Minimum Capital

Federal RegisterJun 8, 1995

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SUMMARY: The Office of Federal Housing Enterprise Oversight (OFHEO)

proposes to issue a regulation for determining the minimum capital

requirement for the Federal National Mortgage Association and the

Federal Home Loan Mortgage Corporation (collectively, the Enterprises).

The proposed regulation defines the necessary terms and sets forth the

methodology for computing the minimum capital level. The proposed

regulation also establishes procedures for the filing of quarterly

minimum capital reports by each Enterprise. In addition, the proposed

regulation establishes procedures under which OFHEO will determine the

capital classification of each Enterprise on a quarterly basis.

DATES: Written comments on the proposed regulation must be received by

August 7, 1995.

ADDRESSES: All comments concerning the proposed regulation should be

addressed to Anne E. Dewey, General Counsel, Office of Federal Housing

Enterprise Oversight, 1700 G Street NW., 4th Floor, Washington, D.C.

20552. Copies of all communications received will be available for

examination by interested parties at the Office of Federal Housing

Enterprise Oversight.

FOR FURTHER INFORMATION CONTACT: Gary L. Norton, Deputy General Counsel

(202/414-3800); or Michael P. Scott, Assistant Director, Office of

Research, Analysis and Capital Standards (202/414-3800), 1700 G Street

NW., 4th Floor, Washington, D.C. 20552.

SUPPLEMENTARY INFORMATION:

I. Background

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, 12 U.S.C. 4501 et seq. (Act),

established the Office of Federal Housing Enterprise Oversight (OFHEO).

OFHEO is an independent office within the Department of Housing and

Urban Development with responsibility for ensuring that the Federal

National Mortgage Association (Fannie Mae) and the Federal Home Loan

Mortgage Corporation (Freddie Mac) (collectively, the Enterprises) are

adequately capitalized and operating in a safe and sound manner.

Included among the express statutory authorities of the Director of

OFHEO is the authority to issue regulations establishing the capital

level requirements.1

\1\ Act, section 1313(b)(1) (12 U.S.C. 4513(b)(1)).

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On February 8, 1995, OFHEO published an Advance Notice of Proposed

Rulemaking 2 as the first step toward developing the risk-based

capital regulation required by section 1361 of the Act.3 The risk-

based capital requirements will be based on a stress test to be

developed by OFHEO. The stress test will determine the amount of

capital that an Enterprise must hold to absorb the projected losses

associated with credit and interest rate risks during a ten-year period

of economic stress. That amount plus an additional 30 percent to cover

management and operations risks will constitute the risk-based capital

level of the Enterprise.

\2\ 60 FR 7468, Feb. 8, 1995.

\3\ 12 U.S.C. 4611.

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Separate from the risk-based capital requirements, section 1362 of

the Act prescribes the minimum capital requirement for the

Enterprises.4 Unlike the risk-based capital requirements, which

are based on the stress test, the minimum capital level is computed

largely on the basis of statutorily established ratios that are applied

to certain defined on- and off-balance sheet items of the Enterprises.

\4\ 12 U.S.C. 4612.

An Enterprise's capital serves as a cushion to absorb financial

losses, thereby reducing the risk of failure. As specified by the Act,

the minimum capital level of an Enterprise represents an essential

amount of capital needed as protection against the broad categories of

risk in its businesses. The minimum capital level is not designed to

address the risks of specific exposures within these categories. In

addition, none of the capital levels specified in the Act represents

the amount needed by an Enterprise to operate safely and soundly under

all circumstances.

Section 1364 of the Act 5 requires the Director of OFHEO to

determine the capital classification of each Enterprise not less than

quarterly. The proposed minimum capital regulation provides procedures

for each Enterprise to file a minimum capital level report each quarter

and at other times, as required by the Director. In addition, it

implements the provisions of section 1368 of the Act,6 which

require OFHEO to provide each Enterprise with notice and an opportunity

to comment on its capital classification.

\5\ 12 U.S.C. 4614.

\6\ 12 U.S.C. 4618.

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II. Interim Procedures

As discussed below, the Act specifies the minimum capital ratios

applicable to on-balance sheet assets and to certain off-balance sheet

obligations, e.g., mortgage-backed securities (MBS), but requires

adjustment of the minimum capital ratio applicable to other off-balance

sheet obligations. Following the appointment of the Director of OFHEO,

OFHEO implemented the statutory minimum capital and capital

classification provisions by establishing, through administrative

action, interim procedures for computing the minimum capital level.

These interim procedures will continue to be used until the effective

date of the final minimum capital regulation.

On-Balance Sheet Assets

The interim procedures apply the minimum capital ratio applicable

to on-balance sheet assets as specified in section 1362(a)(1) of the

Act.7 That section establishes a minimum capital ratio of 2.50

percent of the aggregate on-balance sheet assets of the Enterprises

determined in accordance with generally accepted accounting principles

(GAAP).

\7\ 12 U.S.C. 4612(a)(1). [[Page 30202]]

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Mortgage-Backed Securities 8

\8\ Mortgage-backed securities are defined in the proposed

regulation as securities, investments, or substantially equivalent

instruments that represent an interest in a pool of loans secured by

mortgages or deeds of trust where the principal or interest payments

to the investor in the security or substantially equivalent

instrument are guaranteed or effectively guaranteed by an

Enterprise.

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For MBS, the interim procedures apply the minimum capital ratio

specified in section 1362(a)(2) of the Act.9 That section

establishes a minimum capital ratio of 0.45 percent of the unpaid

principal balance of outstanding MBS and substantially equivalent off-

balance sheet instruments 10 that the Enterprises issue or

guarantee. It only applies to MBS and substantially equivalent

instruments that are not included among the on-balance sheet items of

the Enterprises.

\9\ 12 U.S.C. 4612(a)(2).

\10\ An off-balance sheet obligation is defined in the proposed

regulation to mean a binding agreement, contract, or similar

arrangement that requires or may require future payment(s) in money

or kind by another party to an Enterprise or that effectively

guarantees all or part of such payment(s) to third parties, where

such agreement or contract is a source of credit risk for an

Enterprise not included on its balance sheet.

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Other Off-Balance Sheet Obligations

Section 1362(a)(3) of the Act 11 requires OFHEO to adjust the

minimum capital ratios for off-balance sheet obligations other than

MBS. That adjustment must reflect the differences between the credit

risk of such obligations and the credit risk of MBS. That section

further provides that commitments in excess of 50 percent of the

average dollar amount of the commitments outstanding each quarter over

the preceding four quarters are to be excluded from minimum capital

level computations. The following discussion describes the interim

procedures for determining minimum capital requirements for off-balance

sheet obligations other than MBS.

\11\ 12 U.S.C. 4612(a)(3).

Commitments \12\

\12\ A commitment is defined in the proposed regulation to mean

any contractual, legally binding arrangement that obligates an

Enterprise to purchase mortgages for portfolio or securitization.

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OFHEO determined that there is no significant difference between

the credit risk of commitments and the credit risk of MBS. Therefore,

the interim procedures set a minimum capital ratio for commitments of

0.45 percent, which is applied to 50 percent of the average of the

dollar amounts of commitments outstanding on the date for which the

minimum capital level is being computed and the dates of the three

preceding quarter-ends.

Multifamily Credit Enhancements

Multifamily credit enhancements (MFCEs) are guarantees by an

Enterprise of payments on multifamily mortgage revenue bonds issued by

state and local housing finance agencies. The guarantees permit state

and local agencies to obtain a lower cost of funds. The bonds are

collateralized by multifamily mortgages to which the Enterprise has

recourse in the event of a default. OFHEO concluded that the risk of

MFCEs is most analogous to the risk of multifamily MBS. Therefore, the

interim procedures apply the minimum capital ratio for MBS (0.45

percent) to the outstanding principal amount of bonds with MFCEs.

Sold Portfolio Remittances Pending

Sold portfolio remittances pending are funds held in custodial

accounts awaiting collection by one of the Enterprises for disbursement

to the holders of MBS. The obligations associated with these funds

arise from the MBS accounting cycle in the accounting system of one of

the Enterprises. Once payments of mortgage principal are received by a

seller-servicer and placed in custodial accounts, the Enterprise

reduces the reported amount of the MBS, or sold portfolio. The

Enterprise eventually passes the mortgage principal payments to MBS

investors.

OFHEO concluded that the sold portfolio remittances pending are

essentially part of MBS. Sold portfolio remittances pending are

reflected separately only as a result of the accounting treatment used

by one Enterprise. Therefore, the interim procedures apply the same

minimum capital ratio for MBS (0.45 percent) to the dollar amount of

sold portfolio remittances pending.

Interest Rate and Foreign Exchange Rate Contracts

The Enterprises use interest rate contracts \13\ to obtain more

desirable financing terms and hedge interest rate risk exposure. Fannie

Mae uses foreign exchange rate contracts \14\ to fix the United States

dollar costs of debt issued in foreign currencies. The credit risk

associated with interest rate and foreign exchange rate contracts is

the risk of loss that may result when a counterparty defaults.

\13\ Interest rate contracts include single currency interest

rate swaps, basis swaps, forward rate agreements, interest rate

options purchased (including caps, collars, and floors), and other

instruments that give rise to similar credit risks (including when-

issued securities and forward deposits accepted).

\14\ Foreign exchange rate contracts include cross-currency

interest rate swaps, forward foreign exchange contracts, currency

options purchased, and other instruments that give rise to similar

credit risks.

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Because the credit risk of interest rate and foreign exchange rate

contracts is not fundamentally different than the risk of those

contracts to banks and bank holding companies, the interim procedures

apply substantially the same requirements as the risk-based

requirements that are applicable to banks and bank holding companies.

Those bank-related requirements are contained in guidelines that have

been adopted by the Board of Governors of the Federal Reserve System at

12 C.F.R. Part 208, Appendix A, for state member banks, and at 12

C.F.R. Part 225, Appendix A, for bank holding companies; by the

Comptroller of the Currency at 12 C.F.R. Part 3, Appendix A, for

national banks; and by the Federal Deposit Insurance Corporation at 12

C.F.R. Part 325, Appendix A, for federally insured state nonmember

banks (hereinafter referred to as the Guidelines).\15\

\15\ The Guidelines are based upon a framework developed jointly

by supervisory authorities from the countries that are represented

on the Basle Committee on Banking Regulations and Supervisory

Practices.

The Guidelines convert off-balance sheet items into balance sheet

equivalents by determining a credit equivalent amount (CEA) for each

item. Risk-weights are applied to the CEA based on the type of

counterparty and on the extent to which qualifying collateral has been

posted.

The CEA for interest rate and foreign exchange rate contracts is an

estimate of the overall credit exposure associated with such contracts.

Under the Guidelines, the CEA is the sum of two components: (1) the

current exposure and (2) the potential future exposure. The current

exposure (often referred to as ``replacement cost'') of a contract is

equal to the contract's market value or zero, if its market value is

negative. The potential future exposure of an interest rate or foreign

exchange rate contract (often referred to as the ``add-on'') is

calculated for each contract, regardless of its current market

value.\16\ Potential future exposure is calculated by multiplying the

notional amount of the contract by a credit conversion factor, which is

determined by the remaining maturity and by the type of the contract

(0.0 percent for interest rate contracts expiring in less than one year

and 0.5 percent for those expiring in more than [[Page 30203]] one

year; 1.0 percent for foreign exchange contracts expiring in less than

one year and 5.0 percent for those expiring in more than a year).

\16\ Because the floating rates associated with basis swaps are

highly correlated, potential future exposure is not material; the

credit exposure for these contracts is evaluated solely on the basis

of the mark-to-market values.

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Once the CEA of an interest rate or foreign exchange rate contract

has been determined, the amount of the contract is assigned a risk-

weight (20 or 50 percent) appropriate to the counterparty or, if

relevant, the nature of any collateral or guarantees. Total risk-

weighted assets are then multiplied by 8.0 percent \17\ to determine

the amounts included in the Enterprise's minimum capital level.

\17\ Eight percent represents the required ratio of total

capital to risk-weighted assets contained in the Guidelines.

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The interim procedures allow the Enterprises to recognize the risk-

reducing benefits of qualifying bilateral netting contracts as outlined

in the Federal Reserve Board's final rule amending the risk-based

capital guidelines (59 FR 62987, Dec. 7, 1994). Thus, the Enterprises

may net positive and negative mark-to-market values of interest rate

and foreign exchange rate contracts in the determination of the current

exposure portion of the CEA.

The interim procedures supplement the Guidelines in the area of

foreign exchange rate contracts. Fannie Mae includes items associated

with foreign exchange rate contracts on its balance sheet. With respect

to such contracts, OFHEO determines the amount that would be required

under the Guidelines and compares it to the amount that would result

from applying the 2.50 percent ratio for on-balance sheet assets

contained in the Act, and applies the higher amount.

III. Basis for the Proposed Minimum Capital Regulation 18

\18\ In the course of developing this proposed regulation, OFHEO

solicited and received comments and recommendations from the

Enterprises regarding alternative approaches. One Enterprise

asserted that a low minimum capital ratio for interest rate and

foreign exchange rate contracts is justified because these contracts

are not used for speculative purposes; credit losses on these

contracts have not been experienced; the contracts are mostly

executed under master netting agreements with counterparties that

are investment-grade; and, depending on counterparty credit quality,

require the posting of collateral or other credit enhancements. The

Enterprise suggested that OFHEO continue to apply the Guidelines to

calculate the CEA to measure the credit exposure of interest rate

and foreign exchange rate contracts, but that OFHEO apply a fixed

ratio of 0.45 percent to the CEA, rather than apply the 8.00 percent

ratio and various risk-weights, as required by the Guidelines. The

Enterprise suggested the elimination of risk-weights because it

believes they do not measure credit quality. The Enterprise

suggested that the enforcement of strict credit and performance

standards for its counterparties, coupled with aggressive collateral

requirements for credit exposure, eliminates the need for credit

differentiation among counterparties and the corresponding risk-

weights. The Enterprise also recommended that OFHEO's regulations

reflect, without amendment, the proposed and final changes to the

Guidelines related to the calculation of current and potential

future exposure. These changes would incorporate the impact of

bilateral netting in the calculation of credit exposure, extend the

capital treatment under the Guidelines to activities other than

interest rate and currency contracts, and add higher credit

conversion factors for longer-term contracts.

The other Enterprise supported the application of the Guidelines

to calculate the CEA and recommended that OFHEO apply, as a starting

point, a capital ratio of 0.45 percent to that amount. It made

further recommendations that would collectively have the effect of

lowering the capital requirements, namely, that OFHEO consider: (1)

easing the requirements under which bilateral netting contracts

become ``qualifying,'' enabling an institution to ``net'' and thus

reduce its current and potential future exposure; (2) increasing the

benefit of netting over what proposed amendments to the Guidelines

provide by applying the ``net-to-gross ratio'' (the current net

positive market value of swaps divided by their current gross

positive market value) on a portfolio-wide basis rather than

counterparty-by-counterparty, and applying it to 100 percent of the

notional amount rather than 50 percent; and (3) adjusting the 0.45

percent capital ratio applied to the CEA of interest rate and

foreign exchange rate contracts downward based on the credit ratings

of the counterparties, collateral arrangements, and other credit

enhancements.

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The proposed regulation continues the interim approach with respect

to on-balance sheet items, MBS, commitments, multifamily credit

enhancements, and sold portfolio remittances pending. However, the

proposed regulation modifies the interim approach with respect to

interest rate and foreign exchange rate contracts. A discussion of how

OFHEO arrived at the approach adopted by the proposed regulation

follows.

The Act requires OFHEO to adjust the statutory minimum capital

ratio applicable to any class of off-balance sheet obligations if the

credit risk of that class of obligations differs from the credit risk

of MBS. OFHEO believes that the credit risk of interest rate and

foreign exchange rate contracts, as measured by their CEAs, is

significantly greater than that of MBS. Accordingly, the proposed

regulation contains a minimum capital ratio for interest rate and

foreign exchange rate contracts that is higher than the ratio

applicable to MBS. Under the proposed regulation, this ratio will be

applied to the CEAs of these contracts. The proposed regulation

provides a relatively lower ratio for exposures that are collateralized

than for those that are not collateralized. However, the proposed

regulation does not distinguish between different types of

counterparties. The minimum capital amount associated with interest

rate and foreign exchange rate contracts under the proposed regulation

is not expected to be substantially different than it is under the

interim procedures.

Risk of MBS

In developing the proposed regulation, OFHEO analyzed the relative

risk of interest rate and foreign exchange rate contracts as compared

with MBS. The source of credit risk of MBS to the Enterprises is the

risk of defaults and losses on the underlying mortgages. Guarantee fees

provide a continuing source of income to offset these losses.

The aggregate risk associated with the Enterprises' underlying

mortgages is low because the Enterprises have--

Very broad geographic diversification;

Strict and consistent mortgage underwriting standards; and

Requirements for minimum initial collateralization of 125

percent (i.e., maximum 80 percent loan-to-value ratio) or supplemental

mortgage insurance, as well as increasing levels of collateralization

as loans amortize and property values increase.

Neither Enterprise has experienced a net credit loss on its MBS.

Annual losses to date have ranged from two basis points to ten basis

points (expressed as a percentage of the outstanding portfolio) and

have been easily covered by guarantee fee income, which has ranged from

20 to 25 basis points.

Risks of Interest Rate and Foreign Exchange Rate Contracts

The Enterprises limit the credit risk of interest rate and foreign

exchange rate contracts by restricting their business to high quality

counterparties and adjusting collateral requirements on the basis of

the current replacement cost and counterparty credit quality of

interest rate and foreign exchange rate contracts. Notwithstanding

these limitations of risk, interest rate and foreign exchange rate

contracts entail the following risks beyond those of MBS:

Large swings in market rates, on which interest rate and

foreign exchange rate contracts are based, may simultaneously increase

exposure to, and risk of default by, one or more counterparties, which

are typically financial firms.

While losses may be infrequent, systemic problems could

cause disproportionately high losses when they do occur.

Counterparty risk is concentrated. The loss resulting from

the default of a single counterparty could be many times larger than

the amount of capital that would be associated with the application of

a 0.45 percent capital ratio.

The interest rate and foreign exchange rate contracts

market is [[Page 30204]] comparatively new; therefore, the functioning

of this market is less predictable in terms of operational and legal

risk.

Interest rate and foreign exchange rate contract exposures

are not as fully-collateralized as are the mortgages underlying the

Enterprises' MBS.

There is no current stream of fee income to offset losses

on interest rate and foreign exchange rate contracts associated with

counterparty failures.

The effect of these differences is difficult to quantify.

Derivative markets are relatively new. While the Enterprises have not

experienced any losses on interest rate or foreign exchange rate

contracts, recent losses by major participants make clear that the

unexpected, sudden failure of a financial firm that is a counterparty

is a risk that must be seriously considered.

Based on a weighing of these factors, the proposed regulation

applies a higher ratio to the CEAs of interest rate and foreign

exchange rate contracts than to MBS. The proposed regulation applies a

ratio of 3.00 percent to uncollateralized exposure and a ratio of 1.50

percent to collateralized exposure. OFHEO believes that the proposed

regulation will encourage prudent management of counterparty risk by

reducing the capital requirement by half to the extent a counterparty

posts collateral that qualifies under the Guidelines. This approach is

consistent with a minimum capital level that focuses on the general

risk characteristics of instruments rather than the credit quality of

third parties.

The proposed regulation continues to allow the Enterprises to

recognize the risk-reducing benefits of qualifying bilateral netting

contracts. As under the interim procedures, the Enterprises are allowed

to net positive and negative mark-to-market values of interest rate and

foreign exchange rate contracts in the determination of the current

exposure portion of the CEA.\19\

\19\ Proposals by the Comptroller of the Currency (59 FR 45243,

Sept. 1, 1994) and the Board of Governors of the Federal Reserve

System (59 FR 43508, Aug. 24, 1994) would make other changes to the

Guidelines. First, they would increase the number of credit

conversion factors that are used to measure the potential future

exposure, subjecting contracts with longer maturities to higher

factors. Second, they would set new credit conversion factors for

contracts related to equities, precious metals, and other

commodities. (These are not currently relevant to the Enterprises.)

Finally, they would change the way that potential future exposure is

calculated when the contracts are subject to a qualifying bilateral

netting agreement, resulting in a reduction in the amount of capital

required for the netted interest rate and foreign exchange rate

contracts.

OFHEO will continue to review the progress of the banking agency

proposals which permit similar risk-reducing benefits of netting in

the calculation of potential future exposure and which address other

issues identified in this proposal. OFHEO will make a determination

of the appropriateness of the inclusion of these changes in the

minimum capital regulation if and when these banking agency

proposals become effective.

In developing this proposal, OFHEO compared the results of the

application of the interim procedures and the proposed regulation with

respect to interest rate and foreign exchange rate contracts. For each

of the past five quarters, OFHEO determined the weighted average

capital ratio that resulted from the application of the interim

procedures for all interest rate and foreign exchange rate contracts.

The weighted average capital ratio for each Enterprise over this period

ranged between 2.24 percent and 3.41 percent. Had the ratios in the

proposed regulation been used, the average ratio for each Enterprise

would have ranged from 2.32 percent to 3.00 percent. Thus, the

application of the ratios in the proposed regulation will result in a

minimum capital level roughly consistent with the minimum capital level

under the interim procedures.

OFHEO considered the argument that because MBS are accorded a much

lower capital ratio by the Act than MBS under the Guidelines,

consistency requires that interest rate and foreign exchange rate

contracts be accorded a similarly lower ratio. Unlike the Enterprises,

institutions subject to the Guidelines do not issue MBS that are fully

guaranteed by the institutions. The Guidelines would apply the same

capital ratio to MBS backed by the issuers' guarantees as is applied to

mortgages held in portfolio. Banks' mortgage loans held in portfolio

are considerably more risky than the mortgages underlying the

Enterprises' MBS because they are not as well-diversified, on average

have experienced higher loss rates, are not required to be as well-

collateralized, and are not protected by a stream of guarantee fee

income.

OFHEO has also considered the argument that OFHEO should establish

a low minimum capital ratio for interest rate and foreign exchange rate

contracts in recognition of the steps the Enterprises take to manage

that risk. Further, OFHEO has considered the argument that OFHEO should

apply different minimum capital ratios for interest rate and foreign

exchange rate contracts based on the specific counterparty risk of the

contract. OFHEO believes that these arguments are inconsistent with the

purpose of minimum capital requirements. The proposed minimum capital

regulation is designed to establish an essential amount of capital that

an Enterprise, with given levels of outstanding business, must hold to

address broad categories of risks. The minimum capital ratios should

reflect risk inherent in types of instruments, not the Enterprises'

current practices.

IV. Proposed Minimum Capital Regulation: Section-by-Section Summary

The proposed regulation sets forth the minimum capital requirements

that will replace the interim procedures currently in use. The proposed

minimum capital regulation also establishes procedures for the filing

of minimum capital reports by the Enterprises each quarter, or at other

times as required by the Director. The proposed minimum capital

regulation also requires OFHEO to provide each Enterprise with notice

and opportunity to comment on its capital classification. A summary of

the treatment of the on- and off-balance sheet items, the filing

procedures, and the notice of capital classification follows.

On-Balance Sheet Assets

The minimum capital ratio for on-balance sheet assets is specified

in section 1362(a)(1) of the Act.\20\ That section establishes a

minimum capital ratio equal to 2.50 percent of the aggregate on-balance

sheet assets of the Enterprises determined in accordance with GAAP. The

proposed regulation adopts that ratio.

\20\ 12 U.S.C. 4612(a)(1).

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Mortgage-Backed Securities

Section 1362(a)(2) of the Act \21\ establishes a minimum capital

ratio of 0.45 percent of the unpaid principal balance of outstanding

MBS and substantially equivalent instruments issued or guaranteed by

the Enterprises that are not included in the on-balance sheet assets of

the Enterprises. The proposed regulation adopts that ratio.

\21\ 12 U.S.C. 4612(a)(2).

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Other Off-Balance Sheet Obligations

Section 1362(a)(3) of the Act \22\ also establishes a minimum

capital ratio of 0.45 percent for all other off-balance sheet

obligations, except as adjusted by the Director to reflect the

differences in the credit risk of those off-balance sheet obligations

in relation to MBS and substantially equivalent instruments. The

proposed regulation continues the interim treatment for three of the

four major categories of off-balance sheet obligations: (1) commitments

will require capital equal to 0.45 percent of 50 percent of the average

dollar amount [[Page 30205]] of commitments outstanding each quarter

over the preceding four quarters, (2) multifamily credit enhancements

will require capital equal to 0.45 percent of the unpaid principal

balance, and (3) sold portfolio remittances pending will require

capital equal to 0.45 percent of the dollar amount.\23\ Any individual

interest rate and foreign exchange rate contract or group of contracts

subject to a recognized netting agreement will require capital equal to

3.00 percent of the CEA, except to the extent that the Enterprises hold

qualifying collateral. The portion of the CEA equal to the market value

of the collateral for that contract or group of contracts will equal

1.50 percent.

\22\ 12 U.S.C. 4612(a)(3).

\23\ Freddie Mac accounts for these funds held by seller-

servicers in custodial accounts separately from MBS until principal

payments are passed on to MBS investors. Fannie Mae includes these

custodial accounts in its MBS accounts.

Minimum Capital Report

The proposed regulation requires that each Enterprise file with the

Director of OFHEO a minimum capital report each quarter or at other

times, as required by the Director. The report will contain the

information required by OFHEO in written instructions to the

Enterprise, including, but not limited to, an estimate of the minimum

capital level and an estimate of core capital overage or shortfall

relative to the estimated minimum capital level. The proposed

regulation provides the Director flexibility to determine the specific

items to be included in the minimum capital report. The proposed

regulation also addresses the timing, certification, and amendment of

the report. The information provided by each Enterprise in the minimum

capital report will be used by OFHEO in determining the capital

classification of the Enterprise.

Notice of Capital Classification

Section 1368 of the Act 24 requires OFHEO to provide the

Enterprises with notice of, and an opportunity to comment on, the

proposed minimum capital classification. This proposed regulation

provides that before OFHEO determines the capital classification of an

Enterprise, OFHEO will provide the Enterprise with written notice of

the proposed classification and a 30-day period during which each

Enterprise may submit its views regarding the classification. The

proposed regulation provides that OFHEO may extend the period for up to

30 days and may shorten the period to less than 30 days if the Director

determines that the condition of an Enterprise so warrants. Following

the expiration of the response period, OFHEO will take into

consideration any comments received from an Enterprise prior to issuing

the final notice of capital classification.

\24\ 12 U.S.C. 4618.

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Regulatory Impact

Executive Order 12606, The Family

This proposed regulation does not have potential for significant

impact on family formulation, maintenance, and general well-being, and

thus, is not subject to review under Executive Order 12606.

Executive Order 12612, Federalism

This proposed regulation has no federalism implications that

warrant the preparation of a Federalism Assessment in accordance with

Executive Order 12612.

Executive Order 12866, Regulatory Planning and Review

This proposed regulation has been reviewed by the Office of

Management and Budget pursuant to Executive Order 12866.

Unfunded Mandates Reform Act of 1995

This proposed regulation does not include a federal mandate that

may result in the expenditure by State, local, and tribal governments,

in the aggregate, or by the private sector, of $100,000,000 or more

(adjusted annually for inflation) in any one year. As a result, this

proposed regulation does not warrant the preparation of an assessment

statement in accordance with the Unfunded Mandates Reform Act of 1995.

Regulatory Flexibility Act

This proposed regulation will not have significant economic impact

on a substantial number of small entities.

Paperwork Reduction Act

This proposed regulation contains no information collection

requirements that require the approval of the Office of Management and

Budget pursuant to the Paperwork Reduction Act of 1980, 44 U.S.C. 3501

et seq.

List of Subjects in 12 CFR Part 1750

Minimum capital, capital classifications.

Accordingly, for the reasons set forth in the preamble, OFHEO

proposes to amend Chapter XVII of Title 12 of the Code of Federal

Regulations by adding Part 1750 to read as follows:

PART 1750--CAPITAL

Subpart A--Minimum Capital

Sec.

1750.1 General.

1750.2 Definition.

1750.3 Procedure and timing.

1750.4 Minimum capital level computation.

1750.5 Notice of capital classification.

Appendix A to Subpart A of Part 1750--Minimum Capital Level

Components for Interest Rate and Foreign Exchange Rate Contracts

Subpart B--[Reserved]

Authority: 12 U.S.C. 4513, 4514, 4612, 4614, 4618.

Subpart A--Minimum Capital

Sec. 1750.1 General.

The regulation contained in this Subpart A establishes the minimum

capital requirements for each Enterprise. The board of directors of

each Enterprise is responsible for ensuring that the Enterprise

maintains capital at a level that is sufficient to ensure the continued

financial viability of the Enterprise and in excess of the minimum

capital level contained in this Subpart A.

Sec. 1750.2 Definitions.

For purposes of this Subpart A, the following definitions shall

apply.

Act means the Federal Housing Enterprises Financial Safety and

Soundness Act of 1992, found at Title XIII of the Housing and Community

Development Act of 1992, Pub. L. No. 102-550, 12 U.S.C. 4501 et seq.

Affiliate means any entity that controls, is controlled by, or is

under common control with, an Enterprise, except as otherwise provided

by the Director.

Commitment means any contractual, legally binding arrangement that

obligates an Enterprise to purchase mortgages for portfolio or

securitization.

Core Capital (1) means the sum of--

(i) the par or stated value of outstanding common stock,

(ii) the par or stated value of perpetual, noncumulative preferred

stock,

(iii) paid-in capital, and

(iv) retained earnings; and

(2) Does not include any amounts the Enterprise could be required

to pay at the option of an investor to retire capital or debt

instruments.

Director means the Director of OFHEO.

Enterprise means the Federal National Mortgage Association and any

affiliate thereof or the Federal Home Loan [[Page 30206]] Mortgage

Corporation and any affiliate thereof.

Foreign exchange rate contracts means cross-currency interest rate

swaps, forward foreign exchange contracts, currency options purchased,

and any other instruments that give rise to similar credit risks.

Interest rate contracts means single currency interest rate swaps,

basis swaps, forward rate agreements, interest rate options purchased

(including caps, collars and floors purchased), and any other

instruments that give rise to similar credit risks (including when-

issued securities and forward deposits accepted).

Mortgage-backed security means a security, investment, or

substantially equivalent instrument that represents an interest in a

pool of loans secured by mortgages or deeds of trust where the

principal or interest payments to the investor in the security or

substantially equivalent instrument are guaranteed or effectively

guaranteed by an Enterprise.

Multifamily credit enhancement means a guarantee by an Enterprise

of the payments on a multifamily mortgage revenue bond issued by a

state or local housing finance agency.

Notional amount means the face value of the underlying financial

instrument(s) on which an interest rate or foreign exchange rate

contract is based.

Off-balance sheet obligation means a binding agreement, contract,

or similar arrangement that requires or may require future payment(s)

in money or kind by another party to an Enterprise or that effectively

guarantees all or part of such payment(s) to third parties, where such

agreement or contract is a source of credit risk that is not included

on its balance sheet.

OFHEO means the Office of Federal Housing Enterprise Oversight.

Other off-balance sheet obligations means all off-balance sheet

obligations of an Enterprise that are not mortgage-backed securities or

substantially equivalent instruments.

Perpetual, noncumulative preferred stock means preferred stock that

(1) does not have a maturity date, (2) provides the issuer the ability

and the legal right to eliminate dividends and does not permit the

accruing or payment of impaired dividends, (3) cannot be redeemed at

the option of the holder, and (4) has no other provisions that will

require future redemption of the issue, in whole or in part, or that

will reset the dividend periodically based, in whole or in part, on the

Enterprise's current credit standing, such as auction rate, money

market, or remarketable preferred stock, or that may cause the dividend

to increase to a level that could create an incentive for the issuer to

redeem the instrument, such as exploding rate stock.

Qualifying collateral means cash on deposit, securities issued or

guaranteed by the central governments of the OECD-based group of

countries,1 United States Government agencies, or United States

Government-sponsored agencies, and securities issued or guaranteed by

multilateral lending institutions or regional development banks.

\1\ The OECD-based group of countries is comprised of all full

members of the Organization for Economic Cooperation and Development

(OECD), as well as countries that have concluded special lending

arrangements with the International Monetary Fund (IMF) associated

with the Fund's General Arrangements to Borrow. The OECD includes

the following countries: Australia, Austria, Belgium, Canada,

Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy,

Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal,

Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the

United States. Saudi Arabia has concluded special lending

arrangements with the IMF associated with the IMF's General

Arrangements to Borrow.

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Sec. 1750.3 Procedures and timing.

(a) Each Enterprise shall file with the Director a minimum capital

report each quarter or at such other times as the Director requires, in

his or her sole discretion. The report shall contain the information

that responds to all of the items required by OFHEO in written

instructions to the Enterprise, including, but not limited to:

(1) estimate of the minimum capital level;

(2) estimate of core capital coverage or shortfall relative to the

estimated minimum capital level;

(3) such other information as may be required by the Director.

(b) The quarterly minimum capital report shall be submitted not

later than April 30, July 30, October 30, and January 30 of each year.

in such other format as may be required by the Director.

(d) In the event an Enterprise makes an adjustment to its financial

statements for a quarter or a date for which the information was

requested, which would cause an adjustment to a minimum capital report,

the Enterprise shall file with the Director an amended minimum capital

report not later than 3 business days after the date of such

adjustment.

(e) Each minimum capital report or any amended minimum capital

report shall contain a declaration by an officer authorized by the

board of directors of the Enterprise to make such a declaration,

including, but not limited to a president, vice president, or

treasurer, that the report is true and correct to the best of such

officer's knowledge and belief.

Sec. 1750.4 Minimum capital level computation.

(a) The minimum capital level for each Enterprise shall be computed

by adding the following amounts:

(1) 2.50 percent times the aggregate on-balance sheet assets of the

Enterprise;

(2) 0.45 percent times the unpaid principal balance of mortgage-

backed securities and substantially equivalent instruments that were

issued or guaranteed by the Enterprise;

(3) 0.45 percent of 50 percent of the average dollar amount of

commitments outstanding each quarter over the preceding four quarters;

(4) 0.45 percent of the outstanding principal amount of bonds with

multifamily credit enhancements;

(5) 0.45 percent of the dollar amount of sold portfolio remittances

pending;

(6) (i) 3.00 percent of the credit equivalent amount of interest

rate and foreign exchange rate contracts except to the extent of the

current market value of posted qualifying collateral, computed in

accordance with Appendix A to this subpart;

(ii) 1.50 percent of the credit equivalent amount of interest rate

and foreign exchange rate contracts equal to the market value of posted

qualifying collateral, computed in accordance with Appendix A to this

subpart; and

(7) 0.45 percent of the outstanding amount of other off-balance

sheet obligations, excluding commitments, multifamily credit

enhancements, sold portfolio remittances pending, and interest rate

contracts and foreign exchange rate contracts, except as adjusted by

the Director to reflect differences in the credit risk of such

obligations in relation to mortgage-backed securities.

(b) Any asset or financial obligation that can be properly

classified in more than one of the categories enumerated in paragraphs

(a)(1) through (7) of this section shall be classified in the category

that yields the highest minimum capital level.

means the last day of the quarter just ended (or the date for which the

minimum capital report is filed, if different), and the three preceding

quarter-ends.

Sec. 1750.5 Notice of capital classification.

(a) Pursuant to section 1364 of the Act (12 U.S.C. 4614), OFHEO is

required to determine the capital classification of [[Page 30207]] each

Enterprise on a not less than quarterly basis.

(b) The determination of the capital classification shall be made

following a notice to, and opportunity to respond by, the Enterprise.

(1) Not later than 60 calendar days after the date for which the

minimum capital report is filed, OFHEO will provide each Enterprise

with a proposed notice of classification in accordance with section

1368 of the Act (12 U.S.C. 4618). The proposed notice shall contain the

following information:

(i) the proposed classification;

(ii) the proposed minimum capital level; and

(iii) the summary computation of the proposed minimum capital

level.

(2) Each Enterprise shall have a period of 30 calendar days

following receipt of a proposed notice of classification to submit a

response regarding the proposed classification. The response period may

be extended for up to 30 additional calendar days at the sole

discretion of the Director. The Director may shorten the response

period with the consent of the Enterprise or without such consent if

the Director determines that the condition of the Enterprise requires a

shorter period.

(3) The Director shall take into consideration any response to the

proposed notice received from the Enterprise and shall issue a final

notice of capital classification for each Enterprise not later than 30

calendar days following the end of the response period in accordance

with section 1368 of the Act (12 U.S.C. 4618).

Appendix A to Subpart A of Part 1750--Minimum Capital Level Components

for Interest Rate and Foreign Exchange Rate Contracts

The minimum capital level components for interest rate and

foreign exchange rate contracts are computed on the basis of the

credit equivalent amounts of such contracts. Credit equivalent

amounts are computed for each of the following off-balance sheet

interest rate and foreign exchange rate instruments:

1. Interest Rate Contracts

a. Single currency interest rate swaps.

b. Basis swaps.

c. Forward rate agreements.

d. Interest rate options purchased (including caps, collars, and

floors).

e. Any other instrument that gives rise to similar credit risks

(including when-issued securities and forward deposits accepted).

2. Foreign Exchange Rate Contracts

a. Cross-currency interest rate swaps.

b. Forward foreign exchange rate contracts.

c. Currency options purchased.

d. Any other instrument that gives rise to similar credit risks.

Foreign exchange rate contracts with an original maturity of 14

calendar days or less and instruments traded on exchanges that

require daily payment of variation margins are excluded from the

minimum capital level computation. Over-the-counter options

purchased, however, are included and treated in the same way as the

other interest rate and foreign exchange rate contracts.

3. Calculation of Credit Equivalent Amounts

a. The credit equivalent amount of an off-balance sheet rate

contract that is not subject to a qualifying bilateral netting

contract in accordance with this Appendix A is equal to the sum of

the current exposure (sometimes referred to as the replacement cost)

of the contract and an estimate of the potential future credit

exposure over the remaining life of the contract.

b. The current exposure is determined by the mark-to-market

value of the contract. If the mark-to-market value is positive, then

the current exposure is the mark-to-market value. If the mark-to-

market value is zero or negative, then the current exposure is zero.

Mark-to-market values are measured in United States dollars,

regardless of the currency or currencies specified in the contract,

and should reflect changes in the relevant rates, as well as

counterparty credit quality.

c. The potential future credit exposure of a contract, including

a contract with a negative mark-to-market value, is estimated by

multiplying the notional principal amount of the contract by a

credit conversion factor. The Enterprises shall use the effective

rather than the apparent or stated notional amount in this

calculation. The credit conversion factors are:

------------------------------------------------------------------------

Foreign

Interest exchange

Remaining maturity rate rate

contracts contracts

(percent) (percent)

------------------------------------------------------------------------

One year or less.................................. 0.0 1.0

Over one year..................................... 0.5 5.0

------------------------------------------------------------------------

d. Because foreign exchange rate contracts involve an exchange

of principal upon maturity, and foreign exchange rates are generally

more volatile than interest rates, higher conversion factors have

been established for foreign exchange rate contracts than for

interest rate contracts.

e. No potential future credit exposure is calculated for single

currency interest rate swaps in which payments are made based upon

two floating rate indexes, so-called floating/floating or basis

swaps. The credit exposure on these contracts is evaluated solely on

the basis of their mark-to-market values.

4. Avoidance of Double Counting

In certain cases, credit exposures arising from the interest

rate and foreign exchange instruments covered by this Appendix A may

already be reflected, in part, on the balance sheet. To avoid double

counting such exposures in the assessment of capital adequacy,

counterparty credit exposures arising from the types of instruments

covered by this Appendix A may need to be excluded from balance

sheet assets in calculating the minimum capital level.

5. Collateral

The sufficiency of collateral and guarantees for off-balance

sheet items is determined by the market value of the collateral in

relation to the credit equivalent amount. Collateral held against a

netting contract is not recognized for minimum capital level

purposes unless it is legally available to support the single legal

obligation credit by the netting contract. The only forms of

collateral that are formally recognized by the minimum capital level

framework are cash on deposit in the bank; securities issued or

guaranteed by the central governments of the OECD-based group of

countries,1 United States Government agencies, or United States

Government-sponsored agencies; and securities issued by multilateral

lending institutions or regional development banks. Excess

collateral held against one contract or a group of contracts for

which a recognized netting agreement exists may not be considered.