program 1995 1996 1997 1998Farmer Mac I $113.5
$162.3 $230.5 424.3

Farmer Mac II 56.3 92.5 95.0 119.8 Total $169.8 $254.8 $325.5
$544.1 Source: Farmer Mac.

The dollar value of Farmer Mac-guaranteed securities and loans
held forsecuritization are also key indicators of secondary market
development.

After loans are purchased by Farmer Mac, they are grouped into
packages,or pooled, and issued as Farmer Mac-guaranteed securities
(i.e., AMBS). Farmer Mac either sells the securities to others or
holds them in portfolio.Decisions to hold securities in portfolio
or offer them for sale depend upon prevailing market conditions
and are influenced by factors such as themarket liquidity of the
securities, the ability of investors to estimate risks of holding
the securities, and general market knowledge about andacceptance
of the securities. As shown in table 3, the amount of Farmer Mac-
guaranteed securities outstanding has more than doubled since
year-end 1995. Additionally, the amount held in portfolio has been
fairly stable while the amount held by others has grown, which
indicates a growingacceptance of AMBS, leading to a broader
secondary market.

Indicators of Farmer Mac'sMission Fulfillment Table 2: Annual Loan
Purchases byFarmer Mac at Year-end 1995-98

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Page 31 GAO/GGD-99-85 Enhancing AgMortgage Liquidity

Dollars in millions Category 1995 1996 1997 1998

Percentagechange

1995-98Farmer Mac I held byFarmer Mac $278.6 $217.1 $192.9 $228.5
(18.0)% Farmer Mac IIheld by Farmer Mac

138.5 199.4 249.5 306.8 121.5

Subtotal $417.1 $416.5 $442.4 $535.3 28.3 Farmer Mac Iheld by
others $94.7 $214.4 $385.8 $567.5 499.3

Farmer Mac IIheld by others 4.8 11.6 23.3 30.1 527.1  Subtotal  $
99.5 $226.0 $409.1 $597.6 500.6 Totalsecurities

outstanding

$516.6 $642.5 $851.3 $1,132.9 119.3

Loans held forsecuritization 0.0 13.0 47.2 168.1 -- Totalsecondary
market

$516.6 $655.5 $898.5 $1,301.0 151.8%

Source: Farmer Mac. Even though Farmer Mac's operating results
have been positive since its1996 statutory changes, its secondary
market penetration rate (i.e., percentage share of the
agricultural mortgage market) remains small andis low compared to
the penetration rate of the housing enterprises in the residential
secondary markets. Interest income from nonmortgageinvestments is
a significant source of income at Farmer Mac.

In 1991, we reported33 that Farmer Mac's authorizing legislation
indicatedthat Congress expected Farmer Mac would be able to
develop a large, nationwide secondary market quickly, and that it
would be widely used.We also reported that the secondary market
development to that point had been slow, and that the future was
uncertain. While Farmer Mac's penetration of the agricultural
mortgage market hasbeen growing, it remains relatively small. As
shown in table 4, at year-end 1995 there were about $517 million
Farmer Macs I and II securitiesoutstanding. Agricultural mortgage
debt outstanding at that time was about $84.8 billion; Farmer
Mac's market penetration was about 0.6percent of this total
market. Farmer Mac estimated that about half of the
33GAO/RCED-91-181.

Table 3:  Farmer Mac's SecondaryMarket at Year-end 1995-98

Secondary MarketPenetration Rate Remains Small

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Page 32 GAO/GGD-99-85 Enhancing AgMortgage Liquidity agricultural
mortgage loans outstanding at that time met its
underwritingstandards. Thus, Farmer Mac's penetration would have
been about 1.2 percent of the agricultural mortgages meeting
Farmer Mac underwritingstandards. As of the third-quarter of 1998,
Farmer Mac's market penetration rate was about 1.2 percent of the
agricultural mortgage loansoutstanding and about 2.4 percent of
those estimated by Farmer Mac as meeting its underwriting
standards.

Dollars in millions Category 1995 1996 1997  1998 Farmer
Macsecondary

market

$516.7 $655.5 $898.6 $1,301.0

Agriculturalmortgage debt 84,800.0 87,300.0 90,200.0 94,295.0a
Farmer Macmarket share (percent)

0.61% 0.75% 1.0% 1.2%

aPreliminary 1998 third-quarter Federal Reserve Bulletin data.
Year-end data were not available as of April 1, 1999. Sources:
Economic Report of the President (Feb. 1999) and Farmer Mac.

Of the approximately $94 billion in total agricultural mortgage
debtoutstanding as of the third-quarter of 1998, about 31 percent
was accounted for by FCS holdings, 29 percent by commercial banks,
and 39percent by other lenders, such as life insurance companies.
The remaining approximately 1 percent was accounted for by Farmer
Mac AMBS. Farmer Mac's market penetration is low when compared to
that of thehousing enterprises. To provide perspective, we
compared Farmer Mac's penetration to the housing enterprises'
penetration of the conventionalsingle-family (one- to four-unit)
and conventional multifamily residential mortgage markets. As
shown in figure 1, mortgage pools of the housingenterprises
accounted for about 43 percent of conventional single-family and
16 percent of conventional multifamily residential
mortgagesoutstanding as of year-end 1997.

34 As of year-end 1980, about one decade

after the housing enterprises were chartered as GSEs, the single-
familymarket penetration rate was about 9 percent. The enterprises
did not enter

the conventional multifamily market until 1983. The
multifamilypenetration rate may provide a better comparison with
Farmer Mac's

34The housing enterprises compete for purchases of primarily
conventional residential mortgages. To

the degree that they purchase federally insured mortgages, the
reported shares of the housingenterprises are overstated.

Table 4: Farmer Mac's Share ofAgricultural Mortgage Debt
Outstanding at Year-end 1995-98

Farmer Mac's MarketPenetration Is Low Compared to the Housing
Enterprises

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Page 33 GAO/GGD-99-85 Enhancing AgMortgage Liquidity penetration
rate, because multifamily mortgages, just as
agriculturalmortgages, are supported by income flows from
commercial properties. During its first decade of operations,
Farmer Mac had the disadvantage ofa more limited charter in
relation to the housing enterprises.  However, compared to the
housing enterprises in their early years, Farmer Mac alsohad the
advantage in that securitization of a wide variety of financial
assets had already been achieved.  We recognize differences such
as these inmaking our comparisons.  We are not suggesting that
Farmer Mac should mirror the market penetration levels achieved by
the housing enterprisesin their first decade of operations.  Nor
are we suggesting that Farmer Mac should be expected to reach the
market penetration levels reached by thehousing enterprises in the
long-term.  For example, the possibly greater heterogeneity of
borrowing farm operators and of farm properties servingas
collateral for agricultural mortgages, even in comparison to
multifamily residential mortgages, could lead to a different long-
term outcome.

B-280648

Page 34 GAO/GGD-99-85 Enhancing AgMortgage Liquidity aFannie Mae
and Freddie Mac holdings of multifamily mortgages in 1980 were
comprised of federally insured mortgages. bFarmer Mac was
established in 1988 and did not issue guaranteed securities until
1991.

Sources:  Federal Reserve Bulletin, Economic Report of the
President (Feb. 1999) and Farmer Mac.

According to Farmer Mac's 1996 annual report, Farmer Mac had
achievedlimited penetration into the agricultural mortgage credit
market because of the (1) historical preference of lenders,
particularly FCS institutions, toretain the loans in their own
portfolios; (2) excess liquidity of many agricultural lenders; (3)
disinclination of lenders to offer intermediate-adjustable term or
long-term, fixed-rate loans as a result of higher profitability on
short-term loans; and (4) lack of borrower demand forintermediate
and long-term loans due to lower interest rates associated with
short-term loans. Many of the factors are largely beyond the
controlof Farmer Mac.

Opinions from our survey support the first two reasons cited for
limitedpenetration into the agricultural mortgage market. For
example, 66 percent of nonparticipant lenders said that choosing
to hold loans in portfolio wasa reason that contributed a "very
great" or "great" extent to their decision not to sell loans to
Farmer Mac. The reason of having adequate funding to

Figure 1:  Secondary Market Penetrationof Single-family,
Multifamily, and Agricultural Mortgages

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Page 35 GAO/GGD-99-85 Enhancing AgMortgage Liquidity meet
agricultural mortgage loan demands was also noted by 64 percent
ofthe nonparticipant lenders. Other reasons were considered to be
significantly lower in importance, according to our survey. One
particular change to Farmer Mac's program, cited as
encouragingparticipation by both approved sellers and
nonparticipating lenders, was the elimination of or phasing out of
the prepayment penalty. Among theapproved sellers we surveyed, 80
percent said that eliminating the penalty, and 54 percent said
phasing out the penalty, would encourage them to sellmore loans to
a "very great" or "great" extent. Among nonparticipating lenders,
these figures were 47 percent and 35 percent, respectively
forencouragement to participate in Farmer Mac programs. For both
groups of respondents, eliminating or phasing out the penalty led
the list of proposedchanges that would encourage lenders to sell
agricultural mortgage loans to Farmer Mac. However, phasing out or
eliminating the penalty wouldincrease prepayment risks faced by
investors and, therefore, could lead them to demand higher
interest rates charged borrowers for loans sold toFarmer Mac. In
our survey, we did not ask lenders how much they thought borrowers
would be willing to pay for eliminating or phasing out
theprepayment penalty.

In addition to its rate of market penetration, another indicator
of FarmerMac's mission fulfillment would be a declining percentage
of its nonmortgage investments compared to its agricultural
mortgage-servicingportfolio.

35  This would show that Farmer Mac was depending more on

agricultural mortgages for viability and less on nonmortgage
investments.In a previous report,

36 we identified profits from nonmortgage investments

(i.e., investments other than those in agricultural mortgages) as
a primarysource of income at Farmer Mac. These investments were
part of Farmer

Mac's debt issuance strategy. According to Farmer Mac officials,
thisstrategy has the stated purpose of increasing Farmer Mac's
presence in the capital markets and improving the pricing of its
AMBS, thereby enhancingthe attractiveness of the loan products
offered through its programs for the benefit of agricultural
lenders and borrowers. Farmer Mac officials told usthat the
strategy's contribution to mission achievement should develop over
a reasonable period of time. In doing our previous work, we voiced
aconcern that Farmer Mac's temporary approach could become a

35Farmer Mac's agricultural mortgage-servicing portfolio includes
agricultural mortgages backing

Farmer Mac AMBS (i.e., those held in Farmer Mac's portfolio and by
other investors) plus mortgagesheld for securitization.

36Government-Sponsored Enterprises: Federal Oversight Needed for
Nonmortgage Investments (GAO/GGD-98-48, Mar. 11, 1998).

Income From NonmortgageInvestments Is a Significant Source of
Farmer Mac Income

B-280648

Page 36 GAO/GGD-99-85 Enhancing AgMortgage Liquidity permanent
strategy to enhance profits even if it does not enhance
FarmerMac's ability to purchase agricultural mortgages. Farmer Mac
held about $1.2 billion in nonmortgage investments as ofDecember
31, 1998. These investments were about 60 percent of Farmer Mac's
balance sheet assets and slightly more than the approximately
$1.1billion in Farmer Mac's agricultural mortgage-servicing
portfolio. Interest income from nonmortgage investments is a
significant source of income atFarmer Mac.

Although it is difficult to measure the overall benefits and costs
associatedwith government sponsorship of Farmer Mac, a necessary
condition for its overall benefits to exceed its cost is that
Farmer Mac's direct economicbenefits be positive. That is, Farmer
Mac would have to be profitable or economically viable in carrying
out its mission. If Farmer Mac cannot beprofitable in its mission-
related activities with the implicit subsidy it receives from
government sponsorship, it is not likely that it is
providingenough public benefit with its existing charter to
justify the potential cost the implicit financial subsidy may be
imposing on the federal government. We constructed financial
scenarios using various assumptions to helpillustrate the
relationship between Farmer Mac's secondary market penetration and
its long-term ability to sustain mission viability.  Weconsidered
the possibility of unfavorable economic conditions leading to no
growth as well as favorable economic conditions leading to
substantialgrowth in Farmer Mac's secondary market penetration.

To take into account the uncertainties regarding Farmer Mac's
futuregrowth, we constructed two economic scenarios to help
illustrate Farmer Mac's ability to sustain mission viability. We
define mission viability as theability of Farmer Mac to generate a
profit from its core business of operating a secondary market in
agricultural mortgages and to provide areasonable return to its
investors. Farmer Mac is owned by its shareholders and its stock
is publicly traded.37 In our analysis, viability is along-term
concept in which the time horizon is defined at a future point in
time when Farmer Mac could eventually become characterized as
amature, rather than a newly created, growing institution. Just as
growth is uncertain, the number of years necessary for Farmer Mac
to eventuallybecome a mature institution is uncertain.  Farmer Mac
has yet to pay dividends to its shareholders, but returns to
shareholders have been
37Farmer Mac stock without ownership restrictions is traded on The
Nasdaq Stock Market under the

name "FedAgri" and the symbol "FAMCK."

Analysis of Farmer Mac'sFuture Viability Economic Scenarios
SuggestThat Farmer Mac Could Be Viable if Prevailing
EconomicConditions Continue

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Page 37 GAO/GGD-99-85 Enhancing AgMortgage Liquidity generated by
increases in Farmer Mac's stock price.  For long-termviability,
our scenarios require cash flows that eventually compensate
shareholders for the opportunity costs of their financial
capitalinvestments and associated risks.

38  This requires shareholders to receive a

rate of return that is competitive with other investments.  In our
scenarios,we assume that the average required return on equity
equals FCS' average

return of 11.25 percent as of June 1998. The first scenario holds
the outstanding amount of Farmer Mac AMBSconstant near its current
level of about $1.5 billion, and the second scenario doubles
Farmer Mac AMBS to $3 billion.  The first scenario wasconstructed
to illustrate whether Farmer Mac could be viable in the event that
its mortgage-servicing portfolio did not substantially grow.
Thesecond scenario was constructed to illustrate Farmer Mac's
viability if AMBS experienced a substantial increase, that is, if
AMBS backed byagricultural mortgages doubled. The calculations are
presented in appendix III.39 The scenarios do not represent
forecasts of the future. Inpresenting these scenarios, we rely on
publicly available data and make a number of simplifying
assumptions. Our results were sensitive to alternative assumptions
and to our relianceon annual 1998 Farmer Mac financial performance
data. For example, the shares of Farmer Mac business were
accounted for by pre-1996 Actguarantee activity; post-1996 Act
guarantee and purchase activity; and Farmer Mac II activity was
affected by choosing annual 1998, rather thanthe fourth-quarter of
1998, financial performance data. Specifically, the post-1996 Act
Farmer Mac I activity involves relatively higher guaranteefees and
greater credit risk than the other activities. Although the
fourthquarter 1998 statistics may provide a more accurate basis
than annualstatistics for estimating future trends in some
variables, such as guarantee fees, the fourth-quarter statistics
may reflect temporary rather thansustainable levels of some other
variables, such as loan loss provisions.

40

38Shareholders could be compensated either in the form of dividend
payments or increases in stock

price resulting from Farmer Mac's retention of earnings.  Either
form of compensation is dependent onFarmer Mac profits in the long
term.

39The $1.5 billion of AMBS in the first scenario include a $408
million long-term standby purchase commitment entered into in
January 1999. Farmer Mac reported in a press release that the
long-termcommitment operates as a swap in agricultural mortgages.

40If we had chosen fourth-quarter 1998 data, adjustments in loan
loss provision statistics would have been required to make them
more consistent with values that would correspond to likely
expansion innew Farmer Mac I activity.  Our reliance on publicly
disclosed information would have limited our

ability to make such adjustments.

B-280648 Page 38 GAO/GGD-99-85 Enhancing AgMortgage Liquidity For
future nonmortgage investment holdings, we distinguished
between(1) investment securities and (2) cash and cash
equivalents. As of December 31, 1998, Farmer Mac's nonmortgage
investment holdings wereabout $1.2 billion dollars, with $644
million accounted for by investment securities. On the basis of
Farmer Mac's view that the debt issuancestrategy's contribution to
mission achievement should develop over a reasonable period of
time, we arbitrarily reduced holdings of investmentsecurities by
half, or $322 million. Even with this reduction in investment
securities, Farmer Mac investment securities would account for
largershares of balance sheet assets and mortgage-servicing
portfolios than such investments for the housing enterprises. Cash
and cash equivalents, whichare short-term investments that can
help Farmer Mac facilitate liquidity in the agricultural mortgage
market, were kept constant at current levels. To calculate
revenues for each scenario, we assumed that the splitbetween AMBS
held in portfolio and sold to investors would equal the percentage
splits as of December 31, 1998. We also used the year-end
1998levels to specify average AMBS guarantee fees, average gain on
AMBS issuance, and average interest-rate spread between retained
portfolioholdings (i.e., mortgage and nonmortgage investments
combined) and debt costs. To determine expenses and opportunity
costs for each scenario, wecalculated Farmer Mac capital
requirements on the basis of the current statutory minimum capital
standards. We specified required return onequity on the basis of
the annual 1998 return of 11.25 percent on equity for FCS. We
assumed the average provision for loan losses to equal the year-
end 1998 average. Some expenses were treated as variable
(depending on size); we calculated these expenses using average
operating costs. Otherexpenses that we assumed to be subject to
economics of scale were held constant. We recognize that by
assuming fixed operating costs, we mayhave understated Farmer
Mac's costs, particularly in scenario 2, which anticipates a
substantial expansion in Farmer Mac's agricultural
mortgagepurchases. Our scenarios also did not incorporate Farmer
Mac corporate income tax liabilities that would have the effect of
reducing after-taxcorporate income.

Results from the first scenario showed that Farmer Mac would
haveestimated revenues of $16.6 million and expenses of $15.6
million, or an economic profit of about $1 million. In the second
scenario, Farmer Macwould have estimated revenues of $26.7 million
and expenses of $20.4 million, or an economic profit of about $6.3
million. If we had developedscenarios with larger specified
increases in Farmer Mac AMBS, estimated economic profits would
have been greater than $6.3 million. However, our

B-280648 Page 39 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
assumption of fixed operating costs would become more unrealistic
insuch a specified scenario. Farmer Mac's nonmortgage investments
affected the level of profitabilityin both scenarios. If we
removed Farmer Mac's investment securities from our scenarios,
annual revenues would be reduced by about $2 million andrequired
return on equity would be reduced by about $1 million for both
scenarios. With these reductions, economic profit would become
aboutzero (i.e., a breakeven level) in our first scenario and
about positive $5.3 million in our second scenario. In our 1998
report,41 we questioned theneed for a mature GSE to hold long-term
nonmortgage investments to fulfill its statutory mission. The
Department of the Treasury agreed withour assessment when it
commented on our 1998 report.

Farmer Mac's potential for growth will be affected by its ability
to providebenefits to commercial banks, FCS institutions, and
other agricultural mortgage lenders. In addition, a number of
other factors could have amajor impact on Farmer Mac's viability.
These factors include the following: (1) changing economic
conditions in the national andagricultural economies, (2)
potential changes affecting participation by FCS institutions in
Farmer Mac programs, and (3) risk-based capitalstandards to be
promulgated by FCA.

An important element in Farmer Mac's growth potential is that it
continuesto take actions intended to provide benefits to
agricultural lenders.  Our survey suggests that continued growth
is possible. Seventy-three percentof the approved sellers who
participated in our survey said that they are likely to increase
sales to Farmer Mac in the next 3 years. In addition,about one-
fourth of the nonparticipants responding to our lender survey said
that they expect to begin participating in Farmer Mac programs in
thenext 3 years.  To the extent these lenders' inclinations are
carried out, they could enhance agricultural secondary market
activity. Economic conditions in the national and agricultural
economies can affectthe size of the overall agricultural mortgage
debt market.  Farmer Mac's rate of growth will be affected to some
extent by the size of this overallmarket. While the residential
mortgage market has grown, agricultural mortgage debt has
declined. The 1997 constant dollar value of agriculturalmortgage
debt outstanding was slightly more than half of its 1980 value. If
the decline in the constant dollar value of agricultural mortgage
debtcontinues, it could directly affect Farmer Mac's growth
potential.
41GAO/GGD-98-48.

A Number of Factors CouldHave Major Impacts on Farmer Mac's
Viability

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Page 40 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Economic
conditions in the agricultural and aggregate national economycan
affect participants in the primary and secondary mortgage markets
in other ways. For example, over the last 5 years, the economic
environmentfaced by financial institutions has generally been
favorable and interest rates have generally declined to relatively
low levels. The agriculturaleconomy has also been fairly strong.
However, recent adverse trends in agricultural economic
conditions, such as low commodity prices, reducedexport demand,
and weather-related problems in certain areas of the United
States, have provided stress to the agricultural economy that
couldlessen the credit quality of agricultural mortgages. Over the
past 2 years, delinquency rates on Farmer Mac I AMBS have
generally been under 1percent (except for the first quarter of
1998 when it was 1.15 percent). During the fourth quarter of 1998,
FCS experienced an increase in loanlosses and its provision for
loan losses expanded dramatically. Farmer Mac's ability to serve
as a safety valve for the agricultural sector if FCSencountered
difficulties has yet to be tested. However, one financial industry
group we interviewed suggested that within the next few years,we
may have a test for whether Farmer Mac could help in a situation
similar to the one presented in the 1980s in which agricultural
real estateprices plummeted, the credit quality of agricultural
mortgages declined, and FCS essentially stopped making loans.
Before Farmer Mac's recent, long-term, standby purchase
commitmenttransaction, FCS institutions had not been active
participants in Farmer Mac programs. An expansion of FCS'
participation in Farmer Macprograms as a means to manage credit
and interest-rate risks could help Farmer Mac's business expand.
Farmer Mac's January 1999 transaction of $408 million with a
FCSinstitution illustrates the use of a Farmer Mac program to
manage credit risk, because Farmer Mac is providing a guarantee to
the FCS institution inthe event of borrower defaults. In providing
this service, Farmer Mac has the ability to diversify its credit
risk by purchasing agricultural mortgagesthroughout the nation.
However, in terms of evaluating credit risk, Farmer Mac is
currently at a disadvantage compared to primary market lenderswho
have personal relationships with borrowers and knowledge of their
local economies to evaluate credit risk. In the future, credit
scoring, whichhas recently been introduced to evaluate credit risk
associated with commercial lending, could help Farmer Mac evaluate
credit risk. Farmer Mac also has the ability to help lenders
manage interest-rate risk.Increased demand by agricultural
borrowers for long-term, fixed-rate agricultural mortgages could
help facilitate growth in Farmer Mac's

B-280648 Page 41 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
business as FCS lenders seek to manage the potentially higher
level ofinterest-rate risk. Conditions for such expansion differ
somewhat from those for participation by commercial banks.
Specifically, FCS institutionshave access to national capital
markets. Therefore, they can be better able to manage interest-
rate risk without secondary market sales than lenderswho rely on
their deposit bases.

42

Increased AMBS issuance itself could facilitate the role of two
otherfactors that could in turn promote greater expansion. First,
increased AMBS issuance can create the possibility that investors
may obtainexpanded historical information on AMBS cash flow
performance, improve investors' ability to evaluate risks from
secondary market activity, loweryields they demand, and thus
promote a further increase in secondary market sales. Second,
increased AMBS issuance could help Farmer Macrealize economies of
scale--a condition where average costs decline as output (i.e., in
this case, loan purchase and other secondary marketactivity)
increases.  Farmer Mac is a relatively small corporation operating
in a secondary market activity often characterized as exhibiting
economiesof scale.  Therefore, the direct impact of expansions in
Farmer Mac purchases could indirectly cause further expansion in
the presence ofeconomies of scale.

In the future, the relative importance of FCS institutions and
commercialbanks in making agricultural mortgage loans could have
an effect on Farmer Mac's expansion. Commercial banks compete with
FCSinstitutions in the primary mortgage market. However, because
they are GSEs, FCS institutions (1) are less likely to rely on
Farmer Mac to helpthem manage interest-rate risk than would
commercial banks and (2) have been less likely to participate in
Farmer Mac programs than commercialbanks.  If commercial banks
continue to be more likely to sell their agricultural mortgages to
Farmer Mac than FCS institutions, Farmer Mac'sexpansion could be
better served by an expansion in the share of agricultural
mortgages originated by commercial banks. FCA hasannounced changes
in its regulatory policies and practices that are intended to
increase competition among FCS institutions. If this
increasedcompetition increases efficiency, improvements in the
ability of FCS institutions to compete with commercial banks could
result.  If this, inturn, would lead to an increase in FCS' share
of the primary market for agricultural mortgages, Farmer Mac's
growth potential could beconstrained.

42GSEs can issue callable and noncallable debt with a wide range
of maturities to manage their interest

rate risk.

B-280648 Page 42 GAO/GGD-99-85 Enhancing AgMortgage Liquidity The
purpose of establishing a risk-based capital standard for Farmer
Macis to help ensure that its capital is aligned with the risks of
its financial activities, including potential risks to taxpayers.
Congress has recognizedthe role of risk-based capital standards in
mitigating the risk to taxpayers from GSE financial activities.
FCA has a congressional mandate toestablish risk-based capital
standards for Farmer Mac no sooner than February 1999. FCA must
develop a stress test that exposes Farmer Mac tostatutorily
specified interest-rate and credit stresses. For example, the
credit stress must be based on the worst credit conditions
experienced bya region of the country accounting for at least 5
percent of the nation's population. FCA issued an advance notice
of proposed rulemaking in 1998seeking comments on its possible use
of loan credit performance data for the Farm Credit Bank of Texas
in developing the capital standard. FCAplans to issue a notice of
proposed rulemaking in 1999 seeking comments on its proposed risk-
based capital standards for Farmer Mac. As of December 31, 1998,
Farmer Mac held regulatory capital of $80.7million, $30.5 million
in excess of its regulatory minimum capital requirement of $50.2
million. Farmer Mac has stated that it does not expectthe risk-
based capital standards will require it to raise additional
capital. However, in the long-term, the risk-based requirements
could becomemore difficult to meet and, under such circumstances,
Farmer Mac may need to make adjustments to its book of business or
raise more capital tomeet the standard. In such a situation,
shareholders would likely require compensation for any additional
equity investments. In turn, Farmer Mac'sfunding costs could rise,
and, therefore, its growth could be reduced. This possibility, in
which Farmer Mac may be called upon to raise capital tomitigate
risk to taxpayers from Farmer Mac's financial activities,
illustrates that Farmer Mac's viability under current capital
standards is notnecessarily the proper basis for judging the
benefits and costs of government sponsorship. Government
sponsorship of a financial institution can generate a numberof
public benefits and costs, which are difficult to quantify. The
benefits Farmer Mac can generate in the agricultural mortgage
market depend onwhether its new loan programs and products help
agricultural lenders manage risks in ways that improve loan terms
offered to borrowers. Itspotential costs depend on the likelihood
that taxpayers may be called upon if Farmer Mac is unable to meet
its obligations. The net benefits and costsalso depend on how
Farmer Mac's activities interact with those of the two other
GSEs*FCS and the FHLBank System.

Value Created FromGovernment Sponsorship of Farmer Mac Depends
onActivities of Other GSEs

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Page 43 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Government
sponsorship of a financial institution can generate a numberof
benefits. To the degree that lower funding costs and other
benefits are passed on to borrowers in the affected financial
sector, public benefits aregenerated. The special purpose charters
can also provide GSEs with motivation to make investments that
enhance efficiency in the affectedfinancial sector. For example,
GSEs that create secondary markets have incentives to make
investments that facilitate standardization. In a 1996report,

43 we found that government sponsorship of the housing enterprises

was associated with lower interest rates on single-family
residentialmortgages, and that the enterprises increased
efficiency through greater

standardization of mortgage products and processes.
Governmentsponsorship of Farmer Mac has the potential, if it
remains viable and continues to grow, to generate benefits through
loan programs andproducts that help agricultural lenders manage
risks.

Government sponsorship also generates potential public costs.
Onepotential cost is that taxpayers could be called upon if a GSE
is unable to meet its financial obligations. Such a situation
occurred in the late 1980swhen FCS encountered financial
difficulties. Opportunity costs can also be generated when the
implied backing of certain financial institutions divertsfunding
from other financial institutions that may be able to serve the
sector more efficiently.  For example, the possibility is present
thatgovernment sponsorship of Farmer Mac could reduce the
incentives of other financial institutions to develop secondary
market products of valueto agricultural lenders.  In addition,
opportunity costs can also be generated when implied backing of
financial institutions serving a specificsector diverts funding
from other sectors.

As previously discussed, one limitation on Farmer Mac's growth
could beits inability to reach a size sufficient to generate
economies of scale. One approach to improving its growth potential
could be to expand FarmerMac's charter beyond agricultural
mortgages, for example, to other rural and agricultural loans.
While such an expansion could increase the scopeof potential
benefits generated by Farmer Mac, it could also increase potential
costs and could affect both FCS and the FHLBank System. The
financial performance and benefits provided by FCS and the
FHLBankSystem affects Farmer Mac and are affected by Farmer Mac's
charter authorities and activities. For example, Farmer Mac's
current programsand products provide an alternative-funding source
for agricultural mortgage lenders, such as commercial banks that
compete with FCS
43GAO/GGD-96-120.

B-280648 Page 44 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
institutions in the primary mortgage market. The AgVantage
Programcompetes with FHLBank advances to rural lending
institutions. In July 1998, the FHLBank System's regulator (the
Federal Housing FinanceBoard) authorized mortgages on farm
properties on which a residence is located and constitutes an
integral part of the property, as collateral foradvances received
by FHLBank member institutions with total assets of $500 million
or less. Given that there is currently a degree of overlapbetween
Farmer Mac's activities and the activities of other GSEs, any
expansion of Farmer Mac's charter would probably have effects on
theseother entities that would need to be taken into
consideration.

Removing Farmer Mac's charter would eliminate potential benefits
andcosts resulting from its activities as a GSE.  Elimination of
Farmer Mac's charter could affect the public benefits and costs
associated with FCS andFHLBank System activities.

Likewise, expansions in FCS lending to a wider variety of
companiesparticipating in the agricultural economy could create
benefits. However, such expansion could increase the potential
costs from governmentsponsorship of FCS, reduce agricultural loans
made by depository institutions, and reduce agricultural mortgage
loans sold to Farmer Mac.Expansion in the FHLBank System, such as
the recent expansion to include certain agricultural mortgages as
eligible collateral for obtainingFHLBank advances, may also limit
Farmer Mac's growth potential.

In summary, charter revisions, regulatory changes, or other
actionsaffecting the activities of each GSE in relation to
agricultural and rural finance could in turn affect the financial
performance and benefitsgenerated by the other GSEs.

The share of loans in a primary market that are sold by lenders in
asecondary market depends on the benefits generated by the
secondary market. Farmer Mac has used its post-1996 charter
authorities tostreamline the process for buying loans and to
develop new programs and products that have provided an
alternative funding source for someagricultural lenders. Farmer
Mac has also standardized some aspects of the secondary market
transaction by requiring participating agriculturalmortgage
lenders to make representations and warranties that their loans
meet Farmer Mac underwriting standards, but Farmer Mac has
notstandardized loan documents because state laws governing
agricultural mortgage loans and agricultural lending practices
vary. In addition, FarmerMac employs risk management techniques to
measure and manage its various risks and to help ensure that
Farmer Mac conducts its secondary

Conclusions

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Page 45 GAO/GGD-99-85 Enhancing AgMortgage Liquidity market
operations in a safe and sound manner. We noted that elements
ofFarmer Mac's risk management techniques appeared to be generally
consistent with industry risk management principles. Since its
1996restructuring, Farmer Mac has made some progress in developing
a secondary market in agricultural mortgages, but it currently has
arelatively small market presence.

Farmer Mac is a niche player as a secondary market entity in
theagricultural mortgage market. It appears that Farmer Mac can be
viable if it continues to expand, it experiences returns that are
comparable tocurrent levels, and economic conditions in the
overall and agricultural economies of the nation remain stable.
Even if Farmer Mac continued tobe economically viable under its
current operating structure, it is difficult to determine whether
the public benefits created justify continuedgovernment
sponsorship. The future benefits from government sponsorship of
Farmer Mac are potentially limited by possible expansionsof
competing FHLBank funding alternatives and increased competitive
pressures from FCS institutions. Therefore, the potential public
benefitscreated from government sponsorship of Farmer Mac could be
affected by legislative, regulatory, and other developments
affecting the FHLBankSystem and FCS as well as Farmer Mac.

Farmer Mac, FCS, and FHLBanks now offer programs that
competedirectly and indirectly with one another.  Therefore, the
public benefits and costs of these three GSEs are interrelated.
Congressional committeeswith jurisdiction may want to consider
interactions among the activities and the charters of these three
GSEs as part of their ongoing oversight. We received comments on a
draft of this report from Farmer Mac.  Thesewritten comments are
provided in appendix IV.

Farmer Mac said, in general, it did not disagree with our
statements on thebackground, history, and progress of Farmer Mac's
development. However, Farmer Mac disagreed with our (1) conclusion
that it is difficultto determine whether the public benefits
created justifies continued government sponsorship of Farmer Mac,
(2) comparison of Farmer Mac'ssecondary market penetration to the
housing enterprises, and (3) characterization that Farmer Mac
continues to rely on nonmortgageinvestments as a primary source of
income.

Matter forCongressional Consideration

Farmer MacComments and Our Evaluation

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Page 46 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Farmer Mac
stated, "The Report's ultimate conclusion, that it is difficult
todetermine whether the public benefits provided by Farmer Mac
justify continued government sponsorship, is inconsistent with the
GAO'sfindings and analyses regarding Farmer Mac's economic
viability and program development."  Farmer Mac agreed with the
positive findingsabout Farmer Mac's development and its economic
viability and said that our ultimate conclusion conflicted with
these findings. Farmer Mac alsotook issue with our conclusion that
the activities of FCS and the FHLBank System affect the net public
benefits provided by Farmer Mac.  In addition,Farmer Mac stated
that we should have but did not take into account its contribution
to a more efficient agricultural credit market and theavailability
of a competitive supply of mortgage credit for agricultural
borrowers. In this report, a number of factors contribute to our
conclusion that it isdifficult to determine whether the public
benefits created justifies continued government sponsorship of
Farmer Mac.  First, although ouranalysis shows that Farmer Mac is
currently viable in its agricultural mortgage mission activities,
its growth potential in the secondary marketfor agricultural
mortgage and the prospects for realizing that potential are
unclear.  Since its restructuring resulting from the 1996 Act,
Farmer Machas experienced a favorable interest-rate environment
that has contributed to profitability for financial institutions
in general.  Perhaps of greaterimportance, its agricultural
mortgage-servicing portfolio has not been subject to major credit
stress, such as a prolonged increase in defaultrates.  Therefore,
its ability to manage interest-rate and credit risks under
stressful conditions has not been tested since the 1996 Act. In
addition, while Farmer Mac competes in various ways with
FCSinstitutions and the FHLBank System, interaction between Farmer
Mac and FCS institutions is subject to countervailing forces.  On
the one hand,as we explain in this report, FCS institutions have
access to GSE-issued debt, and, therefore, FCS institutions may
not have the same incentives asbanks to sell mortgages to Farmer
Mac to manage interest-rate risk. If banks remain more likely than
FCS institutions to use Farmer Mac'sproducts, the possibility of
an expanded presence in agricultural lending (i.e., directly or
indirectly) by FCS or the FHLBank System, as explained inthis
report, could lessen potential benefits to be generated by Farmer
Mac. On the other hand, Farmer Mac has completed transactions with
FCSinstitutions, but its limited experience to date is not
sufficient to establish the likelihood of any future trend for its
business with FCS. In addition, amore expansive definition of
eligible mortgages on farm properties as collateral for FHLBank
advances has increased the potential for

Net Public BenefitsResulting From Government Sponsorship

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Page 47 GAO/GGD-99-85 Enhancing AgMortgage Liquidity competition
between Farmer Mac's AgVantage Program with FHLBankadvances.
Since 64 percent of Farmer Mac approved sellers responding to our
survey indicated that they were also members of the FHLBank
System,the potential for overlap between GSE programs is
significant.  Because there is overlap in the three GSEs'
activities, it is not clear how much valueis added by a given
GSE's existence that would not be generated by the others in its
absence. Most importantly, viability is not necessarily the only
proper measure ofthe benefits and costs of government sponsorship.
At some places in its comments, Farmer Mac appears to imply that
viability is sufficient toindicate that its public benefits are
greater than its public costs, although the viability measure does
suggest that broader benefits might result fromincreased lender
competition and wider availability of credit.  There are a number
of public costs and benefits that are not included in the
viabilitymeasure.  For example, due to potential liabilities and
opportunity costs associated with government sponsorship, it is
possible that the public costgenerated by Farmer Mac activities
may exceed its private cost. One potential public cost is that
taxpayers could be called upon if a GSE isunable to meet its
financial obligations. Opportunity costs can also be generated
when the implied backing of certain financial institutions
divertsfunding from other financial institutions that may be able
to serve the sector more efficiently. These potential costs
resulting from governmentsponsorship of Farmer Mac cannot be
statistically estimated.

Farmer Mac also stated that a broader standard than economic
results,focusing on the secondary market's contribution to
increased lender competition and wider availability of
agricultural mortgage credit, wouldbe a more appropriate measure
of public benefits than viability.

44  To the

extent that Farmer Mac develops unique programs and processes
thatimprove the efficiency of agricultural mortgage markets,
public benefits

from such functions can exceed economic returns to Farmer Mac
(i.e.,spillover public benefits can be created). However, in
activities where the GSEs provide similar or overlapping
functions, market shifts among theGSEs are less likely to generate
such spillover benefits. In the absence of statistical measures of
lender competition and agricultural mortgageavailability, these
potential benefits also cannot be statistically estimated. In
light of the measurement difficulties of the potential costs and
potential
44Farmer Mac's comment letter also cited efforts that have
attracted other nontraditional lenders into

the agricultural mortgage market, particularly commercial mortgage
lenders and agricultural supplyand equipment companies.  We
discussed Farmer Mac outreach to nontraditional lenders, such as

mortgage bankers, in this report.  Also of note, we did not
receive survey results from any respondentidentifying itself as an
agricultural supply and equipment company.

B-280648 Page 48 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
benefits and the difficulty in predicting Farmer Mac's growth
potential, wereached the conclusion that it is difficult to
determine whether the net public benefits resulting from
government sponsorship of Farmer Macjustify continued government
sponsorship.

Farmer Mac said that our draft report misleadingly compared
FarmerMac's market penetration to that of the housing enterprises
during different time frames.  Farmer Mac noted that the
comparison in the draftreport did not account for differences in
operating charters, stage of development when the respective GSEs
were created, and availableresources to foster secondary market
development.  For these reasons, Farmer Mac stated that our report
"contains no valid foundation for thefinding that Farmer Mac's
market penetration at its early stage of development is low
compared to the housing enterprises and all referencesto that
effect should be deleted from the report." In contrast to our
conclusion, Farmer Mac stated, "...we believe the correct finding
is thatFarmer Mac's 2% market penetration during its first three
years of operations compares very favorably to the housing GSEs'
progress in themultifamily market, which is the more appropriate
market for comparison with agricultural mortgages." A major point
of the section in the report containing these comparisons isthat
Farmer Mac's penetration of the agricultural mortgage market is
relatively small.  As Farmer Mac stated in its 1998 annual report,
its $1.3billion of secondary market activity at December 31, 1998,
represented only 1.5 percent of all outstanding agricultural
mortgages. In comparing Farmer Mac's penetration to that of the
housing enterprisesover the first decade of their operations as
GSEs, we recognize differences in operating charters, stage of
development when the respective GSEswere created, and available
resources to foster secondary market development. However, we
believe that these market penetrationcomparisons, especially with
multifamily residential mortgages, provide useful perspective in
analyzing Farmer Mac's development.45  In makingthese comparisons,
we were not suggesting that Farmer Mac should mirror the market
penetration levels achieved by the housing enterprises in
theirfirst decade of operations.  Nor were we suggesting that
Farmer Mac should be expected to reach the market penetration
levels reached by thehousing enterprises in the long-term.  For
example, the possibly greater heterogeneity of borrowing farm
operators and of farm properties serving
45As discussed in this report, multifamily mortgages, just as
agricultural mortgages, are supported by

income flows from commercial properties.

Comparison of FarmerMac's Market Penetration to That of the
HousingEnterprises

B-280648

Page 49 GAO/GGD-99-85 Enhancing AgMortgage Liquidity as collateral
for agricultural mortgages, even in comparison to
multifamilyresidential mortgages, could lead to a different long-
term outcome. We have revised the report to clarify our purpose in
making these marketpenetration comparisons.

Farmer Mac was established as a GSE in 1988, and the 1996 Act
madeFarmer Mac's operating structure essentially the same as
Freddie Mac's and Fannie Mae's.  Fannie Mae and Freddie Mac became
GSEs in 1968 and1970, respectively.  Prior to 1968, Fannie Mae was
a government corporation.  Freddie Mac was one of the first
financial institutions in thenation to develop the ability to buy
loans, form loan pools, and issue securities backed by loan pools.
Fannie Mae began to issue securitiesbacked by loan pools in the
1980s. As stated in this report, the housing enterprises did not
enter the conventional multifamily market until 1983. In relation
to differences in operating charters, Farmer Mac's originalcharter
was more limited than the housing enterprises' charters in that it
created the necessity to operate through third-party poolers and
establisha mandatory reserve or subordinated interest in its
guarantee function. The housing enterprises did not have these
constraints.  However, FarmerMac also had advantages during its
first decade of operations compared to the housing enterprises
during their first decade of aspirations as GSEs.Farmer Mac had
the benefit of learning from the experiences of the housing
enterprises, because it began operations in 1988, after the
housingenterprises had developed the securitization concept for
residential mortgages.  In the 1990s, Farmer Mac also had the
benefit of observing andlearning from the dramatic expansion in
securitization of residential mortgages and other financial
assets. While, Fannie Mae had been a government corporation before
it wasestablished as a GSE, this advantage was limited, because it
became a GSE and continued as one for over a decade before it
securitized residentialmortgages.  Regarding available resources
to foster secondary market development, the housing enterprises
initially focused their availableresources on establishment of a
secondary market in single-family rather than multifamily
residential mortgage loans.  In contrast to the housingenterprises
lack of focus on multifamily mortgages, Farmer Mac, consistent
with its statutory authority, has focused its available
resourceson establishment of a secondary market in agricultural
mortgages.

B-280648

Page 50 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Farmer Mac
said that our draft report incorrectly stated that interestincome
from nonmortgage investments continues to be a primary source of
income at Farmer Mac.  Farmer Mac said that net interest income
frominvestments, including that from interest on cash and cash
equivalents, was about one quarter of Farmer Mac's total revenues
in 1998.  FarmerMac also stated that its nonmortgage investments
are part of its debt issuance strategy as part of a broad business
strategy to achieve increasedmarket presence for Farmer Mac
securities.  Farmer Mac stated that the draft report should be
revised to reflect more accurately the purposes forits debt
issuance strategy and note that nonmortgage interest income should
be characterized as a minor source rather than a primary source
ofincome.

We relied on a number of statistical indicators for our analysis
of interestincome from nonmortgage investments. None of these
indicators provided a precise measure of the percentage of Farmer
Mac's net incomeaccounted for by nonmortgage investments, because
data are not publicly available on the allocation of Farmer Mac's
interest and operatingexpenses among its various financial
activities. In our 1998 report,

46 we

indicated that as of June 30, 1997, Farmer Mac's nonmortgage
investmentsof $931 million represented about 66 percent of Farmer
Mac's assets.  In its

comment letter on our 1998 report, Farmer Mac stated that Farmer
Mac'sincome from nonprogram investments represented about 38
percent of total net income.47  As of December 31, 1998, Farmer
Mac held $1.18 billionin nonmortgage investments (including cash
and cash equivalents) that accounted for about 61 percent of total
assets.  As indicated in our report,Farmer Mac AMBS held by other
investors has grown dramatically, which would logically lessen the
relative importance of nonmortgage investmentincome compared to
earlier periods.  Because of the difficulty in precisely
determining the importance of interest income from
nonmortgageinvestments, we now characterize it as a significant
rather than a primary source of income at Farmer Mac. Farmer Mac
has stated that the purpose of its investment policy is toincrease
its presence in the capital markets.  In its comments, Farmer Mac
stated that the number of investors purchasing Farmer Mac's debt
andmortgage-backed securities has increased significantly as the
market acceptance and liquidity of the securities has improved.
As we stated in
46GAO/GGD-98-48.

47We understand that Farmer Mac's definition of nonprogram
investments is equivalent to our definition of nonmortgage
investments.  We did not verify Farmer Mac's calculation nor
determineFarmer Mac's method for allocating interest and operating
expenses.

Nonmortgage InvestmentIncome

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Page 51 GAO/GGD-99-85 Enhancing AgMortgage Liquidity our 1998
report, these developments could be beneficial to achievingFarmer
Mac's mission if they lead to benefits to Farmer Mac that are then
passed on to borrowers in the form of more favorable loan terms.
As arranged with your office, unless you publicly announce the
contents ofthis report earlier, we plan no further distribution
until 20 days after its issue date.  At that time, we will send
copies of this report toRepresentative Paul E. Kanjorski, Ranking
Minority Member, of your Subcommittee; Senators Richard G. Lugar,
Chairman, and Tom Harkin,Ranking Minority Member, of the Senate
Committee on Agriculture, Nutrition and Forestry; Representatives
Larry Combest, Chairman, andCharles W. Stenholm, Ranking Minority
Member, of the House Committee on Agriculture; Senators Phil
Gramm, Chairman, and Paul S. Sarbanes,Ranking Minority Member, of
the Senate Committee on Banking, Housing and Urban Affairs;
Representatives Jim Leach, Chairman, and John J.LaFalce, Ranking
Minority Member, of the House Committee on Banking and Financial
Services; Henry Edelman, President and Chief ExecutiveOfficer of
Farmer Mac; and Marsha Pyle Martin, Chairman and Chief Executive
Officer of FCA. We will also make copies available to others
onrequest.

Major contributors to this report are listed in appendix VI.
Please contactme or William Shear, Assistant Director, at (202)
512-8678 if you or your staff have any questions. Sincerely yours,

Thomas J. McCoolDirector, Financial Institutions   and Markets
Issues

Page 52 GAO/GGD-99-85 Enhancing AgMortgage Liquidity

Contents

1Letter 54Survey Population and Sample 54 Questionnaire Design
54Survey Administration 55 Disposition of Survey Sample 55Survey
Error and Data Quality 56

Appendix IMethodology for Survey of Farmer MacApproved Sellers and
Nonparticipants

58Appendix II GAO Survey Results ofFarmer Mac Approved

Sellers andNonparticipants

81Appendix III GAO Analysis ofFarmer Mac's Future

Viability

85GAO Comments 97Appendix IV Comments From theFederal Agricultural

Mortgage Corporation

99Newly Originated Loan Standards 99 Seasoned Loan Standards
101Facility Loan Standards 102 Part-time Farm Loan Standards 102

Appendix VFarmer Mac's UnderwritingStandards

Contents

Page 53 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix
VIMajor Contributors to This Report

104

Table 1:  Farmer Mac programs and products 14Table 2: Annual Loan
Purchases by Farmer Mac at Year

end 1995-98 30Table 3:  Farmer Mac's Secondary Market at Year-end
1995-98 31Table 4: Farmer Mac's Share of Agricultural Mortgage
Debt Outstanding at Year-end 1995-98 32Table I.1:  Disposition of
Samples 56 Table III.1: Scenario 1: No Secondary Market Growth
ButInvestment Securities Reduced by 50 Percent 82 Table III.2:
Scenario 2: Farmer Mac Doubles Its Share ofthe Agricultural
Mortgage Market 84

Tables

Figure 1:  Secondary Market Penetration of Single-
family,Multifamily, and Agricultural Mortgages 34Figures
Abbreviations AMBS agricultural mortgage-backed securities ARM
adjustable rate mortgage FCA Farm Credit Administration FCS Farm
Credit System GAAP generally accepted accounting principles GSE
government-sponsored enterprise LTV loan-to-value (ratio) SPI
subordinated participation interests USDA United States Department
of Agriculture OSMO Office of Secondary Market Oversight FHLBank
Federal Home Loan Bank

Appendix IMethodology for Survey of Farmer Mac Approved Sellers
and Nonparticipants

Page 54 GAO/GGD-99-85 Enhancing AgMortgage Liquidity To help
determine the potential market benefits from a governmentsponsored
secondary market for agricultural loans, we surveyed all 263
financial institutions that were currently approved to sell loans
to FarmerMac (as of Oct. 1998) and a sample of 334 commercial
banks and insurance companies (as of Oct. 1998) that were not
currently approved sellers buthad been targeted by Farmer Mac as
program candidates.

We asked officials at these financial institutions for their views
on FarmerMac programs and the secondary market for agricultural
loans, their use of Farmer Mac services, and their behavior in the
agricultural lending market.We conducted this mail questionnaire
survey beginning in November 1998 and received 200 usable
responses from approved sellers and 189responses from
nonparticipants by mid-February 1999.

Our ideal target populations were current participants in Farmer
Macprograms and comparable institutions not currently approved to
participate in any Farmer Mac programs. The actual study
populations we were able to survey were limited to thosedefined by
available Farmer Mac records. We obtained a list of 263

1

financial institutions that had been approved to originate or
poolagricultural loans and then sell them to Farmer Mac. Farmer
Mac also

provided us with a list of 331 nonparticipating (not approved to
sell loansto Farmer Mac) commercial banks that met the marketing
criteria developed by Farmer Mac. These banks had been designated
by FarmerMac as banks with significant potential for becoming
Farmer Mac approved sellers. To this list of nonparticipants, we
added three largeinsurance companies that were active in
agricultural mortgage lending, but were not Farmer Mac members. We
chose to survey all 263 approved sellers and 334
nonparticipatinginstitutions. No stratification or random
probability sampling was used to select elements from the study
populations. We created two self-administered mail questionnaires,
one for approvedsellers and another for nonparticipants. See
appendix II for reproductions of the questionnaires and the
results of the survey. To develop thequestionnaires, we consulted
officials from Farmer Mac and experts in the field of agricultural
finance and asked them to review the draft
1In addition to the 263 approved sellers on our original sample
frame, during the course of the survey

we discovered 2 institutions on the nonparticipant sample that had
become approved sellers, bringingthe total to 265.

Survey Population andSample Questionnaire Design

Appendix I Methodology for Survey of Farmer Mac Approved Sellers
and Nonparticipants

Page 55 GAO/GGD-99-85 Enhancing AgMortgage Liquidity
questionnaires. We also conducted six pretest interviews by
telephonewith a variety of institutions selected from both survey
populations. The information gathered from these sources was used
to improve thestructure of the questionnaires and the wording of
individual questions and response choices on the questionnaires.
We mailed questionnaires to our samples on November 12, 1998. For
theapproved seller survey, we addressed the questionnaires to the
individuals identified as contacts in Farmer Mac's records. For
the nonparticipantsurvey, questionnaires were addressed to the
President or Chief Executive Officer of the institution.
Respondents were instructed to mail or fax theircompleted
questionnaires. On December 3, 1998, we mailed replacement
questionnaires to those who had not yet responded. On December 23,
wesent an additional follow-up mailing to the remaining
nonrespondents.

In early February 1999, we selected 6 approved sellers from the 57
whohad not yet responded, and 11 nonparticipants out of 105 who
had not yet responded and telephoned them to determine their
reason for nonresponseand to prompt them to return questionnaires.

During our fieldwork, we discovered that 37 institutions on
thenonparticipants' sample frame were already represented on the
approved seller sample and were in fact approved sellers. These
duplicate caseswere removed from further consideration as
nonparticipant sample elements. When our fieldwork was concluded
in mid-February 1999, we had received200 usable approved seller
questionnaires and 167 usable nonparticipant questionnaires. In
addition, some of the nonparticipating institutions thatdid not
return questionnaires told us that they did no agricultural
lending, or reported that their answers were included in a
questionnaire returnedby another surveyed institution in the same
bank holding company, which we counted as substantive responses. A
total of 189 responses fromnonparticipants were received.

The final response rate was 77 percent for the approved seller
survey and66 percent for the nonparticipant survey. See table I.1
for a more complete description of the dispositions of our survey
samples.

Survey Administration Disposition of SurveySample

Appendix I Methodology for Survey of Farmer Mac Approved Sellers
and Nonparticipants

Page 56 GAO/GGD-99-85 Enhancing AgMortgage Liquidity

Disposition Approved sellers Nonparticipants Total initial samples
263 334 Additional eligibles discovered duringfieldwork 2 0

Sampled elements outside study population(ineligible)     Out of
business 5 10    Duplicate element or became seller 0 37 Sampled
elements in the study population(eligible)--nonrespondents
Undeliverable questionnaire 1 2    Refusal 3 6     All other
nonresponses 56 90 Sampled elements in the study
population(eligible)--respondents

No agricultural lending 0 20    Responses rolled up on one
questionnaire 0 2     Usable response 200 167 Response rate
(respondents/totaleligible) 76.9% 65.8%

Source: GAO.

Although we did not use any random probability sampling techniques
toselect our sample, and therefore our survey results are not
subject to sampling error (imprecision in survey estimates caused
by the naturalvariation that can occur among different possible
samples of the same size), the practical difficulties of
conducting any survey may introduceother types of errors. As
discussed in the remaining text in this appendix, we took steps to
minimize the extent of such errors. Surveys may be subject to
coverage error. Coverage error occurs when thesampling frame does
not fully represent the target population of interest. For our
seller survey, Farmer Mac gave us a list of approved sellers as
ofOctober 1998, but we did not verify this list nor did we
necessarily capture all sellers approved after that date but
before our survey ended. Becausethe nonparticipant sample was
uniquely defined as those institutions that Farmer Mac was
targeting as possible candidates for membership, it wouldnot be
subject to coverage error as commonly defined.

Measurement errors are defined as differences between the reported
andtrue value of a characteristic under study. Such errors can
arise from differences in how questions are interpreted by
respondents, deficienciesin the sources of information available
to respondents, the misreporting by respondents, or poorly
designed questions. We received expert review ofour survey
questionnaire from a nationally recognized survey firm retained

Table I.1:  Disposition of Samples

Survey Error and DataQuality

Appendix I Methodology for Survey of Farmer Mac Approved Sellers
and Nonparticipants

Page 57 GAO/GGD-99-85 Enhancing AgMortgage Liquidity by Farmer
Mac. We also conducted pretests with sampled respondents
tominimize such measurement errors. Nonresponse error arises when
surveys are unsuccessful in obtaining anyinformation from eligible
elements or fail to get valid answers to individual questions on
returned questionnaires. To the extent that those notproviding
information would have provided significantly different
information from those that did respond, bias from nonresponse can
alsoresult. Because the seriousness of this type of error is often
proportional to the level of missing data, response rates are
commonly used as indirectmeasures of nonresponse error. We took
steps to maximize response rates, such as multiple mailings and
telephone calls to convert nonrespondents.In addition, during
telephone follow up with 17 nonrespondents, we asked them why they
had not yet responded, and none of the answers indicatedthat they
held beliefs that could be associated with extreme questionnaire
answers that would differ substantially from those who did
respond. Finally, surveys may be subject to processing error in
data entry,processing, and analysis. We verified the accuracy of a
small sample of keypunched records by comparing them to their
correspondingquestionnaires, and we corrected errors found. Less
than 1 percent of the data elements we checked had random keypunch
errors that would nothave been corrected during data processing.
In addition, we performed diagnostics to check the reliability of
results during the processing andtabulation of survey data.
Analysis programs were also independently verified. We did not,
however, verify the substantive answers given bysurvey
respondents.

Appendix IIGAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 58 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 59 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 60 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 61 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 62 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 63 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 64 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 65 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 66 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 67 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 68 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 69 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 70 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 71 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 72 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 73 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 74 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 75 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 76 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 77 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 78 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 79 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix II
GAO Survey Results of Farmer Mac Approved Sellers and
Nonparticipants

Page 80 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix
IIIGAO Analysis of Farmer Mac's Future Viability

Page 81 GAO/GGD-99-85 Enhancing AgMortgage Liquidity SCENARIO 1
Would Farmer Mac have been viable in 1998 (profitable including
areasonable return to shareholders) at its current agricultural
mortgage market level but with a 50-percent reduction in its
investment securityportfolio?

Assumptions:

*  The agricultural mortgage debt market remains the same size.*

The secondary market for agricultural mortgage securities
outstandingremain constant at the December 31, 1998, levels. This
includes $552

million held in Farmer Mac's portfolio (on balance sheet) and $598
millionheld by others (off balance sheet). However, we have
included the $408 million swap transaction announced in January
1999 and madeadjustments to guarantee fee income and loan loss
provisions for this transaction. Thus, the size of the secondary
market for scenario I is $1.558billion.

*  The net yield for on balance sheet interest earning assets is
63 basis pointsfor calendar year 1998. (Net interest income =
$10.569 million for calendar

year 1998. The average balance for interest earning assets =
$1,682 million;average net yield on interest earning assets =
$10.569 million /$1,682 million or 63 basis points.)*   Investment
securities are reduced by 50 percent from the December 31,1998,
total of $644 million to $322 million.  Cash and cash equivalents
and

loans held for securitization remain at the December 31, 1998,
totals of$541 million and $168 million, respectively.

*  Guarantee fees remain constant at the calendar year 1998 total
of $3.727million.

*  Gain on the sale of Farmer Mac agricultural mortgage-backed
securities(AMBS) securities remain constant at the calendar year
1998 total of

$1.400 million.*   Miscellaneous income remains constant at the
calendar year 1998 total of$0.142 million.

*  Other expenses/loan loss reserves remain constant at the
calendar year1998 total of $9.323 million, except for an extra
provision for the swap

transaction.*   Average required return on equity is assumed to
equal the Farm CreditSystem's average return of 11.25 percent at
June 1998.

*  No capital above the minimum capital standards is retained.

Appendix IIIGAO Analysis of Farmer Mac's Future Viability

Page 82 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Annual
Revenues IncomeDollars in MillionsNet Interest Income Calculation

Balance Sheet Interest EarningAssets at December 31, 1998 Amount
(in millions) Net Spread (basis points)

Farmer Mac Securities $552Loans held for securitization 168
Investment Securities 322Cash/Cash equivalents 541 Total Interest
Earning Assets $1,583   times    63 basis points equals $9.973
Guarantee fees: 3.727 Gain on sale of AMBS: 1.400Estimated
guarantee fee from Jan 1999 swap:

a 1.346

Miscellaneous income: 0.142

Total Annual Revenues $16.588 Annual Expenses (excludes interest
expense netted out above)Provision for loan losses: $1.614

Extra provision for swap loss reservesb 0.579 Total other expenses
(excluding provision for loan losses): 7.709Return on equity:

Minimum capital:                     On balance sheet: $1,583.0
million x 2.75%       =    $43.533 million
Off balance sheet:      598.0 million x 0.75%       =        4.485
million                     Swap adjustment:      408.0 million x
0.75%        =        3.060 million

Total       $51.078 million  x 11.25% 5.746 Total Annual Expenses
$15.648

Economic Profit $0.940

aCalculation: Average guarantee fee = total guarantee fees/AMBS
outstanding = $3.727

million/$1,133 million = .00328 = 33 basis points.  Swap amount =
$408 million x 33 basis points =$1.346 million.

bCalculation: Provision for losses/guarantee income = $1.614
million/$3.727 million = 43 percent. Extra provision = estimated
guarantee fees x 43% = $1.346 million x 43% = $0.579 million.
Source:  GAO.

Table III.1: Scenario 1: No Secondary Market Growth But Investment
Securities Reduced by 50 Percent

Appendix IIIGAO Analysis of Farmer Mac's Future Viability

Page 83 GAO/GGD-99-85 Enhancing AgMortgage Liquidity SCENARIO 2
What would Farmer Mac's situation be if it were able to double
itsDecember 31, 1998, market share from $1.558 billion (amount in
scenario I) to $3.116 billion in outstanding Farmer Mac
securities? Assumptions:

*  The agricultural mortgage debt market remains the same size.*

The $3.116 billion in outstanding Farmer Mac securities consist of
$1.104billion on balance sheet and $2.012 billion off balance
sheet. This is the

same distribution between on and off balance sheets as used in
scenario 1but doubles the amounts of agricultural mortgage
securities outstanding.

1

*  All other assets are fixed at the same levels as in scenario
1.*

The net yield for on balance sheet interest earning assets is 63
basis pointsas in scenario 1.

*  Revenues from guarantee fees, gains on AMBS issuance,
andmiscellaneous sources are doubled to reflect the doubling of
the

outstanding securities.*   Other expenses are considered fixed
except for loan losses. Loan lossexpense is doubled to reflect the
doubling of the outstanding securities.

*  Average return on equity is computed at 11.25 percent as in
scenario 1.

1On balance sheet calculation:  $552 million x 2  = $1.104 billion
on balance sheet. Off balance sheet

calculation = ($598 million off balance sheet + $408 million swap)
x 2 = $2.012 billion.

Appendix IIIGAO Analysis of Farmer Mac's Future Viability Page 84
GAO/GGD-99-85 Enhancing AgMortgage Liquidity Annual Revenues
IncomeDollars in MillionsNet Interest Income Calculation

Balance Sheet Interest EarningAssets Amount (in millions) Net
Spread (basis points)

Farmer Mac Securities $1,104Loans held for securitization 168
Investment Securities 322Cash/Cash equivalents 541 Total Interest
Earning Assets $2,135  times    63 basis points equals $13.451
Guarantee fees:  $3.727 million annually x 2 7.454  $1.346 million
for swap x 2 2.692Gain on sale of AMBS:  $1.400 million annually x
2 2.800

Miscellaneous income:  $0.142 million annually x 2 0.284 Total
Annual Revenues $26.681 Annual Expenses (excludes interest expense
netted out above)Provision for loan losses: $1.614 million
annually x 2 $3.228

Extra provision for swap x 2 1.158 Total other expenses (excluding
provision for loan losses): $7.709 million annually 7.709Return on
equity:

Minimum capital:                     On balance sheet: $2,135.0
million x 2.75%       =   $58.713 million                      Off
balance sheet:   2,012.0 million x 0.75%       =     15.090
millionTotal      $73.803 million  x 11.25% 8.303

Total Annual Expenses $20.398 Economic Profit $6.283

Source:  GAO.

Table III.2:  Scenario 2: Farmer Mac Doubles Its Share of the
Agricultural Mortgage Market

Appendix IVComments From the Federal Agricultural Mortgage
Corporation

Page 85 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Note:  GAO
commentssupplementing those in the report text appear at theend of
this appendix.

Now on p. 1.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 86 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Now on pp. 44
and 45. Now on p. 45. Now on p. 29.

Now on p. 36.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 87 GAO/GGD-99-85 Enhancing AgMortgage Liquidity See comment
2. See comment 2.

See comment 1. Now on p. 29. Now on p. 2.

Now on p. 37.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 88 GAO/GGD-99-85 Enhancing AgMortgage Liquidity See comment
3. See comment 2.

Now on p. 36. Now on p. 39.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 89 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Now on p. 10.
Now on p. 32. Now on p. 8.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 90 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Now on p. 32.
Now on p. 34.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 91 GAO/GGD-99-85 Enhancing AgMortgage Liquidity See comment
1. Now on pp. 35 and 36. Now on p. 35.

Now on pp. 40 and 41. Now on p. 41.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 92 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix IV
Comments From the Federal Agricultural Mortgage Corporation

Page 93 GAO/GGD-99-85 Enhancing AgMortgage Liquidity See comment
4. See comment 5.

See comment 6. See comment 7. Now on p. 23.

Now on p. 18.

Now on p. 10. Now on p. 20. Now on pp. 16-28.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 94 GAO/GGD-99-85 Enhancing AgMortgage Liquidity See comment
8. See comment 9. See comment 10. Now on p. 39.

Now on pp. 27 and 28. Now on p. 25. Now on p. 24.

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 95 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix IV
Comments From the Federal Agricultural Mortgage Corporation

Page 96 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Appendix IV
Comments From the Federal Agricultural Mortgage Corporation

Page 97 GAO/GGD-99-85 Enhancing AgMortgage Liquidity The following
are GAO's comments on the Farmer Mac letter dated May10, 1999. 1.
We discussed Farmer Mac's accomplishments and growth
throughoutthis report. 2.  Farmer Mac suggested that instead of
total assets, we use earningassets, a slightly smaller number, in
constructing our scenarios on its future viability.  Additionally,
it was suggested that we use 63 basis pointsto calculate net
interest income since it was the 1998 yield on the average balance
of earning assets.  These suggested changes have beenincorporated
into the scenario calculations.  Farmer Mac also disagreed with
the approach used in the economic scenarios in which we
includereturn on equity as an opportunity cost.  Farmer Mac
referred to our approach as a novel concept not supported by
generally acceptedaccounting principles.  We measured long-term
viability using an economic rather than an accounting definition
of profit.  This approach requiresequity investors to receive a
rate of return to compensate them for the opportunity cost of
equity investment.  The approach is based on acceptedprinciples
used in economics and finance.

3. In its comments, Farmer Mac stated that under both of our
scenarios,Farmer Mac meets our viability test.  Further, Farmer
Mac said its track record is that of a growing and innovative
company, and it reiterated thepositive findings of our survey
results.  Among those who participated, 73 percent of the approved
sellers said they are likely to increase sales toFarmer Mac in the
next 3 years; and about one-fourth of nonparticipants expect to
begin participating in Farmer Mac programs in the next 3 years.To
put these findings in perspective, we have clarified our report to
show that these findings represent inclinations of lenders' future
actions, whichcould enhance agricultural secondary market
activity, but only to the extent that they are carried out. 4.
Farmer Mac stated that a significant portion of the draft report
iswritten with the use of the phrase "is to" as if to suggest that
the matters under discussion are to be, but have not yet been,
implemented. We use "isto" in cases where we have not verified the
actions.  In cases where we reviewed documents verifying that
action had been taken, the text of thereport has been changed to
reflect that the respective action was taken.

5.  Farmer Mac took issue with a statement that secondary market
entitieshave relatively less ability than lenders to rely on
borrower relationships to assess credit risk.  The comment cited
standards Farmer Mac has in place

GAO Comments

Appendix IV Comments From the Federal Agricultural Mortgage
Corporation

Page 98 GAO/GGD-99-85 Enhancing AgMortgage Liquidity for
underwriting, appraisal, and field servicers.  We added
qualifyinglanguage that is based on Farmer Mac's comment. 6.
Farmer Mac asked that we clarify its position concerning
thestandardization of loan documents.  The President and Chief
Executive Officer of Farmer Mac stated that it is not Farmer Mac's
position thatfurther standardization lacks merit, but that the
costs to Farmer Mac of achieving further standardization of loan
documents exceed the benefits ofdoing so at this time.  We have
incorporated this position into the report.

7. Farmer Mac stated that it monitors delinquency rates on a
monthlyrather than a quarterly basis.  The report now reflects
this change. Additionally, in commenting on our report, Farmer Mac
referred to ourstatement that "Farmer Mac does not have a history
of loan performance data, so it uses the historical loan loss data
of a FCS  institution" for lossestimation purposes, and  noted
that it does maintain an extensive loan information database on
all loans it purchases.  We added qualifyinglanguage to our report
to address this comment.

8.  Farmer Mac took issue with our statement that it contracts out
certainfunctions where it lacks in-house expertise.  In its
response, Farmer Mac stated that it was a business decision to
contract out certain functions totake advantage of the experience
and efficiency of outside resources.  The report has been revised
accordingly. 9.  In its comment letter, Farmer Mac noted that the
draft reportincorrectly stated that Farmer Mac does not
incorporate credit scoring into its loan approval process.  We
revised the text to note that FarmerMac does use credit scoring in
connection with the credit approval process, but not as a
determinative factor for credit approval. 10. Farmer Mac took
issue with our statement that if the decline in theconstant dollar
value of agricultural mortgage debt continues, it could directly
affect Farmer Mac's growth potential.  Farmer Mac stated
theopinion that it would have significant opportunity even if
decline in agricultural debt occurred.  Farmer Mac's rate of
growth could be affectedto some extent by the size of the overall
market.  On the basis of this premise, we have not changed this
language.

Appendix VFarmer Mac's Underwriting Standards

Page 99 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Underwriting
standards are to be used by Farmer Mac to determine whichmortgages
it will buy, which it could then choose to hold as investments or
place into mortgage pools.  Generally, eligible loans must meet
each of thestandards. The standards are meant to limit the risk
that the mortgages will create losses for the pools or Farmer Mac
by ensuring that the buyer hasthe ability to pay; the buyer is
creditworthy and is likely to meet scheduled payments; and, in the
event of default, the value of the agricultural realestate limits
any losses. Farmer Mac requires lenders to provide representations
and warranties to help ensure that the qualified loans1conform to
these standards and other requirements of Farmer Mac.

Farmer Mac's underwriting standards have elements (e.g., factors
such aspast credit history and current and projected income and
expenses that reflect the potential borrower's willingness and
ability to repay the loan)that are similar to the standards in the
housing secondary markets.

The underwriting standards are based on credit ratios, other
quantitativemeasures, and qualitative terms. Farmer Mac's
underwriting standards, by law, may not discriminate against small
agricultural lenders or small loansof at least $50,000.

Farmer Mac has nine underwriting standards for newly originated
loans,each of which is summarized below. A newly originated loan
is one that has been originated for less than a year.

*  Standard 1: Creditworthiness of the Borrowers. Standard one
confirms the5Cs (character, capital, capacity, collateral, and
conditions) of credit that

are to be involved in each loan and requires loan originators to
obtaincomplete and current credit reports for each borrower. The
credit report must include historical experience, identification
of all debts, and otherpertinent information. All sellers are
required to verify all information contained in the credit report.

*  Standard 2: Balance Sheets and Income Statements. This standard
requiresthe loan applicant to provide fair market value balance
sheets and income

statements for at least the last 3 years.

*  Standard 3: Debt-to-Asset (or Leverage) Ratio. The entity being
financedshould have a pro forma debt-to-asset ratio of 50 percent
or less on a

market value basis. The debt-to-asset ratio is calculated by
dividing pro
1A qualified loan is a loan that is on U.S. farmland secured by a
first lien that meets the credit

underwriting requirements of Farmer Mac.

Newly Originated LoanStandards

Appendix VFarmer Mac's Underwriting Standards

Page 100 GAO/GGD-99-85 Enhancing AgMortgage Liquidity forma
liabilities by pro forma assets. A pro forma ratio shows the
impactof the amount borrowed on assets and liabilities.

*  Standard 4: Liquidity and Earnings. The entity being financed
should beable to generate sufficient liquidity and net earnings,
after family living

expenses and taxes, to meet all debt obligations as they come due
over theterm of the loan and provide a reasonable margin for
capital replacement and contingencies. This standard is achieved
by having a pro forma currentratio of not less than 1.0; and a pro
forma total debt service ratio of not less than 1.25, after living
expenses and taxes. The current ratio iscalculated by dividing pro
forma current assets by pro forma liabilities. Total debt service
coverage ratio is calculated by dividing net operatingincome by
annual debt service. Net income from farm and nonfarm sources may
be included.

*  Standard 5: Loan-to-Value (LTV) and Cash Flow/Debt Service
CoverageRatio. The LTV should not exceed 70 percent in the case of
a typical

Farmer Mac loan secured by agricultural real estate, 75 percent in
the caseof qualified facility loans, or 85 percent in the case of
part-time farm loans, with private mortgage insurance coverage
required for amounts above 70percent. A minimum debt service cash
flow ratio of not less than 1.0 from the subject real estate
securing the loan is required, except for loans inwhich the
borrower's principal residence is on the property securing the
loan. The pro forma total-debt service coverage ratio of the
entity to befinanced must not have been less than 1.50 for the
last 3 years. The LTV ratio is important in determining the
probability of default and themagnitude of loss.

*  Standard 6: Minimum Acreage and Annual Receipts
Requirement.Agricultural real estate must consist of at least five
acres or be used to

produce annual receipts of at least $5,000 to be eligible to
secure aqualified loan.

*  Standard 7: Loan Conditions. The loan (1) must be at a fixed
payment leveland either fully amortize the principal over a term
not to exceed 30 years

or amortize the principal according to a schedule not to exceed 30
yearsand (2) mature no earlier than the time at which the
remaining principal balance (i.e., balloon payment) of the loan
equals 50 percent of the originalappraised value of the property
securing the loan. The amortization is expected to match the
useful life of the mortgaged asset and paymentsshould match the
earnings cycle of the farm operations. For facilities, the
amortization schedule should not extend beyond the useful
agriculturaleconomic life of the facility.

Appendix VFarmer Mac's Underwriting Standards Page 101 GAO/GGD-99-
85 Enhancing AgMortgage Liquidity

*  Standard 8: Rural Housing Loans Standards. Farmer Mac has
adopted thecredit underwriting standards applicable to Fannie Mae,
adjusted to reflect

the usual and customary characteristics of rural housing. These
standardsinclude, among other things, allowing loans secured by
properties that are subject to unusual easements, having larger
sites than those for normalresidential properties in the area, and
having property that is located in areas that are less than 25
percent developed.

*  Standard 9: Nonconforming Loans. On a loan-by-loan
determination,Farmer Mac may decide to accept loans that do not
conform to one or

more of the underwriting standards or conditions, with the
exception ofstandard 5. Farmer Mac may accept those loans that
have factors (i.e., compensating strengths) that outweigh their
inability to meet all of thestandards. Examples of compensating
strength include substantial borrower net worth or a larger
borrower down payment. The granting ofstandard 9 exceptions is not
intended to provide a basis for waiving or lessening in any way
Farmer Mac's focus on buying only high-quality loans.According to
a Farmer Mac official, nonconforming loans currently comprise
about 10 percent of the loans approved for sale to Farmer Mac.

In addition to the previously listed underwriting requirements,
the 1999maximum loan size to a single borrower is limited to $3.5
million for loans secured by more than 1,000 acres and $6 million
for loans secured by 1,000acres or less. The maximum size of an
individual loan is indexed to the rate of inflation and is changed
annually by Farmer Mac. Farmer Mac views the history of loan
repayment as an indicator of theoperation's profitability and the
borrower's willingness to repay the loan on time. As a result,
Farmer Mac has developed loan criteria for seasonedloans. A
seasoned loan is a loan that was originated at least 1 year before
purchase and has completed at least one full installment of
principal andinterest payments.

The degree of re-underwriting required is dependent on the age of
the loanand its updated LTV. If a loan is less than 5 years old,
with an updated LTV of less than 60 percent and on which the
borrower has paid on time sinceorigination, the loan is eligible
for sale to Farmer Mac if it met Farmer Mac standards at the time
of origination. If a loan is over 5 years old with acurrent LTV
equal to or less than 60 percent, and the borrower has paid on
time for each of the last 3 years, no underwriting analysis is
required andthe loan is eligible for sale to Farmer Mac. Seasoned
loans with an updated LTV of greater than 60 percent must be re-
underwritten to meet all of

Seasoned LoanStandards

Appendix VFarmer Mac's Underwriting Standards

Page 102 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Farmer Mac's
standards. Farmer Mac reserves the right to verify the
creditquality and performance characteristics of seasoned loans.
Facility loans are loans made to specialized facilities such as
dairies,feedlots, packing facilities, storage units, grow-out
facilities (poultry and hog), and processing buildings. To qualify
as a specialized agriculturalfacility, the currently appraised
value of the buildings must exceed 60 percent of the total
appraised value of the property. All facility loans must comply
with the previously listed credit standardsfor newly originated
loans. In addition, they must meet certain requirements depending
on the type of facility loan and on whether theborrower has a
contractual relationship with product users. For example, the
maximum LTV for hog and poultry facilities is 75 percent, whereas
themaximum LTV for agribusiness facilities is 65 percent. Another
example is where a poultry facility has a production contract or
other creditenhancement with a financially strong product user,
then the Farmer Mac underwriting thresholds are a maximum LTV
ratio of 75 percent, amaximum debt-to-asset ratio of 65 percent,
and a minimum total debt service coverage ratio of 1.25 to 1.
Under a scenario without a creditenhancement, the thresholds would
be a maximum LTV ratio of 65 percent, a maximum debt-to-asset
ratio of 50 percent, and a minimum totaldebt service coverage
ratio of 1.35 to 1. The difference in the underwriting
requirements reflects the presumed ability that the loan can be
repaid froma financial source not tied to the mortgaged property.

For part-time farm loans (a loan designed for borrowers who live
onagricultural properties but derive a significant portion of
their income from nonfarm employment) the requirements concerning
acreage and annualagricultural income are the same as for the
full-time program. The property must contain a single-family
detached residence that should constitute atleast 30 percent of
the total appraised value of the property.

Because part-time farmers and part-time farms have much in common
withconventional residential lending, this type of loan is
underwritten according to conforming residential housing loans
standards (i.e., 28percent of monthly housing expense to gross
monthly income and 36 percent of total monthly debt expense to
gross monthly income). Themaximum LTV for a part-time farm loan is
85 percent; private mortgage insurance is required on any part-
time farm loan with an LTV greater than70 percent. The maximum
loan size is limited to $2.3 million, but there is no minimum loan
size and no maximum acreage. Compensating factors,such as
substantial borrower net worth or the borrower's making a large

Facility LoanStandards Part-time Farm LoanStandards

Appendix VFarmer Mac's Underwriting Standards

Page 103 GAO/GGD-99-85 Enhancing AgMortgage Liquidity down
payment, allow Farmer Mac to approve loans that vary from
thestandards. Appendix VIMajor Contributors to This Report

Page 104 GAO/GGD-99-85 Enhancing AgMortgage Liquidity Richard J.
Hillman, Associate DirectorWilliam B. Shear, Assistant Director
Joe E. Hunter, Evaluator-in-ChargeMarion L. Pitts, Senior
Evaluator James R. Black, Senior EvaluatorCarl M. Ramirez, Senior
Social Science Analyst Anne K. Rhodes-Kline, Senior Social Science
AnalystMichelle A. Sager, Social Science Analyst Jerry T. Sandau,
Computer Specialist Rachel DeMarcus, Assistant General Counsel

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