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Testimony:

Before the Committee on Agriculture, House of Representatives:

United States General Accounting Office:

GAO:

For Release on Delivery Expected at 10:00 a.m. EDT:

Wednesday, June 2, 2004:

Farmer Mac:

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

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

Jeanette Franzel, Director, Financial Management and Assurance:

GAO-04-827T:

GAO Highlights:

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

Why GAO Did This Study:

This testimony is based on ourGAOís October 2003 report, Farmer Mac: 
Some Progress Made, but Greater Attention to Risk Management, Mission, 
and Corporate Governance Is Needed, (GAO-04-116). GAOís testimony 
presents a brief overview of Farmer Mac and discusses issues raised in 
its 2003 report, including Farmer Macís (1) risk management practices, 
(2) and line of credit with Treasury, (3) mission-related activities, 
(4) board structure and Class C common stock, and (5) oversight, which 
is provided by the Farm Credit Administration (FCA).

What GAO Found:

Farmer Mac, a government-sponsored enterprise (GSE), was established to 
provide a secondary market for agricultural real estate and rural 
housing loans and to increase agricultural mortgage credit. In 2003, 
GAO reported that several aspects of Farmer Macís financial risk 
management practices had not kept pace with its increasing risk 
profile. First, Farmer Mac had $3.1 billion in off-balance-sheet 
commitments and other agreements that could obligate it to buy the 
underlying loans or cover related losses under certain conditions. 
Farmer Mac and the Farm Credit System institutions that participate in 
the agreements are required to hold far less capital than is otherwise 
required. Because Farmer Macís loan activities are concentrated in a 
small number of financial institutions and in the West, the risk is not 
reduced while less capital is required to be held. Under stressful 
agricultural economic conditions, Farmer Mac could be required to 
purchase large amounts of impaired or defaulted loans if large amounts 
of the commitments were exercised. Second, the coverage of Farmer Macís 
$1.5 billion line of credit with the U.S. Treasury was controversial, 
as the entities disagreed on whether the securities it has issued and 
kept in its portfolio would be eligible. Third, GAO reported that while 
Farmer Mac had increased its mission-related activities since its 1999 
report, their impact on the agricultural real estate market was 
unclear. The effects were difficult to measure partly because Farmer 
Macís statute lacks specific mission goals. For this and other reasons, 
GAO concluded that the public benefits derived from Farmer Macís 
activities are not clear. Finally, for profitability reasons, Farmer 
Mac had a strategy of holding securities it issued in its portfolio 
instead of selling them to investors in the capital markets. As a 
result, the depth and liquidity of the market for Farmer Macís 
securities is unknown.

Farmer Macís board structure, set in federal law, may make it difficult 
to ensure that the board fully represents the interests of all 
shareholders and meets independence and other requirements. The board 
structure contains elements of both a cooperative and an investor-owned 
publicly traded company. For example, two-thirds of the board members 
do business with Farmer Mac and hold the only voting stock, while the 
common stock holders have no vote. GAO also identified challenges FCA 
faced in its oversight of Farmer Mac, including a lack of specific 
criteria for measuring how well it was achieving its mission. Although 
FCA had taken steps to improve its safety and soundness oversight, more 
needs to be done to improve its off-site monitoring and assessment of 
risk-based capital.

Farmer Mac and FCA have efforts underway to address many of GAOís 
recommendations and it was too early to assess them. 

What GAO Recommends:

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

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

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

[End of section]

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

We are pleased to be here today to discuss the results of GAO's work on 
the Federal Agricultural Mortgage Corporation, commonly referred to as 
Farmer Mac. Our testimony is based on the report we issued on October 
16, 2003, at the request of the Senate Committee on Agriculture, 
Nutrition, and Forestry: Farmer Mac: Some Progress Made, but Greater 
Attention to Risk Management, Mission, and Corporate Governance Is 
Needed, GAO-04-116 (Washington, D.C.: October16, 2003). Our overall 
objective today is to provide the committee with information and 
perspectives to consider as it continues to oversee Farmer Mac. My 
remarks are divided into two sections. First, I will provide an 
overview of Farmer Mac, its mission and portfolio, and potential risks 
to taxpayers. Second, I will provide our report findings on a variety 
of items associated with Farmer Mac, including its risk management 
practices and its line of credit with Treasury, mission-related 
activities, board structure, and oversight provided by the Farm Credit 
Administration (FCA). Throughout my statement, I will comment on Farmer 
Mac's and FCA's responses to the findings and recommendations in our 
report. Information discussed in our report was gathered from August 
2002 to May 2003 from reviews of documents and interviews we had with 
representatives from Farmer Mac, FCA, other market participants, and 
individuals with expertise in the agricultural real estate market. We 
also reviewed FCA's examinations of Farmer Mac and consultants' studies 
related to Farmer Mac. To update our report for this testimony, we 
obtained more recent financial data on Farmer Mac and Farmer Mac's and 
FCA's responses to our recommendations. We conducted our work in 
accordance with generally accepted government auditing standards.

In summary, I will first give a brief overview of Farmer Mac. Farmer 
Mac is a government-sponsored enterprise or GSE[Footnote 1] established 
by Congress to create a secondary market in agricultural real estate 
and rural housing loans, and to improve the availability of 
agricultural mortgage credit. FCA, through its Office of Secondary 
Market Oversight (OSMO), regulates Farmer Mac. In extreme 
circumstances, Farmer Mac may borrow up to $1.5 billion from the U.S. 
Treasury. Among its program activities, Farmer Mac purchases 
agricultural mortgages from lenders and periodically securitizes these 
loans into guaranteed securities or agricultural mortgage-backed 
securities (AMBS). During the last 2 years, Farmer Mac sold AMBS 
principally to related parties.

Farmer Mac also issues long-term standby purchase commitments or 
standby agreements for eligible loans. To date, all of these 
commitments are with institutions in the Farm Credit System (FCS), 
which is also a GSE. As of December 31, 2003, loans underlying standby 
and similar agreements[Footnote 2] totaled $3.1 billion and represent 
53 percent of the book value of total loans included in Farmer Mac's 
programs (see fig. 1). These agreements are held off balance sheet 
because Farmer Mac does not own the loans underlying these agreements 
and is conditionally obligated to purchase them. In the case of the 
$722.3 million of standby agreements that was converted into a Farmer 
Mac I Guaranteed Security, Farmer Mac may, at its discretion, 
repurchase the defaulted loans or choose to pay the associated losses 
under the guarantee without purchasing the loan. Although the 
underlying loans have been performing better than its on-balance sheet 
loans, the standby agreements include provisions that commit Farmer Mac 
to purchasing the loans under specific conditions--for example, when 
they become 120-day delinquent.

Farmer Mac also faces potential liquidity risk as a result of these 
standby and similar agreements, which can create unexpected demands for 
additional funding. In other words, at a time when either the 
agricultural sector is severely depressed or interest rates are 
falling, Farmer Mac could be required to purchase large amounts of 
impaired or defaulted loans under the agreements, thus subjecting 
Farmer Mac to increased funding liquidity risks and the potential for 
reduced earnings. Notwithstanding the risk these standby and similar 
agreements could generate for Farmer Mac under stressful economic 
conditions, their off-balance sheet status allows Farmer Mac to hold 
less capital against the loans placed under them compared with its own 
on-balance sheet loans. These agreements also allow the FCS 
institutions to hold less capital against the loans placed under them. 
Further, the amount of capital that Farmer Mac would be required to 
hold against these underlying loans if required to buy them is less 
than what the FCS institutions are required to hold against the loans. 
The result of Farmer Mac's $3.1 billion in standby and similar 
agreements is to significantly reduce the amount of capital held 
against these loans in the FCS as a whole without correspondingly 
reducing risk because of its geographic and lender concentration.

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

[See PDF for image]

Note:

[A] These are loans purchased by Farmer Mac prior to the change in its 
statutory charter in 1996.

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

[End of figure]

Second, we looked at a number of issues associated with Farmer Mac. For 
instance, our findings showed that Farmer Mac's income had increased 
since 1999 and that its capital continued to exceed required levels. At 
the same time, however, the rapid growth in Farmer Mac's standby 
agreements presents additional risk. We also identified trends 
indicating certain aspects of Farmer Mac's risk management systems have 
not kept pace with its increasingly complex portfolio. We made 
recommendations to Farmer Mac to enhance its risk management practices. 
Our study also pointed out that Farmer Mac faces some uncertainty 
involving its $1.5 billion line of credit with the U.S. Treasury 
(Treasury). In particular, while the legal opinion of Farmer Mac's 
outside counsel disagrees, Treasury has taken the position that it is 
not obligated to cover losses on the AMBS held in Farmer Mac's 
portfolio because the Treasury line of credit is not for the purpose of 
protecting Farmer Mac shareholders or general creditors. AMBS totaled 
$1.5 billion and made up 35 percent of Farmer Mac's total assets as of 
December 31, 2003.

We found that Farmer Mac has increased its mission-related activities 
since we last reported on them in 1999.[Footnote 3] However, Farmer 
Mac's statute lacks specific or measurable mission goals beyond 
providing a secondary market and stable long-term financing. Without 
specific mission goals, it is difficult to meaningfully assess whether 
the increased activities are having the desired impact on the 
agricultural real estate market. In addition, Farmer Mac's loan 
activities have been largely concentrated in a small number of 
financial institutions--during 2003, 80.8 percent of Farmer Mac I loan 
activities were with ten institutions--and its loan portfolio is 
concentrated in the West. Therefore, we concluded that Farmer Mac has 
increased its mission-related activities, but the public benefits 
derived from these activities are not clear. We suggested that Congress 
consider legislative changes to establish clearer mission goals for 
Farmer Mac. Further, because Farmer Mac has elected to retain nearly 
all its AMBS in its portfolio instead of selling them to investors in 
the capital markets, we could not ascertain the depth and liquidity of 
the secondary market for AMBS, which is unknown even in good market 
conditions. We made recommendations to Farmer Mac to reevaluate its 
current strategy of holding AMBS in its portfolio and issuing debt to 
obtain funding.

Next, we found that Farmer Mac's board structure may make it difficult 
to ensure that the board fully represents the interests of all 
shareholders and could hamper Farmer Mac's efforts to comply with the 
independence requirements of the New York Stock Exchange's (NYSE) 
listing standards. As a GSE, Farmer Mac has a board set by statute that 
contains elements of both a cooperative and an investor-owned publicly 
traded company. In most respects, Farmer Mac's board policies and 
processes appear reasonable, but we found that some processes could be 
further developed and formalized and made recommendations to Farmer Mac 
to make them more transparent and consistent. We further suggested that 
Congress consider legislative changes to amend the structure of the 
Farmer Mac board and the structure of Farmer Mac's Class C nonvoting 
common stock.

Finally, we found that FCA had improved its oversight of Farmer Mac and 
strengthened its examination approach but that more needs to be done to 
enhance the assessment of risk-based capital and Farmer Mac's 
accomplishment of its mission. This enhanced focus is especially 
important given Farmer Mac's increasing risk profile, its concentration 
of business with few business partners in the West, and its holdings of 
non-mission related assets. Since the law does not include any 
measurable goals or requirements to assess Farmer Mac's progress in 
furthering its mission, FCA lacks criteria and procedures to 
effectively oversee this aspect of Farmer Mac. We made several 
recommendations to FCA to enhance the effectiveness of its oversight. 
To further assist FCA's with its oversight effort, we also suggested 
that Congress consider a legislative change to allow FCA more 
flexibility in setting minimum capital requirements for Farmer Mac.

To update our information for this testimony, we met with 
representatives from Farmer Mac and FCA to discuss the status of our 
recommendations. We found that Farmer Mac has either taken actions to 
address or is in the process of implementing most of our 
recommendations. FCA is also engaged in efforts to address and 
implement our recommendations. FCA staff told us they considered and 
decided not to adopt certain elements of our recommendation to enhance 
the risk-based capital model for Farmer Mac, including a "run-off" 
approach, the effect of yield maintenance penalties, and the use of 
land value declines as the independent variable in loan loss 
regression. Since most of the actions undertaken by Farmer Mac and FCA 
will not be fully completed for some time, it is too early for us to 
evaluate their effectiveness.

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

Farmer Mac is a government-sponsored enterprise or GSE that was 
chartered by Congress in 1987.[Footnote 4] It is a federally chartered 
and privately operated corporation that is publicly traded on the New 
York Stock Exchange. Farmer Mac is also an independent entity within 
the Farm Credit System or FCS, which is another GSE. As an FCS 
institution, Farmer Mac is subject to FCA's regulatory authority. FCA, 
through OSMO, has general regulatory and enforcement authority over 
Farmer Mac. According to the 1987 Act, Farmer Mac, in extreme 
circumstances, may borrow up to $1.5 billion from the U.S. Treasury to 
guarantee timely payment of any guarantee obligations of the 
corporation.[Footnote 5] Congress established Farmer Mac with a mission 
to create a secondary market--a financial market for buying and selling 
loans, individually or by securitizing them--in agricultural real 
estate and rural housing loans, and improve the availability of 
agricultural mortgage credit. When loans are securitized, they are 
repackaged into a "pool" by a trust in order to be sold to investors in 
the capital markets to generate liquidity. Generally, to carry out its 
mission, Farmer Mac purchases mortgages or bonds directly from lenders 
using cash generated by issuing debt obligations. It also issues 
standby agreements for eligible loans whereby Farmer Mac is committed 
to purchase eligible loans from financial institutions at an 
undetermined future date when a specific event occurs. The intent for 
these activities is to provide real estate credit to farmers at rates 
or conditions more favorable than those that would be available in the 
absence of Farmer Mac. Farmer Mac also securitizes the mortgages it 
purchases and issues AMBS and guarantees the timely payment of interest 
and principal on these securities. However, instead of selling the AMBS 
in the capital markets to generate cash, Farmer Mac holds most of the 
AMBS that it issues in its retained portfolio.

Farmer Mac Faces a Variety of Risks:

Farmer Mac faces potential losses primarily from four sources:

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

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

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

* Operations risk, or the potential that inadequate or failed internal 
processes, people and systems, or external events will affect financial 
condition.

Although the federal government explicitly does not guarantee Farmer 
Mac's obligations, it is generally assumed in financial markets that 
the government will not allow the GSE to default on its debt and AMBS 
obligations. In fact, during the 1980s the federal government provided 
financial assistance to both Fannie Mae and the Farm Credit System when 
they experienced difficulties due to sharply rising interest rates and 
declining agricultural land values, respectively. Because the markets 
perceive that there is an implied federal guarantee on Farmer Mac's 
obligations, Farmer Mac can borrow money at interest rates that are 
lower than those generally available to comparably creditworthy private 
corporations and thus can extend credit and other forms of liquidity to 
financial institutions at favorable rates.

The Size and Composition of Farmer Mac's Portfolio:

The assets associated with Farmer Mac's activities can generally be 
divided into program assets and nonmission investments. Program assets 
are agricultural mortgage loans held by Farmer Mac, the guaranteed 
securities backed by agricultural loans, and loans underlying Farmer 
Mac's standby agreements. As of December 31, 2003, Farmer Mac's loan 
and guarantee portfolio and standby agreements totaled about $5.8 
billion. Of that total, nearly $3.1 billion was in off-balance sheet 
standby and similar agreements. Standby agreements represent a 
potential obligation of Farmer Mac that does not have to be funded 
until such time as Farmer Mac is required to purchase a loan. As such, 
these commitments are not on Farmer Mac's balance sheet and are subject 
to a statutory minimum requirement of 0.75 percent capital instead of 
2.75 percent for on-balance sheet assets. Let me point out that 
whenever Farmer Mac is obligated under a standby agreement to purchase 
a delinquent loan, it must also increase the capital held against the 
loan from 0.75 to 2.75 percent, nearly a 270 percent increase. Farmer 
Mac funds its loan purchases and other activities primarily by issuing 
debt obligations of various maturities. As of December 31, 2003, Farmer 
Mac had $2.8 billion of payable notes due within one year and 
$1.1billion of payable notes due after one year outstanding. At the 
same time, Farmer Mac held approximately $1.1 billion in nonmission 
investments.

Farmer Mac's Income and Risk Levels Have Increased:

Farmer Mac's net income increased from $4.6 million in 1997 to $27.3 
million in 2003, for a total increase of 493 percent. Farmer Mac's two 
primary revenue sources are (1) interest income earned on its loan 
portfolio, guaranteed securities, and nonmission investments, and (2) 
commitment fees earned on standby agreements. In recent years, Farmer 
Mac's earnings growth has principally been driven by fees generated by 
its off-balance sheet standby and similar agreements, which grew 
rapidly from zero in 1998 to $3.1 billion as of December 31, 2003.

Farmer Mac's risk levels have increased along with its income. First, 
increased risk is apparent in the growing number of impaired loans, 
real estate owned, and write-offs of bad loans, as well as in the rapid 
growth in its on-and off-balance sheet loans, guarantees, and standby 
agreements. Impaired loans totaled $69.96 million at December 31, 2003, 
compared to zero at December 31, 1997. Part of our concern about the 
increased credit risk involves Farmer Mac's loan loss model, which is 
based on loans that differ from those held in the corporation's own 
portfolios and those covered under its standby agreements in terms of 
geographic distribution and interest rate terms. This lack of 
comparability and other limitations of the model may affect the 
reasonableness and accuracy of Farmer Mac's estimated losses from 
credit risk either upward or downward. A complicating factor is that 
notwithstanding the quality of the loans underlying standby agreements, 
which have been performing better than the loans on Farmer Mac's 
balance sheet, Farmer Mac lacks the historical experience with standby 
agreements that is needed to accurately estimate the type and amount of 
loans it may ultimately be obligated to purchase and any associated 
losses.

Farmer Mac also faces potential liquidity risk as a result of these 
standby and similar agreements, which can create unexpected demands for 
additional funding. In other words, at a time when either the 
agricultural sector is severely depressed or interest rates are 
falling, Farmer Mac could be required to purchase large amounts of 
impaired or defaulted loans under the agreements, thus subjecting 
Farmer Mac to increased funding liquidity risks and the potential for 
reduced earnings. Although our study found that Farmer Mac has 
maintained sufficient liquidity to support its loan purchase and 
guarantee activity, Farmer Mac's liquidity may not be adequate to cover 
its obligations under its standby or similar agreements. We did not 
have the necessary historical information to project the number of 
covered loans that Farmer Mac might need to purchase in the future. 
Thus, we could not determine the extent of the liquidity risk Farmer 
Mac might face. At the same time, Farmer Mac management did not have 
the quantitative data it needed to make accurate risk management and 
other operating decisions.

As noted earlier, we made recommendations to Farmer Mac to enhance its 
risk management practices. We would like to report that Farmer Mac has 
responded to our recommendations but it is too early for us to assess 
the actions taken to implement them. Farmer Mac management recently 
showed us a loan classification system that will be completed in 2005 
that is based on Farmer Mac's loan loss experience. Staff are also now 
documenting the supporting underwriting decisions for loans that Farmer 
Mac management approved by overriding one or more specific criteria 
based on the compensating strengths of those loans. Farmer Mac has also 
adopted a formal contingency funding and liquidity plan but this plan 
does not address our concerns about providing for liquidity if a large 
amount of standby and similar agreement loans were put to Farmer Mac 
unexpectedly. Farmer Mac representatives told us they are also 
developing a capital adequacy model. In addition, Farmer Mac management 
said that they are working with an outside consultant to develop a 
prepayment model to ensure accurate interest rate risk measurements.

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

Now I want to focus on an issue involving Farmer Mac's $1.5 billion 
line of credit with Treasury that could impact the corporation's long-
term financial condition. This issue is significant because it centers 
around the AMBS in Farmer Mac's retained portfolio, which as we have 
seen, makes up 35 percent of its total on-balance sheet assets of $4.3 
billion and 26% percent of Farmer Mac's total program assets of $5.8 
billion--including off-balance sheet loans underlying the standby and 
other agreements. Treasury has expressed serious questions about 
whether it is required to purchase Farmer Mac obligations to meet 
Farmer Mac-guaranteed liabilities on AMBS that Farmer Mac or its 
affiliates hold.[Footnote 6] On the other hand, a legal opinion from 
Farmer Mac's outside counsel states that Treasury would be required to 
purchase the debt obligations whether the obligations are held by a 
subsidiary of Farmer Mac or by an unrelated third party. This 
disagreement could create uncertainty as to whether Treasury would 
purchase obligations held in Farmer Mac's portfolio in times of 
economic stress. This uncertainty also relates to statements made by 
Farmer Mac to investors concerning Treasury's obligation to Farmer Mac, 
which in turn, could affect Farmer Mac's ability to issue debt at 
favorable rates. Ultimately, this uncertainty could impact its long-
term financial condition.

Farmer Mac's subsidiary, Farmer Mac Mortgage Securities Corporation, 
holds the majority of AMBS that Farmer Mac issued. Farmer Mac's charter 
(the 1987 Act) gives it the authority to issue obligations to the 
Secretary of the Treasury to fulfill its guarantee obligations. 
According to the 1987 Act, the Secretary of the Treasury may purchase 
Farmer Mac's obligations only if Farmer Mac certifies that (1) its 
reserves against losses arising out of its guarantee activities have 
been exhausted and (2) the proceeds of the obligations are needed to 
fulfill Farmer Mac's obligations under any of its guarantees.[Footnote 
7] In addition, Treasury is required to purchase obligations issued by 
Farmer Mac in an amount determined by Farmer Mac to be sufficient to 
meet its guarantee liabilities not later than 10 business days after 
receipt of the certification. However, Treasury has indicated that the 
requirement to purchase Farmer Mac obligations may extend only to those 
obligations issued and sold to outside investors.

In a comment letter dated June 13, 1997, and submitted to FCA in 
connection with a proposed regulation on conservatorship and 
receivership for Farmer Mac (1997 Treasury letter),[Footnote 8] 
Treasury stated "Öwe have 'serious questions' as to whether the 
Treasury would be obligated to make advances to Farmer Mac to allow it 
to perform on its guarantee with respect to securities held in its own 
portfolio---that is, where the Farmer Mac guarantee essentially runs to 
Farmer Mac itself." The 1997 Treasury letter indicated that if the 
purchase of obligations extended to guaranteed securities held by 
Farmer Mac this would belie the fact that the securities are not backed 
by the full faith and credit of the United States, since a loan to 
Farmer Mac to fulfill the guarantee would benefit holders of Farmer 
Mac's general debt obligations. The 1997 Treasury letter stated 
"Treasury's obligation extends to Farmer Mac only in the prescribed 
circumstances, and is not a blanket guarantee protecting Farmer Mac's 
guaranteed securities holders from loss. Nor is the purpose of the 
Treasury's obligation to protect Farmer Mac shareholders or general 
creditors." According to Treasury, the 1997 letter remains its position 
concerning Farmer Mac's line of credit.

Meanwhile, the legal opinion of Farmer Mac's outside counsel is that 
the guarantee is enforceable whether AMBS are held by a subsidiary of 
Farmer Mac or by an unrelated third party. Farmer Mac's legal opinion 
also states that Treasury could not decline to purchase the debt 
obligations issued by Farmer Mac merely because the proceeds of the 
obligations are to be used to satisfy Farmer Mac's guarantee with 
respect to AMBS held by a subsidiary. According to Farmer Mac, if the 
conditions set forth in the 1987 Act are met--required certification 
and a limitation on the amount of obligations of $1.5 billion--then 
there is no exception in the 1997 Act that authorizes Treasury to 
decline to purchase the obligations. Farmer Mac states that 
discriminating among Farmer Mac guaranteed securities based on the 
identity of the holder in determining whether Farmer Mac could fulfill 
its guarantee obligations would lead to an anomalous situation in the 
marketplace and thereby hinder the achievement of Congress' mandate to 
establish a secondary market for agricultural loans.

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

Before I go into whether Farmer Mac's activities have had an impact on 
the agricultural real estate loan market, I want to point out that the 
enabling legislation contains only broad statements of the 
corporation's mission and purpose. The legislation is not specific and 
does not provide measurable mission-related criteria that would allow 
for a meaningful assessment of Farmer Mac's progress in meeting its 
public policy goals. Our attempt to determine the extent to which 
Farmer Mac had met its public policy mission led us to conclude that 
although Farmer Mac has increased its mission-related activities since 
our previous review, the public benefits derived from these activities 
are not clear.

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

In trying to assess whether Farmer Mac had made long-term credit 
available to farmers and ranchers at stable interest rates, we found 
that from 2001 to 2002, its long-term fixed interest rates on Farmer 
Mac I loans were similar to the rates offered by commercial banks and 
FCS institutions. We also found that since 1998, Farmer Mac had been 
operating under a strategy of retaining the loans it purchased and 
securitized as AMBS in its portfolio. Farmer Mac stated that this 
strategy would lower funding costs and increase profitability but as a 
result, the depth and liquidity of the secondary market for AMBS is 
unknown. In our report, we recommended that Farmer Mac reevaluate this 
strategy. Recently, Farmer Mac management said that the corporation had 
reevaluated its strategy for holding AMBS but determined to continue 
holding them for economic reasons. However, Farmer Mac management also 
indicated that the corporation was committed to selling newly issued 
AMBS periodically, when the conditions of the capital markets and the 
size of loan pool made such transactions efficient.

Standby Agreements Reduced Total Capital Required To Be Held in FCS:

As I mentioned earlier, Farmer Mac has increased its mission-related 
activities, primarily by developing the standby agreement program. As 
of December 31, 2003, all of Farmer Mac's standby agreements are with 
FCS institutions and 3 FCS institutions represented 51 percent of the 
standby agreement program. While standby agreements provide greater 
lending capacity for those institutions, they also lower the amount of 
capital lending institutions are required to hold against their loans. 
Fig. 2 shows the effect of standby agreements on the total capital 
required to be held against the underlying loans in the entire FCS.

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

[See PDF for image]

[End of figure]

Our concern is that standby and similar agreements reduce the sum of 
capital required to be held by the Farm Credit System and Farmer Mac. 
Generally, institutions can help mitigate the risks associated with 
lower capital by maintaining a relatively large number of participating 
lenders and a geographically diverse portfolio. However, Farmer Mac's 
business activities are concentrated among a small number of business 
partners and its portfolio is concentrated largely in the western 
United States.

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

Before discussing governance issues at Farmer Mac, I want to describe 
how Farmer Mac's board of directors is structured in federal law. 
Farmer Mac's 15-member board of directors includes 5 members elected by 
Class A stockholders, which include banks, insurance companies, and 
other financial institutions that do business with Farmer Mac; 5 
members elected by Class B stockholders, which are FCS institutions 
that do business with Farmer Mac; and 5 members appointed by the 
President of the United States. Farmer Mac also issues nonvoting Class 
C stock to the general public. Class A and Class B shareholders are 
concerned with the use of Farmer Mac services, while Class C 
shareholders are generally investors concerned with maximizing their 
profits.

According to statements made at the time Farmer Mac's enabling 
legislation was being considered, this structure was intended to 
protect the interests of both FCS and commercial lenders by providing 
for equal representation by FCS, commercial lenders, and the public 
sector. Under this structure, Farmer Mac resembles a cooperative. At 
the same time, however, it is a publicly traded company, because its 
Class A and C stock are traded on the NYSE. But unlike most other 
publicly traded corporations, Farmer Mac is controlled by institutions 
with which it has a business relationship. For this reason, the board 
may face difficulties representing the interests of all shareholders. 
Good corporate governance requires that the incentives and loyalties of 
the board of directors of publicly traded companies reflect the fact 
that the directors are to serve the interests of all the shareholders. 
However, we found that the statutory structure of Farmer Mac's board 
and the voting structure of its common stock hamper Farmer Mac's 
ability to have such a focus.

Farmer Mac is subject to NYSE listing standards on corporate 
governance, as well as statutory and regulatory requirements such as 
the Sarbanes-Oxley Act of 2002. Collectively, these standards and 
provisions require that a majority of the board be independent and that 
key committees (audit, nominating or corporate governance, and 
compensation) consist entirely of independent directors. During our 
review, the listing standards were being revised and criteria for 
independence had not been finalized. [Footnote 9] Based on the proposed 
standards, our assessment was that business relationships between 
Farmer Mac and the directors of its board may have prevented these 
individuals from meeting the standards of independence under NYSE 
rules. In updating our information for this testimony, we noted that 
Farmer Mac's 2004 annual proxy statements had identified 2 of 15 
directors as not meeting the independence standards. One of the 2 
directors is not a nominee for re-election. The other director has 
decided to withdraw as a member of the corporate governance committee 
if elected as a director at 2004 annual meeting.

We found that Farmer Mac's board nomination process, director training, 
and management succession planning were not as concise, formal, or well 
documented as best practices would suggest. We also found that Farmer 
Mac's stock option vesting program appears generous compared to general 
industry practices. We made recommendations to Farmer Mac's board to 
improve the transparency and disclosure of these processes and to 
reevaluate stock option levels and vesting period. Since our 2003 
report, according to Farmer Mac management, the board has reviewed and 
confirmed that all board members fully understand the nomination 
process and that it has established a formal executive management 
succession plan. Further, the board has initiated a formal training 
program for its members that included external training and briefings 
on subjects relevant to the operations of Farmer Mac. Finally, the 
board had extended the vesting period of the corporation's stock 
options.

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

The final area of our 2003 review involved regulatory oversight of 
Farmer Mac. We reported that since 2002 FCA had taken several steps to 
enhance supervisory oversight of Farmer Mac but it faced significant 
challenges that could limit its regulatory effectiveness. We made 
several recommendations to FCA designed to enhance the risk-based 
capital model, improve off-site monitoring of Farmer Mac, and help 
assess and report how well Farmer Mac is achieving its mission. In 
updating our information for this testimony, we found that FCA had 
taken or planned to take a number of actions to further address many of 
our concerns and recommendations.

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

During our 2003 review, we noted that FCA had begun strengthening its 
oversight of Farmer Mac by doing a more comprehensive safety and 
soundness examination and undertaking initiatives to expand its 
regulatory framework. These initiatives included developing 
regulations to limit the level and quality of Farmer Mac's nonmission 
investments and issue specific liquidity standards, and studying the 
implications of regulatory capital arbitrage between FCS institutions 
and Farmer Mac. However, we found that FCA continued to face 
significant challenges in sustaining and improving its oversight and 
more remained to be done to improve its off-site monitoring, assessment 
of risk-based capital, and mission oversight. For example, FCA had not 
been updating and reformatting Farmer Mac's call report schedules and 
corresponding instructions to fully conform to FCA regulations and to 
reflect recent accounting changes. We also identified a number of 
issues related to the data used in and structure of FCA's risk-based 
capital model, but the overall impact these issues have on the estimate 
of risk-based capital for Farmer Mac's credit risk is uncertain. Some 
concerns, such as the potential undercounting of loans which 
experienced credit losses, or greater prepayment of the loans in the 
database used to build FCA's credit risk model relative to the kinds of 
loans that Farmer Mac now purchases, may result in the FCA credit risk 
model underestimating the credit risk capital requirement. Other 
issues, such as lacking a variable to track land price changes for any 
but the year with the most economic stresses, may cause the model to 
overestimate the credit risk capital requirement. Augmented data and 
more analysis could better determine the relative magnitudes of these 
effects.

Our study found that FCA's oversight of Farmer Mac had typically 
focused on safety and soundness and that FCA lacked criteria and 
procedures to effectively oversee how well Farmer Mac achieves its 
mission. At the same time, Farmer Mac's enabling legislation is broadly 
stated and does not include any measurable goals or requirements to 
assess progress toward meeting its mission. More explicit mission goals 
or requirements would help FCA in improving its oversight of Farmer 
Mac.

Since our 2003 report, FCA has continued to make a concerted effort to 
further enhance its oversight of Farmer Mac. First, FCA staff are 
drafting regulatory revisions to the risk-based capital model that 
covers a range of issues. They plan to present a proposed rule to the 
FCA board for consideration in the fall of 2004. According to FCA 
officials, they are engaged in efforts to address the issues related to 
the risk-based model raised in our report but there are certain 
elements of our recommendation they have considered and decided not to 
adopt, including a "run-off" approach, the effect of yield maintenance 
penalties, and the use of land value declines as the independent 
variable in loan loss regression. Second, FCA has made some revisions 
to the Farmer Mac quarterly call reports, and is in process of making 
additional revisions. These initial revisions included adjustments to 
call report schedules that were identified during our 2003 review. FCA 
has a number of capital-related projects in progress that, taken 
collectively, may address the issue of capital arbitrage within the 
Farm Credit System. In addition, FCA has a number of ongoing projects 
that may address our recommendation related to requiring Farmer Mac to 
obtain a credit rating. Finally, FCA has begun planning for a project 
that will consider different approaches for assessing the impact Farmer 
Mac's activities have on the agricultural real estate lending market.

Conclusions:

Our 2003 review showed that Farmer Mac's income, mission-related 
activities and risks have all increased since we last reported in 1999. 
At the same time, we found that Farmer Mac, FCA, and Congress could 
each take actions to ensure that Farmer Mac operates in a safe and 
sound manner while fulfilling its public policy mission. We recommended 
in our report that Farmer Mac strengthen its risk management and 
corporate governance practices and reevaluate its strategies to carry 
out its mission. Our report also recommended that FCA make several 
enhancements to its oversight tools to more effectively oversee both 
the safety and soundness and mission of Farmer Mac. Farmer Mac and FCA 
agreed with several of our report's findings and conclusions. During 
our recent discussions with Farmer Mac and FCA, both entities 
demonstrated that they are taking steps to implement many of our 
recommendations. Finally, our report suggested that Congress consider 
making legislative changes to ensure that Farmer Mac's public benefits 
can be measured and FCA has the necessary flexibilities to carry out 
its oversight responsibilities.

Mr. Chairman, this concludes our prepared statement. We would be happy 
to respond to any questions you or other members of the Committee may 
have at this time.

GAO Contacts and Staff Acknowledgements:

For information about this testimony, contact Davi D'Agostino, 
Director, Financial Markets and Community Investment, at (202) 512-
8678, or Jeanette Franzel, Director at (202) 512-9471. In addition to 
the individuals named above, Rachel DeMarcus, Debra Johnson, Austin 
Kelly, Paul Kinney, Bettye Massenburg, Kimberley McGatlin, John 
Treanor, and Karen Tremba made key contributions to this testimony.

FOOTNOTES

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

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

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

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

[5] Id.

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

[7] 12 U.S.C.2279aa-13.

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

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