Office of Federal Housing Enterprise Oversight; Minimum Capital

DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

12 CFR Part 1750

RIN 2550-AA03

Office of Federal Housing Enterprise Oversight; Minimum Capital

AGENCY: Office of Federal Housing Enterprise Oversight, HUD.

ACTION: Final regulation.

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

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

issuing a final regulation that sets forth the methodology for

computing the minimum capital requirement for the Federal National

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

Corporation (Freddie Mac) (collectively, the Enterprises). The final

regulation also establishes procedures for the filing of quarterly

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

regulation establishes procedures under which OFHEO will determine the

capital classification of each Enterprise on a quarterly basis.

EFFECTIVE DATE: August 7, 1996.

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

(202/414-3800); Isabella W. Sammons, Associate General Counsel (202/

414-3800); Michael P. Scott, Assistant Director, Office of Research,

Analysis and Capital Standards (202/414-3800), 1700 G Street, N.W., 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 (1992 Act), established OFHEO as an

independent office within the Department of Housing and Urban

Development. OFHEO is responsible for ensuring that 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 minimum and

risk-based capital standards.1

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

\1\ 1992 Act, section 1313(b)(1) (12 U.S.C. 4513(b)(1)).

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

As a separate rulemaking procedure, OFHEO published an Advance

Notice of Proposed Rulemaking (ANPR) 2 as the first step toward

developing the risk-based capital regulation required by section 1361

of the 1992 Act.3 The risk-based capital regulation will specify a

stress test that will determine the amount of capital that an

Enterprise must hold to maintain positive capital throughout a 10-year

period of economic stress. That amount, plus an additional 30 percent

to cover management and operations risk, will constitute the risk-based

capital requirement of the Enterprise.

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

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

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

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

The ANPR solicited public comment on a variety of issues concerning

the development of the risk-based capital regulation. In light of the

complex issues, OFHEO decided to issue the proposed risk-based capital

regulation in two Notices of Proposed Rulemaking (NPRs).

The first NPR addresses two key components of the stress test--the

``benchmark loss experience'' (the basis for determining the extent of

Enterprise credit losses during the stress test) and the use of the

OFHEO House Price Index (HPI) in the stress test to estimate changes

over time in the values of single-family properties securing Enterprise

mortgages.4 A second NPR, currently being developed, will address

the remaining aspects of the risk-based capital stress test and how the

stress test will be used to determine the Enterprises' risk-based

capital requirements.

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

\4\ 61 FR 29592, Jun. 11, 1996.

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

In addition to the risk-based capital standard, the 1992 Act

prescribes a minimum capital standard for the Enterprises.5 This

final regulation implements the minimum capital standard of the 1992

Act. Unlike the risk-based capital requirement that is computed by

applying the stress test, the minimum capital requirement is computed

on the basis of capital ratios that are applied to certain defined on-

balance sheet assets and off-balance sheet obligations of the

Enterprises.

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

\5\ Section 1362 (12 U.S.C. 4612).

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

OFHEO issued a proposed Minimum Capital regulation on June 8,

1995.6 As discussed in the preamble to the proposed regulation,

the proposed regulation contained the interim administrative procedures

with respect to the methodology for computing the minimum capital

requirement for on- and off-balance sheet items, except for interest

rate and foreign exchange rate contracts for which the methodology was

modified. The proposed regulation also established procedures for the

filing of minimum capital reports by the Enterprises each quarter, or

at other times as required by the Director. The proposed regulation

further required OFHEO to provide each Enterprise with notice and

opportunity to comment on its proposed capital classification.

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

\6\ 60 FR 30201.

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

OFHEO received five comments in response to the proposed

regulation. Comments were received from a federal government agency

(Office of Thrift Supervision), both Enterprises, and two trade

associations (America's Community Bankers and Mortgage Bankers

Association of America). OFHEO has carefully considered the comments in

developing the final regulation. A discussion of the comments received

follows.

II. Comments on the Proposed Minimum Capital Regulation

General Comments

Freddie Mac commented generally on OFHEO's role with respect to the

[[Page 35608]]

minimum capital standard of the 1992 Act. First, Freddie Mac noted that

the 1992 Act details what the capital standard is, unlike the statutes

governing the capital standards for banks and thrifts. Therefore,

Freddie Mac concluded that the Minimum Capital regulation should

reflect Congress' intent that OFHEO act as the implementor, rather than

the creator, of the minimum capital standard.

OFHEO agrees that its role is to implement the minimum capital

standard set forth in the 1992 Act. Nevertheless, Congress specifically

authorized OFHEO to adjust the capital ratios that are applied to

certain off-balance sheet obligations, the credit risk of which differs

from that of mortgage-backed securities (MBS). Additionally, in

implementing the 1992 Act, OFHEO must define those terms not defined

therein. OFHEO believes that the final regulation effectively

implements the minimum capital standard in a manner completely

consistent with the specific provisions and overall intent of the 1992

Act.

Secondly, Freddie Mac stated that Congress recognized that the

minimum capital standard would create marginal capital requirements and

that marginal capital requirements tend to induce changes in the

Enterprises' behavior.7 Therefore, Freddie Mac explained, Congress

cautioned OFHEO against creating ``perverse incentives'' that may

induce Freddie Mac to make inappropriate changes in the conduct of its

businesses.8 Freddie Mac further noted that, in the context of

OFHEO's risk-based capital standard, ``OFHEO has expressed a policy of

designing the [risk-based] capital regulation to reflect closely the

relative risks inherent in the Enterprises' different activities,

rather than setting out to encourage or discourage particular

activities by means of a [risk-based] capital regulation that rewards

or punishes an Enterprise that engages in such activities.' Freddie Mac

urged OFHEO to apply this policy to its design of the Minimum Capital

regulation.

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

\7\ Marginal capital requirements are incremental capital

requirements for each additional dollar of business.

\8\ Freddie Mac cites S. Rep. No. 282, 102d Cong., 2d Sess. 24

(1992).

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

As recognized by Freddie Mac, congressional concern regarding the

creation of perverse incentives was expressed in the context of the

discussion of risk-based capital and the appropriate level of detail of

the stress test.9 OFHEO has stated that, where feasible, it will

endeavor to avoid the creation of perverse incentives in its risk-based

capital regulation for the Enterprises. However, this concept has

little relevance to the minimum capital standard. The minimum capital

requirement is computed on the basis of simple leverage ratios.

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

\9\ The Senate report accompanying the legislation states: ``A

more detailed [stress test] model will be more likely to create the

right incentives and less likely to create perverse incentives.'' S.

Rep. No. 282, 102d Cong., 2d Sess. 24 (1992).

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

The proposed regulation deviates from the specific statutory ratios

in only one area--by adjusting the statutory ratio of 0.45 percent for

certain off-balance sheet obligations relative to the credit risk of

MBS. The proposed regulation establishes different minimum capital

ratios for collateralized and uncollateralized exposure for interest

rate and foreign exchange rate contracts. Although OFHEO considered

using a single capital ratio applied to all interest rate and foreign

exchange rate contracts, thus treating contracts as one broad risk

category, OFHEO believes that making a distinction between

collateralized and uncollateralized exposure provides the Enterprises

with better risk management incentives.

Section 1750.1 General

Section 1750.1 of the proposed Minimum Capital regulation provides

in part that:

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.

Freddie Mac recommended that the phrase ``is sufficient to ensure

the continued financial viability of the Enterprise'' be deleted from

section 1750.1 because it appears to establish a new or additional

capital standard not provided for in the 1992 Act. Freddie Mac stated

that, in light of the comprehensive guidance in the 1992 Act as to how

to determine the levels of capital that the Enterprises are required to

hold, it would be inappropriate for OFHEO, by regulation, to amend the

minimum capital standard of the 1992 Act by adding a financial

viability standard.

OFHEO disagrees with Freddie Mac's view because OFHEO has the duty

and authority to ensure the safe and sound financial operation of the

Enterprises, and none of the capital levels specified in the 1992 Act

represent the amount needed by an Enterprise to operate safely and

soundly under all circumstances. The language in proposed section

1750.1 is consistent with OFHEO's authority under section 1313(a) of

the 1992 Act,10 which provides that the duty of the Director is to

ensure that the Enterprises are adequately capitalized and operating

safely. OFHEO's specific authority to issue the Minimum Capital

regulation is derived from section 1313(b) of the 1992 Act,11

which provides the Director with the authority to issue regulations to

carry out (a) part 1 of subtitle A of the 1992 Act (which establishes

OFHEO and sets forth OFHEO's authorities), (b) subtitle B (which sets

forth the required capital levels for the Enterprises and OFHEO's

special enforcement powers with respect to capital levels), (c)

subtitle C (which sets forth OFHEO's enforcement provisions), and (d)

``other matters relating to safety and soundness.'' As explained in

section 1302 of the 1992 Act,12 Congress finds that--

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

\10\ 12 U.S.C. 4513(a).

\11\ 12 U.S.C. 4513(b).

\12\ 12 U.S.C. 4501.

* * * an entity regulating such enterprises should have the

authority to establish capital standards, require financial

disclosure, prescribe adequate standards for books and records and

other internal controls, conduct examinations when necessary, and

enforce compliance with the standards and rules that it establishes

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

* * *.

Section 1750.1 is also consistent with the manner in which the

capitalization provisions of the 1992 Act are designed to operate. The

capitalization provisions in the 1992 Act are structured in the

following way. The 1992 Act provides for both ``mandatory'' and

``discretionary'' capital classifications.13 The 1992 Act also

sets forth certain supervisory actions that are specific to each

capital classification.14

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

\13\ Section 1364 (12 U.S.C. 4614).

\14\ Sections 1365-1367 (12 U.S.C. 4615-4617).

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

Under the discretionary capital classification criteria, the

Director may reclassify an Enterprise at a lower capital level than it

would be classified under the mandatory classification criteria. The

Director may do so if the Enterprise is engaging in conduct that could

result in a rapid depletion of core capital or the value of the

property subject to mortgages held or securitized by the Enterprise has

decreased significantly.15

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

\15\ Section 1364(b) (12 U.S.C. 4614(b)).

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

When the Enterprise is placed in a lower capital classification as

a result of either a mandatory or discretionary classification, it is

required to increase its capital pursuant to a mandatory capital

restoration plan.16 The Director's discretionary classification

authority thus could have the effect of requiring

[[Page 35609]]

an Enterprise that is engaging in certain types of risky activities to

increase the amount of capital it holds, pursuant to a mandatory

capital restoration plan, even though it meets or exceeds the minimum

capital or risk-based capital requirement.17

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

\16\ Sections 1365(a)(1) and 1369C (12 U.S.C. 4615(a)(1) and

4622).

\17\ Section 1365 (12 U.S.C. 4615).

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

The discretionary classification authority reflects the statutory

scheme that the minimum capital ratios in the 1992 Act establishes a

``floor'' on capital, not a ``ceiling.'' The legislative history of the

1992 Act indicates that there was some confusion regarding this issue

that was resolved in favor of the ``floor'' approach. For example,

during Senate consideration of the bill, Senator Metzenbaum stated to

the Chairman of the Committee:

[You] said on this floor that the Director [of OFHEO] did indeed

have the authority to set the required ratios above the minimum

levels * * * if necessary to protect the health and security of an

enterprise and that it is important that the Director act in those

circumstances. Since that time, I have learned that some Senators

may have a different view about the Director's authority. I would

like to be assured by the chairman of the committee and the manager

of this bill that the director has authority to raise capital

standards, if necessary.

Senator Riegle, in replying, explained that:

[T]he Director is given the duty to ensure that the enterprises

are adequately capitalized and operating safely in accordance with

this act and the Charter Acts. Under section 103(a)(1) of the bill,

the Director is authorized to issue regulations concerning the

financial health and security of the enterprises, including the

establishment of capital standards. There is no way the Director can

discharge these responsibilities unless he or she has the authority

to prescribe capital standards to be met by the enterprises.

* * * * *

Unless the legislation specifically and affirmatively prohibits

the Director from establishing required capital ratios, it must be

assumed that the Director has that authority in order to discharge

his or her duties assigned under section 102 * * *. The only

constraint on the Director's authority is that the required capital

ratios cannot be set below the minimum levels contained in section

202.

* * * * *

If the Director believed that the minimum statutory ratios * * *

should be raised, he or she would obviously have to seek a change in

the law. A Director might believe an increase in the statutory

minimum ratios * * * to be necessary if he or she concluded that

they were clearly inadequate under all foreseeable circumstances. If

the Congress were to so raise the statutory minimum ratios * * * it

would establish a new and higher floor applicable to the Director's

discretionary authority to prescribe capital ratios. However, there

is nothing in the legislation that would preclude the Director from

setting the required rated * * * without further legislation. If the

circumstances that gave rise to the need for higher ratios changed,

the Director could then reduce the required capital ratios, but not

lower than the minimum ratios * * *.18

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

\18\ 138 Cong. Rec. S9353-54 (July 1, 1992). This colloquy was

with respect to section 202, Minimum Capital Levels, of S. 2733.

Although the 1992 Act was a compromise between S. 2733 and H.R.

2900, section 202 of S. 2733 is substantially similar to section

1362 of the 1992 Act. Therefore, the colloquy with respect to

section 202, cited above, is relevant to the discussion of section

1362 of the 1992 Act.

In the House of Representatives, the issue of whether the minimum

capital ratios constituted a floor or a ceiling was raised during the

consideration of the conference report. In a discussion between the

Chairman and Ranking Member of the Committee, the two members agreed

that the duty of the Director to ensure that the Enterprises are

adequately capitalized and operating safely in accordance with the 1992

Act authorizes the Director to require a higher ratio than the minimum

ratio specified in the statute.19

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

\19\ 138 Cong. Rec. H11,102 (Oct. 3, 1992) (discussion by Mr.

Gonzalez, Mr. Frank, and Mr. Leach). In response to Mr. Gonzalez'

explanation, Mr. Leach stated that ``I fully share with you the

interpretation that would imply that the Director could go above the

2.5-percent requirement that is currently in statute [sic] * * *.''

Id.

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

Freddie Mac further questioned why the board of directors of each

Enterprise is held responsible for maintaining capital at a level that

is sufficient to ensure the continued viability of the Enterprise.

Freddie Mac stated that the board of directors has a fiduciary duty to

protect the interests of the Enterprise's shareholders, and that

maintaining an adequate level of capital under varying circumstances

would be one aspect of the overall set of responsibilities represented

within that duty. Furthermore, Freddie Mac stated that the fiduciary

duties of corporate directors are derived principally from state common

law, so the adoption of a viability standard and corresponding

responsibility could interfere with the subtleties and complexities of

that law.

OFHEO believes that to the extent there is any conflict between

state law and the 1992 Act, the conflict would be resolved in favor of

the 1992 Act and implementing regulations. The Enterprises are

federally-chartered entities subject to federal statutory and

regulatory requirements. The 1992 Act imposes capital requirements on

the Enterprises and makes clear that the board of directors of each

Enterprise is responsible for the financial safety and soundness of the

Enterprise. Specifically, the Director is authorized to take

enforcement actions, e.g., cease and desist orders and civil money

penalties, against directors of an Enterprise for actions that deplete

the core capital of the Enterprise, cause a loss to the Enterprise, or

violate an order or regulation of OFHEO.20 In exercising its

enforcement powers, OFHEO will be cognizant of all of the relevant

federal and, if applicable, state requirements. However, to the extent

there are any applicable state law requirements relating to the

fiduciary responsibilities of the directors, they would not override

the obligations created by the 1992 Act or the Minimum Capital

regulation.

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

\20\ See sections 1371, 1372, and 1376 (12 U.S.C. 4631, 4632,

and 4636).

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

Freddie Mac also recommended that the phrase ``in excess of the

minimum capital level'' be replaced by ``is equal to or exceeds the

minimum capital level'' in order to reflect accurately the minimum

capital standard set forth in the 1992 Act. OFHEO agrees and has

revised section 1750.1 accordingly. OFHEO has also substituted, where

appropriate, the word ``requirement'' for ``level'' to ensure

consistency of terms throughout the Minimum Capital regulation.

Section 1750.1 of the proposed regulation also contains a sentence

that reads: ``The regulation contained in this Subpart A establishes

the minimum capital requirements for each Enterprise.'' Freddie Mac

recommended an editorial change that would clarify that the regulation

sets forth the ``methodology'' for computing the minimum capital

requirement for each Enterprise. OFHEO agrees with the need for this

change and the final regulation has been revised accordingly.

Section 1750.2 Definitions

Proposed Section 1750.2 defines various terms used in the Minimum

Capital regulation. OFHEO received comments on the definitions of the

following terms: commitment, core capital, foreign exchange rate

contract, interest rate contract, multifamily credit enhancement, off-

balance sheet obligation, other off-balance sheet obligations, and

qualifying collateral. The comments are discussed below.

Commitment

Freddie Mac recommended that, for the purpose of the minimum

capital requirement computation, the term ``commitment'' should be

defined as a legally binding agreement that obligates an Enterprise to

purchase mortgages that

[[Page 35610]]

specify all the terms of the transaction, including price, volume, and

fees.

Freddie Mac referenced its comments to OFHEO's ANPR on risk-based

capital.21 In those comments, Freddie Mac stated that, as a matter

of general contract law, an agreement is legally binding only if all of

its key terms are included and agreed upon. Therefore, any definition

of a contractual commitment should include a requirement that it be a

binding contractual obligation of the Enterprise to purchase mortgages

and specify price, volume, and fees.

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

\21\ ``Comments of the Federal Home Loan Mortgage Corporation on

the Advance Notice of Proposed Rulemaking on Risk-Based Capital of

the Office of Federal Housing Enterprise Oversight,'' 139-146 (May

9, 1995) (available at OFHEO).

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

OFHEO agrees that for purposes of the Minimum Capital regulation

the term ``commitment'' should mean any legally binding agreement that

obligates an Enterprise to purchase or securitize mortgages, and has

defined the term as such. However, OFHEO does not believe it necessary

or appropriate to restrict the definition of the term ``commitment'' by

reference to price, volume, and fees because agreements may be legally

binding even when there is a lack of specificity on all terms.22

It would not be possible for OFHEO to reflect the complexities of this

area of contract law in a regulatory definition. Moreover, to do so

would be inadvisable in light of Congress' specific concerns regarding

the need for capital to support commitments and other off-balance sheet

obligations.

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

\22\ See Restatement (Second) of Contracts section 204 (1981).

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

For example, in discussing the need for the capital requirements of

the 1992 Act, Congress expressed the concern that off-balance sheet

obligations had not been previously captured under prior capital

standards:

The capital provisions of the GSEs' charter Acts limit their

debt to 15 times their capital unless HUD sets a higher ratio * * *

This is unsatisfactory because no capital need be held against the

GSEs' $750 billion of off balance sheet guarantees * * *. 23

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

\23\ S. Rep. No. 282, 102d Cong., 2d Sess. 11 (1992).

Recognizing this concern, it would be inappropriate for OFHEO to

promulgate a narrow definition that could exempt certain legally

binding commitments from the minimum capital calculation.

OFHEO has made editorial revisions to the definition of the term

``commitment'' by substituting the word ``agreement'' for

``arrangement'' and by deleting the phrase ``for portfolio.''

Core Capital

In drafting the definition of core capital in the proposed

regulation, OFHEO made minor changes to the statutory language that

were intended to improve the clarity of the provision. Freddie Mac

commented that since Congress expressly defined core capital in section

1303(4) of the 1992 Act,24 the regulation should use the same

statutory language to avoid confusion. In light of the comment

received, OFHEO wants to ensure that the regulation does not create any

confusion and has revised the definition of core capital in the final

regulation to mirror the statutory definition.

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

\24\ 12 U.S.C. 4502(4).

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

Foreign Exchange Rate Contracts and Interest Rate Contracts

OFHEO received a comment from Freddie Mac on the definitions of the

terms ``foreign exchange rate contracts'' and ``interest rate

contracts.'' Freddie Mac stated that the definitions of these terms as

they appear in section 1750.2 and Appendix A of the proposed regulation

are not identical. To avoid any implication that the differences are

intentional, Freddie Mac recommended that OFHEO define the terms only

in one location, or that OFHEO conform the language of the two sets of

definitions.

The different ways these terms are used in the regulation and

Appendix A make it is necessary to include a definition in the main

body of the regulation as well as a separate discussion in Appendix A.

However, in light of the comment, OFHEO has made editorial changes to

conform the definitions of the terms ``foreign exchange rate

contracts'' and ``interest rate contracts'' in section 1750.2 to the

discussion of such terms in Appendix A.

Multifamily Credit Enhancement

Section 1750.2 of the proposed regulation defines the term

multifamily credit enhancement to mean ``a guarantee by an Enterprise

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

state or local housing finance agency.''

Fannie Mae recommended that OFHEO revise the definition to describe

more fully the routine types of transactions in which an Enterprise

engages ``to support multifamily bond issues.'' Fannie Mae stated that

it normally provides credit enhancement through a collateral pledge,

purchase agreement, or other contractual obligation by which the

mortgage loan risk is borne by the Enterprise during a period in which

the bonds are credit enhanced by a letter of credit or surety

obligation of another party.

Fannie Mae also commented that under many state laws, other state

and local governmental units or instrumentalities may issue mortgage

revenue bonds, not only state and local housing finance agencies.

Therefore, Fannie Mae recommended that the definition should be

expanded to include any state and local governmental issuers authorized

to issue such revenue bonds secured by mortgages.

OFHEO agrees with the comment and has revised the definition of the

term ``multifamily credit enhancement'' to describe more fully the

routine types of transactions in which an Enterprise engages to support

multifamily bond issues.

Off-balance Sheet Obligation and Other Off-Balance Sheet Obligations

OFHEO received comments from Freddie Mac on the definitions of the

terms ``off-balance sheet obligation'' and ``other off-balance sheet

obligations.'' The term ``off-balance sheet obligation'' is defined in

proposed section 1750.2 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 that is not included on its

balance sheet.

The term ``other off-balance sheet obligations'' is defined in proposed

section 1750.2 to mean--

* * * all off-balance sheet obligations of an Enterprise that are

not mortgage-backed securities or substantially equivalent

instruments.

Freddie Mac noted that section 1362(a)(3) of the 1992 Act 25

requires the Enterprises to hold 0.45 percent core capital against

other off-balance sheet obligations (excluding commitments in excess of

50 percent of the average dollar amount of commitments outstanding each

quarter over the preceding four quarters), except as the Director

adjusts the 0.45 percent ratio to reflect differences between the

credit risk of such obligations and MBS. Freddie Mac stated that an

obligation of an Enterprise does not subject the Enterprise directly to

credit risk: ``it is the party holding the obligation that bears the

credit risk of an Enterprise obligation.'' However, while the

obligations of an Enterprise create no

[[Page 35611]]

direct credit risk for the Enterprise, certain obligations, such as MBS

or commitments to purchase mortgages, involve identifiable credit risk

that is related in one way or another to those obligations (the risk of

the default on the associated mortgages). Freddie Mac believes that

this related credit risk is what Congress intended to capture when it

enacted the minimum capital requirement applicable to other off-balance

sheet obligations. Therefore, Freddie Mac believes that a definition of

``other off-balance sheet obligations'' will not capture the related

credit risk that is apparently the focus of the 1992 Act.

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

\25\ 12 U.S.C. 4612(a)(3).

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

To resolve this concern, Freddie Mac recommended that OFHEO delete

the definition of the term ``off-balance sheet obligation'' and take a

targeted approach in the definition of the term ``other off-balance

sheet obligations'' by identifying only those items that OFHEO intends

to include within the scope of the term, i.e., commitments, multifamily

credit enhancements, sold portfolio remittances pending, and interest

rate and foreign exchange rate contracts. Freddie Mac believes that

because OFHEO has considered no other items to be other off-balance

sheet obligations, such a definition would fully implement section

1362(a)(3) of the 1992 Act.26 Freddie Mac stated that, to the

extent that the Director determines in the future that other items

should be considered to be other off-balance sheet obligations, the

Director should address such items in a future rulemaking proceeding to

amend the Minimum Capital regulation. In connection with this

recommendation, Freddie Mac also recommended that section 1750.4(a)(7)

be deleted. That section provides for other off-balance sheet

obligations to be included in the computation of the minimum capital

requirement.

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

\26\ Id.

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

After considering Freddie Mac's comments, OFHEO has determined not

to adopt the recommendations with respect to the definition of the

terms ``off-balance sheet obligation'' and ``other off-balance sheet

obligations.'' The capital provisions of the 1992 Act require the

Enterprises to hold sufficient capital to ensure against risks of both

on- and off-balance sheet items. For off-balance sheet obligations, the

1992 Act specifies the ratio of 0.45 percent of the unpaid principal

balance of MBS and substantially equivalent instruments issued or

guaranteed by the Enterprise. The Act also specifies a ratio of 0.45

percent of other off-balance sheet obligations (excluding commitments

in excess of 50 percent of the average dollar amount of the commitments

outstanding each quarter over the preceding four quarters), except that

the Director must adjust the 0.45 percent ratio to reflect differences

between the credit risk of such obligations and MBS.

OFHEO believes that it is appropriate to provide for a definition

of other off-balance sheet obligations, which ensures that capital will

be held against all off-balance sheet obligations whether or not they

are now used by the Enterprises or at any time in the future. The 1992

Act requires that OFHEO apply a ratio of 0.45 percent to other off-

balance sheet obligations until OFHEO determines whether an adjustment

is necessary. OFHEO has determined the appropriate ratios for

commitments, multifamily credit enhancements, sold portfolio

remittances pending, interest rate contracts, and foreign exchange rate

contracts. When an Enterprise begins to use a new type of obligation,

OFHEO will apply the statutory ratio of 0.45 percent. OFHEO will then

analyze the obligation to determine whether an adjustment to the 0.45

percent ratio is necessary, and will amend the Minimum Capital

regulation, as appropriate.

Freddie Mac believes that the proposed definitions could create

confusion because they appear to conflict with how the term

``obligation'' is used elsewhere in the 1992 Act and in the

Enterprises' Charter Acts. The proposed regulation defines the term

``off-balance sheet obligation'' as a binding agreement or contract

that requires another party to make future payments in money or in kind

to an Enterprise (or guarantees of such payments to a third party). In

contrast, Freddie Mac stated that the term ``obligation'' used

elsewhere in the 1992 Act and the Enterprises' Charter Acts applies

only to future payments from an Enterprise to a third party--and not to

future payments from another party to the Enterprise (or guarantees of

such payments to a third party).

Freddie Mac also stated that the proposed definition of the term

``other off-balance sheet obligations'' could create confusion as to

whether resecuritizations of MBS, such as real estate mortgage

investment conduits and other multi-class MBS, are included in that

definition. Freddie Mac believes that it was the intent of Congress

that such resecuritizations should not be included and that OFHEO's

interim procedures do not include resecuritizations. Also, Freddie Mac

believes that the definition of the term ``other off-balance sheet

obligations'' is too narrow because commitments, which Congress

expressly considered to be other off-balance sheet obligations, would

not fall within the proposed definition of that term.

OFHEO believes that because the term ``obligation'' may be used

differently in the 1992 Act and the Enterprises' Charter Acts, it more

important to include a definition of the terms ``off-balance sheet

obligation'' and ``other off-balance sheet obligations'' for purposes

of the computation of the minimum capital requirement. However, to

eliminate any confusion regarding the treatment of commitments, the

definition of the term ``off-balance sheet obligation'' has been

revised to include an express reference to commitments. Also, the

definition of the term ``other off-balance sheet obligations'' has been

revised to clarify that resecuritizations of MBS are not included in

the definition.

Qualifying Collateral

Freddie Mac noted that the definition of the term ``qualifying

collateral'' in section 1750.2 differs from the discussion of what

constitutes qualifying collateral in paragraph 5 of Appendix A.

Consistent with this comment, OFHEO has made conforming editorial

changes to both the definition in section 1750.2 and the discussion in

Appendix A.

OFHEO has also revised the footnote in connection with the

definition of the term ``qualifying collateral'' by defining the term

``OECD-based group of counties'' to conform with the Joint Final Rule

published by the Federal Reserve System, the Office of the Comptroller

of the Currency, and the Federal Deposit Insurance Corporation.27

This final rule was promulgated after the publication of the proposed

Minimum Capital regulation.

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

\27\ 60 FR 66042, Dec. 20, 1995.

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

Section 1750.4 Minimum Capital Requirement Computation

Section 1750.4(a) of the proposed regulation provides that the

minimum capital requirement for each Enterprise is the sum of the

following amounts--

--2.50 percent times the aggregate on-balance sheet assets of the

Enterprise;

--0.45 percent times the unpaid principal balance of mortgage-backed

securities and substantially equivalent instruments that were issued or

guaranteed by the Enterprise;

--0.45 percent of 50 percent of the average dollar amount of

commitments outstanding each quarter over the preceding four quarters;

[[Page 35612]]

--0.45 percent of the outstanding principal amount of bonds with

multifamily credit enhancements;

--0.45 percent of the dollar amount of sold portfolio remittances

pending;

--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;

--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; and

--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 and foreign

exchange rate contracts, except as adjusted by the Director to reflect

differences in the credit risk of such obligations in relation to MBS.

Section 1750.4(b) provides that any asset or financial obligation

that can be properly classified in more than one of the enumerated

categories shall be classified in the category that yields the highest

minimum capital amount.

OFHEO received comments with respect to section 1750.4, as

explained below.

Section 1750.4(a)(6) Ratios With Respect to Interest Rate and Foreign

Exchange Rate Contracts

Notice of Adjustment

Freddie Mac asserted that OFHEO has not provided adequate notice to

the Enterprises of the basis, in quantifiable terms, for the proposed

upward adjustment it makes to the 0.45 percent ratio with respect to

interest rate and foreign exchange rate contracts.

OFHEO believes that it provided adequate notice of the basis of the

proposed adjustment in the preamble of the proposed Minimum Capital

regulation. The preamble explained how OFHEO analyzed the relative

credit risk of interest rate and foreign exchange rate contracts as

compared with the credit risk of MBS. However, in light of this

comment, OFHEO believes it appropriate to summarize its reasons for

adjusting the 0.45 percent ratio.

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

defaults and losses on the mortgages underlying the MBS. The aggregate

credit risk associated with the underlying mortgages is low because the

Enterprises require very broad geographic diversification; strict and

consistent mortgage underwriting standards; minimum initial

collateralization of 125 percent (i.e., maximum 80 percent loan-to-

value ratio) or supplemental mortgage insurance; and increasing levels

of collateralization as loans amortize and property values increase.

Moreover, the credit risk of MBS is offset by the continuing source of

income provided by guarantee fees.

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.

The source of credit risk of interest rate and foreign exchange

rate contracts is the risk of counterparty default. The credit risk of

interest rate and foreign exchange rate contracts is greater than that

of MBS, even though the Enterprises attempt to limit the credit risk of

the contracts by restricting their business to high quality

counterparties and adjusting collateral requirements on the basis of

the counterparty credit quality and the current replacement cost of the

contracts. The credit risk associated with interest rate and foreign

exchange rate contracts is a result of the following characteristics:

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, the high level of

interdependence of the world's major financial institutions, many of

which are important interest rate and foreign exchange rate contract

counterparties, could cause disproportionately high losses when they do

occur. This phenomenon is often referred to as ``systemic risk.''

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.

Interest rate and foreign exchange rate contract exposures

are not as fully collateralized as are the mortgages underlying the

Enterprises' MBS.

The interest rate and foreign exchange rate contracts

markets are comparatively new; therefore, the functioning of these

markets is less predictable in terms of operational and legal risk.

There is no current stream of fee income to offset losses

on interest rate and foreign exchange rate contracts associated with

counterparty failures.

OFHEO recognizes that, although the credit risk characteristics of

interest rate and foreign exchange rate contracts can be identified,

they are difficult to quantify. However, the 1992 Act does not require

such quantification. Rather, it requires a reasonable analysis, based

on available information, of the credit risk of interest rate and

foreign exchange rate contracts relative to that of MBS.

The fact that the Enterprises have not experienced a net credit

loss on their MBS does not mean that there are no risks associated with

these instruments. Similarly, the fact that the Enterprises have not

experienced losses associated with interest rate and foreign exchange

rate contracts does not mean that there are no risks associated with

these contracts. In these circumstances, it is appropriate for OFHEO to

analyze the relative risks of these instruments by comparing their

respective credit risk characteristics. Based on an analysis of these

relative credit risk characteristics, OFHEO adjusted the 0.45 percent

ratio applicable to MBS upward to reflect the greater risk of interest

rate and foreign exchange rate contracts. As OFHEO and the Enterprises

accumulate data on the risk of, and gain experience with the

application of the ratios for, interest rate and foreign exchange rate

contracts, OFHEO may make adjustments to the ratios, as appropriate.

Freddie Mac also commented on the upward adjustment of ratios for

interest rate and foreign exchange rate contracts in light of OFHEO's

statement in the Annual Report to Congress that the credit risk of the

Enterprises' derivatives (interest rate and foreign exchange rate)

contracts ``is very small relative to the credit risk the Enterprises

face with regard to mortgages they hold or guarantee.'' 28 This

statement was in the context of the notional values of the contracts.

As the Annual Report to Congress notes two sentences later, the

replacement cost (current credit exposure) of the contracts is

relatively small. In other words, the replacement cost, which together

with an amount for potential future credit exposure constitutes the

credit equivalent amount, is very small in comparison with the notional

amount. We note that the credit equivalent amount represents the

overall credit risk of interest rate and foreign exchange rate

contracts.

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

\28\ OFHEO, Annual Report to Congress, 9 (June 15, 1995).

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

Lowering the Proposed Ratios

Fannie Mae recommended lowering the proposed ratios from 3.0

percent of

[[Page 35613]]

the credit equivalent amount of uncollateralized interest rate and

foreign exchange rate contracts and 1.5 percent of the credit

equivalent amount of collateralized contracts to 2.0 percent and 0.5

percent respectively. Fannie Mae believes that the proposed ratios are

unreasonably high in relation to the historical loss experience for

similar obligations.

Fannie Mae stated that the factors that determine an adequate

amount of required capital for interest rate and foreign exchange rate

contracts include the probability of default and the severity of

possible loss. To determine the probability of default of

collateralized interest rate and foreign exchange rate contracts,

Fannie Mae analyzed historical default statistics from Moody's

Investors Service over the past 25 years for unsecured, 5- to 9-year

term senior debt of corporations with debt ratings from Aaa to Baa.

Fannie Mae stated that it uses historical data for unsecured senior

debt because data on interest rate and foreign exchange rate contracts

is limited due to the relative newness of the market in such contracts.

Fannie Mae believes that their default rates are functionally

equivalent because interest rate and foreign exchange rate contracts

and unsecured senior debt represent general corporate obligations.

Fannie Mae stated that the average rating of its interest rate and

foreign exchange rate counterparties is Aa or A. Using the Moody's

Investors Service historical data, the default rates for unsecured

senior debt in those categories ranges from 0.3 percent to 1.5 percent.

Thus, Fannie Mae suggested that an appropriate estimate of default

incidence for its interest rate and foreign exchange rate contracts is

between 0.3 and 1.5 percent.

Fannie Mae then stated that the historical data demonstrates that

the average loss severity from 1974 through 1994 is 51.1 percent for

all corporate unsecured senior debt, and 28.4 percent for Baa or better

corporate unsecured senior debt. Multiplying the default incidence by

the loss severity yields a ``capital ratio.'' Thus, according to Fannie

Mae, a default incidence in the range of 0.3 to 1.5 percent and a

severity level in the range of 28.4 to 51.1 percent produces a

``capital ratio'' for uncollateralized interest rate and foreign

exchange rate contracts in the range of 0.1 to 0.75 percent. The ratio

that Fannie Mae recommended--2.0 percent for uncollateralized interest

rate and foreign exchange rate contracts--is 2\2/3\ times its estimated

``worst case'' ratio of 0.75 percent. Consequently, Fannie Mae believes

the recommended ratio to be an adequate and suitable minimum capital

ratio for uncollateralized interest rate and foreign exchange rate

contracts.

Fannie Mae further believes that the use of collateral

significantly reduces the severity of loss associated with interest

rate and foreign exchange rate contracts. Fannie Mae asserted that 10

percent is a reasonable estimate of expected loss severity for

collateralized interest rate and foreign exchange rate contracts,

because Fannie Mae evaluates the market value of collateral and

exposures at least monthly, Fannie Mae requires over-collateralization

if credit quality deteriorates below a specific level, and the loss

severity of uncollateralized exposures is best represented by the 28.4

percent historical loss severity experience for unsecured senior debt.

By multiplying the 10 percent loss severity by the 0.3 to 1.5 percent

historical average default rates, Fannie Mae estimated a ``capital

ratio range'' of 0.03 percent to 0.15 percent. Thus, Fannie Mae's

recommendation of a 0.5 percent ratio for collateralized interest rate

and foreign exchange rate contracts is 3\1/3\ times its estimated

``worst case.''

After carefully considering Fannie Mae's arguments, OFHEO has

decided not to reduce the proposed ratio for interest rate and foreign

exchange rate contracts. Fannie Mae's analysis assumes that the default

rate for interest rate and foreign exchange rate contracts will conform

with the historical default rates for corporate unsecured senior debt.

As Fannie Mae noted, interest rate and foreign exchange rate contracts

are relatively new instruments and historical default rates are

lacking. Therefore, OFHEO cannot assume that the default rates of

unsecured senior debt and interest rate and foreign exchange rate

contracts will prove to be comparable.

Even assuming the default rates would be comparable, Fannie Mae's

proposal does not provide an adequate capital cushion. Fannie Mae

derives what it calls ``capital ratios'' based on more than twenty

years' experience of a national sample of corporate credits. These

``capital ratios'' are in fact average national loss rates for a period

not marked by extreme economic stress. For minimum capital purposes,

Fannie Mae proposes to apply rates to both uncollateralized and

collateralized counterparty exposure that are roughly three times as

high as these capital ratios. The 1992 Act requires that any adjustment

to the 0.45 percent ratio reflect the credit risk relative to MBS.

Fannie Mae's proposed multiples are not consistent with this

requirement. As the above discussion notes, neither Enterprise has

experienced any net credit loss on its MBS. However, ignoring guarantee

fee income, annual losses to date have ranged from two basis points to

ten basis points. Thus the 0.45 percent statutory capital ratio for MBS

ranges from 4.5 to 22.5 times the historical loss experience for MBS--

higher than the 2\2/3\ and 3\1/3\ times the estimated ``worst case''

loss proposed by Fannie Mae.

Fannie Mae's analysis also ignores a number of factors which

increase the potential loss associated with the credit exposure of

interest rate and foreign exchange rate contracts that are not present

with MBS. The credit exposures of interest rate and foreign exchange

rate contracts are highly concentrated, large swings of interest rates

may simultaneously increase both the credit exposure and the default

risk, and systemic problems could cause disproportionately high losses

when they do occur.

Furthermore, Fannie Mae predicates its proposal on its current risk

management practices, with respect to counterparty creditworthiness and

collateral requirements and their enforcement. OFHEO believes that a

minimum capital requirement establishes an essential amount of capital

that an Enterprise with given levels of business must hold to address

broad categories of risk, not specific exposures. Accordingly, it

should not attempt to reflect the quality of current risk management

practices. For example, Fannie Mae's analysis assumes that it will

continue to manage credit risk by doing business with counterparties

with Aa and A ratings and that such counterparties are not subject to

sudden declines in ratings. Fannie Mae also assumes that, if ratings

decline, it will require and be able to obtain more collateral.

Even if these assumptions were valid, OFHEO believes that they

cannot be the basis of a minimum capital requirement. The minimum

capital requirement is not intended to be a risk-based capital

requirement. The 1992 Act separately provides for a risk-based capital

requirement in which credit, interest, and operational and management

risk are calculated using a stress test. The 1992 Act requires that the

0.45 percent ratio for other off-balance sheet obligations be adjusted

to reflect differences in the credit risk of the obligation and MBS.

OFHEO believes that the adjustment should be for differences in risk

associated with the inherent risk characteristics of different

instruments, not the risk characteristics of counterparties to these

obligations or

[[Page 35614]]

current risk management practices for these obligations.

Right to Raise the Ratio

America's Community Bankers recommended that OFHEO explicitly

reserve the right to raise the ratio for uncollateralized interest rate

and foreign exchange rate contracts to 4.0 percent depending on the

specific counterparty risks involved. As discussed above, OFHEO

believes that counterparty credit ratings are not the appropriate focus

of minimum capital ratios and that it has required an adequate amount

of capital for uncollateralized interest rate and foreign exchange rate

contracts. If OFHEO's experience with the application of the ratio for

interest rate and foreign exchange rate contracts proves otherwise,

OFHEO will raise the ratio. In addition, as discussed in connection

with the comments on section 1750.1, if the business practices of an

Enterprise were to endanger the capital adequacy of the Enterprise,

OFHEO would take any actions necessary to ensure the financial safety

and soundness of the Enterprise's operations.

Avoid Changing the Capital Calculation

Mortgage Bankers Association of America (MBA) stated that the

proposed change from the interim guidelines in the calculation of the

capital ratio for interest rate and foreign exchange rate contracts

does not appear to be so significant as to cause the Enterprises to

increase current guarantee fees, which would ultimately harm consumers

in the form of higher interest rates or fees. MBA understands that the

Enterprises currently have sufficient capital to meet the higher

capital ratios that would result from the proposal. Nevertheless, MBA

urged OFHEO to remain cautious and avoid changing the capital

calculation of interest rate and foreign exchange rate contracts if the

calculation influences the Enterprises' selection of funding and

hedging instruments in a way that affects their ability to manage

risks, is detrimental to their housing mission, or increases the cost

of credit to consumers.

MBA recognizes that OFHEO does not wish to jeopardize the

Enterprises' ability to meet their housing mission and goals, but must

ensure the safety and soundness of the Enterprises. MBA believes that

OFHEO should strive to strike a balance and avoid imposing inefficient

capital requirements that inhibit the management of risk.

OFHEO agrees that the capital requirements should ensure the safety

and soundness of the Enterprises while not jeopardizing the

Enterprises' ability to meet their housing mission and goals.

Consistent with that approach, OFHEO does not believe that the change

in the calculation of the capital ratio for interest rate and foreign

exchange rate contracts will adversely affect the Enterprises' ability

to manage risk or increase the cost of mortgage credit to consumers.

Furthermore, mindful of the need to strike a balance among competing

interests, OFHEO believes that it is in the best long-term interests of

consumers and the Enterprises that the Enterprises have an adequate

cushion of minimum capital to ensure against loss. While a decrease in

capital requirements could result in a reduction in mortgage credit

costs for consumers in the short-term, the decrease would not be

beneficial in the long-term if it jeopardized the financial viability

of the Enterprises.

This view is consistent with the congressional findings set forth

in the 1992 Act that recognize the Enterprises' important housing

mission and the need to provide long-term safeguards in the form of

capital requirements to reduce the risk of failure.\29\ The

congressional findings also recognize the Enterprises' obligation to

facilitate the financing of affordable housing while maintaining a

strong financial condition and a reasonable economic return.\30\

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

\29\ See section 1302 (12 U.S.C. 4501).

\30\ Section 1302(7) (12 U.S.C. 4501(7)).

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

``Pro Rata'' Capital Charge

The Office of Thrift Supervision asked whether the proposed

regulation would provide a reduced ``pro rata'' capital charge for

partially collateralized interest rate and foreign exchange rate

contracts. In response to this comment, OFHEO notes that section

1750.4(a)(6) provides a ratio of 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;

and 1.50 percent of the market value of qualifying collateral posted to

secure interest rate and foreign exchange rate contracts, not to exceed

the credit equivalent amount of such contracts. Thus, an interest rate

or foreign exchange rate contract partially collateralized with

qualifying collateral will have a reduced capital charge to the extent

of the qualifying collateral.

Enterprises' Right to Require Collateral

Fannie Mae and Freddie Mac both stated that the market widely

perceives an agreement with a Aaa rated counterparty that agrees to

post collateral if it is downgraded to be as safe as, or safer than, a

comparable agreement with a lesser-rated counterparty that posts

collateral. They claimed that the proposed regulation would run counter

to well-established market practices by rewarding an Enterprise with a

lower capital requirement if its Aaa rated counterparties are

downgraded and post collateral under their collateral agreements, or if

the Enterprise avoids Aaa rated counterparties in favor of lesser-rated

counterparties.

Freddie Mac recommended the following standard: The same minimum

capital ratio would apply for collateralized agreements and for

uncollateralized agreements where the counterparty holds the highest

credit rating of any entity effectively recognized by the Division of

Market Regulation of the Securities and Exchange Commission as a

nationally recognized statistical rating organization for the purposes

of capital rules for broker-dealers, and has entered into a binding

agreement to post qualifying collateral if and when the counterparty no

longer holds the highest rating of such an entity. As an alternative,

Freddie Mac recommended treating the contract as fully collateralized

for purposes of computing the minimum capital requirement where a Aaa

rated counterparty has agreed to post collateral when it is downgraded.

OFHEO has considered Fannie Mae's and Freddie Mac's

recommendations, but has decided not to adopt them. The Enterprises'

recommendations rely heavily on the credit ratings of counterparties

and current Enterprise practice. In fact, Freddie Mac has noted

elsewhere that credit enhancements in which the counterparty is

required to post collateral only when its credit rating or capital

begins to deteriorate ``present some management-and-operations risk

because the arrangements need to be monitored and the collateral needs

to be posted in a timely fashion.'' \31\

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

\31\ ``Comments of the Federal Home Loan Mortgage Corporation on

the Advance Notice of Proposed Rulemaking on Risk-Based Capital of

the Office of Federal Housing Enterprise Oversight,'' 72 (May 9,

1995)(available at OFHEO).

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

OFHEO believes that reliance on the credit ratings of

counterparties and current Enterprise practice should not be the basis

for establishing minimum capital ratios. Even though the 1992 Act

requires that credit risk be taken into account when adjusting the

ratio for certain off-balance sheet obligations, the minimum capital

requirement essentially is computed on the basis of simple leverage

ratios. Categories of obligations that are assigned a specific ratio

include obligations with a mixture

[[Page 35615]]

of greater and lesser risk, depending on borrower or counterparty

characteristics.

Consistent with the concepts underlying ``minimum'' as opposed to

``risk-based'' capital, when developing the proposed regulation, OFHEO

considered whether the minimum capital ratio should be the same for

interest rate and foreign exchange rate contracts regardless of whether

collateral was posted. In adopting the proposed regulation, OFHEO

determined that a lower minimum capital ratio for the collateralized

portion of an obligation was appropriate. This determination was made

based on the recognition that a collateralized position affords the

Enterprises greater certainty of collection than an uncollateralized

position in the event of a decline in the financial condition of a

counterparty. In contrast, the value of a promise by a counterparty to

post collateral in the event that it is downgraded is subject to the

diminished capacity of a counterparty during times of financial stress

to identify and pledge adequate liquid assets to secure its contractual

obligations.

OFHEO also recognizes that the value of a promise by a counterparty

to post collateral when it is downgraded is influenced by the speed of

the rating agency's ability to recognize changes in credit conditions.

Recent incidents, such as the default of Barings from trading losses,

illustrate how rapidly the financial health of a well-respected entity

can deteriorate. When a decline occurs very rapidly, a promise to post

collateral to secure counterparty obligations may be of little value.

Finally, as a point of comparison, OFHEO notes that the risk-based

capital standards for banks and thrifts do not treat agreements to post

collateral as the equivalent of collateral and do not incorporate

counterparty credit ratings into the determination of risk weights

assigned to different counterparties.

Section 1750.4(a)(7) Ratio With Respect to Other Off-Balance Sheet

Obligations

Section 1750.4(a)(7) of the proposed regulation provides the amount

of other off-balance sheet obligations that is to be included in the

computation of the minimum capital requirement. The amount is--

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.

Freddie Mac recommended that proposed section 1750.4(a)(7) be

deleted in connection with its comments that (1) the definition of the

term ``off-balance sheet obligation'' be deleted and (2) the definition

of the term ``other off-balance sheet obligations'' be defined in terms

of commitments, multifamily credit enhancements, sold portfolio

remittances pending, and interest rate and foreign exchange rate

contracts. (See the full discussion under section 1750.2, above.) If

section 1750.4(a)(7) is retained, Freddie Mac recommended that OFHEO

delete the phrase ``the outstanding amount.'' Freddie Mac believes that

the phrase could create confusion if, in the future, OFHEO determines

that an item should be treated as an ``other off-balance sheet

obligation,'' and OFHEO also determines that the appropriate measure of

credit risk should be something other than an ``outstanding amount.''

OFHEO agrees with Freddie Mac; however, rather than deleting the

phrase ``outstanding amount,'' OFHEO has substituted the phrase

``credit equivalent amount, or other appropriate measure, as determined

by the Director.'' This revision will clarify that, depending on the

specific characteristics of the obligation, the computation of the

minimum capital requirement may be based on the credit equivalent

amount or other measures that the Director determines are appropriate.

OFHEO also has made a clarifying editorial revision to proposed

section 1750.4(a)(6)(ii) with respect to the computation of the minimum

capital amount for interest rate and exchange rate contracts.

Section 1750.4(b) Capital Treatment of On-Balance Sheet and Off-

Balance Sheet Items

Section 1750.4(b) of the proposed regulation provides that, for

purposes of the minimum capital requirement computation, any asset or

financial obligation that is properly classifiable in more than one

category of items must be classified in the category that yields the

highest requirement.

Freddie Mac expressed the concern that the proposed regulation

would require capital charges for foreign exchange rate contracts to be

computed as if such contracts were reflected on the balance sheet, even

if they are not. Freddie Mac also recommended that OFHEO clarify that

the regulation will not require an Enterprise to make adjustments to a

balance sheet that has been prepared in accordance with generally

accepted accounting principles (GAAP).

As noted by Freddie Mac, the Enterprises are required to prepare

their balance sheets in accordance with GAAP. Consistent with that

requirement, the Minimum Capital regulation does not require an

Enterprise to adjust its balance sheet prepared in accordance with

GAAP. The requirements of the Minimum Capital regulation relate only to

the computation of the minimum capital requirement.

Under GAAP, it is possible that some assets or obligations may

properly be reflected either on or off the balance sheet. OFHEO

believes that, for minimum capital purposes, it is appropriate to

classify any asset or obligation that may be properly reflected either

on or off the balance sheet in the category that yields the highest

minimum capital requirement. The purpose of capital is to serve as a

cushion to absorb losses and thereby reduce the risk of failure of the

Enterprise. The minimum capital requirement represents a level of

capital for an Enterprise which, if not met, will result in the

institution being classified as 'significantly undercapitalized.''

Consequently, it would be inappropriate for the Minimum Capital

regulation to permit an Enterprise to determine its minimum capital

requirement by favoring one accounting treatment over another. The

purpose of section 1750.4(b) is to avoid such a circumstance.

In addition, Freddie Mac commented on the relationship between

section 1750.4(b) and paragraph 4 of Appendix A, suggesting that they

articulated inconsistent requirements with respect to interest rate and

foreign exchange rate contracts. In that regard, Freddie Mac

recommended that OFHEO treat all foreign exchange rate contracts as

other off-balance sheet obligations, and then subtract from the

computed minimum capital requirement the amount, if any, that is

attributable to the contracts as on-balance sheet assets.

OFHEO does not believe there is any inconsistency between section

1750.4(b) and paragraph 4 of Appendix A. The scope of the two

provisions is different and, to the extent they deal with the same

issue, they address different aspects of the issue. As explained above,

section 1750.4(b) provides that an Enterprise's assets or obligations

that may be properly classified in more than one of the on- or off-

balance sheet categories will be classified according to the category

that yields the highest

[[Page 35616]]

minimum capital requirement. The scope of section 1750.4(b) encompasses

not only interest rate and foreign exchange rate contracts, but also

any other assets or obligations that could be classified in more than

one category.

In contrast, paragraph 4 of Appendix A, Avoidance of Double

Counting, is restricted in scope to interest rate and foreign exchange

rate contracts and only addresses the issue of double counting. The

purpose of paragraph 4 is to ensure that the capital amount for such

contracts is not double counted if the proper accounting treatment

results in a portion of the credit exposure of the contract(s) being

reflected on and off the balance sheet. To that end, paragraph 4

provides that the amount of credit exposure arising from interest rate

and foreign exchange rate contracts may need to be excluded from on-

balance sheet assets in calculating the minimum capital requirement.

Section 1750.5 Notice of Capital Classification

Section 1750.5 outlines the procedures that OFHEO will follow when

notifying each Enterprise of its capital classification.

Freddie Mac noted that while the proposed regulation sets forth a

process that could result in a final capital classification not being

issued until a full 150 days after the end of a quarter, it hopes that

a process of less than 90 days would continue to be the norm.

Section 1750.3 provides that an Enterprise has 30 days after the

end of each quarter to file a minimum capital report. Section 1750.5

provides that within 60 days of receiving the minimum capital report,

OFHEO will provide each Enterprise with a notice of proposed capital

classification. The Enterprise has 30 days in which to respond to the

proposed capital classification. The Enterprise's response period may

be extended up to 30 additional calendar days, or shortened, at the

sole discretion of the Director. The Director, after taking into

consideration the Enterprise's response, has up to 30 calendar days

following the end of the response period in which to issue a final

notice of capital classification.

The time periods specified in the regulation are designed to

establish the longest possible timeframes for actions by the

Enterprises and OFHEO in the capital classification process. OFHEO

would expect that under most circumstances the total elapsed time for a

capital classification will be substantially less than the maximum

period contemplated in the regulation. In that regard, the timing of

the submission of the Enterprise's minimum capital report and its

response to the proposed classification will have a significant impact

on the time period for receipt of the final capital classification.

Appendix A

Appendix A provides the methodology for computing the minimum

capital component for interest rate and foreign exchange rate

contracts.

The Office of Thrift Supervision questioned whether OFHEO had

considered whether the proposed treatment of interest rate and foreign

exchange rate contracts, including the bilateral netting provisions,

adds unnecessary complexity to the minimum capital standard in light of

the sophisticated risk-based capital regulation that OFHEO is

developing.

Although the minimum capital standard is a minimum leverage ratio

standard, Congress has required that OFHEO consider the credit risk of

off-balance sheet obligations and adjust the 0.45 percent ratio to

reflect the difference between the credit risk of interest rate and

foreign exchange rate contracts and MBS. Thus, OFHEO believes that the

adjusted ratios should be applied to the credit equivalent amount of

interest rate and foreign exchange rate contracts because the credit

equivalent amount best represents the dollar amount at risk. OFHEO also

believes that bilateral netting, that is, the offsetting of positive

and negative mark-to-market values in the determination of a current

credit exposure used in the calculation of a credit equivalent amount,

provides a more accurate representation of the dollar amount at risk.

Consequently, OFHEO believes that the more complex treatment with

respect to interest rate and foreign exchange rate contracts is

appropriate.

Paragraph 5. Collateral

Freddie Mac noted that the definition of the term ``qualifying

collateral'' in section 1750.2 differs from the discussion of what

constitutes qualifying collateral in paragraph 5 of Appendix A. OFHEO

does not intend that there be any difference and has revised the

discussion in Appendix A to conform with the definition set forth in

section 1750.2. (See the full discussion of this comment under section

1750.2, Qualifying collateral, above.)

Additionally, OFHEO has renumbered paragraphs 1 and 2 of Appendix A

of the proposed regulation to ensure ease of reading and reference.

IV. Section-by-Section Analysis

Section 1750.1 General

This section states that the regulation sets forth the methodology

for computing the minimum capital requirement for each Enterprise. It

further states that 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 that equals or exceeds the minimum capital

requirement.

Section 1750.2 Definitions

Section 1750.2 provides definitions for the terms used in the

regulation.

The term ``affiliate'' is defined as to mean any entity that

controls, is controlled by, or is under common control with, an

Enterprise, except as otherwise provided by the Director.

The term ``commitment'' is defined to mean any contractual, legally

binding agreement that obligates an Enterprise to purchase or to

securitize mortgages.

The term ``core capital'' is defined to mean the sum of (as

determined in accordance with generally accepted accounting principles)

the par or stated value of outstanding common stock; the par or stated

value of outstanding perpetual, noncumulative preferred stock; paid-in

capital; and retained earnings. This definition does not include debt

instruments or any amounts an Enterprise could be required to pay at

the option of an investor to retire capital instruments. The amount of

retained earnings includable in the calculation of core capital is the

net of the carrying value of Treasury stock. Treasury stock is stock

that an Enterprise has issued and subsequently acquired, but has not

retired or resold. Carrying value is typically the amount the

Enterprise paid for the Treasury stock.

The term ``Director'' is defined to mean the Director of OFHEO.

The term ``Enterprise'' is defined to mean the Federal National

Mortgage Association and any affiliate thereof or the Federal Home Loan

Mortgage Corporation and any affiliate thereof.

The term ``foreign exchange rate contracts'' is defined to mean

cross-currency interest rate swaps, forward foreign exchange contracts,

currency options purchased (including currency options purchased over-

the-counter), and any other instrument that gives rise to similar

credit risks. The definition clarifies that the term ``foreign exchange

rate contracts'' does not mean foreign exchange rate contracts with an

original maturity of 14 calendar days or less and

[[Page 35617]]

foreign exchange rate contracts traded on exchanges that require daily

payment of variation margins.

The term ``interest rate contracts'' is defined to mean single

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

interest rate options purchased (including caps, collars, and floors

purchased), over-the-counter options purchased, and any other

instrument that gives rise to similar credit risks (including when-

issued securities and forward deposits accepted). The definition of the

term ``interest rate contracts'' does not include instruments traded on

exchanges that require daily payment of variation margins.

The term ``mortgage-backed security'' is defined to mean 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.

The term ``multifamily credit enhancement'' is defined to mean any

guarantee, pledge, purchase arrangement, or other obligation or

commitment provided or entered into by an Enterprise with respect to

multifamily mortgages to provide credit enhancement, liquidity,

interest rate support, and other guarantees and enhancements for

revenue bonds issued by a state or local governmental unit (including a

housing finance agency) or other bond issuer.

The term ``1992 Act'' is defined to mean 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.

The term ``notional amount'' is defined to mean the face value of

the underlying financial instrument(s) on which an interest rate or

foreign exchange rate contract is based.

The term ``off-balance sheet obligation'' is defined 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 (including commitments), where such

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

on its balance sheet.

The term ``OFHEO'' is defined to mean the Office of Federal Housing

Enterprise Oversight.

The term ``other off-balance sheet obligations'' is defined to mean

all off-balance sheet obligations of an Enterprise that are not

mortgage-backed securities or substantially equivalent instruments and

that are not resecuritized MBS such as real estate mortgage investment

conduits or similar resecuritized instruments.

The term ``perpetual, noncumulative preferred stock'' is defined to

mean preferred stock that does not have a maturity date, provides the

issuer the ability and the legal right to eliminate dividends and does

not permit the accruing or payment of impaired dividends, and that

cannot be redeemed at the option of the holder. It is further defined

as preferred stock that 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. For purposes of

minimum capital, perpetual, noncumulative preferred stock must provide

capital that is available to absorb losses of the Enterprise from any

source.

The term ``qualifying collateral'' is defined to mean cash on

deposit; securities issued or guaranteed by the central governments of

the OECD-based group of countries,32 United States Government

agencies, or United States Government-sponsored agencies; and

securities issued by multilateral lending institutions or regional

development banks.

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

\32\ The OECD-based group of countries comprises full members of

the Organization for Economic Cooperation and Development (OECD)

regardless of entry date, as well as countries that have concluded

special lending arrangements with the International Monetary Fund

(IMF) associated with the IMF's General Arrangements to Borrow, but

excludes any country that has rescheduled its external sovereign

debt within the previous 5 years. A rescheduling of external

sovereign debt generally would include any renegotiation of terms

arising from a country's mobility or unwillingness to meet its

external debt service obligations, but generally not include any

renegotiation to allow the borrower to take advantage of a decline

in interest rate or other change in market conditions.

As of November 1995, the OECD countries included the following

countries: Australia, Austria, Belgium, Canada, Denmark, Finland,

France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg,

Mexico, the Netherlands, New Zealand, Norway, Portugal, Spain,

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

States; and Saudi Arabia has concluded special lending arrangements

with the IMF associated with the IMF's General Arrangements to

Borrow.

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

Section 1750.3 Procedures and Timing

Section 1750.3 provides that each Enterprise must 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

must contain the information that responds to all of the items required

by OFHEO in written instructions to the Enterprise, including, but not

limited to an estimate of the minimum capital requirement; an estimate

of core capital overage or shortfall relative to the estimated minimum

capital requirement; and such other information as may be required by

the Director.

This section further provides that the report must be submitted not

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

and that it must be in writing and in such other format as may be

required by the Director.

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,

section 1750.3 requires that the Enterprise file an amended minimum

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

adjustment.

Finally, section 1750.3 provides that each minimum capital report

or any amended minimum capital report must 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.

Section 1750.4 Minimum Capital Requirement Computation

Section 1750.4 sets forth the methodology for computing the minimum

capital requirement. The minimum capital requirement is the sum of the

following amounts:

--2.50 percent times the aggregate on-balance sheet assets of the

Enterprise;

--0.45 percent times the unpaid principal balance of mortgage-backed

securities and substantially equivalent instruments that were issued or

guaranteed by the Enterprise;

--0.45 percent of 50 percent of the average dollar amount of

commitments outstanding each quarter over the preceding four quarters;

--0.45 percent of the outstanding principal amount of bonds with

multifamily credit enhancements;

--0.45 percent of the dollar amount of sold portfolio remittances

pending;

[[Page 35618]]

--3.00 percent of the credit equivalent amount of interest rate

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

the current market value of posted qualifying collateral, computed in

accordance with Appendix A; 1.50 percent of the market value of

qualifying collateral posted to secure interest rate and foreign

exchange rate contracts, not to exceed the credit equivalent amount of

such contracts, computed in accordance with Appendix A; and

--0.45 percent of the outstanding amount, credit equivalent amount, or

other measure determined appropriate by the Director, 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.

In the event that any asset or financial obligation is properly

classifiable in more than one of the above categories, section 1750.4

provides that, for minimum capital purposes, the asset or financial

obligation must be classified in the category that yields the highest

minimum capital requirement.

The section further explains that the term ``preceding four

quarters'' 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.

Section 1750.5 Notice of Capital Classification

Section 1750.5 states that not later than 60 calendar days after

the date for which the minimum capital report is filed, OFHEO will

provide each Enterprise with a notice of proposed capital

classification in accordance with section 1368 of the 1992 Act.33

The notice of proposed capital classification includes the proposed

minimum capital requirement and the summary computation of the proposed

minimum capital requirement.

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

\33\ 12 U.S.C. 4618.

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

Each Enterprise has a period of 30 calendar days following receipt

of a notice of proposed capital classification to submit a response.

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 response period.

Section 1750.5 further provides that the Director must take into

consideration any response to the notice of proposed capital

classification received from the Enterprise and must issue a notice of

final capital classification for each Enterprise not later than 30

calendar days following the end of the response period.

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

Interest Rate and Foreign Exchange Rate Contracts

Calculation of Credit Equivalent Amounts

Appendix A provides that the minimum capital components for

interest rate and foreign exchange rate contracts are computed on the

basis of the credit equivalent amounts of such contracts. The credit

equivalent amount of an off-balance sheet interest rate or foreign

exchange rate contract that is not subject to a qualifying bilateral

netting contract in accordance with 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.

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.

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 effective rather than the apparent or stated

notional amount must be used in this calculation. The credit conversion

factors for interest rate contracts are 0.0 percent for interest rate

contracts with a remaining maturity of 1 year or less; 0.5 percent for

interest rate contracts with a remaining maturity of over 1 year; 1.0

percent for foreign exchange rate contracts with a remaining maturity

of 1 year or less; and 5.0 percent for foreign exchange rate contracts

with a remaining maturity of over 1 year.

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.

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.

Avoidance of Double Counting

Appendix A provides that, in certain cases, credit exposures

arising from the interest rate and foreign exchange rate contracts

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

requirement.

Collateral

Appendix A provides that the sufficiency of collateral 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 standard

purposes unless it is legally available to support the single legal

obligation created by the netting contract. Excess collateral held

against one contract or a group of contracts for which a recognized

netting agreement exists may not be considered.

The only forms of collateral that are formally recognized by the

minimum capital standard framework are cash on deposit; securities

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

of countries, United States Government agencies, or United States

Government-sponsored agencies; and securities issued by multilateral

lending institutions or regional development banks.

Netting

For purposes of Appendix A, netting refers to the offsetting of

positive and negative mark-to-market values in the determination of a

current exposure to be used in the calculation of a credit equivalent

amount. Any legally enforceable form of bilateral netting (that is,

netting with a single counterparty) of interest rate and foreign

exchange rate contracts is recognized for purposes of calculating the

credit equivalent amount if it meets the following requirements.

Netting is

[[Page 35619]]

accomplished under a written netting contract that creates a single

legal obligation, covering all included individual contracts, with the

effect that the Enterprise would have a claim to receive, or obligation

to pay, only the net amount of the sum of the positive and negative

mark-to-market values on included individual contracts in the event

that a counterparty, or a counterparty to whom the contract has been

validly assigned, fails to perform due to default, insolvency,

liquidation, or similar circumstances.

The Enterprise must obtain a written and reasoned legal opinion(s)

representing that in the event of a legal challenge--including one

resulting from default, insolvency, liquidation, or similar

circumstances--the relevant court and administrative authorities would

find the Enterprise's exposure to be such a net amount under--

--the law of the jurisdiction in which the counterparty is chartered or

the equivalent location in the case of noncorporate entities, and if a

branch of the counterparty is involved, then also under the law of the

jurisdiction in which the branch is located;

--the law that governs the individual contracts covered by the netting

contract; and

--the law that governs the netting contract.

The Enterprise must establish and maintain procedures to ensure

that the legal characteristics of netting contracts are kept under

review in the event of possible changes in relevant law. Furthermore,

the Enterprise must maintain in its files documentation adequate to

support the netting of rate contracts, including a copy of the

bilateral netting contract and necessary legal opinions.

A contract containing a walkaway clause is not eligible for netting

for purposes of calculating the credit equivalent amount. A walkaway

clause is a provision in a netting contract that permits a non-

defaulting counterparty to make lower payments than it would make

otherwise under the contract, or no payment at all, to a defaulter or

to the estate of a defaulter, even if the defaulter or the estate of

the defaulter is a net creditor under the contract.

By netting individual contracts for the purpose of calculating its

credit equivalent amount, the Enterprise represents that it has met the

requirements of Appendix A, and that all the appropriate documents are

in the Enterprise's files and available for inspection by OFHEO. OFHEO

may determine that an Enterprise's files are inadequate or that a

netting contract, or any of its underlying individual contracts, may

not be legally enforceable under any one of the bodies of law described

in Appendix A. If such a determination is made, the netting contract

may be disqualified from recognition for minimum capital standard

purposes or underlying individual contracts may be treated as though

they are not subject to the netting contract.

The credit equivalent amount of interest rate and foreign exchange

rate contracts that are subject to a qualifying bilateral netting

contract is calculated by adding the current exposure of the netting

contract and the sum of the estimates of the potential future credit

exposures on all individual contracts subject to the netting contract,

estimated in accordance with Appendix A. Offsetting contracts in the

same currency maturing on the same date will have lower potential

future exposure as well as lower current exposure. Therefore, for

purposes of calculating potential future credit exposure to a netting

counterparty for foreign exchange rate contracts, and other similar

contracts in which notional principal is equivalent to cash flows,

total notional principal is defined as the net receipts falling due on

each value date in each currency.

The current exposure of the netting contract is determined by

summing all positive and negative mark-to-market values of the

individual contracts included in the netting contract. If the net sum

of the mark-to-market values is positive, then the current exposure of

the netting contract is equal to that sum. If the net sum of the mark-

to-market values is zero or negative, then the current exposure of the

netting contract is zero. OFHEO may determine that a netting contract

qualifies for netting treatment even though certain individual

contracts may not qualify. In such instances, the nonqualifying

contracts should be treated as individual contracts that are not

subject to the netting contract.

In the event a netting contract covers contracts that are normally

excluded from the minimum capital requirement computation--for example,

foreign exchange rate contracts with an original maturity of 14

calendar days or less, or instruments traded on exchanges that require

daily payment of variation margin--an Enterprise may elect consistently

either to include or exclude all mark-to-market values of such

contracts when determining net current exposure.

As stated in the preamble to the proposed regulation, in developing

Appendix A, OFHEO considered provisions of the regulations of the

federal banking agencies with respect to the calculation of the credit

equivalent amount for interest rate and foreign exchange rate

contracts. Subsequent to the publication of the proposed Minimum

Capital regulation, the federal banking agencies amended their

regulations with respect to interest rate and foreign exchange rate

contracts.34 The amendments increase the number of credit

conversion factors that are used to measure the potential future credit

exposure of interest rate and foreign exchange rate contracts. They

also change the way the potential future credit exposure is calculated

when the interest rate and foreign exchange rate 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.

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

\34\ 60 FR 46170 (Sept. 5, 1995).

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

OFHEO is analyzing those amendments and considering whether to

conform Appendix A to the final regulations of the federal banking

agencies. Based on the results of that analysis, OFHEO will publish a

proposal, as appropriate.

Regulatory Impact

Executive Order 12606, The Family

This 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 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 regulation has been reviewed by the Office of Management and

Budget pursuant to Executive Order 12866.

Executive Order 12988, Civil Justice Reform

This proposed regulation meets the applicable standards of sections

3(a) and (b) of Executive Order 12988.

Unfunded Mandates Reform Act of 1995

The regulation does not require the preparation of an assessment

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

Assessment statements are not required for regulations that incorporate

requirements specifically set forth in

[[Page 35620]]

law. As explained in the preamble, this regulation implements the

minimum capital standard contained in the 1992 Act. In addition, this

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 1 year.

Regulatory Flexibility Act

This regulation is applicable only to the Enterprises, which are

not small entities for purposes of the Regulatory Flexibility Act, and

does not have a significant effect on a substantial number of small

entities. Therefore, the General Counsel of OFHEO has certified that

the final regulation will not have significant economic impact on a

substantial number of small entities.

Paperwork Reduction Act

This 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

Banks, banking, Federal Home Loan Mortgage Corporation, Federal

National Mortgage Association, Mortgages, Securities.

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

amends 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 Definitions.

1750.3 Procedure and timing.

1750.4 Minimum capital requirement computation.

1750.5 Notice of capital classification.

Appendix A to Subpart A of Part 1750--Minimum Capital 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 sets forth the

methodology for computing the minimum capital requirement 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 that equals or exceeds the minimum capital requirement

contained in this subpart A.

Sec. 1750.2 Definitions.

For purposes of this subpart A, the following definitions shall

apply:

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 agreement that

obligates an Enterprise to purchase or to securitize mortgages.

Core Capital--(1) Means the sum of (as determined in accordance

with generally accepted accounting principles)--

(i) The par or stated value of outstanding common stock;

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

noncumulative preferred stock;

(iii) Paid-in capital; and

(iv) Retained earnings; and

(2) Does not include debt instruments or any amounts the Enterprise

could be required to pay at the option of an investor to retire capital

instruments.

Director means the Director of OFHEO.

Enterprise means the Federal National Mortgage Association and any

affiliate thereof or the Federal Home Loan Mortgage Corporation and any

affiliate thereof.

Foreign exchange rate contracts--

(1) Means cross-currency interest rate swaps, forward foreign

exchange contracts, currency options purchased (including currency

options purchased over-the-counter), and any other instrument that

gives rise to similar credit risks; and

(2) Does not mean foreign exchange rate contracts with an original

maturity of 14 calendar days or less and foreign exchange rate

contracts traded on exchanges that require daily payment of variation

margins.

Interest rate contracts--

(1) Means single currency interest rate swaps, basis swaps, forward

rate agreements, interest rate options purchased (including caps,

collars, and floors purchased), over-the-counter options purchased, and

any other instrument that gives rise to similar credit risks (including

when-issued securities and forward deposits accepted); and

(2) Does not mean such instruments traded on exchanges that require

daily payment of variation margins.

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 any guarantee, pledge,

purchase arrangement, or other obligation or commitment provided or

entered into by an Enterprise with respect to multifamily mortgages to

provide credit enhancement, liquidity, interest rate support, and other

guarantees and enhancements for revenue bonds issued by a state or

local governmental unit (including a housing finance agency) or other

bond issuer.

1992 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. 102-550, 12 U.S.C. 4501 et seq.

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 (including

commitments), 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 and that are not resecuritized

mortgage-backed securities, such as real estate mortgage investment

conduits or similar resecuritized 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,

[[Page 35621]]

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 by multilateral

lending institutions or regional development banks.

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

\1\ The OECD-based group of countries comprises full members of

the Organization for Economic Cooperation and Development (OECD)

regardless of entry date, as well as countries that have concluded

special lending arrangements with the International Monetary Fund

(IMF) associated with the IMF's General Arrangements to Borrow, but

excludes any country that has rescheduled its external sovereign

debt within the previous 5 years. A rescheduling of external

sovereign debt generally would include any renegotiation of terms

arising from a country's mobility or unwillingness to meet its

external debt service obligations, but generally not include any

renegotiation to allow the borrower to take advantage of a decline

in interest rate or other change in market conditions. As of

November 1995, the OECD countries included the following countries:

Australia, Austria, Belgium, Canada, Denmark, Finland, France,

Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico,

the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden,

Switzerland, Turkey, the United Kingdom, and the United States; and

Saudi Arabia has concluded special lending arrangements with the IMF

associated with the IMF's General Arrangements to Borrow.

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

Sec. 1750.3 Procedure 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 requirement;

(2) Estimate of core capital overage or shortfall relative to the

estimated minimum capital requirement;

(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.

(c) Each minimum capital report shall be submitted in writing and

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 requirement computation.

(a) The minimum capital requirement 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 contracts 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 market value of qualifying collateral

posted to secure interest rate and foreign exchange rate contracts, not

to exceed the credit equivalent amount of such contracts, computed in

accordance with appendix A to this subpart; and

(7) 0.45 percent of the outstanding amount, credit equivalent

amount, or other measure determined appropriate by the Director, 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 is properly classifiable

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 requirement.

(c) As used in this section, the term ``preceding four quarters''

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 1992 Act (12 U.S.C. 4614),

OFHEO is required to determine the capital classification of 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 notice of proposed capital classification in accordance with

section 1368 of the 1992 Act (12 U.S.C. 4618). The notice shall contain

the following information--

(i) The proposed capital classification;

(ii) The proposed minimum capital requirement; and

(iii) The summary computation of the proposed minimum capital

requirement.

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

following receipt of a notice of proposed capital classification to

submit a response regarding the proposed capital 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

notice of proposed capital classification received from the Enterprise

and shall issue a notice of final 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 1992 Act (12

U.S.C. 4618).

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

Interest Rate and Foreign Exchange Rate Contracts

1. The minimum capital 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

[[Page 35622]]

interest rate and foreign exchange rate contracts:

a. Interest Rate Contracts

i. Single currency interest rate swaps.

ii. Basis swaps.

iii. Forward rate agreements.

iv. Interest rate options purchased (including caps, collars,

and floors purchased).

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

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

b. Foreign Exchange Rate Contracts

i. Cross-currency interest rate swaps.

ii. Forward foreign exchange rate contracts.

iii. Currency options purchased.

iv. Any other instrument that gives rise to similar credit

risks.

2. Foreign exchange rate contracts with an original maturity of

14 calendar days or less and foreign exchange rate contracts traded

on exchanges that require daily payment of variation margins are

excluded from the minimum capital requirement 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 minimum capital components for interest rate and foreign

exchange rate contracts are computed on the basis of the credit

equivalent amounts of such contracts. The credit equivalent amount

of an off-balance sheet interest rate and foreign exchange 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 effective rather than the apparent or

stated notional amount must be used in this calculation. The credit

conversion factors are:

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

Foreign

Interest rate exchange rate

Remaining maturity contracts contracts

(percent) (percent)

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

1 year or less............................ 0.0 1.0

Over 1 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 requirement.

5. Collateral

a. The sufficiency of collateral 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 standard purposes unless it is

legally available to support the single legal obligation created by

the netting contract. Excess collateral held against one contract or

a group of contracts for which a recognized netting agreement exists

may not be considered.

b. The only forms of collateral that are formally recognized by

the minimum capital standard framework are cash on deposit;

securities issued or guaranteed by the central governments of the

OECD-based group of countries, United States Government agencies, or

United States Government-sponsored agencies; and securities issued

by multilateral lending institutions or regional development banks.

6. Netting

a. For purposes of this appendix A, netting refers to the

offsetting of positive and negative mark-to-market values in the

determination of a current exposure to be used in the calculation of

a credit equivalent amount. Any legally enforceable form of

bilateral netting (that is, netting with a single counterparty) of

interest rate and foreign exchange rate contracts is recognized for

purposes of calculating the credit equivalent amount provided that

the following criteria are met:

i. Netting must be accomplished under a written netting contract

that creates a single legal obligation, covering all included

individual contracts, with the effect that the Enterprise would have

a claim to receive, or obligation to pay, only the net amount of the

sum of the positive and negative mark-to-market values on included

individual contracts in the event that a counterparty, or a

counterparty to whom the contract has been validly assigned, fails

to perform due to default, insolvency, liquidation, or similar

circumstances.

ii. The Enterprise must obtain a written and reasoned legal

opinion(s) representing that in the event of a legal challenge--

including one resulting from default, insolvency, liquidation, or

similar circumstances--the relevant court and administrative

authorities would find the Enterprise's exposure to be such a net

amount under--

A. The law of the jurisdiction in which the counterparty is

chartered or the equivalent location in the case of noncorporate

entities, and if a branch of the counterparty is involved, then also

under the law of the jurisdiction in which the branch is located;

B. The law that governs the individual contracts covered by the

netting contract; and

C. The law that governs the netting contract.

iii. The Enterprise must establish and maintain procedures to

ensure that the legal characteristics of netting contracts are kept

under review in the event of possible changes in relevant law.

iv. The Enterprise must maintain in its files documentation

adequate to support the netting of rate contracts, including a copy

of the bilateral netting contract and necessary legal opinions.

b. A contract containing a walkaway clause is not eligible for

netting for purposes of calculating the credit equivalent

amount.1

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

\1\ A walkaway clause is a provision in a netting contract that

permits a non-defaulting counterparty to make lower payments than it

would make otherwise under the contract, or no payment at all, to a

defaulter or to the estate of a defaulter, even if the defaulter or

the estate of the defaulter is a net creditor under the contract.

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

c. By netting individual contracts for the purpose of

calculating its credit equivalent amount, the Enterprise represents

that it has met the requirements of this appendix A and all the

appropriate documents are in the Enterprise's files and available

for inspection by OFHEO. OFHEO may determine that an Enterprise's

files are inadequate or that a netting contract, or any of its

underlying individual contracts, may not be legally enforceable

under any one of the bodies of law described in this appendix A. If

such a determination is made, the netting contract may be

disqualified from recognition for minimum capital standard purposes

or underlying individual contracts may be treated as though they are

not subject to the netting contract.

d. The credit equivalent amount of interest rate and foreign

exchange rate contracts that are subject to a qualifying bilateral

netting contract is calculated by adding the current exposure of the

netting contract and the sum of the estimates of the potential

future credit exposures on all individual contracts subject to the

netting contract, estimated in accordance with paragraph 3 of this

appendix A. Offsetting contracts in the same currency maturing on

the same date will have lower potential future exposure as well as

lower current exposure. Therefore, for purposes of calculating

potential future credit exposure to a netting counterparty for

foreign exchange rate contracts and other similar contracts in which

notional principal

[[Page 35623]]

is equivalent to cash flows, total notional principal is defined as

the net receipts falling due on each value date in each currency.

e. The current exposure of the netting contract is determined by

summing all positive and negative mark-to-market values of the

individual contracts included in the netting contract. If the net

sum of the mark-to-market values is positive, then the current

exposure of the netting contract is equal to that sum. If the net

sum of the mark-to-market values is zero or negative, then the

current exposure of the netting contract is zero. OFHEO may

determine that a netting contract qualifies for minimum capital

standard netting treatment even though certain individual contracts

may not qualify. In such instances, the nonqualifying contracts

should be treated as individual contracts that are not subject to

the netting contract.

f. In the event a netting contract covers contracts that are

normally excluded from the minimum capital requirement computation--

for example, foreign exchange rate contracts with an original

maturity of 14 calendar days or less, or instruments traded on

exchanges that require daily payment of variation margin--an

Enterprise may elect consistently either to include or exclude all

mark-to-market values of such contracts when determining net current

exposure.

Subpart B--[Reserved]

Aida Alvarez,

Director, Office of Federal Housing Enterprise Oversight.

[FR Doc. 96-17120 Filed 7-5-96; 8:45 am]

BILLING CODE 4220-01-P