Risk-Based Capital

Federal RegisterSep 13, 2001

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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

Office of Federal Housing Enterprise Oversight

12 CFR Part 1750

RIN 2550-AA02

Risk-Based Capital

AGENCY:

Office of Federal Housing Enterprise Oversight, HUD.

ACTION:

Final rule.

SUMMARY:

The Office of Federal Housing Enterprise Oversight (OFHEO) is directed by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 to issue a risk-based capital regulation for the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association (collectively, the Enterprises). The regulation specifies the risk-based capital stress test that will be used to determine each Enterprise's risk-based capital requirement and, along with the minimum capital requirement, to determine each Enterprise's capital classification for purposes of possible supervisory action.

EFFECTIVE DATE:

September 13, 2001.

FOR FURTHER INFORMATION CONTACT:

Edward J. Szymanoski, Acting Associate Director, Office of Risk Analysis and Model Development; Dorothy J. Acosta, Deputy General Counsel; or David A. Felt, Associate General Counsel, Office of Federal Housing Enterprise Oversight, 1700 G Street, NW., Fourth Floor, Washington, DC 20552, telephone (202) 414-3800 (not a toll-free number). The telephone number for the telecommunications device for the deaf is (800) 877-8339.

SUPPLEMENTARY INFORMATION:

I. Introduction

A. Background

The Office of Federal Housing Enterprise Oversight (OFHEO) was established by title XIII of the Housing and Community Development Act of 1992, Pub. L. No. 102-550, known as the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (1992 Act). OFHEO is an independent office within the U.S. Department of Housing and Urban Development (HUD) with responsibility for examining and regulating the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae) (collectively, the Enterprises) and ensuring that they are adequately capitalized. The 1992 Act expressly directs OFHEO's Director (the Director) to issue a regulation establishing the risk-based capital standard.

12 U.S.C. 4513(b)(1).

Fannie Mae and Freddie Mac are government-sponsored Enterprises that engage in two principal businesses: investing in residential mortgages and guaranteeing securities backed by residential mortgages. The securities the Enterprises guarantee and the debt instruments they issue are not backed by the full faith and credit of the United States and nothing in this document should be construed otherwise.

Nevertheless, financial markets treat Enterprise securities more favorably than securities issued by comparable firms. The market prices for Enterprise debt and mortgage-backed securities (MBS) and the fact that the market does not require that those securities be rated by a nationally recognized rating statistical organization suggest that investors perceive that the government implicitly guarantees those securities. Factors contributing to this perception include the Enterprises' public purposes, their Congressional charters, their potential direct access to U.S. Department of Treasury (Treasury) funds, and the statutory exemptions of their debt and MBS from otherwise mandatory investor protection provisions.

See

Federal Home Loan Mortgage Corporation Act, section 306(h)(2) (12 U.S.C. 1455(h)(2)); Federal National Mortgage Association Charter Act, section 304(b) (12 U.S.C. 1719(b)); and 1992 Act, section 1302(4) (12 U.S.C. 4501(4)).

See, e.g.,

12 U.S.C. 24 (authorizing unlimited investment by national banks in obligations of or issued by the Enterprises); 12 U.S.C. 1455(g), 1719(d), 1723(c) (exempting securities from oversight from Federal regulators); 15 U.S.C. 77r-1(a) (preempting State law that would treat Enterprise securities differently from obligations of the United States for investment purposes); 15 U.S.C. 77r-1(c) (exempting Enterprise securities from State blue sky laws).

B. Statutory Requirements for Risk-Based Capital

The final rule implements the 1992 Act's requirement to establish, by regulation, a risk-based capital “stress test” to determine the amount of capital each Enterprise needs to survive a ten-year period characterized by large credit losses and large movements in interest rates (stress period).

The 1992 Act also provides that, in order to meet its risk-based capital standard, each Enterprise is required to maintain an additional 30 percent of this amount to protect against management and operations risk.

The level of capital

required under this standard for an Enterprise will reflect that Enterprise's specific risk profile at the time the stress test is run.

12 U.S.C. 4611.

12 U.S.C. 4611(c)(2).

For purposes of the risk-based capital standard, the term “capital” means “total capital” as defined under section 1303(18) of the 1992 Act (12 U.S.C. 4502(18)).

The 1992 Act requires that the stress test subject each Enterprise to large credit losses on the mortgages it owns or guarantees. The rates of default and severity that yield these losses must be reasonably related to the highest rates of default and severity of mortgage losses experienced during a period of at least two consecutive years in contiguous areas of the United States that together contain at least five percent of the total U.S. population (benchmark loss experience).

The 1992 Act also prescribes two interest rate scenarios, one with rates falling and the other with rates rising.

The risk-based capital amount is based on whichever scenario requires more capital for the Enterprise. In prescribing the two scenarios, the 1992 Act describes the path of the ten-year constant maturity yield (CMT) for each scenario and directs OFHEO to establish the yields on Treasury instruments of other maturities in a manner reasonably related to historical experience and judged reasonable by the Director.

12 U.S.C. 4611(a)(1).

12 U.S.C. 4611(a)(2).

Congress provided OFHEO significant discretion to determine many aspects of the risk-based capital test. This flexibility is evidenced by section 1361(b), which states that “[i]n establishing the risk-based capital test under subsection (a), the Director shall take into account appropriate distinctions among types of mortgage products, differences in seasoning of mortgages, and any other factors the Director considers appropriate.”

The subsection further states that other non-specified characteristics of the stress period, “such as prepayment experience and dividend policies, will be those determined by the Director, on the basis of available information, to be most consistent with the stress period.”

The statute also provides OFHEO flexibility in establishing other aspects of the stress test, including “the rate of default and severity,”

the yields on Treasury securities relative to the ten-year CMT yield,

and the definition of “type of mortgage product.”

12 U.S.C. 4611(b)(1).

12 U.S.C. 4611(b)(2).

12 U.S.C. 4611(a)(1).

12 U.S.C. 4611(a)(2).

12 U.S.C. 4611(d)(2).

The 1992 Act requires that, initially, the stress test not provide for the conduct of new business by the Enterprises during the stress period, except to fulfill contractual commitments to purchase mortgages or issue securities. Four years after the final risk-based capital regulation is issued, OFHEO may modify the stress test to incorporate assumptions about additional new business conducted during the stress period.

In doing so, OFHEO is required to take into consideration the results of studies conducted by the Congressional Budget Office and the Comptroller General of the United States on the advisability and appropriate form of new business assumptions. The 1992 Act requires that the studies be completed within the first year after issuance of the final regulation.

12 U.S.C. 4611(a)(3)(B) and (D).

12 U.S.C. 4611(a)(3)(C).

C. Rulemaking Chronology

OFHEO has issued a series of

Federal Register

notices soliciting comment on the development of the risk-based capital regulation. The first notice, an Advance Notice of Proposed Rulemaking (ANPR),

sought public comment on a number of issues relating to the development of the regulation.

OFHEO received 17 comments on the ANPR from a variety of interested parties, including other Federal agencies, Fannie Mae, Freddie Mac, trade associations, and financial organizations. OFHEO considered these comments in the development of two subsequent Notices of Proposed Rulemaking (NPRs), each addressing different components of the risk-based capital regulation. The first Notice of Proposed Rulemaking (NPR1)

addressed two issues: (1) The methodology for identifying the benchmark loss experience, and (2) the use of OFHEO's House Price Index (HPI) to update original loan-to-value ratios (LTVs) and to determine house price appreciation paths during the stress period.

NPR1 included OFHEO's responses to all of the ANPR comments that related to those two areas.

The second Notice of Proposed Rulemaking (NPR2) proposed the remaining specifications of the stress test, including how the HPI would be used and how losses predicted by the stress test would be calibrated to the benchmark loss experience.

In addition, OFHEO issued a notice soliciting reply comments to provide interested parties an opportunity to respond to other commenters that addressed NPR2.

Risk-Based Capital, ANPR, 60 FR 7468, February 8, 1995.

The comment period for the ANPR ended on May 9, 1995, and was extended through June 8, 1995. Risk-Based Capital, Extension of Public Comment Period for ANPR, 60 FR 25174, May 11, 1995.

Risk-Based Capital, NPR1, 61 FR 29592, June 11, 1996.

61 FR 29616, June 11, 1996.

The comment period for NPR1 ended on September 9, 1996, and was extended through October 24, 1996. Risk-Based Capital, Extension of Public Comment Period for NPR1, 61 FR 42824, August 19, 1996.

Risk-Based Capital, Second Notice of Proposed Rulemaking (NPR2), 64 FR 18084, April 13, 1999. The agency extended the comment period twice. The first extension was until November 10, 1999 (64 FR 31756, June 14, 1999), and the second extension was until March 10, 2000 (64 FR 56274, October 19, 1999).

Risk-Based Capital, Solicitation of Reply Comments, 65 FR 13251, March 13, 2000.

OFHEO received comments from 11 commenters on NPR1 and 48 commenters on NPR2. These commenters included Fannie Mae, Freddie Mac, housing and financial trade associations, financial services companies, housing advocacy groups, and other interested parties. Approximately 12 commenters, including the Enterprises, GE Capital Mortgage Corporation, Mortgage Insurance Companies of America, The Consumer Mortgage Coalition, and the Mortgage Bankers Association of America submitted reply comments to NPR2.

The final rule reflects OFHEO's consideration of all of the comments on NPR1 and NPR2, including the reply comments. A summary of the comments by topic and OFHEO's response is set forth below in III., Comments and Responses.

II. Summary of the Stress Test

A. Overview

OFHEO's risk-based capital regulation is part of a larger regulatory framework for the Enterprises that includes a minimum capital requirement and a comprehensive examination program. The purpose of this regulatory framework is to reduce the risk that an Enterprise will fail by ensuring that the Enterprises are capitalized adequately and operating safely, in accordance with the 1992 Act. The 1992 Act requires OFHEO to develop a stress test that simulates the effects of ten years of adverse economic conditions on the existing assets, liabilities, and off-balance-sheet obligations of the Enterprises. OFHEO issued for comment two proposals that implement this requirement.

This summary describes the stress test adopted in the final rule after considering extensive comments from interested parties on the risk-based capital proposals. It includes changes made to the stress test to address the concerns of the commenters where possible and appropriate. These changes are consistent with applicable statutory requirements and with OFHEO's obligation to promote safety and soundness of the housing finance system and to ensure the Enterprises' ability to fulfill their important public missions. These changes are discussed in section III., Comments and Responses. In addition, the final rule includes technical and clarifying changes to the risk-based capital proposals.

The final rule describes a stress test that meets the statutory requirements of the 1992 Act and captures accurately and appropriately the risks of the Enterprises' businesses. The stress test determines, as of a point in time, how much capital each Enterprise would require to survive the economically stressful conditions outlined by the 1992 Act. At a minimum, the stress test will be run quarterly using data on interest rates, housing markets, and an Enterprise's assets, liabilities, off-balance-sheet items, and operations. The stress test is comprised of econometric, financial, and accounting models used to simulate Enterprise financial performance over a ten-year period called the “stress period.” The final regulation determines the risk-based capital requirement by computing the amount of starting capital that would permit an Enterprise to maintain a positive capital position throughout the stress period (stress test capital) and adding 30 percent of that amount to cover management and operations risk.

B. Data

OFHEO uses data from the Enterprises and public sources to run the stress test. The stress test utilizes data that characterize, at a point in time, an Enterprise's assets, liabilities, and off-balance sheet obligations, as well as data on economic conditions, such as interest rates and house prices. OFHEO obtains data on economic conditions from public sources. The Enterprises are required to submit data to OFHEO at least quarterly for all on- and off-balance-sheet instruments in a specified format, which is input directly into the computer model. This data submission is called the Risk-Based Capital Report (RBC Report) and serves as the financial “starting position” of an Enterprise for the date for which the stress test is run.

As a part of the RBC Report, the Enterprises report aggregated data from groups of loans having similar risk characteristics. The loans within these groups share common values for a set of classification variables. For single family loans, classification variables are original interest rate, current interest rate, original loan-to-value ratio (LTV), mortgage age, Census Division, loan size, status as securitized or unsecuritized, status as government or conventional loan, and product type (e.g. fixed rate, adjustable rate, balloons). Classification variables for multifamily loans are product type, original interest rate, current interest rate, original LTV, debt coverage ratio (DCR);

book of business designation,

status as securitized or unsecuritized, status as Government or conventional loan, status as interest only or amortizing, and a ratio update flag, which indicates whether LTV and DCR were updated at acquisition. Both single family and multifamily ARM loans are also classified by index, rate reset period, payment reset period, and cap type. These distinctions are associated with different risk characteristics. In this way, over 24 million loans can be aggregated into the minimum number of loan groups that captures important risk characteristics.

DCR is the ratio of net operating income to mortgage payment for a specific property.

“Old book” loans are those originated before 1988 for Fannie Mae and before 1993 for Freddie Mac. All other multifamily loans are considered “new book” loans.

Loan groups of new mortgages are also created to simulate the fulfillment of commitments to purchase and/or securitize mortgages that are outstanding at the start of the stress test. The stress test adds new single family mortgages in one of four product types: 30-year fixed-rate, 15-year fixed-rate, one-year CMT adjustable-rate, and 7-year balloon. The percentage of each type added is based on the relative proportions of those types of loans securitized by an Enterprise that were originated during the six months preceding the start of the stress period. The mix of characteristics of these new loans also reflects the characteristics of the loans originated during the preceding six months. All new mortgages are considered to be securitized.

In the down-rate scenario, described below, the stress test specifies delivery of 100 percent of the loans that the Enterprise is obligated to accept under outstanding commitment agreements. These loans are added during the first three months of the stress period. In the up-rate scenario, described below, only 75 percent of these loans are added and deliveries are phased in during the first six months of the stress period. The new loan groups are then treated like the loan groups reported by the Enterprise in the RBC Report.

Because of the smaller number and greater diversity of the Enterprises' nonmortgage financial instruments, the stress test projects these cash flows at the individual instrument level, rather than at a group level. The RBC Report includes the instrument characteristics necessary to model the terms of the instruments, which include both investment and debt securities and derivative contracts.

C. Stress Test Conditions

1. Benchmark Loss Experience

To identify the stressful credit conditions that are the basis for credit losses in the stress test, (benchmark loss experience), OFHEO uses a methodology based on historical analysis of newly originated, 30-year, fixed-rate, first-lien mortgages on owner-occupied, single family properties. Using this methodology, OFHEO identifies the worst cumulative credit losses experienced by loans originated during a period of at least two consecutive years in contiguous states comprising at least five percent of the U.S. population, as required by the 1992 Act. Loans originated in Arkansas, Louisiana, Mississippi and Oklahoma in 1983 and 1984 currently serve as the benchmark loss experience. These loans (benchmark loans) had an average ten-year cumulative default rate of 14.9 percent and an average ten-year loss severity of 63.3 percent. The loss rate (default incidence times loss severity in the event of default, without considering the effect of credit enhancements) for this region and time period was 9.4 percent. OFHEO will continue to monitor loss data and may choose to establish a new benchmark loss experience if a higher loss rate for a different region and time period is determined using this methodology.

When the single family models of default and prepayment are applied to the benchmark loans, using the pattern of interest rates from the benchmark time and place, losses are close to those of benchmark loans. The difference results from the fact that OFHEO based its single family default and prepayment models on all Enterprise historical loan data, not just the limited data for benchmark loans for which the losses were particularly severe. This difference provides the basis for calibration factors for each LTV category, which the stress test applies to adjust the single family default rates upward or downward, making them more consistent with the benchmark loss experience. However, because the stress test simulates the performance of an Enterprise's entire mortgage portfolio at a point in time and includes loans of all types, ages, and characteristics, overall Enterprise mortgage loss rates in the stress test can be lower or higher than the loss rates for benchmark loans, even with the calibration adjustment.

Because there were very few Enterprise multifamily loans in the benchmark region and time period, the stress test uses patterns of vacancy rates and rent growth rates that are consistent with the benchmark time and place to determine property income, a key factor in determining defaults for multifamily loans. In this way, the stress test relates the performance of multifamily loans to the benchmark loss experience.

2. Interest Rates

Interest rates are a key component of the adverse economic conditions of the stress test. The 1992 Act specifies two paths for the ten-year Constant Maturity Treasury yield (CMT) during the stress period. During the first year of the stress period, the ten-year CMT:

• Falls by the lesser of 600 basis points below the average yield during the nine months preceding the stress period, or 60 percent of the average yield during the three years preceding the stress period, but in no case to a yield less than 50 percent of the average yield during the preceding nine months (down-rate scenario); or

• Rises by the greater of 600 basis points above the average yield during the nine months preceding the stress period, or 160 percent of the average yield during the three years preceding the stress period, but in no case to a yield greater than 175 percent of the average yield during the preceding nine months (up-rate scenario).

The ten-year CMT changes in twelve equal monthly increments from the starting point, which is the average of the daily ten-year CMT yields for the month preceding the stress period. The ten-year CMT stays at the new level for the remainder of the stress period.

The stress test establishes the Treasury yield curve for the stress period in relation to the prescribed movements in the ten-year CMT. In the down-rate scenario, the yield curve is upward sloping during the last nine years of the stress period; that is, short term rates are lower than long term rates. In the up-rate scenario, the Treasury yield curve is flat for the last nine years of the stress period; that is,

yields of other maturities are equal to that of the ten-year CMT.

Because many different interest rates affect the Enterprises' business performance, the ten-year CMT and the Treasury yield curve are not the only interest rates that must be determined. For example, current mortgage rates impact prepayment rates; adjustable-rate mortgages periodically adjust according to various indexes; floating rate securities (assets and liabilities) and many rates associated with derivative contracts also adjust; and appropriate yields must be established for new debt and investments issued during the stress test. Thus, the stress test requires rates and indexes other than Treasury yields for the entire stress period. Some of the key rates that are used in the stress test are the Federal Funds Rate, London Inter-Bank Offered Rate (LIBOR), Federal Home Loan Bank 11th District Cost of Funds Index (COFI), and the Enterprise Cost of Funds. The stress test establishes these rates and indexes using an average of the ratio of each non-Treasury spread to its comparable CMT (the proportional spread) for the two-year period prior to the start of the stress test. Indexes of mortgage interest rates are calculated using the average absolute basis-point spread for the same two-year period.

3. Property Values

The 1992 Act requires OFHEO to consider the effect of loan “seasoning,” which is defined as the change in LTVs over time.

The analogous multifamily measure is current debt-service-coverage ratio (DCR).

12 U.S.C. 4611(d)(1).

For single family loans, the stress test updates the original LTV to the start of the stress period, using the amortized loan balance and a house price growth factor for the period between origination and the start of the stress period. The house price growth factor is derived from OFHEO's House Price Index (HPI) for the Census Division in which the property is located. The stress test then applies the pattern of house price changes from the benchmark time and place to compute changes in property values during the stress period. The HPI values represent average property value appreciation. In simulating mortgage performance, the stress test also captures variations from average house price movements, called dispersion. For this purpose, the stress test uses dispersion parameters for the Census Division containing most benchmark states, which OFHEO published along with the HPI for the third quarter, 1996.

Multifamily property values are not updated in the stress test. LTV at loan origination is the only variable that measures property values directly in the multifamily model. If the original LTV is unknown, LTV at loan acquisition is substituted. The effect of seasoning on multifamily loans is captured by projecting changes in property income during the stress period, based upon rent and vacancy indexes consistent with the benchmark time and place.

When the ten-year CMT increases by more than 50 percent over the average yield during the nine months preceding the stress period, the stress test takes general price inflation into consideration. In such a circumstance, adjustments are made to the house price and rent growth paths during the stress period that correspond to the difference between the ten-year CMT and the level reflecting a 50 percent increase in the ten-year CMT. The stress test phases in this increase in equal monthly increments during the last five years of the stress period.

D. Mortgage Performance

To simulate mortgage performance during the adverse conditions of the stress period, the stress test uses statistical models that project default, prepayment and loss severity rates during the stress period. These models simulate the interaction of the patterns of house prices, residential rents, and vacancy rates from the benchmark time and place with stress test interest rates and mortgage risk characteristics, to predict the performance of Enterprise loans throughout the stress test. The default and prepayment models calculate the proportion of the outstanding principal balance for each loan group that defaults or prepays in each of the 120 months of the stress period. As described below in further detail, the models are based on the historical relationship of economic conditions, mortgage risk factors, and mortgage performance, as reflected in the historical experience of the Enterprises.

1. Single Family Default and Prepayment

The single family mortgage performance models were estimated using available historical data for the performance of Enterprise loans in the years 1979-1999. To simulate defaults and prepayments, the stress test uses a 30-year fixed-rate loan model, an adjustable-rate loan (ARM) model, and a third model for other products, such as 15-year loans and balloon loans. Each of the three single family models was separately estimated based on data for the relevant product types

and includes a calibration adjustment by LTV category, so that the results properly reflect a reasonable relationship to the benchmark loss experience, as described earlier.

Historical data sets for the ARM and other single family product models were pooled with data for 30-year fixed-rate loans to capture performance differences specific to product types relative to 30-year fixed-rate loans.

All three single family models simulate defaults and prepayments based on the projected interest rates and property values, as described above, and variables capturing the mortgage risk characteristics described below. Certain variables are used only in prepayment equations. The single family default and prepayment variables are listed in Table 1.

Table 1.—Single Family Default & Prepayment Variables

Variables for All Single Family Models

Single Family Default

Variables

Single Family Prepayment Variables

Mortgage Age

Original LTV

Probability of Negative Equity

Burnout

Occupancy Status

Relative Spread

Yield Curve Slope

Relative Loan Size

Product Type (ARMs, Other Products only)

Payment Shock (ARMs only)

Initial Rate Effect (ARMs only)

• Mortgage Age—Patterns of mortgage default and prepayment have characteristic age profiles; defaults and prepayments increase during the first years following loan origination, with a peak between the fourth and seventh years.

• Original LTV—The LTV at the time of mortgage origination serves as a proxy for factors relating to the financial status of a borrower, which reflects the

borrower's future ability to make loan payments. Higher original LTVs, which generally reflect fewer economic resources and greater financial risk, increase the probability of default and lower the probability of prepayment. The reverse is true for lower original LTVs.

• Probability of Negative Equity—Borrowers whose current loan balance is higher than the current value of their mortgaged property (reflecting negative borrower equity) are more likely to default than those with positive equity in their properties. The probability of negative borrower equity within a loan group is a function of (1) house price changes (based on the HPI), and amortization of loan principal, which together establish the average current LTV, and (2) the dispersion of actual house prices around the HPI value. Thus, even when the average current LTV for a loan group is less than one (positive equity), some percentage of the loans will have LTVs greater than one (negative equity).

• Burnout—This variable reflects whether a borrower has passed up earlier opportunities to refinance at favorable interest rates during the previous eight quarters. Such a borrower is less likely to prepay the current loan and refinance, and more likely to default in the future.

• Occupancy Status—This variable reflects the higher probability of default by investor-owners compared with that of owner-occupants. The RBC Report specifies the proportion of investor loans for each loan group.

• Relative Spread—The stress test uses the relative spread between the interest rate on a loan and the current market rate on loans as a proxy for the mortgage premium value, which reflects the value to a borrower of the option to prepay and refinance.

• Yield Curve Slope—This variable measures the relationship between short and long term interest rates. The shape of the yield curve, which reflects expectations for the future levels of interest rates, influences a borrower's decision to prepay a mortgage.

• Relative Loan Size—This variable reflects whether a loan is significantly larger or smaller than the State average. Generally, lower balance loans are less likely to refinance (and therefore prepay) because refinancing costs are proportionately larger, and the interest savings are proportionately smaller, than a larger balance loan.

• Product Type—The differences in performance between 30-year fixed-rate loans and other products, such as ARM and balloon loans, are captured by this variable.

• Payment Shock—This variable captures the effect of increasing or decreasing interest rates on the payments for ARMs. Although a borrower with an ARM loan may still have positive equity in the mortgaged property, the borrower may be unable to make a larger monthly payment when interest rates increase, resulting in increases to ARM default and prepayment rates. Conversely, decreasing interest rates make it easier for borrowers to make monthly payments, resulting in lower ARM default and prepayment rates.

• Initial Rate Effect—Borrowers with ARM loans with a “teaser rate” (an initial interest rate lower than the market rate) may experience payment shock even if market rates do not rise, as the low teaser rate adjusts to the market rate over the first few years of the loan. The stress test includes a variable which captures this effect in the first three years of the life of the loan.

2. Multifamily Default and Prepayment

The stress test uses a statistical model for multifamily default and a set of simple rules for multifamily prepayment. The default model was estimated using historical data through 1999 on the performance of Enterprise multifamily loans. As with the models of single family mortgage performance, the multifamily default model simulates the probability of default based on stress test conditions and loan group risk characteristics. To account for specific risks associated with multifamily loans, these loans are grouped somewhat differently than are single family loans and have somewhat different explanatory variables, to characterize stress test conditions. To characterize stress test conditions, the multifamily model specifies interest rates, rent growth rates, and vacancy rates.

The following variables are factors in determining the probability of default for multifamily loan groups:

• Mortgage Age—As with single family loans, the risk of default on multifamily loans varies over their lives.

• New Book Flags—These variables capture the performance differences between the Enterprises' original multifamily programs and their current, restructured programs. The reduced default risk under the “new book of business” is more pronounced for fixed rate loans than for balloon loans and ARMs, which are flagged separately.

• Current DCR and Underwater DCR Flag—Rental property owners tend not to default unless a property's debt coverage ratio (DCR) is less than one, indicating insufficient net cash flow to service the mortgage debt. The stress test updates the DCR of multifamily loans during the stress period using rent and vacancy indexes consistent with the benchmark loss experience. The higher the DCR, the less likely that the borrower will default. Conversely, a DCR below one indicates that the borrower cannot cover the mortgage payment, significantly increasing the risk of default.

• Original LTV—As with single family loans, the risk of default for multifamily loan borrowers is greater for higher original LTV loans than for lower original LTV loans.

• Balloon Maturity Risk—When a balloon mortgage matures, the borrower is required to pay off the outstanding balance in a lump sum. This variable captures the greater risk of default in the year before a balloon mortgage matures.

• Ratio Update Flag—This variable captures the decreased probability of default if the DCR and LTV were either calculated at loan origination, or recalculated at Enterprise acquisition, in accordance with current Enterprise standards.

To project prepayment rates for multifamily loans, the stress test implements a simple set of prepayment rules. In the up-rate scenario, multifamily loans do not prepay. In the down-rate scenario, two percent of multifamily loan balances prepay each year if they are inside the prepayment penalty time period. Outside the prepayment penalty period, multifamily loans prepay at an annual rate of 25 percent.

3. Loss Severity

Loss severity is the net cost to an Enterprise of a loan default. The stress test uses the costs associated with different events following the default of a mortgage to determine the total loss or cost to an Enterprise. Loss severity rates are computed as of the date of default, and are expressed as a percentage of the unpaid principal balance (UPB) of a defaulting loan.

In general, losses are composed of three elements associated with loan foreclosure and disposition (sale) of the property: loss of principal, transactions costs, and funding costs. Transaction costs include expenses related to foreclosure, property holding costs (real estate owned or REO costs) and disposition costs. For single family loans, transactions costs are fixed percentages based on historical averages computed from Enterprise data. For multifamily loans, transactions costs are based on the average costs through 1995 from Freddie Mac old book loans (

See

Footnote 24).

Loss of principal is the amount of defaulting loan UPB, offset by the net proceeds of the sale (disposition) of the foreclosed property. For single family loans, sale proceeds of foreclosed properties are a fixed percentage of defaulting UPB, based on benchmark recovery rates for real estate owned as a result of loan defaults (REO).

For multifamily loans, sale proceeds are a fixed percentage of the defaulting UPB, based on REO recovery rates from Freddie Mac old book loans through 1995.

Recovery rate is the proportion of defaulted UPB that is recovered through the sale of the property.

Since foreclosure, property holding, disposition and associated costs occur over time, the stress test calculates loss severity rates by discounting the different elements of loss back to the time of default, based on stress period interest rates. This discounting also captures losses associated with funding costs, including passthrough interest on sold loans, at appropriate interest rates. For single family loans, the timing of each element is based on averages for the benchmark loans; for multifamily loans it is based on the average for Freddie Mac Old Book loans, using REO data through 1995. The loss severity rates are used in the cash flow components of the stress test to calculate credit losses for the Enterprises.

E. Other Credit Factors

1. Mortgage Credit Enhancements

A portion of Enterprise mortgage losses are offset by some form of credit enhancement. Credit enhancements are contractual arrangements with third parties that reduce Enterprise losses on defaulted loans. By including the effect of mortgage credit enhancements, the stress test more realistically reflects Enterprise risks related to mortgage defaults and credit losses during the stress period.

The stress test captures many types of credit enhancements, with differing depths and methods of coverage, for both single family and multifamily loans. The stress test divides mortgage credit enhancements into two categories—loan limit and aggregate limit. Loan limit credit enhancements cover a specified percentage of losses on individual loans with no limit on the aggregate amount paid under the contract. This category includes mortgage insurance for single family loans and loss-sharing agreements for multifamily loans. Aggregate limit credit enhancements cover losses on a specified set of loans, up to a specified aggregate amount. This category includes limited and unlimited recourse to seller/servicers, indemnification, pool insurance and modified pool insurance, cash or collateral accounts, third-party letters of credit, spread accounts, subordination agreements, and FHA risk-sharing.

The amount by which credit enhancements reduce monthly loss severity rates is based on information reported by the Enterprises in the RBC Report for the level of coverage for both loan limit and aggregate limit credit enhancements for each loan group. The stress test applies loan limit credit enhancements first. Then aggregate limit credit enhancements are applied to the remainder of the loss balance, up to the contractual limit. The stress test reduces the loss severity rate for a specific loan group based on the combined loan limit and aggregate limit credit enhancements associated with loans in that group.

2. Counterparty Default

In addition to mortgage credit quality, the stress test considers the creditworthiness of companies and financial instruments to which the Enterprises have credit exposure. These include most mortgage credit enhancement counterparties, securities held as assets, and derivative contract counterparties.

For these contract or instrument counterparties, the stress test reduces—or applies “haircuts” to—the amounts due from these instruments or counterparties according to their level of risk. The level of risk is determined by public credit ratings at the start of the stress test, classified into five categories: AAA, AA, A, BBB and unrated/below BBB. When no rating is available or the instrument or counterparty has a rating below BBB (below investment grade), the stress test applies a 100 percent haircut in the first month of the stress test, with the exception of unrated seller/servicers, which are treated as BBB, and unrated, unsubordinated obligations of government sponsored enterprises, which are treated as AAA. For other categories, the stress test phases in the haircuts monthly in equal increments until the total reduction listed in Table 2 is reached five years into the stress period. For the remainder of the stress period the haircut applies.

Table 2.—Stress Test Final Haircuts by Credit Rating Category

Ratings

Classification

Derivative

Non-

derivative

AAA

15%

20%

BBB

16%

40%

Unrated/Below BBB

100%

Unrated, unsubordinated obligations issued by government sponsored enterprises other than the reporting Enterprise are treated as AAA. Unrated seller/servicers are treated as BBB. Other unrated counterparties and securities are subject to a 100% haircut applied in the first month of the stress test, unless OFHEO specifies another treatment, on a showing by an Enterprise that a different treatment is warranted.

Because the stress test does not model currency exchange rates through the stress period, the stress test reflects the associated risk by modeling the debt and the swap as a single debt transaction that pays the dollar-denominated net interest rate paid by the Enterprise, and no haircut is applied.

F. Cash Flows

For each month of the stress period, the stress test calculates cash flows for every loan group and individual instrument reported in the RBC Report and applies the haircuts to cash flows to reflect the credit risk of securities and counterparties. These cash flows are used to create pro forma financial statements that reflect an Enterprise's total capital in each month of the stress period.

1. Mortgage Cash Flows

The cash flow component of the stress test applies projected default, prepayment, and loss severity rates net of credit enhancements to amortized loan group balances to produce mortgage cash flows for each month of the stress period. Cash flows are generated for each single family and multifamily loan group. For retained loan groups, cash flows consist of scheduled principal, prepaid principal, defaulted principal, credit losses, and interest. For sold loans, cash flows consist of credit losses, guarantee fee income, and float income.

2. Mortgage-Related Security Cash Flows

Because losses on sold loans are absorbed by the Enterprises directly and are not passed through to security holders, no additional credit losses are

reflected in cash flows calculated for an Enterprise's own mortgage-backed securities (MBSs) held as investments. Cash flows for single-class MBSs issued by an Enterprise and held as investments consist only of principal and interest payments. Cash flows for mortgage securities not issued by the Enterprise consist of principal and interest payments and credit losses based on haircuts according to rating level. Principal payments are calculated by applying default and prepayment rates that are appropriate for the loans underlying the MBS. The stress test specifies that defaulted and prepaid principal and scheduled amortization are passed through to investors. Interest is computed by multiplying the security principal balance by the coupon rate.

Multiclass mortgage securities such as Real Estate Mortgage Investment Conduit securities (REMICs) and stripped MBS (strips) are treated in the same manner as single class MBS. The stress test generates cash flows for the underlying collateral, usually single-class MBSs, and applies the cash flow allocation rules of the particular multiclass security to determine cash flows of the specific class(es) held by an Enterprise. In generating cash flows for mortgage-linked derivative contracts, where the notional amount of the contract is based on the declining principal balance of a specified MBS, the stress test applies the terms of each contract and tracks the appropriate changing balances. The stress test generates cash flows for mortgage revenue bonds by treating each bond as a single-class MBS backed by 30-year, fixed-rate single family mortgages maturing on the bond's stated maturity date.

3. Nonmortgage Instrument Cash Flows

The stress test calculates cash flows for securities that the Enterprises hold as assets, or have issued as liabilities. The stress test also generates cash flows for derivative instruments such as interest rate swaps, caps, and floors. For nonmortgage investments, outstanding debt securities, and liability-linked derivative contracts, payments of principal and interest are calculated for each instrument based on contractual terms and stress test interest rates. For fixed-rate asset-backed securities, the stress test applies a 3.5 percent collateral prepayment speed; for floating-rate securities a two percent speed is applied in both interest rate scenarios.

For each month during the stress period that a security is subject to early redemption (put/call), the stress test calculates the effective remaining yield-to-maturity

of that instrument and compares it to the yield of a replacement security, under the given stress period interest rate scenario. If the yield on the replacement instrument is more than 50 basis points below the cost of the existing instrument, the call or cancellation option is exercised. The stress test applies a similar rule to derivative contracts that are subject to cancellation.

Yields are calculated based on the outstanding principal balances for securities and notional amounts for derivative contracts.

G. New Products or Activities

Given the continuing evolution and innovation in the financial markets, OFHEO recognizes that the Enterprises will continue to develop and purchase new products and instruments and engage in other new activities. To the extent that the current stress test treatments are not applicable directly, OFHEO will combine and adapt current stress test treatments in an appropriate manner in order to ensure that the risks of these activities are adequately captured in the risk-based capital requirement. For example, OFHEO might employ the mortgage performance models and adapt its cash flow components to simulate accurately the loss mitigating effects of credit derivatives. Where there is no reasonable approach using existing combinations or adaptations, the stress test will employ an appropriately conservative treatment, consistent with OFHEO's role as a safety and soundness regulator. Similarly, the Director has discretion to treat an existing instrument as a new activity if OFHEO determines there have been significant increases in volume that change the potential magnitude of the risk of the instrument, or where other information indicates that the risk characteristics of the instrument are not appropriately reflected in a treatment previously applied.

An Enterprise that has a new activity is encouraged to suggest a treatment which will be considered by OFHEO. The Enterprise will also be able to comment on OFHEO's treatment before it is used for a final capital classification. The public will have a subsequent opportunity to submit views on these treatments, which will be considered for future stress test applications.

H. Other Off-Balance-Sheet Guarantees

In addition to guaranteeing mortgage-backed securities they issue as part of their main business, the Enterprises occasionally provide guarantees for other mortgage-related securities to enhance the liquidity and appeal of these securities in the marketplace. These securities, notably single family and multifamily whole-loan REMIC

securities and tax-exempt multifamily housing bonds, represent a small part of the Enterprises' businesses and have a significant level of credit enhancement that protects the Enterprises from losses. Consequently, the stress test does not explicitly model the performance of these securities, but uses an alternative modeling treatment. As a proxy for the present value of net losses on these guarantees during the stress period, the outstanding balance of these instruments at the beginning of the stress period is multiplied by 45 basis points. The resulting amount is subtracted from the lowest discounted monthly capital balance for the calculation of stress test capital, as described below in II.K., Calculation of the Risk-based Capital Requirement.

Real Estate Mortgage Investment Conduit (REMIC) securities are multiclass mortgage passthrough securities. The classes of a REMIC security can take on a wide variety of attributes with regard to payment of principal and interest, cashflow timing, (un)certainty and maturity, among others.

I. Alternative Modeling Treatments

The stress test also assigns alternative modeling treatments to any items for which data are incomplete, and any on- or off-balance sheet items for which there is neither a specified treatment in the final regulation nor a computationally equivalent proxy. An alternative modeling treatment is a series of rules that assigns simple, appropriately conservative assumptions, based on the interest rate scenario, to an asset, liability, or off-balance-sheet item in the stress test. Missing data elements are assigned a conservative default value. This treatment will only be needed for extremely unusual items or when all the necessary data for modeling an instrument are not included in the RBC Report.

J. Enterprise Operations, Taxes and Accounting

The stress test simulates the issuance of new debt or purchase of new investments, exercise of options to retire debt early or cancel derivative contracts, payment of dividends by the Enterprises, operating expenses, and income taxes. The stress test computes Federal income taxes using an effective tax rate of 30 percent. Estimated income tax is paid by the Enterprises quarterly in the stress test.

When necessary, the stress test simulates the issuance of new debt or

purchase of new investments by an Enterprise. A mix of short- and long-term debt is issued in months when there is a shortfall of cash. New short-term debt is six-month discount notes at the simulated Enterprise Cost of Funds. New long-term debt is five-year debt, callable after the first year, at the five-year Enterprise Cost of Funds, plus a 50 basis-point premium for the call option. Short- and long-term debt issuance is targeted to achieve and maintain a total liability mix of 50 percent short-term debt and 50 percent long-term debt. Excess cash is invested in one-month securities bearing the six-month Treasury rate.

Capital distributions are made during the stress period. If an Enterprise's core capital

exceeds the minimum capital requirement in any quarter, dividends on preferred stock are paid based on the coupon rates of the issues outstanding. Common stock dividends are paid only in the first four quarters of the stress period. The amount paid is directly related to the earnings trend of the Enterprise. Generally, if the trend is positive, the dividend payout ratio is the same as the average of the four quarters preceding the stress test. Otherwise, dividends are based on the dollar amount per share paid in the last quarter preceding the stress test. Share repurchases are made in the first two quarters of the stress period, based on the average stock repurchase for the four quarters preceding the stress test. No capital distribution is made if core capital is below the minimum capital requirement. If a capital distribution would cause core capital to fall below the minimum capital requirement, the distribution is made only to the extent of the core capital that exceeds the minimum capital requirement.

Core capital, as defined at 12 U.S.C. 4502(4) consists of par value or stated value of outstanding common, and perpetual, noncumulative, preferred stock, paid-in capital, and retained earnings, determined in accordance with Generally Accepted Accounting Principles.

Operating expenses decline during the stress test as the Enterprise's mortgage portfolios decline, but the decline is not strictly proportional. The baseline level from which they decline is the average monthly operating expenses of the Enterprise for the three months preceding the start of the stress test. In each month of the stress test, the amount of the decline is determined by computing a base amount comprised of a fixed component and a variable component. The fixed component is one third of the baseline level, and the variable component begins as the remaining two thirds of the baseline level and declines in direct proportion to the decline in the UPB of the combined portfolios of retained and sold loans during the stress period. The base amount is further reduced by one-third, except that this further reduction is gradually phased in during the first 12 months of the stress test.

To the extent possible, the stress test makes use of Generally Accepted Accounting Principles (GAAP). However, the stress test does not reflect certain securities and derivatives at their fair value, as required by the Financial Accounting Standards Board's Statement of Financial Accounting Standard (FAS) Nos. 115 and 133. In the first month of the stress test, these assets are adjusted to an amortized cost basis.

K. Calculation of the Risk-Based Capital Requirement

The stress test determines the amount of capital that an Enterprise must hold at the start date in order to maintain positive capital throughout the ten-year stress period (stress test capital). Once stress test capital has been calculated, an additional 30 percent is added to protect against management and operations risk. This total is the risk-based capital requirement.

In order to calculate stress test capital, the capital balance for each month is discounted back to the start of the stress period, using capital as calculated in the pro forma financial statements and interest rates for both stress test scenarios. The stress test uses the six-month Treasury rate when the Enterprise is a net lender and the six-month Enterprise Cost of Funds when the Enterprise is a net borrower. The lowest discounted monthly capital balance is then decreased as described above to account for certain items given alternative modeling treatments, including the other off-balance-sheet obligations described above in II.H., Other Off-Balance-Sheet Guarantees. This lowest discounted monthly balance, if positive, represents a surplus of initial capital, that is, capital that was not “used” during the stress period. If negative, it represents a deficit of initial capital. The lowest discounted monthly balance is then subtracted from the Enterprise's initial capital. The resulting amount is the smallest amount of starting capital required to maintain positive capital throughout the stress period.

For example, if an Enterprise holds starting capital of $10 billion and the lowest discounted monthly balance is $1 billion (representing a positive capital balance in the worst month of the stress period), then the amount of starting capital necessary to maintain positive capital throughout the stress period is $9.0 billion. If, on the other hand, the lowest discounted monthly balance is −$1 billion (representing a negative capital balance in the worst month), the necessary starting capital to maintain positive capital throughout the stress period is $11.0 billion.

Finally, required starting capital is multiplied by 1.3 to complete the calculation of the risk-based capital requirement required by the 1992 Act.

III. Comments and Responses

The final rule reflects OFHEO's consideration of all the comments on NPR1 and NPR2, including responses from those commenters who replied to the initial comments on NPR2. After careful review and analysis of the comments, OFHEO determined that a number of recommendations had merit. OFHEO accepted these recommendations and made changes in the stress test accordingly. In other cases where commenters recommended changes, OFHEO did not accept the specific suggestion, but modified the stress test to address the commenters' concerns. Other recommendations proved to be contrary to the 1992 Act, did not offer a better alternative to the existing stress test, or had merit but required further study before they could be implemented.

The commenters on NPR1 and NPR2 included the Enterprises, financial services and housing-related trade associations, financial service companies, affordable housing groups and agencies, a governmental agency, a private rating agency and several individuals.

Trade associations commenting included American Bankers Association (ABA), America's Community Bankers (ACB), Consumer Mortgage Coalition (CMC), Mortgage Bankers Association of America (MBA), Mortgage Insurance Companies of America (MICA), National Association of Home Builders (NAHB), National Association of Realtors (NAR), Credit Union National Association (CUNA), National Bankers Association (NBA), National Association of Real Estate Brokers (NAREB), and National Home Equity Mortgage Association (NHEMA).

Financial services companies commenting included GE Capital Mortgage Corporation (GE Capital), Chase Manhattan Mortgage Corporation, Charter One Bank, Goldman Sachs, Newport Mortgage Company L.P., J.P. Morgan & Co. Incorporated, Bear Stearns & Co. Inc., Morgan Stanley Dean Witter (Morgan Stanley), Lehman Brothers, Salomon Smith Barney, Triad Guaranty Insurance Corporation, Merrill Lynch, Promentory Financial Group LLC, PW

Funding Inc., Amresco Capital, L.P., Golden West Financial Corporation (World Savings), Countrywide (Mid-America Bank FSB), American International Group Inc. (AIG), the Federal Home Loan Bank of Chicago, and WMF Group.

Affordable housing groups and agencies included The Enterprise Foundation and the Local Initiatives Support Corporation, National Center for Community Self Help, National Council of State Housing Agencies (NCSHA), Association of Local Housing Finance Agencies, Nebraska Investment Finance Authority, Neighborhood Housing Services of America, Inc., National Association of Affordable Housing Lenders (NAAHL), PT & Associates Community Development Consulting, National Neighborhood Housing Network, National Community Reinvestment Coalition, and Coalition on Homelessness & Housing in Ohio.

Other commenters included Office of Thrift Supervision, Fitch ICBA, Nelson Yu, O'Melveny & Myers LLP, and L. William Seidman.

A summary of the comments and OFHEO's responses are set forth below, by topic.

A. Approach

Commenters generally agreed on the basic premises underlying OFHEO's proposal to implement a risk-based capital requirement for the Enterprises: the importance to the nation's housing finance system of financially strong Enterprises, and the appropriateness of the weight the 1992 Act places on a risk-based capital requirement to protect the Enterprises' capital adequacy. The views of commenters, however, diverged on the question of whether a stress test, such as the one proposed in NPR2, provided the best approach to setting a risk-based capital requirement for the Enterprises. Among the commenters who agreed that a stress test was the best approach, the views diverged on the question of how the stress test should be implemented. The general comments on OFHEO's approach are discussed below by topic.

1. Bank and Thrift Approach

a. Comments

Some commenters suggested that OFHEO take an overall approach to capital regulation similar to that emerging among the bank and thrift regulators and the Basel Committee on Banking Supervision. The suggestions of these commenters included using ratios to set capital requirements for credit risk and Value at Risk (VaR) methodologies for market risk rather than a stress test. One Enterprise and one commenter, however, noted that although VaR methodology is a valuable analytical tool, it is not appropriate for determining risk-based capital as prescribed by the 1992 Act.

The approach evolving in the bank regulatory community applies ratios to categories of on- and off-balance-sheet items to derive capital requirements, but also begins to incorporate VaR and other methodologies that financial institutions employ in their proprietary models. The approach, which is outlined in the June 1999 report by the Basel Committee on Banking Supervision (Committee) titled “A New Capital Adequacy Framework,” also puts more emphasis on supervisory review and greater market discipline based on expanded disclosure of risk. The June 1999 report discusses a new capital framework consisting of three “pillars”: minimum capital requirements, a supervisory review process, and market discipline.

The three pillars approach to bank regulatory capital seeks to improve the relationship of bank capital requirements to risk that was set out in the 1988 Accord. The 1988 Accord was itself a major departure from the simple leverage ratios applied by regulators to total assets. It introduced a capital framework that applied ratios to broad categories of assets according to their relative riskiness as reflected by type of instrument (e.g., residential mortgages, commercial loans, or lines of credit) or by obligor (e.g., sovereign government, national bank, or industrial company). At the time the Accord was introduced, the Committee recognized the limitations inherent in quantifying credit risk by applying ratios to such broad categories of assets. The Committee also recognized that credit risk was only one element of the risk profile of a financial institution. Subsequent enhancements, most notably permitting the use of proprietary models to calculate a supplemental capital requirement reflecting the market risk of a large financial institution's trading portfolio, have continued to improve the process of quantifying risk and calculating an appropriate level of capital based on risk.

In January of 2001, the Committee published for comment a proposal embodying the three pillars to replace the 1988 Accord.

The proposal is intended to be a more risk-sensitive framework containing a range of new options for measuring both credit and operational risk. Key elements of the proposal were a refinement of the minimum capital requirement to make it more risk-sensitive, a greater emphasis on the bank's own assessment of its risk, and a decision to treat interest rate risk under the second pillar, the supervisory review process.The proposal described a “foundation” or standardized approach to credit risk, which was a refinement of the 1988 approach to minimum capital, and an “advanced” internal ratings-based approach for banks that meet more rigorous supervisory standards. The latter made use of internal estimates, subject to supervisory review, but stopped short of permitting banks to calculate their capital requirements on the basis of their own portfolio credit risk models. Separate disclosure requirements were set forth as prerequisites for supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques, and asset securitization. The Committee indicated that similar disclosure prerequisites would attach to the use of advanced approaches to operational risk.

Committee on Banking Supervision, “Overview of the New Basel Capital Accord,” Bank for International Settlements, Basel, Switzerland (January 2001). A copy of this document can be obtained from the BIS website at

http://www.bis.org.

After reviewing the comments on the January 2001 proposal, the Committee announced in June of 2001 that the proposal needs further adjustment to maintain equivalency between the two approaches and to ensure that the capital incentives are appropriate to encourage banks to adopt the more advanced approaches.

The Committee reaffirmed its support for the three pillars approach and announced that it would release a complete and fully specified proposal for an additional round of consultation in early 2002, with a target implementation date of 2005.

See press release of June 25, 2001, “Update of the New Basel Accord.” A copy of this document may be obtained on the BIS website at

http://www.bis.org.

b. OFHEO's Response

Although the 1992 Act requires a risk-based capital standard for the Enterprises that is based on a stress test, OFHEO's overall approach to regulation is broadly parallel to the three pillars approach proposed by the Committee. OFHEO already pursues a “multidimensional” approach to regulating the Enterprises' capital, as one commenter urged. OFHEO's minimum and risk-based capital requirements are quantifiable capital requirements, which are the goals of the Committee's first pillar; OFHEO employs risk-based examination and

oversight of the Enterprises that provides the type of oversight contemplated in the second pillar; and OFHEO is currently reviewing the Enterprises' public disclosures to determine whether they would provide an adequate basis for market discipline as contemplated in the third pillar.

Although OFHEO will follow with interest the Committee's progress in developing a new regulatory capital framework and, where appropriate, consider incorporating aspects of this new framework into its regulation of the Enterprises, OFHEO believes that its stress test is appropriate to implement the statutory requirements and ties capital more closely to risk than either the current Basel Accord or recent proposals. The current capital adequacy regime for large banks quantifies credit risk by applying ratios to risk-weighted asset and off-balance-sheet amounts and quantifies market risk only to the extent of the interest rate risk in the banks' trading portfolios. In refining the treatment of credit risk, the Committee's three pillars approach would continue to rely on ratios. Interest rate risk would be addressed under the second pillar, the supervisory review process. By contrast, OFHEO's stress test simultaneously captures credit risk and interest rate risk of an Enterprise's entire business.

OFHEO also believes that VaR methodologies that large banks use to evaluate the interest rate risk of their trading portfolios are not adequate to implement the requirements of the 1992 Act. VaR approaches are best used to evaluate risk over relatively short time periods and are, therefore, appropriate for evaluating trading portfolios. The Enterprises' asset portfolios, however, are not a “trading book,” as one commenter suggested. Rather, these portfolios are comprised largely of assets that are held to maturity. The Enterprises' actual trading portfolios are, in fact, a small part of the Enterprises' balance sheets. Further, although large banks continue to use VaR models for calculating day-to-day trading risk, since the disruptions in the global financial markets in 1997 and 1998, these banks increasingly have employed stress tests to measure their market exposure.

These banks found that VaR models were less able to measure risk under extreme market conditions than stress tests.

Committee on the Global Financial System, “Stress Testing by Large Financial Institutions: Current Practice and Aggregation Issues,” 14 Bank for International Settlements, Basel, Switzerland (April 8, 2000). A copy of this document may be obtained from the BIS website at

http://www.bis.org.

2. Proprietary/Internal Models

a. Comments

Some of the commenters who recommended the bank and thrift regulatory approach urged that OFHEO permit the Enterprises to use their proprietary models to determine interest rate risk. A number of other commenters contended that each Enterprise should calculate its own risk-based capital requirement using a stress test model specified by OFHEO but developed by the Enterprise. Each Enterprise would then report its risk-based capital requirement to OFHEO in the same manner as the minimum capital requirement is reported. All of these commenters suggested that OFHEO could ensure the integrity of the capital calculation process through its examination function. In arguing for the use of internal models, one commenter also noted that the risk-based capital proposals of the Farm Credit Administration (FCA) and the Federal Housing Finance Board (FHFB) also permit the use of proprietary and/or internal models to varying degrees.

Both Enterprises agreed that they should calculate their own risk-based capital requirement, contending that it is sufficient for OFHEO to publish the specifications for the model. They recommended that they should run the stress test as specified by OFHEO on their own internal systems, at least as a transitional measure. The Enterprises believe this would be the fastest and most efficient way to implement a risk-based capital rule that would produce capital numbers in a timely way.

Other commenters believed that allowing an Enterprise to calculate its own capital requirement using its proprietary models or a model that OFHEO specifies would undermine OFHEO's regulatory independence and impede the transparency of the stress test for third parties. These commenters felt that OFHEO must retain control of both the model and the process for determining the Enterprises' risk-based capital requirements to ensure the integrity of the calculation of risk-based capital.

The Congress has required FCA, which regulates the Federal Agricultural Mortgage Corporation (Farmer Mac), and FHFB, which regulates the Federal Home Loan Banks, to establish risk-based capital standards for the entities they regulate. The statutory requirements for FCA's risk-based capital regulation,

which parallel the requirements of the 1992 Act, include a ten-year stress test, a worse-case historical credit loss experience, and stressful interest rate scenarios. The FCA rule specifies the basic structure and parameters of the risk-based capital stress test and allows Farmer Mac to use FCA's spread sheet model or implement the stress test using an internal model built to FCA's specifications to determine its risk-based capital requirement.

66 FR 19048, April 12, 2001. FCA's rule determines stressful credit conditions by applying loss frequency and severity equations to Farmer Mac's loan-level data. From these equations, FCA's test calculates loan losses, assuming Farmer Mac's portfolio remains at a “steady state,” and allocates the calculated losses to each of the ten years. Interest rate risk is quantified using the results of Farmer Mac's interest rate risk shock-test to determine the change in the market value of equity (MVE). The change in MVE is posted to the first period in the stress test.

In its notice of proposed rulemaking, FCA noted “that because of the proprietary nature of specific, transaction loan level and financial data used in the risk-based capital stress test, it is unlikely that results of the test will be fully reproducible by parties other than Farmer Mac and us. Other parties, however, will be able to approximate the test results on an aggregate basis using publicly available information.” 64 FR 61741, November 12, 1999.

The statutory requirements for FHFB's recently adopted capital regulation,

which takes an approach similar to that of the bank and thrift regulators, are much less specific than either OFHEO's or FCA's, but direct FHFB to take OFHEO's stress test into consideration. In the FHFB rule, each Federal Home Loan Bank calculates its own risk-based capital charge.

12 FR 8262, Jan. 30, 2001; 12 CFR parts 915, 917, 925, 930, 931, 932, 933, 956, and 960.

Capital to cover credit risk is calculated from leverage ratios that are based upon the credit ratings of counterparties and collateral supporting the credit. 66 FR 8313 (Jan. 30, 2001). Market risk capital is based on internal VaR models or stress tests and a determination of the amount by which the current market value of a Federal Home Loan Bank's total capital is less than 85 percent of the book value of total capital.

Id.

at 8317. Capital for operations risk is 30 percent of credit risk capital, although the FHFB may approve a lesser amount (not less than 10 percent) where the Federal Home Loan Bank obtains appropriate insurance or provides an acceptable alternative method for assessing and quantifying operations risk capital.

Id.

at 8318.

b. OFHEO's Response

The final rule continues to provide for capital classifications to be determined based on a stress test specified, developed, and administered by OFHEO. OFHEO believes this approach best fulfills the statutory purposes and maintains the integrity of the risk-based capital regulation. Allowing the Enterprises to use their proprietary models or models they develop based

on OFHEO's specifications to calculate their own capital requirements could result in a weaker and inconsistently applied standard. However, each Enterprise will receive the source code for the stress test, which will enable it to compute its own capital requirement for internal purposes and to comment on its proposed capital classification.

Although FCA's statutory framework is similar to the 1992 Act, statutory interpretations that are appropriate for FCA's statute are not necessarily appropriate interpretations of the 1992 Act, and differences in regulatory responsibilities make the FCA approach unworkable for OFHEO. FCA is charged with developing a stress test for a single entity, while OFHEO regulates two entities, both of which must be subject to the same stress test.

Models that the Enterprises develop themselves would inevitably differ in their details, which could result in significant variations, and make it difficult to apply the stress test consistently to both Enterprises. In addition, the 1992 Act requires that the stress test be set forth in a regulation subject to notice and comment rulemaking,

that the risk-based capital regulation be sufficiently specific to permit someone other than the Director to apply the test,

and that OFHEO make the stress test model publicly available.

For these reasons, OFHEO concluded that the most practical way to comply with these statutory provisions was to develop and administer its own model on its own systems and apply the stress test even-handedly to both Enterprises.

See

12 U.S.C. 4611(a) (“The Director shall, by regulation, establish

risk-based capital test for the Enterprises. When applied to an Enterprise,

the

risk-based capital test shall determine the amount of total capital for the Enterprise * * *”) (emphasis added). See also H.R. Rep. No. 102-206 at 62 (1991). “Beyond these traditional capital ratios, the bill sets forth guidelines for the creation, in highly specific regulations, of a risk-based capital standard * * *

The

model, or stress test, will generate a number for each Enterprise, which will become the risk-based standard for that Enterprise.”) (emphasis added).

12 U.S.C. 4611(e)(1).

12 U.S.C. 4611(e)(2).

12 U.S.C. 4611(f).

Use of the FHFB approach is not viable for OFHEO under the 1992 Act, which requires a specific stress test, and does not provide the option of allowing each institution to design an appropriate risk-based capital test. The FHFB compared the agencies' approaches in the preamble to its final rule, noting that “[f]or example, the GLB Act requires that the [FHFB] develop a stress test that rigorously tests for changes in interest rates, interest rate volatility and changes in the shape of the yield curve, while the statutory requirements governing Fannie Mae and Freddie Mac set forth specific scenarios for downward and upward shocks in interest rates.”

Other examples of statutory differences include the requirement in the 1992 Act that credit losses be related to the benchmark loss experience and an extensive list of factors that OFHEO must consider in designing the stress test. Further, the procedural requirements that the details of the stress test be published by regulation and made available to the public also make an internal models approach impractical for OFHEO.

66 FR at 8283.

OFHEO also finds that regulatory independence and rigor is best served by OFHEO's approach. The availability of the stress test on OFHEO's systems allows OFHEO greater flexibility to run the stress test whenever it may be needed. Maintaining the infrastructure to support the stress test also gives OFHEO the ability to independently test alternative risk scenarios in addition to the two stress test scenarios, which ensures the integrity of the stress test. This capability will also permit OFHEO to test possible improvements and adjustments to the stress test.

In sum, OFHEO concurs with the concerns of the commenters who recommended that OFHEO develop and maintain a single stress test model and require the Enterprises to provide the necessary data for the stress test. The Enterprises certainly may replicate that model from OFHEO's model specifications and computer code and use it to determine the capital impact of various business decisions. For the purposes of determining the capital classifications, however, OFHEO will run its own model using data submitted by the Enterprises. To alleviate some of the Enterprises' concern about the ability of the model to produce accurate capital numbers in a timely way, the final regulation establishes a standardized data reporting format for the RBC Report. This Report will enable OFHEO to produce capital numbers within the regulatory time frame.

See

sections III.B., Operational Workability of the Regulation and III.E., Enterprise Data.

3. Mark to Market for “Tail Risk”

a. Comments

Two commenters said that OFHEO should consider losses beyond the end of the stress test period, either by marking to market remaining positions or otherwise requiring additional capital to cover the risk that remained at the end of the ten-year stress period. One Enterprise responded that marking to market to capture this “tail risk” would be contrary to the 1992 Act.

b. OFHEO's Response

The final regulation does not adopt the commenters' suggestions to require capital for on- and off-balance-sheet items that remain at the end of the ten-year stress period or to mark these items to their market value. The 1992 Act specifies that the stress period is ten years and that total capital must meet or exceed the amount of capital necessary to survive the stress period with positive capital. Marking to market balance sheet items that remain at the end of the 120 month period would bring into the stress test period earnings or losses beyond the ten-year period and would be inconsistent with the 1992 Act.

4. Additional Interest Rate Scenarios

a. Comments

Several commenters suggested that OFHEO study additional interest rate scenarios to ensure that smaller changes in interest rates do not result in risk-based capital requirements that are larger than the requirements generated by the interest rate scenarios in the 1992 Act. These commenters expressed concern that the risk-based capital rule will be inadequate unless OFHEO runs more than two interest rate scenarios. They also urged OFHEO to monitor any attempts by the Enterprises to take advantage of the limited number of interest rate scenarios in the stress test. The comment implies, for example, that an Enterprise could enter into inexpensive interest rate derivatives contracts that would allow the Enterprise to easily pass the two interest rate scenarios of the stress test. Under slightly different and possibly less stressful interest rate scenarios, these derivatives might be useless, but a stress test based on only two interest rate scenarios would not uncover this deficiency. To prevent this problem, the commenters said that OFHEO should run additional scenarios with a variety of assumptions, including combinations of smaller interest rate changes, more volatile interest rates, different yield curves, and alternative changes in house prices. They recommended that OFHEO set the risk-based capital requirement for an Enterprise at the highest amount generated by any additional scenarios. One Enterprise disagreed, saying that more moderate interest rate movements would probably result in lower capital requirements. The Enterprise also noted that OFHEO's examination process

ensures the integrity of Enterprises' risk management process.

b. OFHEO's Response

In response to these comments, OFHEO notes that the 1992 Act provides only two scenarios for the stress test and requires that risk-based capital be based on whichever of the two scenarios results in the higher capital requirement. Although OFHEO intends to run additional scenarios in order to monitor an Enterprise's capital adequacy, OFHEO does not need to modify the regulation to include scenarios beyond those specifically required in the 1992 Act. Moreover, it is not clear that specifying additional scenarios in the risk-based capital regulation would address the concerns of the commenters. If OFHEO were to add scenarios to the final rule, an Enterprise could simply enter into additional derivatives contracts that would hedge the new scenarios.

The 1992 Act specifies two interest rate scenarios, but it does not prohibit the running of additional scenarios as part of OFHEO's on-going monitoring of safety and soundness of the Enterprises. OFHEO can only test how well the results of the statutory scenarios reflect risk if OFHEO continues to run additional scenarios based on market conditions and other factors the Director considers appropriate. Should OFHEO discover any capital weakness when it runs additional scenarios, OFHEO has supervisory tools available to correct the situation. For example, if additional stress testing reveals that scenarios equally or less stressful than those in the 1992 Act would cause an Enterprise to fail the stress test, the Director may determine that grounds for discretionary capital reclassification exist under section 1364(b) of the 1992 Act. Similarly, a finding by the Director that an Enterprise is conducting itself in a way that threatens to cause a significant depletion of core capital would provide grounds for a cease and desist order.

B. Operational Workability of the Regulation

A broad theme of the comments was that OFHEO should move expeditiously to a final rule that is operationally workable. By operationally workable, most commenters meant that the regulation must provide for accurate and timely calculations of risk-based capital requirements. From a regulatory perspective, OFHEO agrees, because the risk-based capital requirement, together with the minimum capital requirement, serves as the basis for classifying the Enterprises as “adequately capitalized” or “undercapitalized.” OFHEO must determine these classifications as quickly as possible to minimize delays in identifying capital shortfalls. However, a number of commenters also expressed more specific concerns related to how the rule and the stress test that underlies it will operate in practice. These comments and OFHEO's responses to them are explained below.

1. Replicability and Transparency

To the Enterprises and some other commenters, the concept of operational workability meant that the stress test should be sufficiently transparent that the Enterprises can use it for internal planning and analysis. This level of transparency would allow the Enterprises to calculate capital numbers on their own systems with reasonable assurance that the results will closely mirror OFHEO's results. To certain non-Enterprise commenters, however, the concept of transparency meant complete replicability of OFHEO's results—that is, the ability of parties other than OFHEO and the Enterprises to run the stress test and to evaluate the potential impacts on Enterprise regulatory capital requirements of changes in the economy or Enterprise business mix. These commenters asserted that in order to promote market discipline, the stress test should be this transparent to third parties. They recommended that OFHEO release the computer code as well as the complete specifications of the stress test. A few commenters stated that the stress test could not be completely transparent without the release of Enterprise data, some of which may be proprietary.

OFHEO strongly supports a concept of operational workability that allows capital classifications to be determined in a timely manner, allows the Enterprises to use the stress test as a planning tool, is transparent to third parties, and allows capital classifications to be calculated in a timely manner. To this end, OFHEO, working with the Enterprises, has developed a standardized reporting format, the RBC Report, that will permit the reported data to be input into the stress test without manipulation and will work with the Enterprises to assist them in aligning their data systems with the reporting format so that they will be able to run the stress test on their systems and achieve the same result as the Director. This will permit timely classifications and will permit the Enterprises to anticipate what their capital classification will be. OFHEO's treatment of new activities, discussed below in III.B.3., New Enterprise Activities, is also designed to allow the Enterprises to understand the probable impact of new activities on their regulatory capital requirements. In addition, OFHEO will release to the Enterprises and other requesting parties a copy of the computer code. A stylized data set also will be made available to interested parties to permit them to understand the sensitivities and implications of the stress test.

This information will allow parties other than OFHEO to apply the stress test to any set of starting data in the same manner as OFHEO.

The stylized data set will include a realistic mix of on- and off-balance sheet items of a hypothetical Enterprise. It will allow any interested party to run the test, to vary the mix of items, add or delete items, change starting interest rates, modify historical house price patterns, and understand potential impacts of these actions or events upon Enterprise capital.

OFHEO disagrees, however, with commenters who suggest that third parties should be provided the actual starting position data that are input to the stress test. These data include Enterprise information that is not public and may be subject to legal prohibitions or restrictions on disclosure or may otherwise unfairly disadvantage an Enterprise if disclosed. Given the statutory protections for proprietary data included in the 1992 Act and elsewhere,

OFHEO believes that the requirement of the 1992 Act that others be able to apply the test in the same manner as the Director should not be read to require the release of proprietary data. OFHEO anticipates that the information it is supplying to the public about the model meets this statutory requirement and provides interested parties with a solid understanding of the interaction in the model of credit and interest rate stresses and an ability to understand the capital implications of changes in an Enterprise's risk profile. OFHEO strongly favors promoting market discipline. Because of the forward-looking nature of the stress test, OFHEO's periodic publication of the current capital numbers together with current capital classifications will promote such discipline.

See

e.g.,

12 U.S.C. 4611(e)(3); 18 U.S.C. 1905.

2. Predictability v. Flexibility

The comments suggest that in order for the stress test to be useful to the Enterprises in their businesses, its results must be sufficiently predictable to permit it to be used as a planning tool, while sufficiently flexible to take into account new products or other innovations by the Enterprises. From these somewhat competing considerations flowed a range of comments concerning the frequency with which OFHEO should amend the

regulation, the process that would be followed for changing the regulation, and the treatment of new activities and instruments, i.e., those for which the stress test does not currently prescribe a treatment.

Some commenters suggested that the final rule specify a process for routine updating of the stress test to incorporate industry improvements in risk management techniques. One commenter recommended specifying a threshold, expressed as a percentage of the minimum capital requirement, that would determine when changes require notice and comment. For changes that would not reach the threshold, the commenter recommended specifying a one-year implementation period and for changes that are proposed for notice and comment, a two-year period. Other commenters, including Fannie Mae, recommended severely limiting changes to create “stability” in the stress test. Freddie Mac recommended that OFHEO affirm that it would follow the Administrative Procedure Act (APA) when changes are made to the final regulation.

The final rule balances the concern for stability with the concern for flexibility, recognizing that the nature of the Congressional mandate and the dynamic nature of the Enterprises' businesses will require an ongoing assessment of how well the stress test achieves its objectives. To achieve its statutory objective of aligning capital to risk, the stress test necessarily must evolve as the risk characteristics of new and complex instruments and activities become better understood and modeling techniques more highly developed. Therefore, OFHEO cannot eliminate uncertainty about how the stress test might evolve without reducing the sensitivity of the stress test to risk. Sufficient discretion must be retained by the Director to respond to innovations as they occur. And yet, in its important particulars, there must be enough stability in the stress test to allow the Enterprises and others to predict with reasonable confidence the impact that changes in their business plans or the economy may have on their capital requirements.

OFHEO will continue to monitor and study changes in the Enterprises' businesses and the markets in which they operate. OFHEO also will evaluate new statistical data that become available to determine whether they have implications for Enterprise risks. These continuing efforts will, doubtlessly, suggest reestimation of the models and other changes to the stress test from time to time. However, OFHEO does not find it appropriate at this time to specify a process, beyond the APA, for routine updating of the rule or to commit in advance to limiting the size or frequency of changes to the rule. Only after the rule has been operational for a significant period of time can OFHEO assess whether there is a need for further rulemaking to specify a change process. In any event, OFHEO affirms that any future amendments to the regulation will comply with the APA.

3. New Enterprise Activities

a. Proposed Rule

Section 1750.21 of the proposed regulation and section 3.11 of the Proposed Regulation Appendix together were designed to implement the substantive risk-based capital requirements of the 1992 Act,

the notice and comment requirements of the APA,

and the replicability and public availability requirements of sections 1361(e) and (f) of the 1992 Act.

The quarterly capital calculations required by the 1992 Act

must, as accurately and completely as possible, capture the risks in the portfolio of each Enterprise. The requirement that classifications be done on not less than a quarterly basis is designed to ensure that changes in the risk profile of an Enterprise are captured frequently and reasonably close in time to when they are reflected on an Enterprise's books.

12 U.S.C. 4614, 4618.

5 U.S.C. 553.

12 U.S.C. 4611(e), (f).

12 U.S.C. 4614(c).

Given the dynamics of the marketplace and the Enterprises' business, it is not possible to construct a regulation that specifies a detailed model that could predict every new type of instrument or capture every new type of risk that might emerge from quarter to quarter. Therefore, to comply with the requirements of the 1992 Act, the proposed regulation included a provision, section 3.11 of the proposed Regulation Appendix, to address future instruments and activities, thus enabling each quarterly capital classification to be as accurate as possible. Section 3.11, together with other provisions in the regulation, was intended to help achieve that accuracy.

More specifically, section 3.11 of the proposed Regulation Appendix provided that the credit and interest rate risk of new activities and instruments would be reflected in the stress test by simulating their credit and cash flow characteristics using approaches already described in the Appendix. To the extent those approaches were not applicable directly, OFHEO proposed to combine and adapt them in an appropriate manner to capture the risk in the instruments. Where there is no reasonable approach using combinations or adaptations of existing approaches, the proposed stress test would employ an appropriately conservative treatment, which would continue until such time as additional information is available that would warrant a change to the treatment.

In addition to the substantive provisions of section 3.11 of the proposed Regulation Appendix, procedures were proposed in that section and in section 1750.21 of the regulation that would give the Enterprise involved advance notice of the treatment to be implemented and an opportunity to comment on it before it is implemented. Procedurally, proposed section 3.11 provided that an Enterprise should notify OFHEO of any pending proposal related to new products, investments, or instruments before they are purchased or sold or as soon thereafter as possible. The procedures in the proposed rule were also intended to encourage the Enterprise to provide OFHEO with any suggestions it may have as to an appropriate risk-based capital treatment for the activity or instrument. With the benefit of the information provided by the Enterprise, OFHEO would then notify the Enterprise of its estimate of the capital treatment as soon as possible.

Beyond these provisions, proposed section 1750.21 provided that the Enterprise would be notified of the proposed treatment when OFHEO provided the quarterly Notice of Proposed Capital Classification. After receiving that notice, the Enterprise would have thirty days to provide further comments to OFHEO. Those comments would be considered by OFHEO prior to issuing the final capital classification. Further, to ensure that the rest of the public could apply the test in the same manner as the Director, OFHEO planned to make the new treatment available to the public through an appropriate medium, such as the

Federal Register

, OFHEO's website, or otherwise. Comments from the public on these notices would be considered by OFHEO. Taken together, all of these provisions implement the procedural provisions of the 1992 Act and the APA, while assuring that the timely, complete and accurate capital classifications required by the 1992 Act are carried out.

b. Comments

Numerous comments addressed the capital treatment of new activities proposed in section 3.11 of the Regulation Appendix in NPR2. These

comments all urged OFHEO to adopt a clearly understood procedure that would be sufficiently flexible to allow the Enterprises to continue introducing new products. They emphasized that delay and uncertainty about treatments of new activities could frustrate introduction of innovative new products and business lines at the Enterprises.

The Enterprises both recommended that the process for new activities should allow them to understand as soon as possible the effect on capital of any new types of products or instruments that they introduce. Both Enterprises offered suggestions in the context of their recommendation that the stress test be run using their own infrastructures.

Although these suggestions differed in their details, both would allow the Enterprises to develop and implement capital treatments for new activities, subject to subsequent review and change by OFHEO.

See

III.A.2., Proprietary/Internal Models.

Other commenters suggested that if OFHEO determined that a proposed treatment for a particular new activity would have a minimal impact upon total risk-based capital, that the treatment should be expedited and that no notice and comment process should be required. Treatments that would have a substantial impact on capital would be implemented using notice and comment procedures under the APA. One commenter suggested that a risk-based capital “surcharge” be applied “on top of the normal capital requirements” to account for any new activities until sufficient data could be compiled to determine the risk inherent in such activities. Another commenter recommended three modifications to the treatment of new activities in the NPR: first, that OFHEO use historical data from reliable sources and confer with bank regulators to determine the most appropriate treatments; second, that OFHEO use a transparent comment process, including review by a technical advisory board that would allow input on treatments of new activities from all interested market participants; and third, that the treatments for new activities should be incorporated timely into the stress test.

c. OFHEO's Response

The Enterprises' recommended approaches, in which they would implement capital treatments subject to subsequent OFHEO review, are not practicable within the framework of the final rule because OFHEO will run the stress test using its own computers and its own infrastructure. Nevertheless, OFHEO recognizes the importance of making timely decisions about the capital treatments for new activities. Before the risk-based capital amount of the affected Enterprise for a particular quarter can be calculated, those decisions must be made about all new activities introduced during that quarter. Accordingly, OFHEO has developed a process to make its own independent and informed determination of the appropriate capital treatment for new activities as early as possible, with input from the Enterprises, rather than relying upon their judgments for the first quarterly capital classification after a new activity reported in the RBC Report. OFHEO believes that this process (discussed below) will not impede the development or introduction of new products or other types of business innovation.

As discussed above, OFHEO received various recommendations regarding the appropriate notice and comment procedures for new activities. OFHEO has fully utilized notice and comment procedures, discussed at IC., Rulemaking Chronology, in promulgating this regulation and OFHEO included procedures in NPR2 that will provide ongoing notice and comment for treatments of new activities. In addition, the final rule modifies NPR2 to clarify that the Enterprises are encouraged to provide their recommendations regarding treatments of their new activities and that the broader public will be notified of treatments once they are included in a final capital classification. The public is encouraged to submit their views regarding such treatments, which will be considered by OFHEO on an ongoing basis.

OFHEO believes that public input in the development of rules is essential for sound and fair regulation of the Enterprises. At the same time, to comply with the 1992 Act, OFHEO needed to establish procedures for new activities that would permit the accurate and timely capital classifications required by the 1992 Act. Accordingly, the regulation provides for notice to the affected Enterprise and the public and for consideration of comments received, while it also ensures the ability of OFHEO to conduct continuous, timely and complete capital calculations.

As time passes and a significant volume of new activities has been addressed through the section 3.11 New Activities process, it may be appropriate to propose an amendment to the regulation, utilizing the notice and comment procedures of 5 U.S.C. 553, that would specify treatments for a group of new activities. Although the public will have had the opportunity to provide comments on individual activities on an ongoing basis, this additional process would enable OFHEO to benefit from supplementary comments that are framed in the context of a broader body of risks.

In response to the recommendation regarding an external technical advisory board, OFHEO does not consider it appropriate to require by rule that such a board review the treatment of all new activities. OFHEO is satisfied that the wide diversity of technical expertise of its staff, combined with the normal notice and comment process, will generally provide adequate analysis and review of new activities.

As to the comment suggesting a capital “surcharge” for new activities on top of the “regular” risk-based capital requirement, OFHEO believes that its approach to new activities is appropriately flexible to take into account the risks inherent in any new, untested activity. OFHEO anticipates that it will be able to model effectively many (if not most) new activities explicitly according to their terms or with combinations or adaptations of existing treatments. Where the risk of a new asset type cannot be captured adequately using specified treatments or combinations or adaptations of treatments, OFHEO may use an appropriately conservative fixed capital charge instead of or in addition to an existing modeling treatment. However, in a cash flow model (in contrast to a leverage ratio approach), a fixed capital charge may not be the best method to implement a conservative capital treatment for most instruments. In particular, applying a fixed capital charge for liabilities or for activities that are designed to reduce risk is rarely appropriate.

A more appropriate means of increasing the incremental capital associated with a particular asset in a cash flow model may be to apply a “haircut” to the cash flows from that asset, either directly or by otherwise specifying certain attributes that are relevant to the cash flows of these instruments.

A similar approach can be applied to instruments, such as derivative or insurance contracts that are designed to reduce risk. To the extent that a liability can not be modeled according to its terms, the appropriate approach is generally to

incorporate certain conservative assumptions about the amount of cash flow that will be required from the Enterprise.

For these reasons, OFHEO believes that the flexibility afforded by section 3.11 is preferable to the imposition of a surcharge for new activities.

For example, requiring certain interest-bearing assets that are on the balance sheet to pay no earnings through the stress period could be an extremely conservative treatment, because the liabilities necessary to fund that asset would be paying interest throughout the stress period.

If, for example, the amount of interest on a note was indexed to a volatile indicator that could not be modeled in the stress test, a conservative treatment might be to require that instrument to pay interest throughout the stress period at a rate significantly higher than the average return of the Enterprise on its assets during that period.

In sum, the OFHEO has not altered its proposed approach to new activities, but, based upon the comments, determined that some clarification of that approach in the final regulation would be useful. Therefore, the final rule adopts § 1750.12 of the proposed regulation and section 3.11 of the proposed Regulation Appendix with some modifications. The revised definition of new activities in section 3.11.1.b of the Regulation Appendix clarifies that the section applies not only to new transactions and instruments, the most common new activities, but also other types of new activities. The term “new activities” is, therefore, defined broadly to include any asset, liability, off-balance-sheet item, accounting entry, or activity for which a stress test treatment has not previously been applied. This definition would include any such items that are similar to existing items, but that have risk characteristics that cannot be taken into account adequately with existing treatments. The definition further clarifies that an instrument or activity may be treated as a “new activity” if it increases in volume to such an extent, or if new information indicates, that an existing treatment does not account adequately for its risk.

In section 3.11.2.a, which replaces proposed section 3.11(c), the words “are expected to” have been replaced with the word “shall” and the phrase “no later than in connection with submission of the RBC Report provided for in § 1750.12” has been replaced with the phrase “within 5 calendar days after the date on which the transaction closes or is settled.” This requirement is also reflected in the regulation text at § 1750.12(c) in the final regulation. These changes are designed to address concerns that appropriate capital treatments of new products be determined as quickly as possible. Timely determinations of capital classifications and required capital amounts provide an early warning of a potential strain on an Enterprise's capital. They also serve the interests of many commenters who felt that delay and uncertainty about capital treatments of new activities could impede innovation at the Enterprises.

OFHEO anticipates that, ordinarily, the Enterprises will notify OFHEO of significant new activities well in advance of entering into the actual transactions and will provide draft documentation, anticipated cash flow analysis, and recommended capital treatments as that information is developed for the Enterprises' internal decision-making. For new activities that do not involve transactions, such as an accounting change, OFHEO anticipates that relevant information will be made available well before actual implementation of the new activity. This type of coordination will allow OFHEO to develop initial capital treatments at the same time that an Enterprise is incorporating the new instruments into its own internal models, reducing uncertainty about the capital impact of new activities and allowing the new treatments to be implemented quickly enough to facilitate timely capital calculation and classification. OFHEO anticipates that the Enterprises will incorporate into their internal systems and procedures for product development the process of obtaining the views of OFHEO as to the appropriate capital treatment of each new activity. However, OFHEO realizes that it might not always be possible for the Enterprises to provide notification to OFHEO of a new activity well before submission of the quarterly RBC Report. As with any federally-regulated financial institution, if an Enterprise were to market a new instrument or engage in some new business activity without coordinating with its regulator to determine, in advance, an appropriate initial capital treatment, that initial treatment would necessarily be conservative—that is, it would ensure, in the absence of complete information, that sufficient capital is set aside to offset any risks that may be associated with the new instrument or activity.

Section 3.11 as proposed in NPR2 has also been changed to include three new provisions that expressly state OFHEO's intentions in the implementation of this section. First, section 3.11.2.a encourages an Enterprise that is in the process of or has engaged in a new activity to provide OFHEO with its recommendations regarding the treatment of that activity when it first provides information regarding the activity to OFHEO. Any recommendations will be considered by OFHEO in developing the proposed capital classification. The Enterprise will have the opportunity to comment on that treatment in connection with its other comments on the proposed capital classification.

Second, section 3.11.3.d provides that after a treatment has been incorporated into a final capital classification, OFHEO will provide notice to the other Enterprise and the broader public of that treatment. OFHEO will consider any comments it receives from those parties regarding such treatment during subsequent quarters.

Finally, section 3.11.2.b provides that the stress test will not give an Enterprise the benefit associated with a new activity where the impact of that activity on the risk-based capital level is not commensurate with its economic benefit to the Enterprise. Although it is not expected that the Enterprises would want to deal in transactions or instruments that do not have legitimate business purposes, OFHEO must retain the authority to exclude such instruments from risk-based capital calculations should they occur.

4. Standardized Reporting

The Enterprises suggested that OFHEO specify a standardized RBC Report. Such specifications would include sufficiently detailed instructions to allow the Enterprises to aggregate the data in a format that can be input directly into the stress test. OFHEO agreed with this suggestion and has developed such a report. The report will shorten considerably the time needed to produce the risk-based capital requirements. It will also provide the Enterprises with more certainty in performing their own risk-based capital calculations.

See

II.B., Data.

5. Capital Classification Process

a. Comments

The Enterprises requested that the regulation describe a practical and timely process for reporting risk-based capital and determining capital classifications. A number of specific suggestions were made. First, they both recommended that they would report stress test results quarterly along with the data used to run the stress test and OFHEO would then determine quarterly capital classifications based on the Enterprises' calculations. Freddie Mac also recommended that OFHEO classify an Enterprise as adequately capitalized if it meets the minimum capital requirement and quickly remedies a failure to meet the risk-based capital requirement before the classification is reported. Freddie Mac further recommended that OFHEO retain the discretion to specify when the quarterly

capital reports are due rather than specifying that they must be filed within 30 days of the end of the quarter. Finally, Freddie Mac recommended that the regulation require an Enterprise to amend a capital report only if a data input revision might result in a capital reclassification.

b. OFHEO Response

As noted above, OFHEO will run the stress test and determine capital classifications using its own systems using data reported by the Enterprises in a standardized format. The Enterprises may duplicate OFHEO's stress test calculations by running the stress test in the same manner as OFHEO. If an Enterprise believes there are discrepancies, it may comment on them during the 30-day response period following OFHEO's notice of proposed capital classification.

OFHEO did not adopt Freddie Mac's suggestion that the Enterprises be given an opportunity to remedy capital shortfalls before the capital classification is reported. Since the risk-based capital requirement is based on data submitted by the Enterprises as of a particular point in time, it is appropriate to determine whether an institution meets the standard as of that date for classification purposes. Although the classification could be accompanied by a description of any remedial actions an Enterprise has taken since the reporting date, it would not be possible to know with certainty that the remedial action brought the Enterprise into compliance with its risk-based capital standard without running the stress test again with new starting position data on its entire book of business.

The final regulation does not change the requirement that the RBC Report be filed within 30 days of the end of the quarter. OFHEO believes the RBC Report should be filed as promptly as possible after the end of quarter so that the capital classification can be determined promptly, and, in any event, within the same 30 days required for the minimum capital report. OFHEO recognizes that, initially, Enterprise preparation of the RBC Report will require more time and effort than is needed for the minimum capital report. Therefore, during the one year period following promulgation of the final rule, OFHEO will consider requests for an extension on a case-by-case basis.

OFHEO has determined that an amended RBC Report should be filed whenever there are errors or omissions in a report previously filed and not, as Freddie Mac suggested, only when the change would result in a different capital classification. In OFHEO's view, prudent monitoring of risk-based capital requires the reporting of all changes. The rule makes clear that the Enterprise is obligated to notify OFHEO immediately upon discovery of such errors or omissions and file an amended RBC Report within three days thereafter. In addition, the final rule clarifies that if there is an amended report, the computation of the risk-based capital level will still be based on the original report unless the Director, in his/her sole discretion, determines that the amended report will be used.

The final rule also requires the board of directors of an Enterprise to designate the officer who is responsible for overseeing the capital adequacy of the Enterprise as the officer who must certify the accuracy and completeness of the RBC Report.

NPR2 proposed to delete existing section 1750.5, which sets forth the capital classification procedure under the minimum capital rule, and replace it with a new subpart that would govern capital classification under both the minimum and risk-based capital rules. Subsequent to the publication of NPR2, OFHEO published a notice of proposed rulemaking entitled Prompt Supervisory Response and Corrective Action,

which includes a more comprehensive proposal related to capital classification than NPR2. Because OFHEO anticipates that the Prompt Supervisory Response and Corrective Action rule will be adopted prior to the first classification of the Enterprises under the risk-based capital rule, existing section 1750.5 is not deleted and proposed subpart C is not adopted in this final rule.

66 FR 18694 (April 10, 2001).

6. Interaction With Charter Act Provisions

Freddie Mac requested that OFHEO clarify the interaction of this risk-based capital regulation with the capital distribution provisions of Enterprises' respective Charter Acts during the one-year period following the effective date of the regulation. The Charter Act provisions are already in effect and have been since enactment of the 1992 Act.

During the one-year period after promulgation of the final rule, OFHEO will take into consideration the need for the Enterprises to adjust to the new rule, and will exercise its authority under the Charter Act provisions in a manner appropriate to the circumstances and consistent with OFHEO's intent to provide the Enterprises a one-year transition period to adjust to the risk-based capital requirement. During such period, there would be no impact on an Enterprise's ability to make capital distributions absent adequate prior notice to the Enterprise of its capital position and adequate opportunity to take reasonable and prudent steps to address any articulated deficiency.

7. Implementation

OFHEO has taken appropriate proactive measures to ensure a smooth implementation of the risk-based capital (RBC) rule and the computer code that implements the rule. These measures, which include independent verification and testing of the code, minimize the likelihood of unforeseen technical or operational issues. However, should any such issues arise, OFHEO has ample and flexible authority, which it will utilize to resolve them quickly.

a. Computer Code Enhancements

After publication of the RBC rule, OFHEO will make available to requesting parties the computer code that implements the technical specifications of the rule and a dataset representative of the Enterprises' businesses. OFHEO encourages feedback on the operation of the code by parties who utilize it, including suggestions for more efficient ways to code the technical specifications of the rule.

The computer code that implements the RBC rule will necessarily evolve over time as the businesses of the Enterprises evolve and as OFHEO builds efficiencies into the code to enhance its operation and utility. Also, as the Enterprises seek to adapt their systems to run the stress test internally, they may suggest alternative methods of coding the technical specifications of the rule that would enable them to compile their data submissions more quickly or produce results more efficiently. OFHEO will consider adopting a suggested change in the code provided it accurately reflects the computational instructions of the rule and can be applied accurately and fairly to both Enterprises. OFHEO will develop a process for the receipt, review, and disposition of suggested changes to the code.

In addition, OFHEO has the authority to make any changes it deems necessary to the code at any time, without notice and comment, as long as those changes are not inconsistent with the technical specification of the RBC rule. This authority allows OFHEO to address any technical or other problems that might arise in the operation of the code on a timely basis. Any changes to the code will be made available to the public.

b. RBC Rule Revisions

OFHEO will consider over time the need for formal amendments to the RBC rule after its effective date. If at any time after the effective date a need arises to amend the rule on an urgent basis, OFHEO has ample authority under the 1992 Act

to make such changes on a timely basis consistent with the APA. The Senate Report accompanying the 1992 Act makes it clear that Congress recognized that the stress test must necessarily evolve as the Enterprises' businesses evolve and contemplated that a variety of procedural options for quick action would be necessary to keep current the risk-based capital regulation. In regard to the risk-based capital regulation, the Report states that “[t]he regulations must be sufficiently detailed to allow others to comment meaningfully on them and approximate closely their effects.” It goes on to emphasize that “[o]rders or guidelines may be used for some of the finer details to permit flexibility to make small changes on a rapid basis when necessary.”

12 U.S.C. 4513, 4526, 4611.

S. Rep. No. 102-262 (1992), p. 23.

The APA provides a variety of procedural options that would be available to remedy technical problems in the RBC rule, whether they are minor or significant. First, the Director may act quickly, without notice and comment, to make technical corrections, clarifications, or interpretations of the rule. This authority would permit most technical and operational problems to be remedied expeditiously. The Director would publish the correction, clarification, or interpretation of the rule in the

Federal Register

and make revisions to the code available. Second, should a more substantive change to the technical specifications be required, the Director may separately issue a direct final rule or a final rule on an interim basis with request for comment, either of which would take effect immediately. Third, the Director, in a separate rulemaking with a relatively short comment period, may propose amendments to the risk-based capital regulation and move quickly to a final rule amending the risk-based capital regulation. These and other administrative tools are available to address any technical or operational problems that may arise in the implementation of the rule.

C. Implications

OFHEO received extensive comments about the implications of the proposed risk-based capital rule from the Enterprises, financial service organizations, trade associations, and affordable housing advocacy groups. The commenters focused on three primary issues: (1) Whether the risk-based capital rule properly aligns required capital to economic risk, (2) whether the rule would increase the cost of home ownership generally; and (3) whether the rule would result in the Enterprises reducing their support for affordable housing. There was a diversity of opinion on these issues. Commenters also provided many specific recommendations with respect to the implications of the risk-based capital rule. OFHEO has responded to these recommendations under the specific topics to which they relate.

1. Aligning Capital to Economic Risk

The commenters generally agreed that a stress test is an appropriate method to align capital to risk. Nevertheless, some commenters, including the Enterprises, investment firms, and some trade associations, stated that OFHEO needs to improve the alignment of capital to economic risk and offered specific suggestions to accomplish this, which are discussed under the specific topics to which they relate. These commenters claimed that failure to align capital to economic risk may reduce the availability of certain products, create disincentives to risk sharing and risk reduction, and result in price distortions.

OFHEO continues to believe that the significant stresses that the regulation applies to the Enterprises' books of business are appropriate for determining the risk-based capital requirement and to align required capital closely to the economic risk. Nevertheless, many of the modifications to the regulation made by OFHEO align capital more closely to the economic risk, based in part on specific suggestions offered during the rulemaking process. These modifications are also discussed under the specific topics to which they relate. As a result of these changes, OFHEO believes that the final risk-based capital rule provides an even better mechanism for closely aligning regulatory capital to economic risk than the proposed rule.

OFHEO is charged with ensuring the continued viability of the regulated entities so that they can continue to carry out their important public purposes, including promoting affordable housing and a stable and liquid secondary mortgage market. As a financial regulator, OFHEO may have a different perspective on the types of risks that must be capitalized and the appropriate corresponding capital levels than the financial institutions it regulates. Prudent risk managers generally respond to increased risk by either increasing their capital in line with the increase in risk or by taking steps to reduce or hedge risk. Publicly traded companies, such as the Enterprises, will always be under pressure to obtain a competitive return on equity for their shareholders and to maintain a significant level of capital distributions. OFHEO's risk-based capital regulation provides a strong incentive for the Enterprises to resist excessive shareholder pressure for short-term returns and essentially requires the Enterprises to exercise the kind of prudent risk management that will ensure that they have sufficient capital to protect them in times of economic stress and volatility.

2. Effect on Home Ownership Generally

a. Comments

Commenters voiced significant disagreement about whether the risk-based capital rule would increase mortgage rates and the cost of home ownership generally. The Enterprises, Wall Street investment firms, and some trade groups expressed concern that the proposed regulation would require an Enterprise to hold what they termed an “unreasonable” amount of capital. These commenters asserted that requiring an “unreasonable” amount of additional capital would increase mortgage interest rates and thus decrease the affordability of a mortgage and the availability of funding for home purchases.

Other financial services organizations, including GE Capital, AIG, and CMC argued that higher capital requirements do not necessarily translate into higher mortgage interest rates. They noted that the Enterprises have several options other than passing along the cost of higher capital to lenders and ultimately home buyers. For instance, these commenters stated that the Enterprises could issue additional equity, take on less risk, or implement various risk mitigation activities. These commenters further noted that critics of the risk-based capital proposal focused only on the negatives, while ignoring the benefits of an effective risk-based capital standard, particularly the significant benefit of decreasing the risk of failure of the Enterprises. One commenter stated that OFHEO should err on the side of requiring more capital rather than less, given the Enterprises' size and importance to the U.S. economy.

b. OFHEO's Response

After a review and analysis of the comments, OFHEO concluded that the risk-based capital regulation, as

modified, properly implements Congress' desire for the Enterprises to hold an appropriate level of capital to minimize the risk of failure of the Enterprises, increasing the likelihood that the Enterprises can continue to carry out their important public purposes. The significant credit and interest rate stresses mandated by the 1992 Act are designed to produce a capital requirement that encourages the Enterprises to manage risk appropriately and that results in a capital requirement that adequately reflects risk.

OFHEO does not agree that the rule would necessarily or even likely result in higher mortgage rates that would ultimately be passed along to consumers. First, OFHEO believes that the Enterprises will be able to meet the requirements of the regulation at relatively little or no cost, as discussed in NPR2.

Moreover, prices are not tightly tied to costs in any event. Second, because the Enterprises are subject to a stringent capital regulation, the financial markets may perceive that the Enterprises are less risky. Such a market assessment would likely be reflected in the pricing of the Enterprises' debt and equity, especially subordinated debt, which is particularly market sensitive. Third, even if the risk-based capital regulation were to have some minor effect on one Enterprise's cost of lending and that Enterprise attempted alone to pass this cost along through higher guarantee fees, that Enterprise would risk losing market share.

64 FR 18114, April 13, 1999.

As noted by several commenters, an Enterprise has numerous cost-effective methods to offset any additional risk-based capital requirements and may adjust to the standard in ways that do not necessarily result in increased mortgage rates. OFHEO agrees with this observation and notes that an Enterprise has several options to accomplish this task. For instance, financial markets provide a wide array of sophisticated ways to manage interest rate risk, including callable long-term debt, caps and floors, swaps and swaptions, and interest rate derivative contracts. In addition, an Enterprise could reduce credit and interest rate risk by reducing the rate of growth of its asset portfolio, increasing the credit protection on riskier assets that it guarantees or holds in portfolio, or reducing the rate of growth of its mortgage guarantee business. An Enterprise may also respond to increased capital requirements by increasing capital by reducing share repurchases, adjusting dividends, or issuing new equity shares.

OFHEO therefore concludes that an Enterprise has broad latitude to select the method or methods to manage its risks and comply with the risk-based capital requirement without increasing mortgage rates. These various strategies will have different direct costs, but may well result in fewer credit and interest rate losses over time.

3. Effect on Affordable Housing

a. Comments

A number of commenters voiced significant disagreement about whether the risk-based capital rule would impair the Enterprises' efforts to promote the availability of mortgage funds to support affordable housing for low- and moderate-income Americans. The Enterprises, affordable housing advocacy groups, and some trade associations and financial firms expressed concern that the rule may cause the Enterprises to decrease the availability of funds used to purchase affordable housing. These commenters believed that the rule could impair the Enterprises' ability to serve low-income borrowers and hinder the financing of multifamily and rental properties. One commenter stated that the Enterprises should be awarded capital bonuses for engaging in affordable housing activities.

In contrast, other financial service organizations stated that there is no “automatic” conflict between having rigorous capital standards for the Enterprises and increasing the supply of funds for affordable housing. These commenters noted that HUD, not OFHEO, should address affordable housing issues through its affordable housing regulations.

b. OFHEO's Response

OFHEO continues to believe that the risk-based capital standard will not have a noticeable adverse affect on the Enterprises' ability to purchase affordable housing loans, particularly with respect to single family loans. OFHEO notes that the Enterprises obtain similar profitability from their affordable housing loans as their general loan portfolio. As OFHEO noted in NPR2,

the capital cost of single family loans meeting HUD's affordable housing goals is not materially different from the cost of other loans for equivalent loan-to-value (LTV) ratios. Although the stress test distinguishes among loans based on LTV ratios, it makes no specific distinctions with respect to loans to different income groups. Moreover, OFHEO has modified the single family model to calibrate defaults to the benchmark loss experience by LTV category, which should alleviate some of the commenters' concerns about the treatment of high LTV loans.

See

III.I.1., Single Family Mortgage Defaults and Prepayments. OFHEO further notes that the Enterprises' affordable housing programs are currently well run, and the Enterprises effectively mitigate increased risks associated with high LTV loans with credit enhancements. In addition, the final rule modifies the treatment of low-income housing tax credits, which some commenters considered to be punitive.

See

III.N., Accounting, Taxes, and Operating Expenses.

64 FR 18116, April 13, 1999.

OFHEO disagrees with the comment that OFHEO should award capital bonuses to an Enterprise for engaging in affordable housing activities. OFHEO agrees with those commenters who stated that HUD's affordable housing regulations are the appropriate method for ensuring that sufficient attention is given to affordable housing. The purpose of the risk-based capital regulation is to ensure that the Enterprises' capital is properly aligned with risk. Even if the risk-based capital standard required additional capital related to a portion of the Enterprises' affordable housing activities, such a requirement would be consistent with ensuring that the Enterprises hold sufficient capital for the risks they take. Failure to align capital with the credit risk of particular loan programs could result in curtailment or cessation of those programs. Freddie Mac's early experience with multifamily loans is a case in point. Losses on that program caused Freddie Mac to cease multifamily lending altogether in the early 1990s.

D. Benchmark Loss Experience

In NPR1, OFHEO proposed the methodology to identify the contiguous areas containing five percent or more of the U.S. population that experience the highest rate of default and severity of mortgage losses for a time period of two or more years as required by the 1992 Act.

Losses experienced by loans in the identified time and place are referred to as the “benchmark loss experience.” The credit stress of the stress test must be reasonably related to the benchmark loss experience.

12 U.S.C. 4611(a)(1).

The proposed methodology involves four steps. The first step is to identify the benchmark loss experience using historical loan-level data submitted by each Enterprise. The analysis is based on currently available data of conventional, 30-year fixed-rate loans

secured by first liens on single-unit, owner-occupied, detached properties. The data include only loans that were purchased by an Enterprise within 12 months after loan origination and loans for which the Enterprise has no recourse to the lender. The second step is to organize the data from each Enterprise to create two consistent data sets. During this process, OFHEO separately analyzes default and severity data from each Enterprise. The third step is to calculate for each Enterprise the cumulative 10-year default rates and severity rates for each combination of States and origination years (State/year combination) by grouping all of the Enterprise's loans originated in that combination of States and years. In this step, hundreds of State/year combinations are calculated and analyzed. The fourth step is to calculate the “loss rate” by multiplying the average default rate for that State/year combination by the average severity rate. The State/year combination fulfilling the population and time requirements with the highest loss rate constitutes the benchmark loss experience. Using this methodology, OFHEO identified loans originated in 1983-1984 in the four State region of Arkansas, Louisiana, Mississippi, and Oklahoma (ALMO) as the current benchmark loss experience (“ALMO benchmark loss experience”).

In NPR2, OFHEO described how the benchmark loss experience would be used in the stress test and, building on the methodology proposed in NPR1, used the benchmark cohort of loans

to conduct simulations to demonstrate the sensitivity and implications of the proposed rule. As explained in NPR2, the equations used in the mortgage performance models are estimated based upon OFHEO's historical database of mortgage information to predict the most likely default and severity rates for any given group of mortgages under any given pattern of interest rates and house prices.

NPR2 also proposed methods of reasonably relating the credit stress of the stress test to the benchmark loss experience.

Those conventional 30-year fixed-rate loans in the State/year combination (i.e. loans originated in ALMO in 1983-1984) with the highest loss rate.

See

64 FR 18118, April 13, 1999, for a more detailed description.

1. Methodology

Most commenters, including the Enterprises, mortgage insurers, and trade groups, generally stated that the proposed methodology was workable, but suggested changes. A number of commenters, who criticized the benchmark loss experience methodology based on NPR1, were significantly less concerned when they evaluated the issue in the context of NPR2. Freddie Mac concurred generally with OFHEO's methodology to identify the benchmark loss experience and specifically with the selection of the ALMO benchmark loss experience. Nevertheless, as discussed below, Freddie Mac stated that the historical data used to identify the benchmark loss experience should be adjusted or else the benchmark loss experience default and loss severity rates' loss rates would be overstated. Fannie Mae stated that while the methodology for identifying the benchmark loss experience has certain difficulties, such difficulties could be addressed by adjusting the default and severity models. GE Capital stated that because the proposed methodology is reasonable, any changes should wait until the next generation of the model.

Commenters had divergent views on whether the credit conditions identified by the methodology were sufficiently stressful. Some commenters claimed that the proposed methodology does not produce a benchmark loss experience that is stressful enough. These commenters asserted that the proposed methodology identified only a two-year origination period rather than a ten-year period for default and severity rates and that by averaging certain factors (e.g., time and Enterprises' default rates), the methodology resulted in an average rather than a worst case scenario. In contrast, other commenters, including the Enterprises, stated that the benchmark loss experience was more severe than any national experience and more severe than could be expected to occur in a diversified national economy.

The final regulation makes no changes in the proposed methodology for identifying the benchmark loss experience. In evaluating the commenters' suggestions for modifications, OFHEO's first priority was to implement the 1992 Act appropriately. Accordingly, OFHEO determined that it was appropriate under the statute to select the loans originated during a two-year period that had the highest ten-year cumulative default and severity rate (rather than selecting the two-year period that experienced the highest losses on all loans) and to average between the Enterprises. Further, because the purpose is to identify a regional benchmark loss experience and apply it to the nation as a whole, OFHEO did not consider the comments about geographic diversification to be relevant.

OFHEO also sought to balance the benefit of the recommended modifications with the associated costs. With respect to costs, adopting the recommended modifications would divert time and resources from modifications to the stress test in response to comments, delaying the issuance and implementation of the regulation. Based on an analysis of the proposed methodology in light of the related comments, OFHEO has concluded that implementing the commenters' recommendations for revising the methodology would at best provide only modest improvements in identifying a benchmark loss experience, and in some cases would provide little or no benefit. Consequently, OFHEO has decided not to modify the methodology at this time. The proposed methodology provides a reasonable method for identifying the region in which the Enterprises' mortgage loans experienced their worst credit losses.

2. Data Issues

The dataset used to identify the benchmark had certain limitations. Fannie Mae is unable to provide complete historical data for purposes of identifying the benchmark loss experience. Specifically, Fannie Mae has no loss severity data for retained loans originated before 1987 or for loans securitized under its swap program before 1991. In addition, a number of loans were misclassified by Fannie Mae. In NPR1, OFHEO concluded that, for the purpose of the benchmark analysis, it would be better to use the available data, than to speculate about the missing data or otherwise make adjustments to account for the missing or misclassified data.

Both Enterprises expressed concern that without making adjustments to account for the missing data, the benchmark loss experience calculation would overstate the actual default and loss severity rates. They were particularly concerned that these rates would be overstated for the ALMO benchmark loss experience in those years. Accordingly, they recommended that OFHEO introduce weighting and other techniques to adjust for the missing data. With respect to the missing swap program data, Freddie Mac recommended that OFHEO compare mortgages purchased under Fannie Mae's swap program with Freddie Mac's own program, and adjust the default rates accordingly. With respect to missing pre-1987 loss severity data, Freddie Mac recommended that OFHEO adjust the available loss severity data by weighting techniques to

eliminate what it viewed as bias caused by assuming all loans were 30 year fixed-rate loans. The effect of this adjustment would lower loss severity rates in the benchmark loss experience.

After analyzing the comments, OFHEO has confirmed its original determination that it would be inappropriate to modify or otherwise “adjust” for the missing Fannie Mae historical data. It does not appear that Fannie Mae will ever be able to provide this data, and any attempt to adjust existing data based on assumptions about non-existing data would be speculative at best. Accordingly, OFHEO declines to introduce any additional weighting techniques or other assumptions to its initial decision to use the historical data as they exist. OFHEO believes that using the data as submitted by the Enterprises is appropriate, particularly given that the Enterprises' recommendations were based on speculative premises about how historical data would perform rather than empirical or other quantitative evidence.

3. Benchmark Region and Time Period

In NPR1 and NPR2, OFHEO stated that it would periodically monitor available data and reevaluate the benchmark loss experience using the methodology set forth in the Regulation Appendix. OFHEO noted that, using this methodology, it may identify a new benchmark loss experience in the future that has a higher loss rate than the one identified at the time of the regulation's issuance. It further noted that if such a benchmark is identified, OFHEO may incorporate the resulting new benchmark loss experience in the stress test.

Freddie Mac requested that the regulation specify not only the methodology to identify a benchmark loss experience, but also a specific benchmark loss experience, such as the ALMO benchmark loss experience for loans originated in 1983-1984. OFHEO has determined that it is more appropriate to include only the methodology in the regulation. The 1992 Act does not require that OFHEO specify a particular benchmark region and time period in the regulation. Moreover, given Congress' desire for the benchmark loss experience to represent a stressful credit environment, it would be inappropriate to reduce OFHEO's flexibility to identify a different benchmark loss experience if new data indicate that a change is appropriate.

4. Compactness

Freddie Mac suggested adding an additional criterion to the statutory criteria for identifying the benchmark loss experience. Specifically, Freddie Mac recommended that the regulation include what it termed a “compactness” requirement so that, in addition to the statutory requirement that the benchmark region comprise “contiguous” areas, the benchmark region would have to be a region in which a person could travel from any one State to any other State in the region, without traveling through more than one other State within the region.

OFHEO has determined that modifying the definition of the benchmark loss experience to include an additional compactness requirement is inappropriate and would be unworkable. As discussed in NPR1, OFHEO rejected options that would not provide for a reasonably compact benchmark region. For that reason, the proposed regulation specified States as the smallest geographic unit rather than using smaller geographic units such as zip codes and rejected a definition of “contiguous” that would include meeting at a point. It is possible that using smaller units could result in the equivalent of a gerrymandered benchmark loss experience in which it would contain only units with relatively more severe loss experience while excluding regions in the same State with a more benign loss experience. Freddie Mac's recommendation would impose an additional requirement that goes beyond what Congress specified and could preclude identification of an appropriately stressful credit environment. Moreover, the modification recommended by Freddie Mac might be difficult to determine and even unworkable, since there could still be numerous non-compact regions that would comply with Freddie Mac's recommended definition of compactness.

5. Population Requirement

Fannie Mae expressed concern that the ALMO benchmark loss experience may contravene the requirement that the benchmark loss experience contain at least five percent of the United States population, since it believed that the ALMO benchmark loss experience includes States that contribute significant parts of the population but may have few mortgage loans. That Enterprise was also concerned that the ALMO benchmark loss experience may not meet the five percent requirement over the entire stress period.

OFHEO has determined that neither concern is valid. First, the 1992 Act requires that the benchmark loss experience include “contiguous areas of the United States” containing at least five percent of the U.S. population. The statutory provision does not address the distribution of loans within that area or specify the designation of a “State” as a factor. Accordingly, it is the population of the identified area, not of a State or States within it, that is relevant in determining the benchmark loss experience. Second, the 1992 Act only addresses the population and not the number of mortgage loans. Congress could have specified loan volume as a criterion, but did not, and OFHEO declines to read such a specification into the statute. Third, the 1992 Act does not require that the population requirement be met during the entire stress period for the purpose of determining the benchmark loss experience. The statute only requires the stress conditions to persist for “two or more years.” The ALMO benchmark loss experience complies with the statute because it had over five percent of the United States' population in the two year period of 1983 and 1984. OFHEO further notes that a region experiencing significant credit stresses may very well experience a decrease in population. Including the additional limitations suggested by Fannie Mae would reduce the severity of the benchmark loss experience and the stress test as a whole, a result that was not intended by Congress. Based on these considerations, OFHEO concludes that each of Fannie Mae's arguments is without merit.

6. Improvements in the Underwriting

GE Capital, in its reply comments, expressed concern that OFHEO would be persuaded by the Enterprises' arguments that the benchmark loss experience should be adjusted to reflect improvements in their underwriting practices, subsequent to the benchmark period. GE noted that although the Enterprises have improved their underwriting techniques since 1986, these improvements may not serve to reduce the frequency of default rates, given regional recessions such as in California and New England that occurred after 1986.

OFHEO believes that it would be inconsistent with the 1992 Act and inappropriate to adjust the benchmark loss experience based on the view that the Enterprises have improved their underwriting. First, improved underwriting is not relevant to identifying the benchmark loss experience, i.e., the worst time and place for credit stress. Rather, Congress intended the benchmark loss experience to define a severe level of credit stress that the Enterprises should be able to survive during a ten year period. To

“adjust” for improved underwriting would be inconsistent with the statute, since it suggests that the Enterprises could never experience such a level of credit stress again. In addition, periodic modifications based on changes in underwriting would be difficult to implement.

E. Enterprise Data

In NPR2, OFHEO explained that the stress test would utilize data characterizing an Enterprise's assets, liabilities, stockholders equity, and off-balance sheet items at a point in time (“starting position data”). Under the proposal, OFHEO anticipated that each Enterprise would submit all data for mortgages, securities, and derivative contracts at the instrument level. The proposed stress test aggregated individual loans into groups with common risk and cash flow characteristics, known as “loan groups.”

Data for these loans groups, instead of individual loans, were used as inputs by the mortgage performance and cash flow components of the stress test. In addition to the loan groups for existing loans, the stress test created loan group data for mortgages expected to be added to the Enterprises' books of business as a result of commitments outstanding as of the reporting date, using a process that is discussed in the “Commitments” section of this preamble III. F., Commitments. With respect to nonmortgage financial instruments (investments, debt, and derivative contracts), NPR2 proposed to project their cash flows at the individual instrument level rather than at an aggregated level, because they are fewer and more diverse.

For example, a loan group might include all 30-year fixed-rate mortgages for single family homes in the same geographic region, originated in the same year, with similar interest rates and LTVs, and held in an Enterprise's portfolio. Such a process would allow over 24 million loans to be aggregated into a smaller number of loan groups that capture the important risk characteristics. Even with aggregation, there would be thousands of loan groups.

1. Comments

Only Freddie Mac and Fannie Mae commented on OFHEO's proposed treatment of Enterprise data for the stress test. Both Enterprises emphasized the complexity of the proposed data submission process. Freddie Mac stated that in its submission for the second quarter of 1997, it provided more than 600 million data elements to OFHEO, which OFHEO then “translated” into data sets. It stated that this process results in “a substantial number of translation errors” which could impair the accuracy and reliability of the stress test. Similarly, Fannie Mae attributed most of the difficulty in operationalizing the stress test to the use and handling of instrument-level data, since the regulation requires the exchange, management and application of data on hundreds of thousands of different instruments and contracts.

Because of these problems, both Enterprises recommended that they, rather than OFHEO, be responsible for compiling and, where appropriate, aggregating the data into a standardized report, which would then be submitted to OFHEO. Freddie Mac stated that OFHEO should eliminate the need to perform data file translations by requiring the Enterprises to report their data files in a standardized format that OFHEO specifies in a “call-report-like” approach. Similarly, Fannie Mae recommended that each Enterprise submit a RBC Report with standardized elements.

Both Enterprises stated that such an approach is similar to the one taken by other Federal financial regulators with their reporting and capital requirements.

These recommendations were accompanied by recommendations that the Enterprises be allowed to use models they would develop to OFHEO specifications to compute their risk-based capital requirement and report it to OFHEO along with the RBC Report. This recommendation is discussed in III. B., Operational Workability of the Regulation.

2. OFHEO's Response

Consistent with the comments, OFHEO has decided to have the Enterprises compile, and, where appropriate, aggregate their data and submit it to OFHEO in a standardized format specified by OFHEO. To implement this approach, OFHEO has specified a RBC Report with instructions for aggregating and reporting data in a standardized format. OFHEO agrees with the commenters that the data submission process must result in the submission of complete and accurate inputs to allow for the reliable and timely generation of a risk-based capital number. OFHEO believes that the approach in the final rule will fulfill this goal, because it serves to increase the efficiency and transparency of the process and the timeliness of the capital classification. OFHEO further believes that the data submission process will continue to be reliable, because each Enterprise will be required to certify that its submission is complete and accurate. In addition, the compilation of such data by the Enterprises will be subject to examination by OFHEO. This approach will permit capital classifications to be more timely because the standardized data can be input directly into the stress test without the need for data translation by OFHEO.

The stress test makes provision for items reported by the Enterprises that do not fall into the categories specified in the RBC Report or items for which the data is incomplete. If the item is a new activity, it will be treated as specified in section 3.11, Treatment of New Enterprise Activities, of the Regulation Appendix. Otherwise, where there is no appropriate specified treatment in the Regulation Appendix, or where data required to model the item are missing and there is no computational equivalent for such data and no available proxy acceptable to OFHEO, the item will be given one of the conservative treatments specified in section 3.9, Alternative Modeling Treatments, of the Regulation Appendix, depending on whether the item is an asset, a liability, or an off-balance sheet item. The treatments vary in the up-rate and down-rate scenarios and prescribe values for missing terms needed to determine cash flows. It is necessary to make provision for such items in order to permit the stress test to operate with incomplete data and to take into account highly unusual items that cannot be accommodated by specific stress test treatments. OFHEO expects that there will be few of these items in any given quarter.

F. Commitments

1. Background

The 1992 Act specifies that during the stress period the Enterprises will purchase no additional mortgages nor issue any MBS, except that—

[a]ny contractual commitments of the enterprise to purchase mortgages or issue securities will be fulfilled. The characteristics of resulting mortgage purchases, securities issued, and other financing will be consistent with the contractual terms of such commitments, recent experience, and the economic characteristics of the stress period.

12 U.S.C. 4611(a)(3)(A). The 1992 Act does provide for later amendment of the rule to address new business during the stress period, but not until after the risk-based capital regulation is final. The 1992 Act requires that, within one year after this regulation is issued, the Director of the Congressional Budget Office and the Comptroller General of the United States shall each submit to the Congress a study of the advisability and appropriate form of any new business assumptions to be incorporated in the stress test. 12 U.S.C. 4611(a)(3)(C). 12 U.S.C. 4611(a)(3)(B) authorizes the Director to consider these studies and make certain new business assumptions. However, that subparagraph does not become effective until four years after the risk-based capital regulation has been issued.

The term “contractual commitments” generally refers to binding agreements that the Enterprises enter into with

seller/servicers to purchase mortgages or to swap mortgages for MBS. The term also refers to agreements to sell such securities to investors.

In NPR2, OFHEO proposed to model commitments outstanding on the beginning date of the stress test by adding new loans to the books of business of the Enterprises during the first year of the stress test, using specified decision rules that govern the volume and characteristics of these new loans. To avoid the complexity of modeling the mix of securitized mortgages versus those purchased for portfolio (which is largely determined by seller/servicers, based on a number of market factors) NPR2 specified that all loans delivered under commitments would be securitized. Second, NPR2 specified that, in the down-rate scenario, 100 percent of all loans that the Enterprises are obligated to accept would be delivered and, in the up-rate scenario, 75 percent of those loans would be delivered. Third, the proposal specified that, in the up-rate scenario, loans would be delivered over the first six months of the stress test and, in the down-rate scenario, over the first three months, at the rates specified in Table 3.

Table 3.—Mortgage Deliveries by Month of the Stress Test as a Percentage of Total Commitments

Months

Up-Rate

Scenario

Down-Rate

Scenario

18.75%

62.50%

18.75%

25.00%

12.5%

12.50%

12.5%

0.00%

6.25%

0.00%

6.25%

0.00%

Total

75%

100%

Finally, OFHEO proposed that the mix of characteristics (type, term, LTV ratio, coupon, geographic location, and credit enhancements) of commitment loans would be based upon the characteristics in loans that were delivered for securitization within the immediately preceding six-month period.

2. Comments and Responses

a. General Comments

Only the two Enterprises commented upon the proposed treatment of commitments. Both Enterprises agreed with OFHEO's decision that all loans delivered under commitments would be securitized. On the other hand, both Enterprises expressed concern that the capital impact of commitments was too great and that the stress test may overstate the risks posed by outstanding commitments. They cautioned that such an overstatement could reduce the use of certain types of commitments.

Freddie Mac stated that OFHEO's approach was probably more complex than is warranted, but, nevertheless, would be operationally workable. However, Freddie Mac also stated that if its recommended changes in the modeling approach to commitments and adjustments to the benchmark loss experience are not made, the Enterprises will have strong economic incentives to reduce the use of longer term commitments and further that “it is doubtful that commitments could support [NPR2] capital levels.” Fannie Mae made similar comments, suggesting that “the proposed regulation's failure to recognize behavioral differences among commitment types may unnecessarily restrict the widespread use of optional commitments.”

In response, OFHEO notes that its decisions about how to model commitments are not intended to promote or discourage the use of one type of commitment over another, or to encourage the use of commitments in general. To the extent that long-term commitments may have a greater capital impact than short-term commitments, that is due to the relative level of risk of each type of commitment. Further, if empirical analysis regarding commitments indicates that the stress test should be modified, OFHEO will consider doing so. However, in the absence of historical data from which to construct a statistical model of commitments, the final regulation includes a few straightforward and conservative decision rules, which reflect the conditions of the stress period and the operation of commitment agreements. These rules make the commitments model easily replicable and the impact of commitments on capital predictable.

b. Remittance Cycle

Freddie Mac pointed out that NPR2 proposes to set the remittance cycle for commitment loans to the shortest period used at each Enterprise, even though some loans delivered and securitized just

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