# Federal Agricultural Mortgage Corporation; Risk-Based Capital Requirements

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3A99-29214

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** November 12, 1999
- **Citation:** 64 FR 61740

## Text

SUMMARY: This proposed rule amends Farm Credit Administration (FCA)
regulations, through the Office of Secondary Market Oversight (OSMO),
by establishing risk-based capital requirements for the Federal
Agricultural Mortgage Corporation (Corporation or Farmer Mac). The
proposed regulations: Set forth the risk-based capital rules for Farmer
Mac, including definitions, methods, parameters and guidelines for
developing and implementing the risk-based capital stress test; specify
capital calculation, reporting, and compliance requirements; delineate
our monitoring, examination, supervisory, and enforcement activities;
and, prescribe certain policy requirements for business and capital
planning.

DATES: Please send your comments to us by March 13, 2000.

ADDRESSES: You may mail or deliver written comments to Carl A.
Clinefelter, Director, Office of Secondary Market Oversight, Farm
Credit Administration, 1501 Farm Credit Drive, McLean, Virginia 22102-
5090, or send them by facsimile transmission to (703) 734-5784. You may
also send comments via electronic mail to ``[email protected]'' or
through the Pending Regulations section of our website at
``www.fca.gov.'' You may review copies of all comments we receive in
the Office of Policy and Analysis, Farm Credit Administration.

FOR FURTHER INFORMATION CONTACT:

Carl A. Clinefelter, Director, Office of Secondary Market Oversight,
Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4280, TDD
(703) 883-4444, or Dennis K. Carpenter, Senior Policy Analyst, Office
of Policy and Analysis, Farm Credit Administration, McLean, VA 22102-
5090, (703) 883-4498, TDD (703) 883-4444,

or

Joy Strickland, Senior Attorney, Office of General Counsel, Farm Credit
Administration, McLean, VA 22102-5090, (703) 883-4020, TDD (703) 883-
4444.

SUPPLEMENTARY INFORMATION:

I. Objective

The purpose of this proposed regulation is to establish a risk-
based capital stress test for the Corporation as required by section
8.32 of the Farm Credit Act of 1971, as amended (Pub. L. 92-181)(Act).
Section 8.32 of the Act requires us to establish a risk-based capital
stress test that will determine the level of regulatory capital \1\
necessary for the Corporation to maintain positive capital during a 10-
year period where stressful credit and interest rate conditions occur.
The proposed rule contains specific information on the structure of the
risk-based capital stress test, including guidelines for its
implementation, monitoring, reporting and examination. The rule also
includes requirements for business and capital planning. The guidelines
and procedures for implementation of the stress test are available to
the public through the proposed regulation, technical appendix to part
650, subpart B, and an electronic version of the risk-based capital
stress test (spreadsheet-based) that is available on our website
``www.fca.gov'' or on written request. The technical appendix contains
details on how to construct the risk-based capital stress test,
including basic assumptions used in the test.
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\1\ ``Regulatory capital'' is defined in section 8.31(5) of the
Act as core capital plus an allowance for losses and guarantee
claims (in accordance with generally accepted accounting principles
(GAAP)). For the purposes of this definition, regulatory capital
includes any allowance or reserve accounts that Farmer Mac maintains
for losses on loans that are held in portfolio and for losses on
securities it has guaranteed, particularly, reserves required by
section 8.10 of the Act.
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II. Farmer Mac Organization

Farmer Mac is a federally chartered instrumentality of the United
States (U.S.) established on January 6, 1988 by the Agricultural Credit
Act of 1987 (Pub. L. 100-233)(1987 Act), which amended the Act. The
Corporation's status as a Government-sponsored enterprise (GSE)
requires it to fulfill the public policy mission of providing a
secondary market for agricultural real estate loans. The Corporation is
charged with increasing liquidity to rural lenders, increasing
available long-term credit to farmers and ranchers at stable interest
rates, and enhancing the ability of individuals in rural communities to
get financing for moderately priced homes. Congress established the
Corporation as part of its efforts to resolve the agricultural crisis
of the 1980s. Congress believed that a secondary market for
agricultural mortgages would increase available mortgage credit to
America's farmers, ranchers and rural homeowners. Farmer Mac serves
this role mainly by buying and securitizing ``qualified loans'' \2\
from lenders, thereby restoring the lenders' availability of funds to
make new loans. Although created by Congress, Farmer Mac is privately
owned with its common stock publicly traded on the New York Stock
Exchange.
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\2\ A qualified loan is a loan secured by a first lien, fee
simple mortgage or a long-term leasehold mortgage on agricultural
real estate or rural housing that is located in the U.S.
Agricultural real estate is defined by Farmer Mac as a parcel or
parcels of land, which may be improved by buildings or other
structures permanently affixed to the parcel or parcels, that (1)
Are used for the production of one or more agricultural commodities,
and (2) consist of a minimum of five acres or are used in the
production of agricultural receipts of at least $5,000. In
accordance with the Act, the maximum principal amount of a qualified
loan secured by agricultural real estate is indexed to inflation and
currently is $3.49 million, unless the loan is secured by 1,000
acres or less, in which case the maximum loan size is set by Farmer
Mac at $6.0 million.
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III. Corporation Authorities and Statutory Requirements for Risk-
Based Capital

Farmer Mac's statutory authority, which was established under title
VIII of the Act, has been substantively amended three times since its
origination in 1988 (i.e., 1990, 1991, and 1996). The 1990 amendments
authorized the Farmer Mac II program at the request of the United
States Department of Agriculture (USDA). The 1991 amendments authorized
the Farmer Mac linked portfolio program.\3\ The 1991 amendments created
OSMO and established the FCA, acting through OSMO, as the regulator of
Farmer Mac. The 1991 amendments also set forth definitions for core
capital \4\ and regulatory capital. The 1991 amendments also
established minimum

[[Page 61741]]

capital \5\ and critical capital \6\ levels and required us to
establish risk-based capital requirements for Farmer Mac.
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\3\ The linked portfolio authority allows Farmer Mac to purchase
guaranteed securities that have been issued by Farmer Mac or another
authorized issuer and hold the securities indefinitely in its
portfolio.
\4\ ``Core Capital'' is defined in section 8.31(2) of the Act as
the sum (as determined in accordance with GAAP) of: (1) The par
value of outstanding common stock; (2) the par value of outstanding
preferred stock; (3) paid-in capital; and (4) retained earnings.
\5\ The Corporation's ``minimum capital'' requirements are
described under section 8.33 of the Act. The minimum capital level
for the Corporation is an amount of core capital equal to the sum
of: (1) 2.75 percent of the aggregate on-balance sheet assets of the
Corporation, as determined in accordance with GAAP; and (2) 0.75
percent of the aggregate off-balance sheet obligations of the
Corporation which include: (a) The unpaid principal balance of
outstanding securities that are guaranteed by the Corporation and
backed by pools of qualified loans; (b) instruments that are issued
or guaranteed by the Corporation and are substantially equivalent to
(a); and (c) other off-balance sheet obligations. These minimum
statutory capital standards will continue in effect after the risk-
based capital rule becomes effective.
\6\ The Corporation's ``critical capital level'' is described in
section 8.34 of the Act. The critical capital level for the
Corporation is an amount of core capital equal to 50 percent of the
total minimum capital amount determined under section 8.33 of the
Act.
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The 1996 amendments served to streamline Farmer Mac's operating
structure to be more competitive. Specifically, and most importantly,
Farmer Mac was allowed to buy loans directly from lenders and issue
guaranteed securities representing 100 percent of the principal of the
purchased loans. This amendment removed the previous requirement for
poolers to hold at least a 10-percent subordinated interest against
loan losses on pools of loans securitized by Farmer Mac.
The Food, Agriculture, Conservation, and Trade Act Amendments of
1991 (Pub. L. 102-237)(1991 Act) required us to develop and issue a
risk-based capital stress test for the Corporation. The Farm Credit
System Reform Act of 1996 (Pub. L. 104-105)(1996 Act) further amended
the Act by prohibiting us from establishing a risk-based capital stress
test prior to February 10, 1999, 3 years following the effective date
of the 1996 Act. The risk-based capital stress test required by the
1991 Act determines the amount of capital necessary for the Corporation
to preserve positive capital while undergoing stressful credit and
interest rate risk conditions during a 10-year period. The 1991 Act
also required an added amount of capital to cover management and
operational risk.
Section 8.32 of the Act requires that the risk-based capital stress
test subject the Corporation to credit losses on agricultural mortgages
it owns or guarantees. The frequency of loan default and severity of
losses must be reasonably related to a ``benchmark'' with the highest
rate of default and severity of agricultural mortgage losses
experienced during a historical period of at least 2 consecutive years.
The credit losses also must be related to those experienced in
contiguous areas of the U.S. containing at least 5 percent of the total
U.S. population. The establishment of the benchmark loss experience is
more fully discussed later in this preamble.
The 1991 Act also required us to incorporate in the risk-based
capital stress test an interest rate risk stress scenario based on
rising and falling interest rates on Treasury obligations of various
terms. Under the interest rate stress scenario, current rates on
Treasury obligations are instantaneously shocked up and down. For the
first 12 months of the 10-year stress period, rates either increase or
decrease by: (1) 50 percent of the average rates on various Treasury
obligations during the 12-month period preceding the stress period, or
(2) 600 basis point (bp), whichever is less. The rates must remain at
the increased or decreased level for the remainder of the 10-year
stress period.
In addition to the risk-based capital level required as a result of
the credit loss and interest rate change components of the risk-based
capital stress test, Farmer Mac is required to maintain additional
capital to protect against management and operational risk. This
additional capital level is specified in the Act to be 30 percent of
the capital level required for the sum of the credit loss and interest
rate change components of the risk-based capital stress test.
In developing the risk-based capital stress test, the Act permits
us to take into account appropriate distinctions relative to various
types of agricultural mortgage products, varying terms of Treasury
obligations, and any other factors considered appropriate. We may also
consider credit loss protection provided by retained subordinated
participation interests, which were required for guaranteed securities
under section 8.6(b)(2) of the Act prior to the enactment of the 1996
Act.\7\ The 1991 Act does not require a specific adjustment for any of
these factors, but allows us to determine how best to account for them.
Unlike the risk-based capital stress tests applicable to other GSEs,
the 1991 Act does not contain specific requirements for addressing new
business and other corporate activities during the stress period,
including growth, product types, and pricing.\8\
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\7\ Section 8.32 of the Act states that we must also conform
loan loss data to the geographic and commodity diversification
standards that the Corporation loan pools had to meet based on
provisions of the 1991 Act. Because the geographic and commodity
diversification requirement was eliminated in the 1996 Act, this
consideration is no longer applicable.
\8\ See 12 U.S.C. 4611(a)(3).
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Our risk-based capital regulations must contain specific
information on the requirements, definitions, methods and parameters
used in implementing the risk-based capital stress test in order to
enable others to apply the test in a similar manner. Finally, we must
ultimately make available to the public any statistical model used to
implement the risk-based capital stress test.

IV. Philosophy and Development of the Risk-Based Capital Stress
Test

The principal objective of the risk-based capital standard is to
ensure that Farmer Mac has sufficient capital to remain solvent in the
face of extreme economic conditions. We believe that effective capital
standards should also permit Farmer Mac to fulfill its public policy
mission while pursuing prudent business practices and strategies.
Although the risk-based capital stress test can produce a single
capital requirement, it effectively creates marginal capital
requirements, that is, incremental requirements based on the riskiness
of each additional dollar of business for every type of product that
Farmer Mac guarantees or holds in its portfolio. Marginal capital
requirements for mortgages held in portfolio will vary depending on the
interest rate and credit risk associated with the mortgages as well as
the Farmer Mac's funding strategy. These marginal capital requirements
may have significant bearing on how Farmer Mac implements its business
strategies.
We developed the risk-based capital stress test to closely reflect
the risks inherent in Farmer Mac's various business activities. We
incorporated, to the extent permitted by the Act, consistent
relationships between the economic environment of the stress period and
Farmer Mac's business activities. This required modeling Farmer Mac's
assets, liabilities, and off-balance sheet positions at a sufficient
level of detail to capture their various risk characteristics.
Our philosophy guiding the development of the risk-based capital
stress test was that it should:
Be consistent with the requirements of the statute, i.e.,
it should reflect worst-case credit conditions and interest rate
movements, as defined in the Act;
Reflect Farmer Mac's regulatory capital needs for credit
and interest rate risks measured under stressful conditions;
Be internally consistent;

[[Page 61742]]

Not create inappropriate economic incentives;
Aim for simplicity; and
Reflect, to the extent practical and meaningful, Farmer
Mac's current operating policies and practices.
In developing the risk-based capital regulations, we also compared
our statutory requirements with the Basle Accord risk-based capital
framework. Although the current Basle Accord and our risk-based capital
framework significantly differ, both strive to equate risk with an
appropriate capital requirement. We note that the proposed direction of
the Basle Committee suggests an increasing reliance and acceptance of
econometric and statistical models for measuring credit and market risk
and allocating capital.\9\ Additionally, we both advocate that
proactive regulatory measures, such as our risk-based capital stress
test, should be complemented by effective monitoring, supervision, and
examination. For these reasons, we believe our risk-based capital
framework is consistent with the current opinions of the Basle
Committee.
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\9\ A New Capital Adequacy Framework is a consultative paper
issued by the Basle Committee on Banking Supervision. A copy of this
paper can be found at www.bis.org.
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In developing the risk-based capital stress test, we engaged in
three distinct activities that vary in complexity and time horizons:
Identification of the benchmark loss experience;
Construction of the risk-based capital stress test; and
Examination and oversight.

A. Identification of the Benchmark Loss Experience

Our first initiative was to identify the worst-case historical loss
experience as required by the Act. We published our results for comment
in the Federal Register on July 28, 1998 (63 FR 40282). This study
entitled, ``Risk-based Capital Regulations for Farmer Mac: Loan Loss
Estimation Procedures,'' is available through our website at
(www.fca.gov/pubs/farmmac). The study was prepared by Barry &
Associates,\10\ consultants who also assisted us in all facets of
development of the risk-based capital stress test. The following is a
brief summary of our efforts to locate agricultural mortgage loan data
and identify the worst-case loss rates to serve as a benchmark for the
loss rates used in the risk-based capital stress test.
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\10\ Barry & Associates is a consulting group that conducts
research and education projects in agricultural finance on behalf of
industry, policy, and non-profit organizations. Projects have
included analyses of capital regulations for financial institutions,
insurance modeling, risk pricing of loans, community banks' access
to agency market funds, and Farm Bill changes. Principal members of
Barry & Associates are Peter Barry (Managing Partner), Bruce
Sherrick, Paul Ellinger, and Del Banner. Each of these members is
affiliated with the Center for Farm and Rural Business Finance at
the University of Illinois, Urbana-Champaign.
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1. Available Loan Data
We were unable to use Farmer Mac loan data for establishing the
benchmark loss experience because Farmer Mac is a relatively new
enterprise and did not have historical data. Therefore, we searched for
other possible data sources, including the Economic Research Service
(ERS) of the USDA, commercial banks, life insurance companies, and
System banks. After an exhaustive search, we identified the Farm Credit
Bank of Texas (FCBT) and the former Farm Credit Bank of St. Paul
(FCBSP) as the only data sources with available historic loan-level
performance data on Farmer Mac-eligible loans that satisfied the
statutory provisions.
After an extensive evaluation of the available data, we concluded
that the FCBT had the most relevant data available for developing a
benchmark loss experience for use in a risk-based capital stress test.
Data from the FCBT is the most useful available for determining
benchmark losses because losses were taken expeditiously as charge-offs
and are thus clearly measurable. In contrast, although the FCBSP
experienced substantial financial distress during the 1980s, charge-off
rates were relatively low due to the FCBSP's strategy of forbearance
and restructuring of problem loans. Thus, the FCBSP experienced most of
its financial stress through reduced earnings on loans and increased
servicing costs. This stress is more difficult to measure in the form
of loan default rates and severity of defaults, which the statute
requires us to measure. Also, we proposed to use only the FCBT loans
that would have met the Farmer Mac underwriting standards that were in
place at loan origination because non-conforming loans could present
significantly different credit, market, and institutional risks.
2. Identification of Worst-Case Losses
According to the USDA, Texas ranked fourth among the 50 states in
terms of farm financial stress in the 1980s. In addition, our
experience with the System banks indicates that the FCBT did not
experience the worst historical losses on agricultural real estate
mortgages. Therefore, the only usable loan data we were able to
identify, the FCBT data, did not represent the worst-case agricultural
mortgage loss experience. We, thus, found it necessary to consider how
Texas loss rates related to other states and regions for determining
worst-case loss experience.
We employed a statistical procedure to expand the loan loss rates
for the FCBT to estimate loss rates for other states and regions of the
U.S. This procedure is explained in detail in the study published for
public comment. Briefly, the preferred regression equation identified
by Barry & Associates was based on the relationship between FCBT loss
rates and the annual percentage change in Texas farmland values over
the next 2 years. This regression equation was used to estimate
historical loss rates for every state from 1976 to 1993. Then a ranking
was compiled of 2-year loss rates for contiguous regions representing
at least 5 percent of the 1990 U.S. population. Our study concluded
that the worst-case region was found to contain Minnesota, Iowa and
Illinois during the 1983-1984 time period with a 2-year loan loss rate
of 4.18 percent. This region represents 7.5 percent of the U.S.
population. Our experience in overseeing FCS institutions with severe
credit problems and high default rates during this period also points
to the upper mid-west as the focal point of agricultural stress.
3. Use of the Benchmark Losses
Following our identification of the worst-case benchmark loss rate,
we began our development of the risk-based capital stress test. The Act
requires that the risk-based capital stress test use losses that occur
throughout the U.S. The identified losses are to be at a rate of
default and severity ``reasonably related'' to the rate and severity
that occurred for at least 2 years in contiguous areas of the U.S.
containing not less than 5 percent of the U.S. population.
The published study used loss rates extrapolated from the FCBT data
to identify the worst-case region. The primary variable used in the
extrapolation was the change in farmland values. However, we are not
proposing to use the benchmark loss rate in the risk-based capital
stress test. The extrapolation method used in the study was an
appropriate method for estimating aggregate loss rates on agricultural
mortgages. The method proposed here allows us to incorporate the
current risk characteristics of Farmer Mac's portfolio, including loan-
level data, in addition to the farmland value changes for the worst-
stress time period. These loan-level risk characteristics include loan
size, loan-to-value ratio (LTV), debt service coverage ratio

[[Page 61743]]

(DSCR), and debt-to-asset (D/A) ratio. The statistical method proposed
makes it easier for Farmer Mac to implement and for us to examine the
results.
Although we are not using the benchmark loss rate identified in the
published study, we use the percentage changes in farmland values from
the published study as a primary variable in estimating the loss rates
used in the stress test. Using the farmland value changes from the
published benchmark worst-case region of Minnesota, Iowa, and Illinois
as input in the credit risk portion of the risk-based capital stress
test is a direct linkage to the benchmark loss rate. The loss rates
used in the risk-based capital stress test are closely related to the
benchmark loss rate, because both are limited to changes in farmland
values. The changes in farmland values identified in the published
benchmark loss rate study are primary variables in the default equation
used in the risk-based capital stress test. Changes in farmland values,
as used in the risk-based capital stress test and the benchmark loss
rate study, represent the combined effects of the level and growth
rates of farm income, interest rates, and inflationary expectations.
More detailed information on the procedure for calculating loss rates
in the risk-based capital stress test is presented later in this
supplementary information and in the technical appendix.
4. Comments on the Benchmark Loss Report
As noted earlier, in July 1998 we published a ``Notice of
availability of study and request for comment'' on the loan loss study
completed by Barry & Associates. (See 63 FR 40282, July 28, 1998.)
Through the Notice, we made the results of the study available for
public comment in expectation that it would lead to improved input for
the credit risk component of the risk-based capital stress test. Due to
the complexity of the study and the importance of the benchmark loss
experience in the risk-based capital stress test, several parties
requested that we extend the comment period on the Notice from
September 15, 1998, to January 4, 1999, which we did.
We received five letters on the study from a variety of interested
parties. The commenters were Farmer Mac (2 letters), AgFirst Farm
Credit Bank, the American Bankers Association, and the Independent
Bankers Association of America (now the Independent Community Bankers
of America). We have considered these comments in the development of
this proposed risk-based capital regulation. Many of the comments were
related to the benchmark loss rates that were identified rather than
the loan loss data we used as the starting point or the land value
changes we identified. Because we are not using the benchmark loss
rates as the loss rates in the risk-based capital stress test, we do
not believe that a detailed response to each comment is relevant in
this supplementary information. Thus, we are providing a summary of,
and our response to, the primary comments relevant to this proposed
rule.
First, the commenters stated that the statute does not permit
extrapolation procedures in identifying the worst-case loss data. The
commenters asserted that the statute required us to use as benchmark
losses, the worst-case data that are available to us, i.e., the losses
from the FCBT portfolio. We disagree with this interpretation of the
statute. The statute directs us to use the worst-case data, not the
worst-case data ``that are available.'' Congress directed us to use
loan loss rates in the risk-based capital stress test that are
reasonably related to the area of the U.S. that experienced the
``highest rates of default and severity.'' Therefore, our first step
was to determine the benchmark worst-case losses pursuant to this
requirement.
Second, the commenters stated that the study failed to account for
appropriate credit risk distinctions between the historical FCBT data
and Farmer Mac's current portfolio. We believe it was appropriate to
use only those agricultural mortgages that would have been Farmer Mac-
eligible loans at the time the study was conducted so that the
benchmark losses would reflect losses on relevant loans. We reviewed
the process for selecting the screening criteria used in the study and
found it to be appropriate given the underwriting data of Farmer Mac's
portfolio, the statutory criteria for loan eligibility, and the
limitations of the FCBT data set. We also reviewed the eligible loan
set obtained from the FCBT data and determined that all variables were
within the values found in Farmer Mac's current portfolio. Thus, we
believe the data used for the benchmark study are appropriate. We also
consider it appropriate to account for Farmer Mac's current portfolio
risk factors in applying the loss rates in the risk-based capital
stress test. Thus, we consider the current make-up of Farmer Mac's
portfolio when we apply the loan loss default equation to determine the
loss rates used in the risk-based capital stress test. Later
discussions in this supplementary information and the technical
appendix further explain how the risk characteristics of Farmer Mac's
portfolio are incorporated in determining the loss rates used in the
risk-based capital stress test.

B. Construction of the Statutory Stress Test

Our second major undertaking was to develop a financial model to
represent Farmer Mac's assets, liabilities and off-balance sheet
positions at a sufficient level of detail to capture important risk
characteristics and project Farmer Mac's financial performance over a
hypothetical period of stress lasting 10 years. The focus of our
efforts was to determine the appropriate parameters and economic
relationships necessary for the risk-based capital stress test to
fulfill the statutory requirements. To accomplish this task, we worked
in consultation with Barry & Associates. Additionally, Farmer Mac and
PriceWaterhouseCoopers provided information relative to loan data,
Farmer Mac's operations, and economic relationships and statistical
methodologies for use in measuring various types and levels of risk.
A summary of the major components of the risk-based capital stress
test is provided in a subsequent section of this preamble and the
regulation. A more thorough discussion of all the technical aspects of
the risk-based capital stress test can be found in the technical
appendix to the proposed regulation. Due to the nature and complexity
of the risk-based capital stress test, we are also making an electronic
version of the risk-based capital stress test available to the public
through our website at www.fca.gov.
The proposed rule specifies the basic structure and parameters of
the risk-based capital stress test and allows Farmer Mac to implement
the stress test internally using a model built according to our
specifications to determine its risk-based capital level. During the 1-
year period following adoption of the final risk-based capital
regulation and on an ongoing basis thereafter, we will examine and
verify Farmer Mac's implementation of the risk-based capital stress
test to ensure compliance with the regulation, including the
specifications identified in the technical appendix to the regulation.
Furthermore, we are proposing that Farmer Mac have its implementation
of the risk-based capital stress test verified and audited once every 3
years by an external independent party. The audit should ensure that
the financial data used in the stress test are accurate and that stress
test is implemented in accordance with our regulations and procedures.
We note that because of the proprietary nature of specific, transaction
level loan and financial data used in the risk-based

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capital stress test, it is unlikely that results of the test will be
fully reproducible by parties other than Farmer Mac and us. Other
parties will, however, be able to approximate the test results on an
aggregate basis using publicly available information.

C. Examination and Oversight

From a regulatory perspective, the ongoing nature of the risk-based
capital stress test facilitates our understanding of how changes in
Farmer Mac's business activities will affect its risk profile and
resulting capital requirements. A risk-based capital stress test,
because it is based on statistical relationships, is limited in a
number of important ways that must be understood before it can be used
as an effective regulatory tool. Foremost, the risk-based capital
stress test uses econometric relationships based on historical data to
estimate potential loss rates. Past historical data, even though
required by the statute, may not be the best basis for projecting the
performance of new agricultural mortgages originated using a different
set of underwriting criteria and subject to a different set of economic
conditions. As a result, we may need a significant period of time to
collect and analyze new data to appropriately update the risk-based
capital stress test procedures. Furthermore, the effectiveness of the
risk-based capital stress test may be influenced by changes in Farmer
Mac's operations, underwriting standards or products and services
offered. Lastly, the risk-based capital stress test best measures
identifiable and quantifiable risks.
Therefore, our ongoing monitoring and on-site examination will be
integral in assessing Farmer Mac's capital adequacy. Our monitoring and
examination program will help ensure that Farmer Mac appropriately
implements the risk-based capital stress test and aid in identifying
non-quantifiable risks that the risk-based capital stress test cannot
measure. Together, the ongoing monitoring and examination by OSMO will
enable us to provide effective regulatory oversight and ensure the
adequacy of regulatory capital standard set by the risk-based capital
stress test.

V. Risk-Based Capital Stress Test

The risk-based capital stress test is intended to be forward-
looking and sensitive to fluctuations in the economy, as well as to
changes in Farmer Mac's asset composition, funding strategies, and on-
and off-balance sheet exposures. The risk-based capital level, unlike
simple leverage ratios, is tailored to specific risks in Farmer Mac's
book of business. In designing the risk-based capital stress test, we
sought to identify and incorporate all significant credit and interest
rate risks to which Farmer Mac is exposed.
Given the risk-based capital stress test's sensitivity to changing
risk conditions, the risk-based capital requirement bears no direct
relationship to the statutory minimum capital requirements. Based on a
Farmer Mac condition of relatively low risk exposure, the risk-based
capital stress test could produce a risk-based capital requirement
below that of the statutory minimum standard. When this occurs, Farmer
Mac must continue to meet its statutory minimum capital level.
Econometric models are used to project the effects of stressed
conditions on Farmer Mac's assets, liabilities and off-balance sheet
activities. The risk-based capital stress test will project credit
losses from defaults on agricultural mortgages and loss severities
comparable to the worst historical agricultural mortgage default loss
experience in any region of the country.
The risk-based capital stress test is designed to capture Farmer
Mac's specific exposure to credit and interest rate risks under
stressed conditions. Economic conditions of the stress scenario affect
Farmer Mac's agricultural mortgage performance, earnings and market
values, and ultimately required capital. For example, movement in
farmland values, which reflect changes in farm income and interest
rates, influence mortgage credit loss rates, which in turn affect
Farmer Mac's cashflows and capital accretion or depletion. By requiring
the risk-based capital stress test to be conducted on a quarterly
basis, we will strive to identify changes in capital needs before such
economic events as declining farmland values can impact Farmer Mac's
balance sheet to any significant degree. Thus, the risk-based capital
stress test is more dynamic than simple leverage ratios because the
entire business profile of Farmer Mac from assets and liabilities to
off-balance sheet obligations is modeled.
The goal of the risk-based capital stress test is to align capital
requirements with risk and avoid creating incentives for the
Corporation to engage in inappropriately risky activities. The stress
test approach also provides greater flexibility to meet regulatory
requirements than is available in traditional capital requirements. For
instance, the stress test approach recognizes risk-mitigating
activities. As an example, Farmer Mac may meet its risk-based capital
needs by reducing risk and/or increasing capital.
Proposed Sec. 650.24 describes the main components of the risk-
based capital stress test that Farmer Mac must apply to its current
operations. The technical appendix to the regulation provides details
on the specification and estimation of the statistical (econometric)
model used to project Farmer Mac performance over the 10-year stress
period. Additionally, the technical appendix discusses how the
statistical model is applied in the proposed risk-based capital stress
test. The key stress test components, include data requirements,
specifications of credit risk, interest rate movements, the cashflow
generator, and the capital calculation.
The following discussions provide a general overview of the risk-
based capital stress test components and explanation of the concepts
underlying the stress test.

A. Data Requirements

Historical loan data from the FCBT are used to determine
appropriate relationships among mortgage-risk factors, rates of loan
default and loss occurrence. Data on Farmer Mac's current book of
business are used to establish Farmer Mac's initial balance sheet
structure, financial position and risk profile for the start of the
risk-based capital stress test. Current interest rate information as
described in the technical appendix is needed for the interest rate
component of the risk-based capital stress test.
Farmer Mac will be required to provide additional information in
its quarterly financial reports to us. Specific details regarding the
new requirements will be provided through modifications to our Call
Report instructions. Although we are allowing Farmer Mac the
flexibility to determine its risk-based capital level and report its
results to us, we believe it is essential for FCA to retain the
capability to also determine Farmer Mac's risk-based capital level.
Therefore, we intend to modify the current Call Report instructions to
accommodate our data and information needs.

B. Farmer Mac Programs and Risk Characteristics

Farmer Mac operates a variety of secondary market programs with
varying amounts of risk to fulfill its mission. A brief description of
these programs follows.

[[Page 61745]]

1. Farmer Mac I--Direct Loan Purchases
Farmer Mac purchases from approved lenders\11\ qualified loans
secured by a first mortgage on agricultural real estate, including
part-time farms that meet specified credit standards. Farmer Mac
provides liquidity to the agricultural mortgage market by: (1)
Purchasing newly originated qualified loans directly from lenders on a
continuing basis through its ``cash window''; (2) exchanging qualified
loans for securities issued and guaranteed by Farmer Mac (Farmer Mac
Guaranteed Securities) through ``swap'' transactions; and (3)
purchasing portfolios of existing loans on a negotiated basis.\12\
Qualified loans purchased by Farmer Mac are aggregated into pools that
back Farmer Mac Guaranteed Securities, which are periodically issued
and sold to investors in the capital markets. Farmer Mac also has the
authority to purchase these securities and hold them in its portfolio.
Farmer Mac receives income from guarantee fees on securities it
guarantees. Farmer Mac also receives interest income on securities it
holds.
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\11\ Approved lenders are financial institutions that have met
Farmer Mac's technical, financial and stock ownership requirements.
\12\ See Farmer Mac's 1998 Annual Report.
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2. Farmer Mac I--Long-term Standby Purchase Commitment
Under a standby purchase commitment agreement with the lender,
Farmer Mac receives an annual fee in return for its commitment to
purchase certain loans in the future. The lender services the loans and
retains them on its books in a segregated pool. This program allows
approved lenders to reduce credit risk and free capital to make
additional loans.
3. Farmer Mac I--AgVantage Bond Sales
AgVantage bonds are highly collateralized corporate debt issued by
approved lenders to Farmer Mac, which in turn guarantees the bonds. The
approved lenders pledge qualified loans and other securities (Treasury
securities) as collateral, which are retained by the lenders. This
program provides approved lenders with another means to fund qualified
loans and generates revenue for Farmer Mac. Farmer Mac receives revenue
in the form of interest income on AgVantage bonds.
4. Farmer Mac II
Under Farmer Mac II, the Corporation purchases the portions of
loans guaranteed by the USDA. The Food, Agriculture, Conservation, and
Trade Act of 1990 (Pub. L. 101-624) (1990 Act) gives Farmer Mac the
authority to operate a secondary market for certain USDA-guaranteed
loans. The guaranteed portions of loans are pooled and securitized by
Farmer Mac or other certified facilities. Farmer Mac then guarantees
the repayment of the securities. Farmer Mac receives income from
guarantee fees on securities it guarantees. Farmer Mac also receives
interest income on securities it holds.
5. Farmer Mac--Rural Housing
Home mortgages from lenders in rural areas and small communities
are eligible for sale to Farmer Mac for pooling and securitization.
Rural housing is defined by Farmer Mac as a one-to-four family, owner-
occupied principal residence that is a moderately priced dwelling
located in a community having a population of 2,500 or fewer
inhabitants; the dwelling (excluding the land to which it is affixed)
cannot have a purchase price or current appraised value of more than
$100,000 (adjusted annually for inflation). This figure is currently
$133,000. In addition to the dwelling, a rural housing loan can be
secured by land associated with the dwelling having an appraised value
of no more than 50 percent of the total appraised value of the combined
property. As of August 31, 1999, Farmer Mac had not issued any
securities backed by rural home mortgages.
6. Risk Characteristics
Farmer Mac's primary exposure to credit risk is the risk of loss
resulting from the inability of borrowers to repay their mortgages.
Farmer Mac is exposed to credit risk on the loans it holds or
guarantees against default, as well as securities it guarantees. Farmer
Mac guarantees the timely payment of principal, including any balloon
payments, and interest on securities. Loans held or guaranteed by
Farmer Mac can be divided into three groups: (1) Pre-1996 Act Farmer
Mac I loans; (2) post-1996 Act Farmer Mac I loans; and (3) Farmer Mac
II loans. Within these general groupings, Farmer Mac, as previously
discussed, operates other programs. Each of these programs carries
different amounts of credit risk that must be appropriately reflected
in the credit risk component of the risk-based capital stress test.
For pre-1996 Act loans, subordinated interests mitigate Farmer
Mac's credit risk exposure. Before Farmer Mac incurs a credit loss,
recourse must be taken against the subordinated interest. At December
31, 1998, the subordinated interest of each outstanding security on
pre-1996 Act Farmer Mac I loans was equal to or greater than 10
percent. The 1996 Act eliminated the subordinated interest requirement.
As a result, Farmer Mac assumes 100 percent of the credit risk exposure
on the post-1996 Act Farmer Mac I loans. Farmer Mac mitigates the
credit risk related to these loans through the application of its
underwriting standards and by requiring collateral in the form of real
estate. Farmer Mac's credit exposure on Farmer Mac II loans is covered
by the ``full faith and credit'' of the U.S. Government by virtue of
the USDA guarantee of the principal and interest on all guaranteed
portions.
There is very limited, if any, credit risk exposure on the pre-1996
Act loans due to the subordinated interest, or on the Farmer Mac II
loans because of the USDA guarantee. For this reason, we are not
requiring Farmer Mac to project any credit losses on these programs
during the stress period of the test. Farmer Mac's credit risk exposure
on post-1996 Act Farmer Mac I loans is fully reflected in the risk-
based capital stress test. Farmer Mac I rural home loans are subject to
the same loss rates as agricultural mortgages. Rural home loan loss
rates are not computed independently given the lack of data and the
fact that there is no outstanding loan volume held on the balance sheet
or guaranteed.
Farmer Mac is also exposed to institutional credit risk relating
to: (1) Issuers of AgVantage bonds and other investments held by Farmer
Mac; (2) sellers and servicers; and (3) interest-rate contract
counterparties. We decided not to model these sources of institutional
credit risk for several reasons. AgVantage bonds are general
obligations of the AgVantage bond issuers and secured by collateral in
an amount ranging from 120 percent to 150 percent of the bond amount.
In addition to requiring collateral, Farmer Mac mitigates credit risk
related to AgVantage bonds by evaluating and monitoring the financial
condition of the AgVantage issuers. Farmer Mac manages institutional
credit risk related to sellers and servicers by requiring such
institutions to meet certain standards and by monitoring their
financial condition and servicing performance. The credit risk inherent
in the investment portfolio is mitigated by Farmer Mac's policy of
investing in highly rated institutions and by establishing
concentration limits, which reduce exposure to any one counterparty.
Furthermore, the short-term nature of Farmer Mac's investment portfolio
limits credit risk. Farmer Mac mitigates credit risk arising from
interest-rate swaps by dealing only with counterparties with high
credit ratings,

[[Page 61746]]

establishing and maintaining collateral requirements, and entering into
netting agreements.
We are proposing to capture Farmer Mac's institutional credit risk
exposure through the 30-percent management and operations risk add-on
required by the statute. At this time, we believe modeling
institutional credit risk presents many challenges that would
unnecessarily complicate the risk-based capital stress test. However,
if Farmer Mac significantly increases its credit risk exposure in these
areas through modifications to its current operating policies, we will
reconsider how to best reflect institutional credit risk exposure in
the risk-based capital stress test.
Farmer Mac is also exposed to credit risk concentration in the
mortgages it holds and guarantees. Farmer Mac's current policy is to
limit its credit exposure in a particular geographic region or
commodity to a percentage of total principal amount of all loans
outstanding. Additionally, Farmer Mac employs more stringent
underwriting criteria in regions with higher loan volume
concentrations. Such underwriting criteria consider the credit quality
of the loans in a particular geographic region or commodity based on
the borrower's LTV, DSCR, equity-to-asset and working capital-to-
current asset ratios. The effectiveness of Farmer Mac's underwriting
standards is specifically measured in the risk-based capital stress
test through our model of loan losses as described more thoroughly in
the next section as well as in the technical appendix.

C. Credit Risk

A statistical methodology is used to model the stress conditions
described in the statute. Econometric models are used to estimate the
probability of mortgage defaults and the severity of loss under
stressed conditions. Detailed instructions for measuring credit risk
are provided in the technical appendix.
1. Estimation of Default.
A logistic model is used to estimate the frequency of defaults from
historical FCBT loan data. Logistic models are widely accepted as an
appropriate methodology for modeling loan-level mortgage defaults.
There are several well-known predictors of mortgage default, including
loan age, payment burden, LTV, and interest rates. Additionally, there
are other variables that are specific to farm mortgages, such as
farmland prices, net farm income, commodity prices and the D/A ratio.
These variables, in addition to a host of others, were considered in
the process of modeling defaults of FCBT loans. After extensive
statistical analyses, the final equation for estimating the frequency
of default includes the following variables:
Maximum decline in farmland values
LTV ratio
DSCR
Original loan balance in 1997 dollars
D/A ratio
These variables have logical relationships to the incidence of loan
default and loss.
a. Farmland values. Changes in farmland prices are an important
factor in the model because they directly affect the likelihood of
mortgage defaults and the magnitude of potential losses. In estimating
the default frequency equation, the largest annual percentage decline
in farmland values resulted in the strongest relationship between an
economic variable and default frequency. For stress test purposes, we
used the largest decline in farmland values from the benchmark loss
experience as an input variable.
Because the lives of loans are unknown at origination and differ
among loan observations, annual economic variables or annual changes
throughout the life of the loan cannot be consistently applied across
all loans. Economic variables need to be expressed in a form that can
be applied to loans regardless of the life of the loan. For example,
geometric average lifetime changes, minimum changes, or maximum changes
could be considered. The maximum percentage decline in annual Texas
farmland values resulted in the strongest relationship among economic
variables considered in the estimated equation for default frequency.
b. Loan-to-value Ratio. Another important variable known to drive
defaults is the LTV ratio. LTV is equal to the loan amount divided by
the appraised value of the underlying property. This variable is one of
the primary underwriting ratios that Farmer Mac uses in its loan
purchasing decisions. LTV indicates the relative safety of
collateralized debt. Large equity investments represent a substantial
incentive for a borrower to continue making mortgage payments to
safeguard their equity position in their property. Furthermore, if an
income problem does arise, lower LTVs provide a significant cushion for
the borrower to sell the underlying asset at a price that is sufficient
to cover accrued interest and the remaining outstanding principal.
Conversely, high LTV loans are more likely to default.
Ideally, an updated LTV could be calculated each year, which would
take into account amortization and changes in property value. While we
cannot obtain updates in the market value of the underlying collateral,
the USDA Texas farmland value series could serve as a proxy for helping
to update the denominator of the LTV. Since the amortization schedule
of the FCBT data was not available, however, updating the numerator
would require making payment assumptions as well. Rather than making
additional assumptions, we opted to use LTV at origination.
c. Debt Service Coverage Ratio. A key factor in our assessment of
potential frequency of default is the DSCR of a loan at origination.
The numerator in the DSCR is net income plus depreciation, interest on
capital debt, capital lease payments, and net off-farm income less
living expenses and income taxes. The denominator is the sum of the
total annual debt service requirements. Loans with low DSCRs have a
higher expected frequency of default because borrowers cannot be
expected to fund losses indefinitely. Conversely, loans with high DSCRs
have a lower likelihood of default because they have an excess cashflow
buffer, which would have to erode before the borrower would experience
losses and consider defaulting. This variable would ideally be updated
over the term of the loan. However, because of data limitations and the
cyclical nature of agricultural receipts, DSCR at origination is used
as the variable.
d. Origination Loan Balance. The beginning loan balance also proved
to be a significant factor of default. We adjusted the origination loan
balance for current constant dollars when we estimated the default
equation and applied it to Farmer Mac's data. The base year we selected
is 1997 and we adjusted the current dollars based on the consumer price
index. It has been observed in the agricultural mortgage market that
larger loans tend to have higher default rates. Liquidity constraints
are the likely cause of this phenomenon. For a borrower who is
experiencing financial difficulty, one of the alternatives is to sell
the property and prepay the loan. Considering that there is relatively
less demand for large farm properties, the owners of these properties
may have difficulty in selling their properties in such an illiquid
market. This inability to sell and then prepay eventually limits the
farmers' alternatives to default.
e. Debt-to-asset ratio. The D/A ratio at origination is the last
explanatory variable used in the default frequency estimation model.
The D/A ratio

[[Page 61747]]

indicates the borrower's total amount of financial leverage. This is an
important factor in agricultural lending because agricultural producers
typically have significant amounts of debt from operations in addition
to farm real estate debt. Borrowers with high D/A ratios experience
higher default rates because they have limited capacity to withstand
adverse conditions.
2. Loss Severity
Loss severity is a key element in the estimation of loan losses.
Loss severity is defined as the total dollar amount of losses on a
defaulted loan expressed as a percentage of origination loan balance.
The loss severity rate is estimated with the same FCBT data employed in
the estimation of defaults. To estimate loss severity, we searched for
a significant statistical relationship between loss rate and various
independent indicators in the FCBT loan-level data. We concluded, after
extensive analysis, that the data set was insufficient to estimate an
acceptable loss severity rate. As a result, the loss severity rate is
calculated by taking the weighted average loss of defaulted loans. The
resulting loss severity rate is 20.9 percent. When a more extensive
data set becomes available, loss severity can be re-estimated.
3. Age Adjustment
Mortgage seasoning (aging) is widely accepted as an important
determinant in default frequency. The probability of default is low in
the early life of a loan and increases as the loan ages until it peaks
in years 6 to 8. After this peak period, the borrower has developed
greater equity in the property and the likelihood of default tapers
off. Therefore, we adjust loan-level loss to reflect the differences in
loss occurrence attributed to loan seasoning. We used FCBT data to
estimate the distribution function for loan seasoning assuming that the
loans have a 14-year average life.
4. Time Pattern of Loss Occurrence
The age-adjusted losses are then distributed through time on a
deterministic path that is representative of a stressful scenario. The
loss rates estimated in the credit risk component of the risk-based
capital stress test are based on an origination year concept. Under
this approach, all losses arising from loans originated in a particular
year are expressed as a percent of that year's originated loan volume
irrespective of when the losses actually occur. The stress test must
adjust the origination loss rates to an exposure year concept, in which
losses occurring in any 1 year are related to the total outstanding
loan volume in that year. Because all loans held at any time are not
all originated in that year (or, conversely, loan principal balances
are reflected on more than 1 year's balance sheet), the origination
year loss rates must be adjusted to exposure year rates. To adjust from
origination to exposure year losses, we apply a deterministic time path
for loss occurrence during the 10-year stress period. The deterministic
time path for converting from origination year to exposure year was
determined by calculating exposure year losses in the FCBT data and
expressing such losses as proportions of total losses for each
origination year. The maximum 1-, 2-, 3-, and 4-year commutative
proportions of total origination loss observed in the FCBT data are
used in the first four periods of the stress test. The remaining losses
are equally allocated to years 5 through 10 of the stress test.

D. Interest Rate Risk

The statute requires the risk-based capital stress test to
incorporate an interest rate risk component. Interest rate risk is the
risk that interest rate changes could materially affect Farmer Mac's
market value of equity and future earnings. Farmer Mac may be exposed
to interest rate risk through any product or activity that is sensitive
to changes in interest rates. Farmer Mac is exposed to three primary
sources of interest rate risk: (1) Farmer Mac I and Farmer II
securities; (2) other assets held for investment; and (3) loans held
for securitization.
Farmer Mac's primary strategy to manage interest rate risk related
to Farmer Mac I and II securities and other assets held for investment
is to fund them with liabilities that have similar durations or average
cashflow patterns over time.\13\ To achieve the desired liability
duration, Farmer Mac uses a mix of short-term discount notes and
callable and non-callable medium term notes. By using a mix of
liabilities that includes callable debt, the duration of the
liabilities will tend to increase or decrease as interest rates change
in a manner similar to the changes in the duration of assets. Farmer
Mac also uses a variety of off-balance sheet derivative financial
instruments to manage its interest rate risk exposure.
---------------------------------------------------------------------------

\13\ See Farmer Mac's 1998 Annual Report.
---------------------------------------------------------------------------

The Treasury yield curve represents the market's view of risk-free
borrowing over a range of maturities. As such, it serves as a
foundation for all other market rates. In the context of the risk-based
capital stress test, the general level of interest rates will directly
affect major components of Farmer Mac's business, including borrowing
costs and earnings on mortgages and investments.
The statute specifically describes how Treasury rates must vary
during the 10-year risk-based capital stress test period. While the Act
provides a fairly specific description of how rates change in the
stress scenario, it is silent on how we are to measure the financial
effect of those rate changes. Accordingly, we are proposing the
following procedures for implementing the statutory stress test and
measuring Farmer Mac's exposure to interest rate risk.
Measurement of Farmer Mac's interest rate risk exposure requires
the ability to estimate the sensitivity of the Corporation's assets and
liabilities to interest rate risk. Vulnerability to interest rate risk
is expressed through the degree of match between an institution's rate
sensitive assets and liabilities, or between the durations of its
assets and liabilities. More closely matched positions reduce the
vulnerability to interest rate risk. By determining its duration gap,
as measured by the difference between the duration of assets and
liabilities under various parallel and instantaneous shifts in the
yield curve, Farmer Mac can assess the potential effects of mismatches
between the durations of its assets and liabilities. Farmer Mac derives
its interest rate sensitivity measures using a commercially developed
model, current market information, and other proprietary information.
We are proposing to use Farmer Mac's duration measures as inputs
into the stress test to capture the cumulative effects of the
Corporation's interest rate risk exposure under the interest rate shock
scenarios required by the Act. We have two reasons for using this
approach. One, we routinely assess Farmer Mac's interest rate risk
measurement and management through our examination process. During this
process, we closely evaluate the assumptions and inputs used in Farmer
Mac's interest rate risk sensitivity measures. Therefore, we can
validate the process and obtain the necessary confidence in the
accuracy and integrity of the results to permit us to use them as
inputs into the stress test. Our second reason for using Farmer Mac's
internal duration measures is that it reduces the complexity of the
stress test, thereby increasing the efficiency in implementing the
model.
To estimate the effects of the interest rate shocks (up and down
scenarios) on Farmer Mac's equity position, we compute effective
duration over each

[[Page 61748]]

interest rate shock scenario using information supplied by Farmer Mac.
The duration measure is then used as a proxy for market value effects
under each interest rate scenario. We consider Farmer Mac's assets and
liabilities to be available for sale under GAAP. Thus, Farmer Mac must
record changes in market values as increases or decreases to equity on
its balance sheet. Finally, Farmer Mac must determine its risk-based
capital level based on the rate movement (increase or decrease) that
results in the highest level of required capital.
As noted, Farmer Mac is subject to interest rate risk on all assets
held for investment because of the timing differences in the cashflows
of the assets and related liabilities. This risk is primarily related
to Farmer Mac I and II securities because of the ability of borrowers
to repay their mortgages. Mortgage prepayments can cause fluctuations
in the value of Farmer Mac securities to the extent they change
cashflows of Farmer Mac's on- and off-balance sheet assets. Yield
maintenance provisions associated with many of the loans underlying
Farmer Mac securities significantly reduce, but do not eliminate, this
risk.\14\
---------------------------------------------------------------------------

\14\ Yield maintenance provisions require borrowers to make an
additional payment to Farmer Mac when they repay their loans.
---------------------------------------------------------------------------

Although the effects of increasing and decreasing prepayments are
captured in Farmer Mac's market value results, we are also proposing to
use prepayment rates as input variables for generating balance sheet
cashflows. We provide Farmer Mac the option to use their actual
prepayment experience or assumed prepayment rates estimated from other
data sources for the reasons explained below.
Prepayment rates often are estimated statistically by measuring
relationships between prepayment and a set of independent variables
that have been found to influence the prepayment rate. For several
reasons, however, statistical relationships were not feasible to
estimate in this case. During the historic time period in which the
FCBT data were compiled, the FCBT priced its farm real estate loans
with floating interest rates that adjusted annually in response to
changes in the FCBT's average cost of funds. The resulting loan rates
followed changes in market rates but with slower and lower rates of
change. Because Farmer Mac does not engage in average cost pricing,
estimating a prepayment function from the FCBT data would bear little,
if any, relationship to prepayment rates experienced by Farmer Mac in
the future. Moreover, an explicit or implicit prepayment measure was
not available or obtainable from the FCBT data.\15\
---------------------------------------------------------------------------

\15\ The FCBT data set has a ``status'' variable that indicates
whether the loan was active, foreclosed, re-amortized, paid in full
or merged with a new loan.
---------------------------------------------------------------------------

Implementation of the interest rate shock requires several steps.
The statutory interest rate shock is applied to the initial interest
rate level, which is the preceding 3-month average of the 10-year
Constant Maturity Treasury (CMT) rate. The 10-year CMT is frequently
used for financial modeling of GSEs \16\ since it is viewed as a good
index for the cost of funds. Previous studies by Barry & Associates
found the 10-year CMT to be a reliable index for System funding costs,
and the 10-year CMT did not suffer random or unexplainable variations
observed at shorter-term points on the yield curve. Thus, using a 3-
month average avoids the possibility of unusual and extreme short-term
movements in interest rates unduly influencing the results of the test
and Farmer Mac's risk-based capital requirement. The interest rates
resulting after the rate shock serve as the index needed to simulate
mortgage and investment performance over the stress period and to
calculate the risk-based capital level. Because many different interest
rates affect Farmer Mac's business performance, we allow the use of
other non-Treasury yield curves to simulate the financial effects of
the interest rate shock on Farmer Mac's cashflows, income statement,
and balance sheet.
---------------------------------------------------------------------------

\16\ The Office of Federal Housing Enterprise Oversight also
used the 10-year CMT as a component of their previously published
proposed risk-based capital rule. (See 64 FR 18083, April 13, 1999.)
---------------------------------------------------------------------------

Subject to our concurrence, Farmer Mac may use additional indexes,
such as the London Interbank Offer Rates (LIBOR), in the risk-based
capital test as long as the relationships between those indexes and the
10-year CMT are based on standard, widely used term structure modeling
relationships. Farmer Mac may use these relationships to compute the
cost of new debt, yields on investments, and coupon rates on mortgages
purchased or guaranteed by Farmer Mac. The interest rate index and rate
shock procedures described in the technical appendix are minimum
guidelines, and although Farmer Mac can use additional indexes, the
resulting risk-based capital level cannot be lower than it would be if
only the 10-year CMT were used.

E. Cashflows

Our spreadsheet based model projects cashflows from all of Farmer
Mac's assets, liabilities and off-balance sheet activities. Farmer Mac
may use its own internal cashflow generator system and programming for
this aspect of the risk-based capital stress test. However, Farmer Mac
must first obtain our concurrence for any internal cashflow generator
system and follow the procedures described in the technical appendix to
this regulation.
There are numerous modeling constructs and assumptions used in the
proposed cashflow component of the stress test. For the test,
investments are aggregated into the following categories: (i) Cash and
money market securities; (ii) commercial paper; (iii) certificates of
deposit; (iv) Agency mortgage-backed securities and collateralized
mortgage obligations; (v) and other investments. With our concurrence,
Farmer Mac is permitted to more finely disaggregate these categories.
Any new category deemed material to its operation in the future will
also be required to be added as a separate account. The level of
aggregation must appropriately reflect the contributions of revenues
and expenses of major program activities. For each asset class, we must
be able to discern the earnings rate and funding cost. Loan items
requiring separate accounts include: (i) Farmer Mac I program assets,
post-1996 Act; (ii) Farmer Mac I post-1996 Act swap balances; (iii)
Farmer Mac I pre-1996 Act loans; (iv) Farmer Mac I AgVantage
securities; (v) loans held for securitization; and (vi) Farmer Mac II
loans.
During the stress test, the balance sheet remains a constant size
over the 10-year period. This reflects a steady state scenario, meaning
that when on-balance sheet assets and liabilities and off-balance sheet
obligations amortize or pay-down, they are replaced with similar
assets, liabilities, and obligations. However, as discontinued loan
programs (e.g., pre-1996 Act Farmer Mac I program) amortize, they are
assumed to be replaced by current loan programs to more appropriately
reflect Farmer Mac's current operations.
We use effective years to maturity to simulate the amortization of
financial instruments, such as loans and other investments. A constant
prepayment rate (CPR) is used for all assets that have embedded
prepayment options. Together, the effective years to maturity and the
CPR are used to establish a roll-off rate and generate cashflows
reflecting a steady state over the stress

[[Page 61749]]

period. All cashflows and losses are computed on an annual basis.
To construct pro forma income statements for each period of the
stress test, it is necessary to establish rules and relationships for
deriving future income and expense items. Information from the first
period balance sheet is used in conjunction with the earnings and cost-
spread relationships from Farmer Mac supplied data to generate the
first period's income statement. In our spreadsheet model, each
investment account, loan item, and liability account can be specified
as either: (i) A fixed rate investment; or (ii) an instrument with a
fixed spread to Treasury with initial rates determined by actual data.
The specific spreads (weighted average yield less initial 10-year CMT)
by category are calculated directly in the stress test from the
weighted average yield data supplied by Farmer Mac in accordance with
the data requirements described in the technical appendix.
For non-interest income items, we follow certain decision rules for
generating earnings over time. For example, gains on agricultural
mortgage-backed security (AMBS) sales are a function of the amount of
new AMBS being issued. We based the relationship on historical
financial information. Expense items, such as fixed cost and variable
cost, are measured using a regression equation where operating expenses
is the dependent variable and the sum of investments and Farmer Mac
program assets held on-balance sheet is the independent variable. We
use the historical relationship of reserves to loan assets (that are
subject to reserves, post-1996 Act Farmer Mac I loan items, on- and
off-balance sheet) to simulate the loan reserves over time. The
corporate tax rate is estimated from actual Farmer Mac financial data.
Guarantee fee rates are obtained from actual guarantee fees charged by
Farmer Mac on its loan programs.

F. Financial Reports

Pro forma financial statements showing the resulting capital levels
for each period of the stress test are developed. Annual pro forma
balance sheets and income statements are generated for the stress
period using Farmer Mac's starting position, the stress conditions,
resulting cashflow outputs, and current operating strategies and
policies, as well as other assumptions. The proposed regulation
provides Farmer Mac with the option to use its own financial software
to produce the projected financial statements using the risk-based
capital stress test specifications and parameters described in the
technical appendix to this regulation. Projected financial statements
must comply, to the extent practical, with GAAP.

G. Capital Calculation

The risk-based capital stress test determines the amount of
starting capital Farmer Mac must hold to maintain a positive amount of
capital throughout the stress period using an iterative methodology.
Also, Farmer Mac must add on an additional 30 percent to this amount to
account for management and operational risk. Section 8.31(5) of the Act
defines regulatory capital as core capital (the par value of
outstanding common and preferred stock, paid-in capital, and retained
earnings), plus the allowance for losses and guarantee claims, as
determined in accordance with GAAP.
More specifically, to calculate the risk-based capital, our model
includes a section to solve for the minimum initial capital amount that
results in at least zero capital at the end of each period of the 10-
year stress test. In solving for initial capital, it is assumed that
reductions or additions to the initial capital accounts are made in the
retained earnings accounts and are balanced in the debt accounts at
levels proportionate to initial balances (same relative proportion of
long- and short-term debt as existing initial proportions). Because the
initial capital position affects the earnings, and hence capital
positions and appropriate discount rates through time, the initial and
future capital are simultaneously determined and must be solved using
an iterative process.

H. Future Changes to the Stress Test

Farmer Mac's performance over the stress period reflects its
current operating policies and other assumptions about its operations
to make the model functional. Due to significant data limitations
relating to a variety of issues, we were required to make a number of
simplifying assumptions. We recognize this may require us to revisit a
number of issues, particularly as more data become available from
Farmer Mac's own operations. Therefore, we will continually monitor the
risk-based capital stress test results and consider whether
modifications to the risk-based capital stress test are warranted. In
particular, we anticipate that as more data from agricultural mortgage
losses, especially those loans currently securitized by the Corporation
become available, changes may be required in the risk-based capital
stress test through amendment of this subpart.
Through our ongoing evaluations of the risk-based capital stress
test, we also may find it necessary to make technical modifications to
the risk-based capital stress test procedures. If we modify the
procedures for implementing the risk-based capital stress test, we will
notify Farmer Mac and provide them with written instructions to
implement the changes. We will make these modifications available to
the public on a quarterly basis on our web site.

VI. Statistical Properties of the Default Equation

This section provides further details about the credit risk
component, including the underlying theory, analytical methods, data,
model specifications, econometric estimation results, and conformance
with the worst-case conditions specified in the statute. This section
is intended for readers who desire further information on the
measurement of credit risk and the statistical properties of the
default estimation equation.

A. Estimation Methods

Historic time series on the frequency and severity of losses on
farm mortgage loans are compiled from available loan-level data.\17\
The measures of frequency and severity are related to selected loan-
level characteristics and macroeconomic conditions through
appropriately specified regression equations in order to account
explicitly for the collective effects of these characteristics on
frequency and severity of loss. The resulting regression equations are
applied to estimate Farmer Mac's future credit risk position by
substituting the respective values of their loan level characteristics
and macroeconomic (farmland value changes) measures into the estimated
regression equations, calculating the results, and determining the
performance implications.
---------------------------------------------------------------------------

\17\ As previously discussed, the historic loan data was
obtained from FCBT.
---------------------------------------------------------------------------

Several estimation approaches are possible, although the ultimate
choice depends on the degree of conformance between the characteristics
of the data and the properties of the respective regression methods. In
the case of frequency of default and loan loss occurrence, the loan
outcome is a qualitative, binary variable--default and loss either
occur or do not occur. Therefore, the appropriate regression procedure
must also accommodate qualitative characteristics (e.g., loan default
and loss is coded with a value of 1, while successful loan performance
is coded with a value of 0).

[[Page 61750]]

Regression approaches with qualitative dependent variables include
the linear probability model, logit, and probit. The linear probability
model has a number of shortcomings and is rarely used. Under the linear
probability model, estimates can occur outside the 0-1 interval
resulting in nonsense probabilities and negative variances. Logit and
probit are the most commonly used approaches. The primary difference
between the two approaches is the assumed underlying probability
distribution. The probit model assumes a normal distribution while the
logit model uses the logistic distribution. Logit is used more
frequently in modeling loan defaults, and is utilized in the credit
risk component of the stress test.
In the case of severity of loss, the resulting magnitude of loan
loss does not have a qualitative characteristic. Rather, magnitude of
loss occurs in a continuous form, bounded at zero, thus requiring a
different modeling approach.
The two equations for frequency and severity could be estimated
independently. If they are estimated independently, but are in fact
related, inconsistent estimates result. A method to accommodate
possible dependence is to use a Heckman two-step approach that first
assesses the probability of default then subsequently estimates the
level of loss based on similar or different covariates. Accordingly,
Heckman's two-step or ``Heckit'' estimation method was also explored.
The Heckman two-step approach is estimated using method of moments
techniques that results in consistent estimates.\18\ Basically, it is a
discrete model estimated on the basis of sample selection criteria.
Then, a linear regression is performed in the second step. Examples of
the two-step estimation procedure include Miller, Barry, Ellinger, and
Lajili and Nakosteen and Zimmer.\19\ The method utilizes an asymptotic
covariance for the two-step estimation and results in a consistent
estimator for variance (e2). The system
specification is appropriate in this case because of the relationship
between the two equations. That is, severity of loss only occurs on
defaulted loans. Default is required in order for loss to occur. While
we explored this approach, the two-step procedure did not yield
significant results for estimating a loss severity equation. Severity
was not found to vary systematically and considered constant across the
tested loan characteristics and lending conditions. Therefore, the
simple weighted average by loss volume of 20.9 percent is used in the
stress test.
---------------------------------------------------------------------------

\18\ Greene, W. A. Economic Analysis, 3rd ed., Prentice Hall,
1997.
\19\ Miller, L.P.N. Ellinger, P.J. Barry, and K. Lajili. ``Price
and Non-Price Management of Agricultural Credit Risk,'' Agricultural
Finance Review, 53 (1993): 28-41. Nakosteen, R. and M. Zimmer.
``Migration and Income: The Question of Self-Selection,'' Southern
Economic Journal, 7 (1980): 840-851.
---------------------------------------------------------------------------

Due to Farmer Mac's relatively short history, its own loan-level
data are insufficiently developed for use in estimating default
frequency and loss severity equations. In the future, however,
expansions in both the scope and historic length of Farmer Mac's
lending operations likely will warrant use of its data in estimating
the regression equations.

B. Model Specifications

Agricultural credit and residential mortgage literature suggest
several independent financial variables to consider in modeling loan
default. These include the D/A ratio, LTV ratio, DSCR, age of the loan,
payment burden, interest rate changes, land price changes, net farm
income and changes in commodity prices. These variables were each
considered in modeling the default experiences of FCBT loans. Standard
goodness-of-fit measures and the credibility of outcomes were used to
select the final equation used to estimate the loss probabilities.
The FCBT farm real estate loans were included in the estimating
data if they satisfied at least three of four underwriting standards
currently utilized by Farmer Mac. The four standards specify that: (1)
The D/A ratio must be less than or equal to 0.50, (2) the LTV ratio
must be less than or equal to 0.70,(3) the DSCR must exceed 1.25, (4)
and the current ratio must exceed 1.0. Farmer Mac may waive complete
compliance with these standards if a loan is judged to have appropriate
offsetting strengths. Accordingly, the approach employed in the 1998
study requires that loans satisfy at least three of the four specified
standards.
Furthermore, the D/A and LTV ratios were restricted to be less than
or equal to 0.85. It is unlikely that Farmer Mac would waive these
standards if the ratios exceeded these values. Inspection of a portion
of Farmer Mac's loan portfolio indicated several instances where the D/
A and LTV ratios exceed .50 and .70, respectively, with values of both
ratios rarely exceeding 0.85. In the Farmer Mac data, 3.3 percent of
the loans and 3.1 percent of the current outstanding loan balances have
LTV ratios exceeding 0.70. The use of the maximum values for LTV and D/
A and the three-out-of-four standards requirement for passing standards
is intended to emulate Farmer Mac's underwriting standards, and
includes the practice of waiving selected standards.
Several limitations in the FCBT loan-level data affect construction
of the default function. The data contained loans that were originated
between 1979 and 1992, but there were virtually no losses during the
early parts of the sample period. As a result, losses attributable to
specific loans are only available from 1986 through 1992. In addition,
no prepayment information was available in the data.
The data set used for estimation also includes loans that were re-
amortized, paid in full, or merged with a new loan as performing loans.
Including these loans may lead to an underestimation of defaults, if
some of the re-amortized, paid, or merged loans default and incur
losses. In contrast, when the loans that are re-amortized, paid in full
or merged are excluded from the analysis, the default rates are
overestimated if a higher proportion of loans that are re-amortized,
paid in full, or combined (merged) into a new loan are non-default
loans compared to live loans. Excluding loans with defaults, 11,527
loans were active and 7,515 loans were paid in full, re-amortized or
merged as of 1992. Application of a t-test \20\ for differences in the
means for these two groups indicated that active loans had
significantly higher D/A and LTV ratios, and lower current ratios than
other loans. These results indicate that, on average, active loans have
potentially higher risk than loans that were re-amortized, paid in
full, or merged.
---------------------------------------------------------------------------

\20\ The t-test used evaluates the hypothesis that the means
from the two loan groups are statistically different. The t-test
uses a statistic derived from the student distribution.
---------------------------------------------------------------------------

C. Estimation Results

From a statistical perspective, models utilizing information based
on origination information and subsequent economic information were
consistently more reliable than models using loans that are transformed
into multiple observations.
The structure of the historical FCBT data supports estimation of
defaults based on origination information and economic conditions.
Under an origination year approach each observation is used only once
in estimating loan default. The underwriting variables at origination
and economic factors that occur over the life of the loan are used to
estimate loan default.
The final estimated equation for loss frequency is:

[[Page 61751]]

[GRAPHIC] [TIFF OMITTED] TP12NO99.000

where p is the probability that a loan defaults and has positive losses
(Pr(Y=1|x)); B0 to B5 are the estimated
coefficients for the intercept and variables X1 to
X5; X1 is the LTV ratio at loan origination
raised to the power 5.38027; \21\ X2 is the largest annual
percentage decline in FCBT farmland values during the life of the loan
discounted by 4.8 percent per year; \22\ X3 is the DSCR at
loan origination; X4 is the original loan balance in 1997
dollars; and X5 is the D/A ratio at loan origination. It is
commonly accepted that farmland values at any point in time reflect the
discounted present value of expected returns to the land.\23\ Thus,
changes in land values, as expressed in the default equation, represent
the combined effects of the level and growth rates of farm income,
interest rates, and inflationary expectations--each of which is
accounted for in the discounted, present value process.
---------------------------------------------------------------------------

\21\ Loss probability is likely to be more sensitive to changes
in LTV at higher values of LTV. To test and implement this non-
linearity, the model was first estimated with 8 dummy variables at
LTV intervals of 0 to 0.399, 0.400 to 0.499, 0.500 to 0.599, 0.650
to 0.699, 0.700 to 0.749, 0.750 to 0.799 and 0.800 to 0.850. A power
functional form for the LTV variable was fit to replace the
individual dummy variables. The result using generalized least
squares (GLS) was LTV 5.38027. The default equation is
re-estimated with the power function. The power function increases
the degrees of freedom for the model and provides a continuous
relationship between LTV and defaults.
\22\ Discounting reflects the declining effect that the maximum
land value decline has on the probability of default when it occurs
later in a loan's life. The value of 4.8 percent was determined by
iteratively solving the default equation with the default equation
dummy variable ranging from 0 percent to 10 percent. The 4.8 percent
rate yielded the highest goodness-of-fit values.
\23\ Barry, P. J., P. N. Ellinger, J. A. Hopkin, and C. B.
Baker. Financial Management in Agriculture, 5th ed., Interstate
Publishers, 1995.
---------------------------------------------------------------------------

These variables have logical relationships to the incidence of loan
default and loss, as evidenced by the findings of numerous credit
scoring studies in agricultural finance.\24\ Each of these anticipated
directions of relationship signifies greater risk for the borrower, and
thus greater credit risk and incidence of loan loss for the lender. The
frequency of loan default was found to differ significantly across all
of the loan characteristics and lending conditions, as indicated by the
results of the logit equation. The estimated logit coefficients and p-
values are:
---------------------------------------------------------------------------

\24\ Splett, N.S., P. J. Barry, B. Dixon, and P. Ellinger. ``A
Joint Experience and Statistical Approach to Credit Scoring,''
Agricultural Finance Review, 54 (1994):39-54.

------------------------------------------------------------------------
Coefficients p-value
------------------------------------------------------------------------
Intercept.................................... -9.7267 0.0001
X1: LTV...................................... 2.7337 0.0001
X2: Max farmland value decline............... -0.3138 0.0001
X3: DSCR..................................... -0.1822 0.0003
X4: Loan size................................ 8.222E-7 0.0001
X5: D/A ratio................................ 2.3229 0.0001
------------------------------------------------------------------------

The low p-values on each coefficient indicate a highly significant
relationship between loan default and the respective independent
variables. Other goodness-of-fit indicators are:

Hosmer and Lemeshow goodness-of-fit p-value--0.2232
Max-rescaled R2--0.1204
Concordant--79.4%
Disconcordant--16.5%
Tied--4.1%

Explanations of these indicators follow:
1. Hosmer and Lemeshow Goodness-of-Fit Test divides subjects into
deciles based on predicted probabilities, then computes a chi-square
test statistic from observed and expected frequencies. A probability
(p) value is computed from the chi-square distribution with 8 degrees
of freedom to test the fit of the logistic model. If the Hosmer and
Lemeshow goodness-of-fit test statistic is .05 or less, the null
hypothesis that there is no difference between the observed and
predicted values of the dependent is rejected. If it is greater, the
null hypothesis of no difference is not rejected, implying that the
model's estimates fit that data at an acceptable level. This result
does not, however, indicate that the model necessarily explains much of
the variance in the dependent variable. Because the p-value of 0.22 is
greater than 0.05, the null hypothesis of no difference between the
observed and predicted values cannot be rejected. No other information
about the default equation's goodness-of-fit is provided by this
statistic.
2. Max-rescaled R-squared. Several measures often are used to
develop R-squared measures with logistic regression. The logistic
measures do not specifically measure the degree of variation explained
by the model. However, the measures often are scaled from 0 to 1.0 to
provide a relative index of degree of fit. The one reported here is a
modification of the Cox and Snell coefficient that compares the
likelihood function with the intercept only with the likelihood
function with all the variables. Nagelkerke proposed normalizing the
value between 0 and 1 by dividing by the likelihood function with
intercepts only. The specific formula is:
[GRAPHIC] [TIFF OMITTED] TP12NO99.001

where L(0) is the likelihood of the intercept-only model, L(()
is the likelihood of the specified model and n is the sample size. The
quantity R\2\ achieves a maximum of less than 1 for discrete models,
where the maximum is given by:
[GRAPHIC] [TIFF OMITTED] TP12NO99.002

The Nagelkerke adjustment to normalize the value between 0 and 1
is:
[GRAPHIC] [TIFF OMITTED] TP12NO99.003

While the default equation has strong statistical significance, the
Max-rescaled R-squared value of 0.1204 indicates that other variables
and factors not included in the default equation may also influence
default rates. Limitations on availability and quality of data,
however, restrict the access to, and use of, other variables.
Other statistical measures that are indicative of a model's
performance for correctly estimating the probability of loan default,
include concordant, disconcordant, and ties. Generally, model
performance is superior when the concordant measure is high and the
other two measures are low. Each measure is discussed below.
3. Concordant. The predicted values for each possible pair of non-
defaulted and defaulted loans are compared. The number of possible
pairs is equal to the number of non-default loans times the number of
defaulted loans. The percent of pairs that have defaulted loans with
higher predicted default rates than predicted default rates for non-
defaulted loans are included in the concordant category. Given all
possible non-default/default pairwise combinations, the concordant
percentage is the proportion that has defaulted loans with a higher
predicted percentage than non-default loans. The concordant value for
the default equation of 79.4 percent

[[Page 61752]]

indicates a relatively high incidence of correct rankings for the
possible pairs of defaulted and non-defaulted loans, when the estimated
coefficients of the default equation are used to estimate default
rates.
4. Disconcordant. The disconcordant value is the proportion of
pairwise estimates that have higher predicted default rates for non-
default loans than defaulted loans. The discordant value of 16.5
percent indicates a relatively low incidence of incorrect rankings of
default and non-default loans.
5. Ties. The proportion of pairwise estimated probabilities that
are equal between non-default and default is 4.1 percent, which is
relatively low.

D. Comparison of Actual to Predicted Losses

We compared the actual and predicted loss rates based on
origination date and the 20.9 percent severity rate applied to all FCBT
loans for the years 1979 to 1992. The largest discrepancies between the
series occur on loans originated in 1984 and 1987. A problem associated
with errors on specific loans is the application of an average severity
value. Using an average severity rate underestimates losses on specific
loans that have actual severity rates exceeding 20.9 percent. Using the
average severity rate restricts the maximum estimated loss on any loan
in the portfolio to 20.9 percent of the origination loan balance.
Application of the estimated loss equations to the FCBT data
results in total estimated loss over the entire sample period equal to
$9,417,704. Actual losses incurred total $9,805,472. The average of the
predicted loss rates is 0.48 percent while the average of the actual
default rates during 1979-92 is 0.50 percent. The maximum 1- and 2-year
loss rates are 1.54 percent and 2.17 percent in 1985 and 1984-85,
respectively. The maximum 1- and 2-year loss rates estimated by the
model are 1.20 percent in 1984 and 1.85 percent in 1984-85.

VII. Sensitivity of Risk-Based Capital Requirement

The stress test is responsive to changes in the risk profile
inherent in Farmer Mac's financial positions. The stress test requires
higher levels of risk-based capital when Farmer Mac's risk levels
increase and a lower requirement when risk levels decrease. Risk
increases or decreases when Farmer Mac modifies its loan underwriting
standards and/or interest rate risk exposure through various funding
and hedging strategies. In addition, the mix and volume of assets and
liabilities, both on- and off-balance sheet, affect risk levels as does
the initial market interest rate used in the stress test. Some assets
such as high quality investments, Farmer Mac II program mortgages,
AgVantage, and Farmer Mac I pre-1996 Act mortgages present little or no
loss exposure (lower credit risk exposure assets), while other assets
such as Farmer Mac I post-1996 Act mortgages present greater levels of
credit risk (higher credit risk exposure assets).
We evaluated the sensitivity of the stress test using two different
initial financial positions. Financial position one is consistent with
Farmer Mac's current business activities and risk profile. Financial
position two is a hypothetical portrayal of Farmer Mac as a more mature
business. For this scenario, we increased Farmer Mac's size, business
activities, and risk profile. We specifically designed financial
position two to evaluate the sensitivity of the stress test assuming
additional growth in Farmer Mac program I assets. The characteristics
of financial position one and two are as follows.

Table 1. Financial Positions Used in Performing the Sensitivity Analysis
------------------------------------------------------------------------
Financial Financial
Financial Component (in millions) Position Position
1 2
------------------------------------------------------------------------
Assets............................................ $2,566 $3,206
Liabilities....................................... 2,481 3,095
Capital........................................... 84 111
Off-Balance Sheet Assets..........................
Overall Portfolio Characteristics 828 3,187
Lower Credit Risk Exposure Assets................. 1,931 2,133
Higher Credit Risk Exposure Assets................ 1,459 4,260
------------------------------------------------------------------------

We used these two hypothetical financial positions as our initial
starting positions. For each initial position, we calculated a ``base''
case risk-based capital requirement. We then increased or decreased
Farmer Mac's risk levels by varying:
Mortgage factors that influence loss performance (D/A
ratio, LTV ratio, DSCR, loan size, and loan age);
Interest rate risk exposure as measured by Farmer Mac in a
market value framework;
The initial interest rate environment;
Spread relationships of interest earning assets to
interest rate index used in the stress test; and
Guarantee fee charged by Farmer Mac.
We then recalculated the risk-based capital requirement for each
varied condition and compared the results to the ``base'' case. The
results of this analysis follow.

A. Sensitivity to Changes in Mortgage Risk Factors

The stress test calculates increases in the risk-based capital
requirement when the risk increases in Farmer Mac's mortgage portfolio
of held and guaranteed loans. We found that, if Farmer Mac increases
risk by loosening origination loan underwriting standards, the stress
test calculates a higher capital requirement. Conversely, if Farmer Mac
tightens its underwriting standards, the stress test calculates a lower
capital level. As shown in the following table, the stress test
consistently produces these results when mortgage characteristics are
changed individually or on a combined basis.

Table 2.--Changes in Risk-Based Capital Requirements for Changes in
Mortgage Characteristics
------------------------------------------------------------------------
Risk-Based Capital Requirement
Sensitivity Cases (in -------------------------------------------
millions) Financial Position Financial Position
1 2
------------------------------------------------------------------------
1. Base Case................ $29.5 $43.2
2. Origination D/A Ratios 38.3 65.8
Increase...................
3. Origination LTV Ratios 37.2 63.1
Increase...................
4. Origination DSCR Decrease 30.3 45.3
5. Origination Loan Size 65.2 141.6
Increases..................

[[Page 61753]]

6. Increases Stated 2 to 5 109.5 266.9
Above Occur Simultaneously.
------------------------------------------------------------------------

The mortgage factors were increased from the base case on a loan-
by-loan basis to increase risk levels in Farmer Mac's current
portfolio. In each case, the increase in a mortgage factor was limited
to the maximum permitted under Farmer Mac's underwriting standards or
the unadjusted existing loan origination value, whichever was greater.
We used the existing origination values in Farmer Mac's current
portfolio as our starting point and then increased and decreased
individual loan underwriting ratios to perform our sensitivity testing.
The sensitivity tests are:
1. Base case;
2. D/A ratio for individual loans was increased 50 percent
resulting in an increase in the portfolio-weighted average ratio to 56
percent from 37 percent;
3. LTV ratio for individual loans was increased 25 percent
resulting in an increase in the portfolio-weighted average ratio to 70
percent from 56 percent with the maximum individual loan increase
capped at 85 percent;
4. DSCR for individual loans was decreased 25 percent resulting in
a decrease in the portfolio-weighted average ratio to 1.26 from 1.71;
5. Origination size for each loan in Farmer Mac's current portfolio
was doubled resulting in an increase in the portfolio average to $956
thousand from $478 thousand with the maximum individual increase capped
at $3.49 million; and
6. All increases stated in tests 2 to 5 occurring simultaneously.
Loan age affects the level of risk-based capital required by the
stress test. Older loans represent lower credit risk and, therefore,
reduce the risk-based capital requirement while the opposite is true
for new loans. We evaluated how the capital requirement changes for an
increase in loan age of 1 year. The results show a reduced risk-based
capital requirement from the base case as follows:

Table 3.--Changes in Risk-Based Capital Requirements for Changes in Loan
Age
------------------------------------------------------------------------
Risk-Based Capital Requirement
Sensitivity Cases (in -------------------------------------------
millions) Financial Position Financial Position
1 2
------------------------------------------------------------------------
1. Base Case................ $29.5 $43.2
2. Loan Age Increases by 1 26.9 35.8
year.......................
------------------------------------------------------------------------

B. Sensitivity to Changes in Interest Rate Risk Exposure and the
Initial Rate Environment

The stress test requires Farmer Mac to hold more capital as it
increases its interest rate risk exposure and less capital as it
decreases exposure. The stress test uses Farmer Mac's market value
measurement of interest rate risk to quantify the effects that changes
in interest rates have on risk-based capital. Farmer Mac can change its
market value exposure by varying its funding, asset holdings, and
hedging strategies. We evaluated the effect on the risk-based capital
requirement if Farmer Mac pursues strategies that either increase or
decrease its interest risk exposure as measured by the market value
methodology. For the increase in interest rate risk scenario, we assume
Farmer Mac doubles its interest rate risk exposure. In this scenario, a
277 bp movement in interest rates caused the loss to capital to
increase by $25.1 million compared to the base case. We also evaluated
the situation where Farmer Mac's interest rate risk exposure declines
50 percent from the base case. The results of our sensitivity tests are
summarized below.

Table 4.--Changes in Risk-Based Capital Requirements for Changes in
Interest Rate Risk Exposure
------------------------------------------------------------------------
Risk-Based Capital
Requirement
---------------------
Sensitivity Cases (in millions) Financial Financial
Position Position
1 2
------------------------------------------------------------------------
1. Base Case...................................... $29.5 $43.2
2. IRR Exposure Increases......................... 54.7 74.9
3. IRR Exposure Decreases......................... 16.9 27.3
------------------------------------------------------------------------

The interest rate environment affects stress test results. When
interest rates are low, the rate change used in the stress test is
relatively small compared to when interest rates are high. Clearly,
interest rates can change by a greater degree when they are high
compared to when they are low. In addition, the large changes in
interest rates expose Farmer Mac to greater risk. The stress test,
therefore, requires higher risk-based capital in rate environments
where interest rates are high relative to low rate environments as
indicated in the following table:

[[Page 61754]]

Table 5.--Changes in Risk-Based Capital Requirements for Different Initial Rates
----------------------------------------------------------------------------------------------------------------
Risk-Based Capital
Requirement
Sensitivity Cases (in millions) Initial Rate -------------------------------
(percent) Financial Financial
Position 1 Position 2
----------------------------------------------------------------------------------------------------------------
1. Base Case.................................................... 5.54 $29.5 $43.2
2. Higher Initial Rate.......................................... 11.08 62.6 75.8
----------------------------------------------------------------------------------------------------------------

C. Sensitivity to Changes in Spread Relationships and Guarantee Fees

The stress test requires higher risk-based capital when earnings
are under pressure from a tightening in spreads on interest earning
assets or a reduction in guarantee fees charged by Farmer Mac. On the
other hand, the risk-based capital requirement would be lower when
yield spreads widen or Farmer Mac increases its guarantee fees. The
stress test incorporates earnings when calculating risk-based capital.
We evaluated the sensitivity of the stress test for decreases in
spreads on interest earning assets of 5 bp and 10 bp. The stress test
uses current spreads (i.e., the difference in current yields and the
interest rate index used in the model) to determine asset yields when
interest rates are changed. Therefore, a tightening in spreads will
reduce asset yields used to generate earnings. We also evaluated stress
test results assuming Farmer Mac reduced guarantee fees currently
charged by half. The stress test calculated a higher risk-based capital
requirement under diminished earnings capacity as follows:

Table 6.--Changes in Risk-Based Capital Requirements for Changes in
Earning Spreads and Guarantee Fees
------------------------------------------------------------------------
Risk-Based Capital
Requirement
---------------------
Sensitivity Cases (in millions) Financial Financial
Position Position
1 2
------------------------------------------------------------------------
1. Base Case...................................... $29.5 $43.2
2. Spread Tighten by 5 bp......................... 31.0 44.2
3. Spread Tighten by 10 bp........................ 33.8 45.2
4. Guarantee Fee Decrease......................... 38.4 59.6
------------------------------------------------------------------------

VIII. Impact of the Risk-Based Capital Stress Test on Farmer Mac

The impact of the stress test depends on Farmer Mac's risk profile
and starting capital position. High-risk assets and unhedged interest
rate risk will result in larger risk-based capital requirements.
Conversely, if Farmer Mac maintains a low risk profile, the stress test
will produce a low capital requirement. Given Farmer Mac's current
financial position and risk profile, the proposed stress test would not
require Farmer Mac to increase its capital. The risk-based capital
requirement for Farmer Mac produced by the proposed stress test is
below the statutory minimum and critical capital standards.
Furthermore, Farmer Mac's current capital level exceeds both the
statutory minimum and critical capital standards. We emphasize that
this result is only based on Farmer Mac's current financial position
and risk profile. If Farmer Mac accepts more risk as it grows into a
mature business, the risk-based capital requirement could exceed the
statutory minimum and critical capital standards as well as current
capital level. In such a situation there are several options available
to Farmer Mac, including:
Issue additional stock,
Increase guarantee fees to build earnings and capital,
Reduce credit risk through modifications to loan
underwriting standards or obtain credit enhancements,
Mitigate interest rate risk through funding and hedging
strategies.

IX. Reporting Requirements

Proposed Secs. 650.25 and 650.26 outline Farmer Mac's basic
responsibilities for determining its risk-based capital level and
reporting the results to us. Farmer Mac must determine its risk-based
capital level in accordance with the procedures in Sec. 650.24 and the
technical appendix of the subpart. Farmer Mac must at all times
maintain compliance with the risk-based capital levels established by
the risk-based capital stress test and must be able to determine its
risk-based capital level at any time. If, at any time, the risk-based
capital level computed using the risk-based capital stress test
procedures is less than the minimum capital requirements set forth in
section 8.33 of the Act, Farmer Mac must maintain the statutory minimum
capital level.
Proposed Sec. 650.26 requires Farmer Mac to determine its risk-
based capital level at least quarterly. However, changing circumstances
that may have a significant effect on capital may necessitate that
Farmer Mac determine its risk-based capital level more frequently than
quarterly. For example, we may require the Corporation to determine its
risk-based capital level and report the results to us more frequently
than quarterly if:
1. The Corporation is receiving special supervisory attention;
2. The Corporation has, or is expected to have, losses resulting in
capital depletion;
3. The Corporation has significant exposure due to operational
risk, the risks from concentrations of credit, certain risks arising
from other products, services, or related activities, or management's
overall inability to monitor and control financial risks;
4. The Corporation is exposed to a high volume of, or particularly
severe, problem loans;
5. The Corporation is growing rapidly;
6. The Corporation may be adversely affected by the activities or
the condition of other institutions with which it has significant
business relationships or in which it has significant investments; or
7. The Corporation has significant exposure to declines in net
income or in the market value of its capital due to a change in
interest rates and/or the exercise of embedded or explicit options.
In addition, if Farmer Mac anticipates entering into any new
business activity that could have a significant effect on capital, it
must determine a pro forma risk-based capital level that includes the
new business activity. Farmer Mac must provide the pro forma
determination to us 10 days prior to implementation of the new business
program. Proposed Secs. 650.27 and 650.28 provide further instructions
on how and when to report the risk-based capital level.

X. Business and Capital Plans

Well-conceived strategic and operational business and capital plans
promote safety and soundness and are essential ingredients in meeting
institutional objectives. The process of identifying, measuring and
controlling

[[Page 61755]]

an institution's risks and the resulting capital requirements starts
with the development of the institution's goals and objectives. Such
goals and objectives should identify the direction in which an
institution wants to proceed, its stated mission, business structure,
and how it intends to achieve its stated goals.
We expect that any strategic and operational business and capital
plans will address the long-term purpose and mission of the business.
In addition, we believe that such plans should include quantifiable
goals and objectives, and recognize and discuss internal and external
factors that are likely to influence the future operations of the
business. We also expect that the strategic planning process will
include an appropriate capital adequacy plan.
Proposed Sec. 650.22 sets forth the responsibilities of the
Corporation's board to ensure that the Corporation maintains its
capital at a level that is sufficient to sustain continued financial
viability and provide for growth. The Board must take appropriate
measures so that the Corporation's capital is not only adequate to meet
formal regulatory standards, but is also sufficient to support the
Corporation's business objectives and strategies. This requires the
Board to set explicit goals for capitalization with respect to risk and
return objectives. The capital adequacy target levels should be part of
the Corporation's internal process for evaluating capital adequacy. The
Board should annually review and approve the Corporation's capital
adequacy target and composition of capital.
Proposed Sec. 650.22(b) requires the Board to adopt a 3-year
strategic and operational business plan. The plan must contain the
elements of both a basic strategic and operational business plan as
well as a capital adequacy plan. Among other items listed in proposed
Sec. 650.22(b), the capital adequacy plan must include any projected
dividends, equity retirements, or other action that may decrease the
Corporation's capital. The Board should also consider other relevant
factors that may affect Farmer Mac's capital adequacy, such as the
capability of management to measure, manage, and control risk, the
development of new lines of business or Farmer Mac's continued ability
to access the market at favorable rates.

XI. Supervision and Notification

Section 8.35(a) of the Act describes the various levels (I-IV) of
enforcement under which the Corporation will be classified by the OSMO
Director. Proposed Sec. 650.29 establishes the regulatory procedure for
the OSMO Director to notify Farmer Mac of a determination that it is
not meeting the risk-based capital level calculated by the Corporation
as required by Sec. 650.23 or the minimum or critical capital
requirements specified by sections 8.33 and 8.34 of the Act. Proposed
Sec. 650.29 provides for the submission of a capital restoration plan,
as appropriate, when it has been determined that the Corporation is not
meeting the required capital levels.

List of Subjects in 12 CFR Part 650

Agriculture, Banks, banking, Conflicts of interest, Rural areas.
For the reasons stated in the preamble, part 650 of chapter VI,
title 12 of the Code of Federal Regulations is proposed to be amended
to read as follows:

PART 650--FEDERAL AGRICULTURAL MORTGAGE CORPORATION

1. The authority citation for part 650 is revised to read as
follows:

Authority: Secs. 4.12, 5.9, 5.17, 8.11, 8.31, 8.32, 8.33, 8.34,
8.35, 8.36, 8.37, 8.41 of the Farm Credit Act (12 U.S.C. 2183, 2243,
2252, 2279aa-11, 2279bb, 2279bb-1, 2279bb-2, 2279bb-3, 2279bb-4,
2279bb-5, 2279bb-6, 2279cc); sec. 514 of Pub. L. 102-552, 106 Stat.
4102; sec. 118 of Pub. L. 104-105, 110 Stat. 168.

2. Subpart B is added to read as follows:

Subpart B--Risk-Based Capital Requirements

Sec.
650.20 Definitions.
650.21 General.
650.22 Corporation board of directors guidelines.
650.23 Risk-based capital stress test.
650.24 Risk-based capital level.
650.25 Your responsibility for determining the risk-based capital
level.
650.26 When you must determine the risk-based capital level.
650.27 When to report the risk-based capital level.
650.28 How to report your risk-based capital determination.
650.29 Failure to meet capital requirements.
650.30 Effective date for compliance with regulation.
650.31 Audit of the risk-based capital stress test.
Appendix A to Subpart B. of Part 650--Risk-Based Capital Stress
Tests.

Sec. 650.20 Definitions.

For purposes of this subpart, the following definitions will apply:
(a) Farmer Mac, Corporation, you, and your means the Federal
Agricultural Mortgage Corporation and its affiliates as defined in
subpart A of this part.
(b) Our, us or we means the Farm Credit Administration.
(c) Regulatory capital means the sum of the following as determined
in accordance with generally accepted accounting principles:
(1) The par value of outstanding common stock;
(2) The par value of outstanding preferred stock;
(3) Paid-in capital, which is the amount of owner investment in the
Corporation in excess of the par value of stock;
(4) Retained earnings; and
(5) Any allowances for losses on loans and guaranteed securities.
(d) Risk-based capital means the amount of regulatory capital
sufficient for the Corporation to maintain positive capital during a
10-year period of stressful conditions as determined by the risk-based
capital stress test described in Sec. 650.23.

Sec. 650.21 General.

You must hold risk-based capital in an amount determined in
accordance with this subpart.

Sec. 650.22 Corporation board of directors guidelines.

(a) Your board of directors is responsible for ensuring that you
maintain total capital at a level that is sufficient to ensure
continued financial viability and provide for growth. In addition, your
capital must be sufficient to meet statutory and regulatory
requirements.
(b) No later than 30 days after the beginning of each calendar
year, your board of directors must adopt an operational and strategic
business plan for at least the next 3 years. The plan must include:
(1) A mission statement;
(2) A review of the internal and external factors that are likely
to affect you during the planning period;
(3) Measurable goals and objectives;
(4) Pro forma financial statements for each year of the plan;
(5) A detailed operating budget for the first year of the plan;
and,
(6) A capital adequacy plan.
(c) The capital adequacy plan must include capital targets
necessary to achieve the minimum, critical and risk-based capital
standards specified by the Act and this subpart as well as your capital
adequacy goals. The plan must address any projected dividends, equity
retirements, or other action that may decrease your capital or its
components for which minimum amounts are required by this subpart. You
must specify in your plan the circumstances in which stock or equities
may be retired. In addition to factors that must be considered in
meeting the statutory

[[Page 61756]]

and regulatory capital standards, your board of directors must also
consider at least the following factors in developing the capital
adequacy plan:
(1) Capability of management;
(2) Strategies and objectives in your business plan;
(3) Quality of operating policies, procedures, and internal
controls;
(4) Quality and quantity of earnings;
(5) Asset quality and the adequacy of the allowance for losses to
absorb potential losses in your retained mortgage portfolio, securities
guaranteed as to principal and interest, commitments to purchase
mortgages or securities, and other program assets or obligations;
(6) Sufficiency of liquidity and the quality of investments; and
(7) Any other risk-oriented activities, such as funding and
interest rate risks, contingent and off-balance sheet liabilities, or
other conditions warranting additional capital.

Sec. 650.23 Risk-based capital stress test.

You will perform the risk-based capital stress test as described in
summary form below and as described in detail in appendix A to this
subpart. The risk-based capital stress test spreadsheet is also
available electronically at www.fca.gov. The risk-based capital stress
test has five components:
(a) Data requirements. You will use the following data to implement
the risk-based capital stress test.
(1) You will use Corporation loan-level data to estimate the credit
risk component of the risk-based capital stress test.
(2) You will use Call Report data as the basis for Corporation data
over the 10-year stress period supplemented with your interest rate
risk measurements and tax data.
(3) You will use other data, including the 10-year Constant
Maturity Treasury (CMT) and the applicable Internal Revenue Service
corporate income tax schedule, as further described in the technical
appendix.
(b) Credit risk. The credit risk part estimates loan losses during
a period of sustained economic stress.
(1) For each loan in the Farmer Mac I portfolio, you will determine
a default probability by using the logit functions specified in
appendix A to this subpart with each of the following variables:
(i) Borrower's debt-to-asset ratio at loan origination;
(ii) Loan-to-value ratio at origination, which is the loan amount
divided by the value of the property;
(iii) Debt-service-coverage ratio at origination, which is the
borrower's net income (on- and off-farm) plus depreciation, capital
lease payments, and interest, less living expenses and income taxes,
divided by the total term debt payments;
(iv) The origination loan balance stated in 1997 dollars based on
the consumer price index; and
(v) The worst-case percentage change in farmland values (23.52
percent).
(2) You will then calculate the loss rate by multiplying the
default probability for each loan by the estimated loss severity rate,
which is the average loss of the defaulted loans in the data set (20.9
percent).
(3) You will calculate losses by multiplying the loss rate by the
origination loan balances stated in 1997 dollars.
(4) You will adjust the losses for loan seasoning, based on the
number of years since loan origination, according to the functions in
appendix A to this subpart.
(5) The losses must be applied in the risk-based capital stress
test as specified in appendix A to this subpart.
(c) Interest rate risk. (1) During the first year of the stress
period, you will adjust interest rates for two scenarios, an increase
in rates and a decrease in rates. You must determine your risk-based
capital level based on whichever scenario would require more capital.
(2) You will calculate the interest rate stress based on changes to
the quarterly average of the 10-year CMT. The starting rate is the 3-
month average of the most recent CMT monthly rate series. To calculate
the change in the starting rate, determine the average yield of th

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A99-29214. Public record. Not legal advice.