Risk-Based Capital

DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

Office of Federal Housing Enterprise Oversight

12 CFR Chapter XVII

RIN 2550-AA02

Risk-Based Capital

AGENCY: Office of Federal Housing Enterprise Oversight, HUD.

ACTION: Advance Notice of Proposed Rulemaking.

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SUMMARY: Title XIII of the Housing and Community Development Act of

1992, known as the Federal Housing Enterprises Financial Safety and

Soundness Act of 1992, gives the Office of Federal Housing Enterprise

Oversight (OFHEO) the responsibility for developing a risk-based

capital regulation for the Federal National Mortgage Association and

the Federal Home Loan Mortgage Corporation (collectively, the

Enterprises). To discharge this responsibility, OFHEO must develop and

implement a risk-based capital ``stress test'' that, when applied to

the Enterprises, determines the amount of capital that an Enterprise

must hold initially to maintain positive capital throughout a ten-year

period of economic stress.

This Advance Notice of Proposed Rulemaking (ANPR) announces OFHEO's

intention to develop and publish a risk-based capital regulation and

solicits public comment on a variety of issues prior to the publication

of a proposed rule. OFHEO requests comment from the public concerning

issues set forth in the ``Solicitation of Public Comment'' subsection

of the Supplementary Information section below.

DATES: Comments regarding the ANPR must be received in writing on or

before May 9, 1995.

ADDRESSES: Send written comments to Anne E. Dewey, General Counsel,

Office of General Counsel, Office of Federal Housing Enterprise

Oversight, 1700 G Street, NW, Fourth Floor, Washington, D.C. 20552.

FOR FURTHER INFORMATION CONTACT: David J. Pearl, Director, Research,

Analysis and Capital Standards; or Gary L. Norton, Deputy General

Counsel, Office of Federal Housing Enterprise Oversight, 1700 G Street,

NW, Fourth Floor, Washington, D.C. 20552, telephone (202) 414-3800 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

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)

as an independent office within the Department of Housing and Urban

Development. OFHEO's primary function is to ensure the financial safety

and soundness and the capital adequacy of the nation's two largest

housing finance institutions--the Federal National Mortgage Association

(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie

Mac) (collectively, the Enterprises).

Fannie Mae and Freddie Mac are Government-sponsored enterprises

that serve important public purposes and receive significant financial

benefits, including exemption from state and local income taxes and

special treatment of their securities in a variety of regulatory and

transactional situations. Although the securities that they issue or

guarantee are not backed by the full faith and credit of the United

States,\1\ their status as Government-sponsored enterprises creates, in

the view of financial market participants, an implicit Federal

guarantee of those securities. Furthermore, the failure of either of

the Enterprises would have serious consequences for the performance of

the nation's housing markets, with a potentially disproportionate

effect on low- and moderate-income families.

\1\See section 306(h)(2), Federal Home Loan Mortgage Corporation

Act (12 U.S.C. 1455(h)(2)) and section 304(b), Federal National

Mortgage Association Charter Act (12 U.S.C. 1719(b)).

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The Enterprises engage in two principal businesses. First, they

maintain a portfolio of residential mortgages and, second, they issue

and guarantee pools of residential mortgages--in the form of mortgage-

backed securities (MBS)--that are held by investors. One of the

Enterprises' principal financial risks stems from losses associated

with defaults on mortgages that they hold or guarantee. The other

financial risk stems from losses associated with changes in interest

rates. Because the effective maturities of the Enterprises' assets and

liabilities are not the same, interest rate changes could cause the

margin between the average yield on assets and the average yield on

liabilities to narrow or even become negative.

The Enterprises' capital serves as a cushion to absorb financial

losses for a [[Page 7469]] period of time until the cause of the losses

can be remedied, thereby reducing the risk of failure. The Act requires

OFHEO to establish, by regulation, risk-based capital standards for the

Enterprises. The regulation will describe a risk-based capital stress

test (stress test) that OFHEO will develop and implement to determine

for each Enterprise the amount of capital\2\ necessary to absorb losses

throughout a hypothetical ten-year period marked by severely adverse

circumstances (stress period).

\2\For purposes of the ANPR, the term ``capital'' means ``total

capital'' as defined under section 1303(18) of the Act (12 U.S.C.

4502(18)) to mean the sum of the following:

(A) The core capital of the [E]nterprise;

(B) A general allowance for foreclosure losses, which--

(i) shall include an allowance for portfolio mortgage losses, an

allowance for nonreimbursable foreclosure costs on government

claims, and an allowance for liabilities reflected on the balance

sheet for the [E]nterprise for estimated foreclosure losses on

mortgage-backed securities; and

(ii) shall not include any reserves of the [E]nterprise made or

held against specific assets.

(C) Any other amounts from sources of funds available to absorb

losses incurred by the [E]nterprise, that the [Director of OFHEO] by

regulation determines are appropriate to include in determining

total capital.

The term ``core capital'' is defined under section 1303(4) of

the Act (12 U.S.C. 4502(4)) to mean the sum of the following (as

determined in accordance with generally accepted accounting

principles):

(A) The par or stated value of outstanding common stock.

(B) The par or stated value of outstanding perpetual,

noncumulative preferred stock.

(C) Paid-in capital.

(D) Retained earnings.

The core capital of an [E]nterprise shall not include any

amounts that the [E]nterprise could be required to pay, at the

option of investors, to retire capital instruments.

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Use of a stress test will enable OFHEO to tailor carefully the

Enterprises' capital standards to the specific risks of the

Enterprises' businesses. It also will provide a structure for

incorporating interrelationships among different types of risk

(prepayments, for example, relate to both credit and interest rate

risk).

Statutory Requirements

The Act specifies a risk-based capital standard for each

Enterprise. This standard establishes the amount of capital necessary

to withstand simultaneously adverse credit and interest rate risk

scenarios during the stress period plus an additional amount to cover

management and operations risk, as follows:

Credit Risk

The Act establishes a credit risk scenario based on a regional

recession involving the highest rates of default and loss severity

experienced during a period of at least two years in an area containing

at least five percent of the total U.S. population. The stress test

will apply these default and loss rates, with any appropriate

adjustments, over the ten-year stress period on a nationwide basis to

the Enterprises' books of business.\3\

\3\Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).

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Interest Rate Risk

The Act presents two interest rate risk scenarios, one with rates

rising and the other with rates falling. The Act further describes the

path of the ten-year Constant Maturity Treasury (CMT) yield for each

scenario and directs OFHEO to establish the yields of other financial

instruments during the stress period in a reasonably consistent manner.

The stress test for each Enterprise incorporates the scenario with the

most adverse impact.\4\

\4\Section 1361(a)(2) (12 U.S.C. 4611(a)(2)).

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In the rising rate scenario, the ten-year CMT yield increases

during the first year of the stress period and then remains constant at

the greater of (a) 600 basis points above the average yield during the

preceding nine months or (b) 160 percent of the average yield during

the preceding three years. The Act further limits the increase in yield

to a maximum of 175 percent of the average yield over the preceding

nine months.\5\

\5\Section 1361(a)(2)(C) (12 U.S.C. 4611(a)(2)(C)).

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In the falling rate scenario, the ten-year CMT yield decreases

during the first year of the stress period and then remains constant at

the lesser of (a) 600 basis points below the average yield during the

preceding nine months or (b) 60 percent of the average yield during the

preceding three years. The Act further limits the decrease in yield to

not more than 50 percent of the average yield in the preceding nine

months.\6\

\6\Sections 1361(a)(2)(B) (12 U.S.C. 4611(a)(2)(B)).

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New Business and Other Activities and Considerations

Initially the stress test assumes that the Enterprises conduct no

additional new business once the stress period begins, except for the

fulfillment, in a manner consistent with recent experience and the

economic characteristics of the stress period, of contractual

commitments to purchase mortgages and issue securities.\7\

\7\The Act states that OFHEO may consider the impact of new

business conducted during the stress period after taking into

consideration the results of studies conducted by the Congressional

Budget Office and the Comptroller General on the advisability and

appropriate forms of new business assumptions. The studies must be

completed within the first year after the issuance of the final

risk-based capital regulation. OFHEO may incorporate new business

into the stress test four years after the regulation is issued.

Section 1361(a)(3)(C) and (D), (12 U.S.C. 4611(a)(3)(C) and (D)).

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The stress test must take into account distinctions among mortgage

product types, different loan-to-value ratios (LTVs), and any other

appropriate factors.\8\ OFHEO determines the appropriate consideration

and treatment of all other factors, activities, or characteristics of

the stress period not explicitly identified and/or treated in the Act--

such as mortgage prepayments, hedging activities, operating expenses,

dividend policies, etc.--on the basis of available information, in a

manner consistent with the stress period.\9\

\8\Sections 1361(b)(1) and (d) (12 U.S.C. 4611(b)(1) and (d)).

The Act uses the phrase ``differences in seasoning of mortgages''

which is equivalent to differences in LTVs. The term ``seasoning''

is defined as the change over time in the ratio of the unpaid

principal balance of a mortgage to the value of the property by

which such mortgage loan is secured. Section 1361(d)(1) (12 U.S.C.

4611(d)(1)).

\9\Sections 1361(b) and (d)(2) (12 U.S.C. 4611(b) and (d)(2)).

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Management and Operations Risk

Finally, to provide for management and operations risk, after

determining the amount of capital an Enterprise needs to survive the

stress test, the Act requires OFHEO to increase that amount by 30

percent to set the required risk-based capital level for each

Enterprise.\10\

\10\Section 1361(c)(2) (12 U.S.C. 4611(c)(2)).

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Philosophy Guiding Stress Test Development

The mission of OFHEO is to ensure that the Enterprises are

adequately capitalized and operating in a safe and sound manner,

consistent with the achievement of their public purposes. The principal

objective of risk-based capital standards is protection of the taxpayer

from potential Enterprise insolvency. However, effective capital

standards should also permit the Enterprises to fulfill their public

purposes while pursuing prudent business practices and strategies.

Although the stress test produces a single capital requirement, it

effectively creates marginal capital requirements--incremental

requirements for each additional dollar of business--for every type of

product the Enterprises guarantee or hold in portfolio. Marginal

capital requirements for mortgages held in portfolio will vary

depending on the risk, as reflected in the stress test, of an

Enterprise's funding strategy. These marginal capital requirements will

have significant bearing on how the Enterprises choose to conduct their

businesses.

OFHEO will seek to design the stress test so that the incentives it

creates closely reflect the relative risks inherent [[Page 7470]] in

the Enterprises' different activities. To this end, OFHEO will

incorporate, to the extent feasible, consistent relationships between

the economic environment of the stress period and the Enterprises'

businesses. This will require modeling the Enterprises' assets,

liabilities, and off-balance sheet positions at a sufficient level of

detail to capture their various risk characteristics. Taking all this

into consideration will require a balance between the complexity and

realism of the stress test and its timeliness.

Solicitation of Public Comments

OFHEO requests public comment on a number of subjects that must be

addressed in its risk-based capital regulation. OFHEO will consider the

comments received in response to this ANPR when developing a proposed

rule. Following consideration of comments on the proposed rule, OFHEO

will issue a final regulation. When addressing a specific question

contained in this ANPR, OFHEO asks that commenters specifically note by

number which question is being addressed.

I. Credit Risk

The Enterprises face similar mortgage credit risk in their

portfolio and securitization businesses. OFHEO defines mortgage credit

risk as the risk of financial loss due to borrower default and

subsequent foreclosure and liquidation of a mortgaged property. Losses

are realized when the unpaid loan balance on a defaulted mortgage

exceeds the net proceeds of a foreclosure sale, after deducting

carrying and selling costs, less any recoveries from any private

mortgage insurer, recourse agreement, or other credit enhancements.

Loans with high current LTVs, where the borrowers have little to no

equity in their homes, are the most likely to default.\11\ For any

given set of mortgage loans, the probability of default is typically

low in the first year after origination, rises to a peak somewhere

between the third and seventh year, and declines thereafter. If

declining interest rates induce prepayments on a group of mortgage

loans due to borrower refinancing activity, defaults and losses on

those mortgage loans likely will be reduced, because some of the

prepaid loans would ultimately have defaulted. However, the remaining

group of loans is likely to be at greater risk of default, because it

includes all of the original loans where the borrower would not have

qualified for refinancing, but only some of the loans where the

borrower was eligible.

\11\For example, see C. Foster and R. Van Order, ``An Option

Based Model of Mortgage Default Rick,'' Housing Finance Review,

3(4):351-372, 1984; C. Foster and R. Van Order, ``FHA Terminations:

A Prelude to Rational Mortgage Pricing,'' AREUEA Journal, 13(3):273-

291, 1985; and R.L. Cooperstein, F.S. Redburn, and H.G. Meyers,

``Modelling Mortgage Terminations in Turbulent Times,'' AREUEA

Journal, 19(4):473-494. For a review of the literature in this area,

see R.G. Quercia and M.A. Stegman, ``Residential Mortgage Default: A

Review of the Literature,'' Journal of Housing Research, 3(2):341-

379, 1992.

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Economic downturns result in more frequent and severe losses in all

categories of mortgage loans, especially in a period of house price

declines. The stress test will incorporate changes in the economic

environment and simulate the relationship of those changes to mortgage

defaults.

A. Defining a Stress Benchmark

The Act, in defining the risk-based capital stress test, refers to

two time periods--a hypothetical ten-year ``stress period'' during

which the Enterprises' capital should be sufficient to absorb losses

and maintain a positive capital level while being subjected to adverse

credit and interest rate risk scenarios, and the time period of ``not

less than two years'' for which the ``highest rates of default and

severity of mortgage losses'' occurred in a region containing at least

five percent of the total population of the United States.\12\ For the

purposes of this ANPR, OFHEO characterizes the latter time period and

region as a ``stress benchmark.'' The stress benchmark will provide the

basis for the development of the credit risk stress scenario that will

be applied during the ten-year stress period.

\12\Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).

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The Act permits the identification of one or more stress

benchmarks. A single benchmark is conceptually appealing but presents a

number of difficult issues. A single benchmark may not include

sufficient data on all Enterprise product types. Patterns of

multifamily and single family mortgage losses differ (see ``Mortgage

Types'' below) and a stress benchmark for multifamily mortgages

representing the worst regional experience for those mortgages may not

coincide with the benchmark for single family mortgages based on their

worst experience. Finally, data limitations may prevent OFHEO from

determining loss severities during the period of highest default rates;

alternatively, highest loss severities may not coincide with highest

rates of default by time period or region.

Although the Act does not refer to a particular mortgage product in

its reference to ``highest rates of default and severity,'' single

family, 30-year, fixed-rate mortgages have long comprised the bulk of

Enterprise mortgages. OFHEO expects to define a stress benchmark for

these mortgages on the basis of a weighted average (by unpaid loan

balance of various LTV groups) of default rates.

Existing data on loss severities may be inadequate to contribute to

establishing the timing or location of the worst regional experience.

Systems for the storage and analysis of data on foreclosed properties

are a relatively recent development. To overcome these data

deficiencies, OFHEO will consider a number of approaches to determining

loss severity rates during the stress benchmark. These approaches

include the use of loss severity estimates obtained from different

sources and for different time periods and regions than those used to

estimate the benchmark default rates.

OFHEO may use models (see ``Models of Default and Prepayment'' and

``Models of Loss Severity'' below) to establish aspects of the

benchmark for which data are insufficient or unavailable. These might

include, in addition to loss severities for all products, default rates

for mortgage products poorly represented or non-existent in the stress

benchmark. Econometric models for default, mortgage prepayment, and

loss severity would facilitate consideration of the simultaneous impact

of many factors on default rates, such as changes in LTVs, the impact

of contemporaneous prepayments, and the impact of factors associated

with mortgage product types. Models would provide a link between the

performance of mortgages owned or guaranteed by the Enterprises during

the stress period and performance during the stress benchmark, with due

consideration of the economic circumstances of the stress period, e.g.,

interest rates and house prices.

Data Issues

OFHEO has received access to detailed information about the loss

experience on mortgages that the Enterprises owned or guaranteed from

the mid-1970s through the present. The type of information on mortgages

that OFHEO needs to develop the stress test includes date of

origination, original LTV ratio, type of mortgage, location, nature and

degree of any credit enhancements, date of last paid installment,

termination type, e.g., default or prepayment, and the amount of any

ultimate loss (including holding and selling costs). However, there are

serious gaps in the data on loss severity through the early 1980s

resulting from the lack of systems for the storage and

[[Page 7471]] analysis of data on foreclosed properties and the manner

in which loan balances were reported by seller/servicers.

In general, however, with the increase over time of the

Enterprises' share of the overall mortgage market, the data grow

increasingly rich. If necessary, OFHEO could supplement these data with

data from the Federal Housing Administration or other sources such as

TRW Redi and Mortgage Information Corporation.

If the stress benchmark is wholly or primarily based on Enterprise

data, the loan-level data could be aggregated across the two

Enterprises in order to determine the worst historical experience.

Preliminary analysis suggests that the worst historical experience may

be different for the two Enterprises. An alternative would be to

determine the worst historical experience for each Enterprise

separately and then use a simple or weighted average of default rates.

Question 1: What data and methodology should OFHEO use in its

determination of the stress benchmark?

Benchmark Time Period and Region

OFHEO has considered at least two approaches for defining the

benchmark time period. It could be defined as the period in which the

highest rates of default occurred, that is, an ``exposure year''

approach; or the period in which the loans with the highest cumulative

or lifetime rates of default were originated, which can be termed an

``origination year'' approach. At the start of the stress period, the

Enterprises' books of business will include survivors from many loan

origination years. An exposure year benchmark corresponds more closely

to the manner in which the Enterprises' mortgage portfolios will

experience the risk of credit losses as they move through the ten-year

stress period. However, using exposure years may complicate adjustments

for differences in LTVs and other factors (see ``Relating Stress Period

Default Rates to Benchmark Default Rates'' below). Using origination

years may require some adjustment for differences in mortgage age (see

``Mortgage Age'' below) since virtually all of the Enterprise mortgages

will have been originated prior to the start of the stress period.

Alternative approaches to defining the stress benchmark (exposure

year versus origination year) suggest alternative analyses of defaults.

An exposure year approach requires the determination of default rates

on loans of varying age at risk of failure within a specified period.

The resulting time-period specific default rates for loans outstanding

at the beginning of the period can be termed ``conditional rates.''

Because default rates vary with the age of a mortgage (see ``Mortgage

Age'' below), OFHEO might define an age schedule of conditional default

rates for loans outstanding at the start of the stress benchmark.\13\

For comparison across time periods and regions, synthetic cumulative

default rates for the stress benchmark could be derived under a common

set of prepayment assumptions. In an origination year approach, either

cumulative or conditional default rates could be used.

\13\Age is often a proxy for additional unobserved factors

affecting the default probabilities of individual mortgages.

Immediately after origination, default is unlikely for all

borrowers. Default rates first rise over time as new information

about properties and borrowers is revealed. Then as relatively

weaker borrowers default, the average rate of default declines. See,

for example, the discussion in C. Pestre, P. Richardson, and C.

Webster, ``The Lehman Brothers Mortgage Default Model and Credit-

Adjusted Spread Framework,'' Mortgage Market Analysis, Lehman

Brothers, Fixed Income Research, January 28, 1992. Other influential

default studies that have included mortgage age as an explanatory

factor include: T. Campbell and J. Dietrich, ``The Determinants of

Default on Conventional Residential Mortgages,'' Journal of Finance,

38(5):1569-1581, 1983; D. Cunningham and C. Capone, ``The Relative

Termination Experience of Adjustable to Fixed-Rate Mortgages,'' The

Journal of Finance, 45(5):1687-1703, 1990; and J.M. Quigley and R.

Van Order, ``More on the Efficiency of the Market for Single Family

Homes: Default,'' Center for Real Estate and Urban Economics,

University of California, Berkeley, 1992.

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The Act requires that the benchmark region comprise a contiguous

area containing at least five percent of the total United States

population. Part or all of states such as Texas or California satisfy

this population requirement; however, areas experiencing the highest

rates of default may cross over one of these state's boundaries into

adjoining states. As appropriate, OFHEO will use a definition of

benchmark region that includes more than one state, part of one state,

or parts of several states.

Question 2: How should the benchmark time period be defined?

Measurement of Default

Default can be defined in several ways: Defaults can be deemed to

occur at the time a borrower ceases making payments, when a loan

payment is past due by a contractually specified number of days, on the

date of foreclosure, or on the date when losses are recognized.

Defaults can be measured on a gross basis or net of any subsequent

cures.

Question 3: What are the relative merits of the alternative

approaches for the measurement of mortgage defaults?

B. Relating Stress Period Default Rates to Benchmark Default Rates

Default rates during the stress period may differ from the default

rates associated with the stress benchmark. This difference may result

from differences between the characteristics and composition of an

Enterprise's mortgages at the start of the stress period relative to

those of the mortgages identified with the stress benchmark. Stress

period default rates may also differ from stress benchmark rates as a

result of differences in the stress period environment, such as

interest rates and inflation. OFHEO must also specify the timing of

defaults and losses during the stress period.

The Act requires that OFHEO, in establishing the stress test, take

into account appropriate distinctions among types of mortgage products,

differences in LTVs, and other factors that OFHEO's Director considers

appropriate.\14\ Such factors include prepayment activity, mortgage

age, and loan size. The Act also requires an adjustment for the effects

of general inflation in the highest interest rate environment in the

stress test.\15\

\14\Section 1361(b)(1) (12 U.S.C. 4611(b)(1)).

\15\Section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).

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Loan-to-Value Ratios

The payment of principal and changes in the value of the property

securing a mortgage affect LTVs over time. Repayments of loan principal

and rising property values lower LTVs, while falling property values

raise LTVs. Because LTV is a common measure of borrower equity, and

borrower equity is a major factor determining defaults and losses, the

stress test must take into account changes in LTVs. If distributions of

LTVs during the stress period differ from those for the same types of

loans associated with the stress benchmark, defaults and losses during

the stress period will likely differ from those of the benchmark.

All loans owned or guaranteed by the Enterprises at the start of

the stress period will have been originated prior to that time.

Although relatively good estimates of property value are available at

the time of loan origination, OFHEO will need to use house price

indexes to obtain estimates of the LTVs for mortgages at the start of,

and possibly throughout, the stress period.\16\ OFHEO

[[Page 7472]] intends to use a repeat sales index based on sales (or

appraisals undertaken by borrowers in conjunction with refinancing the

mortgages) of the Enterprises' owned and guaranteed portfolios (see

``House Price Indexes'' below).

\16\For an origination year benchmark, OFHEO will likely have

access to accurate information about the original LTVs for all

benchmark loans. On the other hand, to develop an exposure year

benchmark, OFHEO will have to estimate LTVs during the benchmark

time period for all loans originated earlier. OFHEO would use house

price indexes for this purpose.

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Models of mortgage default and prepayment (see ``Models of Default

and Prepayment'' below) emphasize the importance of LTV because of its

direct relationship to homeowner's equity, defined as the difference

between the value of a property and the outstanding principal balance

of the related mortgage. These models differ in their treatment of

house price changes and with regard to how changes in equity affect

default and prepayment. For example, one approach assumes that defaults

occur only among loans with negative equity.\17\ House price indexes

only provide estimates of the average change in property values between

two dates. Because changes in individual property values are not

continuously observed, simulation models have been used to characterize

the distribution of changes in house prices relative to the market

average. Estimates of the percentage of loans with negative equity and

estimates of default rates can be derived from these distributions.

\17\See Foster and Van Order, supra, (1984, 1985).

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This approach assumes that homeowner's equity includes not just the

difference between property value and outstanding loan amount, but also

the current value of the mortgage to the borrower. A below-market rate

loan has positive value. The precise value of the mortgage depends on

the loan interest rate relative to the current market rate and the

borrower's expectations about future interest rates and mobility. A

borrower whose loan has a fixed contract rate below current market

yields has more to lose by defaulting than a borrower with a note rate

above the current market rate.

Question 4: What is the appropriate way in which to adjust the LTVs

of mortgages in the stress test?

Question 5: If estimates of the distribution of house price changes

are used to adjust the LTVs of mortgages, what is an appropriate

method, e.g., stochastic process?

Question 6: In what manner, if at all, should OFHEO incorporate

mortgage value as a factor affecting defaults?

Mortgage Types

Single Family

The Act requires that the stress test consider differences in

mortgage types (single family or multifamily, fixed or adjustable rate,

first or second lien, owner-occupied or investor owned, positive or

negative amortization, alternate term to maturity, etc.).\18\ Risk

characteristics of different types of mortgages vary considerably.

Because of the fundamental differences between single family and

multifamily mortgage risk, we discuss the latter in a separate section

below.

\18\Sections 1361(b)(1) and (d)(2) (12 U.S.C. 4611(b)(1) and

(d)(2)).

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Given that OFHEO plans to establish the stress benchmark based on

single family, 30-year, fixed-rate mortgages, the Act calls for OFHEO

to identify the worst rates of default and losses for any time period

or region.\19\ The Enterprises may not have held certain types of

single family mortgages in the stress benchmark OFHEO identifies. Other

types of single family mortgages held during the stress benchmark may

have experienced their worst defaults and losses at other times or in

other regions.

\19\Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).

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Alternative approaches could include use of multivariate models to

estimate separate equations for different mortgage products or

different mortgage features, default rates representing some multiple

of the standard single family mortgage, or some combination of these

approaches (see ``Models of Default and Prepayment'' below).

Question 7: How should OFHEO relate other types of mortgages to a

single stress benchmark developed based on single family, 30-year,

fixed-rate mortgages?

Multifamily

While single family properties are both a source of shelter and,

for most families, their most valuable financial asset, multifamily

properties are primarily income-producing businesses for their owners.

Multifamily loans are less homogeneous and subject to a more diverse

set of risks than single family loans. The multifamily market has more

pronounced business cycles and is heavily affected by tax and

regulatory policy. Patterns of losses over time for multifamily loans

have not tracked those of the single family market. The Enterprises

operate several different types of multifamily programs, some of which

rely heavily on lender recourse or other forms of credit enhancement

with differing risk characteristics.

Data needs in analyzing multifamily loans are greater than for

single family loans and yet the quality of such data is poorer. Data

are incomplete and cover a smaller portion of the multifamily market

than the single family market. There is also a dearth of research on

critical multifamily credit risk issues.

For the owner of a multifamily property, net operating income (NOI)

plays a more important role than equity in the decision to default. A

property's debt service coverage, rather than LTV ratio, may be the

most important indicator of multifamily credit risk, yet available data

can only provide a short time-series for income. Multifamily value

indexes are problematic because there are fewer transactions than in

the single family market and property appraisals are less reliable.

Appraisals are less reliable due to the varying methodologies used to

calculate multifamily property income and the application of so-called

``capitalization rates'' to NOI.\20\

\20\Government Accounting Office, ``Federal Home Loan Mortgage

Corporation: Abuses in Multifamily Program Increase Exposure to

Financial Losses'' (Oct. 1991); J.M. Abraham, ``On the Use of a Cash

Flow Time-Series to Measure Property Performance,'' forthcoming in

Journal of Real Estate Research; and J.M. Abraham, ``Credit Risk in

Commercial Real Estate Lending, ``Federal Home Loan Mortgage

Corporation, 1994 presented at the 1994 meetings of the American

Real Estate and Urban Economics Association (available from OFHEO).

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Prepayments play a far less significant role in the analysis of

multifamily credit risk than single family credit risk because

``lockouts'' and yield maintenance agreements effectively prevent most

multifamily borrowers from refinancing to take advantage of declining

interest rates. The Enterprises' activity in the multifamily market is

expected to increase significantly in future years in order to meet the

affordable housing goals established under the Act.\21\ Thus, the

treatment of multifamily risks will be increasingly important.

\21\Sections 1331-1336 (12 U.S.C. 4561-4566).

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Question 8: How should existing and emerging multifamily data

sources be identified?

Question 9: What are alternative empirical and theoretical

approaches to the estimation of multifamily credit risk?

Question 10: How should the projection of defaults and losses on

the Enterprises' multifamily portfolio be related to a single family

stress benchmark?

General Price Inflation

The Act requires that OFHEO adjust credit losses in the stress test

when large increases in interest rates imply higher rates of general

price inflation.\22\ If the ten-year CMT yield is assumed to increase

by more than 50 percent over the average yield during the preceding

[[Page 7473]] nine months, inflation is presumed to be

``correspondingly higher.'' If, for example, the ten-year CMT yield

were to have averaged eight percent during the past nine months, a 50

percent increase would raise it to 12 percent. The Act, however, would

permit an increase to 14 percent.

\22\Section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).

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OFHEO would first determine what annual percentage difference in

general inflation rates best corresponds to the difference between a 12

percent and a 14 percent ten-year CMT yield over a nine-year period.

The difference in inflation rates could be assumed to be equal to the

difference in interest rates or it could be based on an estimated

historical relationship.

OFHEO would then translate that higher inflation rate into

individual house price changes. Again, the differences in house price

changes could be assumed to be equal to the difference in general price

inflation rates or could be based on an estimated relationship.

As the last step, OFHEO would translate the difference in house

price changes into differences in defaults. This could be done in the

context of a multivariate default and prepayment model used for making

many adjustments simultaneously (see ``Models of Default and

Prepayment'' below), or it could be the subject of a separate analysis.

Question 11: Should OFHEO assume a ``one-to-one'' relationship

between long-term differences in interest rates, general price

inflation rates, and house price inflation rates or should it estimate

more complex, but potentially more realistic, relationships between

these phenomena?

Question 12: What is the best method of modeling the effects of

higher house prices on defaults?

Mortgage Prepayments--Credit Risk

Prepayments are a significant factor in interest rate risk, but

they also affect credit losses. Interest rate changes have a

significant influence on mortgage prepayments. Prepayment rates are

sensitive to the differences between current market yields and the

levels of mortgage rates among outstanding mortgages. A homeowner today

will refinance (and prepay) when current mortgage rates fall as little

as 50 basis points below the rate on his or her mortgage.

Prepayment rates also depend on the time paths of interest rates.

Homeowners who fail to refinance once mortgage rates become

advantageous are relatively unlikely to do so in the future (many may

not qualify for refinancing). Thus, prepayment rates for mortgages with

a given coupon rate rise as interest rates fall below a particular

threshold, but they eventually will slow, even if interest rates remain

at the new lower levels or continue to decline. This phenomenon is

commonly known as ``burn-out.''

The expected pattern of prepayments in the stress period might be

quite different from the pattern experienced during the benchmark

period. The drastic yield curve shifts that will be experienced during

the initial year of the stress period will almost certainly not be

found during the benchmark period that OFHEO must identify. The greater

number of mortgages that prepay, the fewer are the candidates for

subsequent default. Conversely, the fewer mortgages that prepay, the

greater the number remaining that might default. At the same time, the

default risk of mortgages remaining after a refinancing wave may be

higher than previously. Many homeowners who did not take advantage of

attractive refinancing opportunities may have been unable to do so

because of higher risk profiles. Given the widely divergent interest

rate movements that the Enterprises may experience during the stress

period, loss adjustments for differing prepayment behavior could be

considerable.

If OFHEO expresses mortgage default rates as conditional rates,

defaults during any given time interval of the stress period will

depend on the proportion of mortgages outstanding at the beginning of

that time interval. Such an approach would, in effect, make a

substantial adjustment for prepayments. A more complicated adjustment

would take into account the generally higher quality of loans eligible

for refinancing. In a stress scenario involving falling interest rates,

for example, the stress test might take into account the generally

higher quality of loans that qualify for refinancing and the

potentially lower quality of surviving loans (see ``Models of Default

and Prepayment'' below). Alternatively, if the stress test involves no

interaction of the total amount of defaults and prepayments, OFHEO

still might adjust the timing of defaults during the stress period to

be consistent with prepayments expected in a particular interest rate

scenario. Mortgage prepayments are discussed further under ``Interest

Rate Risk'' below.

Question 13: Should anticipated prepayments affect the volume or

timing of defaults in the stress period?

Mortgage Age

Holding homeowner's equity constant, a number of factors make the

likelihood of borrower default vary over the life of a loan. On one

hand, changes in a borrower's circumstances subsequent to the loan's

origination, such as unemployment, marriage, divorce, childbearing,

mortality, and residential mobility, affect the likelihood of default

and prepayment, and the cumulative frequency of such events increases

as a loan ages. On the other hand, a record of consistent payments by a

borrower over time increases the probability of continued loan

performance.

Models that have included variables for both homeowner's equity and

mortgage age have found the contribution of age to be statistically

significant.\23\ This may be particularly important if an origination

year approach is used in the benchmark. Using an origination year

approach, loans in the stress benchmark would all be newly originated

loans, while those at the beginning of the stress period would be a

mixture of old and new loans.

\23\For example, see the papers cited in footnote 11 above.

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Question 14: Is it appropriate for OFHEO to factor mortgage age

into the stress test, and, if so, what is the best method of doing so?

C. Models of Default and Prepayment

There are a number of approaches to relating the factors discussed

above, such as LTV, mortgage type, mortgage age, and prepayments, to

the performance of the Enterprises during the stress period. A

comprehensive way to incorporate all of these factors into the stress

test would be to estimate joint multivariate models of default and

prepayment.\24\ A joint model of default and prepayment would ensure

the consistency of these key variables and reflect an appropriate time

pattern of defaults as well. Researchers have estimated a number of

such models.\25\

\24\Due to the unique difficulties of modeling multifamily

default and prepayment, multifamily and single-family loans would

probably need to be modeled separately. The modeling of loss

severity is discussed in the next section.

\25\Multinomial logit models for default have been estimated by

Campbell and Dietrich (1983) supra; P. Zorn and M. Lea, ``Mortgage

Borrower Repayment Behavior: A Microeconomic Analysis with Canadian

Adjustable Rate Mortgage Data, AREUEA Journal, 17(1):188-136, 1989;

and Cunningham and Capone (1990) supra. More recently, proportional

hazards models have been used to analyze default and prepayment.

See, for example, J. Quigley, ``Interest Rate Variations, Mortgage

Prepayments and Household Mobility, Review of Economics and

Statistics, 119(4):636-643, 1987; and J.M. Quigley and R. Van Order,

``More on the Efficiency of the Market for Single Family Homes:

Default,'' Center for Real Estate and Urban Economics, University of

California, Berkeley, 1992. [[Page 7474]]

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A joint approach to default and prepayment would generate default

rates reasonably related to the stress benchmark, while simultaneously

generating prepayment rates that are consistent with the interest rate

characteristics of the ten-year stress period. To estimate a

multivariate default/prepayment model, OFHEO could draw on all relevant

historical data, not just data from the stress benchmark. The model

might include explanatory variables such as LTVs at origination,

current LTVs (determined through the application of an appropriate

house price index), differences between actual mortgage coupons and

current market rates, interest rate paths, mortgage age, dummy

variables for time period and location of mortgaged property, and

additional characteristics specific to different mortgage products. The

estimation procedure could allow for changing coefficients over time to

reflect structural changes in prepayment and default behavior. During

the stress period, explanatory or dummy variables, reflecting the

special circumstances of the stress benchmark, would be set at their

benchmark levels.

While multivariate models allow for the most realistic estimates of

defaults and prepayments, OFHEO recognizes the difficulties of such an

approach. Insufficient data may complicate model selection and the

estimation of some individual parameters. One of the most simple

approaches would be to measure cumulative defaults in the stress

benchmark for the most common 30-year, fixed-rate, 80 percent LTV

mortgages and then spread those defaults evenly or according to some

predetermined pattern over the ten-year stress period, with no

consideration of prepayments. Losses on other mortgage types and LTVs

could be set at simple multiples of the ``standard'' loss rate based on

average historical experience. All other possible variables might be

ignored.

Many approaches of intermediate complexity exist. For example,

OFHEO could determine the stress benchmark default rates for standard

30-year, fixed-rate, single family mortgages for several LTV categories

and a few other types of mortgages. Relative defaults on additional

mortgage types would be determined from more recent data using

multivariate models, which would also provide adjustment factors for

some mortgage features and other relevant variables. Prepayments could

be modeled separately, affecting projected defaults by changing the

volume of surviving loans (See ``Mortgage Prepayments--Interest Rate

Risk'' below). The time patterns of defaults could also be modeled

separately as a function of mortgage age.

Question 15: What are the relative merits of using a joint model of

default and prepayment in the stress test?

Question 16: What is an appropriate statistical method for

estimating a joint model of default and prepayment?

Question 17: Should defaults be expressed in terms of conditional

failure rates (hazards), cumulative default rates, or in some other

manner?

Question 18: What explanatory variables should be included in a

statistical model for default and prepayment?

Question 19: What is an appropriate level of statistical

aggregation for the estimation of a joint model of default and

prepayment?

Question 20: How should the impact of house price trends, interest

rates, and other economic factors be incorporated into a model of

default and prepayment?

D. Models of Loss Severity

Due to the varying quality of data on losses on defaulting loans,

OFHEO may be unable to establish actual loss severities for the stress

benchmark. Even if loss severities are incorporated in the stress

benchmark, OFHEO may make adjustments to reflect changes in factors

that affect loss severities. Consequently, OFHEO will conduct a

separate analysis of loss severity based on all available data. This

section examines some of the issues involved in modeling loss severity,

including approaches for linking loss severity rates to the stress

benchmark.

Loss severity refers to the actual dollars lost on a defaulted loan

and allows credit risk to be quantified in dollar terms. Severity is

the extent to which the costs associated with default, foreclosure, and

disposition exceed the revenues associated with these processes. The

major costs are the loss of loan principal, transaction costs at both

foreclosure and disposition, and carrying costs throughout the process.

The major revenues are foreclosure sale price and mortgage insurance

payments.

Loss severity, like default, depends on numerous factors. Some

factors--original LTV ratio, LTV ratio at time of default, original

loan size, occupancy status, type of structure, and presence or absence

of mortgage insurance--are the factors that also influence the

likelihood of default. Other factors--methods of disposition, state

foreclosure laws, and home price movements after default--influence

severity without affecting the likelihood of default.\26\

\26\See, for example, T. Clauretie and T.N. Herzog, ``How State

Laws Affect Foreclosure Costs,'' Secondary Mortgage Markets,

6(Spring):25-28, 1989; T. Clauretie and T.N. Herzog, ``The Effect of

State Foreclosure Laws on Loan Losses: Evidence from the Mortgage

Insurance Industry,'' Journal of Money, Credit, and Banking,

22(2):221-233, 1990; E. Bruskin and M. Buono, ``A New Understanding

of Loss Severity: Time is (of) the Essence,'' in Mortgage Securities

Research, Goldman-Sachs, September 1994; and V. Lekkas, J. Quigley,

and R. Van Order, ``Loan Loss Severity and Optimal Mortgage

Default,'' AREUEA Journal, 21(4):353-371, 1993.

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OFHEO is considering using a multivariate statistical model to

estimate the separate effects of these factors on severity. OFHEO may

develop a separate model for each of the cost and revenue components of

loss severity since each component is affected by different factors. In

the event that data on the individual revenue and cost components of

loss severity are unavailable, an alternative approach would be to

model overall loss severity directly.

Another less complex option is to estimate the individual

components without multivariate statistical analysis. OFHEO could set

fixed parameters for the components of severity--foreclosure costs

might be x percent of unpaid principal balance (UPB), carrying costs

equal to y percent of UPB and sales prices being z percent of UPB--

while allowing severity to vary based on, for example, the presence or

absence of private mortgage insurance or state foreclosure laws. The

simplest possible option would be to assume that all defaulted loans

face the same level of severity as a percentage of UPB.

There are a number of ways in which rates of loss severity may be

related to the stress benchmark rates of default and the corresponding

rates of default during the stress period. Given the impact of state

foreclosure laws on loss severity, default rates and loss severity will

be linked through the geographic location of the mortgages. For

example, loss severities are likely to be lower in states where

foreclosure laws are relatively more favorable to the lender.

The assumptions about changes in house prices in the stress

benchmark and during the stress period will affect the determination of

foreclosure sales prices and loss severity. Defaults are more likely to

have occurred when borrowers' properties have appreciated much less

than the average for their region. This implies that house price

indexes used to model loss severity would best be based on properties

that have experienced lower than average appreciation. [[Page 7475]]

Question 21: What are the explanatory factors OFHEO should consider

in modeling loss severity?

Question 22: Should OFHEO model the individual cost and revenue

components of severity or should OFHEO model only overall severity?

Question 23: What is an appropriate house price index for real

estate owned (REO) properties? In estimating foreclosure sales prices,

should OFHEO use a house price index based on all properties or a house

price index based only on REO properties?

E. House Price Indexes

The Act requires that OFHEO use house price indexes to determine

changes in the values of properties securing mortgages owned or

guaranteed by the Enterprises and the corresponding changes in LTVs.

Changes in property values are--

determined on an annual basis by region, in accordance with the

Constant Quality Home Price Index published by the Secretary of

Commerce (or any index of similar quality, authority, and public

availability that is regularly used by the Federal Government).\27\

\27\Section 1361(d)(1) (12 U.S.C. 4611(d)(1)).

Since the second quarter of 1994, the Enterprises have published

the quarterly Conforming Mortgage House Price Index (CMHPI) for the

nine Census divisions. This represents a significant improvement over

the annual four Census region Commerce Constant Quality Index (CCQI).

The CMHPI is based on a weighted repeat sales (WRS) approach in which

multiple transactions, i.e., mortgage originations, for individual

properties are matched by street address to obtain changes in sales

prices or appraisal values. Observed property values and transactions

dates are then combined in a multivariate statistical model to estimate

an index of housing values.\28\

\28\See W. Stephens, Y. Li, V. Lekkas, J. Abraham, C. Calhoun,

and T. Kimner, ``Agency Repeat Transactions,'' revised August 1994,

forthcoming in Journal of Housing Research (available from OFHEO).

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OFHEO believes that a WRS index based on Enterprise data offers a

number of advantages for estimating the changing LTVs of the

Enterprises' mortgage assets. Perhaps foremost among these is the

direct correspondence between index data and the housing segment

serviced by the Enterprises. This factor, along with others, should

make the index more accurate for establishing the current market values

of properties securing mortgages held or guaranteed by the Enterprises.

In addition, a WRS index based on Enterprise data will allow OFHEO to

estimate changes in housing values at lower levels of geographic and

temporal aggregation, and with greater statistical precision, than the

CCQI allows. In order to meet the requirements of the Act regarding the

use of an alternative house price index, OFHEO will produce and publish

a similar house price index or indexes using data on the historical

mortgage transactions of the Enterprises.

Issues that have a bearing on the application of house price

indexes to the risk-based capital test include the appropriate level of

geographic aggregation, sample selection and appraisal bias, and the

effect of index revisions as new data becomes available.\29\

\29\Methodological issues related to the estimation of repeat

transaction house price indexes are discussed in the following

papers: M.J. Bailey, R.F. Muth, and H.O. Nourse, ``A Regression

Method of Real Estate Price Index Construction,'' Journal of the

American Statistical Association, 58:933-942, December 1963; K.E.

Case and R.J. Shiller, ``Prices of Single-Family Homes since 1970:

New Indexes for Four Cities,'' New England Economic Review, 45-56,

September/October 1987; K.E. Case and R.J. Shiller, ``The Efficiency

of the Market for Single Family Homes,'' American Economic Review,

79:125-137, 1989; J.M. Abraham, J.M. and W.S. Schauman, ``New

Evidence on Home Prices from Freddie Mac Repeat Sales,'' Journal of

the American Real Estate and Urban Economics Association, 19:333-

352, 1991; C.A. Calhoun, ``Estimating Changes in Housing Values from

Repeat Transactions,'' Federal National Association International

meetings (available from OFHEO); and C.A. Calhoun, P. Chinloy, and

I.F. Megbolugbe, ``Temporal Aggregation and House Price Index

Construction,'' Federal National Mortgage Association, forthcoming

in Journal of Housing Research (available from OFHEO); and B. Case,

H.O. Pollakowski, and S.M. Wachter, ``On Choosing Among House Price

Index Methodologies,'' Journal of the American Real Estate and Urban

Economics Association, 19(3):286-307, 1991.

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Geographical Aggregation

Aggregation across housing markets with imperfectly correlated

house price changes will result in biased estimates of the average

levels of appreciation in individual markets. This bias can be

characterized in terms of the smoothing of market-wide indexes, with a

corresponding increase in the apparent volatility of individual house

prices around the market index. Excessive disaggregation, however, may

reduce the frequency at which indexes can be meaningfully computed and

subject them to large revisions.

Question 24: What principles should OFHEO use in selecting the

optimal level of geographic aggregation for the stress test?

Bias

As discussed below, potential sources of statistical bias include

sample selection bias and appraisal bias.

Sample Selection Bias

Even within the total database of Enterprise mortgages, non-random

sampling of individual properties with repeat transactions could result

in an index that is biased for the larger population of Enterprise

properties. For example, the conforming loan limit and year-to-year

changes in the limit could result in sample selection bias in the

estimated parameters of a repeat transactions index. A closely related

form of sample selection bias can occur when the waiting time between

repeat transactions is correlated with the change in house prices. For

example, if more rapidly appreciating properties turn over within

shorter time intervals, they will appear in the repeat sample more

quickly. In this case, appreciation rates for repeat transactions near

the end of the sample period will not be representative. Thus, sample

selection bias would be greater near the end of the index.

Appraisal Bias

Approximately 85 percent of the repeat transactions used by the

Enterprises to estimate WRS house price indexes involve a refinance

transaction.\30\ Appraisals provide useful information on house values

in the absence of sales transactions. However, the use of appraisals in

real estate valuation is thought to impart bias by smoothing the

fluctuations in housing values. Appraisals are derived through

comparisons with properties that have either been sold or listed for

sale within the past several months and may fail to indicate more

recent changes in housing values.

\30\See Stephens, et al., supra.

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Question 25: Should house price indexes estimated using Enterprise

data include adjustments for identifiable sources of statistical bias?

Question 26: What additional sources of statistical bias exist and

what are possible corrective actions that may be taken to address them?

Question 27: What methods of accounting and correcting for sample

selection bias should be used?

Question 28: Should a statistical adjustment to the WRS house price

index be made to address the impact of appraisal bias?

Revision Volatility

As data on new transactions are obtained each quarter, new repeat

transactions can be combined with transactions that occurred in the

past. Thus, the quarterly index estimation process involves the

revision of the entire index in light of new information.

[[Page 7476]] Depending on the level of geographic aggregation, this

can result in substantial changes in historical values of the index and

the implied changes in the LTVs of Enterprise mortgages.

Question 29: Should changes in WRS indexes resulting from revision

volatility be reflected in indexes used in a stress test? If so, what

should be the frequency of such revisions?

F. Third Party Credit Issues

The Enterprises have credit exposure to institutions that provide

mortgage credit enhancements or that serve as counterparties to

derivative transactions. This exposure arises because the adverse

economic environment of the ten-year stress period may cause some

fraction of these institutions to fail and be unable to meet their

financial obligations to the Enterprises.

Credit Enhancements

The Enterprises reduce their exposure to mortgage credit losses

through a variety of credit enhancements that transfer some or all of

the risk to other parties. These credit enhancements include lender

recourse, mortgage insurance, and pool insurance.

The use of mortgage insurance illustrates how credit enhancements

work to mitigate credit losses and highlights some of the issues OFHEO

must address. Generally, the Enterprises may not purchase a

conventional mortgage whose LTV ratio exceeds 80 percent unless the

seller retains a participation interest or enters into a repurchase

agreement, or unless the mortgage is insured by a qualified

insurer.\31\ If insured mortgages experience actual losses, the

insurance fully or partially compensates the Enterprises for those

losses.

\31\Federal National Mortgage Association Charter Act, section

302(b)(2) and (5)(C) (12 U.S.C. 1717(b)(2) and (5)(C)), and Federal

Home Loan Mortgage Corporation Act, section 305(a)(2) and (4)(C) (12

U.S.C. 1454(a)(2) and (4)(C)).

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Applying an approach used by credit rating agencies for private

mortgage insurers, some insurers may be assumed to go out of business

during the stress period.\32\ To reflect this possibility, OFHEO's

stress test might assume the failure of some fraction of the private

mortgage insurers who would then be unable to entirely fulfill their

contractual obligations to the Enterprises.

\32\``S&P's Structured Finance Criteria,'' Standard & Poor's

(1988).

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Question 30: How should OFHEO calculate loss mitigation due to

credit enhancements?

Question 31: What should OFHEO assume about the scope of coverage

provided by credit enhancements?

Question 32: What assumptions should OFHEO make regarding the

failure of credit enhancements over the stress period?

Derivatives Counterparties

The Enterprises use non-mortgage derivatives--interest rate and

foreign exchange rate contracts--to hedge interest rate and foreign

exchange rate risk. Should a counterparty default on its obligation

under a derivative contract, an Enterprise may have to pay a new

counterparty to take on the remaining obligation.

Derivatives counterparties present some of the same issues as

credit enhancements. Generally, during an economic downturn, as one

counterparty's credit deteriorates, the other party to the transaction

may increase collateral requirements until eventually the value of

pledged collateral more than covers risk exposure. Therefore, with

prudent counterparty risk management, losses are most likely to occur

due to unexpected counterparty bankruptcies. Such losses may be more

directly related to potential financial market disturbances than to

general economic conditions.

Question 33: How, if at all, should OFHEO incorporate the effect of

counterparty defaults in the risk-based capital test?

G. Non-Mortgage Investments

The Enterprises maintain non-mortgage investment portfolios that

include Treasury securities, federal funds, time deposits, obligations

of states and municipalities, auction rate preferred stock, medium-term

notes, asset-backed securities, repurchase agreements, and other

instruments. At the end of the third quarter in 1994, these investments

totaled $11.5 billion at Freddie Mac and $35.1 billion at Fannie Mae.

On average in recent quarters, these investment portfolios have ranged

from two to five percent of assets plus MBS.

Many of these investments or their issuers are rated by the credit

rating agencies. Even though these are very short-term and liquid

investments, some of the issuers or the investments may be assumed to

default during the stress period. To reflect this possibility, OFHEO's

stress test might assume the failure of some fraction of the

investments or issuers, based on their credit rating.

Question 34: How should OFHEO simulate the default behavior of

investments or issuers of short-term, liquid investments?

Question 35: What assumptions should OFHEO make about the

performance of rated investments or issuers over the stress period?

Question 36: What assumptions should OFHEO make about gains and

losses on the sale of collateral for repurchase agreements?

II. Interest Rate Risk

Interest rate risk, associated primarily with the maintenance of a

retained portfolio, caused the most serious losses ever experienced by

the Enterprises. For a time during the early 1980's, Fannie Mae, which

was then almost exclusively a portfolio institution, was insolvent on a

mark-to-market basis.33 (Freddie Mac focused much more completely

on mortgage pass-through securities during that time period.) As did

much of the thrift industry at the time, Fannie Mae funded long-term,

low-yield, fixed-rate, single family mortgages with short-term

liabilities; rising interest rates drove up funding costs, causing

Fannie Mae to incur significant losses.

\33\The market value of Fannie Mae's liabilities (primarily

market-rate, short-term securities) exceeded the market value of its

assets (primarily below market-rate residential mortgages).

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Since then, Fannie Mae and Freddie Mac (the latter has built a

substantial retained portfolio over the past decade) have developed

funding strategies that reduce their exposure to interest rate risk. To

protect against rising rates, liabilities have been lengthened to match

more closely the maturity of mortgage assets. When falling interest

rates result in accelerated mortgage prepayments, callable debt

structures now allow the Enterprises to retire some debt early or issue

new debt to maintain more closely their desired net interest margin.

Adjusting hedging strategies for adjustable-rate mortgage investments

presents a more difficult problem.

The Enterprises have recently been building mortgage derivative

portfolios that have an interest rate risk profile more complex than

those of whole mortgages.

Interest rate risk also affects income from the Enterprises'

securitization businesses. Float income--the return on invested

mortgage principal and interest payments prior to the corresponding

payment to investors--varies with the level of interest rates at which

the Enterprises reinvest such funds. Interest rates affect prepayment

rates, and changing prepayments affect float income at each Enterprise.

A number of issues related to the interest rate risk of the

Enterprises are discussed below. [[Page 7477]]

A. Yield Curve Construction

The Act provides specific instructions concerning the ten-year CMT

yield over the ten years of the stress test, but other points on the

Treasury yield curve are important as well. The Treasury yield curve

determines, directly or indirectly, the yields on adjustable-rate

mortgages, the returns on non-mortgage investments and the costs of

borrowing. The Act calls for Treasury yields of different maturities to

be determined in a way that is ``reasonably related to historical

experience and are judged reasonable by the Director.''34

\34\Section 1361(a)(2)(D) (12 U.S.C. 4611(a)(2)(D)).

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Question 37: How should OFHEO determine the remainder of the

Treasury curve and apply the curve through the ten-year stress period?

Question 38: How should the other points on the yield curve change

during the first year when the ten-year CMT yield is rising or falling?

Question 39: How, if at all, should those yields vary after the

one-year period when the ten-year CMT yield has reached its maximum or

minimum level?

B. Mortgage Prepayments--Interest Rate Risk

The financing of a mortgage portfolio presents one of the greatest

challenges of asset/liability management. A portfolio manager can

eliminate interest rate risk only if he or she issues liabilities with

maturities, rate adjustments, and embedded options matching those of

the mortgage assets. In a declining rate environment, should mortgages

pay down more quickly than liabilities, new low-yield mortgages added

to the portfolio will likely reduce the net interest margin; in a

rising rate environment, if liabilities run off more quickly than the

mortgage assets, the net interest margin will likely fall due to higher

funding costs.

Since the Enterprises absorb the credit risk of MBS, MBS dealers

and investors principally concern themselves with interest rate risk.

The tremendous volume of MBS outstanding, and the great sensitivity of

MBS value to interest rate movements and resulting prepayment rates,

have resulted in a significant research emphasis on prepayments by Wall

Street analysts. Although most Wall Street MBS pricing models focus on

prepayments, these models are estimated based on mortgage termination

data that do not distinguish prepayments from defaults. For the purpose

of modeling interest rate risk, the distinction is irrelevant.

The section above titled ``Models of Default and Prepayment''

suggests an approach to the stress test that combines the simulation of

defaults and prepayments in a joint multivariate model, making a

termination model unnecessary. Use of a mortgage termination model for

interest rate risk analysis runs the risk of generating implausible

patterns of prepayments because, depending on the approach to default

projections, defaults in some years of the stress period might approach

or exceed total projected mortgage terminations.

Question 40: What are the relative merits of the alternative

approaches, e.g., a joint multivariate default/prepayment model versus

a mortgage termination model, to modeling mortgage prepayments in the

stress test?

C. Liabilities

The Enterprises' liabilities may take the form of bonds and notes

with simple structures; so-called ``structured notes,'' possibly

combined with interest rate swap, cap or floor contracts; and foreign

currency denominated debt coupled with foreign exchange swap contracts.

Many bonds and contracts incorporate call or cancellation options,

respectively. Enterprise funding costs are affected by management

decisions to retire debt or cancel derivative contracts prior to stated

maturities, as well as decisions about the characteristics of debt

issued and derivatives activities initiated during the stress period.

Even though the initial stress test involves a ``winddown'' of the

Enterprises' businesses, decisions with respect to bond calls and

derivatives contract cancellations must be simulated. The financing of

mortgages purchased to fulfill contractual commitments may require the

issuance of new liabilities and possibly the initiation of new

derivatives contracts. The run-off of liabilities at a faster rate than

assets may also require new issuances.

Question 41: What should be the decision rules that OFHEO applies

in the stress test related to the exercise of bond calls and

derivatives contract cancellations?

Question 42: What should be the characteristics of simulated

liabilities issued by the Enterprises during the stress period, e.g.,

maturities, option structure, and coupon structure?

Question 43: What are the implications for simulated liabilities of

the pattern of interest rate movements modeled during the initial year

of the stress period?

D. Yield Curve Volatility and Option Pricing

The Act states that the ten-year CMT yield will be held at a

constant level for the last nine years of the stress period,35 but

remains silent on the volatility of the remainder of the Treasury yield

curve. Theoretically, the historical volatility of the yield curve has

some bearing on expectations of future volatility. Expectations of

future volatility, in turn, are a determinant of the current value of a

call option on debt.

\35\Section 1361(a)(2) (B) and (C) (12 U.S.C. 4611(a)(2) (B) and

(C)).

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Question 44: How does OFHEO implement the link between the

volatility of the yield curve experienced during the stress test and

the market's expectations of future volatility?

Question 45: What assumptions should OFHEO make about the speed

with which the Enterprises adjust to changes in volatility during the

stress period?

Question 46: If the actual volatility of yields experienced during

the stress test reaches extraordinarily low levels, what assumptions

should OFHEO make to ensure reasonable pricing and use of call options

on new debt?

E. Enterprises' Costs of Borrowing

As any organization depletes its capital reserves, the

organization's cost of borrowing increases due to its higher perceived

risk. Spreads over Treasury securities might also be affected by other

aspects of the stress period, including the sharp interest rate changes

early in the period and the prolonged general economic weakness.

Question 47: What techniques should OFHEO use to project the

Enterprises' borrowing costs? How should the stress test link capital

levels and quality spreads (borrowing rates relative to Treasuries)?

Question 48: Should yields relative to Treasuries widen during the

stress period in response to general interest rate changes or credit

problems? If so, by how much should they widen?

F. Hedging Activities

Hedging activities associated with structured notes, which convert

specific securities into a preferred debt structure, are addressed

above under ``Liabilities.'' The Enterprises engage in other hedging

activities to manage interest rate risk more generally. The Act

provides that:

Losses or gains on other activities, including interest rate and

foreign exchange hedging activities, shall be determined by the

Director, on the basis of available [[Page 7478]] information, to be

consistent with the stress period.36

\36\Section 1361(a)(4) (12 U.S.C. 4611(a)(4)).

Question 49: How should OFHEO simulate gains and losses (other than

those associated with counterparty failures) on derivative activities

in the stress test?

G. Investment of Excess Cash

Under certain circumstances, simulation of the stress scenarios may

require decision rules concerning the investment of excess cash. For

example, in the stress test scenario where the ten year CMT yield

falls, mortgage prepayments will increase. The proceeds from

prepayments of mortgages in the retained portfolio may exceed the cost

of retiring associated debt. Likewise, in the rising rate stress test

scenario, mortgages will prepay more slowly than in other scenarios.

Slower prepayments may lead to the receipt of more guarantee fee income

than initially anticipated on the Enterprises sold portfolio because

the mortgages remain outstanding longer than originally anticipated.

Since the Act does not permit the simulation of new business in the

initial stress test model, any excess cash generated during the stress

test period must be assumed to either be retained as cash or reinvested

in an interest-bearing asset.

Question 50: What decision rules should govern the investment of

excess cash during the stress period?

Question 51: What rate of interest should excess cash be assumed to

earn?

Question 52: Should excess cash be assumed to earn a single rate or

a weighted average rate, representing a range of possible investment

choices?

H. Other Indexes and Yields

Values must be created for other indexes and yields, e.g., the

Federal Home Loan Bank Eleventh District Cost of Funds Index and the

London Interbank Offer Rate, over the stress period in order to

reasonably project liability costs, as well as amortization,

prepayment, and default rates on affected adjustable rate mortgages.

One reasonable approach might be for OFHEO to create equations that

project these indexes based on their relationship to points on the

Treasury yield curve and assumed market conditions consistent with the

circumstances of the stress test.

Question 53: What techniques should be used to simulate the

behavior of these indexes and yields?

III. New Business and Other Considerations

OFHEO's risk-based capital test must incorporate a number of

decision rules to reflect management actions that would significantly

affect the financial performance of the Enterprises during the stress

period. Initially, the Act requires that OFHEO's stress test

incorporate no new business for the Enterprises during the stress

period other than the fulfillment of contractual commitments to

purchase mortgages or issue securities.37 The Act specifically

states that:

\37\Section 1361(a)(3) (12 U.S.C. 4611(a)(3)).

The characteristics of resulting mortgage purchases [and]

securities issued * * * will be consistent with the contractual

terms of such commitments, recent experience, and the economic

characteristics of the stress period.38

\38\Id.

The Act also requires that characteristics of the stress period other

than those discussed above in the ``Credit Risk'' and ``Interest Rate

Risk'' sections (such as, for example, dividend policies and operating

expenses) be determined by the Director, on the basis of available

information, to be most consistent with the stress period.39

\39\Section 1361(b)(2) (12 U.S.C. 4611(b)(2)).

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A. Commitments

At this time, the only ``new business'' OFHEO can assume during the

stress period is the fulfillment of contractual commitments to purchase

mortgages or issue new securities. As a regular business practice, the

Enterprises enter into commitments to purchase mortgages for periods

that may extend from a few weeks up to a year. The commitments specify

underwriting and pricing criteria for the mortgages to be delivered. If

the Enterprise intends to securitize the mortgages listed in the

commitment, then the Enterprise will hedge the commitment at the time

it is executed by selling the mortgages forward.

Often the seller/servicer that has agreed to sell to an Enterprise

under a commitment has not yet originated the mortgages at the time the

commitment is executed. When the seller/servicer actually delivers

mortgages, their characteristics may differ from those specified in the

original commitment.

Question 54: How should OFHEO define the term ``commitments''?

Question 55: On what basis, if any, should OFHEO simulate the

fulfillment of outstanding commitments?

Question 56: What mix of product types and underwriting qualities

should be assumed?

Question 57: What delivery timing should be assumed?

Question 58: What assumptions should be made with regard to

securitization versus retention in portfolio?

B. Dividend Policies

During the stress period, net income will fall, reducing cash

available for distribution to shareholders. In such circumstances,

Enterprise management might be expected to suspend dividends or reduce

the dividend rate. However, Enterprise management may be reluctant to

take such actions, because dividend reductions send a negative signal

to investors and would be expected to depress the market price of

Enterprise shares.

Question 59: Should OFHEO assume continuation of the present

dividend policies of each Enterprise for the entire stress period?

Question 60: If OFHEO simulates a reduction in the dividend payout

rate, at what point in the scenario should it take place?

Question 61: By how much should dividends be reduced if they are

reduced?

C. Operating Expenses

The Act is silent on how operating expenses should be treated in

the stress test, but OFHEO interprets the Act to require that OFHEO

model operating expenses in a manner most consistent with the stress

period. Operating expenses lower the Enterprises' earnings or increase

their losses, and thereby reduce their capital. The major portion of

operating expenses at each of the Enterprises consists of costs related

to personnel, occupancy, and equipment. Each Enterprise is divided by

business function, such as purchase of mortgages, credit analysis, and

investment management. Each Enterprise has regional offices. The

cessation of additional business at the commencement of the stress

period (beyond the fulfillment of contractual obligations) creates

conditions that would quickly eliminate some operations and gradually

reduce others.

Question 63: How should OFHEO appropriately model operating

expenses in the stress test?

Question 64: To what extent, if any, should operating expenses be

disaggregated and treated in distinct categories?

Question 65: How, if at all, should the stress test distinguish

between the Enterprises in their management of operating expenses

during the stress period? [[Page 7479]]

Conclusion

OFHEO has identified and highlighted many of the significant issues

that must be addressed in connection with development of the stress

test and the associated risk-based capital regulation. OFHEO seeks

comment on these and any additional issues that may be identified.

The development of the stress test and the risk-based capital

regulation is one of the critical statutory responsibilities of OFHEO.

In carrying out this responsibility, OFHEO is committed to a regulatory

process that will provide the broadest possible range of opinions from

the widest array of information sources for consideration during the

regulatory process. The development of the stress test and the

implementation of the risk-based capital regulation will provide

regulatory and analytical standards and tools that will safeguard the

financial safety and soundness of the Enterprises and in turn will

ensure that the Enterprises continue to accomplish their public

missions. Given the significance of this undertaking, OFHEO encourages

all interested parties to analyze the issues raised in this ANPR and

submit comments on the specific questions. OFHEO will thoroughly

analyze and carefully consider all comments during the course of the

development of the stress test and risk-based capital regulation.

Dated: February 2, 1995.

Aida Alvarez,

Director, Office of Federal Housing, Enterprise, Oversight.

[FR Doc. 95-3076 Filed 2-7-95; 8:45 am]

BILLING CODE 4220-01-P