Risk-Based Capital
Federal RegisterApr 13, 1999
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SUMMARY: The Office of Federal Housing Enterprise Oversight (OFHEO) is
directed by the Federal Housing Enterprises Financial Safety and
Soundness Act of 1992 to develop a risk-based capital regulation for
Freddie Mac and Fannie Mae (collectively, the Enterprises). The
regulation specifies the risk-based capital stress test that will
determine the amount of capital an Enterprise is required to hold to
maintain positive capital throughout a ten-year period of economic
stress. The results of the risk-based capital stress test will be used
to determine each Enterprise's risk-based capital requirements and,
along with the minimum capital requirement, to determine each
Enterprise's capital classification for purposes of possible
supervisory action.
This Notice of Proposed Rulemaking is the second of two notices of
proposed rulemaking pertaining to the risk-based capital regulation,
both of which respond to comments received on the Advance Notice of
Proposed Rulemaking. The first Notice of Proposed Rulemaking describes
the methodology and rationale OFHEO used to identify the proposed
benchmark loss experience, which is used to determine Enterprise credit
losses during the stress test, and proposes the use of OFHEO's House
Price Index in the stress test. The second Notice of Proposed
Rulemaking specifies the interest rate risk and other components of the
stress test, as well as the overall structure of the test.
DATES: Comments regarding this NPR must be received in writing on or
before August 11, 1999.
ADDRESSES: Send written comments to Anne E. Dewey, General Counsel,
Office of General Counsel, Office of Federal Housing Enterprise
Oversight, 1700 G Street, NW., Fourth Floor, Washington, D.C. 20552.
Written comments may also be sent by electronic mail at
[email protected]
FOR FURTHER INFORMATION CONTACT: Patrick J. Lawler, Director of Policy
Analysis and Chief Economist; David J. Pearl, Director, Office of
Research, Analysis and Capital Standards; or Gary L. Norton, Deputy
General Counsel, Office of General Counsel, Office of Federal Housing
Enterprise Oversight, 1700 G Street, NW., Fourth Floor, Washington,
D.C. 20552, telephone (202) 414-3800 (not a toll-free number). The
telephone number for the Telecommunications Device for the Deaf is
(800) 877-8339.
SUPPLEMENTARY INFORMATION: The Supplementary Information is organized
according to this table of contents:
I. Introduction
A. Background
B. Statutory Requirements for Risk-Based Capital
C. History of the Development of the Regulation
II. Structure and Operation of the Regulation
A. Summary of the Stress Test
1. Introduction
2. Data
3. Stress Test Conditions
4. Mortgage Performance
5. Other Credit Factors
6. Cash Flows
7. Enterprise Operations & Taxes
8. Financial Reporting
9. Calculation of the Risk-based Capital Requirement
B. Sensitivity of Capital Requirement to Risk
1. MBS Guarantees (Sold Loans)
2. Commitments
3. Assets and Liabilities
4. Administrative Costs
5. External Economic Conditions
C. Implications of the Proposed Rule
1. Capital Requirements Under the Proposed Rule
2. Enterprise Adjustments to Meet the Proposed Standard
3. Guarantee Fees
4. Mortgage Interest Rates
III. Issues, Alternatives Considered
A. Mortgage Performance
1. Statutory Requirements
2. Overview of Mortgage Performance
3. Statistical Models of Mortgage Performance
4. General Methodological Issues
5. Default/Prepayment Issues
6. Loss Severity
7. Relating Losses to the Benchmark Loss Experience
8. Inflation Adjustment
B. Interest Rates
1. Yields on Treasury Securities
2. Yields of Non-Treasury Instruments
C. Mortgage Credit Enhancements
1. Background
2. Modeling Approach
3. Comments and Alternatives Considered
D. Liabilities and Derivatives
1. Modeling Methodology
2. Foreign Currency Linked or Unusual Instruments
3. Call and Cancellation Options
4. Counterparty Risk
E. Non-mortgage Investments
F. Other Housing Assets
1. Mortgage Revenue Bonds
2. Private Label REMICs
3. Interests in Partnerships and Joint Ventures
G. Commitments
1. Definition of the Term ``Commitment''
2. Retained vs. Securitized Mortgages
3. Modeling Delivery Percentages
4. Delivery Timing
5. Loan Mix Distribution
6. No New Business Rule
H. New Debt and Investment Rules
1. Rationale for New Debt and New Investment Rules
2. Analysis of ANPR Comments
I. Operating Expenses
J. Dividends and Other Capital Distributions
1. Introduction
2. Statutory Provisions
3. Proposed Approach
4. Analysis of ANPR Comments
K. Other Off-Balance Sheet Guarantees
L. Calculation of the Risk-Based Capital Requirement
1. Proposed Approach to Calculating Capital
2. Justification for Using a Present Value Approach
IV. Technical Supplement
A. Purpose and Scope
B. Single Family Default/Prepayment
1. Introduction
2. Conceptual Framework
3. Data
4. Specification of the Statistical Model
5. Explanatory Variables for Default and Prepayment
6. Empirical Results
7. Application of the Models in the Stress Test
8. Consistency with the Historical Benchmark Experience
9. References
C. Single Family Loss Severity
1. Introduction
2. Conceptual Framework
3. Data
4. Statistical Analysis
5. Consistency with the Benchmark Loss Experience
6. Application to the Stress Test
7. References
D. Multifamily Default/Prepayment
1. Introduction and Conceptual Framework
2. Historical Data
3. Statistical Estimation
4. Explanatory Variables
5. Results of the Statistical Estimation of Default and
Prepayment Equations
6. Application to the Stress Test
7. References
E. Multifamily Loss Severity
1. Introduction
2. Conceptual Framework
3. Sources of Data
4. Data Analysis
5. Application to the Stress Test
6. References
F. Property Valuation
1. Introduction
2. Conceptual Framework
3. Data Sources
4. Statistical Analysis
V. Regulatory Impact
A. Executive Order 12612, Federalism
B. Executive Order 12866, Regulatory Planning and Review
[[Page 18085]]
C. Executive Order 12988, Civil Justice Reform
D. Regulatory Flexibility Act
E. Paperwork Reduction Act
I. Introduction
A. Background
The Office of Federal Housing Enterprise Oversight (OFHEO) was
established by title XIII of the Housing and Community Development Act
of 1992, Pub. L. No. 102-550, known as the Federal Housing Enterprises
Financial Safety and Soundness Act of 1992 (1992 Act). OFHEO is an
independent office within the U.S. Department of Housing and Urban
Development (HUD) with responsibility for ensuring that the Federal
Home Loan Mortgage Corporation (Freddie Mac) and the Federal National
Mortgage Association (Fannie Mae) (collectively, the Enterprises) are
adequately capitalized and operating in a safe and sound manner.
Included among the express statutory authorities of OFHEO's Director
(the Director) is the authority to issue regulations establishing
minimum and risk-based capital standards.\1\
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\1\ 1992 Act, section 1313(b)(1) (12 U.S.C. 4513(b)(1)).
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Fannie Mae and Freddie Mac are Government-sponsored Enterprises
with important public purposes.\2\ These include providing liquidity to
the residential mortgage market and increasing the availability of
mortgage credit benefiting low-and moderate-income families and areas
that are underserved by lending institutions. The Enterprises engage in
two principal businesses: investing in residential mortgages and
guaranteeing securities backed by residential mortgages. The securities
the Enterprises guarantee and the debt instruments they issue are not
backed by the full faith and credit of the United States and nothing in
this document should be construed otherwise.\3\ Yet financial markets
accord the Enterprises' securities preferential treatment relative to
securities issued by potentially higher-capitalized, fully private, but
otherwise comparable firms. The market prices for Enterprise debt and
mortgage-backed securities, and the fact that the market does not
require that those securities be rated by a national rating agency,
suggest that investors perceive that the government implicitly
guarantees those securities. This perception evidently arises from the
public purposes of the Enterprises, their Congressional charters, their
potential direct access to U.S. Department of Treasury (Treasury)
funds, and the statutory exemptions of their debt and mortgage-backed
securities (MBS) from otherwise mandatory investor protection
provisions.\4\
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\2\ 1992 Act, sections 1331-38 (12 U.S.C. 4561-67, 4562 note).
\3\ See, Federal Home Loan Mortgage Corporation Act, section
306(h)(2) (12 U.S.C. 1455(h)(2)); Federal National Mortgage
Association Charter Act, section 304(b) (12 U.S.C. 1719(b)); and
1992 Act, section 1302(4) (12 U.S.C. 4501(4)).
\4\ See, e.g., 12 U.S.C. 24 (authorizing unlimited investment by
national banks in obligations of or issued by the Enterprises); 12
U.S.C. 1455(g), 1719(d), 1723(c) (exempting securities from
oversight from Federal regulators); 15 U.S.C. 77r-1(a) (preempting
State law that would treat Enterprise securities differently from
obligations of the United States for investment purposes); 15 U.S.C.
77r-1(c) (exempting Enterprise securities from State blue sky laws).
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Congress created OFHEO as the safety and soundness regulator of the
Enterprises to reduce their risk of failure. Although each Enterprise
at the time had experienced profitability and sustained growth,
Congress determined that there was a need for a strong and independent
regulator to promote the capital adequacy of the Enterprises. This
determination was grounded in the recognition of many factors,
including (1) the important public purpose served by the Enterprises in
the secondary market for residential mortgages, and (2) the
Enterprises' important role in providing access to mortgage credit in
central cities, rural regions, and underserved areas.
Another important factor leading to OFHEO's creation was the
recognition that the Enterprises are largely insulated from private
market discipline relative to fully private firms. This insulation
results from the apparent investor perception of an implied guarantee,
and is best exemplified by the market's acceptance of Fannie Mae
securities in the early 1980s and the Farm Credit System's securities
in the mid-1980s when these GSEs were experiencing financial
difficulties. The absence of normal market discipline on risk-taking is
a strong argument for effective government regulation, including
capital regulation.
Congress was also concerned about the serious disruptions to the
nation's housing markets that could result from an Enterprise's
failure. In introducing legislation in the House of Representatives,
then House Banking Committee Chairman Henry Gonzalez noted that--
The savings and loan crisis and the large losses incurred by the
Federal Government to resolve the crisis, raises concerns about the
scope of other potential liabilities of the United States, including
the liabilities of Fannie Mae, Freddie Mac, and the [Federal Home
Loan] banks. These entities are privately owned federally chartered
enterprises established to meet certain credit needs. Together they
have more than $800 billion in mortgage-related liabilities.\5\
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\5\ Comments by Rep. Gonzalez upon introducing H.R. 2900, 137
Cong. Rec. H5497 (July 16, 1991).
In expressing his view that the legislation did not go far enough
to ensure the Enterprises' safety and soundness, then Ranking Minority
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Member Jim Leach stated that--
If there is a singular lesson of the 1980's, it is that
prudential capital ratios are critical not only for providing a
cushion between an institution's liabilities and the taxpayer's
pocket book, but they ground institutional decision-making in less
risky behavior. Where there is minimal private capital at risk there
is always an inordinate incentive to bet the bank on speculative
investments or interest rate moves. And perhaps most consequently,
capital ratios determine constraints on growth. If institutions are
allowed 50 or 100 to 1 leveraging, as occurred so recently in the
thrift industry, imprudent or conflict driven decision making can
too quickly cause disproportionate growth in certain institutions,
industries and parts of the country, with the taxpayer on the line
for management stupidity, foul play or bad luck.
Fortunately, both GSEs are well run today. Fannie, in particular
has been a major market winner as the cost of funds has declined
with more restrained levels of inflation. But Congress must
understand that if interest rates had gone up rather than down in
the 1980's, Fannie Mae would be the single largest institutional
liability the U.S. government would ever have been forced to
oversee.\6\
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\6\ Dissenting views of Rep. Leach, Government-Sponsored Housing
Enterprises Financial Safety and Soundness Act of 1991, H.R. Rep.
No. 102-206 on H.R. 2900, at 114 (1991) (House Report).
Similarly, the Senate Report \7\ stated that--
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\7\ Federal Housing Enterprises Regulatory Reform Act of 1992,
S. Rep. No. 102-282 (1992) (Senate Report).
Past performance indicates that [the risks of an Enterprise's
failure] are not just hypothetical. While both GSEs are currently
very prosperous, HUD estimated in a 1986 report to Congress, that
Fannie Mae was insolvent on a marked-to-market basis at year-end
1978 and did not return to solvency until 1985. Its negative net
worth reached a peak of more than $20 billion in 1981, which was
roughly 20 percent of its outstanding liabilities. Its recovery owed
partly to improved management, but also, in considerable measure to
fortuitous declines in interest rates.\8\
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\8\ S. Rep. No. 102-282, at 10 (1992).
Because of Congress' concerns, OFHEO was established as the safety
and soundness regulator of Fannie Mae and Freddie Mac. OFHEO is
responsible for conducting examinations to ensure the Enterprises'
safety and soundness and establishing and enforcing compliance with two
types of capital
[[Page 18086]]
standards required by the 1992 Act. The first is the minimum capital
standard.\9\ Using this standard, which is based on a set of leverage
ratios, OFHEO has classified each Enterprise's capital position every
quarter since OFHEO's inception. After initially using an interim
procedure, OFHEO published a rule regarding minimum capital, which
incorporates a more careful evaluation of the credit risks associated
with swaps and other off-balance sheet obligations.\10\ The resulting
standard is comparable in its construction to the risk-based capital
standards of other financial institution regulators.
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\9\ 1992 Act, section 1362 (12 U.S.C. 4612).
\10\ 12 CFR 1750.4; see Minimum Capital, Final Rule, 61 FR
35607, July 8, 1996.
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The second capital standard required by the 1992 Act is the risk-
based capital standard. This standard requires each Enterprise to hold
sufficient capital to survive a ten-year period characterized by
adverse credit losses and large movements in interest rates, plus an
additional amount to cover management and operations risk.\11\ The
level of capital \12\ required under this standard for an Enterprise
will reflect that Enterprise's specific risk profile at the beginning
of each quarter for which the stress test will be run.
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\11\ 1992 Act, section 1361 (12 U.S.C. 4611).
\12\ For purposes of the risk-based capital standard, the term
``capital'' means ``total capital'' as defined under section
1303(18) of the 1992 Act (12 U.S.C. 4502(18)) to mean the sum of the
following:
(A) The core capital of the enterprise;
(B) A general allowance for foreclosure losses, which--
(i) shall include an allowance for portfolio mortgage losses, an
allowance for nonreimbursable foreclosure costs on government
claims, and an allowance for liabilities reflected on the balance
sheet for the enterprise for estimated foreclosure losses on
mortgage-backed securities; and
(ii) shall not include any reserves of the enterprise made or
held against specific assets.
(C) Any other amounts from sources of funds available to absorb
losses incurred by the enterprise, that the Director by regulation
determines are appropriate to include in determining total capital.
The term ``core capital'' is defined under section 1303(4) of
the 1992 Act (12 U.S.C. 4502(4)) to mean the sum of the following
(as determined in accordance with generally accepted accounting
principles):
(A) The par or stated value of outstanding common stock.
(B) The par or stated value of outstanding perpetual,
noncumulative preferred stock.
(C) Paid-in capital.
(D) Retained earnings.
The core capital of an enterprise shall not include any amounts
that the enterprise could be required to pay, at the option of
investors, to retire capital instruments.
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The risk-based standard is an essential component of the safety and
soundness regulation of the Enterprises. Without the risk-based
standard, an Enterprise might adopt risk positions of sufficient
magnitude to make a capital level that just meets the minimum standard
inadequate for maintaining a safe and sound financial condition.
However, the risk-based standard cannot, by itself, ensure
sufficient capital to meet all contingencies. While the interest rate
and credit stresses that are incorporated in the stress test, as
specified by statute, are historically unprecedented, future economic
environments may be even more adverse. Additionally, the nature of
actual future stresses may differ from the precise stresses
incorporated in the model. Furthermore, the model contains factors such
as mortgage default and prepayment rates that are based on historical
experience and therefore may be less adverse than those actually
occurring in future economic environments. Similarly, the consequences
of risks other than interest rate and credit risks may also prove more
serious than the fixed proportional amount allowed for management and
operations risk.
In addition to the risk-based standard, there is a minimum capital
standard, which requires that in the absence of large measurable risks,
the Enterprise maintain a minimally acceptable level of capital.
Complementing the two capital standards are OFHEO's examination and
enforcement authorities, which provide the knowledge and authority
necessary to require prudent management practices in all environments.
All of these regulatory mechanisms operate in tandem to promote the
safety and soundness of the Enterprises.
B. Statutory Requirements for Risk-Based Capital
The 1992 Act requires that OFHEO, by regulation, establish a risk-
based capital test (known as the stress test) which, when applied to an
Enterprise, shall determine that amount of total capital for the
Enterprise that is sufficient for the Enterprise to maintain positive
capital during the stress period. The 1992 Act also provides that, in
order to meet its risk-based capital standard, each Enterprise is
required to maintain an additional 30 percent of this amount to protect
against management and operations risk.\13\
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\13\ 1992 Act, section 1361(c)(2) (12 U.S.C. 4611(c)(2)).
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The 1992 Act requires that the stress test subject each Enterprise
to large credit losses on mortgages it owns or guarantees. The
frequency and severity of those losses must be reasonably related to
the highest rates of default and severity of mortgage losses
experienced during a period of at least two consecutive years in
contiguous areas of the United States that together contain at least
five percent of the total U.S. population.\14\ OFHEO is required to
identify what it has characterized as the ``benchmark loss experience''
that resulted in the highest loss rate.\15\ In this context, default
and severity behavior means the frequency, timing, and severity of
losses on mortgage loans, given the specific characteristics of those
loans and the economic circumstances affecting those losses.
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\14\ 1992 Act, section 1361(a)(1) (12 U.S.C. 4611(a)(1)).
\15\ In this document, the word ``benchmark,'' when used as an
adjective or a noun, refers to the benchmark loss experience.
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The 1992 Act also prescribes two interest rate scenarios, one with
rates falling and the other with rates rising.\16\ The risk-based
capital amount is based on whichever scenario would require more
capital for the Enterprise. In prescribing the two scenarios, the 1992
Act describes the path of the ten-year constant maturity yield (CMT)
for each scenario and directs OFHEO to establish the yields on Treasury
instruments of other maturities in a manner reasonably related to
historical experience and judged reasonable by the Director.
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\16\ 1992 Act, section 1361(a)(2) (12 U.S.C. 4611(a)(2)).
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In the falling or down-rate scenario, the ten-year CMT decreases
during the first year of the stress period and then remains constant at
the lesser of (a) 600 basis points below the average yield during the
nine months preceding the stress period or (b) 60 percent of the
average yield during the three years preceding the stress period.
However, the 1992 Act limits the decrease in yield to 50 percent of the
average yield in the nine months preceding the stress period.\17\
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\17\ 1992 Act, section 1361(a)(2)(B) (12 U.S.C. 4611(a)(2)(B)).
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In the rising or up-rate scenario, the ten-year CMT increases
during the first year of the stress period and then remains constant at
the greater of (a) 600 basis points above the average yield during the
nine months preceding the stress period or (b) 160 percent of the
average yield during the three years preceding the stress period.
However, the 1992 Act limits the increase in yield to 175 percent of
the average yield over the nine months preceding the stress period.\18\
The 1992 Act recognizes that interest rates can affect credit risk,
specifically requiring that credit losses be adjusted for a
correspondingly higher rate of general price inflation if
[[Page 18087]]
application of the stress test produces an increase of more than 50
percent in the ten-year CMT.\19\
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\18\ 1992 Act, section 1361(a)(2)(C) (12 U.S.C. 4611(a)(2)(C)).
\19\ 1992 Act, section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).
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The Act requires that the stress test take into account
distinctions among mortgage product types and differences in seasoning.
It may also take into account any other factors that the Director deems
appropriate. The 1992 Act does not require a specific adjustment for
any of these factors, allowing the Director to determine how best to
account for them. Likewise, the 1992 Act requires the Director to
determine losses and gains on Enterprise activities not specifically
addressed, and all other characteristics of the stress test not
explicitly defined in the 1992 Act, on the basis of available
information, in a manner consistent with the stress test.\20\ These
stress test characteristics could include, among others, mortgage
prepayment rates and Enterprise funding activities, operating expenses,
and capital distribution activities.
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\20\ 1992 Act, sections 1361(b) and (d)(2) (12 U.S.C. 4611(b)
and (d)(2)).
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The 1992 Act requires the stress test to provide initially that
each Enterprise will conduct no new business within the stress period,
except to fulfill contractual commitments to purchase mortgages or
issue securities. Four years after the final risk-based capital
regulation is issued, OFHEO is authorized to modify the stress test to
incorporate assumptions about additional new business conducted during
the stress period.\21\ In doing so, OFHEO is required to take into
consideration the results of studies conducted by the Congressional
Budget Office and the Comptroller General of the United States on the
advisability and appropriate forms of new business assumptions. The
1992 Act requires that the studies be completed within the first year
after issuance of the final regulation.\22\
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\21\ 1992 Act, sections 1361(a)(3)(B) and (D) (12 U.S.C.
4611(a)(3)(B) and (D)).
\22\ 1992 Act, section 1361(a)(3)(C) (12 U.S.C. 4611(a)(3)(C)).
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In developing this proposal, OFHEO considered whether it would be
permissible and appropriate not to propose a detailed risk model, and
instead to rely on the risk models developed by the Enterprises
themselves.\23\ Under such a regulatory approach, OFHEO would specify
only the basic interest rate and credit assumptions, rely on the
Enterprises' internal modeling of these scenarios and review those
models and the results.
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\23\ This approach, which OFHEO considered in detail as it began
to develop the risk-based capital regulation, was raised most
recently by Fannie Mae during the OMB review process. See the
letters from Ms. Jamie S. Gorelick, Vice Chair, Fannie Mae of
December 4, 1998 to various OMB officials; and of March 10, 1999, to
Dr. Janet Yellen, Chair, Council of Economic Advisers.
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OFHEO has thoroughly considered this approach and believes that it
would not be consistent with the 1992 Act, which anticipates that a
publicly-available, transparent and reproducible test would be applied
to the Enterprises. The 1992 Act provides for both Enterprises to be
subject to the same stress test; \24\ that the full test be subject to
notice and comment rulemaking; \25\ that the risk-based capital
regulation be sufficiently specific to permit anyone to apply the test,
given relevant Enterprise data; \26\ and that OFHEO must make the
stress test model public.\27\ Relying on the Enterprises to compute
their own capital requirements with their proprietary models would be
inconsistent with all of these provisions.
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\24\ See 12 U.S.C. 4611(a) (``The Director shall, by regulation,
establish a risk-based capital test for the Enterprises. When
applied to an Enterprise, the risk-based capital test shall
determine the amount of total capital for the Enterprise . . .'')
(emphasis added). See also H.R. Rep. No. 102-206 at 62 (1991).
(``Beyond these traditional capital ratios, the bill sets forth
guidelines for the creation, in highly specific regulations, of a
risk-based capital standard . . . The model, or stress test, will
generate a number for each Enterprise, which will become the risk-
based standard for that Enterprise.'') (emphasis added).
\25\ Section 1361(e)(1), 12 U.S.C. 4611(e)(1).
\26\ Section 1361(e)(2), 12 U.S.C. 4611(e)(2).
\27\ Section 1361(f), 12 U.S.C. 4611(f).
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Moreover, a rule that specifies the details of the model will
provide a more consistent and effective capital regulation and will not
place undue burdens on the Enterprises. The structure of OFHEO's
regulatory and enforcement authorities presumes a strong risk-based
capital standard. The level of the minimum (leverage) capital standard
was established with the assumption that there would be a meaningful
risk-based standard that would address actual or potential risk not
addressed by simple leverage ratios. In addition, important OFHEO
enforcement authorities are tied to the risk-based capital requirement.
An Enterprise's failure to meet these requirements triggers two
important enforcement authorities: the ability to reduce or eliminate
the Enterprise's dividends and the ability to require a capital
restoration plan acceptable to OFHEO. Also, the grounds for a cease and
desist action vary depending on whether an Enterprise meets the risk-
based standard. Thus, a weaker standard would weaken OFHEO's
enforcement authorities.
These objectives are best obtained by a clear standard that is
presented to the public for comment and then employed consistently to
evaluate both Enterprises. Reliance instead on Enterprise models would
likely result in a weaker inconsistently-applied standard. Use of
Enterprise models would give the Enterprises broad discretion to
determine their own risk-based capital requirements because stress test
details beyond basic assumptions and modeling techniques can have a
substantial cumulative effect on the results. Existing market
distortions would give the Enterprises incentives to adjust those
details to produce low requirements.
The Enterprises' status as government-sponsored-enterprises
attenuates market discipline of Enterprise capital levels. The
Enterprises are highly leveraged financial institutions. Fully private
firms that depend heavily on debt markets are inhibited from taking on
large amounts of risk relative to their equity capital. Interest rates
on debt or guaranteed securities are sensitive to the perceived credit
quality of the issuers or guarantors. However, because investors treat
Enterprise obligations as implicitly guaranteed by the Federal
government, the normal linkage between the adequacy of an Enterprise's
capital and the interest rates on its obligations is severed. Thus,
because of the perceived implicit guarantee, the Enterprises have an
incentive to hold less capital, relative to their risk levels, than
they would if their debt costs were subject to normal market forces. A
strong risk-based capital standard can address this distortion, but the
Enterprises have little incentive to assist in producing such a result.
Reliance on different Enterprise internal models would also result
in unequal treatment. The nature of business risks and risk management
techniques are very similar at the two Enterprises. It is most
appropriate and most fair to determine each Enterprise's capital
adequacy in the same way. However, capital models developed by the two
Enterprises would likely differ significantly. Differences in resulting
standards could easily mask significant differences in true capital
adequacy between the Enterprises. Furthermore, a lower effective
standard at one Enterprise could give that Enterprise important
business advantages over the other. The resulting competitive pressures
would give the Enterprise with the higher standard an incentive to
conform with the lower standard.
A model fully specified in regulation and administered by OFHEO, on
the other hand, does not suffer these disadvantages. Such a model is
feasible
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because OFHEO regulates only two institutions, with similar risks and
relatively narrow lines of business. The transparency of this approach
allows all interested parties to comment meaningfully on the precise
method of determining Enterprise capital requirements, and it gives the
Enterprises the ability to internalize the model for planning purposes.
In analyzing this issue, OFHEO is aware that some Federal financial
institution regulators make limited use of internal models. However,
those uses of internal models are made in very different circumstances
and by regulators with different authorizing statutes. Many of the
institutions in which these regulators rely upon internal models are
exposed to substantial market discipline of their capital and risk
positions because they rely heavily on uninsured liabilities. Such
discipline effectively forces large banks to hold capital well in
excess of regulatory requirements.
Even in these circumstances, other regulators depend on internal
models only to a small extent as a supplement to other measures of
capital adequacy. Bank capital requirements are primarily based on
overall or risk-weighted ratios that are substantially higher than
those applied to the Enterprises under the minimum capital standard. To
supplement those ratios, regulators require banks with significant
market risk exposures (those that have large trading accounts) to use
their internal value-at-risk models to calculate a market-risk capital
component of their overall risk-based capital requirements. However,
partly because of the uncertainties surrounding model construction and
verification, bank regulators require a multiple of three or more times
the amount of capital for market risk exposures that the internal
models estimate.\28\ This limited use of internal models in very
different circumstances does not appear applicable to Enterprise
capital regulation.
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\28\ See, for example, Darryll Hendricks and Beverly Hirtle,
``Bank Capital Requirements for Market Risk: The Internal Models
Approach,'' in Economic Policy Review, Federal Reserve Bank of New
York, December 1997, pp. 3-6.
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OFHEO considered whether an internal models approach could permit
greater flexibility and innovation by the Enterprises, because they
could modify their internal risk models at will. OFHEO believes the
issues of flexibility and innovation have been appropriately addressed
in the proposed regulation. In general, OFHEO expects that credit and
interest rate risk of new Enterprise activities and instruments will be
reflected in the stress test by simulating their credit and cash flow
characteristics using the approaches described in the regulation. OFHEO
will provide the Enterprises with its estimate of the capital treatment
of new products, investments or instruments as soon as possible after
the Enterprises notify OFHEO of the new activities. In addition, OFHEO
will monitor the Enterprises' activities and, when appropriate, propose
amendments to this regulation addressing the treatment of new
instruments and activities.
For all the reasons described, OFHEO believes that the approach
proposed in this Notice implements the requirement of the 1992 Act and
provides an appropriate means for ensuring the capital adequacy of the
Enterprises. In accordance with the requirements of the Administrative
Procedure Act, OFHEO is requesting comments on all of the issues raised
in this Notice of Proposed Rulemaking.
C. History of the Development of the Regulation
OFHEO's mission is to ensure that the Enterprises are adequately
capitalized and operating in a safe and sound manner. The principal
objective of the risk-based capital standard is to reduce the risk of
Enterprise insolvency. Another important objective of the risk-based
capital standard is to align the incentives reflected in the regulatory
capital requirement with the incentives of prudent risk management. The
ultimate goal is for the Enterprises to maintain the financial health
necessary to fulfill their public purposes. Although the stress test
produces a single capital requirement, it effectively creates
incremental regulatory capital requirements for each additional dollar
of business for every product type an Enterprise guarantees or holds in
portfolio. Marginal capital requirements for mortgages held in
portfolio will vary depending on the risk inherent in an Enterprise's
funding strategy.
OFHEO designed the stress test so that the incentives it creates
closely reflect the relative risks inherent in the Enterprises'
different activities. To this end, the proposed regulation
incorporates, to the extent feasible, consistent relationships between
the economic environment of the stress period and the Enterprises'
businesses. Doing so required OFHEO to model the Enterprises' assets,
liabilities, and off-balance sheet positions at a sufficient level of
detail to capture important risk characteristics.
However, as the level of detail of the stress test increased, so
did its complexity, along with the time and other resources that were
required to develop it. OFHEO also faced certain practical limits to
the number of variables that could be modeled due to the limitations of
existing data. Therefore, in developing this proposed regulation, OFHEO
sought to achieve a level of complexity and realism in the stress test
that appropriately balanced the associated benefits and costs.
OFHEO's stress test is comprised of a number of components, some
that correspond to subjects specifically cited in the 1992 Act and
others that represent the infrastructure that makes the stress test
operational. Figure 1 illustrates these components and their
interrelationships. The infrastructure components--database, cash
flows, and financial reports--are shaded gray. The unshaded components
implement the specific requirements of the 1992 Act, as well as the
many other aspects of the stress test that the 1992 Act either requires
or permits OFHEO to determine.
[[Page 18089]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.369
On February 8, 1995, OFHEO published an Advance Notice of Proposed
Rulemaking (ANPR) \29\ as its first step in developing the risk-based
capital regulation. The ANPR announced OFHEO's intention to develop and
publish a risk-based capital regulation and solicited public comment on
issues relating to that regulation.
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\29\ Risk-Based Capital, ANPR, 60 FR 7468, February 8, 1995.
---------------------------------------------------------------------------
The comment period for the ANPR ended on May 9, 1995, and was
extended through June 8, 1995.\30\ OFHEO received 17 comments on the
ANPR from a variety of interested parties. Commenters included two
Executive Branch Departments, HUD and Department of Veterans Affairs
(VA); one Federal financial institution regulatory agency Office of
Thrift Supervision (OTS); one Federal regulatory agency, U.S. Commodity
Futures Trading Commission (CFTC); the Enterprises, Fannie Mae and
Freddie Mac; four trade groups, Mortgage Bankers Association of America
(MBA), America's Community Bankers (ACB), National Association of
Realtors (NAR), and Mortgage Insurance Companies of America (MICA); two
mortgage banking firms, PNC Mortgage Corporation of America and Norwest
Mortgage, Inc.), one rating agency Standard and Poor's Ratings Group
(S&P); one thrift institution, World Savings and Loan Association
(MS&L); one private mortgage research firm, Mortgage Risk Assessment
Corporation (MRAC); and one individual, Professor Anthony Yezer of
George Washington University. The responses to the ANPR ranged from a
comment on only one or two specific risk-based capital issues to an
extensive analysis of every question or issue raised. OFHEO has
considered these comments in the development of its risk-based capital
regulation.
---------------------------------------------------------------------------
\30\ Risk-Based Capital, Extension of Public Comment Period for
ANPR, 60 FR 25174, May 11, 1995.
---------------------------------------------------------------------------
OFHEO determined that the scope of the regulatory project required
the issuance of two separate Notices of Proposed Rulemaking (NPR), each
addressing different components of the stress test. On June 11, 1996,
OFHEO published a Notice of Proposed Rulemaking (NPR1),\31\ which
addresses two components. The first component is the methodology for
identifying and measuring the benchmark loss experience, which provides
the basis for determining credit losses that the Enterprises will
experience during the stress period. The second is OFHEO's proposal to
use the OFHEO House Price Index (HPI), which is a weighted repeat
transactions house price index, rather than the Constant Quality Home
Price Index (CQHPI) published by the Secretary of Commerce, to measure
differences in seasoning of single family mortgages in the stress
test.\32\ NPR1 included OFHEO's responses to all of the ANPR comments
that related to those two areas. The comment period for NPR1 ended on
September 9, 1996, and was extended through October 24, 1996.\33\ OFHEO
received 11 written comments on NPR1 and will consider and respond to
those in the final risk-based capital regulation.
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\31\ Risk-Based Capital, NPR1, 61 FR 29592, June 11, 1996.
\32\ 61 FR 29616, June 11, 1996.
\33\ Risk-Based Capital, Extension of Public Comment Period for
NPR, 61 FR 42824, August 19, 1996.
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This Notice of Proposed Rulemaking (NPR2) specifies and proposes
for public comment all of the remaining aspects of the risk-based
capital stress test not covered in NPR1. The notice includes an
overview of the stress test, the stress test's sensitivity to risk, the
implications of the stress test for the Enterprises, and specific
issues related to the stress test. Among the specific issues discussed
are mortgage performance (i.e., default, prepayment, and loss
severity), interest rates, new debt and new investments, commitments,
dividends and other
[[Page 18090]]
capital distributions, operating expenses, credit enhancements,
liabilities and derivatives, non-mortgage investments, and capital
calculation. The notice also includes a technical supplement that
explains the derivation of equations used in the stress test. Finally
the notice contains the regulatory text which includes the regulatory
appendix that provides the technical details of the regulation.
OFHEO believes that it is important for this proposal to receive
full public review and comment. Accordingly, OFHEO invites all
interested parties to comment on the issues raised in this NPR. OFHEO
will consider comments received, together with those received on NPR1,
in the development of the final risk-based capital regulation.
II. Structure and Operation of the Regulation
A. Summary of the Stress Test
1. Introduction
OFHEO's risk-based capital regulation is part of a larger
regulatory framework for the Enterprises that includes a minimum
capital requirement and a comprehensive examination program. The
purpose of this regulatory framework is to reduce the risk of failure
of the Enterprises by ensuring that the Enterprises are adequately
capitalized and operating safely, in accordance with the 1992 Act.
OFHEO's risk-based capital requirement differs from the minimum
capital requirement by relating the required capital to the risk in an
Enterprise's financial activities. In order to determine risk-based
capital for the Enterprises, OFHEO has been charged with creating a
stress test that simulates the effects of ten years of adverse economic
conditions on the existing assets and obligations of the Enterprises.
Both the minimum and the risk-based capital requirements work in
conjunction with OFHEO's examination program to ensure that the
Enterprises are adequately capitalized and operating safely.
In creating the proposed stress test, OFHEO had to ensure that it
met all the statutory requirements outlined in the 1992 Act and that it
accurately and appropriately captured the risks related to the business
of the Enterprises. To accomplish this, OFHEO modeled both sides of the
Enterprises' balance sheets, as well as their off-balance sheet
obligations, at the level of detail necessary to capture the risk
involved. In selecting among alternative approaches, OFHEO sought to
minimize the possibility of perverse incentives in the stress test. The
regulation was designed to ensure that stresses were appropriate in
order to promote safety and soundness and ensure the Enterprises'
ability to fulfill their important public missions.
The stress test determines, as of a point in time, how much capital
an Enterprise requires to survive the economically stressful conditions
outlined by the 1992 Act. At a minimum, the stress test would be run on
a quarterly basis. The stress test takes as inputs data on an
Enterprise's assets and obligations, operations, interest rates, and
the housing market. These data are used in econometric, financial, and
accounting models to simulate Enterprise financial performance over a
ten year period called the ``stress period.'' The stress test then
computes the amount of starting capital that would permit an Enterprise
to maintain a positive capital position throughout the stress period.
To determine the risk-based capital requirement, the 1992 Act requires
that 30 percent of this amount is added to cover management and
operations risk.
This summary provides a high level description of the stress test.
For a more detailed description, refer to the Regulation Appendix. For
explanations of the reasons for the approaches taken, refer to section
III., Issues, Alternatives Considered. For detailed information on
econometric models and historical property valuation-related indexes
used in the stress test, refer to section IV., Technical Supplement.
Throughout the summary, it may be helpful to refer to the stress test
diagram, in section I., Introduction.
2. Data
The stress test utilizes data characterizing at a point in time an
Enterprise's assets, liabilities, and off-balance sheet obligations, as
well as data on economic conditions. The Enterprises submit data to
OFHEO for mortgages, securities, and derivative contracts at the
instrument level, that is, for individual mortgages, securities, and
contracts. OFHEO obtains data on economic conditions from public
sources. All these data are referred to as ``starting position data''
for the date for which the stress test is run.
For modeling efficiency, the stress test aggregates loans into
groups of loans with common risk and cash flow characteristics (``loan
groups''). For instance, 30-year fixed-rate mortgages for single family
homes in the same geographic region, originated in the same year, with
similar interest rates and LTVs,\34\ and held in an Enterprise's
portfolio, are grouped together in one loan group. In this way, over 24
million loans are aggregated into the minimum number of loan groups
that captures important risk characteristics. These loan groups,
instead of individual loans, are then used as inputs by the mortgage
performance and cash flow components of the stress test.
---------------------------------------------------------------------------
\34\ LTV is the loan to value ratio, which is the loan balance
divided by the value of the property securing the loan.
---------------------------------------------------------------------------
In addition to starting position data for existing loans, the
stress test creates loan group data for the new mortgages that will be
added during the stress test. The 1992 Act requires that the stress
test simulate the fulfillment of the Enterprises' contractual
commitments, outstanding at the start of the stress period, to purchase
and/or securitize mortgages. The new mortgages that the stress test
adds consist of four single family loan product types: 30-year fixed-
rate, 15-year fixed-rate, adjustable-rate, and balloon. The percentage
of each type added is based on the relative proportions of those types
of loans securitized by an Enterprise that were originated during the
six months preceding the start of the stress period. The mix of LTV,
region, guarantee fee, and other characteristics of these new loans
also reflects the characteristics of the loans originated during the
preceding six months. All new mortgages are securitized. In the down-
rate scenario, 100 percent of these loans are added during the first
three months of the stress period; in the up-rate scenario, 75 percent
of these loans are added during the first six months. These loan groups
are then treated like the loan groups created for loans on the
Enterprise's books at the start of the stress period.
Because of the smaller number and greater diversity of the
Enterprises' non-mortgage financial instruments (investments and debt),
the stress test projects these cash flows at the individual instrument
level, rather than at a grouped level. Data used for these projections
include the instrument characteristics that are used to model
securities, both investment and debt, as well as derivative contracts.
3. Stress Test Conditions
a. Benchmark Loss Experience
In NPR1, OFHEO proposed the methodology for identifying the
benchmark loss experience, the stressful credit conditions which are
the basis for credit losses in the stress test. With this methodology,
OFHEO identified the worst cumulative credit losses
[[Page 18091]]
experienced by loans originated during a period of at least two
consecutive years, in contiguous states encompassing at least five
percent of the U.S. population. The performance of these loans (i.e.,
the frequency, timing and severity of their losses) and the related
interest rate and housing market environment, comprise the benchmark
loss experience.
The benchmark loss experience is based on newly originated, 30-
year, fixed-rate, first lien mortgages on owner-occupied, single family
properties. The performance of these benchmark loans was a function of
their original LTVs and other characteristics, as well as the specific
house price and interest rate paths they experienced. The stress test
applies the path of house prices from the benchmark loss experience and
the interest rate paths required by the 1992 Act. Furthermore, the
stress test simulates the performance of an Enterprise's entire
mortgage portfolio, including loans of all types, ages, and
characteristics. Primarily for these reasons, overall Enterprise
mortgage loss rates in the stress test are much lower than the loss
rates OFHEO reported in NPR1 for benchmark loans.
When the mortgage performance models are applied to benchmark
loans, using the benchmark pattern of interest rates, losses are very
close to those identified in NPR1. The remaining difference results
from the fact that OFHEO based its mortgage performance models on all
Enterprise historical loan data, not just the limited data for
benchmark loans, and that the benchmark loss experience was
particularly severe. This difference is corrected by calibrating the
single family mortgage performance models, resulting in slight upward
adjustments of default and loss severity rates, so that they are
consistent with the benchmark loss experience.
For multifamily loans, the stress test also incorporates patterns
of vacancy rates and rent growth rates that are consistent with the
benchmark loss experience. In this manner, the stress test relates the
performance of multifamily loans to the benchmark loss experience.
b. Interest Rates
Interest rates are a key component of the adverse economic
conditions of the stress test. The 1992 Act specifies two scenarios for
the ten-year Constant Maturity Treasury yield (CMT) during the stress
period. During the first year of the stress period, the ten-year CMT:
falls by the lesser of 600 basis points below the average
yield during the nine months preceding the stress period, or 60 percent
of the average yield during the three years preceding the stress
period, but in no case to a yield less than 50 percent of the average
yield during the preceding nine months (down-rate scenario); or
rises by the greater of 600 basis points above the average
yield during the nine months preceding the stress period, or 160
percent of the average yield during the three years preceding the
stress period, but in no case to a yield greater than 175 percent of
the average yield during the preceding nine months (up-rate scenario).
Changes to the ten-year CMT occur in twelve equal monthly
increments from the starting point for the ten-year CMT, which is the
average of the daily yields for the month preceding the stress period.
The ten-year CMT stays at the new level for the remainder of the stress
period.
The stress test establishes the Treasury yield curve for the stress
period in relation to the prescribed movements in the ten-year CMT. In
the down-rate scenario the yield curve is upward sloping during the
last nine years of the stress period. In the up-rate scenario the
Treasury yield curve is flat for the last nine years of the stress
period, that is, yields of other maturities are equal to that of the
ten-year CMT.
Because many different interest rates affect the Enterprises'
business performance, the ten-year CMT and the Treasury yield curve are
not the only interest rates that must be determined. For example,
current mortgage rates affect rates of refinancing of existing
mortgages; adjustable-rate mortgages periodically adjust according to
various indexes; floating rate securities (assets and liabilities) and
many rates associated with derivative contracts also adjust; and
appropriate yields must be established for new debt and investments.
Thus, the stress test requires rates and indexes other than Treasury
yields for the entire period of the stress test. Some of the key rates
that are estimated are the Federal Funds rate, London Inter-Bank
Offered Rate (LIBOR), Federal Home Loan Bank 11th District Cost of
Funds Index (COFI), and Enterprise borrowing rates. The stress test
establishes these rates and indexes by using Autoregressive Integrated
Moving Average (ARIMA) procedures--time-series estimation techniques--
to estimate their values based on historical spreads to yields on
Treasuries of comparable maturities. The procedures use historical
information to estimate values during the stress period. To reflect the
market impact of stress test economic conditions on the Enterprises'
costs of borrowing, beginning in the second year of the stress period,
50 basis points are added to the computed yields for Enterprise debt
securities.
c. Property Values
In determining the performance (rates of default, prepayment, and
of loss severity) of an Enterprise's mortgages in the stress test, the
1992 Act requires OFHEO to consider seasoning, which the stress test
captures by the use of current LTVs. The stress test calculates the
numerator of current LTV, the current loan balance, based on the unpaid
principal balance of the loan at the start of the stress period
(starting UPB) and the amortization of the loan based on product type.
Both the starting UPB and the loan product type are included in
starting position data. The stress test uses the OFHEO HPI for the
relevant Census division to track changes in property values--the
denominator of current LTV--from the time of loan origination through
to the start of the stress period. During the stress period, changes in
property values are computed by applying the pattern of house price
changes from the benchmark loss experience.
The HPI values represent average property value appreciation. In
simulating mortgage performance, the stress test also captures
variations from average house price movements, called dispersion. For
this purpose, the stress test uses the mathematical measures of
dispersion that OFHEO publishes along with the HPI.
For multifamily properties, property values are derived from
estimates of a property's net operating income and capitalization rate
multipliers. The stress test uses loan data together with rent growth
rate and vacancy rate indexes to derive estimates of net operating
income (NOI) for multifamily loans. Index values from the benchmark
loss experience are applied to starting property values to derive
current estimates of NOI for each month of the stress period. NOI is
multiplied by a capitalization rate multiplier, reflecting current
interest rates, to generate a property value. For example, if annual
NOI is $200,000 and the capitalization rate multiplier is ten, the
property value is $200,000 x 10, or $2,000,000. This value is the
denominator for current LTV for multifamily loans.
When the ten-year CMT increases by more than 50 percent over the
average yield during the nine months preceding the stress period, the
stress test takes general price inflation into consideration.
Adjustments are made to the house price and rent growth paths of the
benchmark loss experience equal to the percentage change in the ten-
year
[[Page 18092]]
CMT in excess of 50 percent.\35\ For example, if the ten-year CMT
increases by 60 percent, house price and rent growth rates increase by
ten percent. The stress test phases in this increase in equal monthly
increments during the last five years of the stress period.
---------------------------------------------------------------------------
\35\ The stress test computes the difference between the level
of the ten-year CMT in the last nine years of the stress period and
the level of the ten-year CMT if it had increased 50 percent. The
difference in yield is compounded over a nine-year period to
determine the cumulative percentage adjustment to house prices at
the end of the stress period.
---------------------------------------------------------------------------
4. Mortgage Performance
To simulate how mortgages fare during the adverse conditions of the
stress period, the stress test uses models of mortgage performance,
that project default, prepayment and loss severity rates. These models
simulate the interaction of the patterns of house prices, residential
rents, and vacancy rates of the benchmark loss experience, as well as
stress test interest rates, and mortgage risk factors, in order to
determine the performance of Enterprise loans for each month of the
stress test. As described below in further detail, the models are based
on the historical relationship of economic and mortgage risk factors to
mortgage performance, as reflected in the historical experience of the
Enterprises.
a. Loan Groups
Rather than simulating the behavior of individual loans, the models
simulate the behavior of groups of loans with common risk
characteristics. The default and prepayment models calculate the
proportion of the outstanding principal balance for each loan group
that defaults, prepays, or makes regularly scheduled loan payments in
each of the 120 months of the stress period. Single family loans are
aggregated into loan groups based on key risk and cash flow
characteristics: product type \36\ (e.g., 30-year fixed-rate, 15-year
fixed-rate, adjustable rate, balloon), original LTV, interest rate,
origination year, remittance cycle \37\ and Census division.
Multifamily loans are similarly aggregated by product type, original
LTV, origination year, interest rate, and Census region, as well as by
debt coverage ratio (DCR) \38\ and program type. Program type
distinguishes between loans purchased individually rather than as part
of a pool, and loans subject to recourse or repurchase.\39\ These
distinctions are associated with different risk characteristics.
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\36\ The 1992 Act requires that the stress test take into
account appropriate distinctions among mortgage product types,
including single or multifamily, fixed or adjustable interest rates
and the term of the loans.
\37\ For sold loans, the remittance cycle governs the length of
time an Enterprise holds payments remitted by the seller/servicer
before passing them through to the security investor.
\38\ DCR is the ratio of property net income to debt service.
\39\ Recourse refers to the sharing of credit risk with a
seller/servicer; repurchase refers to the obligation of a seller/
servicer to repurchase 90-day delinquent loans.
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b. Single Family Default and Prepayment
The single family models are estimated using historical data on the
performance of Enterprise loans through 1995. To simulate defaults and
prepayments, the stress test uses a 30-year fixed-rate loan model, an
adjustable-rate loan (ARM) model, and a third model for other products,
such as 15-year loans and balloon loans. Each of the three single
family models was separately estimated based on data for the relevant
product types. Each includes a calibration adjustment, so that the
results properly reflect a relationship to the benchmark loss
experience, as described earlier.
All three single family models simulate defaults and prepayments
based on values for interest rates and property values, as described
above, and variables capturing the risk characteristics of loan groups.
The variables described below are the factors used to determine the
rates of default and/or prepayment for single family loan groups:
Mortgage Age--Patterns of mortgage default and prepayment
have characteristic age profiles; defaults and prepayments increase
during the first years following loan origination, and then peak
between the fourth and seventh years.
Probability of Negative Borrower Equity--Borrowers whose
current loan balance is greater than the current value of their
mortgaged property (reflecting negative equity) are more likely to
default than those with positive equity in their properties. The
probability of negative borrower equity within a loan group is a
function of (1) house price changes (based on the HPI), and
amortization of loan principal, which together establish the average
current LTV, and (2) the dispersion of actual house price changes
around the HPI value. Thus, even when the average current LTV for a
loan group is less than one (positive equity), some percentage of the
loans will have LTVs greater than one (negative equity).
Relative Spread--This variable is an important factor in
determining whether a borrower will prepay. It reflects the value to a
borrower of the option to prepay and refinance. The stress test uses
the relative spread between the interest rate on a loan and the current
market rate on loans as a proxy for the mortgage premium value.
Burnout--The value for this variable reflects whether a
borrower has passed up earlier opportunities to refinance at favorable
interest rates. Such a borrower is less likely to prepay the current
loan and refinance, and more likely to default in the future.
Yield Curve Slope--This variable reflects the relationship
between short and long term interest rates. The shape of the yield
curve, which reflects expectations for the future levels of interest
rates, influences a borrower's decision to prepay a mortgage. Depending
on the slope of the yield curve and the type of loan a borrower may
have incentives to refinance to a fixed-rate or an adjustable-rate
mortgage.
Original LTV--The LTV at the time of mortgage origination
serves as a proxy for factors relating to the financial status of a
borrower, which can affect the borrower's future ability to make loan
payments. Higher original LTVs, which generally reflect fewer economic
resources and greater willingness to take financial risk, increase the
probability of default and lower the probability of prepayment. The
reverse is true for lower original LTVs.
Occupancy Status--The value of this variable reflects the
higher probability of default of investor-owners compared to that of
occupant-owners. The stress test applies the portfolio-wide ratio of
investor-to occupant-owners to each loan group. The single family
default and prepayment variables are listed in Table 1.
[[Page 18093]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.186
c. Multifamily Default and Prepayment
The stress test utilizes two multifamily default models and five
multifamily prepayment models to capture the behavior of loans
purchased under different programs and loans at different stages in
their life cycles. The models were estimated using historical data
through 1995 on the performance of Enterprise multifamily loans. The
stress test applies one default model to loans purchased under cash
programs (i.e., loans purchased individually), and another to loans
purchased under negotiated programs (i.e., loans purchased as part of a
pool), because the programs have different risk profiles. The
prepayment models distinguish among product types: fully-amortizing
fixed-rate, balloon, and ARM loans; those with yield maintenance
provisions (i.e., restrictions and/or penalties for prepaying a loan
during a specified period of time); and balloon loans which have
reached their stated maturity, because these distinctions affect the
probability of prepayment.
As with the models of single family mortgage performance, the
multifamily models simulate the probability of default and prepayment
based on stress test conditions and loan group risk characteristics. To
account for specific risks associated with multifamily loans, these
loans are grouped somewhat differently from single family loans. Thus,
multifamily loans are also grouped by original DCR and program type.
All of the multifamily default and prepayment models include interest
rates, rent growth rates, and vacancy rates to characterize stress test
conditions.
The following variables are factors in determining default and
prepayment rates for multifamily loan groups:
Mortgage Age--As with single family loans, the risk of
default and prepayment on multifamily loans varies over their lives.
Relative Spread--As with single family loans, this
variable reflects the value to the borrower of the option to prepay and
refinance.
Program Restructuring--This variable captures the
difference between Enterprises' management of their original
multifamily programs and current, restructured programs. That
difference affects the probability of default.
Joint Probability of Negative Equity and Negative Cash
Flow--This variable plays a role similar to that of the probability of
negative equity for single family loans. However, negative equity is
not a sufficient condition for multifamily loan default. Residential
rental property owners tend not to default unless a property's net cash
flow is negative as well. This variable captures the joint probability
of both conditions.
Balloon Maturity Risk--To reflect the added risk of
default at the balloon maturity date, this variable gives extra weight
to the joint probability of negative equity and negative cash flow in
the year before a balloon mortgage matures.
Default Type--This variable distinguishes between loans
for which the Enterprise is responsible for foreclosure and property
disposition and loans for which the seller/servicer is responsible for
repurchasing if the loan becomes 90 days delinquent.
Current LTV--This variable captures the incentive for
borrowers to refinance in order to withdraw equity from their rental
property.
Probability of Qualifying for Refinance--This variable
captures the effect on prepayments of a borrower who would not qualify
for a new loan (one that lacks an LTV of 80 percent or less and a DCR
of 120 percent or more).
Pre-balloon Refinance Incentive--This variable gives extra
weight to the relative spread in the two years prior to the balloon
maturity. This captures the additional incentive to prepay balloon
loans after the date the yield maintenance period ends, but before the
balloon maturity date.
Conventional Market Rate for Mortgages--Similar to the
single family yield curve slope variable, this variable reflects the
incentives for borrowers with ARMs to refinance into fixed-rate
mortgages.
Value of Depreciation Write-offs--This variable captures
the effect on default rates of the value to a new purchaser of the tax
benefits associated with multifamily property ownership.
Years-To-Go in the Yield Maintenance Period--This variable
captures the decreasing effect of yield maintenance provisions during
the yield maintenance period. As the cost of the provision declines in
the later years of the yield maintenance period, the disincentive to
prepay declines.
Just like the single family default and prepayment models, the
multifamily models produce, for each loan group for each month of the
stress period, default and prepayment rates which are used in the cash
flow components of the stress test. Tables 2 and 3 list the variables
included in the multifamily default and prepayment models.
[[Page 18094]]
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[GRAPHIC] [TIFF OMITTED] TP13AP99.188
d. Loss Severity
Credit losses are determined by multiplying default rates by loss
severity rates and loan group balances. Loss severity rates are
computed as of the date of default, and are expressed as a percentage
of unpaid principal balance of the defaulting portion of a loan group.
In general, losses comprise three elements--loss of principal,
transactions costs, and funding costs. Loss of principal is the amount
of defaulting loan UPB, offset by the net proceeds of the sale
(disposition) of the foreclosed property. Transactions costs include
[[Page 18095]]
expenses related to foreclosure, property holding and disposition
expenses. Funding costs are the costs of funding non-earning assets--
first the defaulted loans, and then the foreclosed properties prior to
disposition (except in the case of sold loans, for which four months of
interest at the passthrough rate replace four months of funding costs).
For single family loans the stress test uses an econometric model
to project the net proceeds from the sale of foreclosed properties. The
model is based on historical data on defaulted Enterprise loans, and
reflects the relationship between LTV at the time of loan default
(based on a loan's original LTV, loan amortization, and house price
changes and dispersion), and proceeds of property disposition. Just as
with models of single family default and prepayment, this model
includes a calibration adjustment to make the results consistent with
the benchmark loss experience.
For multifamily loans, sale proceeds are a fixed percentage of the
defaulting UPB, based on historical experience.
For both single family and multifamily loans, transactions costs
are fixed amounts based on historical averages computed from Enterprise
data. Funding costs are captured in a discounting process described in
the following paragraph.
Foreclosure, disposition and associated costs occur over a period
of time. In order to calculate losses associated with a default as of
the time of the default, the stress test calculates loss severity rates
by discounting the different elements of loss back to the time of
default, based on stress period interest rates. The discounting process
also captures funding costs at appropriate interest rates. For single
family loans, the timing of each element is based on averages for the
benchmark loans; for multifamily loans it is based on the historical
average for the Enterprises, using data through 1995.
The calculation of loss severity rates for two types of multifamily
loans differs from the general approach. In the case of 90-day
delinquent loans that are repurchased from Enterprise security pools by
seller/servicers, rates are a fixed amount based on Enterprise
historical experience representing claims submitted by seller/servicers
for reimbursement by the Enterprise. In the case of FHA-insured loans,
the stress test reflects no losses.
The loss severity component of the stress test generates loss
severity rates for each loan group for each month of the stress period,
which are used in the cash flow components of the stress test to
calculate credit losses for the Enterprises.
5. Other Credit Factors
a. Mortgage Credit Enhancements
In many cases, at least a portion of Enterprise losses on defaulted
loans is offset by some form of credit enhancement. Credit enhancements
are contractual arrangements with third parties that reduce Enterprise
losses on defaulted loans. By including the effect of mortgage credit
enhancements, the stress test more realistically reflects Enterprise
risks related to mortgage defaults and credit losses during the stress
period.
The stress test captures many types of credit enhancements, with
differing depths and methods of coverage, for both single family and
multifamily loans. These credit enhancements include private mortgage
insurance, recourse to seller/servicers, indemnification, pool
insurance, cash accounts, spread accounts, collateral accounts, and
specific risk-sharing agreements for certain multifamily loans.
The stress test divides mortgage credit enhancements into two
categories. One category is credit enhancements that cover losses on
certain loans up to a specified percentage of the loss incurred. This
category includes private mortgage insurance, unlimited recourse,
unlimited indemnification and, for certain multifamily loans, risk-
sharing agreements. The other category includes those credit
enhancements that cover all losses on a specified set of loans, up to a
specified total amount. This category includes limited recourse,
limited indemnification, pool insurance, cash accounts, spread accounts
and collateral accounts.
The benefits of the first category of credit enhancements are
incorporated in the calculation of monthly loss severity rates. The
loss severity rate for a specific loan group is reduced based on the
credit enhancements from the first category associated with loans in
that group. The benefits of the second category of credit enhancements
are taken into account directly in the cash flow calculations. The
dollar balance of these credit enhancements is tracked and drawn down
to offset the amount of credit losses for the covered loans in a loan
group.
b. Counterparty and Other Credit Risk
In addition to mortgage credit quality, the stress test considers
the creditworthiness of companies and financial instruments to which
the Enterprises are exposed. These include most mortgage credit
enhancement counterparties (e.g., private mortgage insurance companies
and seller/servicers), privately issued and municipal securities held
as assets, derivative counterparties, and securities guaranteed for
private issuers.
For credit enhancement counterparties, securities held as assets,
and interest rate contract counterparties, the stress test reduces--or
applies ``haircuts'' to--the amounts due from these instruments or
counterparties according to their level of risk. The level of risk is
determined by public credit ratings which the stress test classifies
into four categories: AAA, AA, A and BBB. When no rating is available,
the instrument or counterparty is rated BBB. The cash flow components
of the stress test phase in the haircuts monthly in equal increments
until the total reduction listed in Table 4 is reached in the final
month of the stress period.
[[Page 18096]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.189
The stress test also applies haircuts to reflect the impact of
impairment of counterparties for derivative contracts hedging foreign
currency denominated debt. Since counterparty impairment would reduce
the effectiveness of a hedge, the stress test reflects the associated
risk by increasing the amounts owed by an Enterprise by the haircut
percentage.
c. Other Off-Balance Sheet Guarantees
In addition to guaranteeing mortgage-backed securities they issue
as part of their main business, the Enterprises occasionally provide
guarantees for other securities. The guarantees provided by the
Enterprises enhance the liquidity and appeal of these securities in the
marketplace. These securities, notably single family and multifamily
whole loan REMIC securities \40\ and mortgage tax-exempt multifamily
housing bonds, represent a small part of the Enterprises' business and
have a significant level of credit enhancement that protects the
Enterprises from losses. The performance of these securities is not
explicitly modeled in the stress test. As a proxy for the present value
of net losses on these guarantees during the stress test, the
outstanding balance of these instruments at the beginning of the stress
period is multiplied by 45 basis points. The resulting amount is
subtracted from the lowest discounted monthly capital balance when
calculating the risk-based capital requirement.
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\40\ Real Estate Mortgage Investment Conduit (REMIC) securities
are multiclass mortgage passthrough securities. The classes of a
REMIC security can take on a wide variety of attributes with regard
to payment of principal and interest, cash flow timing
(un)certainty, and maturity, among others.
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6. Cash Flows
For each month of the stress period, stress test cash flow
components apply projected default, prepayment, and loss severity rates
to loan group balances to produce mortgage cash flows. The cash flow
components also reduce projected mortgage losses resulting from
offsetting credit enhancements that are not accounted for in loss
severity calculations. In addition, the cash flow components calculate
cash flows for securities that the Enterprises hold as assets, or have
issued as liabilities. They generate cash flows for derivative
instruments like interest rate swaps, caps, and floors; and they apply
the haircuts to cash flows to reflect the credit risk of securities and
counterparties other than mortgage borrowers. Projected cash flows are
the principal inputs in the creation of monthly financial statements
during the stress period, which are, in turn, the basis for the
calculation of the risk-based capital requirement.
Cash flows are generated for each single family and multifamily
loan group. For retained loans, cash flows consist of scheduled
principal, prepaid principal, defaulted principal, default losses, and
interest. For sold loans, cash flows consist of credit losses,
guarantee fee income, and float income.
Because losses on sold loans are absorbed by the Enterprises and
are not passed through to security holders, no credit losses are
reflected in cash flows calculated for Enterprise-issued MBS held as
investments (including those issued by an Enterprise and later
repurchased). The credit risk is borne by the MBS issuer rather than
the MBS investor, so the credit risk on MBS has already been taken into
account in the credit risk of sold loans. Thus, cash flows for single
class Enterprise-issued MBS held as investments consist only of
principal and interest payments. Cashflows for private label securities
consist of principal and interest payments and credit losses.\41\
Principal payments are calculated by applying default and prepayment
rates that are appropriate for the loans underlying the MBS (amounts of
defaulted principal are assumed to be passed through to investors, as
well as normal amortization). Interest is computed by multiplying the
security principal balance by the coupon rate.
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\41\ See section II. A. 5. c., Other Off-Balance Sheet
Guarantees for a description of how credit losses for private label
securities are calculated.
---------------------------------------------------------------------------
Multi-class mortgage securities such as REMICs and strips are
treated in the same manner as single class MBS. The stress test
generates cash flows for the underlying collateral, usually single
class MBS, and applies the rules of the particular multi-class security
that govern how these cash flows are directed to determine cash flows
of the specific securities held by an Enterprise. In generating cash
flows for mortgage-linked derivative contracts, where the notional
amount of the contract is based on the declining principal balance of
specified MBS, the stress test applies the terms of each contract and
tracks the appropriate declining balances. The stress test generates
cash flows for mortgage revenue bonds by treating the bonds like single
class MBS backed by 30-year, fixed-rate single family mortgages
maturing on each bond's stated maturity date.
For non-mortgage investments, outstanding debt securities and
liability-linked derivative contracts, payments of principal and
interest are calculated for each instrument based on its
[[Page 18097]]
characteristics by applying the appropriate interest rates and
principal payment rules. For asset-backed securities, one of two
collateral prepayment speeds is applied, depending on the stress test
interest rate scenario. The stress test computes cash flows for debt
securities and liability-linked derivatives according to the rules and
structure of each instrument.
7. Enterprise Operations & Taxes
The stress test simulates the income taxes, operating expenses,
issuance of new debt or purchase of new investments, exercise of
options to retire debt early or cancel derivative contracts, and
payment of dividends by the Enterprises. The stress test computes
Federal income taxes using an effective tax rate of 30 percent.
Estimated income tax is paid by the Enterprises quarterly.
An Enterprise's operating expenses decline in proportion to the
change in the size of its combined mortgage portfolio of retained and
sold loans during the stress period. The baseline level of monthly
operating expenses at the start of the stress period is equal to one-
third of operating expenses reported by the Enterprise for the quarter
preceding the stress period.
When necessary, the stress test simulates the issuance of new debt
or purchase of new investments by the Enterprises. New debt is issued
in months when there is a shortfall of cash. All debt issued during the
stress period is six-month discount notes, at Enterprise borrowing
rates projected from the estimated yield curve. Excess cash is invested
in one-month securities bearing the six-month Treasury yield.
For each month during the stress period that a security is subject
to early redemption (call) or a derivative contract is subject to
cancellation, the stress test calculates the effective remaining yield-
to-maturity \42\ of that instrument and compares it to the yield of a
replacement security, given current stress period interest rates. If
the yield is more than 50 basis points below the cost of the existing
instrument, the call or cancellation option is exercised.
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\42\ Yields are calculated based on the outstanding principal
balances for securities and notional amounts for derivative
contracts.
---------------------------------------------------------------------------
Capital distributions are also made during the stress period. If an
Enterprise's capital exceeds the minimum capital requirement in any
quarter, dividends on preferred stock are paid, unless payment would
reduce the Enterprise's capital to an amount below the minimum
requirement. Common stock dividends are paid only in the first four
quarters of the stress period (based on an estimate of how long capital
would remain above the risk-based requirement), and only if capital
remains above the minimum capital requirement before and after the
dividends are paid. The amount paid is directly related to the earnings
trend of the Enterprise. If the trend is positive, the dividend payout
ratio is the same as the average of the four quarters preceding the
stress test. Otherwise, dividends are based on the dollar amount per
share paid in the last quarter preceding the stress test. The stress
test does not provide for any other capital distributions, such as
repurchases of common stock.
8. Financial Reporting
To the extent applicable, the stress test makes use of Generally
Accepted Accounting Principles (GAAP). The cash flows from the
financial instruments on the books of the Enterprises are the principal
basis for the creation of pro forma financial statements that capture
an Enterprise's performance over the stress period. In addition, the
stress test accounts for numerous non-cash items on the Enterprises'
balance sheets, such as receivables and unamortized and deferred
balances. The balance sheets show the monthly total capital amount for
each Enterprise, which is used in the final calculation of risk-based
capital.
9. Calculation of the Risk-based Capital Requirement
The stress test determines the amount of capital that an Enterprise
must hold at the start date in order to maintain positive capital
throughout the ten-year stress period (stress test capital). Once
stress test capital has been calculated, an additional 30 percent of
that amount is added to protect against management and operations risk.
This total is the risk-based capital requirement.
Using the financial statements generated by the stress test, the
capital balance for each month is discounted back to the start of the
stress period. This is done for both the up-rate and down-rate
scenarios. The lowest discounted monthly capital balance is then
decreased as described above to account for securities that are
guaranteed by the Enterprises which are not explicitly modeled (other
off-balance sheet guarantees). This lowest discounted monthly balance,
if positive, represents a surplus of initial capital, that is, capital
that was not ``used'' during the stress period. If negative, it
represents a deficit of initial capital. The lowest discounted monthly
balance is then subtracted from the Enterprise's initial capital. The
resulting amount is the smallest amount of starting capital required to
maintain positive capital throughout the stress period.
For example, if an Enterprise holds starting capital of $10 billion
and the lowest discounted monthly balance is $1 billion (representing a
positive capital balance even in the worst month of the stress period),
then the amount of starting capital necessary to maintain positive
capital throughout the stress period is $9.0 billion. If the lowest
discounted monthly balance is -$1 billion (representing a negative
capital balance in the worst month), the necessary starting capital is
$11.0 billion.
In the final step, necessary starting capital is multiplied by 1.3
to complete the calculation of the risk-based capital requirement
required by the 1992 Act.
B. Sensitivity of Capital Requirement to Risk
An Enterprise's risk-based capital requirement under this proposed
regulation is sensitive to a wide variety of factors that affect
Enterprise risk. The existing minimum capital requirement depends
almost entirely on the size of an Enterprise's two principal
businesses: MBS guarantees and leveraged investments in mortgages and
in MBS. In contrast, the risk-based capital requirement depends not
only on the outstanding volumes of an Enterprise's guarantees and
assets, but also on the degree of risk taken on by the Enterprise in
connection with these businesses. Thus, the risk-based requirement is
sensitive to the characteristics of mortgages and mortgage guarantees
that affect risk, credit enhancements for those mortgages, the asset/
liability risk management strategies of the Enterprise, the value of
properties collateralizing the mortgages, and recent interest rate
levels.
In designing the stress test on which the risk-based capital
requirement is based, OFHEO sought to incorporate all significant
sources of credit and interest rate risk. OFHEO further sought to
design the stress test so that differences in specific risk factors
affect the risk-based capital requirement in amounts commensurate with
the difference in risk. To quantify the marginal effects of changes in
risk on the capital required for each scenario (required capital),
OFHEO conducted a number of sensitivity tests. OFHEO first computed the
risk-based capital requirement for each Enterprise in each interest
rate
[[Page 18098]]
scenario for June 30, 1997.\43\ These results serve as a base case.
OFHEO then made a series of small adjustments to each Enterprise's risk
positions and compared the results for all four Enterprise-scenario
combinations with the relevant base case results. The differences in
results provide a measure of the incremental changes in required
capital (which may be positive or negative) caused by the risk
adjustment.
---------------------------------------------------------------------------
\43\ The results are discussed in section II. C., Implications
of the Proposed Rule.
---------------------------------------------------------------------------
Section II. B.1., MBS Guarantees (Sold Loans), below presents the
results of sensitivity tests related to an Enterprise's guarantee
business. In each test, OFHEO simulated the effects on required capital
of a hypothetical addition to each Enterprise's outstanding MBS
guarantees (sold loans). The simulation results show, in both an
absolute and relative sense, how different characteristics of sold
loans affect required capital. Section II. B. 2., Commitments,
illustrates how required capital would be affected if each Enterprise
had had a larger volume of outstanding commitments. Section II. B. 3.,
Assets and Liabilities, discusses the effects of hypothetical additions
of retained loans accompanied by additions of debt. Section II. B. 4.,
Administrative Costs, discusses how risk-based capital would be
affected by higher administrative (operating) expenses. Finally,
Section II. B. 5., External Economic Conditions, discusses how risk-
based capital would be affected had house prices or interest rates
behaved differently than they actually did in the period just preceding
the starting date of the stress test.
Sensitivity test results differ between the two Enterprises for two
reasons. First, the risk adjustments made to the two Enterprises'
positions were not precisely the same. For example, in sensitivity
tests involving changes in outstanding sold loan volumes, each
Enterprise's additional sold loans reflect that Enterprise's typical
security remittance cycles, and remittance cycles affect the risk
characteristics of sold loans. Second, the incremental effects on
required capital of any change in an Enterprises's risk positions are
affected by the Enterprise's individual circumstances and policies. Two
examples are the Enterprise's projected Federal income tax situation
during the stress period and its dividend policies. During portions of
the stress period in which an Enterprise is paying taxes or receiving
refunds, financial gains and losses are shared with the government
because changes in income cause changes in taxes. Conversely, during
portions of the stress period in which an Enterprise has exhausted tax
carrybacks, the full benefit or cost of a change in income is
experienced by the Enterprise. In the base case, both Enterprises
exhaust their tax carrybacks mid-way through the stress period in the
down-rate scenario. In the up-rate scenarios, Fannie Mae does the same,
but Freddie Mac either pays taxes or receives refunds throughout the
stress period. An Enterprise's tax situation during the stress period
depends primarily on the Enterprise's risk exposures. The longer an
Enterprise continues to be profitable in the stress environment, the
longer it is affected by taxes.
Differences in recent dividend policies can cause small differences
in the incremental capital associated with specific changes in risk
because common stock dividends during the first year of the stress
period depend on recent dividend payouts. Differences in dividend
policies, therefore, can lead to differences in the amount of earnings
changes that are shared with stockholders.
Results are shown for both interest rate scenarios, even though
only one (the one that results in the highest required capital) can be
binding at any specific time. For June 1997, the up-rate scenario
resulted in higher required capital for Fannie Mae, while the down-rate
scenario was more adverse for Freddie Mac. However, the relative
adversity of the two scenarios may change over time for either
Enterprise depending on business strategies and market conditions.
In the tables of this section, the phrase ``incremental capital''
is used to mean the change in the amount of required capital in a
particular scenario accompanying a small change in the overall risk
profile of an Enterprise. Several considerations affect appropriate
interpretation of these numbers. First, the incremental capital
percentages shown in the tables are not fixed. As discussed below in
section II. B. 5. c., Sensitivity to Risk Characteristics in Different
Economic Environments, future business strategies and economic
conditions may alter the required capital sensitivities from those of
June 1997, which are presented here. Furthermore, bigger or smaller
changes in risk may not have a proportional effect on capital. A $20
billion increase in a particular group of loan guarantees may not have
exactly twice the effect on required capital as a $10 billion increase
in the same group of guarantees.
Second, in anticipating the effect on required capital of a change
in any risk factor, an Enterprise likely will be concerned not only
with the immediate effect, but also with the longer term effect. For
example, in considering the capital implications of making additional
mortgage guarantees, the incremental effects on required capital of the
guarantees at all future dates that the loans continue to be
outstanding are relevant. In this case, an important consideration is
that the incremental effects of mortgage guarantees generally diminish
over time.
Third, the incremental capital percentages do not determine an
amount of capital that must be added in order to accept a specific
increase in risk. As discussed below in Section II. C. 2., Enterprise
Adjustments to Meet the Proposed Standard, it may often be less costly
to increase hedges of other risks than to raise equity funds in
response to an increase in risks.
1. MBS Guarantees (Sold Loans)
The Enterprises have two principal lines of business. They function
both as guarantors of mortgage-backed securities and as leveraged
investors in mortgages and mortgage-backed securities. As guarantors,
the Enterprises receive principal and interest payments on home
mortgages, which they pass through to security investors, minus a share
of the interest payments, which they retain as a guarantee fee. Because
of differences in the timing of their receipt of funds and payments to
investors, they also earn float income (which may be positive or
negative). In return, they bear the risk of loss if a borrower
defaults, and they incur additional administrative expenses.
The stress test projects the flows of income and expenses
associated with loan guarantees based on the characteristics of the
mortgages and the economic circumstances of the stress period. The
resulting net cash inflows or outflows are directly reflected in the
Enterprise's borrowing or investing volumes during the stress period.
The interest paid or received on the new debt issues or investments
that are attributable to the guarantees have further effects on income,
borrowing, and investing volumes. Income, in turn, affects taxes,
dividends, capital, and (ultimately) required capital.
OFHEO examined the implications for required capital of risk
factors associated with sold loans as follows. After computing the
capital required under this proposed rule for data reflecting the
Enterprises' books of business and the accompanying economic
circumstances as of June 30, 1997, OFHEO added a quantity ($10 billion)
of sold loans that embodied the specific risk characteristics under
[[Page 18099]]
examination. The capital required for each scenario was then recomputed
and compared with the capital required for the same scenario before
loans were added. The difference is the incremental capital required
for the additional sold loans in that scenario. The results are
expressed as a percent of the volume of sold loans added.
Additional sold loans would normally be accompanied by additional
administrative expenses. In computing required capital for books-of-
business that included additional sold loans, OFHEO estimated the
additional costs by increasing administrative expense for each
Enterprise in proportion to the increase in that Enterprise's overall
(retained plus sold loan) portfolio. Those costs amounted to about six
basis points (0.06 percent) per year on the new sold loans for each
Enterprise. Different assumptions about administrative costs would
affect the results; Section II. B. 4., Administrative Costs, discusses
the effects on required capital of differences in administrative costs.
Section II. B. 1. a., Loans with Mixed Characteristics Reflecting
Enterprise Portfolios, discusses a simulation incorporating a general
increase in sold loans embodying the same mix of characteristics as
that found in each Enterprise's sold loan portfolio in June 1997 and
describes how the increase affects various types of income and expense
over the course of the stress period. Section II. B. 1. b., Loans with
Specific Identical Characteristics, discusses a series of simulations,
each incorporating an increase in sold loans with specific
characteristics.
a. Loans with Mixed Characteristics Reflecting Enterprise Portfolios
The first simulation (Simulation 1) was designed to examine the
incremental effects of a general increase in each Enterprise's sold
loan portfolio (MBS guarantees). The volume of each loan group
(comprising loans with a common set of risk factors) in each
Enterprise's sold loan portfolio as of June 1997 was increased
proportionally by a factor that resulted in a total of $10 billion of
additional sold loans. The results indicate the effects on risk-based
capital of a general expansion of an Enterprise's MBS guarantee
business. Alternatively, they can be viewed as the average effect on
required capital of sold loans, weighted by each Enterprise's mix of
outstanding sold loan business in June 1997. The results, expressed as
a percent of the increase in sold loans, are summarized in Table 5.
[GRAPHIC] [TIFF OMITTED] TP13AP99.190
In the up-rate scenario, a general increase in sold loans has only
a small effect on required capital for either Enterprise. For Freddie
Mac, sold loans are, on balance, a small source of strength. That is,
income generated over the course of the stress period by sold loans
(principally guarantee fees and float) exceeds related expenses
(principally loan losses and administrative expense). The reverse is
true for Fannie Mae. In the down-rate scenario, the incremental capital
required for these sold loan mixes is near 0.85 percent of the increase
in guarantees for both Enterprises. On average, the results for the two
scenarios are similar to the existing minimum capital ratios for sold
loans of 0.45 percent.
Table 6 illustrates the effects on specific income and expense
categories of the additional sold loans in Simulation 1, and how these
effects translate into changes in capital requirements.
[[Page 18100]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.191
Guarantee fees and administrative expense depend on the volume of
loans outstanding. Thus, they are sensitive to the projected
liquidation rates (the sum of prepayment, default, and amortization
rates) of the additional sold loans. In the down-rate scenario (with a
ten-year constant maturity treasury yield of 3.2 percent during the
last nine years of the stress period), loans prepay rapidly, while in
the up-rate scenario (with all treasury yields at 11.4 percent), loans
prepay slowly. As a result, in the up-rate scenario, guarantee fee
income and administrative expense are roughly 2\2/3\ times as great as
they are in the down-rate scenario.
Credit losses (charge-offs) depend on the credit risk
characteristics of the additional sold loans. They are also larger in
the up-rate scenario than in the down-rate scenario because loans
remain outstanding longer, and therefore, at risk of default. Loss
severity rates also are higher in the up-rate scenario because the
interest carrying cost on foreclosed real estate is higher. These
differences between the two scenarios are moderated by somewhat more
favorable house price behavior and by better average loan quality when
interest rates are high. Loan quality is poorer when interest rates are
low because the better quality loans are projected to prepay much
faster. Because of these offsetting influences, credit losses in the
up-rate scenario are only 1\1/3\ times as great as they are in the
down-rate scenario. Freddie Mac's credit losses are about ten percent
lower than Fannie Mae's, reflecting a slightly less risky mix of loan
characteristics.
Float income depends on security remittance cycles, interest rates,
and loan liquidation rates. This source of income on the additional
sold loans is higher, for both Enterprises, in the scenario with higher
interest rates because of lower liquidation rates and higher earnings
ratios on positive float balances. The difference is much more
pronounced for Freddie Mac because of differences in security
remittance cycles. Freddie Mac holds prepayment funds for a longer
period than Fannie Mae, earning a market rate of interest during the
extra time, while accruing liabilities to investors at the security
coupon rate. When interest rates rise, that provides extra income, but
when rates fall, net losses accrue.
Net interest income is affected because net cash inflows and
outflows associated with the other income and expense categories lead
to changes in borrowing or investing. The effects are small in the up-
rate scenario because the net flows caused by other factors are small.
The effects also are small in the down-rate scenario, even though the
net cash flows are much larger, because the interest rates associated
with new borrowing or investing are low.
Taxes reduce the effects of all income changes by 30 percent as
long as an Enterprise is paying taxes or receiving tax refunds. Because
both Enterprises, in the decreasing interest rate environment, and
Fannie Mae, in the increasing rate environment, exhaust their tax
carrybacks mid-way through the stress period, the tax effects vary
depending on the timing of income flows during the stress period.
Freddie Mac, however, performs well in the up-rate scenario, given its
June 1997 risk positions, and pays taxes or receives refunds throughout
the stress period.
[[Page 18101]]
Dividends on common stock can be affected by additional sold loans
only through changes in income during the first year of the stress
period because the stress test specifies that common stock dividends
are paid only during that year. Common stock dividends are little
affected in this simulation because income changes during the first
year are small and because dividends in the base case simulations for
Fannie Mae in both scenarios, and Freddie Mac in the down-rate
scenario, are insensitive to income. In those cases, dividends are set
at their absolute level in the quarter preceding the stress test
because of income declines during the first year. Preferred stock
dividends are unaffected in this simulation because the changes in
capital are insufficient to affect whether either Enterprise meets its
minimum capital requirement during the stress period.
The total change in capital is the sum (using the appropriate
signs) of the effects measured through all of the above income and
expense categories. The sum equals the net decline in capital at the
end of the stress period (as a percent of the increase in sold loans).
The capital position in the final month of the stress period is the
lowest during the stress period for both Enterprises in both scenarios
for the June 1997 base case, so it is the basis for the required
capital calculations in all of the simulations discussed in this
section.
The cumulative discount factor is based on after-tax borrowing or
investing interest rates. Thus, discount factors are relatively high in
the up-rate scenario. Freddie Mac's discount factor is lower than
Fannie Mae's in that scenario because taxes reduce Freddie Mac's after-
tax interest rates in the second half of the stress period, but do not
reduce Fannie Mae's. The discounted total shows the effects of the
additional sold loans on the amount of capital needed to survive the
stress test. This amount, when multiplied by 1.3 to include the
additional amount for management and operations risks, shows the
effects on required capital of the additional sold loans.
b. Loans with Specific Identical Characteristics
Unlike the first simulation, which showed the combined effects of
each Enterprise's existing mix of risk factors, the following
simulations focus on the effects of changes in specific risk factors.
In each of the following cases, the sold portfolio is increased as
before, but all of the additional loans are identical. The results show
how much required capital would be affected by additional sold loans
with specific risk characteristics and guarantee fees or,
alternatively, how much loans with such characteristics and fees
contribute to required capital. The assumptions about guarantee fees
have a significant effect on the results. Guarantee fees are generally
the same in most of these simulations in order to focus the results on
the incremental capital effects of specific risk factors. In practice,
though, the Enterprises typically vary the guarantee fees charged to a
loan seller depending on the mix of loans they receive from that
seller. Thus, the Enterprises implicitly charge higher fees for riskier
loans. It would be misleading to characterize these simulation results,
which are based on constant guarantee fees, as indicating the relative
capital implications of loans in different risk groups as typically
acquired by the Enterprises, without making an appropriate adjustment
for typical differences in effective guarantee fees. Making such an
adjustment in the model would be difficult, however, because the
Enterprises do not generally make explicit differences in guarantee
fees for individual loans with differences in risk. The same guarantee
fee typically applies to all loans in a pool of loans and may be
affected by the mix of loans in the pool.
Also, Enterprise guarantee fees remain constant over the life of
the loan, but the risk of the loan generally declines as the loan
seasons. A majority of the simulations in this subsection involve new
loans. The comparative results of such simulations provide a measure of
the relative effects on required capital of different risk factors, but
these results do not, by themselves, indicate the expected effects on
required capital of the loans over their lifetimes. Additional
simulations show the effects of loan seasoning on required capital.
In these simulations, securities were assumed to have been sold at
par with coupons equal to the contract interest rates, less the
servicing and guarantee margins. Servicing margins are 30 basis points.
For Fannie Mae, the loans were assumed to be securitized under their
standard programs with seven days of float on passthrough payments. For
Freddie Mac, their ``45-day'' security rules were assumed in float
calculations. These securities have negative three days of float on
scheduled principal and interest (payments are made to investors before
payments are received from servicers) and an average of 38 days of
float on prepayments. (In Simulation 1, both 45-day and 75-day rules
were used for Freddie Mac, based on the mix of securities outstanding
in June 1997.)
(i) Differences in Guarantee Fees
To illustrate the effect on required capital of guarantee fees, two
simulations were performed that were identical except for guarantee
fees. In Simulations 2 and 3, shown in Table 7, the additional sold
loans were all newly originated, fixed-rate mortgages (FRMs) in the
West South Central Census Division (Texas, Oklahoma, Louisiana, and
Arkansas); with 30-year terms, 7.5 percent contract interest rates, and
80 percent loan-to-value ratios (LTVs). In Simulation 2, guarantee fees
were set at 23 basis points, which is roughly the overall average rate
for the two Enterprises, but not necessarily for loans with these
characteristics. This simulation is used as a reference for comparison
in Tables 8, 11, 12, 16, 17, 19, and 20. The average rate was used in
most of the simulations involving additional single family loans for
convenience and to isolate the differential effects of other risk
factors. In Simulation 3, however, the guarantee fee was reduced to 18
basis points to isolate the effects of different guarantee fees. The
differences in the results for Simulations 2 and 3 can be used to
roughly estimate how the results of other simulations might have been
affected by other guarantee fee assumptions.
[[Page 18102]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.192
The incremental capital needed for loans in both of these
simulations is substantially higher than that needed for loans with the
mix of characteristics in Simulation 1. This result occurs mainly
because new 30-year FRMs have nearly double the credit losses in the
up-rate scenario and 50 percent more in the down-rate scenario. For
Freddie Mac, an additional reason is that securities with the 45-day
remittance cycle assumed in Simulations 2 and 3 produce substantially
less float income in the up-rate scenario and more negative float
income in the down-rate scenario than the average guarantee mix in
Simulation 1 did. Freddie Mac's capital need in the up-rate scenario is
reduced relative to Fannie Mae's because of tax effects in the second
half of the stress period.
The effect of lower guarantee fees is to increase required capital
in both scenarios. A five basis-point reduction in guarantee fees
raises required capital by 14 to 18 basis points in the down-rate
scenario. The difference in incremental capital is twice that amount in
the up-rate scenario because the loans survive longer, owing to
significantly fewer prepayments, and so the change in the fee rate
applies to a larger volume of outstanding loans during the stress
period.
(ii) Differences in Loan Age, With Slow and Steady House Price
Inflation
Seasoned loans (those not recently originated) have different risk
characteristics than new loans because loans have different
propensities to default and prepay at different ages and because the
houses collateralizing seasoned loans have experienced changes in
value. Changes in house value alter the probability of negative
borrower equity, a key factor influencing default behavior.
In Table 8, the results of Simulations 4-7, along with Simulation
2, which is repeated here, show the effects of age on risk for loans
originated in the West South Central Census Division. Houses in that
area of the country generally have experienced price appreciation near
the national average in recent years. Average annual appreciation over
the eight years ending in the second quarter of 1997 was 3.0 percent.
Table 9 shows the cumulative average appreciation for houses
collateralizing loans of different ages.
[GRAPHIC] [TIFF OMITTED] TP13AP99.193
All of the simulations reported in Table 8 are identical, except
for the age of the sold loans underlying the additional guarantees.
Given the steady increase in house prices preceding the starting point
of the simulations, loans are less likely to default over the course of
the stress period the older they are at the beginning of the period.
Cumulative credit losses for loans made eight years before the start of
the stress period are only about \1/5\ as great as for new loans in the
up-rate scenario, and about \2/5\ as great in the down-rate scenario.
In addition, loans made more than four years earlier have lower
liquidation rates than new loans, providing a larger stream of
guarantee fees. Consequently, guarantees of older loans cause much
smaller increases in capital requirements in the down-rate scenario and
actually reduce capital required in the up-rate scenario.
[[Page 18103]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.194
(iii) Differences in Past House Price Appreciation
The benefits of loan age in reducing risk can be substantially
increased or reversed by differences in house price appreciation. Table
10 shows results for simulations on four-and eight-year-old loans from
different geographic areas. Simulations 8 and 9 are the same as
Simulation 5, except the loans in Simulation 8 were made on properties
in the Mountain Census Division, where house values rose sharply after
the loans were originated, and loans in Simulation 9 were made in the
Pacific Census Division, where house values were stagnant. Similarly,
Simulations 10 and 11 are the same as Simulation 7, except for the
Census division.
[GRAPHIC] [TIFF OMITTED] TP13AP99.195
For four-year-old loans, differences in credit losses are
substantial and account for almost all differences in results. In both
scenarios, credit losses are more than 2\1/2\ times as great in the
Pacific Census Division as they are in the Mountain Census Division.
However, the effects of different previous changes in house prices
ultimately diminish. For eight-year old loans, charge-offs are only
about \1/3\ higher in the Pacific Census Division, despite increasing
disparity in house price appreciation. Furthermore, that smaller
proportional increase in charge-offs is applied to a smaller base
because charge-offs are much lower for eight-year old loans than for
four-year old loans in all three Census divisions.
(iv) Differences in Loan Age and Loan-to-Value Ratio
The higher the original loan-to-value ratio of a loan, the lower
the borrower equity. Thus, the more likely it is to default and less
likely it is to prepay. The effects of differences in original LTV,
however, generally diminish with age. Table 11 shows the results for
different LTV-age combinations for 30-year FRMs in the West South
Central Division.
[[Page 18104]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.196
In these simulations, the 95 percent LTV loans are assumed to be
covered by private mortgage insurance with 30 percent coverage, the
current Enterprise standard, provided by a double-A rated firm. Even
with the insurance coverage, however, high LTV loans are much riskier
than low LTV loans. Not only are high LTV loans more likely to default
at any time during the stress period, but they are also less likely to
prepay, especially in the down-rate scenario. Thus, they are exposed to
default risk over a longer amount of time.
For newly originated loans, the results are particularly striking.
In the up-rate scenario, credit losses on 95 percent LTV loans are very
much higher than they are for 50 percent LTV loans. In the down-rate
scenario, the difference is even greater. These differences in
performance between high and low LTV loans are much bigger than would
be expected in normal times. But the very poor credit conditions in the
stress test environment have a disproportionate effect on the more
vulnerable high LTV loans.
For seasoned loans, the effects of LTV are muted. Seasoned loans
with 50 percent LTVs reduce required capital less than comparable new
loans. Though credit losses are lower than those of newly originated
loans, the difference is minor, as credit losses are very low in both
cases. More importantly, the older loans amortize faster, reducing
guarantee fees significantly. For loans with 95 percent LTVs, the
difference in credit losses between seasoned and new loans is
substantial. With a 13.7 percent average house price appreciation since
origination, these seasoned 95 percent LTV loans perform only a little
bit worse than newly originated 80 percent LTV loans.
(v) Differences in Product Type and LTV Ratio
The simulations shown in Table 12 show the relative effects of
three different product types (30-year FRMs, 15-year FRMs, and
adjustable-rate mortgages) with low, medium, and high LTVs). All are
newly originated loans. To isolate the effects of loan type, the 7.5
percent contract loan rate was retained for the 15-year FRMs and is the
initial rate on the adjustable-rate mortgages (ARMs). The ARMs adjust
annually to 2.75 percentage points above the one-year constant maturity
Treasury yield, with a two percentage point annual adjustment cap and a
five percentage point lifetime cap.
[[Page 18105]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.197
The intermediate-term (15-year) FRMs have consistently lower credit
losses than long-term (30-year) FRMs because the shorter-term loans
amortize more quickly, and borrowers choosing those loans tend to have
greater financial resources. For 50 percent LTV loans, the difference
in credit losses is small, as credit losses are very low for loans of
both terms. In the up-rate scenario, the 30-year loans benefit from
slower amortization, which results in more guarantee fees. In both the
80 percent and 95 percent LTV categories, the more favorable
incremental capital effects of 15-year loans reflect their greater
safety. For 95 percent LTV loans, the 15-year loans have sharply lower
credit losses, nearly 90 percent below those of 30-year FRMs.
ARM loans are riskier than 30-year FRMs at all LTV levels in the
up-rate scenario, with the differences becoming more pronounced as LTV
ratios rise. ARM credit losses in the up-rate scenario are only
modestly higher than 30-year FRM credit losses for low LTV loans, but
rise to more than double those for 30-year FRMs for high LTV loans.
Credit losses for high LTV ARMs cumulate over the course of the stress
period to 13.5 percent of the initial loan balances. As the loan
interest rates adjust to their lifetime caps, some borrowers have
difficulty meeting the elevated payments.
When interest rates decline, ARMs perform much better. They prepay
much more slowly than FRMs in this environment and, therefore, produce
substantially more guarantee fee income. At low and moderate LTVs, ARMs
have more favorable capital effects than FRMs. However, the greater
sensitivity of defaults on ARMs with high initial LTVs outweighs the
benefits of higher fee income generated by such loans. While credit
losses for high LTV ARMs are still much lower in the down-rate scenario
than in the up-rate scenario, the discounted values of those losses are
larger in the down-rate scenario because the discount rates are so much
lower in that scenario. The capital effects depend on the discounted
values, so they are nearly as large in the down-rate scenario for high
LTV ARMs as they are in the up-rate scenario. Because of the high risk
associated with high LTV ARMs, the Enterprises generally have not
purchased ARMs with LTV ratios above 90 percent under their regular
underwriting guidelines.
(vi) Differences in Multifamily Loans
The Enterprises deal in a large variety of multifamily loan
products, and the products differ significantly between the
Enterprises. The simulations reported in Table 13 show the incremental
effects on required capital of multifamily loans with some relatively
common characteristics. The additional sold loans in Simulation 22 are
newly originated 15-year balloons with 70 percent LTVs, debt coverage
ratios (DCR) of 1.3.\44\ The Fannie Mae loans are assumed to provide
partial recourse to the seller for losses, while the Freddie Mac loans
do not. Accordingly, a higher guarantee fee is assumed for Freddie Mac
loans, 75 basis points, than for Fannie Mae loans, 50 basis points.
Simulations 23, 24, and 25 differ, respectively, by changing the
balloon to five years, changing the LTV to 80 percent and the DCR to
1.2, and changing the loan age to five years.
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\44\ All of the multifamily loans were originated in the West
Census Region with 8.5 percent coupons and servicing margins of 50
basis points.
[[Page 18106]]
[GRAPHIC] [TIFF OMITTED] TP13AP99.198
Unlike single family loans, multifamily loans with a few years of
seasoning have substantially higher credit losses during the stress
period. Both types of loans generally have low credit losses in the
first years after origination, then rise to a peak before declining.
However, the peak loss years for multifamily loans come several years
after those for single family loans. Thus, the five-year old loans in
Simulation 25 experience more bad loss years than comparable new loans
(Simulation 22). Credit losses for high LTV, low DCR loans (Simulation
23) are also higher than comparable lower LTV, higher DCR loans because
there is a higher probability that the borrower would have an economic
incentive to default during the stress period (no equity and negative
cash flow). Five-year balloons have higher losses in the up-rate
scenario because some properties would be unable to manage the higher
interest rates that would accompany a new loan. In the down-rate
scenario, five-year balloons terminate sooner and, thus, provide less
guarantee fee income.
Multifamily loan losses are generally less than guarantee fee
income in the down-rate scenario. This is especially true for newly
originated loans because most of the loans prepay before reaching their
peak loss years. Multifamily loans also benefit in the down-rate
scenario from lower capitalization rates, which improve their estimated
LTVs.
(vii) Differences in Mortgage Insurance on High LTV Loans
By law, conventional loans purchased by the Enterprises with LTVs
greater than 80 percent require credit enhancement. Of the three types
permitted, private mortgage insurance is by far the most commonly used.
As described above, simulations involving additional guarantees for
loans with 95 percent LTV ratios assume that the loans carry 30 percent
coverage by a AA rated firm. The simulations reported in Table 14 show
effects of varying insurance characteristics on single family loans.
The guarantee additions in each case are for newly originated, long-
term FRMs.
[GRAPHIC] [TIFF OMITTED] TP13AP99.199
In 1995, both Enterprises raised their coverage requirements on 95
percent LTV loans from 25 percent to 30 percent. Credit losses in
Simulation 26, with lower coverage than in Simulation 13 (but with all
other characteristics are the same), are 15 percent higher in the down-
rate scenario and 12 percent higher in the up-rate scenario than they
are in Simulation 13. Because the discounted value of those changes is
higher in the down-rate scenario, the
[[Page 18107]]
required capital is affected more significantly in that scenario.
Reducing the credit quality of the coverage (Simulation 28) has much
the same effect as reducing the amount of coverage, while improving the
credit quality (Simulation 27) has the opposite effect.
(viii) Differences in Mortgage Interest Rates
Loans with low interest rates amortize more quickly and prepay more
slowly. The reverse is true for high interest rate loans. Table 15
shows the results of simulations for newly originated, long-term FRMs
with different interest rates. In practice, loans with different
interest rates have been originated in different time periods. However,
to isolate the effects of different mortgage interest rates, all loans
are assumed to be made simultaneously.
[GRAPHIC] [TIFF OMITTED] TP13AP99.200
Faster amortization improves loan quality, so credit losses are
significantly lower for mortgages with low interest rates. Low interest
rate loans also prepay significantly more slowly in the down-rate
scenario, increasing guarantee fees. For Freddie Mac, these differences
between high and low mortgage interest rates are accentuated by
differences in float income. Freddie Mac holds prepayments for an extra
month before passing them through to investors. During that month,
Freddie Mac earns a market rate of return while paying investors at the
mortgage security coupon rate. Float earnings are roughly the same for
both high and low mortgage interest rates, but interest passthrough
payments to investors are much lower on low rate mortgages, increasing
net float income.
(ix) Differences Between Loans on Owner-Occupied and Investor-Owned
Properties
Loans on owner-occupied properties present less credit risk than
loans on investor-owned properties. Simulation 31, presented in Table
16, shows the effects on required capital of adding newly originated,
long-term fixed-rate mortgages that are all investor-owned. Required
capital for loans on investor-owned properties is substantially higher
in all cases because of higher credit losses.
[GRAPHIC] [TIFF OMITTED] TP13AP99.201
2. Commitments
While commitments to purchase mortgages may result in new mortgage
guarantees or new retained mortgages, the risk accepted by the
Enterprise at the time of commitment is comparable to the risk on new
mortgage guarantees. The stress test treats mortgages delivered
pursuant to commitments as guarantees of mortgages that are originated
in the first few months of the stress test at market interest rates.
Hence, no portfolio interest rate risk will be incurred. The mix of
other characteristics of the loans reflects the mix of characteristics
for existing guaranteed loans of the Enterprise that
[[Page 18108]]
were originated during the six months preceding the start of the stress
period.
Simulation 32, shown in Table 17, shows the effects on required
capital of increasing each Enterprise's commitments outstanding in June
1997 by $10 billion. The results are, essentially, an average of the
effects on required capital of a mixture of new loans, in which the
proportions of loans with particular characteristics (including
guarantee fees) match those present in an Enterprise's recently
originated and securitized loans. In the up-rate scenario, the effects
are muted relative to those in the down-rate scenario because the model
assumes that sellers deliver loans for only 75 percent of the
commitment volumes.
[GRAPHIC] [TIFF OMITTED] TP13AP99.202
3. Assets and Liabilities
The Enterprises' other line of business is purchasing mortgages and
mortgage securities for their asset portfolios and funding them with
debt. As holders of mortgages, the Enterprises receive interest income,
incur administrative expenses, and bear the risk of loss if a borrower
defaults. As market interest rates change, the interest rate of a
mortgage becomes more or less favorable, and the value of the mortgage
will change. The Enterprises hedge this risk by issuing callable long-
term debt, which changes in value in a corresponding way. They also
enter into interest rate derivative contracts that further reduce the
overall sensitivity of their income and net worth to interest rate
changes. As a holder of mortgage securities, an Enterprise experiences
cash flows, income, and risks similar to those experienced as a holder
of whole mortgages except that the credit risk is borne by the security
guarantor (usually the Enterprise itself, acting in its other principal
role).
The stress test projects the flows of income and expenses
associated with these assets in much the same way as it does for
mortgage guarantees. However, principal and interest received by an
Enterprise on retained mortgages and mortgage securities is not passed
on to investors, and no credit losses are charged on asset holdings of
mortgage securities guaranteed by either Enterprise or by the
Government National Mortgage Association (Ginnie Mae). In addition, the
stress test projects interest expenses associated with debt and cash
flows associated with derivatives contracts.
a. Assets/Liabilities With Mixed Characteristics Reflecting Enterprise
Portfolios
Table 18 shows the additional capital that would be required in
both scenarios by a general increase in each Enterprise's assets and
liabilities. It is not possible to isolate the average incremental
capital effects of a general increase in an Enterprise's mortgage
assets in the same way that Simulation 1 measured those effects for
guaranteed mortgages. Critical factors in assessing the risk of asset
positions are the characteristics of the debt and equity used to fund
them. However, specific debt and equity issues cannot be matched with
specific assets. It is possible, however, to obtain a measure of the
incremental capital effects of a proportional $10 billion increase in
all of an Enterprise's assets, including non-mortgage assets, and a
simultaneous $10 billion increase in the Enterprise's liabilities and
interest rate derivatives.\45\
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\45\ The process is indirect, using the results of other
simulations. The increase in required capital for an equal
percentage increase in all of an Enterprise's positions, such that
assets increase by $10 billion, is simply that percentage of the
Enterprise's required capital for the base case simulations for June
1997. This increase includes increases in guarantees and
commitments. The effect of these increases can be removed by
subtracting the incremental effects of the guarantees and
commitments as calculated in Simulations 1 and 32, after making
adjustments for the differences between a $10 billion change in
those factors and a change of the percentage amount used in the
first step.
[GRAPHIC] [TIFF OMITTED] TP13AP99.203
These results reflect some differences between the Enterprises in
asset composition, but, mostly, differences in debt structure and
derivatives use in June 1997. In three of the four cases, the
incremental effects are close to or less
[[Page 18109]]
than the 2.50 percent minimum capital ratio for Enterprise assets. For
both Enterprises, the incremental required capital effects of sold
loans were higher in the down-rate scenario while the effects of asset
holdings and liabilities are higher in the up-rate scenario. Thus, the
combined risks of both types of activities are more balanced with
respect to interest rates than the risks of either type separately.
b. Retained Loans With Specific Identical Risk Characteristics
The simulations discussed below show the effect on required capital
of an increase in mortgage assets that is funded by debt. A first group
of simulations shows how different characteristics of mortgages affect
required capital in each scenario. Five-year, fixed-rate notes were
used to fund mortgage assets in each of these simulations. Different
funding would not have an appreciable effect on the relative results
for mortgages of differing characteristics, as long as the funding was
the same for each. In the second group of simulations, mortgage
characteristics were held constant, while the funding varied among
three alternatives.
The Enterprises have available, and utilize, a much wider range of
funding alternatives than those used in these simulations. These
alternatives include debt (both callable and non-callable) of different
maturities, debt-derivative combinations that create synthetic debt
with various maturity and call characteristics, and debt combined with
swaptions (options on swaps) or with interest rate caps, floors, or
corridors. Other hedging techniques, such as asset swaps, are also
used. The proposed risk-based capital requirements are fully sensitive
to all of these alternatives.
In the Simulations presented in Table 19, $10 billion of retained
unsecuritized loans with specific risk characteristics were added to
each Enterprise's asset portfolio. The assets were funded with $10
billion of five-year notes paying 6.5 percent interest, with no call
options. The mortgages in Simulation 33 have the same characteristics
as those in Simulation 2, except they have not been securitized. They
are newly originated 30-year fixed-rate mortgages, with 80 percent LTV
ratios and 7.5 percent contract interest rates from the West South
Central Census Division. In Simulations 34 through 39, one risk
characteristic (mortgage type, LTV, or age) has been changed from
Simulation 29 to illustrate the relative effects on required capital of
changes in various characteristics.\46\
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\46\ While these results are for additional retained whole
loans, the effects on required capital of additional holdings of
mortgage security assets, backed by loans with the same
characteristics and funded with the same debt, can be closely
approximated by subtracting the effects of additional guarantees of
loans with those characteristics. (The comparable loan guarantee
simulations are Simulations 2, 17, 20, 12, 13, 5, and 7
respectively.)
[GRAPHIC] [TIFF OMITTED] TP13AP99.204
As the results make clear, using solely five-year fixed-rate debt
to fund mortgages would not be an appropriate funding strategy to guard
against the risk of large, sustained changes in interest rates like
those incorporated in the stress test. When market interest rates
decline, fixed-rate mortgages prepay rapidly, and the five-year debt is
outstanding far longer than most of the mortgages it originally funded.
When market yields rise, fixed-rate mortgages prepay slowly, and the
debt matures long before most of the mortgages are liquidated.
In the up-rate scenario, ARMs with fixed-rate funding reduce
required capital because interest income rises with market yields
(until lifetime caps are reached), while funding costs remain unchanged
during the first five years. Differences in the impact on required
capital of fixed-rate mortgages of different types in the up-rate
scenario primarily reflect differences in credit losses. However, 15-
year loans also benefit from faster amortization, making their loan
lives correspond more closely to the maturity of the debt used to fund
them.
[[Page 18110]]
In the down-rate scenario, ARMs prepay more slowly than FRMs, but
also provide lower interest income. Among fixed-rate types of loans,
four-year-old loans prepay more rapidly than new or eight-year-old
loans. High-LTV loans, on the other hand, prepay slowly because
borrowers lack sufficient equity for refinancing. These differences in
prepayment rates greatly affect the interest rate risk characteristics
of the loans, so that if they are funded with the same liabilities,
four-year old loans with 80 percent LTVs generate higher capital needs
in down-rate scenario than new loans with 95 percent LTVs, despite much
lower credit losses.
The proposed capital requirements are very sensitive to differences
in funding strategies for mortgage assets because of the magnitude of
the interest rate changes in the two scenarios. Table 20 shows the
results of three alternative funding choices for newly originated long-
term FRMs with 80 percent LTVs like those in Simulation 33.
[GRAPHIC] [TIFF OMITTED] TP13AP99.205
Funding long-term FRMs with short-term debt (six-month discount
notes) provides very substantial benefits when interest rates fall. The
debt matures more rapidly than the mortgages, permitting an Enterprise
to continue receiving the original yield on the mortgages, while paying
much lower interest rates. Short-term funding, though, is extremely
costly when interest rates rise because maturing debt must be replaced
at much higher rates. A portfolio of long-term fixed-rate mortgages
funded with short-term debt, such as those held by Fannie Mae and most
thrifts in the late 1970s, would require a capital/asset ratio of well
over 20 percent under the proposed rule.
Funding with long-term debt (ten-year notes with semi-annual
interest payments at 6\3/4\ percent) provides large benefits when
interest rates rise, but is extremely costly when interest rates fall.
Callable long-term debt (ten-year maturity, with a coupon of 7\3/8\
percent, not callable during the first two years) provides benefits in
both scenarios.\47\ The results for different funding mixes can be
approximated by combining the results shown in Table 20 on a weighted
average basis. Thus, for example, in June 1997, the incremental capital
effects of new fixed-rate mortgages funded with 65 percent callable
long-term debt, 19 percent short-term debt, and 16 percent long-term,
non-callable debt would be in a range of 1.2 percent to 2.6 percent for
both Enterprises in both interest rate scenarios. Less callable debt
would be needed to achieve the same result for seasoned loans.
---------------------------------------------------------------------------
\47\ The interest rates of long-term debt used in the
simulations roughly reflect what the average cost of such
instruments would have been in June 1997.
---------------------------------------------------------------------------
4. Administrative Costs
During the stress period, administrative costs depend not only on
the volume of loans held or guaranteed, but also on the rate of
spending in the quarter immediately preceding the start of the stress
period. A higher rate of administrative expense before the stress
period increases costs and depletes capital during the stress period.
In Simulation 43, shown in Table 21, $10 million in annual
administrative expense ($2.5 million at a quarterly rate) was added to
each Enterprise's reported spending in the year preceding the date of
the base case simulations (June 1997).
[GRAPHIC] [TIFF OMITTED] TP13AP99.206
The results in Table 21 show that if Fannie Mae's annual
administrative expense rate had been $1 higher in the year preceding
the stress period, its capital requirement would have been $5.92 higher
in the up-rate scenario and $3.53 higher in the down-rate scenario. The
stress test projects the higher expense rate to continue throughout the
[[Page 18111]]
ten years of the stress period, except that the dollar amount of
additional expense declines in line with the outstanding loan volume.
Thus, in the up-rate scenario, for example, the initial annual $1
increase in the expense rate leads to an additional $7.65 of
administrative expenses during the stress period. Discounting, taxes,
and dividends reduce the incremental required capital to $5.92, even
after the 30 percent management and operations risk supplement.
Required capital increases more in the up-rate scenario than the down-
rate scenario because administrative expense is tied in the stress test
to outstanding loan volumes, which are larger in the up-rate scenario.
The effect of increased administrative expenses on required capital
is lower for Freddie Mac in both interest rate scenarios. This is true
partly because Freddie Mac's mortgages have slightly shorter lives in
both interest rate scenarios, but more importantly because Fannie Mae
has disproportionately larger commitments outstanding at the start of
the stress period. As commitments are transformed into loans during the
early months of the stress period, Fannie Mae's overall loan balances
rise relative to initial balances by more than Freddie Mac's. This
effect is less significant in the up-rate scenario because only 75
percent of commitments become loans. However, Freddie Mac's costs in
the up-rate scenario are reduced by taxes throughout the stress period,
while Fannie Mae's are not. Therefore, Freddie Mac's administrative
expense rate has a smaller effect on required capital in both interest
rate scenarios.
5. External Economic Conditions
a. House Prices
Stress test results are also greatly affected by changes in
external economic conditions. Seasoned mortgages in the base case
simulations for June 1997 benefited from modest, but steady average
house price appreciation of about three percent per year during the
time between origination and the beginning of the stress period. In
Simulations 46 and 47, shown in Table 22, the house price index was
reduced by one percent and five percent, respectively, in the quarter
immediately preceding the stress period (1997 Q2). That is, house price
appreciation rates between the first and second quarters of 1997 were
assumed to be one percentage point or five percentage points (4 or 20
percentage points at an annual rate) less than they actually were.
Subsequent house price appreciation rates are the same as in previous
simulations.
[GRAPHIC] [TIFF OMITTED] TP13AP99.207
When house prices are decreased by one percent, credit losses for
each Enterprise increase by four to five percent in the up-rate
scenario and by about seven percent in the down-rate scenario. The
increases in credit losses when house prices are decreased by five
percent are about five times as large as they are for a one percent
house price decrease. The increases in incremental capital in both
simulations are larger in the down-rate scenario because the decrease
in house prices slows prepayment rates in that scenario, owing to
higher probabilities of negative equity. Slower prepayment rates
increase the volume of mortgages exposed to the risk of default. While
loans also prepay more slowly in the up-rate scenario, prepayment rates
in the base case simulation for that scenario are already so slow that
a similar percentage change has little absolute effect.
The slowing of prepayment rates with lower house prices in the
down-rate scenario also produces two benefits that offset much of the
increase in loan losses: guarantee fee income and net interest income
increase. The key factor causing the effects on required capital to be
larger in the down-rate scenario is that discount rates are lower in
that scenario, so the present value of similar additional credit losses
is greater.
Differences in the changes in required capital between the
Enterprises primarily reflect lower additional credit losses for
Freddie Mac. Fannie Mae's losses are higher because its owned or
guaranteed loan volume was about 45 percent larger than Freddie Mac's
in June 1997 and its credit losses per dollar of loans are 11 to 14
percent higher in the simulations, owing to a somewhat riskier mix of
loans.
b. Market Interest Rates
The behavior of interest rates in the months before the starting
date of the stress test can also have a significant effect on required
capital. In the simulations shown in Table 23, all market yields were
assumed to be 200 basis points higher (Simulation 46), or lower
(Simulation 47) in the month preceding the stress test period (June
1997) than they actually were.\48\ The principal means by which this
change in market yields affects required capital is through the change
it causes in market interest rates during the last nine years of the
stress test.\49\
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\48\ No changes were made to interest rates on asset, liability,
or off-balance sheet positions that had been put in place during the
month, but they constitute a small share of total positions, and the
effects of adjusting interest rates for those positions would have
been largely offsetting. Nor were any changes made to Enterprise
hedge positions that they might have made had market yields actually
changed.
\49\ In the circumstances of June 1997 (or any other time since
September 1991), the applicable statutory rule for determining the
change in the ten-year constant maturity Treasury yield during the
stress period is that it increases by 75 percent or decreases by 50
percent from the average over the preceding nine months. If interest
rates were 200 basis points higher in June 1997, stress test rates
would have risen to a level 200 9 x 1.75 = 39 basis
points higher for the last nine years in the up-rate scenario. And,
in the down-rate scenario, rates would have decreased to a level 200
9 x 0.50 = 11 basis points higher. Similarly, if interest
rates were 200 basis points lower in June 1997, stress test rates
would have been 39 basis points lower in the last nine years of the
up-rate scenario and would have fallen to a level 11 basis points
lower in the last nine years of the down-rate scenario. These
differences are incorporated in Simulations 46 and 47.
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In Simulation 46, the hypothetical increases in June 1997 yields
make the stress test more severe in the up-rate scenario and less
severe in the down-rate scenario. Simulation 47 does the reverse. The
size of the effects is much greater for Fannie Mae because its asset
size was roughly double Freddie Mac's at the time, and because Fannie
Mae's interest rate risk was less fully hedged then Freddie Mac's.
Although changes in net interest income accounted for nearly all of the
change in required capital, differences in prepayment rates in the
down-rate scenarios of both simulations affected required capital
through changes in other income and expense categories. Lower
prepayment rates in Simulation 46 increased credit losses, but also
increased guarantee fees. Higher prepayment rates in Simulation 47
decreased credit losses and guarantee fees.
c. Sensitivity to Risk Characteristics in Different Economic
Environments
The results of the sensitivity analysis discussed above are
dependent on the risk structure of the Enterprises and the economic
conditions of June 1997. For example, as discussed above, credit losses
on seasoned loans vary depending on house price behavior between the
time of origination and the start of the stress test. At higher
interest rate levels, the consequences of imperfectly matched assets
and liabilities would be greater because stress test changes in
interest rates would be larger. At lower interest rate levels, the
effects would be smaller. Different Enterprise hedging strategies could
affect reported sensitivities because they could result in a different
pattern of profits and losses during the stress period, which could
affect the role of taxes. Changes in common stock dividend payouts
could affect the impact of dividends during the first year of the
simulations.
C. Implications of the Proposed Rule
The Enterprises perform an important role in the nation's housing
finance system. Although the current risk of an Enterprise failure is
small, the continued financial health of the Enterprises cannot be
taken for granted. Over the past two decades, failures of financial
institutions have been commonplace, including more than 2900 banks and
thrifts and a number of securities firms. The risks associated with
Fannie Mae and Freddie Mac differ in some important ways from those
associated with banks, thrifts, and securities firms. However,
government sponsored enterprises are not immune to failure. Fannie Mae
encountered serious financial difficulty in the early 1980s, recovering
in large part because of a fortuitous decline in interest rates, and
the Farm Credit System experienced serious problems later in the
decade. Because of the Enterprises' key role and important public
mission, Congress created OFHEO to ensure their safe and sound
operation. The current combined obligations of the Enterprises amount
to more than $1.7 trillion, and unlike banks, thrifts, and securities
firms, no Enterprise obligations are backed by an insurance fund that
could contribute toward meeting creditor claims.
The risk-based capital rule (in conjunction with OFHEO's other
regulatory tools) is intended to reduce the risk of financial failure
of an Enterprise. The rule can contribute to that goal by requiring the
Enterprises to hold more capital or take less risk than they otherwise
would in some or most potential circumstances, particularly those
circumstances in which the danger of failure is greatest. In
circumstances in which some capital or risk adjustment is necessary,
the rule gives an Enterprise the flexibility to choose whether more
capital, less risk, or a combination of the two best suits its business
needs.
OFHEO believes that the proposed rule would effectively serve its
intended role. By promoting the Enterprises' safety and soundness, the
regulation promotes their ability to continue to carry out their public
purposes.\50\ These include providing stability in the secondary market
for residential mortgages and providing access to mortgage credit in
central cities, rural areas, and underserved areas.
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\50\ 1992 Act, section 1302(2) (12 U.S.C. 4501(2)).
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Capital reduces the risk and costs of failure by absorbing losses.
For most firms, debt markets provide strong capital discipline,
penalizing a firm that is excessively leveraged with higher borrowing
costs. That discipline is largely lacking for the Enterprises because
of their government sponsored enterprise status. The lack of normal
market discipline makes capital requirements particularly important for
the Enterprises.
The minimum capital regulation, currently in place for the
Enterprises, provides important protection against failure. It requires
the Enterprises to have a minimally acceptable level of capital in
relation to their overall size, regardless of their measurable risk.
The establishment of the minimum capital standard was accompanied by
considerable increases in capital at both Enterprises. Because,
however, it is based on simple leverage ratios, it will not be
sufficient if an Enterprise chooses to take risky financial positions
or if market conditions move adversely and increase the risk of what
had been less risky positions. By contrast, the proposed rule is quite
sensitive to risk. It would require an Enterprise to increase capital
when risk rises, well before the potential adverse
[[Page 18113]]
consequences of the rise would be reflected in the Enterprise's
financial statements. Each of the two capital rules is an essential
complement to the other.
1. Capital Requirements Under the Proposed Rule
Consistent with the purpose of reducing the risk of Enterprise
failure, the proposed rule can be expected to influence how the
Enterprises manage their risk and the amount of capital they hold.
Table 24 shows actual total capital (amounts available to meet the
risk-based capital requirement) and required total capital under the
proposed rule for two dates: September 30, 1996 and June 30, 1997.\51\
It also shows actual core capital (amounts available to meet the
minimum capital requirement) and required core capital on the same
dates. The difference between total capital and core capital is that
total capital includes general loss reserves, while core capital does
not.
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\51\ These results include estimated effects on required total
capital for three provisions of the proposed rule that require
credit ratings: credit losses on non-mortgage investments; on
derivative contracts; and on rated mortgage-related securities, such
as mortgage revenue bonds. OFHEO assumed that 50 percent of non-
mortgage investments are rated AAA, 35 percent are rated AA, and 15
percent are rated A. The percentages for derivative contracts are
85, 15, and 0, respectively; and those for rated mortgage-related
securities are 70, 30, and 0, respectively. The results do not
reflect the effects of master netting agreements, nor haircuts on
foreign-denominated contracts. Multifamily credit enhancements,
other than those for Fannie Mae's DUS product are not modeled
explicitly, but are assumed to reduce loss severities by 15.9
percentage points.
[GRAPHIC] [TIFF OMITTED] TP13AP99.209
Table 25 shows the surplus or deficit of total capital for both
interest rate scenarios. The risk-based capital requirement for an
Enterprise is based on the scenario that would result in the greatest
deficit or smallest surplus. To meet the requirement, an Enterprise
must not have a capital deficit in either scenario. Freddie Mac would
have had a risk-based capital surplus of 28 percent on the 1996 date
and 19 percent in 1997, while Fannie Mae would have had a deficit on
each date of 21 percent. In contrast, both firms met the existing
minimum capital standard on both dates, with surpluses ranging from 4
percent to 11 percent. Thus, the risk-based capital requirement would
have been much higher than the minimum capital requirement for Fannie
Mae, even after taking account of the differences in the definition of
capital under the two standards. For Freddie Mac, however, the minimum
capital requirement would have been higher than the risk-based capital
requirement. Thus, the risk-based standard would not have imposed any
additional requirement on Freddie Mac on those dates. The primary
reason Fannie Mae's risk-based capital requirement would have exceeded
its minimum capital requirement, while Freddie Mac's would not, is that
Freddie Mac's asset/liability structure was more fully hedged against
interest rate risk than Fannie Mae's.
[[Page 18114]]
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Risk-based capital requirements in the future may vary
significantly, depending not only on the Enterprises' assets and
obligations, but also on contemporary economic conditions. Declines in
house prices in the years preceding the starting date of the stress
test can greatly raise capital requirements under the proposed rule,
and rapid house price appreciation during these years can greatly
reduce them. Unhedged interest rate exposures would require greater
capital when interest rates are higher at the start of the stress
period because changes in interest rates during the stress period will
be greater. The reverse is true when interest rates are lower. Economic
environments entailing greater than usual uncertainty about future
interest rates or mortgage defaults will be accompanied by higher costs
for hedges, such as callable debt or credit enhancements. In the
absence of a risk-based capital standard, an Enterprise might choose to
maintain capital and hedges that would be sufficient to meet the
proposed standard in low risk environments, but might not do so in high
risk environments owing to the higher cost of capital and hedges in
such environments.
2. Enterprise Adjustments To Meet the Proposed Standard
An Enterprise with capital and risk preferences that are not
consistent with the proposed standard could adjust to the standard by
either increasing capital or decreasing risk or both. Capital can be
increased by reducing share repurchases, adjusting dividends, or
issuing new equity shares. Enterprise risk can be reduced by increasing
the use of interest rate and credit risk hedges, after risk is taken
on, or by reducing the amount of risk taken on.
Financial markets currently provide a wide range of hedges against
interest rate risk. These include, among others: callable long-term
debt, caps and floors, and swaps and swaptions. Adding interest rate
risk hedges may frequently be cheaper than increasing equity. For
example, based on the differences in results of Simulations 40, 41, and
42 shown in Table 20, Fannie Mae could have met the proposed standard
in June 1997 by issuing $22 billion of callable ten-year notes and
using the proceeds to pay off $14 billion of short-term debt and
repurchase $8 billion of ten-year notes.\52\ Given the market yields at
that time, such a change in debt structure would have cost less than
$200 million on an annual basis, after taxes. However, because this
debt restructuring would have provided substantial benefits in terms of
reduced risk, the net cost would have been much lower.
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\52\ The interest rates of long-term debt used in the
simulations roughly reflect what the average cost of such
instruments would have been in June 1997.
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Changes in an Enterprise's asset/liability structure to reduce
interest rate risk, such as the one described in the above example, may
be much cheaper than raising new equity. If the annual cost of equity
capital is assumed to be 15 percent, the net cost of raising sufficient
equity would have been roughly $385 million.\53\ Other forms of
liability restructuring, or changes in the interest rate risk
characteristics of the assets, might have resulted in lower costs than
those estimated here for hypothetical changes in debt structure. Fannie
Mae anticipated the likelihood of such opportunities in its comment on
OFHEO's ANPR: ``* * * if the [mortgage] portfolio is in a position
where its risk-based capital requirement exceeds its actual capital,
the practical remedy would be to change the portfolio's asset/liability
structure so that this is no longer the case.'' An alternative way for
an Enterprise to reduce its interest rate risk is simply to reduce the
size of its asset portfolio. Given the high profitability of those
portfolios in recent years, that currently would not be a likely
choice.
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\53\ In its analysis supporting its affordable housing goal
rule, HUD used an estimate for the cost of equity capital of 17
percent, but subsequent increases in price-earnings ratios suggest a
smaller number for more recent dates. The cost calculation assumes
that the additional equity would have replaced an equal amount of
debt.
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Increasingly, credit risk can also be hedged in financial markets.
Freddie Mac's 1998 MODERNS transaction effectively transferred a
portion of the credit risk on its 1996 mortgage purchases to investors
in the new securities.\54\ Further development of the credit
derivatives market may provide additional opportunities for
transferring credit risk in the future. An Enterprise can also reduce
its credit risk by requiring or ac
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